Illegality and Hardball in Government’s Nationalization of AIG

Lawrence A. Cunningham is Henry St. George Tucker III Research Professor of Law at George Washington University Law School. This post builds on Professor Cunningham’s recent article published in The National Interest, available here. Professor Cunningham is co-author with Hank Greenberg, former chairman and CEO of American International Group (AIG), of The AIG Story.

Suppose your bank offers to lend you money to buy a home, and even if you repaid the loan, the bank would retain ownership of your home as well. Would you sign up? Would you expect a business organization to accept equivalent loan-plus-forfeiture terms? I don’t think so but that is what the U.S. government’s “bailout” of American International Group (AIG) involved and one reason a federal judge has declared it an illegal exaction in violation of the Constitution of the United States.

In the fall of 2008, Treasury Secretary Henry Paulson and New York Federal Reserve President Timothy Geithner demanded the permanent surrender of nearly an 80% stake in AIG as “security” for a usurious loan. They then fired AIG’s CEO, replaced its board members, took control of all the company’s affairs, and divested nearly half the company’s worldwide assets in a series of fire sales—all while using subterfuge and deception to avoid a shareholder vote the officials agreed was required and promised would be held.

The government officials did all this, of course, in the name of the public good. Had they failed to avert AIG’s collapse, they fairly testified under oath, the roiling financial crisis would have crippled economies globally. The officials portrayed their intervention at AIG as punishment, rather than a bailout, amplifying a public and media perception of AIG as lead villain in the crisis. As a result, the government officials emerged looking like civic heroes.

The truth, however, is that AIG was not the worst villain in the crisis and the officials broke the law in their overzealous intervention. To be sure, there was an acute crisis, and AIG needed help. But here was a legal way to do it, as done for scores of other troubled firms: lend money at a fair interest rate with security released upon repayment of the loan and existing ownership and control sustained. Instead, the government advanced money conditional on seizing permanent ownership of 80% of the firm—along with an interest rate four times the going rate and other harsh terms—and proceeded to dismantle the company.

When AIG shareholders sued the government, alleging an illegal exaction, media and the public lashed out in indignation. They hurled specific invective at the largest and best-known AIG shareholder, Hank Greenberg, who led AIG for decades before being driven out in 2005 over matters unrelated to the financial crisis that ensued three years later. Comedians like Jon Stewart led the vitriol when calling Greenberg an ingrate, saying government saved AIG and that its shareholders should be grateful.

Even sober commentators sided with government officials—despite their admittedly illegal actions. A representative of this viewpoint is Philip Wallach, the Brookings Institute, who hailed the government officials as “crisis-fighters,” arguing that even if a court were to find their actions illegal, future “crisis-fighters” would be right to ignore such “second-guessing” and do whatever they felt appropriate in the next crisis, legal or not.

A minority view acknowledged that sympathy for AIG shareholders is difficult, but stressed that they are not the issue, which is instead the rule of law. In this vein, Thaya Knight, of the Cato Institute, noted that officials genuinely felt necessity to halt a crisis for the public good. But that is exactly what prohibitions against government seizure of private property battle, she explained. The executive branch cannot break the law in order to advance the public good, an edict that a crisis makes more important not less.

While Judge Thomas C. Wheeler last week sided with the minority, prevailing opinions seem sticky. For example, Steven Davidoff-Solomon and Peter Henning—law professor friends of mine, say the opinion is “based on a cramped view of what happens in the real world.” They say the government’s tactics were “hardly novel in corporate law” as many a “distressed company is forced to accept the terms offered by a lone suitor driving a hard bargain.” The professors conclude that “none of the government’s conduct toward A.I.G. is particularly special [as any] company in desperate straits can expect to face off against an opponent ready to play hardball.”

This portrait may explain prevailing complacency about government’s actions: the professors portray the transaction as an arms’-length deal with routine hardball tactics. Yet this ignores the fact that this was not a private deal but a government ultimatum. If the government were a private actor, I might agree, but it is not; and some of its hardball tactic crossed the line into the illegal and unethical.

True, as Professors Davidoff-Solomon and Henning contend, hard-ball bidders might give two-hour deadlines with take-it-or-leave it terms, as the government did to AIG. The professors stress that AIG’s board, in considering this ultimatum, was advised by three prominent law firms. But none had time to plan an insurance reorganization which might have walled off AIG’s massive and prosperous insurance operations from the relatively small unit embroiled by crisis. One firm faced conflicts from representing multiple parties during the crisis. And whatever such advice and consent may signify in arms’-length hardball negotiations, neither is an excuse nor a defense to illegal government exaction under the Fifth Amendment to the Constitution.

More problematically, the professors ignore the fact that the government either lied or breached a commitment to a Delaware court during the nationalization process. The nationalization required AIG to amend its charter to issue new stock for delivery to the government. All agreed that Delaware law required a separate class vote of AIG’s common holders to approve. In obtaining a consent decree resolving an AIG shareholder lawsuit to enjoin the takeover, AIG and the government promised a Delaware court to hold such a vote. They never did, a stunning display of disrespect for law, whether an up-front lie or ex-post breach of promise. While the professors rightly note the common practice of designing corporate deals to avoid shareholder votes—citing the classroom classic of Paramount v. Time—the practice examples all involve compliance with law, not repudiation of law.

Professors Davidoff-Solomon and Henning also disagree with Judge Wheeler over the meaning of a federal statute governing the powers of the Federal Reserve. The statute authorizes making secured loans and the court found that the AIG security-plus-forfeiture loan illustrated at the beginning of this article is not such a loan. But the professors believe that such a bizarre loan might well be within the authorization of the statute. They believe that even while acknowledging that the government’s own lawyers, from Davis Polk, admitted during the takeover process that the government officials were “on thin ice and knew it.”

Where the professors and many others agree with Judge Wheeler is that AIG shareholders are better off for the government’s illegality. But this is problematic for two reasons. First, no one can say whether bankruptcy elimination of shareholders’ equity was the only alternative. The board had no more than two hours to decide and not even the best directors or lawyers could have resolved such a question on such short notice. Seven years later, not even the best bankruptcy lawyer or federal judge can know with certainty what fate would have brought. AIG’s management had been exploring various insolvency filings under state insurance laws but the government forced its hand before these could be finalized.

More important, it does not matter whether the AIG shareholders are better or worse off—if government committed illegal actions and flouted the rule of law, citizens should not excuse the misconduct on the grounds that it helped a discrete group of citizens. Indeed, Professors Davidoff-Solomon and Henning assert that “Taxpayers would have expected the government to act as tough as any other bidder.” But “taxpayers,” who are not monolithic, may equally expect the government to act in accordance with law. And even if taxpayers did want government to break the law, that wish does not matter, for the reasons noted earlier by Thaya Knight.

Despite the judicial rebuke of the official illegalities, Professors Davidoff-Solomon and Henning say the government won the dispute because Judge Wheeler awarded no damages. Like Philip Wallach, they predict that future officials may comfortably ignore the opinion and do as they see fit in future emergencies. That is the ultimate lament for proponents of the rule of law.

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