One of AIG’s Largest Shareholders Put the Terms of AIG’s Bailout on Trial
Moral Victory: Plaintiff Wins the Battle (Causation) But Loses the War (Damages)
AIG collapsed in the wake of Lehman’s bankruptcy filing and required a government bailout in order to avoid the same fate as Lehman. The plaintiff (AIG’s shareholders) contended that they were harmed by the relatively harsh bailout terms that were imposed on AIG but no other bailout recipients. The defendant (U.S. government) countered that AIG’s bailout terms were: (1) legal, and (2) benefitted the plaintiff because a bailout under relatively harsh terms was better than no bailout at all. This article explains why the court held that: (a) the terms of AIG’s bailout were illegal, yet (b) AIG’s shareholders were not harmed by the illegal terms.
Were the terms of AIG’s bailout legal? Can the Government illegally take stock in a company yet not harm the company’s shareholders in the process? The United States Court of Federal Claims recently addressed these questions in Starr International Co. v. The United States.
Summary
The recent decision in Starr International Co. v. The United States[i] is an interesting read for anyone who performs damage analyses and/or wants to understand the limitations on the Government’s ability to bail out companies during the 2008 financial crisis. This decision reminds us that proving causation is only half the battle when the plaintiff also has to prove it was harmed by the defendant’s illegal actions to obtain a damage award. This decision also provides an inside peek into how the Government’s bailout of AIG came to be during the frantic days of September 2008. Peeling back the curtain is particularly illuminating because: (1) many senior Government officials testified, and (2) the Government waived attorney-client privilege, which caused many contemporaneous documents to be produced.[ii]
The key debate regarding causation was over the Government’s ability to take equity from the recipient of a bailed out company. The Government took a 79.9% equity stake in AIG when it provided the initial rescue loan. The Government subsequently provided additional rescue loans and its equity stake subsequently increased to greater than 90%. The plaintiff (led by one of AIG’s largest pre bailout shareholders, which was controlled by AIG’s former CEO) alleged that the Government could not legally take this equity from AIG. The defendant (the Government) countered that it could legally take equity from AIG as partial consideration for the bailout loans it provided to AIG.
The key issue regarding damage was over the harm caused by the Government’s taking of equity from AIG. The plaintiff contended that the Government must provide compensation for the shares it illegally took from AIG’s shareholders.[iii] The defendant replied that there should be no damage award because the bailout caused no harm to the plaintiff. Said differently, the defendant argued that even if there was a foul, no harm was caused by the foul.
The Court arrived at a split-decision, which likely leaves both parties unhappy. The Court agreed with the plaintiff on causation as it held that the Government was not legally allowed to take equity from AIG. Nevertheless, the Government did not have to pay any damages because the Court agreed with the defendant: the plaintiff was not harmed, and in fact benefitted, from the Government’s bailout of AIG. This outcome is only a moral victory for the plaintiff (because it won on causation but received no damages) that could also be seen as a moral defeat for the defendant (because the Court held that the Government’s actions were illegal).
The Court’s damage framework focused on the value of AIG’s equity under two scenarios: (1) the real world where the Government bailed out AIG and initially took 80 percent of the equity, and (2) an alternative universe where the Government did not bail out AIG and initially take almost 80 percent of the equity. In the real world, AIG’s shareholders continued to own a (diluted) interest in a viable going concern. In the alternative universe, AIG would have most likely filed for bankruptcy and generated no recovery for its shareholders.[iv] The plaintiff was not harmed because “twenty percent of something [is] better than 100 percent of nothing.”[v]
AIG Needed a Bailout
An argument can be made that some recipients of bailout funds did not need the money at the time. In a perfect world, bailout funds would only be provided to firms that need it. However, as a practical matter, a bailout can sometimes do more harm than good because it may give the impression that a healthy entity is not viable, which has negative consequences. Perhaps in order to reduce the stigma associated with firms that received a bailout during the crisis, the Government provided rescue funds to many systemically important companies, which diluted the negative effects of a bailout on any particular company. This matters because the shareholders of a company that did not need a bailout could be harmed if the company was forced to give up equity in consideration for funds that it did not need.
AIG could not make such an argument because it clearly needed the bailout. In the immediate aftermath of Lehman Brothers’ bankruptcy filing, AIG estimated that it needed at least $75 billion in additional capital to survive on September 15, 2008.[vi] The Federal Reserve concluded that AIG could not raise this money in private markets. Attempts to raise private money would have included “some form of equity”[vii] but were “unsuccessful principally because of the perception that AIG’s borrowing needs exceeded AIG’s value by tens of billions of dollars.”[viii]
The Government Needed to Bailout AIG
AIG was a very large (its balance sheet was ~$1 trillion) and globally interconnected firm whose financial condition quickly deteriorated during September 2008. The Lehman Brothers bankruptcy filing triggered a panic in financial markets that could become significantly worse if AIG was allowed to file for bankruptcy too. With this backdrop, the Government decided to rescue AIG from an imminent bankruptcy filing.
Terms of the AIG Bailout
The terms of the bailout evolved over time, but one important characteristic remained constant: they were more onerous than the terms imposed on banks that were bailed out. The initial bailout of AIG was structured as an $85 billion loan facility that charged a 12 percent interest rate (vs. three to four percent for the banks) and required AIG to provide 79.9% of its equity (vs. no equity for the banks), which the government would keep even after AIG repaid the loan.[ix] The initial loan contained other fees (e.g., 8% on the undrawn portion of the loan facility) and conditions (e.g., AIG’s CEO had to be replaced with a new CEO of the Government’s choosing) that the Government did not impose on banks that were bailed out.[x]
Some have pointed out that the relatively harsh treatment of AIG resulted in a great irony.[xi] Popular opinion is that the Government was too lenient when it bailed out most companies. However, when the Government drove a hard bargain with AIG, it ended up having to go to trial to defend its actions.
Did the Government Expect to Profit from the Bailout of AIG?
Evidence suggests there may have been an expected profit for the Government at the time it bailed out AIG. A September 23, 2008 discussion between the Federal Reserve’s outside counsel and General Counsel stated “[t]he real joy comes when we get back the $85 [billion], with $10 +++ in fees and interest, and make the [T]reasury tens of billions it deserves (and needs!) on the equity.”[xii] A September 22, 2008 discussion between two AIG colleagues states “the [G]overnment stole at gunpoint 80 percent of the company.”[xiii]
This evidence paints an interesting picture that could be characterized as a Rorschach test. Both sides could see what they wanted to see.
On the one hand, the evidence may suggest that the Government expropriated a valuable asset from AIG’s shareholders. As the monopolistic lender-of-last-resort, the Government could dictate whatever terms it could (legally) obtain.
On the other hand, while there was potential for the Government to earn tens of billions on the bailout, there was also potential for the Government to lose tens of billions. As the name suggests, the lender-of-last-resort only provides financing when nobody else is willing to do so. This suggests that there may have been no transfer of value from AIG’s shareholders to the Government’s coffers due to the terms of AIG’s bailout.
Was the AIG Bailout Successful?
The AIG bailout was successful for all parties. Financial capital provided by the Government enabled AIG to remain a going concern outside of bankruptcy, which preserved asset value for its stakeholders (which included, among others: shareholders, lenders, and counterparties on credit default swap contracts). The Government (i.e., taxpayers) was ultimately repaid and recorded a multi-billion dollar profit on its equity in AIG.[xiv] AIG’s pre-bailout shareholders retained a (diluted) interest in the company, which they most likely would have lost if the Government did not provide the rescue loan because old equity is often “wiped out” by a bankruptcy filing.[xv]
So Why Did One of AIG’s Largest Pre Bailout Shareholders Put the AIG Bailout on Trial?
On the one hand, it may seem like there is no basis for the plaintiff to complain. The Government bailed out AIG and AIG’s shareholders benefitted from the Government’s actions. This lawsuit may appear to some as proof of the adage: no good deed goes unpunished.
On the other hand, AIG’s shareholders were treated more harshly than the shareholders of banks that were bailed out. The bailed out banks paid significantly lower interest rates and fees on the rescue loans they received, did not have to give up the overwhelming majority of their equity, and did not have to effectively cede operating control to the Government. According to then Federal Reserve Bank of New York President Timothy Geithner, the Government “forced losses on [AIG] shareholders proportionate to the mistakes of the firm.”[xvi] The bailed out banks were arguably not forced to absorb a corresponding level of losses. To the extent that the rescue loans were essentially a gift to the bailed out companies, why shouldn’t AIG’s shareholders receive a similar gift?[xvii]
The gift-like nature of the bailouts is at the crux of popular opinion against the recipients of bailouts in general and the view that the plaintiff in this case was ungrateful. From the popular opinion perspective, all bailout recipients received a gift from the Government and the plaintiff in this case looked the proverbial gift horse in the mouth when it complained that its gift was not good enough. Perhaps Jon Stewart of The Daily Show best summarized the popular view of the plaintiff’s legal argument in this case as “Wahhhhhh! It’s not fair!”[xviii] The Daily Show compared the plaintiff to a kid complaining that he only got one cookie whereas his sister (the bailed out banks) got two cookies and pointed out that the kid should be happy, that he essentially got the cookie for nothing.[xix]
As a practical matter, the plaintiff made a simple argument that the Court found to be compelling: the Government took something (the overwhelming majority of equity in AIG) that it was not allowed to take when it provided the bailout loans. In essence, the Government got caught with its hand in the cookie jar. The Court further observed that “[c]ommon sense suggests that the Government should return to AIG’s shareholders the $22.7 billion in revenue it received from selling the AIG common stock it illegally exacted from the shareholders for virtually nothing.”[xx]
This sets up a dilemma for the Government. The Government does not have to bail out a company, so it can watch from the sidelines as private businesses file for bankruptcy and its stakeholders absorb losses. However, once the Government chooses (for the greater good) to bail out a company, it has to stay within the confines of the laws that enable it to provide capital. These laws can be restrictive, which can force the Government to provide capital at terms that are favorable to the bailout recipient. This partially explains the public backlash against many of the bailouts.
Interestingly, this also sets up a dilemma for courts. If the Government is not forced to pay damages when it commits certain illegal acts, what will stop the Government from committing similar illegal acts in the future? This was the “troubling feature” of the outcome in this case.[xxi] The Court observed that “[a]ny time the Government saves a private enterprise from bankruptcy through an emergency loan, as here, it can essentially impose whatever terms it wishes without fear of reprisal.”[xxii]
Why Was the Government Not Allowed to Take Equity in the AIG Bailout?
The plaintiff successfully alleged that the government’s taking of equity was an illegal exaction.[xxiii] An illegal exaction occurs when a payment is compelled when no payment is due. The plaintiff alleged that the Government’s taking of equity was an illegal exaction because the Government was not legally allowed to take any amount of equity from a borrower. It does not matter that a private lender would have also taken equity as partial consideration for providing the loan. The only question that matters is if the Government was allowed to take equity as part of the consideration for providing a bailout loan.
The Government’s ability to provide emergency bailout loans was governed by Section 13(3) of the Federal Reserve Act. This act allowed the Federal Reserve to be the lender-of-last-resort when there are “unusual and exigent circumstances where the borrower was unable to secure adequate credit from private sources, but had sufficient assets to secure the loan.”[xxiv]
However, the Court found that “Section 13(3) did not authorize the Federal Reserve Bank to acquire a borrower’s equity as consideration for the loan.”[xxv] The Court also observed that “there is nothing in the Federal Reserve Act or in any other federal statute that would permit a Federal Reserve Bank to take over a private corporation and run its business as if the Government were the owner. Yet, that is precisely what FRBNY did.”[xxvi]
Evidence suggests that the Federal Reserve and its advisors contemporaneously recognized that the Federal Reserve could not obtain equity as partial consideration for a loan. The Federal Reserve’s outside counsel stated in a contemporaneous document “the [government] is on thin ice and they know it. But who’s going to challenge them on this ground?”[xxvii] Other contemporaneous documents echoed this concept. For example, one document stated “we agree that there is no power” for the Federal Reserve “to hold AIG shares”[xxviii] and another document, attributed to Geithner, stated “[u]nder section 13(3) of the Federal Reserve Act, the Fed is prohibited from taking equity or unsecured debt positions in a firm.”[xxix]
The Court stated that the form of the AIG bailout was the first of its kind. The Court observed “[i]n the Federal Reserve’s history of making hundreds of emergency loans to commercial entities, the loan to AIG represents the only instance in which the Federal Reserve has demanded equity ownership and voting control. There is no law permitting the Federal Reserve to take over a company and run its business in the commercial world as consideration for a loan.”[xxx]
The Government unsuccessfully tried to get around Section 13(3) by placing its shares in AIG into an independent trust. The Court found that “[t]he creation of the trust in an attempt to circumvent the legal restriction on holding corporate equity is a classic elevation of form over substance.”[xxxi] This finding was in part based on the fact that the “three appointed trustees had lengthy historical ties to the Federal Reserve”[xxxii] and a contemporaneous document that stated the trustees were the “protectors of the Federal equity stake in AIG” and “should not care about the AIG minority shareholders.”[xxxiii]
Did AIG Agree to the Terms of the Bailout?
AIG’s board of directors agreed to the terms of the bailout. Some may say they were given an offer they couldn’t refuse, as the Federal Reserve was “the only game in town” which provided a “take it or leave it offer” that could not be negotiated.[xxxiv] AIG’s board, which had the benefit of “comprehensive legal advice on whether they should accept the loan or file for bankruptcy,” chose to take the offer.[xxxv] They believed that voting in favor of the terms “was in the best interests of AIG and its shareholders and that it was a better alternative to bankruptcy.”[xxxvi] At this point, it is worth noting that AIG (the legal entity) did not join the plaintiff in this lawsuit.
However, AIG’s shareholders did not get the opportunity to vote on the terms of the bailout. The Government’s contemporaneous lawyers, presumably concerned about the possibility that the shareholders would not approve the bailout, stated that the ultimate form of equity used in the bailout (convertible preferred voting stock) allowed the Government “to gain control of the company without a shareholder vote,” which was a “primary goal” because the Government did not “control” the outcome of the vote.[xxxvii]
As a practical matter, it is not clear that a shareholder vote could have been held. Time was of the essence as AIG was a melting ice berg (its enterprise value was rapidly decreasing) during the September 2008 crisis. There may have been nothing left to save if the bailout funds could not be provided until after a shareholder vote.
Interestingly, the Government argued that AIG voluntarily accepted the terms of the bailout, which renders moot the plaintiff’s argument that the taking of equity was illegal. This argument did not persuade the Court. The Court stated “[t]he record supports a conclusion that FRBNY, Treasury, and their outside counsel from [name omitted] carefully orchestrated the AIG takeover so that shareholders would be excluded from the process. These entities avoided at all cost the opportunity for any shareholder vote. Having intentionally kept the shareholders in the dark as much as possible, it rings hollow for Defendant to contend that the shareholders waived the right to sue by failing to object.”[xxxviii]
Damage
There was a dispute among the parties over how to frame damage. The plaintiff asserted that it should be allowed to recover the monetary value of the stock that the Government took. The defendant countered that damage must be based on the plaintiff’s economic loss that stemmed from the Government’s illegal actions.
Said differently, the debate was over perspective: should damage be based on the defendant’s gain or the plaintiff’s loss? This debate reminds us that the framework for valuation can play a pivotal role in addressing damage-related disputes. The debate over the valuation framework mattered because the Government’s gain and the plaintiff’s loss were not symmetrical.
The Government received a large gain from the shares it took from AIG. The plaintiff used AIG’s common stock price at the time of the bailout to value these shares. AIG’s common stock price was used because: (1) AIG’s common stock was actively traded on the New York Stock Exchange, and (2) the Government’s equity (which was in the form of convertible preferred voting stock) was “economically equivalent to AIG’s common stock.”[xxxix] The plaintiff’s damage expert arrived at a $35.378 billion valuation for the shares taken by the Government as of September 22, 2008.[xl] After other adjustments, total alleged damages exceeded $40 billion. The plaintiff argued that damages should be based on the disgorgement of the Government’s gain.
The Government countered that the plaintiff was not harmed by tens of billions of dollars due to the terms of the bailout. In an alternative universe where the government did not bail out AIG, AIG would have filed for bankruptcy and the plaintiff would have most likely received nothing. Thus, from an economic loss perspective, the plaintiff was not harmed by the bailout.
The Government’s damage-related argument was the “Achilles’ heel” of the plaintiff’s case because “if not for the Government’s intervention, AIG would have filed for bankruptcy. In a bankruptcy proceeding, AIG’s shareholders would most likely have lost 100 percent of their stock value…If the Government had done nothing, the shareholders would have been left with 100 percent of nothing.”[xli] This observation allowed defendant’s counsel during closing arguments to compellingly state “[i]f the Fed had wanted to harm AIG in some way, all it had to do was nothing.”[xlii]
An interesting debate occurred over the relevance of AIG’s stock price. The defendant pointed to the increase in AIG’s stock price after the bailout to prove that the plaintiff was not harmed, and in fact benefitted, from the bailout.[xliii] The plaintiff argued that the pre-bailout stock price was temporarily depressed and that the post bailout increase “simply reflected a correction of market failure back towards AIG’s intrinsic value, once AIG’s liquidity was restored…By extending liquidity assistance to AIG, Defendant did not increase AIG’s intrinsic enterprise value; it simply corrected the impact of a negative externality—that is, the effects of market failure and dysfunction…Valuing AIG’s stock at the low point of the financial crisis is inconsistent with the concept of fair market value.”[xliv]
The Court essentially found the stock price-related argument to be irrelevant because AIG’s stock price would never be able to return to intrinsic value (assuming it was trading below intrinsic value) without the injection of liquidity from the Government. This observation cuts to the core of this debate: should the Government have to reimburse AIG’s shareholders on the basis of an equity valuation “that it helped create with an $85 billion loan”?[xlv] The Court held that the Government should not have to pay damage based on a value that it helped create.
Interestingly, the framework proffered by the plaintiff would result in even greater damage amounts in alternative universes where the Government provided more favorable terms to AIG on the debt portion of the rescue package. This is so because more favorable terms on the debt would result in a transfer of wealth from lenders to shareholders, which would result in a higher stock price. Thus, more favorable terms on the debt portion of the bailout would shift more of the value in the Government’s securities from debt to equity. This would lead to more damages under the plaintiff’s damage theory in this matter because the Government would be allowed to keep its (less valuable) debt but be forced to disgorge its (more valuable) equity.
Appeals
The saga of this case will likely continue. The plaintiff, left with only a moral victory due to the receipt of no damages, has vowed to appeal.[xlvi] Interestingly, the defendant may also want to appeal given the Court’s finding that the Government acted illegally during the crisis.
[i] Starr International Company, Inc. v. U.S., No. 11-779C (Fed. Cl. June 15, 2015).
[ii] The Government waived attorney-client privilege when it made certain arguments and chose to put attorneys who advised the Government on the witness stand during trial. Opinion at 4-5.
[iii] The Government did not technically take shares from AIG’s shareholders. However, as a practical matter, the Government took shares from AIG’s shareholders when it caused AIG to issue additional shares to the Government, which diluted the existing shareholders’ economic and voting interest in AIG.
[iv] The potential for distributions to shareholders, which would be close to zero if AIG was insolvent, would be further complicated by the fact that many of AIG’s assets were in insurance subsidiaries that “would have been seized by state or national governmental authorities to preserve value for insurance policyholders.” Opinion at 10.
[v] Opinion at 10.
[vi] Opinion at 18.
[vii] Opinion at 19.
[viii] Id.
[ix] Said differently, the equity was part of the compensation paid to the Government for making the loan, and not just collateral that would be returned after AIG repaid the loan.
[x] Opinion at 2-3.
[xi] See, for example, http://www.newyorker.com/news/daily-comment/why-the-a-i-g-verdict-kind-of-makes-sense.
[xii] Opinion at 26.
[xiii] Id.
[xiv] The Government recorded a profit on the bailout when using the traditional accounting-based definition of the term “profit.” Some may argue that the Government did not generate a profit when using a valuation-based definition of the term, which also incorporates the opportunity cost of capital.
[xv] Opinion at 22.
[xvi] Opinion at 32.
[xvii] A cynic may argue that the banks ultimately paid for their bailout in other ways. For example, some may argue that the multi-billion dollar settlements for banks’ transgressions that contributed to the financial crisis were partially a quid pro quo to compensate the Government for their bailouts. Notably, the Court did not take a cynical view on this topic when assessing the AIG bailout. Instead, it observed that many of the bailed out banks were charged with fraud whereas AIG was not charged with fraud by the Department of Justice, which suggested to the Court that these other firms were engaged “in much riskier and more culpable conduct than AIG.” Opinion at 41.
[xviii] http://thedailyshow.cc.com/videos/otsnvj/lawsuits-of-the-rich-and-shameless
[xix] While I appreciate the humor and insight often expressed in The Daily Show, I would be remiss to not highlight that The Daily Show made an inapt comparison by comparing contributions that the Government made in the form of debt with the publicly-traded value of AIG’s equity, which only has value upon liquidation after AIG’s debt is repaid. The general point made in the episode still holds, but the numerical comparison is off by several orders of magnitude.
[xx] Opinion at 65.
[xxi] Opinion at 10.
[xxii] Id.
[xxiii] The plaintiff also alleged that the Government violated the takings clause of the Fifth Amendment of the U.S. Constitution. The Court found no basis for this claim because it ruled in the plaintiff’s favor on the illegal exaction claim. The Court stated “a claim cannot be both an illegal exaction (based upon unauthorized action), and a taking (based upon authorized action).” Opinion at 8.
[xxiv] Opinion at 54.
[xxv] Opinion at 7.
[xxvi] Opinion at 8.
[xxvii] Id.
[xxviii] Opinion at 29.
[xxix] Id.
[xxx] Opinion at 54.
[xxxi] Opinion at 62.
[xxxii] Id.
[xxxiii] Opinion at 63.
[xxxiv] Opinion at 22.
[xxxv] Id.
[xxxvi] Id.
[xxxvii] Opinion at 26.
[xxxviii] Opinion at 67.
[xxxix] Opinion at 64.
[xl] Id.
[xli] Opinion at 9-10.
[xlii] Opinion at 10.
[xliii] Opinion at 48.
[xliv] Plaintiff’s Proposed Conclusions of Law at 100-101.
[xlv] Opinion at 9.
[xlvi] http://www.law360.com/articles/669653/greenberg-seeks-broad-appeal-of-judge-s-aig-rulings?article_related_content=1
Michael Vitti joined Duff & Phelps in 2005. He is a managing director in the Morristown office and is part of the Disputes and Investigations practice. He is also a member of the firm’s Complex Valuation and Bankruptcy Litigation group, focusing on issues related to valuation and solvency. Mr. Vitti has more than 19 years of valuation experience.
Mr. Vitti can be reached at (973) 775-8300 or by e-mail at Michael.Vitti@duffandphelps.com.
