Opinion

Alison Frankel

Saving the U.S. financial system trumps Fed’s duty to AIG: NY judge

By Alison Frankel
November 19, 2012

Near the end of his 89-page opinion dismissing Starr International’s breach-of-duty case against the Federal Reserve Bank of New York, U.S. District Judge Paul Engelmayer of Manhattan engaged in a thought experiment. What’s more important, he asked: the Fed’s mission to stabilize the U.S. economy or the state-law fiduciary duties it might assume in the bailout of a private company?

In the abstract, this might seem like an easy question to answer. But Engelmayer was presented with a complaint, filed in November 2011 by Starr in its capacity as a major shareholder of AIG, that posited a breathtaking $25 billion government conspiracy against AIG. Conventional wisdom may regard AIG and its structured products division as a villain of the 2008 economic meltdown; Starr’s lawyers at Boies, Schiller & Flexner and Skadden, Arps, Slate, Meagher & Flom offered a different (and singular) view of recent financial history, in which the U.S. government pushed AIG to the brink of bankruptcy by refusing it access to capital; seized control of the company via an offer AIG’s board had no choice but to accept; plundered the company’s assets while paying off AIG’s credit-default swap counterparties in full; and then illegally engineered a reverse stock split to dilute the interests of AIG’s pre-bailout shareholders. “Starr’s amended complaint paints a portrait of government treachery worthy of an Oliver Stone movie,” Engelmayer wrote.

In the first part of his decision, Engelmayer concluded that Starr (which is controlled by former AIG CEO Hank Greenberg) failed to establish the Fed’s fiduciary duty under Delaware corporate law to AIG shareholders in the actions that weren’t already time-barred when Starr sued last year (namely, th e t akeover of AIG assets and the agreement under which proceeds from their sale would be allocated between the Fed and AIG shareholders; and the mechanism by which the Treasury became AIG’s majority shareholder). In detailed analysis, the judge said, in essence, that the Fed didn’t control AIG at the time of these deals, so it had no fiduciary duty to shareholders. AIG’s board could, after all, have refused to accept the credit facility the Fed offered and entered bankruptcy. It wasn’t a good option, the judge conceded, but the choice between a rock and a hard place is still a choice.

In the more interesting and further-reaching part of the ruling, Engelmayer went on to ask whether any state-law fiduciary duty the Fed might have owed to AIG shareholders is pre-empted by the Fed’s national interest in stabilizing the economy. Or, as Engelmayer posed the question, “Would applying Delaware fiduciary duty law to the various (Fed) actions towards AIG that Starr challenges frustrate, conflict with, burden, or impede (the Fed) in the discharge of its significant statutory responsibilities? If so, such state law may not be applied.”

The judge, in a gracefully written decision, concluded that, indeed, Delaware fiduciary law is pre-empted by the Fed’s mission. “(The Fed’s) challenged actions with regard to AIG during the financial crisis were integrally bound up in the rescue loan packages it furnished AIG in fall 2008, made with the goal of stabilizing the American economy,” he wrote. “And, where imposing state-law duties upon a federal instrumentality would squarely conflict with its federal responsibilities, as would subjecting (the Fed) to Delaware fiduciary duty law in connection with the terms of its serial rescues of AIG, such state law is pre-empted.”

Imagine if he ruled otherwise, Engelmayer said. In the teeth of the financial crisis in September 2008, government officials decided that they had to act decisively to end uncertainty over AIG’s ability to pay CDS counterparties and paid them all par value. AIG argued that the Fed had breached its duty since it could have obtained valuable concessions from CDS counterparties. Engelmayer said that AIG’s theory would put the Fed in an impossible bind. “To act or not to act?” Engelmayer wrote. “Is it better to act decisively, and pay (CDS counterparties) par value, and thereby end the grave threat to the economy posed by AIG’s continuing CDS exposure? Or is it better, at the risk of not helping the economy, to negotiate over price with these counterparties, and thereby avoid being found liable by a jury, years from now, for breach of Delaware fiduciary duty law?”

Similarly, he said, exposing the Fed to state-law liability for structuring payments from the sale of AIG assets to favor the government is against the national interest. If such liability were possible, Fed officials would be forced to decide whether to try to do their best for the public in a transaction with a potentially gargantuan impact on the national economy or, the judge wrote, “to stand down, and give the public no potential upside for its sacrifice and risk, lest a jury in Delaware — or somewhere else — someday sock us with an astronomical verdict.” Asking officials to make that choice, the judge said, would hinder them from discharging their duties.

The Fed and its lawyers at Debevoise & Plimpton have to be breathing a deep sigh of relief at Engelmayer’s ruling, not least because in July Judge Thomas Wheeler of the U.S. Court of Federal Claims kept alive Starr’s parallel claim that the Fed’s takeover of AIG, including the company’s common shares, was unconstitutional under the takings clause. Wheeler said that the takings claim rests on whether AIG’s board was forced to accept the terms of the government bailout or did so voluntarily; he split with Engelmayer and said that Starr had presented sufficient facts to support the theory that AIG had no choice.

Starr counsel at Boies Schiller sent an email statement, pointing out that Monday’s ruling by Engelmayer will have no impact on the Court of Federal Claims case, which also seeks $25 billion. Starr is also considering an appeal of the Engelmayer decision. Fed counsel Gary Kubek of Debevoise referred my call to a Fed representative who didn’t immediately call back.

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