AIG ruling: How Davis Polk and N.Y. Fed structured ‘illegal’ AIG takeover

June 16, 2015

(Reuters) – Maurice Greenberg’s Starr International effectively lost its audacious suit against the U.S. government on Monday, when U.S. Court of Federal Claims Judge Thomas Wheeler ruled AIG shareholders suffered no damages as a result of the Treasury Department’s 2008 takeover of the insurer AIG. Wheeler held Greenberg cannot recover a penny of the $22.7 billion the U.S. eventually reaped from the sale of the AIG shares it acquired under the terms of the bailout because, according to the judge, without the government’s $87 billion loan, AIG would have gone into bankruptcy and Starr’s equity interest would have been worthless.

Wheeler said he reached that conclusion only reluctantly – because he also found the government’s AIG takeover to be an illegal exaction. The bailout terms, he said, violated the Fifth Amendment rights of AIG shareholders, yet those shareholders would have to prove economic losses to recover money damages. Because AIG shareholders could not show they were worse off than they would have been if the government hadn’t taken its illegal action, Wheeler said, he was forced to reach his “troubling” conclusion.

It’s never a good thing when your actions are deemed illegal, but as Judge Wheeler regretfully acknowledged, this ruling alone won’t stop the government from doing exactly the same thing the next time it is forced to bail out an on-the-brink business. “Any 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,” the judge wrote. “Simply put, the government often may ignore the conditions and restrictions of (the Federal Reserve Act) knowing that it will never be ordered to pay damages.” (Treasury said in a statement that the ruling confirmed AIG shareholders were not harmed and said it continues to believe the government acted within legal bounds.)

Judge Wheeler explicitly laid blame for what he considered the problematic structure of the AIG bailout on the Treasury Department, the Federal Reserve Bank of New York and their outside lawyers at Davis Polk & Wardwell, which, he said, “carefully orchestrated the AIG takeover so that shareholders would be excluded from the process (and) avoided at all cost the opportunity for any shareholder vote.” Given the possibility Wheeler anticipates of the government imposing similarly improper terms on future shareholders, I thought it would be worth looking at where and how the New York Fed and Davis Polk supposedly ran afoul of AIG shareholders’ rights.

The big problem with the terms of AIG’s bailout, according to Judge Wheeler, was that Treasury had never before (or after) insisted on shareholder equity, high interest rates and government control of the corporation from borrowers seeking an emergency bailout under the Federal Reserve Act. The judge does not say precisely whose idea it was to condition AIG’s loan on such terms. But he considered it significant that when AIG’s board first voted to accept government aid on Sept. 16, 2008, the board supposedly believed the Federal Reserve wanted not stock itself but warrants for the future purchase of 79.9 percent of AIG common shares. (At 80 percent, according to Judge Wheeler, the Fed would have had to include AIG’s liabilities on its own balance sheet.)

The government put on evidence that the actual term sheet the AIG board voted to accept on Sept. 16 described the proposed equity stake as “equivalent to common shares” in a form to be decided later. But Judge Wheeler didn’t buy the government’s protestations that AIG was on notice about potential changes in the proposed warrant structure of the stock acquisition. Instead, he suggested, the Fed, with help from Davis Polk, unilaterally tinkered over the next several days with the terms of the government’s equity stake in AIG – to the benefit of the government and the extreme detriment of AIG shareholders, according to Judge Wheeler.

Instead of taking its equity stake in warrants, which carry voting rights only after they are exercised at a preset strike price, the Fed’s final term sheet said it would receive convertible preferred shares that carried immediate voting rights. According to Judge Wheeler, the Fed and its lawyers swapped out warrants for preferred shares for two reasons. The strike price to execute the warrants, he said, would have required a $30 million payment that the government was able to avoid by taking its stake in preferred shares. And the preferred shares gave the government voting control of AIG.

“Avoiding a shareholder vote was a key government objective,” Wheeler wrote, citing two Davis Polk emails. One, written on Sept. 17, said, “avoiding a SH vote we don’t control is a primary goal”; the other, from Nov. 5, said, “We succeeded in finding a structure  to gain control of the company without a shareholder vote.” (The government, as I’ve previously explained, lost the right to claim attorney-client privilege over any of its exchanges with Davis Polk.)

The judge also quoted AIG board minutes from its Sept. 21 meeting, when desperate directors agreed to accept the new terms: “The board had originally been led to believe that the form of equity participation by the Treasury Department would be warrants, (but) the form of equity participation to be issued in connection with the credit agreement is now proposed to be convertible preferred stock.”

The government was able to demand preferred shares instead of warrants, according to Judge Wheeler, because sometime around Sept. 17, New York Fed general counsel Thomas Baxter came up with a way to get around a provision of the Federal Reserve Act barring the Fed and Treasury from acquiring equity in bailout borrowers. “Baxter conceived of the idea of putting the Series C Preferred stock in a trust as a way to circumvent FRBNY’s and the Treasury’s lack of authority to own AIG shares directly,” Wheeler said.

The trust also seemed to solve the problem of who would control AIG after the bailout. The government wanted AIG’s leadership out, but Davis Polk had advised that the Fed does not have the right to assume management control of a corporate recipient of an emergency loan. (“The (government) is on thin ice and they know it,” a Davis Polk lawyer wrote in a Sept. 17 e-mail.) Appointing independent (albeit Fed-friendly) trustees to oversee AIG masked the government’s control.

Judge Wheeler didn’t like that legal sleight of hand any more than the trust’s ownership of AIG’s preferred shares, calling it “a classic elevation of form over substance.” Nor did he give much weight to the government’s argument at trial that under Delaware law, which applies to Delaware-incorporate AIG, shareholders were not entitled to vote on the Fed’s takeover so they lost no rights under the structure the government proposed and the AIG board assented to.

Wheeler’s ultimate conclusion was that Treasury and the Fed “possessed the authority in a time of crisis to make emergency loans to distressed entities such as AIG, but they did not have the legal right to become the owner of AIG,” he wrote. “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.”

The N.Y. Fed declined to comment beyond Treasury’s statement Monday. Davis Polk declined to offer a statement.

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