August 19, 2015
The AIG Case, Part 1 - Freewheeling in the Court of Federal Claims
Posted by Philip Wallach

I want to spend two posts on Judge Thomas Wheeler’s Court of Federal Claims opinion in Starr v. United States, better known as “the AIG Trial,” which was released in June and got only a brief mention from David here at the Conglomerate. In my second post, I will address the import (or lack thereof) of the opinion for future financial crisis decision-makers. In this post, though, I want to luxuriate in the strangeness of the opinion and some of its more ambitious conclusions, because it’s a real doozy.

First, there is the unusually partial tone of the introductory section. Judge Wheeler makes it very, very clear that he has bought into the narrative offered by Starr—that is, by Hank Greenberg and his lawyer, David Boies. In no uncertain terms, Wheeler declares: “The weight of the evidence demonstrates that the Government treated AIG much more harshly than other institutions in need of financial assistance” (6). And more: “The Government’s unduly harsh treatment of AIG in comparison to other institutions seemingly was misguided and had no legitimate purpose, even considering concerns about ‘moral hazard’” (7). Although he never uses the particular term, Wheeler has fully internalized the “backdoor bailout” critique of the government’s AIG rescue, judging it to be a clandestine rescue of AIG’s counterparties.

The appeal of this narrative has always been lost on me. As I note in To the Edge, all bailouts are for the benefit of the rescued institution’s counterparties. I’m not sure who exactly was supposed to be kept in the dark about the motive of insulating AIG’s many important counterparties from the liquidity-starved insurance giant’s chaotic failure, and so I’m not sure why “backdoor” has such bite for so many critics. But never mind! Here I just want to note how extraordinary it is for a judge to have so completely absorbed the rhetoric of the government’s critics, rejecting the idea that the government’s perspective has any legitimacy at all.

The next remarkable thing about Wheeler’s opinion is how willing he is to prioritize “effective” reasoning over formal legal reasoning, which manifests itself in a few ways. First, there is his repeated and deliberate use the “n” word: nationalization. In his judgment, AIG was nationalized, full stop. Never mind that this is a term without any precise legal meaning, or that AIG remained a publicly traded company throughout, or that a private board of directors and chief executive retained formal control. For Wheeler, this was so much show without meaning; in fact, everyone knew that officials within the government were calling the shots. So, too, AIG’s board of directors’ decision to take the Fed’s loan terms is to be regarded as a formality emptied of its meaning by the power dynamics of the circumstances. He literally says: “AIG was at the government’s mercy” (8). In the findings of fact section, he includes the following: “On September 22, 2008, AIG’s Dr. Jacob Frenkel stated to a colleague, Oakley Johnson, ‘the [G]overnment stole at gunpoint 80 percent of the company’” (26). Finally, in dismissing the importance of the government’s AIG Trust (which actually held the shares), Wheeler explicitly denounces “a classic elevation of form over substance” (62).

Readers, I am not terribly well versed in trial court opinions in corporate law cases, and so I would be glad to be corrected by those with more experience. But my reaction is: Wow. As far as legal opinions go, this is unfamiliar territory for me.

(Incidentally, Wheeler’s willingness to forego formalist reasoning as to AIG’s corporate form is not at all mirrored when he comes to consider the nature of the Fed’s powers, which he attempts to discern from explicit language in the Federal Reserve Act. This leads him to deny the Fed’s power to take equity—a point I will return to in my next post.)

Some other points seem like they have much broader implications. First, in staking out a sympathetic position with regards to AIG’s troubles in September 2008, Wheeler says the following:

Many market participants such as AIG also “found it difficult to derive fair market values for their securities based on market transactions.” Accordingly, AIG was forced to post collateral to its counterparties that “way exceeded any reasonable estimate of the actual risk of nonpayment on the CDS contracts” and this circumstance further strained AIG’s liquidity. (16, citations omitted)

If I’m reading that right, he is saying that AIG’s counterparties acted inequitably by forcing the company to honor the literal terms of its contracts; by implication, their use of market prices to value securities was “unfair” and this unfairness is somehow worth the court’s cognizance. If you follow out that logic, it takes you to some very strange places, especially in the context of financial crises.

Second, Wheeler’s finding of jurisdiction relies on a rather surprising reading of the Federal Reserve Act. He finds:

Starr is entitled to sue for the return of its money or property because it is an intended beneficiary under the Federal Reserve Act. … The Court declines to read Section 13(3) in a way that limits its benefits to only the governmental side of the financial system, and not to the individual businesses, corporations, partnerships or investors that comprise the entire financial system. Such a reading would allow the Federal Reserve Board to impose any conditions it desired on a Section 13(3) loan and avoid any judicial complaint of its unauthorized acts. (53-54, citations omitted)

This is something vaguely akin to taxpayer standing to challenge Federal Reserve loan-making. That is…unexpected, as I always thought that if there was any well-established judicial principle about the Fed, it was that judges should strenuously avoid second-guessing the terms of the Fed’s loans. I wonder whether the Federal Circuit will shortly revisit this thinking.

Finally, Wheeler makes a bold analogy made between the Fed’s driving a hard bargain with AIG and a 1960 case, Suwanee S.S. Co. v. United States, which featured a Maritime Administrator demanding a payment of $20,000 to the Treasury before he would grant permission for the international sale of two ships. In that case, the government argued that since it had complete discretion as to whether to grant the permission, it was allowed to make that permission conditional on a payment. The Court of Claims sensibly rejected this logic in the clearest terms: “officials have no authority to add to their function of determining the compatibility of the application with the public interest, the supererogatory function of picking up a few dollars for the public treasury” (57).

With his predecessors’ example in mind, Judge Wheeler sees the same dynamic at work in the Fed’s interaction with AIG: government officials going beyond what their statutes clearly authorize to extract resources for the government in exchange for the discharge of their discretionary duties. Not bribery, since the Treasury benefits, but a disallowed form of extortion nevertheless.

The problem with this thinking in the context of the Fed ought to be obvious, but Wheeler never addresses it. Namely: that a central bank is not like other instrumentalities of government, and that it might indeed have some bank-like qualities that make the matter of recovering on its loans more than just “supererogatory,” but quite mandatory and indeed central to its core functioning. But to say that Judge Wheeler does not seem terribly concerned about ensuring that the Fed has the ability to determine the shape of its own operations is perhaps to repeat myself.

None of which is to say that Judge Wheeler seems entirely off-base as he rejects the manner of the Fed’s engagement with AIG. In the next post, on to the core of his opinion and what it will mean for the Fed’s future.

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