It’s déjà vu all over again.
I’m only starting to dig into the AIG bailout trial by reading the transcripts and related exhibits. That means I am behind where the trial is now. However, that gives me the advantage of contrasting what is in the documents with the media reporting to date. And what is really striking is the near silence on the core argument in this case.
The Starr International v. the United States of America suit is, at its core, about whether an insolvent borrower still has the right to the protection of law. It’s thus a high-end, big-ticket replay of the same form of arguments that homeowners fighting foreclosure often tried in court to obtain a mortgage modification: we don’t dispute that we aren’t able to meet our obligations, but the party foreclosing on us needs to go through the proper steps to take possession of our house. In the mortgage borrower’s case, that meant establishing standing, as in proving that they really were the proper party to initiate the foreclosure. In the case of Starr, the AIG executive enrichment vehicle controlled by former CEO Hank Greenberg, the argument is that even though AIG was insolvent, the bailout, which included through a series of maneuvers getting control of 79.9% of AIG stock, was impermissible.
Let me stress I’m no fan of Greenberg. But you can’t ask for the rule of law to operate in one place and not another. We’ve seen the administration repeatedly bend over backwards to give banks all sorts of free or super cheap waivers for bad conduct and not enforce regulations against them, yet borrowers are held in court to strict terms of their agreements and face unreasonably high hurdles when they try to fight abusive conduct.
Despite his considerable warts, Greenberg is unearthing information that shows how one-sided and high-handed the Fed’s conduct during the crisis was. Yet people who claim to be on the side of curbing bank power are instead rallying to support the bank-cronyistic Administration:
We’ve embedded the transcript from the first day of the trial at the end of the post, which included both sides’ opening arguments, along with the testimony of the first witness, Fed Board of Governors general counsel Scott Alvarez, along with the sides each side presented.
The specific legal arguments from the Greenberg camp, represented by uber lawyer David Boies, are that the manner in which the government took control of AIG’s common stock involved a taking (a violation of the 5th Amendment requirement of offering adequate consideration for government seizure of property) and an illegal exactment (more on that shortly). Note that Greenberg can prevail on either contention.
A key issue is whether the Fed exceeded its legal powers in how it structured the bailout and coerced AIG’s board into taking it. The rescue was done as a Section 13(3) loan, which is often referred to as the Fed’s “unusual and exigent circumstances” authority. While that allows the central bank to take pretty much anything it wants to as collateral for a loan and make that loan to pretty much any party it chooses to, Greenberg’s attorneys argue there are still limits on how the Fed can conduct itself. Consider this slide from the Boies’ presentation (click to enlarge):
Again, we’ll go into more detail in future posts, but some of the major Greenberg camp positions include:
1. The interest rate set can’t be punitive, which is something government officials have repeatedly stated in public and acknowledged in trial testimony. The rate is to be set “with a view of accommodating commerce and business.”
2. The central bank does not have the authority to demand the surrender of equity to make a Section 13(3) loan, which is effectively what happened here. The Fed had already obtained equity in the subs as collateral for demand notes that the board agreed to on September 16, and the 10-Q filing announcing that deal made clear that the board though it had also agreed to give equity warrants for 79.9% of the company.
But the Fed apparently determined in the following week that it would be vulnerable even with a demand note secured by all the equity in all the subs if AIG were to file for bankruptcy. The Fed had had enough direct dealings with the board and the company to have become an insider, which would lead its claims against AIG to become subordinated in the event of a bankruptcy filing.* So it wanted voting control to prevent that from happening.
This is one of the ways the illegal exactment argument comes into play. There is case precedent that supports the notion that the government can’t demand the surrender of a right as a condition of granting another. The government already had its normal condition for the granting of a Section 13(3) loan: sufficient collateral. Even though the government’s opening statement discusses the riskiness of taking equity as collateral (true), the Fed’s internal analyses already allowed for that by taking a 25% haircut and still found that the Fed had plenty of excess value.** To ask for equity on top of getting collateral for the loan is thus asking for the surrender of an additional right.
By contrast, the government’s case is almost a straight replay of the deadbeat borrower meme. AIG was toast with no bailout. The authorities could not let AIG’s ginormous liquidity problem lead to a bankruptcy filing that would bring down the financial system. So they were justified in putting in place a punitive rescue. AIG shareholders should be grateful that they got anything.
To put this even more simply, this contest is over whether the government should be allowed to run roughshod over the rule of law in the face of a potential national (actually international) emergency.
What is intriguing about the trial is how wildly divergent the approaches of the two sides are, not simply in their framing of the case, but in their approach to the trial itself. If you read Boies’ opening statement, he is clearly talking to the judge and only the judge. There is no effort to make his arguments more accessible to the media. He walks through what he contends are the thresholds he needs to meet on the two prongs of his argument and how he believes he will be able to satisfy them. The Greenberg side thus has no interest in waging a media war at this juncture. Their assumption appears to be if they win the case, the media will be forced to acknowledge the legitimacy of their position.
By contrast, the government approach to the trial, at least as demonstrated in their opening statement by Kenneth Dintzer, is classic Obama administration “any problem can be solved by better PR.” I’m not exaggerating by much. The opening statement included howlers that would not pass muster with anyone who has a passing knowledge of finance or corporate governance.
To illustrate: one issue the Greenberg camp has made centerpiece of their case is the way the board was muscled into agreeing to the Sept. 16 and Sept. 22 loans (see this post for more detail). For the Sept. 16 loan, only the CEO Robert Willumstad was ever show a term sheet, which he said was so amateurish that his children could have done a better job. The board was merely given a verbal description of terms. Willumstad, on behalf of the board, sent the government a signed blank signature page with no term sheet attached, a literal blank check.
Oh, and here is the priceless part: the government has failed to turn over this term sheet in discovery. Yet, even with this being a contested issue (and prominent enough that the judge almost certainly would remember it), get a load of this visual from the government (click to enlarge):
Do you see the misrepresentation in the slide? It show pages being presented to the board. The board never saw any documents. This is what I mean by playing to the media. The judge knows, or through his review of all the materials later, will be aware of the missing term sheet issue if it proves to be germane. But the press in the room has been given the impression the process was the board was given information they could inspect.
With that as background, Dintzer finesses the issue of whether Willumstad ever saw a term sheet (it only acknowledges that he asked for one) and claims the only one that was presented was given to AIG’s attorney. Oh, that’s Rodgin Cohen, who also happens to be Goldman’s attorney.
This is the government’s contention in the absence of coughing up any documents:
So, instead of identifying a specific form, the term sheet will indicate that the form will equal 79.9 percent of common stock but will not identify a specific type of equity….there is no ambiguity, no confusion regarding the terms of the agreement, and indeed, the parties issue press releases showing that they had the same view of the agreed-upon terms.
Our archives on Sept. 16 show both the pre-announcement leaks and news reports after the deal was done describing the equity component as warrants. AIG was directed by the government to correct its 10-Q, which described the equity component as warrants.
Here is another insulting-to-the-finance-literate discussion:
And, Your Honor, DX 161 is a memorandum written in March of 2008 that addresses just this issue, and it was sent to President Geithner of the New York Fed. The memo states: “This memo discusses whether a Reserve Bank is empowered to take ‘equity kickers’ in discount window lending under Sections 10B or 13(3) of the Federal Reserve Act.” It then goes on to state: “We believe that there are many different permissible routes to a finding that a Reserve Bank is empowered to take an equity kicker…”
An “equity kicker” in the lexicon refers to warrants or other contingent forms of equity. The government needs to provide stronger language than that to prove its claim.
And we have this cute bit that probably went over the heads of the crowd:
Moreover, the illegal exaction argument, Your Honor, it’s a red herring. The credit agreement expressly required that if one form of consideration under the agreement turns out to be illegal, AIG would have to provide an equivalent substitute.
Huh? This is circular. You can’t cure an illegal exaction by substitution.
Oh, and if you read to the end of Dintzer’s opening remarks, you’ll see he states that both the general counsel of the Fed Board of Governors, Scott Alvarez and the general counsel of the New York Fed, Tom Baxter, advised that the loan was legal.
Boies jumped on that right after the opening remarks. The government has just waived attorney client privilege, while the trial is in progress, after discovery is supposed to be finished. This is astonishing. You don’t do this sort of thing casually, if at all, and opening remarks is not the time to do it. The judge agreed to let the Boies perform discovery on this issue while the trial is in progress.
Now I’m picking particulars to demonstrate that the judge can’t have been the intended audience, that indeed, running these sloppy and dubious arguments run the risk of losing credibility with Judge Wheeler, who seems very sharp and sympathetic to the Starr arguments. But you get that impression even more strongly if you skim the government’s opening statement. It’s a dumbed down, low information density exercise in storytelling, not what you’d expect in a case like this.
Even though Boies has gotten off to what looks like a good start, it’s surprising to see him fail to take more aggressive positions on key issues. The government’s statement that an AIG failure would take the financial system down is a damaging admission. The government tries to depict that the tsunami would wash over the banks as a result of an AIG implosion, via the damage to the repo market and the impact on the insurance industry (which is dubious since the insurance subs weren’t part of the problem. The insolvency was at the parent company level).
But it is incorrect to regard the bank balance sheets as separate from AIG’s. The AIG credit default swaps reduced the risk weighting of assets at banks, allowing them to carry less equity. Or to put it in another way, AIG was effectively providing synthetic equity. So a failure of AIG would impact the banks directly as a result of their economic interdependence. I’m not sure why Boies didn’t include this in his line of argument; perhaps to get into how the use of AIG’s credit default swaps allowed banks to lever up more would be too complicated to go into, given that the regulatory treatment was different for the three major types of counterparties: US investment banks, US commercial banks, and European banks. But it seems like a lost opportunity.
The overall impression from the opening day is that the government is so confident of its position that it feels it can play to the gallery. Its assumption seems to be that it deems odds of loss at trial as low, and even if that were to happen, it will beat Starr on appeal. But as Gene Ludwig told me when he was my attorney, litigation is a crapshoot. And I wouldn’t overestimate my odds when playing craps with David Boies.
* Even this seems like a stretch; Bernanke, Paulson, and Geithner all said they would not let AIG file for bankruptcy. So was the concern that AIG would somehow take advantage of the Fed later and threaten a bankruptcy filing to retrade the deal? That seems implausible given that top financial services regulatory lawyer Rodgin Cohen told the AIG board on September 22. Then, the board was expecting the Fed to offer a longer-term credit facility on the same terms as the demand note it had agreed to on September 16. Instead, the board was told that AIG would have to accept a much higher interest rate and give control of the company to the government. Rather than take 79.9% of the equity of AIG in warrants, the government now wanted to have control now by getting voting preferred stock tantamount to a 79.9% interest.
Cohen, who had told the board on September 16 that he would be willing to give an opinion letter supporting the board if they were to file for bankruptcy then, told the board on September 22 he could not provide the same legal cover if they decided to defy the government. I have been told that the reason for the change in Cohen’s views is that on Sept. 22, AIG was encumbered by the Fed’s demand note, which was then $37 billion. On Sept. 16, if AIG had filed for bankruptcy, it could have obtained debtor-in-possession financing. With the Fed demand note in place, that looked a ton more dicey.
** Even if you don’t deem 25% to be high enough, that was the level the Fed used, so they can’t have it both ways.