Constitutional Issues in Nationalization and the Economic Rescue Plan

The more aggressive the government’s responses to the economic crisis become, the more likely that they will end up in the courts. Changes in regulation can be interpreted as constraints on the ownership of property - especially by the people who own that property - and therefore such changes have occasionally ended up in the Supreme Court. The article below is by Ilya Podolyako, a third-year student at the Yale Law School and the co-chair (with me) of a reading group on law, economic policy, and the economic crisis. -James Kwak

As the New York Times reported yesterday, Geithner and Bernanke were on Capitol Hill to ask for greater power to wind down non-bank financial entities like AIG. During the hearing:

[Representative Barney] Frank said the different fates of Lehman Brothers and A.I.G. illustrate the need for options beyond the “all or nothing” approach. “One was the Lehman Brothers example, where they were allowed totally to fail and there was no help to any of the creditors,” Mr. Frank said. “The other is the A.I.G. example, where there was help for all of the creditors. Neither one is what we should be doing going forward.”‘

Geithner and Bernanke largely concurred. Basically, the key actors want to be able to apply a receivership/conservatorship-type system that currently covers members of the FDIC, Savings and Loan institutions, and Fannie/Freddie to any entity whose financial activity poses a systemic risk to the economy.

James has pointed out that proponents of nationalization for Citigroup (C) and Bank of America (BAC) have essentially the same thing in mind: have the government take over an entity, preserve the rights of depositors, and sort out which liabilities deserve payment and which do not. Baseline Scenario has consistently and persuasively argued that such an approach would be prudent. Indeed, it would avoid the awkward political fallout of the type that arose when AIG disclosed that $60+ billion worth of federal aid went directly to its various derivatives counterparties. The problem is, this policy might not be constitutional.

The last phrase of the Fifth Amendment to the U.S. Constitution, known as the takings clause, reads: “nor shall private property be taken for public use, without just compensation.” Its potential application to a significant chunk of the economic recovery programs is straightforward. A facial reading of the above text suggests the U.S. federal government (and state equivalents, similarly bound through the Fourteenth Amendment) cannot unilaterally restructure the contractual obligations of a given entity, summarily dismiss its outstanding debts, or even choose to pay some arbitrary fraction of these while waiving the rest. Curiously, however, there has been precious little commentary on just this point. Laurence H. Tribe, a professor at Harvard Law School, summarily dismissed the issue when evaluating the legality of a 90% tax on bonuses in his email to the Atlantic. Mayer, Morrison, and Piskorski gave it a bit more coverage in their mortgage modification proposal, but still seemed to be glossing over the main point by citing to a recent Supreme Court case that dismissed a very loose standard for takings jurisprudence without explicitly stating whether a taking took place.

Larry Tribe is more of an expert on constitutional law than I may ever be, but a closer look at the doctrine looks rather ominous, even if one presumes that, pursuant to the controversial Supreme Court decision in Kelo v. City of New London, 545 U.S. 469 (2005), any economic recovery program would pass the public use test. First, there is a consensus that contractual rights to cashflows constitute property protected by the Fifth and Fourteenth Amendments. See Eastern Enterprises v. Apfel, 524 U.S. 498 (1998), Webb’s Fabulous Pharmacies, Inc. v. Beckwith, 449 U.S. 155 (1980). Stocks, bonds, and most other financial instruments are thus protected from instantaneous nullification.

Second, the Supreme Court has set out two separate theories under which nationalization of financial institutions may constitute a taking. Per the 2005 decision that Mayer relies on (Lingle v. Chevron U.S.A., 544 U.S. 528), regulations that completely deprive an owner of “all economically beneficial use” of her property trigger the Fifth Amendment unless they fall into certain narrow safety and nuisance exceptions. Alternatively, under a test articulated in Penn Central Transportation Co. v. New York City, 438 U.S. 104 (1978), judges determine whether a taking occurred based on the type of government action, whether the regulation had an adverse economic impact, and the extent to which the regulation “interfered with distinct investment-backed expectations.” A forcible change in the capital structure of a previously un- or under-regulated entity would certainly look like a taking under either of the two tests.

Third, just because the government can currently force banks and thrifts into receivership, doesn’t mean that it can constitutionally do the same to any other enterprise. Decisions evaluating shareholder claims for regulatory takings of the type governed by Penn Central often revolve around the degree to which an entity that suffered economically because of government action knowingly did business in an area fraught with complex, changing rules. For example, a 2003 federal court of appeals case focused on the right of both public entities (former RTC/subsequent FDIC) and private owners to recover a surplus allegedly lost when a change in accounting practices brought about by Congress in 1989 (FIRREA) forced regulators to seize Security Savings, a previously viable S&L organization. Bailey v. United States, 341 F.3d 1342. The court held that the alteration of the accounting rules was not a per se taking under the theory that the S&L voluntarily participated in and reaped the benefits of the deposit insurance system, articulated in a seminal 1996 case Branch v. United States. Problematically, the opinion then dodged the question of whether such an administrative move nonetheless constituted a distinct, regulatory taking by holding that a statutory cost recovery hierarchy for liquidated thrifts would have prevented the private parties from seeing any cash in the first place. In other words, Bailey explained that shutting down an insolvent entity operating in an environment of pervasive government control would not itself constitute a taking, but did not fully resolve how one should treat a sudden administrative change that led to this insolvency in the first place. Indeed, an earlier case in the same court allowed a taking claim to go forward on the grounds that a 1991 law similar to FIRREA reneged on a signed promise by the FDIC to consider a bank’s capital reserves adequate. See First Hartford Corporation Pension Plan & Trust v. United States, 194 F.3d 1279 (1999).

The legal doctrine in these areas is quite complex and there are probably several ways to apply it to various existing and future economic recovery programs. I do believe, however, that entities negatively affected by nationalization/conservatorship/receivership brought about under a brand-new program could make a very good argument that they are entitled to restitution under the Fifth Amendment. If that is the case, Congress can’t do anything to change the outcome. Of course, courts would still have to decide on the extent of “just compensation” that would remedy an otherwise illegal seizure. Historically, such awards have been based on market value, but the inquiry could get quite muddled in the financial arena. Yet any judicial decision that would force the government to pay something close to market value for the liabilities it wrote off would by definition render such restructuring moot. Perhaps this is the reason why the Obama Administration had previously adopted the wait-and-see/just-in-time approach to bank rescues.

Comments

[Socialism c...:]

For 200+ years, we've used bankruptcy court to dissolve failed companies and distribute remaining assets to creditors. Contract law was held in regard. Now, we seek to divert away from that process. Why? Because there are some who would LOVE to be able to steer the assets to different recipients...or to STEER competitors to a long walk off a short financial pier...nothing more than financial blackmail. The new kommandants wielding the power will be able to dangle the new financial "sword of Damacles" over the heads of those who oppose their new rules and interference in running business. Willkommen to Amerika, komrades -- land of the "formerly financially free".

Mar 26 12:07 PM

[GEN X:]

Where's McCarthy when you need him?

Mar 26 12:16 PM

[Mad Hedge F...:]

There is a better plan. There is an easier, cheaper, and faster way to solve the banking crisis which no one is talking about on Capitol Hill. If collateralized debt obligations (CDO’s) are the problem, just get rid of them! Desecuritize them! Just convert them back into the underlying loans. There are $1.4 trillion in CDO’s outstanding backed by Alt-A and subprime loans in the form of 3,700 individual securitizations of perhaps 3.7 million loans. Over 68% of the loans backing these bonds are current. Mark to market rules are forcing the banks to carry this paper on their balance sheets at 50%-80% discounts. The problem is that mark to market is a meaningless accounting fiction when there is no market. If you break up these securities and place the underlying loans back on the banks’ balance sheets, the good mortgages can be valued at 100% of face, and those behind in their payments or in default can be discounted to maybe 70% because they are still secured by the value of the homes. This would boost the value of the entire asset class from the current 20-50 cents up to 90 cents on the dollar. Restored balance sheets would enable banks to resume lending. Of course it would be a massive admin job unwinding the rats’ nests behind some of these securities, but Heaven knows there is abundant subprime and Alt-A expertise available for hire these days. Just sift through the ashes of Lehman Brothers and Bear Stearns. It is a workable plan, and therefore is unlikely to ever see the light of day.

Mar 26 03:49 PM

[Third Party...:]

I agree with Socialism cannot compete!

Why are take overs and the Fifth Amendment even being discussed when the Constitution clearly says what should happen to these institutions that are getting "bailed out":

Article I, Sec. 8.4
The Congress shall have the power To establish... uniform laws on the subject of bankruptcies throughout the United States

Congress seems intent on not acting uniformly when it comes to who should fail and who should not.

Mar 26 04:26 PM

[Hot Richard:]

Very funny, guys. Now what is this "Constitution" thing you keep talking about? I've been following Congress and the President for a long time and I've never heard of it.

But seriously, they don't care if it is Constitutional or not. What could you possibly do about it?

I also agree with "Socialism cannot compete". While I cannot match his enthusiasm, Hot Richard can say we're going in the opposite direction here. When are voters going to start pointing fingers at the state?

Mar 26 07:18 PM

[TR1:]

Just curious why the UAW and other labor groups don't use this defense. I think the reason is the threat of bankruptcy. The catch 22 with the TBTF firms is the counterparty risk versus bankruptcy, which makes it a different poker game.

Mar 27 01:54 PM