On June 15, 2015, Judge Wheeler in the United States Court of Claims issued a ruling on a bench trial in Star International v. United States, (No. 11-779C) ("AIG Ruling"). Hank Greenburg, through his interest in Star International, alleged that the Federal Reserve and the Treasury Department (collectively, "Government") had no authority to demand 92% of the equity of AIG in exchange for a pledge of $182B to bail out AIG during the financial crisis. Consequently, the Government's demands constituted a taking under the Fifth Amendment for which Greenburg demanded $25B in damages.
The Court ruled that the Government's actions were indeed without authority but that under the Economic Loss Doctrine, Greenburg was not entitled to a recovery.
Let's unpack that to discuss some interesting aspects of the ruling itself, the prospects on appeal and the impact on Fannie Mae shareholders.
In a ruling a court finds certain facts and reaches certain conclusions of law. The importance of the distinction will be plain in the discussion of the prospects on appeal.
While a 75 page ruling must of necessity be abbreviated for an article, the most interesting facts the Court found are:
- "Operating as an opportunistic lender of last resort, the Board of Governors imposed a 12 percent interest rate on AIG, much higher than the 3.25 to 3.5 percent interest rates offered to other troubled financial institutions such as Citibank and Morgan Stanley."
- "[T]he government treated AIG much more harshly than other institutions in need of financial assistance.
- "[T]he evidence supports a conclusion that AIG actually was less responsible for the crisis than other major institutions."
- "The Government did not demand shareholder equity, high interest rates, or voting control of any entity except AIG. Indeed, with the exception of AIG, the Government has never demanded equity ownership from a borrower in the 75-year history of Section 13(3) of the Federal Reserve Act."
- "The Government did realize a significant benefit in nationalizing AIG. Since most of the other financial institutions experiencing a liquidity crisis were counterparties to AIG transactions, the Government was able to minimize the ripple effect of an AIG failure by using AIG's assets to make sure the counterparties were paid in full on these transactions. What is clear from the evidence is that the Government carefully orchestrated its takeover of AIG in a way that would avoid any shareholder vote, and maximize the benefits to the Government and to the taxpaying public, eventually resulting in a profit of $22.7 Billion to the U.S. Treasury."
- "AIG's counter parties also received complete releases from AIG for all legal action, including any potential fraud or misrepresentation."
- "In contrast to the wrongful conduct of [Citigroup, Bank of America, Goldman Sachs, JP Morgan, and Morgan Stanley], no claims of fraud or misconduct have been brought by the Department of Justice against AIG for any of AIG's actions in the years leading up to or during the financial crisis."
Now let's turn to the conclusions of law. The court distinguished between a "taking," which is the result of the actions of government officials which are authorized by law, and an "illegal exaction" a payment to the government based on the unauthorized actions of government officials. "An illegal exaction occurs when the Government requires a citizen to surrender property the Government is not authorized to demand as consideration for action the Government is authorized to take." The court concludes that since Section 13(3) of the Federal Reserve Act does not authorize the Government to take equity, the transfer of equity to the Government was an illegal exaction.
So far so good for the shareholders. But, if the Government's actions were an illegal exaction, what is the measure of damages? This is the ugly part.
The court said: "Common sense suggests that the Government should return to AIG's shareholders the $22.7 billion in revenue it received from selling the AIG common stock it illegally exacted from the shareholders for virtually nothing. However, case law construing 'just compensation' under the Fifth Amendment holds the Court must look to the property owner's loss, not to the Government's gain." Thus, the measure of damages is not the Government's gain under the illegal exaction, but the shareholders' loss. What then was the loss Star suffered due to the Government's actions?
Here, the Court makes two errors. First error: There were multiple Government actions, but for the sake of clarity, limit the discussion to two: the making of the loan and the illegal exaction of the equity. The court combines both these actions when it states "[t]he court must examine what would have happened to AIG if the Government had not intervened." The court looks to the $85 billion loan and concludes that without the loan, AIG would have gone into bankruptcy. Since the shares would have been worthless in bankruptcy, the shareholders were not damaged by the illegal exaction. The court's error was in combining the loan and the exaction and concluding since the loan prevented bankruptcy there was no subsequent harm by the taking of the equity.
This is a clear error. The loan saved AIG from the liquidity crisis and preserved shareholder value. The Government then stole that value by illegally demanding equity. The action the court examined should have been the illegal action of taking the equity, not the legal action of providing the loan. This should be a compelling argument on appeal.
The court's second error was to accept the trial testimony of experts opining that in bankruptcy the shares would have been worthless. This is often true, but not always, especially when the bankruptcy is not brought on by a failure of the business model but by the financial markets. AIG was a liquidity based bankruptcy. The intrinsic value of its financial holdings had not changed. Instead, accounting rules required AIG's assets to be "marked to market", that is, revalued as if they were sold in the frozen, artificially depressed markets of the crisis. This is an accounting fiction, not financial reality. Consider, too, the usual bankruptcy, especially of a large, complex company like AIG, takes years to resolve. During those years, creditors are barred from proceeding against the debtor by an automatic stay. Creditors can certainly file claims with the bankruptcy court, but absent permission of the court, no creditor can seize assets or realize any claim against the debtor until a final plan of reorganization is approved. During the years resolving a major bankruptcy, the markets normalize and value returns. Thus, the bankruptcy process itself would have protected AIG's assets from the "mark to market" fiction of insolvency.
As an example of how this could have worked in reality, consider General Growth Properties (NYSE:GGP). GGP is a large REIT in the retail mall space. Its debt came due during the crisis. Its retail properties were performing, but due to the lack of liquidity, GGP was unable to obtain routine refinancing. GGP filed a Chapter 11 bankruptcy, took advantage of the automatic stay and passage of time, secured the refinancing and emerged from bankruptcy unscathed. I purchased GGP stock during the bankruptcy in the $3 range and later saw the stock soar to $18 (although I sold prior to the huge gain, I merely doubled the investment). GGP is a striking example that a sound company insolvent purely because of a liquidity crisis in the market can emerge from bankruptcy with value in the equity.
Let's turn to the appeal. On appeal, the appellate court will examine the findings of fact and the conclusions of law. The distinction is critical. Findings of fact in a bench trial (only a judge, no jury), as here, are reviewed on a "clearly erroneous" standard. That is, the appellate court will defer to the trial court as to the facts unless the reviewing court has a "definite and firm conviction that a mistake has been committed." In my opinion, the trial court took great care to make sure the facts it found, including those cited above, were well grounded in the testimony. The sole exception is the error about the effect of bankruptcy on the equity, which is a matter of professional opinion. These facts should survive appeal.
This is the more interesting part: an appellate court reviews conclusions of law, de novo. That is, without any deference at all to the trial court. Appellate courts are perfectly free to reach different conclusions of law if not convinced by the reasoning of the trial court. Indeed, unless there is controlling U.S. Supreme Court precedent, appellate courts are free to derive new exceptions to existing law or pronounce new doctrines of law.
I think the trial court felt compelled to follow the economic loss doctrine since that is the law as that court found it. Yet, by taking care to establish the facts quoted above, and establishing the court's own dislike of the conclusion, the trial court is providing a careful basis for the appellate court to make an exception to the economic loss doctrine in an extreme case such as AIG.
All in all, given the facts and extreme Government behavior, Greenburg has a fair chance on appeal. The appeal does ask the court to make an exception to the economic loss doctrine but the outrageous facts should pull on the conscience of the appellate court for that exception.
Side observation: the Government justified the exaction of equity to prevent the "moral hazard" of companies taking business risk thinking the Government would provide a bailout. Over and above the exorbitant interest rate, the Government wanted to "punish" AIG. Having been an officer of a publicly traded company, I can affirm that it would be career suicide to take a business risk relying on the possibility of a Government bailout. Second, the real moral hazard here is preventing the Government from doing this in the future. Consider the following quote from the Ruling:
"In mid-September 2008, the Government recognized that the Treasury and FRBNY might not have the legal authority to take the … stock given to the Treasury … See e.g., [quotes taken from Government sources presented at trial]… ('we agree that there is no power' for the Federal Reserve to 'hold AIG shares'). …('Treasury lacks the legal authority to hold directly voting stock of AIG'); (Geithner: 'Under section 13(3)of the Federal Reserve Act, the Fed is prohibited from taking equity or unsecured debt positions in a firm.'); … ('Nice try on the preferred stock investments! We still don't have that authority.')"
Now consider the following quotes from the Wall Street Journal after the above publicly quoted by the Ruling and after the court ruled the Government had no authority to demand the equity:
"In a statement Monday, the Federal Reserve said it 'strongly believes that its action in the AIG rescue during the height of the financial crisis in 20008 were legal, proper and effective' A Treasury spokesman said Monday, 'We disagree with the Court's conclusion regarding the Federal Reserve's legal Authority.'" Wall Street Journal, June 17, 2015, pg C3.
Moral hazard takeaway: The Government stole 92% of AIG's stock, valued at $22.7B, got off on an error, and is completely unrepentant. No Government employee has lost position or pension. The true moral hazard is that future Government officials learn that such conduct creates great career building headlines for being aggressive but carries no professional risk.
Let's apply this to Fannie Mae (OTCQB:FNMA). Fannie Mae is the Federal National Mortgage Association. There are two lines of Fannie Mae shareholder suits against the Government. The first line of cases is in the Federal Court for the District of Columbia, ("Perry Cases") now on appeal before the Federal Appellate Court for the D.C. Circuit. Those cases allege the Government violated various Federal and State laws, but do not allege a taking. The second line of cases ("Fairholme Cases") before the US Court of Claims do allege a taking. The AIG Ruling only applies to the Fairholme Cases.
In very brief summary, in September 2008, Fannie Mae was taken over by the Federal Housing Finance Agency ("FHFA") under the Housing and Economic Recovery Act of 2008 ("HERA"). FHFA then entered into a preferred stock purchase agreement ("PSPA") with Treasury as a vehicle for Treasury to make investments in Fannie to preserve Fannie's solvency. In exchange for Treasury committing to funding up to $100B to Fannie, the PSPA gave Treasury 1 million senior preferred shares with a total liquidation preference of $1B ("Treasury Stock"). Second, the Treasury Stock was entitled to annual cash dividends equal to 10% of the liquidation preference. Third, the PSPA gave Treasury warrants for up to 79.9% of Fannie Mae common at a nominal price.
HERA, unlike section 13(3) of the Federal Reserve Act under which Star sued, does permit the Government to acquire equity securities in Fannie Mae. The alleged taking in the Fairholme case occurred in August, 2012, when FHFA executed a Third Amendment ("Net Worth Sweep") to the PSPA which substituted the 10% dividend for a dividend equal to Fannie Mae's net worth.
Applying the economic loss doctrine to Fannie Mae we ask, assuming that the Net Worth Sweep was an illegal exaction (or taking), what was the value taken from the shareholders? The value taken would be any amounts which Treasury received in excess of the 10% dividend to which Treasury was entitled under the PSPA. As of June, 2015, some sources calculate that amount at $20B, and counting.
Fannie Mae Conclusion: The AIG Ruling helps Fannie Mae shareholders by re-enforcing the economic loss doctrine as the appropriate measure of damages when the Government seizes property either by a taking or by illegal exaction. For those shareholders who are members of the plaintiff class, (click here for more about that) the US Court of Claims should render a $20B judgment in their favor.
Disclosure: I am/we are long FNMA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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