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The AIG Deal.

True, the Fed statute says that loans can be issued with conditions. As a commenter asks, what loan doesn't have conditions? See here also. But the Fed statute does not say that the Fed can purchase businesses, and it seems reasonable to interpret the statute to forbid the Fed to purchase businesses. So here's the question, is the AIG deal a purchase or a loan? I suspect the deal is a loan in form but a purchase in substance. Unfortunately, the details are not available, but the press accounts suggest that the Fed is receiving AIG equity (more precisely, the option to obtain equity) as collateral for the loan but that it's going to exercise the option more or less automatically. Here's an analogy. Suppose that I lend you $100 and we agree that all of the equity in your business will be collateral for the loan. The contract provides, however, that you must pay me interest of a gazillion dollars, due one second after closing, and that if you fail, that counts as a default, whereupon the collateral is mine. The parties use the loan form but substantively a sale occurs. A court would almost certainly interpret the transaction as a sale, not a loan, if tax or other legal consequences turned on the distinction. If the AIG loan is like this, then it's illegal. So: why aren't our rule-of-law friends yowling?

SKardner (mail):
So: why aren't our rule-of-law friends yowling?

Who has standing to sue?
9.17.2008 11:06am
beamish:
I hereby yowl.
9.17.2008 11:13am
beamish:
And what kind of law professor isn't a friend of the the rule of law? Are you more of a divine right of kings guy?
9.17.2008 11:14am
Adam J:
beamish- I don't think I've ever seen yowling done so formally
9.17.2008 11:22am
MR:
Unfortunately, the details are not available, but the press accounts suggest that the Fed is receiving AIG equity (more precisely, the option to obtain equity) as collateral for the loan but that it's going to exercise the option more or less automatically.

Ok, but isn't this just a gentler form of receivership or conservatorship, akin to the stuff we see from the FDIC all the time? At least, that's how I read the structure of the transaction:

"A senior Fed staffer said the most likely outcome was an orderly liquidation of AIG, though it was possible that the firm could survive as an ongoing business."

Financial Times, 17 September 2008

It seems to me that the goal here is not to "sustain the market" via taxpayer dollars and nationalization. The ownership stake was merely the necessary step to expedite the winding down process, which is much different than the government actually stepping in to 'prop' markets.

And by the way, this deal doesn't result in a taxpayer loss of $85 billion. The loans terms carry a somewhat brutal interest rate, suggesting the Fed has every intention of making AIG give it back. This is really just a bridge loan to carry the company through until its assets can be stripped. For those worried about the moral hazard, that still means that those "wealthy Wall St. financiers" are going to take a hit.
9.17.2008 11:22am
M. Lederman (mail):
Eric: Assume you're right that this is a de facto purchase. (I don't know enough about it to question your characterization.) OK, but why does it "seem reasonable to interpret the statute to forbid the Fed to purchase businesses" -- let alone to forbid the Fed from making a loan that is plainly authorized by the terms of the statute but that is also "a purchase in substance"? I'm not denying your interpretation, since I'm not sufficiently familiar with the statute; just curious where the statutory prohibition appears (or can fairly be implied).
9.17.2008 11:39am
John (mail):
While the precedent is probably not so hot, the cost seems very small--as MR notes, the U.S. is getting a lot of interest on the loan (I think 8.5 over LIBOR).

As to ownership, Eric correctly notes that the Fed doesn't own AIG yet--it has an option on something under 80% of the common equity. What other incidents of ownership it may have don't seem to be public (i.e., it might have the right to select board members, or management)--at least I haven't seen them.

If the assets are liquidated it is hard to see how the loan principal and interest will not be paid. The option may well be valueless (since AIG's equity may be), but it is there to provide the threat of an actual takeover, I suppose, if management does not take steps to repay the loan, by liquidation or otherwise.
9.17.2008 11:44am
BarrySanders20:
If the AIG loan is like this, then it's illegal.

Of course it is a sale. Of course it is extraordinary, unprecedented. Is it illegal? Perhaps, but that shows the limits of the law: Who's going to stop them? In times of true crisis, fantasy legal-land yields to reality. As it has even been and so it shall ever be.

Is the "legal" alternative of passively watching a disorderly failure a better alternative than managing an orderly failure?

This is a Chapter 11 without the formalities with some small hope that something(?) will happen to allow AIG to survive. How exactly that can happen when the assets will be lopped off one after another is "above my pay grade."

So boo hoo. The law loses.
9.17.2008 11:49am
wm13:
Add to Prof. Posner's hypothetical the following facts: I don't want your business and do not have the legal power and authority to operate your business. What I really want is for you is to sell your business and give me the sales proceeds as additional contingent interest on the loan. The security interest is just a device to force you to sell your business (because if you don't, I will seize it and sell it myself.) In that case, we may have a clogging the equity problem, but I wouldn't have a problem arguing in tax court or bankruptcy court that we don't have a disguised sale.
9.17.2008 11:49am
SKardner (mail):
I'm not denying your interpretation, since I'm not sufficiently familiar with the statute; just curious where the statutory prohibition appears (or can fairly be implied).


Marty: Assuming that the statutory prohibition can be fairly implied. Who has standing to sue?
9.17.2008 11:49am
A.S.:
Unfortunately, the details are not available, but the press accounts suggest that the Fed is receiving AIG equity (more precisely, the option to obtain equity) as collateral for the loan but that it's going to exercise the option more or less automatically.

Huh? Could Prof. Posner please point to press acounts that say this?

The press acounts I've read state do not state that the equity "as collateral for the loan" - instead, they say that they collateral for the loan is all of AIG's assets. The equity is just the price that AIG had to pay to obtain the loan.

It is perfectly reasonable to expect that a lender will ask for a fee when extending a loan. Virtually every loan I've ever seen is the same (I'm a corporate lawyer who represents both lenders and borrowers). Heck, you even normally pay a fee when you get home mortgage. That fee isn't "collateral for the loan" (as Prof. Posner asserts here) - it's just a plain old fee.

Could Prof. Posner please point to where he is getting this information?
9.17.2008 11:54am
Christopher M (mail):
The Fed statute is not a suicide pact!
9.17.2008 11:55am
MR:
Quick Fact Check:

"It will receive warrants entitling it to a 79.9% stake in AIG. The two-year loan, secured against AIG's insurance businesses, carries an interest rate of LIBOR plus 850 basis points (hundredths of a percentage point). The government will install new management and will have veto power over all important decisions, including asset sales and payment of dividends."

Economist, 17 September 2008

This suggests that Prof. Posner is right that the interest is technically an elective interest. The above also makes clear that the government is indeed exercising some extensive powers that are "incident to ownership."
9.17.2008 12:02pm
Viceroy:
The first commenter hit on something interesting. Who is gonna sue? Obviously the shareholders can't. Who else?
9.17.2008 12:02pm
MR:
The first commenter hit on something interesting. Who is gonna sue? Obviously the shareholders can't. Who else?

I may be stretching the bounds of creativity here, but how about a displaced executive? They certainly suffer a concrete harm from the government's (putatively) illegal action. It's too bad that the Fed doesn't have powers akin to the "FDIC Superpowers" to shield it from any litigation.
9.17.2008 12:08pm
DC:
@SKardner:

It seems like the diluted equity holders might have standing to sue, perhaps suing their own board the first time that someone tries to count votes or allocate distributions to equity, if any assets make it that far down the chain. (Could they just sue the Fed now? I doubt it.)

Would they be worse off if they sued and won now? Almost certainly. Would winning the lawsuit later perhaps trigger some other conditions in the loan instrument that were worse for them? Perhaps.
9.17.2008 12:08pm
DiverDan (mail):
It may well be that the warrants for 79.9% of equity are a tool to prevent AIG from going into Chapter 11, which would stop the clock on all interest to the Fed. If AIG's board does vote to go into Chapter 11, the Fed can exercise the warrants, get 79.9% of equity, call a special shareholder's meeting, kick everyone off the board &fire all the managers, then either move to dismiss the Chapter 11 (which other creditors could oppose), or take control of the process as Debtor-in-possession.
9.17.2008 12:11pm
JKB:
Who is going to try to break up this deal? Anyone who forces the FED out will own the resulting catastrophe, which could be worldwide depression. In any case, unless Congress (who are co-conspirators in this mess) demand the deal be rescinded, any legal challenge will be decided after the benefit of the FED loan has been achieved.

Look at it this way: If AIG is a festering damaged leg on the body of the financial industry, the question came down to how to take it off in the field. Do we use a shotgun and hope for the best or do we use surgical tools and try to control the spread of the gangrene?
9.17.2008 12:12pm
zippypinhead:
This is clearly a proxy for de facto receivership and eventual liquidation of AIG as an ongoing business by the Fed. For obvious market stability reasons, however, the Fed doesn't want to publicly bill it that way for the time being.

But given the market's reaction so far today, the true form of the deal has obviously not gone entirely unnoticed.
9.17.2008 12:23pm
MartyA:
Just so long as our brave MBAs in the financial industry continue to get multi-million dollar bonuses as a reward for ALL they do!
9.17.2008 12:24pm
Adam J:
JKB- I suppose it depends on how good the surgeon is...
9.17.2008 12:33pm
JRL:
Could a competitor sue for tortious interference with prospective advantage? (i.e. We didn't overextend ourselves on purpose so we could be there to pick up the pieces (or a share of the pieces) when AIG failed?)
9.17.2008 12:48pm
A.S.:
To me, zippypinhead is exactly right - AIG is being liquidated. Indeed, the Fed's announcement makes this clear. The Fed said: "This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner".

But I still don't see any evidence supporting Prof. Posner's view of matters. As I pointed out above, the equity is not collateral, as Posner states, but rather is simply a fee for making the loan. Moreover, the example Posner provides is nothing at all like the situation here - there interest rate here is high, but not a "gazillion dollars" and the loan isn't due "one second after closing" but rather in 24 months. I'm truly puzzled why Posner's example is supposed to be apporpriate to explain this situation.

BTW, my theory on why the Fed got an option, rather than just 79.9% of AIG's stock, is that the Fed is going to wait to exercise the option until it sees what's left of AIG after the firesale. If AIG is left with a lot of obligations and hardly any assets, then the Fed won't want to exercise the option and be in a position of controlling an enterprise that is underwater.

All of this is not to say that I have any definite thoughts on whether the statute authorizes the Fed to charge a fee for making a loan. I have no idea about that.
9.17.2008 1:09pm
Cold Warrior:
I would suggest that under PBGC v LTV, 496 US 633 (1990) this deal will be considered to be a valid exercise of the Fed's powers, pursuant to all the general language in the Fed charter; e.g., an appropriate exercise (in the Fed's discretion) of the power to ensure the stability of the currency, etc.
9.17.2008 1:23pm
John Coates (mail):
It is not unusual for lenders to force out CEOs, without thereby becoming "owners." That's what happened to Vivendi in the 2001-2002 period. It's also not unusual for lenders to obtain options or warrants as part of a loan, without being treated as "owners" for (e.g.) purposes of lender liability. Lipshaw has the analysis right, as far as I can tell from public statements about the deal. Anyone who wants to move (as a legal matter) to what they perceive as the "substance" of the deal -- bailout, takeover, liquidation, etc. -- have to reconcile all of the corporate, bankruptcy and contract law decisions coming out the other way -- upholding form over (perceived economic) substance in precisely analogous settings. Descriptively, formalism is an important part of the rule of law. As for Treasury authority, the cite's been given above; see also the 1995 loan to Mexico. On the substance, let's keep things in perspective: even if nothing is ever paid on the loan, and even if the warrants expire worthless, the total cost would be less than 15% of the cost of the Iraq war and occupation to date. And finally, for those above who suggest that a company with assets worth $1 trillion doesn't need a $85 billion loan, please look up and try to understand the concept of liquidity.
9.18.2008 5:53pm

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