federal circuit*Michelle Stilwell, the Mary G. Waterman Fellow at WLF, significantly contributed to this post.

In what is poised to become an extremely influential case, the US Court of Appeals for the Federal Circuit is currently deciding what to do after the federal government unlawfully took over the equity and leadership of one of America’s largest private insurance companies, American International Group, Inc. (AIG), during the 2008 financial crisis.  The government, in order to prevent AIG from declaring bankruptcy, offered it the customary Federal Reserve Act § 13(3) loan in the extraordinary sum of $85 billion.  However, in a virtually unprecedented move, the government conditioned this loan on receiving 80% of AIG’s equity via preferred stock.  This was an offer AIG couldn’t refuse, and it effectively diluted AIG’s shares and all but eliminated the voting and equity rights of the existing shareholders.  So what did AIG’s shareholders receive in return for the extreme devaluing of their shares? Nothing.  Not yet anyway.  The lower court below held, in a lawsuit brought by AIG’s largest shareholder at the time, that the government’s action was illegal, but that no damages would be awarded.  It is now up to the Federal Circuit to provide justice for AIG’s shareholders—and to make sure that the government has an incentive to obey the law in future financial crises.

In 2008, due to the extreme financial recession and collapse of the housing market, AIG—an American company that insures commercial and individual property holders—faced a severe liquidity shortage.  In an effort to prevent a bankruptcy that would have “catastrophic consequences” for the economy, the government provided a term sheet to AIG’s Board of Directors on September 16 of that year that approved an $85 billion §13(3) loan on the condition that AIG also provide the government with 79.9% of its equity.  The term sheet stated that the equity requested would be in the form of non-voting warrants for the purchase of common stock, and the government made it clear that these were “take-it-or-leave-it” terms—meaning relinquishing control of the equity was the only way in which AIG would receive the loan.

AIG’s Board of Directors, left without any other options and given very little time to decide, voted to approve the terms, and the government takeover began immediately; however, the government soon demanded that AIG provide equity in the form of voting preferred stock, in complete contradiction to the non-voting warrants originally agreed upon.  Further, the government set the final loan terms for the $85 billion at a shocking 12% interest rate and an additional $1.7 billion commitment fee.  This interest rate was drastically higher than the traditional 3.25 to 3.5% interest rate the government had offered to other troubled financial institutions in the 75 years prior. Until this takeover, Starr International Co. (Starr) was the majority shareholder of AIG.

In Starr International Co. v. U.S., Starr brought suit against the government and AIG as both a derivative action on behalf of AIG shareholders and a direct action on behalf of itself.   In order to bring a derivative suit, a shareholder is required to make a demand of the Board, unless a demand is futile.  While originally Starr argued that a demand was futile because the Board was under the control of the government (whom it was suing), over the course of this suit, the government sold off all of its equity and relinquished any type of control over AIG.  Thereafter, Starr made a demand to the Board to bring a derivative suit on AIG’s behalf, but the Board unanimously denied this request.

The Court of Federal Claims upheld Starr’s direct claims and found in favor of Starr, while dismissing the derivative claims because the court found that the Board’s refusal to bring a derivative suit was a proper exercise of its business judgment.  The court held that the Federal Reserve Act, under which the § 13(3) loan was approved, did not authorize the government to acquire equity in AIG, and thus this was an illegal exaction.  However, Starr’s victory was merely nominal because the court refused to award any damages, concluding that AIG would have gone bankrupt without the government’s loan.  Both Starr and the government appealed different parts of the court’s split decision.

Starr argued in its appellate brief that the government erred by not awarding any damages to Starr.  Starr criticized the court’s reliance on A&D Auto Sales v. U.S. to justify the lack of damages award.  Significantly, A&D Auto Sales was a takings clause case, not an illegal exaction case, and Starr argued that other illegal exaction cases directly contradicted this holding.

The government’s appellate brief argued that the court erred in holding that Starr could bring a direct claim at all because Starr lacked standing without a particularized injury-in-fact. The government argued that Starr could only bring a derivative suit on behalf of all the shareholders, and that the trial court correctly dismissed that claim.

Both sides delivered their oral arguments last week in front of Judges Reyna, Prost, and Wallach of the Federal Circuit.  The head attorney for Starr is David Boies, a well-known litigator who has made a career of representing parties in high-profile cases, e.g., Al Gore in Bush v. Gore, the Department of Justice in the U.S. v. Microsoft case, etc.  The two biggest issues on which the judges questioned Boies were whether Starr had standing to bring the direct claim and whether AIG’s shares would have been worth anything had the government not intervened. On the standing issue, Boies relied heavily on Alleghany Corp. v. Breswick—a Supreme Court decision that held individual shareholders have standing to bring direct claims in the case of an issuance of preferred stock that diluted the shareholders’ equity.

On the issue of the value of AIG’s shares, Boies argued that in this case the government’s takeover of AIG diluted the shareholders’ equity from 100% to 20.1%, thereby depriving the shareholders of the voting rights and equity rights, which constituted virtually the entire value of the stock.  Boies then argued that when the government sold its illegally exacted shares of AIG after the initiation of this lawsuit, the government made a profit of $25 billion which rightfully should have gone to the shareholders.  Finally, Boies argued that the lower court erred in holding that Starr was not entitled to damages because there is absolutely no precedent to support the lower court’s finding that the value of the exaction should be offset by the value of the loan, which was higher.

Judge Wallach asked whether the government’s acquisition of AIG’s equity was necessary because the $85 billion loan was not enough by itself to prevent AIG from declaring bankruptcy.  Boies replied that the record shows that the government did not necessarily save or make AIG more money than it would have made on its own: for example, when the government took over AIG, the government used AIG’s funds to insure AIG’s policyholders at 100 cents on the dollar, whereas AIG’s policy prior to the government takeover was to repay loans and insurance policies at a lower rate, which would have saved AIG a significant sum of money.

The judges then turned to the lawyer for the government, Mark Stern.  Stern tried to combat Boies’s claim of standing by rejecting Alleghany and stating that Delaware law does not provide Starr with a basis for standing.  The judges then asked Stern whether the taking of equity was a violation of the Federal Reserve Act to which Stern replied that the government did not want to issue this loan to AIG or even to take the equity, but there was no private-sector solution, and the government had no other choice in its efforts to protect the economy.  Stern then addressed the outsized 12% interest rate by stating that these terms were not meant as a punishment for AIG but as a way to compensate the government in case AIG went bankrupt before it could repay the loan.  Stern stated: “If the government wanted to punish AIG, all it would’ve needed to do was nothing.”

While it is not clear how the judges will rule, the three most likely scenarios are as follows: the court could find in favor of Starr by reversing the lower court’s holding in part, as to the damages, and the case would be remanded back to the lower court for a damages determination.  Alternatively, the court could find for the government by reversing in part, and hold that Starr did not have standing to bring the direct claim at all, in which case Starr’s victory would be taken from it and Starr would still receive nothing.  Finally, the court could affirm the lower court’s ruling, which would solidify Starr’s technical victory without granting Starr any financial relief or forcing the government to pay any damages.  Only the first of these scenarios will provide long-awaited relief and well-deserved justice to AIG’s shareholders.

Also published by Forbes.com on WLF’s contributor page.