Is the Federal Reserve a philosopher king or servant of the treasury?
No longer exactly news but still noteworthy and worth noodling over: on November 19, U.S. District Judge Paul A. Engelmeyer (Southern District, NY) dismissed Starr International’s lawsuit against the Federal Reserve Bank of New York (“FRBNY”), arising over the 2008 bailout of AIG. The ruling is right, but it raises very troublesome questions about both the financial system and the rule of law.
Recall the 2008 rescue: in the wake of Lehmann’s collapse, the FRBNY lent AIG close to $182 billion (in several tranches), on draconian conditions. In the course of the operation, Starr’s lawsuit alleges, the FRBNY repeatedly violated fiduciary duties owed to AIG shareholders (prominently including Starr) under the law of Delaware, where AIG is incorporated. Judge Englemeyer’s 89-page opinion dismisses these allegations in terms that are gently described as firm and conclusive.
First, the opinion says, under Delaware law the FRBNY never had control over AIG, and therefore no fiduciary duties to its shareholders. Sure: the initial loan was made at an exorbitant rate; the FRBNY pressed AIG to establish a vehicle (“Maiden Lane III”) to make AIG’s counterparties (Goldman Sachs, Deutsche Bank, and others) whole, allegedly to AIG’s detriment; and a series of stock transactions intermittently put AIG into 80% ownership by a federal “Trust.” But near-usurious terms and bullying aren’t control. As for the Trust, that was the U.S. Treasury’s (Henry Paulson’s operation at the time), not the FRBNY’s (Tim Geithner’s).
Not that, second, Delaware law matters to begin with. Although the FRBNY is organized as a corporation, it’s still a federal authority, and we can’t burden its operations with state law (see M’Culloch, and see Clearfield Trust). Alternatively: the Fed’s statutory authority preempts any state law that stands as an obstacle to federal purposes. The authority here comes from Section 13(c) of the Federal Reserve Act, which authorizes Fed “emergency lending” and, as construed by the court, any and all measures that the Fed or its branches might deem “convenient and useful” to their lending operations. Leave it to CivPro experts to debate which of these two theories is better: both are right, and both displace state law and shareholder remedies.
That said, Judge Englemeyer’s uncompromising, bury-the-plaintiffs opinion leaves a bad taste. By anyone’s reckoning (references available on request, or at the slightest provocation), the AIG rescue was a prime example of government by dealmaking and kneecap-crushing, virtually unguided by meaningful legal constraints. It’s one thing to say that Geithner, Paulson & Co did in 2008 what they had to do to avert a global meltdown; it’s a different thing to celebrate this form of government. Yet celebrate the judge does:
[O]ne need only imagine the predicament confronting the hypothetical FRBNY officials ostensibly “controlling” AIG in late November 2008 were their actions in connection with AIG’s rescue potentially subject to state fiduciary law: “To act or not to act? Is it better to act decisively, and pay par value, and thereby end the grave threat to the economy posed by AIG’s continuing CDS exposure? Or is it better, at the risk of not helping the economy, to negotiate over price with these counterparties, and thereby avoid being found liable by a jury, years from now, for breach of Delaware fiduciary duty law?” It is to avoid distracting and detaining such federal officials—including the FRBNY personnel who in fall 2008 were the paradigmatic men and women “in the arena”—from carrying out their vital official duties that the preemption doctrine covers federal instrumentalities. See In re Franklin Nat’l Bank, 478 F.Supp. at 222–23 (“The critical national and international ramifications of crises in the banking industry require that the initiative and imagination of the regulators not be stifled by the threat of tort actions against the United States. Congress’ grant of broad discretionary powers to banking regulators acknowledges this necessity for creativity and innovation.”).
Footnote 33 to “in the arena” cites Theodore Roosevelt, The Man in the Arena: Citizenship in a Republic, Address at the Sorbonne, Paris (April 23, 1910), available at http://www.theodoreroosevelt.org/research/speech%20arena.htm.
The opinion carries on like this for many pages. However, we should be nervous about this style of decisionmaking—way more nervous than Judge Englemeyer, who in 89 pages never once evinces the slightest discomfort. Here are a few questions:
- Is there or should there be any limit to the “initiative and imagination” and the “creativity and innovation” of the regulators “in the arena”—or are these unqualified virtues? Put differently, should we have a regulatory system that requires and rewards heroic virtue—or a regulatory system in which regulators make things regular and act, more or less, in the regular course of business, under regular laws?
- Fully granting the good faith of all actors in 2008, should we worry about $180 billion financial deals between Tim Geithner, Hank Paulson, and a bunch of boys at Goldman? To what extent are such insider rescue operations conducive to restoring public or investor confidence? Should we worry about the potential for self-dealing—or simply be careful about which men we send “in[to] the arena” and hope for the best?
- Should we worry about self-dealing not just among and for the benefit for private actors (none of whom, frankly, need the money) but for the government? If Fed “emergency lending” operations can be structured to produce certain windfalls for the U.S. Treasury, should we treat the Fed and the Treasury (as in this case) as independent actors—or as arms of a unitary government that is prone to shoveling money from one pocket into another? Does Fed lending at profit make bailouts more likely?
- A state law fiduciary duty, Judge Englemeyer opines, can’t be owed by the (temporary) government/FRBNY owners of a private entity because the fiduciary obligation runs towards the shareholders; the government’s, to the public. Does this mean that the Fed, via its lending operations, may expropriate shareholders at will, in the public interest? Are there any standards to guide conflicted regulators?
- Let’s all agree that there can’t be a state law remedy for shareholders against the FRBNY: what is the remedy for Fed abuse or self-dealing, should that come to pass? (Starr International has a takings claim pending in the Court of Federal Claims, but that is an extremely long shot.) Would any remedy unduly constrain the government gladiators’ creativity?
- Is it a good idea to entrust unconstrained lending-and-all-that-goes-with-it authority to an independent agency? In light of the fact that legal constraints are hard to come by, shouldn’t we at least insist on political accountability and control?
And so on. In fairness to the judge: questions of this sort should in the first instance trouble policymakers and legislators, rather than judges. Alas, Dodd-Frank, enacted in the wake of the 2008 meltdown, steered clear of all perturbing questions and instead furthers institutionalized government by bailout. So the questions remain with us, and they will come to haunt us the next time around.