Is The AIG Bailout Legal?

As might be expected, I've had to come out of finance-law retirement this week to help the Securities/Structured Finance department out (in exchange for their calling my return "Jordan-esque"). It's been a crazy week for a lot of lawyers, too.



One big question following the Fed's bailout of AIG will surely be: Does the Fed have the authority to do that? The answer is probably yes.



The Fed is claiming authority for the AIG bailout under Section 13(3) of the Federal Reserve Act, which provides in pertinent part:

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank ... to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange ... . Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions.

There's no relevant statutory or regulatory definition of "unusual and exigent circumstances," but it should be pretty clear that the current circumstances would qualify as "unusual and exigent." Obviously, AIG is a corporation, so it satisfies the "individual, partnership, or corporation" requirement.



But was AIG "unable to secure adequate credit accommodations from other banking institutions"? We know that AIG turned down a PE offer over the weekend, but as I understand it, that offer was for some form of capital injection, and might not have counted as a "credit accommodation[]." However, I don't think AIG's turning down of the PE offer will ultimately affect the legality of the Fed's bailout, because Section 201.4(d) of Reg A appears to give the Fed wide discretion in determining whether AIG was "unable to secure adequate credit accommodations." Section 201.4(d) provides that the Fed:

may extend credit to an individual, partnership, or corporation that is not a depository institution if, in the judgment of the Federal Reserve Bank, credit is not available from other sources and failure to obtain such credit would adversely affect the economy.

There doesn't appear to be any relevant case law here, so this is as far down the legal-interpretation rabbit hole as we can go.



Thus, it's essentially up to the Fed to decide whether AIG was "unable to secure adequate credit accommodations." And by making the loan to AIG, the Fed obviously decided that the answer was no.



Of course, none of this will ever really matter, because this issue will never go to court. It's an interesting theoretical question though, and one that we'll probably hear asked a lot over the next few days.



UPDATE: Eric Posner thinks the AIG bailout is illegal because a court would hold that the transaction is a sale rather than a loan, and the Fed doesn't have the authority to purchase an insurance company:

[T]he 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.

This strikes me as wrong. Sure, if this were a normal transaction executed in the course of every-day business, a court might hold that it's a sale rather than a loan. But this is, by definition, an "emergency loan," executed in "unusual and exigent circumstances." Any individual, partnership, or corporation (IPC) that gets a loan from the Fed under Section 13(3) of the Federal Reserve Act has to have been "unable to secure adequate credit accommodations from other banking institutions." If an IPC can't get a loan from anywhere else, then it's almost by definition a poor credit risk. For any emergency loan to such an IPC to be "secured to the satisfaction of the Federal Reserve bank," the IPC would have to put up so much collateral that the transaction might start to resemble a sale.



In other words, any emergency loan under Section 13(3) of the FRA is, by definition, going to require an unusual amount of collateral as security, because for a corporation to even be elligible for an emergency Fed loan, it has to be such a poor credit risk that it can't get a normal loan from a private sector bank. The line between a loan and a sale would be shifted substantially in the case of an emergency Fed loan to an insurance company, making it much more likely that a court would consider the transaction a loan.