In the wake of the Lehman Brothers bankruptcy and Merrill’s agreement to be acquired by Bank of America, the investment banking model was shaky at best. On September 21, the final two remaining independent investment banks regulated by the SEC, Goldman Sachs and Morgan Stanley, left the agency’s voluntary regulatory program to become bank holding companies, overseen by the Federal Reserve.27 These two investment banks were pursuing a safe-harbor under the federal regulatory umbrella to boost investor confidence.They were also following a path toward stability by acquiring bank deposits, an ironic event as bank deposits were also short-term financing. Nonetheless, the market perception was that this model was more reliable than one that depended on short-term prime brokerage deposits and same-day repo lending for liquidity. These were financially sophisticated entities who could more speedily shift funds than ordinary Americans.
The Nationalization of AIG
As Lehman Brothers died and Merrill disappeared, another famous financial name independently teetered on the edge of insolvency. AIG, a global financial conglomerate with the largest insurance business in the United States, had suffered approximately $21.7 billion in losses out of its London subsidiary, which had been writing insurance and credit default swaps on mortgage-related assets.28 AIG was principally an insurance company, not an investment bank. Nonetheless, AIG became caught in a different species of feedback loop, one driven by ratings cuts and mark-to-market accounting rules.29
The decline in AIG stock due to its losses and its inability to effectively raise capital due to these stock declines had led the rating agencies to cut AIG from its triple AAA rating to A-.30 Under the $441 billion in derivative contracts AIG was a party to, AIG was consequently required to put up approximately $14.5 billion in collateral.31 AIG had never anticipated that it would be downgraded, but the collateral requirement in the midst of a credit crisis rendered the company insolvent and showed the fallacy of AIG’s assumption. Moreover, in connection with this collateral requirement, AIG’s accountants reviewed its asset values, and AIG was forced to record mark-to-market losses of approximately $60 billion.32 On Monday, September 15, 2008, New York State Insurance Commissioner Eric Dinallo permitted AIG to borrow $20 billion from AIG’s own regulated insurance reserve funds in order to try to save the company.33 It was not enough.
The federal government initially refused to provide financial assistance to AIG. But the Lehman Brothers treatment was short-lived. AIG held more than a trillion in assets and had $971 billion in liabilities, and if it defaulted on its obligations, there was every prospect of a sequence of many cross-defaults beyond the CDS market, which in turn would have forced not just losses but a significant number of corporations to refinance their debt in a credit market that was incapable of doing so.34 AIG was not just too big to fail, it was too interconnected to fail. The Federal Reserve thus decided on September 16 to provide financial assistance to AIG. The Federal Reserve once again justified this extension of credit under a very broad reading of its authority under the Federal Reserve Act.
Once again, though, the government would be constricted by the limits of the law and the lack of a seizure mechanism in structuring its rescue. And once again, the government stuck to its developing game plan for dealmaking, driving a hard bargain in the name of moral hazard. On that day, AIG disclosed: “In connection with the revolving credit facility, AIG issued a warrant to the Board of Governors of the Federal Reserve … that permits the Federal Reserve, subject to shareholder approval, to obtain up to 79.9 percent of the outstanding common stock of AIG (after taking into account the exercise of the warrant).”35
On September 26, AIG announced that it had entered into definitive agreements with regard to its government assistance.36 The Federal Reserve extended an $85 billion loan on hard terms. The interest rate was approximately 12 percent on funds drawn and 8.5 percent on undrawn funds, plus a $1.7 billion commitment fee paid to the Federal Reserve. The credit agreement also required that all of AIG’s free cash flow be paid over to service the Federal Reserve loan, as well as the proceeds of any of AIG’s asset disposals or capital raisings. The loan terms were better than what AIG could get in the market but were still designed to force AIG to downsize or perhaps disappear in order to service the debt.
In exchange for providing this loan, the government received AIG preferred shares equivalent to a 79.9 percent voting and dividend interest in AIG.The GSE precedent in deals had become the norm. Though the loan was issued by the Federal Reserve, the preferred shares were actually issued to a trust for the benefit of the Treasury Department.37 It is unclear why the interest was for the benefit of the Treasury and not the Federal Reserve; presumably, this was a matter of control and who would realize the profits. In addition, the government has yet to fully explain why the interest was placed into trust, rather than issued directly to the government. The presumption, however, is that the government did this in order to keep a distance between the government and AIG and provide some colorable pretext to prevent political meddling in the workings of the company. There was also the question of whether the Government Corporation Control Act, which requires Congressional authorization in certain circumstances for the government to own private companies, would be violated if the government took full control. When the trust instrument was released three months later, it provided the trustees almost complete control of AIG, an extraordinary delegation of the government’s power.38 Clearly, matters of open government and the ordinary controls an investor would desire were not the government’s goals or perhaps within their grasp given the legal limitations.
The ordinary details of corporate law, though, were not the sort of hurdles that the government found very worrying. AIG did not have sufficient authorized common stock in its certificate of incorporation to issue warrants to the government, but it did have a blank check preferred provision in its certificate. This type of provision permits a corporation to issue preferred shares on such terms and with such rights as the board deems appropriate. This permitted AIG to issue out 100,000 shares of convertible participating serial preferred stock with rights to 79.9 percent of the votes and dividends paid on AIG common and preferred stock.39 Once again, the lawyers had innovated to bring about a novel solution to meet the government’s dealmaking needs.
The New York Stock Exchange requirement that a company obtain a shareholder vote prior to the issuance of an amount equal to 20 percent or more of its common stock or preferred shares convertible into common stock would normally have required AIG, a NYSE-listed company, to obtain shareholder approval for this issuance. However, AIG, like Bear Stearns, relied upon the exception available if the delay in vote would “seriously jeopardize the financial viability” of a company. 40 The NYSE had permitted reliance upon this exemption before in the Bear Stearns transaction, and it did so here.41 It appears that this rule was simply ignored in the case of Fannie Mae and Freddie Mac, with the NYSE taking no action.
AIG still was required under Delaware law to hold a shareholder vote to amend its certificate of incorporation to authorize the issuance of the common stock that the preferred is convertible into. AIG initially appeared to take the position that the government’s preferred shares would be able to vote on the transaction, making approval a foregone conclusion. However, when a shareholder suit was brought, challenging this practice as violating Delaware law, which allowed for a separate class vote of the common shareholders, AIG backtracked and asserted that the common stockholders would separately vote to approve this conversion.42
In the months following, the AIG rescue would take up more government resources, showing the perils of an ad hoc bailout. Meanwhile, AIG’s ousted ex-CEO, Hank Greenberg, was reportedly lobbying the government to ease the terms of its bailout.43 On October 8, the Federal Reserve Bank of New York agreed to accept up to $37.8 billion in investment-grade, fixed-income securities from AIG in exchange for cash collateral. The exchange was meant to provide additional liquidity to AIG and allow AIG to exchange that
cash for the securities it had lent to third parties. Then, on October 27, 2008, the Federal Bank of New York allowed four of AIG’s subsidiaries to participate in the Federal Reserve’s commercial paper program, up to an amount of $20.9 billion, and to use the proceeds of the loans to prepay money borrowed by AIG under AIG’s $85 billion credit facility with the Federal Reserve Bank of New York.44
On November 10, the government announced another restructuring of its financial support to AIG, and the New York Federal Reserve announced two new lending facilities for AIG.45 This brought the government’s potential support for AIG up to $173.1 billion. The government’s initial thought—that the bailout of AIG was merely a bridge to fund liquidity—was clearly mistaken. The new rejiggered bailout was a dose of reality. The government had initially failed to comprehensively deal with the AIG situation. Instead, the government’s attempt to downsize AIG had harmed the company and only hastened its deterioration. The government’s new approach was now designed to stabilize AIG rather than dismember it. But AIG would again return to the well for a third time on March 1, 2009, for another $30 billion.The government again reworked the terms of its bailout. AIG had become a black hole for taxpayer money and the government’s aggregate specific commitments to AIG rose to $182.5 billion.
This would explode in public fury the week of March 17, 2009, over the payment of approximately $165 million in bonuses to executives at AIG’s financial products business. This was the selfsame business that had entered into the now infamous CDS contracts that had destroyed AIG.The outrage over these inappropriately structured retention payments—they were paid regardless of performance—was justified. But the outrage was more. It reflected public anger at repeated, unexplained government action that appeared to benefit corporate executives at the expense of the wider public. In the wake of the extreme display of public discontent, President Obama ordered that the government attempt to obtain repayment of the bonuses.
Moreover, the claims by now Treasury Secretary Geithner that he learned of the bonus payments only a week before appeared incredible. These bonuses were agreed to back in early 2008, and the AIG bailout had been arranged by the New York branch of the Federal Reserve at a time when it was headed by Secretary Geithner. At best, the failure of the government to act beforehand to forestall the payments was incompetence. At worst, the government was willfully blind, or otherwise wanted the bonuses to be paid to ensure that the AIG business group continued to unwind AIG’s trillions in derivative contracts.
The outcry missed the real issue with AIG, though. In the wake of the public scrutiny, AIG also disclosed that almost $60 billion in the government’s bailout funds had gone to European banks to satisfy collateral calls. The $165 million was meaningless, compared with this $60 billion payment. And here, the question was why the United States was not asking the European governments to share their burden for salvaging European financial institutions.
The government had also allowed these European and American banks to be made whole at 100 cents on the dollar without value to the American taxpayer except for the decaying AIG businesses. In addition, it was also disclosed that the government had repurchased at notional value $62 billion worth of securities to unwind AIG’s book of CDSs. This payment was made in connection with the November lending facilities and was made despite the fact that these were collateralized at about 57 percent of that value. This represented a pure wealth transfer from U.S. taxpayers to the banks. Goldman Sachs alone received an estimated $5.5 billion in excess value.
The payments may have been justified in order to ensure market confidence in AIG and the full repayment of the government funds. In other words, the government now needed to act to ensure that AIG stayed in a suitable operating condition to ensure that AIG repaid the tens of billions it still owed to the government. Nonetheless, the failure of the government to adequately justify these payments was yet another source of public discontent, at least for those few who took the time to try to understand the government’s complicated Frankenstein-like bailout of AIG.46 Luckily for the government, few did and the AIG uproar faded with the next news cycle.
The Forced Sale of Wachovia
The collapse and workout of Wachovia unfolded in a less orderly manner. As of the weekend of September 27,Wachovia appeared to be insolvent. In a hectic weekend, the FDIC, headed by Sheila Bair, selected Citigroup as the buyer for Wachovia’s depositary assets. In choosing Citigroup, the FDIC refused to support a competing offer by Wells Fargo to acquire the entirety of Wachovia and a proposal by Wachovia itself to maintain it as a stand-alone entity. On Monday, September 29, Citigroup and Wachovia executed an exclusivity agreement, pursuant to which the parties agreed to negotiate definitive documentation for Citigroup to purchase the depositary assets of Wachovia for $2.2 billion. Wachovia would remain a functioning company operating a rump business consisting of Wachovia Securities, which, combined with A.G. Edwards, is the nation’s third largest brokerage firm; Evergreen Investments, which is Wachovia’s asset management business; Wachovia retirement services; and Wachovia’s insurance brokerage businesses.47
Citigroup’s plans were disrupted, however, when Wells Fargo decided to again bid for Wachovia that Thursday. Wells Fargo likely did so because of the imminent passage of the TARP Bill, which would permit Wells Fargo to utilize $74 billion in Wachovia’s carryforward losses, a tax advantage that now made this acquisition quite financially attractive. This time, the FDIC, over Treasury and Federal Reserve protests, apparently provided its approval to this transaction and, in fact, informed Wells Fargo that if a merger proposal was not signed by October 3, Wachovia’s banking subsidiaries would be put into receivership. That Thursday night, Wells Fargo and Wachovia negotiated and signed an acquisition agreement for Wells Fargo to acquire the entirety of Wachovia for approximately $15.1 billion. Bair had acknowledged the legal reality that, under the agreements Citigroup and Wachovia had signed,Wells Fargo could still make a competing bid.48
Wells Fargo’s lawyers were from Wachtell Lipton, the same attorneys who represented JPMorgan in the Bear Stearns acquisition, and they negotiated an agreement with features similar to the one in Bear Stearns.Wachovia agreed to a force-the-vote provision modeled on the one in the Bear Stearns agreement, which required the company to rehold its shareholder meeting to approve the merger repeatedly during a six-month period after a first no vote on the transaction.49 Wells Fargo was also issued 10 shares of preferred stock equivalent to a 39.9 percent preferred share interest in Wachovia in exchange for 1,000 shares of Wells Fargo.50 The power of a blank check preferred stock was clearly on display. Wells Fargo could use these shares to approve the transaction, and once again, as in Bear Stearns and AIG, Wachovia sidestepped the NYSE rules on a shareholder vote for this issuance by invoking the insolvency exception, asserting that Wachovia would have had to file bankruptcy without this transaction.51
Citigroup sued Wells Fargo and Wachovia in New York State Court that Saturday, and the parties litigated in state and federal court over the weekend as Citigroup attempted to salvage its deal in the courts. Citigroup had entered into an exclusivity agreement that provided that Citigroup and Wachovia would negotiate exclusively for a week toward a transaction on the basis of a nonbinding term sheet to complete definitive documentation. During that time, the exclusivity agreement required Wachovia to abstain from entering into negotiations concerning or agreeing to any acquisition proposal. An acquisition proposal was clearly what Wells Fargo made and agreed to, and they did so during this exclusivity time period.
Citigroup’s case, though, was weak. First, there was the question of whether Wachovia had a fiduciary out on the term sheet. Normally, an exclusivity agreement would allow the Wachovia board to deviate if its fiduciary duties require it to do so. This agreement did not have such a provision, but normally courts will still read this into agreements to override any constraints the board agrees to. This is because the court will not sanction an action that violates fiduciary duties, instead de
claring it void. Second, Wachovia could argue that exclusivity was meaningless at this point, because a deal would never be reached. Finally, damages were limited in any event because a shareholder vote would have been required. Citigroup’s asset purchase was a sale of all or substantially all of the assets of Wachovia, which required a shareholder vote under state law. No rational shareholder would vote for Citigroup’s less valuable bid. Here, Citigroup had neglected to even put a break fee in the exclusivity agreement in case of a shareholder no vote or other breach or failure to reach an agreement.This left Citigroup without a strong litigation position and was a lesson to lawyers everywhere on the perils of exclusivity agreements without meaningful penalties for their breach.52
On Tuesday, October 7, 2008, the FDIC privately intervened and forced the parties to halt their litigation and sign a tolling agreement in order to negotiate a resolution. The FDIC then attempted to mediate a deal, but when Citigroup and Wells Fargo couldn’t agree on a resolution, Citigroup dropped its bid for these assets, and Wells Fargo proceeded to acquire Wachovia.53 The government’s preference in these matters for an ordered solution to a designated bidder had once again been in evidence.
Citigroup had in hindsight made a mistake in failing to lock up Wachovia, and Wells Fargo had forced the government to allow a market solution. Wells Fargo, given a measure of government endorsement, had once again showed that buyers in such circumstances were not afraid to push the envelope on the law. Here,Wells Fargo and its lawyers followed the path first trod by JPMorgan in its Bear Stearns acquisition. Again, a government-backed acquisition had substantially stretched, but not broken, the laws for the structuring of an acquisition, safe in the assumption that the courts would not want to intervene.54
Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion Page 30