September 18, 2008
The AIG Deal and Debt Versus Equity
Posted by Jeff Lipshaw
My claim to fame is ego not hubris (there's a subtle difference), so I'm not going to sit here in the middle of the upheaval and claim to know that it is the end of free markets as we knew them or that the invisible hand will get everything settled just fine. It was, however, kind of neat to go off-topic in two business law classes yesterday and, as Usha Rodrigues observes, be cool (a rare event in my life!). I'm also not panicking. The one thing I told both classes was to look with some skepticism at anybody on Today, Good Morning America, The Situation Room, or Larry King Live who assesses the situation without a preface to the effect that this is all very, very complex and not really capable of being reduced to a sound bite. People are, as far as I can tell, getting it wrong. On the other hand, I tried to find the actual AIG-Fed deal documents yesterday, and could not, so I too am speculating.
I've been e-mailing back and forth with David Zaring, however, about his post analyzing the Fed's authority to do this deal in this form. The loose interpretation of the events is that the Fed "bought" AIG, or "took control" of AIG. If you frame the issue that way, it does indeed seem difficult to fit this within Section 13(3) of the Federal Reserve Act:
In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System . . . may authorize any Federal reserve bank . . . to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank. . . . All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.
I moved from litigation to transactional work in the late '80s, and made my bones doing leveraged "vulture capital" deals. Our clients would swoop in and buy up troubled companies (mostly automotive suppliers). The financing consisted of "credit facilities" (the closing books are sitting on my shelves here) we used to negotiate with GE Capital and Westinghouse Capital in those halcyon days of being able to own companies with very little of your own skin in the game (i.e. lots of leverage!). The credit facility would consist of a term loan and preferred stock to buy the company, a revolving credit line for working capital, and warrants as the "equity kicker."
We need to zero in on these warrants, because as I read the press reports (not having seen the documents), the so-called "80% ownership" the Fed got was in the form of "equity participation warrants." This isn't collateral in the sense of an asset owned by AIG and capable of being foreclosed on if there is a default on the loan. (In contrast, what IS collateral is, for example, the shares in National Union Fire Insurance, which writes a huge chunk of the D&O coverage in the U.S. and I believe is nicely profitable.) Warrants are options to buy the stock - a contract right to own in the future, not present ownership.
The reason that lenders like GE Capital took warrants is that they didn't want to own equity (other than the preferred stock). What they wanted to do was exercise the warrants when the leveraged company got sold or went public (known in the parlance as "flipping" the company). The warrants served the purpose of making the potential return on the credit facility commensurate with the risk. What I'm suggesting, if in fact I'm correct about the structure, is that warrants as part of a loan package were ephemeral ownership at best.
Since nobody is going to "flip" AIG, it's less clear to me how the warrants produce value. Let's assume that AIG survives and even thrives. At some point, the government exercises the warrants and there is a humungous public offering of now extremely valuable AIG stock, and the Fed gets a return commensurate with having loaned $85 billion. Or the government sells the warrants and never owns any of AIG even for a fleeting moment.
The rest of the "control" of AIG occurs, I'm assuming, in the positive and negative covenants of the loan agreement. I had the good fortune of teaching the classic partnership case of Martin v. Peyton yesterday, in which the issue is whether the lenders are partners of the borrowers when part of the pay-back involves a profit-sharing plan, and the lenders have significant "control" rights (such as veto power on transactions, etc.) The holding of the case is that, notwithstanding all of the conditions, this is still fundamentally debt and not equity - that is, the lenders are not co-owners of the borrower. David thinks that the Fed's directive to change out the AIG CEO is evidence of "control;" it just doesn't strike me that way. It's the classic case of good lawyers being able to write affirmative covenants as negative covenants - we aren't telling you who to hire, we're just holding a veto over who you do hire, and we veto the incumbent.
So while the transaction may be unprecedented, the Fed doesn't own, and almost certainly never will own AIG. And, by the way, there is precedent for the government swooping in and owning a private enterprise. Way back when I was in law school at Stanford, Victor Palmieri offered a course (I didn't take it) called Crisis Management, the subject of which was the failure of the Penn Central railroad, and the creation of Conrail. Now it's true Congress authorized the creation of Conrail, and it was a private corporation all of whose stock was owned by the United States. But if the government really wants to own AIG (I seriously doubt it!), there's time. As I recall, when Citicorp agreed to acquire Travelers Insurance, which included Salomon Smith Barney, there was this little impediment called Glass-Steagall that had to get amended or repealed before the deal could close.
The bottom line: in complex financing, you reach a very fine line between debt and equity. Nobody can claim to have it absolutely right. But in my world, the equity kicker just sounds like part of the credit package, not "ownership." Accordingly, it didn't seem such a stretch to think it fell within "such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe."
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Professor Lipshaw, you are always cool. Except, of course, when you put down HC.....thats a different story. Nonetheless, thank you for your insight.
Posted by: AS | Sep 18, 2008 8:08:10 AM
Thanks a lot for the analysis. I am a small individual shareholder of AIG. I was wondering if you think there is any chance that this dilution will be undone. Perhaps it was done in too much of a hurry to make it legal. If AIG shareholders can find the capital from SWFs or whoever, perhaps they can get all of the company back. Since it was a liquidity crisis and not a solvency crisis that causes this, it seems to me that this would be fair. As long as we were solvent, we likely would not have lost 80% of our equity if we went into Chapter 11. Not going that route was likely better for the financial system but perhaps not for us shareholders. You might be very interested in this link if you haven't read it already.
Posted by: David Johnston | Sep 20, 2008 11:02:25 PM