Potential Constitutional Obstacles to Nationalization and the Economic Rescue Plan

The more aggressive the government’s responses to the economic crisis become, the more likely that they will end up in the courts. Changes in regulation can be interpreted as constraints on the ownership of property – especially by the people who own that property – and therefore such changes have occasionally ended up in the Supreme Court. The article below is by Ilya Podolyako, a third-year student at the Yale Law School and the co-chair (with me) of a reading group on law, economic policy, and the economic crisis.

As the New York Times reported today, Geithner and Bernanke were on Capitol Hill to ask for greater power to wind down non-bank financial entities like AIG. During the hearing:

[Representative Barney] Frank said the different fates of Lehman Brothers and A.I.G. illustrate the need for options beyond the “all or nothing” approach. “One was the Lehman Brothers example, where they were allowed totally to fail and there was no help to any of the creditors,” Mr. Frank said. “The other is the A.I.G. example, where there was help for all of the creditors. Neither one is what we should be doing going forward.”‘

Geithner and Bernanke largely concurred. Basically, the key actors want to be able to apply a receivership/conservatorship-type system that currently covers members of the FDIC, Savings and Loan institutions, and Fannie/Freddie to any entity whose financial activity poses a systemic risk to the economy.

James has pointed out that proponents of nationalization for Citigroup and Bank of America have essentially the same thing in mind: have the government take over an entity, preserve the rights of depositors, and sort out which liabilities deserve payment and which do not. Baseline Scenario has consistently and persuasively argued that such an approach would be prudent. Indeed, it would avoid the awkward political fallout of the type that arose when AIG disclosed that $60+ billion worth of federal aid went directly to its various derivatives counterparties. The problem is, this policy might not be constitutional.

The last phrase of the Fifth Amendment to the U.S. Constitution, known as the takings clause, reads: “nor shall private property be taken for public use, without just compensation.” Its potential application to a significant chunk of the economic recovery programs is straightforward. A facial reading of the above text suggests the U.S. federal government (and state equivalents, similarly bound through the Fourteenth Amendment) cannot unilaterally restructure the contractual obligations of a given entity, summarily dismiss its outstanding debts, or even choose to pay some arbitrary fraction of these while waiving the rest. Curiously, however, there has been precious little commentary on just this point. Laurence H. Tribe, a professor at Harvard Law School, summarily dismissed the issue when evaluating the legality of a 90% tax on bonuses in his email to the Atlantic. Mayer, Morrison, and Piskorski gave it a bit more coverage in their mortgage modification proposal, , but still seemed to be glossing over the main point by citing to a recent Supreme Court case that dismissed a very loose standard for takings jurisprudence without explicitly stating whether a taking took place.

Larry Tribe is more of an expert on constitutional law than I may ever be, but a closer look at the doctrine looks rather ominous, even if one presumes that, pursuant to the controversial Supreme Court decision in Kelo v. City of New London, 545 U.S. 469 (2005), any economic recovery program would pass the public use test.  First, there is a consensus that contractual rights to cashflows constitute property protected by the Fifth and Fourteenth Amendments. See Eastern Enterprises v. Apfel, 524 U.S. 498 (1998), Webb’s Fabulous Pharmacies, Inc. v. Beckwith, 449 U.S. 155 (1980). Stocks, bonds, and most other financial instruments are thus protected from instantaneous nullification.

Second, the Supreme Court has set out two separate theories under which nationalization of financial institutions may constitute a taking. Per the 2005 decision that Mayer relies on (Lingle v. Chevron U.S.A., 544 U.S. 528), regulations that completely deprive an owner of “all economically beneficial use” of her property trigger the Fifth Amendment unless they fall into certain narrow safety and nuisance exceptions. Alternatively, under a test articulated in Penn Central Transportation Co. v. New York City, 438 U.S. 104 (1978), judges determine whether a taking occurred based on the type of government action, whether the regulation had an adverse economic impact, and the extent to which the regulation “interfered with distinct investment-backed expectations.” A forcible change in the capital structure of a previously un- or under-regulated entity would certainly look like a taking under either of the two tests.

Third, just because the government can currently force banks and thrifts into receivership, doesn’t mean that it can constitutionally do the same to any other enterprise. Decisions evaluating shareholder claims for regulatory takings of the type governed by Penn Central often revolve around the degree to which an entity that suffered economically because of government action knowingly did business in an area fraught with complex, changing rules. For example, a 2003 federal court of appeals case focused on the right of both public entities (former RTC/subsequent FDIC) and private owners to recover a surplus allegedly lost when a change in accounting practices brought about by Congress in 1989 (FIRREA) forced regulators to seize Security Savings, a previously viable S&L organization. Bailey v. United States, 341 F.3d 1342. The court held that the alteration of the accounting rules was not a per se taking under the theory that the S&L voluntarily participated in and reaped the benefits of the deposit insurance system, articulated in a seminal 1996 case Branch v. United States. Problematically, the opinion then dodged the question of whether such an administrative move nonetheless constituted a distinct, regulatory taking by holding that a statutory cost recovery hierarchy for liquidated thrifts would have prevented the private parties from seeing any cash in the first place. In other words, Bailey explained that shutting down an insolvent entity operating in an environment of pervasive government control would not itself constitute a taking, but did not fully resolve how one should treat a sudden administrative change that led to this insolvency in the first place. Indeed, an earlier case in the same court allowed a taking claim to go forward on the grounds that a 1991 law similar to FIRREA reneged on a signed promise by the FDIC to consider a bank’s capital reserves adequate. See First Hartford Corporation Pension Plan & Trust v. United States, 194 F.3d 1279 (1999).

The legal doctrine in these areas is quite complex and there are probably several ways to apply it to various existing and future economic recovery programs. I do believe, however, that entities negatively affected by nationalization/conservatorship/receivership brought about under a brand-new program occur could make a very good argument that they are entitled to restitution under the Fifth Amendment. If that is the case, Congress can’t do anything to change the outcome. Of course, courts would still have to decide on the extent of “just compensation” that would remedy an otherwise illegal seizure. Historically, such awards have been based on market value, but the inquiry could get quite muddled in the financial arena. Yet any judicial decision that would force the government to pay something close to market value for the liabilities it wrote off would by definition render such restructuring moot. Perhaps this is the reason why the Obama Administration had previously adopted the wait-and-see/just-in-time approach to bank rescues.

27 thoughts on “Potential Constitutional Obstacles to Nationalization and the Economic Rescue Plan

  1. I hope Larry Tribe and IIya Podolyaka are reading baselinescenario.com and responding every day!

    Here is a question to Larry and Illya–wouldn’t it have been acceptable for paulson/bernake to have asked for some specific power to give Lehman a 6 billion dollar bridge loan, and for taking over the AIG mess (instead of the current scam) and then later, more power to clean up Citi?

    If Merrill (going into bankruptcy) hadn’t been valued at 2/3 of the value of Bank of America (another gift from the deal making duo ) Bank of America wouldn’t be in it’s current struggle. I think the shareholders of Bank of America have finally figured out this scam and they are acting on it.

    If lehman hadn’t been let to fall by the refusal to give them a 6billion dollar bridge loan, and the subsequent 85B that was given two days later and much went out the back door to Goldman (now up to 180B pass through AIG) it looked like Goldman Sachs (and Morgan) were going down with Lehman.

    I haven’t yet found any articles pointing out the affiliates of Goldman (and Morgan) on the counterparty list–if you add together all the money to Goldman and it’s affiliates, it is a better representation of how much money was at stake for Goldman when the decision was made not to step in as a conservator with AIG, but instead, give massive money to AIG.

    So, if the deal making duo hadn’t chosen not to ask for powers with AIG and then proceeded to take several weekes to scare everyone with the lobby for TARP, Goldman (and maybe Morgan) would have been out of business.

    Since Goldman might have had the same fate of Lehman (after Lehman was refused the 6billion dollar loan), wouldn’t it seem that the approach that the deal making duo chose was self-dealing for the banksters friends?

    Thank you.

  2. If your goal is:

    “have the government take over an entity, preserve the rights of depositors, and sort out which liabilities deserve payment and which do not”

    Then that is what we have today. The licensed banking subsidiary – the only place that has any depositors – gets seized by the FDIC and the depositors paid in full.

    Why do you care what happens to the holding company once it is stripped of its banking sub? It now has assets in non-banking businesses offset by liabilities to non-depositors and equity. If it should become insolvent, run it through plain ol’ bankruptcy; there are no protected players any more.


  3. Which brings me back to the Geithner Plan…

    Our government has to try, in good faith, to establish at least an indication of fair value for legacy assets before it summarily decrees a value. Something like the Geithner Plan must be tried before nationalization.

    If Krugman is correct and trust in the banking system is irretrievably damaged, he is probably correct that the PPIP will simply not function. In that case funding becomes an issue with Congress and the “takings” argument becomes an issue with the banks.

    If, however, the PPIP works, even on a modest scale, a market will have been created for legacy assets. Bank capital positions and forward needs can then be estimated more confidently. Nationalization, to the extent it is then necessary, will have less of an odor of arbitrary valuation.

    If the PPIP gains traction, it will do so as partnership investments become profitable. This will occur when secondary markets demonstrate rising values. Mark Thoma makes this point but his concern that the Treasury will be stuck with mountains of bad debt if the PPIP fails is over wrought. If a PPIP investment fails the private partner still loses 100% of his equity.

  4. The legal question of the proposed legislation are complex. However, I suspect the proposal is designed more for political gain than to give Treasury additional powers.

    The proposal is a symbol of the administration’s desire to (at least appear to) represent the best interests of the taxpayers by asking for additional powers over the banks. While the legislation would not have a long term impact on regulation if struck down by the courts, in the short term the administration will achieve political gains.

    They will appear to be seeking all possible tools to manage the current crisis.

  5. Wouldn’t the relevant precedent be found in FDR’s Emergency Banking Act? Was it unconstitutional? Was the founding of the FDIC itself unconstitutional given the preceding arguments?

  6. Hmmm, and I’ve heard lots of commentary on how the bailout plan, the $3+ trillion in secret loans, all this arrogation of unaccountable power, are illegal and/or unconstitutional.

    I believe we are quite beyond the scope of any legalistic debate by now. There are no longer legal issues in this crisis, only political ones.

  7. You are arguing that the playerz that ran the companies into the ground can be counted on to pursue all legal avenues, no matter how contrived, to make another quick buck. That is certainly true.

    The time to make the insolvent banks an offer they cannot refuse was when the bailout was initially offered. The government could have, from day one, demanded voting shares as a precondition for any investment, and should have majority investment only.

    I would think it is much easier to not exercise voting rights by abstaining on all issues beyond those directly affecting the taxpayer, then it is to resolve bad management after the money has left the barn. Maybe it would also have been possible for the goverment to approach a bankruptcy judge with a proposal.

    Combined with the threat that seizure of records, DOJ investigations and possible charges against the executives would be a priority in the event that the management refused government buy-in and filed for bankruptcy might have incentivized the executives to give the government what it, possibly, cannot take.

    I agree that given the sweeping actions taken by Fed and Treasury with no transparency. let alone Congressional oversight, maybe it would be acceptable to let judges resolve these issues (through all appeals and up to the Supreme Court, quite possibly after 2012 or 2016) and in the meantime, move from bailing out Too Big To Let Fail instead of restructuring it.

    Incidentally, it is my understanding that in Sweden, actions were prepared and taken with the understanding that the legislative framework would be delivered just in time and as needed. Of course, Sweden likely does not have an political class as illerate, corrupt and dysfunctional as the US Senate.

  8. ‘we’ being many of the same bureaucrats and legislators who facilitated the problems in the first place.

    fair and square still being debated

    it would be enlightening to know whom/what the controlling ownership was purchased from – not that governments need to own shares to exercise a great deal of authority over the dealings and future of a firm. If the former shareholders were pension plans, ‘the people’ may have even less say or influence now in firms which were ‘public’.

    it is astonishing how the obama contingent seems to have convinced such a large swath of american voters that government is ‘them’

    It will be interesting to hear what Obama has to say about Khordokovsky, – if he isn’t able to duck an expectation of comment: “…An even greater issue is to fight what Medvedev himself has labeled “legal nihilism.” …Obama cannot possibly avoid raising the Khodorkovsky case…” http://www.themoscowtimes.com/article/1028/42/375649.htm




  10. All of this Takings Clause stuff can go out the window through one simple expedient: The Government conditions the receipt of governemnt aid — whether it be loans, guarantees, or purchases of stock at prices no-one inthe market woudl pay right now — on taking control of the enterprise. That’s completely constitutional, and if the Banksters don’t like the conditions and think that they can raise capital on the markets, then that’s their choice.

  11. Watch out, greg, minority interests have very well defined rights and protections.

  12. James,
    I do have to recognize that this seems like a superfluous “law school” aside for many who are concerned about the day-to-day operations of their jobs and businesses (which I think accounts for most of the comments thus-far). That said, you are 100% right to bring up constitutional concerns in our current setting.

    What does it mean that the government can bail out certain institutions and leave others to face the legal consequences of their actions? The unfairness and un-market-system-ness of this have been discussed ad nauseam, but what about the unconstitutionality? Of course the creditors would have likely fared worse under bankruptcy, but as soon as that comes up each creditor who makes anything less than 100% can sue for discrimination. And when they can point to Goldman making (at least) 100% on every claim, who can argue with them? We may get off easy as a country and Lehman may be the worst thing the Treasury ever did. On the other hand, ignoring the existing law and opening the door for Trillions of dollars of claims against the US (in terms of “I was systematically important too, I should have been bailed out like BofA”) may turn out to have been an even worse idea.

  13. it is a numbers game–low for those who would try to claim that they too were “systemically” important. Most would fear the cost of trying to sue over this issue….and being held up in court forever…..unless someone out there wants to make a class action suit for all of those out there who could show their damage–that might get the attention of those who are turning a blind eye to what is being done!

  14. If a PPIP investment fails the private partner still loses 100% of his equity.

    to quote a line from the original Austin Powers:

    “Who does Number Two work for?!?!?”

  15. >Yet any judicial decision that would force the government to pay >something close to market value for the liabilities it wrote off >would by definition render such restructuring moot.

    The price that investors would pay for toxic assets sold by the government: wouldn’t that be the market value? If nobody wants them, wouldn’t zero be the market value? Just asking.

  16. Remove constitutional protections for corporations–especially status of legal person entitled to human rights protections. Obscene, and apparently fraudulently written by a law clerk into a ruling.

    We have created a predatory super-series and we are now seeing it operating in open defiance of the executive and legislative branches, public opinion and the overwhelming public interest. Invoke eminent domain and move.

  17. And the only reason AIG still has minority owners is political weakness to do the coherent thing and take over the whole company. It should have gone into bankruptcy with perhaps some taxpayer DIP financing to keep the insureds insured.

  18. No takings issue here.

    Because the firms at issue are already insolvent.

    New government authority would not RENDER these companies insolvent, which is the source of most of the case law controversy cited; in such cases, yes, there is room for complex takings clause debate.

    Poster makes the mistaken Geithner-Summers assumption that the firms are solvent if the assets would only be properly valued — ergo, there must be a taking in here somewhere. But, this not true, if firms in fact are underwater, and so no property to “take,” only financial carnage to clean up/minimize the social impact of — clearly proper, constitutional role for government.

  19. Precisely the salient point. Congress has the explicit power to enact bankruptcy laws to govern the orderly winding down of insolvents. If they are actually solvent, they can stand on their own without government help.

  20. What exactly happened when the Fed seized AIG? This was, after all, an insurance holding company regulated by the OTS. Yet the Fed took an 80% ownership in AIG, got its insurance subs as collateral against a loan, and became responsible for contract performance on its derivatives? I do not ever recall a shareholder vote on the matter. This apparently happened in the dead of night, and was announced as a fait accompli to the markets and shareholders.

  21. Further to Bill and DLP’s comments, valuation of the interests “taken” is the factual issue that must be resolved before you even get to the constitutional issue. If the ownership interests taken are truly worth nothing (i.e., because the entity is insolvent), then arguably no “property” has been “taken.” Alternatively, if worthless interests still retain their character as “property,” the compensation owed by the government would be zero. Either way, there is no takings issue.

  22. …the more I learn about this, the more I think this issue is probably the crux of the reason why the administration/Treasury have adopted the plan they have now.

    The legality, if not constitutionality of the government taking over non-bank financial institutions is unclear, but a good argument for its constitutionality can be made if the value of the assets/solvency–or lack thereof–can be established. Thus the focus on trying to establish the value of these assets, and wooing institutions into opening up about them.

    Of course, congress could pass legislation giving the government these powers, but let’s say an institution was taken over and it somehow turned out that the assets actually had value/that the institution was solvent. Bad situation. It’s easy to say “well such and such institution is clearly insolvent”, but where do you draw the line?

  23. You Americans are really a riot. Your Titans Of Finance decided that loaning money blindly to unqualified borrowers is actually a good idea, and dumping mountains of junk portfolios on the rest of us out here in the world is somehow a wonderful plan as well. Your rating agencies knowingly lied to all of us too. Tell me, do you actually think we will EVER trust you again? Like…..ever? And here, all of you are debating the “constitutionality” of it all??? Congratulations on cratering the ENTIRE GLOBAL ECONOMY. Maybe you Americans can debate THAT for awhile. You’ve killed the “other” 95% of us out here…..and we will never forget it. Are you really thinking we will ever buy into any of your nonsense again? American greed has run us all over for the last time. THAT you can bank on. We’re done. Good job America, the other 95% of the worlds citizens are very proud of what you have done. Thanks….we’ll NEVER forget it. The good news is, you can tell your grand kids that you remember when you use to be the reserve currency….the good old days. Thats probably done too. WE CANT TRUST YOU ANYMORE.

  24. I guess this is as good a place as any here, to point out that nationalization may not be so crazy, maybe on a long term basis. I’ve asked or commented on this before here at BaselineScenario, wanting to know why it is that if the government can fix the problem by taking banks over, why can’t it run them full time. Simon answered this point by saying it is a bad idea, and – not having anything but theory in my head and instincts, I bowed (mostly) to his judgment on that.

    Then this evening I ran across this at MotherJones.com:
    “How The Nation’s Only State-Run Bank Became the Envy of Wall Street at http://www.motherjones.com/mojo/2009/03/how-nation%E2%80%99s-only-state-owned-bank-became-envy-wall-street.

    It is a fascinating read, which begins

    The Bank of North Dakota is the only state-owned bank in America—what Republicans might call an idiosyncratic bastion of socialism. It also earned a record profit last year even as its private-sector corollaries lost billions. To be sure, it owes some of its unusual success to North Dakota’s well-insulated economy, which is heavy on agricultural staples and light on housing speculation. But that hasn’t stopped out-of-state politicos from beating a path to chilly Bismarck in search of advice. Could opening state-owned banks across America get us out of the financial crisis? It certainly might help, says Ellen Brown, author of the book, Web of Debt, who writes that the Bank of North Dakota, with its $4 billion under management, has avoided the credit freeze by “creating its own credit, leading the nation in establishing state economic sovereignty.” Mother Jones spoke with the Bank of North Dakota’s president, Eric Hardmeyer.

    In mentioning this, I do not know anything more about it than what is in the article. And I do not profess that this model will fit anything anywhere ales in the world. But it has been working in North Dakota for 90 years.

    I would simply like to state that some of the things in the article fit what is in my own head about how a state or the Federal government can run a bank, and – at least in this case – make it work WELL.

    Repliers to my earlier comments here alleged that a state run bank would be get politics involved in handing out loans. The fact is the opposite: that redlining has been a political reality of private banking for a very long time. And the North Dakota state-run bank was actually started as a response to the difficulties of getting loans from eastern banks and their preferences, at least some of which were certainly political (at least in the east) and that made getting loans nearly impossible in N.D.

    In terms of efficiencies of govt-vs-private (which would always be part of such arguments), I would also point at the Postal Service, which was privatized, and which since then has lost the ability to deliver mail even nearby towns by the next day, yet in my childhood the government-run US Post Office could deliver mail even the SAME day, and up until the privatization promised next day mail in the contiguous 48 states, at First Class rates.

    I’d like to see what basis Simon has for claiming that government banks are a bad idea. Is it a cure-all for the kinds of abuses we’ve all fallen victim to? Maybe not a cure-all, but it should be part of the discussion.

    Let’s not keep our heads in the Reaganomic mindset of “government = evil”, just because we’ve been subjected to that mantra for the last 30 years. Some things government does well. And some things government SHOULD do. Banking, being part of our economic infrastructure, should be moved to the government, for an extended period, in order to see if it could serve the country better than the private banks have. Two horrendous crashes in 80 years should allow us to try a different model. The only other one we have is a government-run banking system. Throwing more patches on the existing model – will that cure things, or just put it off until someone else finds another way to rape the system again? Let’s get it out of the hands of the gamblers and put it in the hands of a government agency.

  25. It’s astounding that these banks — or any corporations — have constitutional protections.

    Corporations aren’t people and can’t have “rights” in the sense people do. Not in the real world. But in the fictional world constructed by lawyers, it seems they do.

    What next — must we give banks the franchise, too?

    Individual, flesh and blood, persons have rights. The people who own stock in the banks have rights. But when they chose to hide behind a corporate veil, they made a bargain with the government, avoiding personal responsibility for the obligations of the bank.

    When the investors in Citi and AIG offer up their personal fortunes to back the obligations of those institutions, then we can talk about “takings”.

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