For years, critics of the bailouts during the financial crisis argued that the rescue efforts weren't harsh enough. The chief executives of failing institutions should have lost their jobs. Shareholders should have suffered more pain. Taxpayers should have received substantial compensation for the risk they took.
All that did come to pass in one case: the bailout of the American International Group, the large insurer and symbol of the crisis. Yet on Monday, a judge in Washington decided that the government's actions were too severe, and the rescue was illegal.
When the Federal Reserve propped up A.I.G. in September 2008, unlike its approach with most of the big banks, it threw out the company's chief executive and took control of 79.9 percent of the company, nearly wiping out many of its shareholders. Taxpayers got all of their money back, and then some, receiving a profit of more than $20 billion.
But in a stunning ruling, Judge Thomas C. Wheeler of the United States Court of Federal Claims said on Monday that those terms were too "draconian." In other words, he suggested taxpayers should have offered A.I.G. a more generous deal.
The judge's decision could have far-reaching consequences should another financial crisis occur — and if history is any guide, one will. Legal experts say that the ruling, coupled with certain provisions of the Dodd-Frank financial overhaul law enacted after the crisis, makes it unlikely the government would ever rescue a failing institution, even if an intervention was warranted.
Should that happen, and the government decides it is handcuffed by the law from any intervention, taxpayers can thank Maurice Greenberg, the company's former chief executive and one of its largest shareholders. He sued the government on behalf of shareholders, contending its takeover was illegal and unfair to investors. The judge largely sided with Mr. Greenberg, confounding many legal experts who considered the case a long shot. A federal judge had previously thrown a companion case out of court, calling Mr. Greenberg's accusations "worthy of an Oliver Stone movie."
However, Judge Wheeler had a more sympathetic ear than his peers. He determined that the takeover of A.I.G. was orchestrated to "maximize the benefits to the government and to the taxpaying public." Contrary to the conventional wisdom — and common sense — he said that goal was troubling. "The government's unduly harsh treatment of A.I.G. in comparison to other institutions seemingly was misguided and had no legitimate purpose," he wrote.
Still, the judge did not award any monetary damages to Mr. Greenberg, making it a moral victory, but not an economic one. Mr. Greenberg had sought $40 billion and has spent millions bringing his case.
Judge Wheeler determined that Mr. Greenberg and the other shareholders did not suffer any economic damage because "if the government had done nothing, the shareholders would have been left with 100 percent of nothing." The judge cited John Studzinski, vice chairman of the Blackstone Group and an adviser to A.I.G., who had instructed the board to accept the government's offer in 2008, telling the room of directors: "Twenty percent of something [is] better than 100 percent of nothing."
Inexplicably, that line of logic did not extend to the judge's ruling that the government had unfairly taken advantage of A.I.G. by requiring tough loan terms, including the equity stake and a 12 percent interest rate.
"No matter how rationally A.I.G.'s board addressed its alternatives that night, and notwithstanding that A.I.G. had a team of outstanding professional advisers, the fact remains that A.I.G. was at the government's mercy," the judge wrote.
Judge Paul A. Engelmayer of Federal District Court in Manhattan, who threw out the earlier companion case, had said that the claim that A.I.G.'s board was under the control of the government was specious. By the logic of Mr. Greenberg's case, the judge had written, "a loan shark whose usurious interest rate is agreed to by a small business so that it may stay afloat could equally be said to have had actual control over that business so as to compel its agreement to a loan."
Dennis Kelleher, president and chief executive of Better Markets, an advocacy group for financial reform, called Judge Wheeler's ruling perplexing.
"The court bizarrely expressed repeated sympathy for A.I.G. while failing to properly weigh the economic wreckage suffered by the American people," Mr. Kelleher said in an email. "It's the U.S. taxpayers that have been victimized here by A.I.G. when it acted recklessly, precipitated the crash of the financial system, took a $185 billion bailout, and then gave bonuses to some of the very same people who irresponsibly sold the derivatives that blew up the company."
Judge Wheeler's analysis, in comparing how A.I.G.'s rescue was handled relative to the big banks, appears to ignore the realities of the regulatory oversight rules at the time. The judge criticized the government for taking control of A.I.G. while not doing so for the banks. But the Fed did not have regulatory oversight of A.I.G., which is an insurance company, and therefore couldn't maintain the same kind of control it did over the banks. Similarly, the judge criticized the Fed for creating a trust to hold the shares of A.I.G. because the Fed technically can't own equity in companies. "The creation of the trust in an attempt to circumvent the legal restriction on holding corporate equity is a classic elevation of form over substance."
The government was sticking to its guns on Monday. "The court confirmed today that A.I.G. shareholders were not harmed by those actions," the Treasury Department said in a statement. "We disagree with the court's conclusion regarding the Federal Reserve's legal authority and continue to believe that the government acted well within legal bounds."
While the ruling is likely to be appealed, possibly all the way to the Supreme Court, the head-scratching decision will undoubtedly have an effect on future bailouts, intended or unintended.
Hester Peirce, a senior research fellow at the Mercatus Center at George Mason University, who is reportedly among the candidates for a Republican seat on the Securities and Exchange Commission, wrote last year that if Mr. Greenberg prevailed in his case, "it would strike a blow to too-big-to-fail by adding to the bailout calculus the specter of subsequent courtroom payouts to allegedly aggrieved shareholders."
By Andrew Ross Sorkin