Academic

In reading about the bailout, you have seen the references to the preferred stock that the Treasury Department will receive from various financial institutions that are receiving taxpayer money. Have you looked at the terms? Inspired by a conversation with Ed Rock and Rom Gilson, I located the terms of the AIG perferred here.

In this instance, Treasury is purchasing 79.9% of the company (when you include the warrants), and you would expect some substantial financial and control rights to follow that sort of investment. On the financial side, this stock carries at 10% cumulative dividend (which may be adjusted (up? down?) "in the sole discretion of the Secretary of the Treasury in light of, inter alia, then-prevailing economic conditions and the financial condition of AIG, with the objective of protecting the U.S. taxpayer") and a liquidation preference of $40 billion, which is the purchase price of the preferred stock. (How is "liquidation" defined here?) The shares are also redeemable for the amount of the liquidation preference plus accrued an unpaid dividends, but only if Treasury "'beneficially owns' less than 30% of the aggregate voting power of AIG?s voting securities and ... no holder of the Senior Preferred controls AIG."

About that control ... the term sheet provides:

"Control" for this purpose means the power to direct the management and policies of AIG, directly or indirectly, whether through the ownership of voting securities, by contract, by the power to control AIG?s Board of Directors or otherwise.

Hmm. We will come back to this provision later.

How does the preferred stock negotiated by Treasury fare on control? Generally speaking, the preferred stock is  non-voting, but if AIG fails to pay dividends for four dividend periods "whether or not consecutive," the preferred stock has the right to "elect the greater of 2 directors and a number of directors (rounded upward) equal to 20% of the total number of directors after giving effect to such election." In addition, consider the following control rights that are allocated to this preferred stock:

• Treasury must consent to any increase in common dividends (subject to various limitations)
• Treasury must consent to repurchases equity securities (subject to various limitations and exceptions)
• Treasury obtains negative covenants related to the issuance of additional securities, adverse charter amendments, or mergers
• AIG becomes subject to the executive compensation and corporate governance requirements of the Emergency Economic Stabilization Act of 2008
• AIG is required to create a risk management committee of the board of directors to "oversee the major risks involved in AIG?s business operations and review AIG?s actions to mitigate and manage those risks"

It's hard to imagine a private investor that would take almost 80% ownership of a company without getting control of the board of directors, but Treasury presumably does not want to be in the business of managing AIG. I assume Treasury's primary motivation here is to get the amount of investment back, not to make money on behalf of US taxpayers. If that assumption were correct, you would think that Treasury would structure these securities to incentivize quick redemption at a low cost. The obvious way to do that would be to charge a high rate of interest (10%?) and provide for a low redemption price (in this case, the liquidation perference plus unpaid dividends). Seems to fit.

The technical problem with this analysis is that AIG cannot redeem the preferred stock if Treasury controls AIG -- i.e., "direct[s] the management and policies of AIG" -- "whether through the ownership of voting securities, by contract, by the power to control AIG?s Board of Directors or otherwise." Treasury will certainly have substantial control rights by contract, even if not what one might expect in a private deal. Perhaps Teasury does not "direct the management and policies of AIG"? It seems unlikely that this argument would ever arise, even if AIG recovered and were able to pay dividends in perpetuity, because Treasury would not be likely to resist a redemption, whenever it came along.