In 1789, as the inchoate American government was climbing out of the mountainous debt left over from the Revolutionary War, a thorny political problem emerged. While most of the chattering class was consumed with the debate over whether the states’ war debt should be federalized, another far more visceral controversy arose. Because the Continental Congress lacked funds during the war, the Revolution was funded partly by wealthy private citizens who invested in bonds. As a result of the lack of governmental money, many American soldiers were given worthless IOUs at the end of the war, as states scampered for a way to give the patriots their back pay. Many of these soldiers panicked, and sold their IOUs to speculators for as little as fifteen cents on the dollar. The problem was, once the federal government began repaying the debt, the value of the bonds soared. So who should get the money: the patriots who fought bravely for their country and only sold the IOUs because of fear they would get nothing from their government, or the speculators?
The answer for many populists was easy—the veterans should not be swindled by greedy money men. However, Treasury Secretary Alexander Hamilton knew that the price of the government breaking a contract was far more costly to a young nation’s character than the ephemeral outrage that many veterans felt. As Hamilton told President Washington, “[t]he general rules of property, and all those general rules which form the links of society, frequently involve in their ordinary operation particular hardships and injuries. Yet the public order and the general happiness require a steady conformity to them. It is perhaps always better that partial evils should be submitted to than that principles should be violated.”
Because history has a way of repeating itself, it should come as no surprise that the debate over contract rights versus populist sentiment has returned with a vengeance. The first sign of trouble came last March when President Obama urged Congress to sever the retention bonuses owed to several AIG derivative traders. The outrage was understandable: AIG had gone belly up and was only kept afloat by the public dole. However, the retention bonuses were agreed to before the TARP bailout; abrogating them would violate a clear contractual obligation.
This did not stop some members of Congress from seeking to pass a Bill of Attainder to recoup the bonuses via the tax code. Congressman Barney Frank even threatened AIG CEO Edward Liddy with a subpoena if Liddy did not hand over the names of the AIG employees who received the bonuses. Just what, pray tell Congressman, did you intend to do with those names?
Not to be outdone on the outrage meter, Republican Senator Charles Grassley stated “I would suggest the first thing that would make me feel a little better toward them [the AIG executives] is if they follow the Japanese example and come before the American people and take that deep bow and say, ‘I am sorry,’ and then either do one of two things: resign or go commit suicide. And in the case of the Japanese, they usually commit suicide.” Goodness.
But the low moment came in May during the Chrysler bankruptcy proceedings. The Obama administration was attempting to spare Chrysler from bankruptcy court by selling Chrysler’s assets to a new company owned by the United Auto Workers (UAW) and Fiat. The only problem for the administration was that a group of plucky Chrysler bondholders refused to sell their assets on the grounds that they could get a better deal in bankruptcy court. Because these bondholders were secured creditors, they were entitled to first priority under bankruptcy law rules. These bondholders rightly pointed out that they owed their shareholders the fiduciary duty to hold out for the best deal possible.
But bankruptcy court would have been bad for the UAW (as it was a junior creditor), so the Obama administration brought out the brass knuckles. Thomas Lauria, the attorney for the group of bondholders, stated that his clients were threatened by the Obama administration into taking a haircut. For a brief moment, it appeared as if the bondholders would fight it out in court, but eventually they relented in the face of governmental pressure. Lauria said that his clients decided against a legal battle once they concluded they could not “withstand the enormous pressure and machinery of the U.S. government.” Bankruptcy Judge Redfield T. Baum quipped that the bondholders had about as much of a chance of winning against the federal government as “the gentleman in Tiananmen Square when the tank came rolling in.”
As we dig ourselves out of the Great Recession, investors must cope with an additional risk: the threat of government abrogation of legal rights for political reasons. Even Warren Buffet bemoaned the Chrysler situation: “If we want to encourage lending in this country, we don’t want to say to somebody who lends and gets a secured position that the secured position doesn’t mean anything.”
Russell Kirk once noted that “[u]pon the foundation of private property, great civilizations are built.” Ignoring these rights is how they fall.