A federal judge in Manhattan has dismissed a $25 billion lawsuit filed by Starr International, an insurance company run by former American International Group CEO Maurice “Hank” Greenberg, against the Federal Reserve Bank of New York over its 2008 bailout of AIG.

Southern District Judge Paul Engelmayer (See Profile) yesterday rejected Starr’s arguments that the bailout was an illegal takeover of multinational insurance company AIG and a “backdoor bailout” for other financial firms that did business with it.

The lawsuit, Starr International v. Federal Reserve, 1:11-cv-08422, was filed last November on behalf of AIG’s shareholders (NYLJ, Nov. 22, 2011). Starr, which owned about 12 percent of AIG, alleged the Federal Reserve effectively took control of AIG and then breached its fiduciary duty to shareholders under Delaware law by taking a two-thirds stake in residual profits from AIG’s credit default swaps and forcing AIG to pay its counter-parties in full even when they offered concessions, among other conditions.

Credit default swaps are insurance policies on structured debt offerings, such as mortgage-backed securities. As issuer of such policies, AIG agreed to make the buyer, or counter-party, whole if the insured security failed to perform—for example, if the underlying mortgages in a mortgage-backed security defaulted.

AIG began issuing credit default swaps in 1998. The company’s credit default swap business picked up sharply in 2005 with the rise of subprime mortgage-backed securities, but by December of that year, AIG decided that credit default swaps on subprime mortgage-backed securities were too risky and stopped issuing them.

Also in 2005, Greenberg stepped down as CEO amid probes into irregular accounting.

In September 2008, following the collapse of the housing market and ensuing financial crisis, AIG found itself unable to honor its credit default swaps. On the verge of bankruptcy, it appealed to the Federal Reserve Bank of New York for help. The Federal Reserve offered AIG an $85 billion credit facility, secured by AIG’s assets, in exchange for common stock in AIG with about 80 percent voting rights in the company. The Federal Reserve later extended AIG an additional $37.8 million in credit.

According to Starr’s suit, AIG tried to reduce its liabilities by negotiating settlements of its credit default swaps with its counter-parties. However, the suit says, the Federal Reserve refused to allow AIG to complete these negotiations, even when counter-parties offered concessions, and forced AIG to pay the counter-parties the face value of the credit default swaps. This amounted to a “covert backdoor bailout” for those counter-parties, Starr alleged.

Starr further alleged the Federal Reserve forced through a reverse stock split without the approval of AIG’s shareholders in order to take its 80 percent voting share.

Starr claimed the Federal Reserve effectively took control of AIG and that it therefore took on a fiduciary duty to AIG’s shareholders under the law of Delaware, which governs AIG’s charter.

‘Corporate Desperation’

Engelmayer ruled that Starr’s arguments failed because Starr had not shown that the Federal Reserve actually controlled AIG. He said the suit described not a takeover but “a moment of corporate desperation, in which AIG’s Board grabbed the sole lifeline extended to the company.”

He added, “By Starr’s logic, 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.”

Engelmayer further ruled that Delaware law could not apply to the Federal Reserve Bank because the bank is a federal instrumentality “entrusted with responsibility for maintaining the stability of the financial system” with “specific powers to be deployed when the economy is in difficulty.”

Starr’s suit also alleged the bailout violated the takings, due process and equal protection clauses of the U.S. Constitution, though it abandoned those claims in the New York lawsuit and is pursuing them in a separate suit in the Court of Federal Claims in Washington, D.C. That suit, which is in the discovery stage, also seeks $25 billion.

Although they were abandoned, Engelmayer addressed the merits of those claims, writing that “there is no private cause of action for damages arising from an alleged deprivation of these rights against either federal agencies.”

Engelmayer dismissed the entire suit with prejudice.

Boies, Schiller & Flexner partner Robert Dwyer, an attorney for Starr, said in an email that Starr is considering an appeal to the U.S. Court of Appeals for the Second Circuit.

Federal Reserve spokesman Jack Gutt said in an email, “We are pleased with the court’s decision to dismiss this case, which we have always believed to be without merit.”

John Kiernan of Debevoise & Plimpton represents the Federal Reserve.