How to stop AIG's bonuses

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NEW YORK (Fortune) -- Everyone wants to know and, today, President Obama has tasked government lawyers with figuring it out: How can we stop AIG from paying more than $165 million in bonuses that it claims it is contractually obligated to pay employees of its financial products unit - the very unit that was responsible for taxpayers having had to spend $170 billion to bail out that company?

Here's one possibility - with a proviso at the end.

One tack would be to invoke a controversial doctrine called "unconscionability." In extremely rare circumstances, judges will invoke this doctrine to refuse to enforce outrageously one-sided - in other words, unconscionable - contract terms, even though the parties entered into those terms knowingly and voluntarily. If the judge concludes that fulfilling the contract's provisions would "shock the conscience," or some similar formulation, he might be empowered to refuse to enforce them.

Courts are understandably reluctant to use the doctrine because it runs contrary to the whole premise of contract law - the notion that courts should not second-guess contracts written by competent adults. Any exception threatens to swallow the rule.

Nevertheless, the doctrine has been used, for instance, to nullify exceedingly onerous consumer credit contracts. To take a famous law-school example, suppose an appliance store agrees to sell someone a blender on credit, but the person defaults. Then suppose that, under the terms of the borrower's contract, the store is entitled not only to repossess the blender, but also to repossess everything else the buyer has ever purchased from that appliance store in the past - including, say, the borrower's refrigerator, TV, vacuum cleaner, and dishwasher.

Then suppose, further, that the borrower can't claim not to have understood the terms of the contract, because he'd already seen that same appliance store repossess a string of items from his next-door neighbor under identical circumstances. In that situation, courts have - notwithstanding the fact that both parties were adults and knew exactly what they were doing - struck down such terms as unconscionable.

So, suppose today the government were to go to a federal court and ask it to cancel AIG's contracts as unconscionable under the absolutely extraordinary circumstances we have here, in which the taxpayers, due to an unprecedented bailout, are paying the company's obligations, and they are allegedly being asked to pay the very people whose mammoth blunders brought about the bailout in the first place. There would be little danger of creating a precedent here that would come back to haunt us, since mammoth federal bailouts are, by definition, rare.

(Note that if taxpayers hadn't bailed AIG (AIG, Fortune 500) out, and it had fallen into bankruptcy, bankruptcy judges would have had broad powers to nullify the debtor's contracts where necessary to achieve the equitable results for creditors.)

Here's the big note of caution. For the sake of argument, I've been assuming that the populist assumptions about what AIG is trying to do here are correct. They might not be.

If and when a judge were to look closely at the precise contract terms involved, that judge might conceivably find that, for instance, most of the people getting the bonuses were, in fact, not the same people truly responsible for the catastrophe; that, in helping wind down the unit, they were providing an invaluable service to taxpayers that no one else was qualified to perform; and that they stayed on to perform that service only because of the contract terms they were offered.

These details have yet to come out, and they are the sorts of things that a judge would, thankfully, have available to him before making a decision.

That said, I personally think that once a company is bailed out by taxpayers, its officers are basically government employees. I don't know any government employees who get $3-million-plus bonuses, which is what at least seven AIG financial products officers reportedly stand to receive if these contracts can't be stopped.