The decision issued Monday by U.S. District Judge Paul Engelmayer in Manhattan was a ringing endorsement for broad central bank power to try to preserve the global financial system from systemic threats.
It was also a defeat for Greenberg, 87, and his Starr International Co. Before the bailout, AIG had been the world's largest insurer by market value and Starr was its largest shareholder with a 12 percent stake.
Starr accused the New York Fed of engineering a "backdoor" bailout for Wall Street banks at the expense of AIG shareholders by forcing the insurer to unwind its bets on mortgage debt through hundreds of billions of dollars of credit default swaps.
It also accused the central bank of breaching duties to shareholders under the law of Delaware, where New York-based AIG is incorporated.
But Engelmayer said AIG acted out of "corporate desperation" in accepting the $182.3 billion bailout.
He also rejected Starr's having likened the New York Fed to a "loan shark" for providing an initial $85 billion credit line at a 14.5 percent interest rate.
"Merely because the AIG board felt it had 'no choice' but to accept bitter terms from its sole available rescuer does not mean that that rescuer actually controlled the company," Engelmayer wrote.
The judge also found nothing to suggest that AIG directors who approved the unwinding of the swaps were "in any way less than 100 percent independent."
Starr and Greenberg sued over the bailout last November, and are still suing the New York Fed in the U.S. Court of Federal Claims in Washington, D.C., under different legal theories.
NO OPTIMAL SOLUTION
Robert Dwyer, a partner at Boies, Schiller & Flexner who represents Greenberg, said Starr may appeal Engelmayer's decision to the 2nd U.S. Circuit Court of Appeals in New York. He said the decision will not affect the Washington, D.C. case.
Greenberg's office had no immediate comment.
The New York Fed said in a statement: "We are pleased with the Court's decision to dismiss this case, which we have always believed to be without merit."
Richard Epstein, a professor at New York University School of Law, said the ruling was not surprising because the New York Fed could not be held legally responsible to always craft perfect solutions in times of crisis.
"It's just too much to demand of anybody that in the face of all these kinds of turmoil, you come up with the optimal solution when no one is clear about what the optimal solution is," he said.
AIG was bailed out on September 16, 2008, one day after Lehman Brothers Holdings Inc went bankrupt, as losses soared from the credit default swaps.
Greenberg, who led AIG for nearly four decades before he was ousted in 2005, accused the New York Fed of wasting more than $60 billion of AIG and taxpayer funds through the bailout.
He said the rescue terms improperly benefited banks such as Goldman Sachs Group Inc, Deutsche Bank AG and Societe Generale, allowing favored counterparties to be repaid in full and freed from legal liability.
Greenberg also said the central bank improperly let the U.S. Treasury take a 79.9 percent stake in AIG without giving a vote to existing shareholders who would be diluted. The government stake has since fallen to about 15.9 percent.
At the time of the bailout, Henry Paulson headed the U.S. Treasury Department, while his successor, Timothy Geithner, had been president of the New York Fed.
Engelmayer found that the central bank appropriately exercised its authority to try to preserve the banking system, reduce the threat of "grave national and international financial repercussions," and minimize losses to the public.
"While driving a hard bargain with the counterparties might have saved AIG and its shareholders money, (the New York Fed)could reasonably conclude that its statutory mission of stabilizing the economy made speed and closure a top priority," he wrote.
"It could reasonably conclude that it was time for the cycle of collateral calls and mammoth rescue loans to end; that the stability of the U.S. economy required decisively terminating AIG's exposure to counterparties; and that paying par value -- as opposed to opening up a bazaar of uncertain and maybe protracted negotiations with counterparties -- was the best means to attain such closure."
Engelmayer also said Delaware law should not be used to impose duties on the New York Fed that "squarely conflict" with the central bank's federal responsibilities.
He dismissed Starr's claims "with prejudice," meaning they cannot be brought again.
In the case before the Court of Federal Claims, which handles lawsuits seeking money from the government, Starr said the AIG bailout deprived shareholders of their due process and equal protection rights through an illegal "taking" of property.
The presiding judge, Thomas Wheeler, in July allowed Starr to pursue that lawsuit.
Shares of AIG were up 60 cents, or 1.9 percent, at $32.40 in morning trading on the New York Stock Exchange. They have lost more than 97 percent of their value since credit conditions began to tighten in the middle of 2007.
The cases are Starr International Co v. Federal Reserve Bank of New York, U.S. District Court, Southern District of New York, No. 11-08422; and Starr International Co v. U.S., U.S. Court of Federal Claims, No. 11-00779.
(Additional reporting by Lauren Tara LaCapra; Editing by Martha Graybow, Gerald E. McCormick, Maureen Bavdek and Grant McCool)