Font Size:

Much has been written about the American International Group, Inc., having run a risky credit default swap business out of its London office. That shop insured all sorts of financial products and bet that the bill would never come due. When it did, the company nearly crashed, and it has been a ward of U.S. taxpayers since last autumn.

What's less well known is that, during this period, the global insurer was operating under the supervision of a U.S. Department of Justice-imposed monitor, whose job was to keep the company out of securities trouble.

Obviously, it didn't work. Indeed, AIG's fall calls into question the efficacy of the entire corporate monitor program and leaves legal experts mulling over this conundrum: Are there some companies that are just too big to watch?

AIG's criminal woes go back to 2000, when for three years its financial products unit was creating ways to help another company move some losing assets off its balance sheet. During roughly the same period, AIG was booking a fake reinsurance deal with another company and altering its own financial records to look better than they were. In 2004 the feds forced AIG to sign a deferred prosecution agreement accepting responsibility for the financial products scam, and demanded that the company take on a corporate monitor to police its compliance. For that role, AIG hired Bryan Cave partner James Cole in early 2005. One of his duties was to oversee the company's new financial transactions committee.

When the government later discovered AIG's fake reinsurance deal, it forced the company in 2006 to sign a nonprosecution agreement. This time the feds expanded Cole's role to supervise reforms to its corporate compliance and financial reporting.

But the government's plan failed miserably. Right under Cole's nose, AIG again undertook high-risk transactions--and within the very financial unit that Cole was first appointed to oversee. AIG's high-stakes gamble on credit default swaps not only drove the company to the edge of financial collapse but also helped to undermine the nation's--and the world's--economic stability.

In essence, the swaps are a type of insurance sold to cover losses on securities in the event of a default. Unlike insurance, they are not regulated and are not required to have specific reserves to pay the buyers, making them more like private bets. And AIG, in the parlance of poker players, "went all in." When the housing bubble burst in 2007, home mortgagers started defaulting in record numbers, and the stock market plunged. AIG couldn't cover its bet.

Since then, the world's largest insurer has undergone major changes. It accepted nearly $180 billion in taxpayer bailouts, hired a chief executive officer to join a new general counsel hired earlier, began to restructure its business, and turned over 80 percent of its shares to the government.

What's more, the company sits on a unique hot seat, with what CEO Edward Liddy calls "unprecedented" supervision by the Federal Reserve Bank of New York and the U.S. Treasury.

Now the company's practices are under investigation by the Justice Department, the Securities and Exchange Commission, Congress, and others.

All of AIG's problems raise another inevitable question: What was the monitor doing while the company foundered?

No one in a position to know would comment on the record. But Corporate Counsel spoke with dozens of current and former federal prosecutors, ex-monitors, banking attorneys, and AIG sources to get a sense of just what went wrong. They say Cole filed periodic reports with federal agencies and sculpted a nice compliance model. Problem is, the model just didn't work for AIG. It's as though Cole were spackling cracks in the compliance walls and never noticed that AIG's financial foundation was crumbling beneath his feet. Part of any good compliance program, says one attorney and ex-monitor, who asked not to be named, is accurately assessing a company's risk. Cole's plan apparently didn't.

What's more, sources say that Cole's compliance plan couldn't address every facet of what Liddy has called "the incredibly complex entity" that is AIG.

The company has so many financial tentacles into major businesses and institutions around the world that former Treasury secretary Henry Paulson, Jr., deemed it "too big to fail." It has more than 4,000 legal entities, cross-ownership, and "myriad special-purpose structures" in 133 countries, according to Liddy's May 13 testimony before the House Committee on Oversight and Government Reform, which is holding hearings on the AIG collapse.

Cole, a former prosecutor in the Justice Department, didn't return repeated calls and e-mail messages. But some current and former federal prosecutors, as well as some experts on Wall Street, suggest that he was simply in over his head. In Cole's defense, people who know him say that he is a decent man and savvy lawyer who worked very hard to set AIG right. And they say that monitors are constrained by the terms of the company's prosecution agreements. Cole was trying to stamp out securities fraud at AIG. "And no one," one attorney who requested anonymity adds, "ever said that credit default swaps were securities fraud."

Now, by all accounts, the government advisers have pushed the monitor aside as they work with Liddy, chief restructuring officer Paula Reynolds, and general counsel Anastasia "Stasia" Kelly to revamp the company. Part of this restructuring, according to plans filed with the SEC, includes shutting down the troublesome financial products unit that Cole could never quite bring under control.

The legal history of AIG under former CEO Maurice "Hank" Greenberg suggests that as a company it was fond of illusion. Its first pretrial prosecution agreement involved pretending that it was capitalizing a special entity when in fact it wasn't. The second involved the fiction that it had booked a multimillion-dollar reinsurance deal when in fact it hadn't. The credit default swaps scheme entailed pretending that it had the reserves to cover them, when in fact it didn't.

In its 2008 10-K report to the SEC filed this March, AIG cited a lack of financial controls in the financial products unit and a failure of internal communication. The report admitted that as of December 31, 2007, the company "did not maintain effective controls over the fair value of the [financial unit's credit default swaps] portfolio and oversight thereof." The report also stated that "the timely sharing of information [about the process] at the appropriate levels of the organization did not operate effectively."

In fairness to Cole, the first two securities fraud issues occurred before he was on board. But the credit default swaps risk worsened while he was there. Should he be blamed for that? Or should Justice's monitor program--which once again appointed an exfederal prosecutor rather than a financial expert, and which apparently told Cole to focus broadly on compliance rather than root out the risky and illusionary ventures?take some of the blame?

Attorney Joshua Hochberg, who negotiated the first Justice Department agreement with AIG when he was chief of the criminal fraud section in Washington, D.C., defends the monitor program. Hochberg, now a partner at McKenna Long & Aldridge in Washington, D.C., says he can't talk about the AIG case specifically. But in general he says, "The biggest issue of any monitorship is to ensure that whoever the monitor reports to has enough expertise to make use of the information."

It is possible that Cole was reporting AIG's risky behavior to government officials who either ignored it or didn't understand what happened. A more definitive answer could come from Cole's contract or his monitor reports to the SEC and Justice. But so far neither the public nor Congress has been allowed to see them. The House Oversight Committee is threatening to subpoena them at this writing. (Corporate Counsel has filed a Freedom of Information Act request for the reports.) U.S. representative Edolphus "Ed" Towns, a Democrat from Brooklyn and chair of the House Oversight Committee, wrote Attorney General Eric Holder about the importance of seeing the reports. "Mr. Cole had a seat at the table. . . . We believe that review of these reports is critical for Congress to better understand how AIG became financially crippled," Towns wrote, "and in assessing whether taxpayer dollars are being properly used." The Justice Department says that it is considering Towns's request.

One person who could shed more light on what Cole was doing at AIG is Ernest Patrikis, who served as general counsel from 1998 to 2006. But he's not talking, and now works at White & Case in New York. Stasia Kelly, who replaced Patrikis in 2006, continues to work with Cole until he leaves in November. But she also declined to comment about his work. Formerly general counsel at MCI WorldCom Communications, Inc., where she first dealt with a prosecution agreement and a monitor, Kelly describes AIG's situation as "WorldCom on steroids" [see "In the Hot Seat Again." ].

But knowing what Cole did or failed to do has significant ramifications beyond one company. In fact, the AIG fiasco bolsters mounting concern that the monitor model itself may be badly broken.

One person who believes that there should be an investigation of the AIG monitoring experience is U.S. representative Bill Pascrell, Jr. (D-New Jersey). If government doesn't closely examine the issue, he says, then the Justice Department's failures at AIG will only be repeated elsewhere. "How can people have faith in the justice system when they see that?" he asks.

Pascrell is cosponsoring a House bill to place more controls on corporate prosecution agreements and the use of monitors.

Pascrell first began questioning Justice about its nonprosecution deals and use of monitors over a year ago. That was when Christopher Christie, then U.S. attorney in New Jersey, appointed his former boss, exattorney general John Ashcroft, as a federal monitor with fees of up to $52 million. In response, the department promulgated internal guidelines for choosing corporate monitors, but the move did not silence critics.

What should happen next with the concept of corporate monitors is being widely debated. In fact, prosecution agreements and the use of monitors were the focus of a conference entitled "Regulation by Prosecutors" in May at New York University's Center on the Administration of Criminal Law. The keynote speaker was James Comey, general counsel at Lockheed Martin Corporation and ex-U.S. deputy attorney general. Comey emphatically defends nonprosecution agreements and monitors, saying that they were especially needed in the post-Enron era to address public outrage. "Our mission then was to change the organization," he said, an objective best achieved, he believes, by supervised reform.

All well and good, countered another congressman, U.S. representative Frank Pallone, Jr., at the conference, but let's hold the monitors accountable.

Pallone, a Democrat from New Jersey and cosponsor of the House bill on monitors, complained about the lack of transparency. "We don't know why specific monitors are selected, or how they are selected, or how their fees are determined," he argued.

For example, government advisers reportedly were shocked when they heard what AIG was paying Cole. While the company won't disclose the amount, one source put it at tens of millions of dollars--and The Wall Street Journal recently reported he has received about $20 million so far. From the few monitor payments on public record, that is not an unusually high sum.

Richard Epstein, an outspoken law professor at the University of Chicago School of Law, argues that the threat of indictment forces corporations to "capitulate to anything," including the high monitor fees. He calls the use of deferred prosecution agreements and monitors "the wrong model. It presupposes the legitimacy of a process at which you [the CEO] negotiate with a gun put to your head."

Complicating the debate is how prosecutors can oversee a company in which the United States is the major stakeholder, as it is at AIG. Epstein questions the government's role in companies like AIG. "We have a system where the party is a proprietor on one hand and the regulator on the other.

That's an inherent conflict of interest," he says.

So what can be done? On the securities side, President Barack Obama has called on Congress to impose regulations on derivatives like credit default swaps. On the monitor side, the House Judiciary subcommittee on commercial and administrative law is holding hearings on Pascrell's bill, dubbed the Accountability in Deferred Prosecution Act of 2009.

The bill would take the selection of federal monitors out of the hands of U.S. attorneys and place it with federal judges, who would maintain oversight of the company. It also would require full disclosure of agreements by placing the text of the prosecution deals on a public Web site, including the terms, compensation, and conditions of any monitor contract.

Using the already overworked federal courts is not such a good idea, says Hochberg, the former prosecutor. He argues that Justice may be better equipped than any judge to supervise a company because "it already knows all the relevant facts and the parties." He also says that there's an ongoing debate over whether corporations should be prosecuted at all, and whether holding individuals responsible for bad acts might be more effective.

Other U.S. attorneys are avoiding pretrial prosecution agreements and corporate monitors altogether, and have taken companies to court. For example, the U.S. attorney in Houston reached a plea deal with BP Products North America, Inc., a unit of British oil giant BP Plc, on charges stemming from a 2005 explosion that killed 15 workers at a Texas refinery. BP pled guilty in court on March 11 and agreed to pay a $50 million fine?the largest criminal environmental fine ever. The company also accepted three years on probation, to be overseen by the court and not a corporate monitor.

Hochberg, though, doesn't think charging companies is the right answer. "Am I trying to cause a company to change policies and become a good corporate citizen? Then the use of nonprosecution agreements by government is a more efficient way to do that," he argues. "If prosecutors had to indict and try every corporate case, it would be logistically impossible."

Comey would probably agree. But he also encourages the debate. Recalling the intense public pressure on government to reform renegade corporations in the Enron era, Comey said, "It's still present today, in spades. And I can't imagine a topic any more important right now."

Subscribe to Corporate Counsel