With AIG’s blush-inducing announcements this weekend, hackles are raised and chokehold government steps threaten.  After the company simultaneously disclosed both egregious compensation packages and staggering sums in collateral payments, counterparty risk and the need for due diligence have new meaning.  Reported as separate issues, compensation and collateral payments are anything but.  They are joined together not only by the stimulus of public ire, but also by a more fundamental legal interplay, which raises issues from fraudulent conveyance to fiduciary duty to failure to regulate.  As if AIG alone wasn't big enough, the issues at play are even bigger -- sweeping in a broad range of both companies and their legal underpinnings.

It’s hard to focus on anything but the numbers – not only because they are so large, but also because AIG’s business is so densely complicated, and thus the details of its alleged offenses are as well.  However, look past the numbers and you quickly see that the problems surrounding AIG (this week) are fundamentally legal problems, mandating legal analysis and legal mechanisms to solve them.  The issues range from Congressional Troubled Asset Relief Program (TARP) mandates to collateral obligations and from fraud to failure to regulate. 

As background for anyone hiding from the news this weekend, AIG recently announced $165 million in incentive bonuses and over $22 billion in collateral-related payments.  Further, the U.S. government has, reportedly, been aware of AIG’s collateral obligations, bonus plans, and credit default swap (CDS) exposure for months.  In addition, the CDS market itself, was far from covert or untraceable.   The list of blue chip U.S. companies disclosing CDS risk couldn’t arrive in richer shades of blue: IBM, Loews, and General Electric are among the operating companies disclosing their involvement, while financial players aplenty AMBAC Financial Group, Genworth Financial, Hartford Financial Services Group, J.P. Morgan, and Citigroup disclosed the same.

The ability to recover funds rests on an understanding of AIG’s contracts, as AIG’s announcements result from two forms of contractual obligation that AIG (and many others) have: executive compensation arrangements and collateral obligations, both of which rested on trigger events or “flip-ins”.  Succinctly put, barring contractual slip-ups, once the trigger event happened, the payments become obligatory, unless one of the following can be found: clawbacks, contractual exceptions or terminations, or contract-undermining fraud.  From the reported contract terms, these are difficult claims to make.

While much of the focus has been on the bonuses, even larger issues, detailed below, surround the payment of fees relating to credit default swap arrangements.  These payments take two forms – posting collateral on them or paying counterparties to cancel outstanding contracts.  Per existing swap agreements, AIG had to post $22.4 billion in collateral where the underlying investments were downgraded.  From a legal perspective, AIG had entered into credit default swaps, structured by a form of trading agreement that required posting of large amounts of collateral, in the event (thought unlikely at the time) that AIG or the insured securities suffered credit rating downgrades.  Apparently, with its proudly burnished Triple-A rating, AIG thought it was safe… but it wasn’t, and large payments had to be made to trading partners as the credit environment worsened.  With reported amounts going to, among others, Goldman Sachs ($2.5 bn), Merrill Lynch ($1.8 bn), Deutsche Bank ($2.6 bn) and Societe General ($4.1 bn), legal questions swirl. 

These issues don’t just relate to AIG…or the U.S. taxpayer.  While AIG is, seemingly, the biggest offender, other players on both sides of credit default swaps and, perhaps, of financial trades overall, risk being affected by moves the government makes this week.  Look no further than the many companies which have recently disclosed involvement in the CDS marketplace (some of which are noted above) to recognize the exposures.  As well, other investors own stakes in AIG apart from the U.S. government – and any claims the government makes may be copied (or super-charged) by private actors. New law, and possibly lawsuits, may quickly follow.

Sweeping policy eggshells result from all of this.  Take the money back on some government-specific grounds, and your risk lawsuits around illicit government takings.  Take the money back on broader claims of fraud, fiduciary duty or failure of the flip-in, and you set broad precedent that risks broad shareholder and creditor lawsuits.  The latter precedent could affect many companies, both financial and operating, who engage in either incentive-driven compensation practices, credit default trades (on either side), or flip-ins or all of the above…that is, all companies.

Among the questions being asked are those relating to TARP, fraudulent conveyance, and fiduciary duty.  From a TARP perspective, the payment of funds to foreign banks rankles.  Some have made noise about whether and how to recover these funds – and this issue may get further play, whether raised directly by the government or indirectly by plaintiff lawyers…or both.   In particular, with the latest bailout of AIG coming out of TARP-proper (provided by the Treasury Department), TARP rules may apply – and one of the foundational rules there was that no foreign bank could receive TARP funds.

Fraudulent conveyance, and fraud more generally, give rise to a second set of concerns.  In particular, plaintiffs’ lawyers acting on behalf of shareholders (who still own 20% of AIG) or creditors may assert fraudulent conveyance claims around payments.  While tough to argue about all payments described above, two classes of claim may emerge: the first, surrounding payments to foreign banks (arguably invalid under TARP) and the second surrounding bonus payments.  While the recipients may claim to be third party beneficiaries, different legal theories may yet require them to disgorge.

Fiduciary duty concerns also come to rest here, with different fiduciary responsibilities applying. First, the board’s perceived breach of its fiduciary duty to shareholders may give rise to direct or derivative suits by shareholders. Second, though, if the company turns out to have entered into the “zone of insolvency” (and it’s just reported $61 billion loss may put it squarely in that zone), the board may have fiduciary duties to its creditors.  These groups include both the U.S. government (in dual roles of shareholder and creditor) and other private actors.

Parties may seek legal recovery, though the likelihood of their success is questionable. As one example, NY Attorney General Andrew Cuomo is now getting involved, particularly on the issues of the troubling bonus payments, using his broad powers under the Martin Act.  This New York State law gives the New York Attorney General the power to fight financial fraud by prosecuting any sort of scheme to defraud for the purpose of gaining money or property through false representations.  He’s using this same tool to challenge the payment of bonuses by Merrill Lynch in its waning hours, covered previously by Legal Currents. While it may feel good to bring a fight of this magnitude, the case may be tougher to win, in part because the U.S. government, as 80% shareholder and massive creditor, acknowledges being aware of the bonuses for months. 

Arguably, none of this would have gone so far if the government had played its hand differently – i.e. less government funds, but more government regulators.  Why did regulators stay away? Not that this is any excuse, but CDS were launched with a regulatory shell game, in which their underlying contracts were structured to keep all of the potential regulators at arm’s length.  Potential regulators could have included, in the U.S., the SEC, CFTC, and state insurance regulators, while in the U.K., the Financial Services Authority (FSA) was a natural.  The market, though, saw them for what they were, leading to a vast, speculative market that includes both the swaps themselves and entire market-wide indices (e.g., CDX, LCDX and iTraxx, among others) developed around them.

Public offense is caused not only by the head-spinning sums at issue, but also by the sheer temerity of it all.  Recovery steps are possible, but give rise to yet another form of risk: litigation risk.  While the government may be pressed on its claims here, private shareholders and creditors are not.  In a form of gift to plaintiff’s lawyers, the government is highlighting all the disclosure failures by AIG over the last number of months (if not longer) and is essentially inviting lawsuits that run the risk of placing the U.S. taxpayer even further on the hook than they already are. 

Published: March 17, 2009