Friday, March 20, 2009

Bushido Culture, AIG Bonuses, Wall Street and Accountability

"Your Highness, if you believe I am your enemy. Command me. And I will gladly take my life." - Tom Cruise in "The Last Samurai"

Senator Chuck Grassley needs to take a refresher course in Japanese culture. Hara-kiri, ritualistic suicide, common amongst samurai warriors in feudal Japan's Bushido culture, pretty much died out a while back. In addition, Bushido is associated with seven virtues, these being: Gi (Rectitude), Yu (Courage), Jin (Benevolence), Rei (Respect), Makoto (Honesty), Meiyo (Honor), and Chugi (Loyalty), all of which are an anathema to Wall Street culture.

While it's true, that after World War II, business employees followed something similar to Bushido Code, where company loyalty was considered extremely important, businessmen did not commit hara-kiri when they failed to uphold company policy, they simply resigned their positions.

So, back to reality. Behind the scenes, as outrage over AIG bonuses grow, investigators are in looking into whether there are grounds for criminal prosecution — not just in the AIG case, but across the broad spectrum of Wall Street and corporate America. Why? Well, in the case of AIG, the reason is that AIG agreed to dole out millions of dollars in bonuses, early last year, despite multi-billion dollar losses, that either they knew about, or should have known about.

Yesterday, in response to a subpoena, documents received by Connecticut attorney general, Richard Blumenthal, show over $218 million, paid out in AIG bonuses. From that total, "at least $1 million were paid to 73 people, and five received more than $4 million."

How much did AIG know at the time that they made this decision? How will we find out? Well, the CEO of every publicly traded company is required to make a statement to the shareholders, every quarter, and as the economy worsens, it becomes more difficult to remain positive without, giving false testimony. However, if it's found that, there is a huge discrepancy between what’s been said in private conversation, emails, etc. and what's been said to shareholders, the CEO opens himself up for prosecution which could result in civil fraud, and possibly even criminal fraud, if the company goes into bankruptcy.

According to Roger Parloff, senior editor at Fortune magazine, author of the article, Wall Street: It's Payback Time, the head of the financial products unit, a.k.a., credit default swaps, made a statement that he did not see how they could lose a dollar on their portfolios back in 2007 and 2008. As it turns out, even if the bonds do not default, which many have not, the threat, of default, alone, is enough to require AIG pay out billions of dollars in order to secure the other party's interest. In and of itself, that is enough to destroy the company.

Post Enron and Serbian Oxley, the US Sentencing Commission created more severe punishments under the federal sentencing guidelines for white-collar offenses, which in this case, includes anything from ordinary stock fraud to insider trading to "Bernie Madoff" sized ponzie schemes. Federal sentencing guidelines for securities fraud links the length of a prison term to the size of the size of the financial loss to the public.

So, we're talking life sentences, here, because CEO’s - most of whom are in their 50s or 60s - of publicly traded corporations who engage in some type of crime involving securities fraud, can face up to a life sentence if financial losses are $2.5 million or higher. In today's market, that 's pocket change.

What about the contract obligations that Larry Summers claims are sacred? Why can't we call into question, the validity of these contracts? It's extremely likely that these contracts were induced via fraud, or that fraud was committed by the employees receiving bonuses.

Michael H. Trotter, in his article, AIG and taxpayers' money, brings up some very interesting points regarding “insurable interest” and the legality of the contracts involved:

However, the more important issue is what is AIG doing with the credit default swaps (CDSs) it issued to purchasers that did not have an “insurable interest” in the debt insured? These purchasers without an insurable interest don't lose anything except the “premium” they paid when they bought their swap, but they stand to make a lot of money on the gamble they have taken. An excellent case can be made that these CDSs unrelated to insurable interests are void as a matter of public policy for the same reason “Joe Doe” can't take out an insurance policy on my life. The rule of law should be and probably is: “No loan, no loss to insure.”

If we permit hedge funds or other gamblers to take out CDSs on the debt of a public company, it gives the gamblers an incentive to kill the company that issued the debt. This can be done in a variety of ways including short-selling (why hasn't the Securities and Exchange Commission reinstated the up-tick rule?), spreading of rumors and saying nasty things about a company's products or services, and none of this is in the public interest. The voiding of these contracts would greatly reduce the size of the CDS problem and the problems at AIG. Has either the new management of AIG or our Treasury Department even considered the possibilities?

What would be the amount of AIG's credit default swap obligations if all of the contracts without an insurable interest were canceled? We have been told that the face amount of these contracts outstanding greatly exceed the amount of debt outstanding to be insured. That tells us that well over half of AIG's obligations on these contracts are likely to be unenforceable, which would greatly reduce AIG's financial obligations. For instance, the newspapers report that Goldman Sachs has been one of the principal beneficiaries of the CDS payments to date. Goldman Sachs seems an unlikely candidate to have loaned large amounts to companies that have been unable to pay it back, especially in light of its bets on the decline of the collateralized debt obligation market.

We need to know how much money has been paid by AIG to the owners of credit default swap contracts without an insurable interest and to whom it has been paid.
Are credit default swaps insurance? Almost certainly! If the debt you insured goes bad, you are entitled to collect the amount of loss you have insured from a third party that issued the policy. The investment and legal geniuses who dreamed up this product went to great lengths to camouflage it to avoid regulation under the insurance laws. Hence we have credit default swaps instead of insurance policies and we have counterparties instead of insureds, but the end result is the same.

As to the enforceability of the bonuses paid to the employees of AIG's Financial Products division, there is an excellent column by Professor Lawrence A. Cunningham of the George Washington University Law School in the March 18, 2009, edition of The New York Times that sets forth the legal issues and theories that should be considered. Among the issues to be considered are the performance of each employee under his or her contract, grounds to terminate the employee for cause, did the employee withhold important information for the employer, did the employee commit fraud, and is AIG functionally insolvent? The government should have insisted that the bonuses be withheld until all of these issues could have been properly addressed in a court of law.


ezrider,  20:03  

Our financial crisis will not be remedied by putting a few fools in jail. That's the republican's answer to everything: throw people in jail, increase the penalties for wrongdoing, and create scapegoats so that the public has targets to focus their anger. Meanwhile, the overall problem is overlooked and real reform and systemic overhaul never happens.

Not that we should let these fools off the hook or anything, but that we should not let the prosecution mentality take over at the expense of real reform.

The Real AIG scandal 22:37  

The AIG bonuses, although infuriating, are a drop in the bucket. When such a big issue is being made of a relatively small amount of money, the reason is usually to distract us from a much bigger issue or an astronomical amount of money.

Anonymous,  09:54  

Didn't you get the message?
The Senator was just kidding.

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