9 - AIG – a Greek tragedy ‘Wickedness’ of the wicked.pdf

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8 Int. J. Critical Accounting, Vol. 2, No. 1, 2010

Copyright © 2010 Inderscience Enterprises Ltd.

AIG – a Greek tragedy ‘Wickedness’ of the wickedand the ‘mischief’ of the virtuous

Abraham J. Briloff and Leonore A. Briloff*

Suite 1600, 274 Madison Avenue, New York, NY 10016, USAFax: 212-533-6292E-mail: [email protected]*Corresponding author

Biographical notes: Abraham J. Briloff is Baruch College’s Emanuel SaxeDistinguished Professor of Accountancy. He is a Board Member of the

International Journal of Critical Accounting and a regular contributor ofarticles to the journal. He was once described by Professor George Foster(Stanford University) as the most famous accountant in the world. Foster wasreferring to the impact of Briloff’s articles, published in the bi-weekly

Barron’s , that dissected the financial statements of the corporate clients of thethen Big 8 accounting firms.

Leonore Briloff is a CPA who practices in New York City. She has been along-term supporter of Baruch College and has been in the vanguard advancingthe cause of small accounting practitioners.

Maurice ‘Hank’ Greenberg is ‘wicked’, at least as seen by the Attorney General of theState of New York. That is so because Greenberg is accused of being responsible for anextensive array of accounting distortions providing false and misleading financialstatements of American International Group, the highly esteemed and successfulinsurance enterprise that Greenberg helped create and headed for some 40 years.

Even before the attorney general’s charges were proved to be just, Greenberg hadalready fallen and suffered a nexus of ‘desserts’. Among them:

• He was ousted peremptorily by the board of directors of his corporation.

• He found it prudent to resign from the many philanthropic and cultural organisationsof which he was a director.

• He found it advisable to ‘plead the Fifth’ when asked to testify.

• He found it desirable to transfer $2 billion of AIG stock to his wife to insulate thatfund from the reach of creditors. (This transfer was later reversed.)

• He was toppled from his pedestal in the pantheon of the great leaders of business andfinance of the 20th and 21st centuries.

In fact, the Greenberg saga is much like a Greek tragedy, along the lines of Oedipus.Thus, both Greenberg and Sophocles’ tragic hero were struck down at the moment whentheir power and glory were at their highest. But there is a difference, one that is invidious,



AIG – a Greek tragedy 9

thus: Oedipus was afflicted with his critical flaw by the gods at the moment ofconception. Greenberg’s affliction was self-induced, i.e., hubris.

But this essay is less to probe the wickedness of Greenberg than to probe themischief, which the very virtuous are responsible for, in the years of false and misleadingfinancial statements by AIG. Therefore, I will consider principally the important avenueof the alleged accounting distortions, i.e., related to the use and abuse of reinsurancearrangements.

First, a brief tutorial regarding reinsurance arrangements, transactions that are ofspecial interest to this commentary.

Reinsurance arrangements between insurer and reinsurer are formal agreementsregularly negotiated at the very highest levels of the parties to the undertakings.Understandably so! These arrangements involve hundreds of millions of dollars of risktransfers between the insurer and reinsurer.

So formal and elaborate are the resultant contracts that they are frequently referred toas ‘reinsurance treaties’. Thus, they are not run-of-the-mill contracts like property andcasualty insurance policies.

So I turn to the nexus of Bahamian reinsurance entities that AIG created and utilisedto pick up its liabilities and/or losses while endeavouring to avoid the inclusion of thesenegatives in its consolidated financial statements. This illicit practice we now recogniseas the kind sparkling with the ‘Enron cachet’.

The practices and procedures were spelled out in a 2 May 2005, civil complaintagainst Greenberg and chief financial officer Howard I. Smith.

Beginning at least in the mid-1980s, AIG set up several offshore entities for the purpose of reinsuring AIG and its subsidiaries. AIG has repeatedly misled regulatorsabout the nature of its relationships with these entities.

In 1987, AIG set up Coral Re, a Barbados-based reinsurer, for the purpose ofreinsuring AIG business. By 1991, AIG had purchased from Coral Re approximately$1 billion in reinsurance, although Coral Re had a capitalisation of only $15 million.

By the early 1990s, Coral Re had come under regulatory scrutiny from insurancedepartments in Delaware, New York and Pennsylvania. In 1995, the New York InsuranceDepartment raised concerns that AIG might control Coral Re. Pursuant to GAAPaccounting on a consolidated basis, if an insurer purchases reinsurance from areinsurance company that it owns or controls, the insurer cannot claim on its books areinsurance recoverable, i.e., protection against potential losses covered by thereinsurance, because the insurer is effectively reinsuring itself.

As a condition of resolving the New York Insurance Department’s examination, thedepartment mandated that AIG agree to stop purchasing reinsurance from Coral Re, andthat AIG would ‘report any reinsurer that has characteristics similar to Coral Re as anaffiliate reinsurer in future filings with state insurance regulators’.

At no time during the negotiations for the resolution of the Coral Re examination orthereafter did AIG disclose to the New York Insurance Department that it already hadtwo pre-existing offshore affiliates with ‘characteristics similar to Coral Re’.

In 1986, AIG had formed Richmond Reinsurance Co., a Bermuda holding companywith a Barbados reinsurance subsidiary similar to Coral Re, and having a similar purpose.And in 1991, AIG had formed Union Excess Reinsurance Co. Ltd., under a differentname, a Barbados reinsurer similar to Coral Re, also for a similar purpose. Although



10 A.J. Briloff and L.A. Briloff

there were minor variations, Richmond, Union Excess and Coral Re shared the following‘characteristics’:• they were created by AIG

• AIG found the investors and drafted all documents related to the initial capitalisation

• they were undercapitalised

• they had passive investors backed by AIG or its affiliates

• the management and administrative functions of each were performed by the sameAIG affiliate

• officers of the three offshore entities had numerous relationships with AIG and witheach other.

Cross examination

I will now put some questions to AIG’s legal counsel, thus:

• You were undoubtedly involved in the covenant to report ‘any reinsurer that hascharacteristics similar to Coral Re as an affiliate reinsurer in future filings with stateinsurance regulators’. Did you not deem it necessary to review AIG’s otherreinsurance arrangements at the time of the 1995 undertaking to see if there weresuch similar captive Bahamian subsidiaries?

• Did you proceed with due diligence subsequent to the 1995 covenant to determinewhether such captive enterprises were involved in the AIG reinsurancearrangements?

• Did you, from time to time, or as the reinsurance arrangements may have beenrenewed, request financial statements from Richmond and Union Excess todetermine whether they were, in fact, financially responsible for the very substantialliabilities that were being ceded to them by AIG?

• Did you consider your responsibility for making these judgement calls to restentirely with the financial people?

• If so, where was the system of internal control, of checks and balances?

• Finally, was AIG’s board of directors informed of the 1995 accord and covenant? Ifso, did you inform the board from year to year regarding AIG’s compliance with thecovenant?

I will then put the foregoing catechism to AIG’s auditors, both internal and external, butvery much more stridently. In addition, I would ask:

• In view of the fact that these off-shore, off-balance sheet enterprises had prevailedfor more than a decade, and in view of the amounts that were involved in these illicitactivities, how did the perversity which prevailed escape your attention and action?

• Going further, you were alerted to the perversity by the insurance regulators back in1995; should that not have served as a shrill signal that the internal controlsenvironment was seriously deficient?




• According to a March 2005 article in Barron’s , there were signals that indicated thatthere may have been some entangling alliances that prevailed between AIG andRichmond and Union Excess down in the Bahamas. According to the article, as ofthe end of 2003, AIG was carrying on its books $1.2 billion of reinsured lossesreceivable from Richmond and Union Excess, out of a total of $3.6 billion of suchassets owing to AIG by all offshore reinsurers. Why did not such indicators ofspecial arrangements lead to further probes by PricewaterhouseCoopers?

• Is it conceivable that you were distracted or diverted from that festering perversity bycharismatic management, or did you find it convenient or beneficial to avoid probingto see whether the perversity had metastasised?

In short, I just cannot comprehend a condition of that nature and magnitude festeringundetected by competent auditors, both internal and external, under the circumstanceshere alleged by the AG!

A definitive response to many of these questions should develop as a consequence ofshareholder litigation; for the present, only a hypothetical response is possible, based onexperience from various other accounting sagas.

The external independent audit firm is presently PwC, which was formed as the resultof the 1998 merger between Price Waterhouse and a second Big Six firm, Coopers andLybrand. Especially noteworthy in this regard is that Howard I. Smith, who was ousted asAIG’s CFO concurrently with Greenberg’s departure, and who is Greenberg’sco-defendant in the AG’s action, had devoted a score of years of his professional careerto C&L before joining AIG in 1984.

While at C&L, Smith had become the head of the firm’s insurance practice. So it isthat the erstwhile C&L executive moved to become an AIG executive, with his erstwhile

firm continuing to serve as AIG’s independent external auditor.Other forensic probes inform me that such corresponding, symbiotic relationshipsmay tarnish the independence of the external auditors. The incumbent auditors may lookwith awe on the extraordinary accomplishments of their erstwhile colleague; then, too,the incumbent auditors may sense that if they find favour with the AIG executive, whoknows but that they, too, might be tapped to join on the trail to AIG’s executive suite?

From the other direction, the new CFO might well be in possession of the audit program being followed by his erstwhile firm, permitting him to steer a course within thecracks.

And now I will provide a collateral series of questions directed to the accountingfirms, presumed to be other than C&L or PwC, responsible for the independent audit ofthe Bahamian enterprises:

• Did you, during the course of your audits, take note of the apparently incongruousrelationship between the liabilities on the books of these enterprises and theirshareholder equity?

• Did the foregoing relationships raise ‘going-concern’ questions for you? If not, whynot?

• During the course of your audits, did you observe the circumstances under whichyour clients were operating, e.g., their process of decision-making andadministration?




• Did you observe that the source for your clients’ business was essentially a singlesource, i.e., AIG?

• Assuming that you observed any of the foregoing or other corresponding incestuousrelationships implying a direct, more-than-casual involvement by AIG in yourclients, did you consider it your professional, ethical responsibility to advise AIG’sindependent registered auditors of your concern? If not, why not?

In short, the creation of offshore special purpose enterprises, where the independent auditresponsibilities are unhinged, should not leave the public unhinged or out on a limb!

Six guys from Chicago

As a coda to AIG’s Bahamian involvements, we have the Barron’s article noting the very

special circumstances that gave rise to the creation of Coral Re back in 1987.As the story goes, Goldman Sachs, acting as the financial intermediary (really as the‘panderer’, in this context), assembled six rich guys mostly from Chicago to become‘shareholders’. None had to ante up a cent; instead, the required capital contribution was

provided by a Japanese bank on a risk-free, non-recourse basis. Coral Re paid as adividend amounts equal to the interest requirements, and to leave something of a

pourboire for the six guys from Chicago assembled by Goldman Sachs. It appears thatthey accepted their desserts on what appears to have been a ‘don’t ask, don’t tell’ basis.

But then, I am left with the gnawing question: While the rich guys from Chicago werewilling to sell their identities for whatever fell into their laps, how do we justify the roleof Goldman Sachs?

So we are now led to Greenberg’s tour de force, in the Berkshire Hathaway GeneralRe/AIG Faustian bargain in late 2000.

According to Allegations 28ff of the AG’s complaint, on 31 October 2000, Greenberginitiated a scheme to falsely inflate AIG’s reserves for the next two quarters. The scheme

began that day when Greenberg called Ronald Ferguson, president of GenRe. In that call,Greenberg suggested that GenRe purchase up to $500 million in reinsurance from AIG,

because he wanted AIG to show increased reserves. But, in the same conversation,Greenberg also said that he wanted the deal to be risk-free. A riskless transaction thatcreates reserves is nonsensical. An insurer can properly generate and record reserves onlyif it is taking on genuine risk that there may be claims that would require future payment.Greenberg wanted AIG to be able to book hundreds of millions of dollars in reservesfrom GenRe, but he did not want there to be any risk that AIG would actually have to payany claims.

On or about 17 November 2000, according to the AG, Greenberg called Ferguson to

discuss the deal. Ferguson told Greenberg that he thought they had put together astructure that would accomplish Greenberg’s objectives. They also discussed the fact thatAIG would ‘not bear real risk’ in the transaction, and that, in the end, AIG would payGenRe a $5 million fee. Greenberg told Ferguson that defendant Smith and Milton wouldhandle the transaction on AIG’s end. Later that day, a GenRe employee e-mailed Miltonat AIG to provide details of the proposed transaction, along with a draft contract.

Ultimately, AIG’s subsidiary, National Union, and GenRe’s subsidiary, Cologne Reof Dublin, entered into two contracts. In form, GenRe was to pay a total of $500 millionto AIG, and AIG was to provide $600 million of reinsurance coverage. As a consequenceof this fiction, AIG would be able to show reserves of $500 million, in accordance with




Greenberg’s original design. The first of the sham contracts would allow AIG to book$250 million of reserves in the fourth quarter of 2000, and the second sham contractwould allow AIG to book another $250 million of reserves in the first quarter of 2001. Infact, GenRe did not pay premiums. And in fact, AIG did not reinsure genuine risk. To thecontrary, AIG paid GenRe $5 million, and the only genuine service performed by either

party was that GenRe created false and misleading documentation to satisfy Greenberg’sillicit goals.

The entire AIG/General Re transaction, the AG alleges, was a fraud.It was explicitly designed by Greenberg from the beginning to create no risk for either

party – AIG never even created an underwriting file in connection with the deal. Indeed,the true nature of the deal is clear if one follows the money: AIG paid GenRe $5 millionfor the deal – exactly the opposite of what would happen if AIG were actually taking on

potential liabilities from GenRe.

The June 2005 Securities and Exchange Commission criminal complaint againstGenRe executive John Houldsworth referred to a conference among the conspiratorsduring mid-November 2000, which includes some especially remarkable observations.

First, the conspirators note that, insofar as GenRe was concerned, the risk was only toits reputation.

More significantly, the conspirators were of the view that the real accounting problemwas with AIG. But even there, ‘there was no real risk’. That was because the paper trail

being developed should mislead the auditors, because the documentation would pass theauditors’ ‘smell test’ – as though PwC was serving as AIG’s independent olfactories.

Casting aside the conspiracy notion, the first smell test for good accountants demandsthat the auditors probe reinsurance arrangements to make certain that they require anappropriate transfer of risks from the ceding enterprise to the reinsurer. The Financial

Accounting Standards Board’s Statement of Financial Accounting Standards 113,Accounting and Reporting for Reinsurance, promulgated in December 1992, sets forth atParagraph 8 a provision especially relevant in this context:

“Indemnification against loss or liability relating to insurance risk. Determiningwhether a contract with a reinsurer provides indemnification against loss orliability relating to insurance risk requires a complete understanding of thatcontract and others or agreements between the ceding enterprise and relatedreinsurers. This understanding includes an evaluation of all contractual featuresthat (a) limit the amount of insurance risk to which the reinsurer is subject(such as through experience refunds, cancellation provisions, adjustablefeatures or additions of profitable lines of business to the reinsurance contract)or (b) delay the timely reimbursement of claims by the reinsurer (such asthrough payment schedules or accumulating retentions from multiple years).”

These risk-transfer provisions were pointed out especially by July 1993 promulgation byFASB’s Emerging Issues Task Force, when schemes that had been pursued by someinsurers in the wake of Hurricane Andrew were put in question.

In these instances, as with AIG and General Re, a paper trail was developed to meetthe smell test of reinsurance, but lacked the risk-transfer standard. That the auditor,confronted with a reinsurance arrangement, was constrained to probe the documentationmost circumspectly is pointed up by the following from the EITF: ‘A task force memberasked whether a contract could be split for purposes of evaluating risk transfer. A staffrepresentative responded that Statement 113 applies to ‘contract’, and that determiningthe substance of a contract is a judgemental matter. If an agreement with a reinsurer




consists of both risk-transfer and non-risk-transfer coverages that have been combinedinto a single legal document, those coverages must be considered separately foraccounting purposes’.

Accepting the allegations by the AG in his complaint, had the PwC auditors fulfilledtheir mission, they would have determined that there was no substance to the whole papertrail, other than the $5 million paid by AIG to General Re.

If, then, we accept the AG’s allegations regarding the absence of the flow of money,as well as the absence of an underwriting file, then the precondition to a valid reinsurancearrangement would not exist. Accordingly, I cannot see how the arrangements in questionwere acceptable to PwC as AIG’s independent auditor. And then, as noted, a priori, evenon a smell test basis, the arrangement should have emitted a disagreeable stench. It isespecially noteworthy that AIG did not create an underwriting file to reflect the presumedassumed risks under the arrangement with General Re. Then, too, assuming PwC was

able to somehow rationalise the arrangement with General Re, should they not havedeemed it appropriate, possibly even necessary, to discuss the contracts with AIG’sindependent audit committee?

If not, why not?But now my olfactories have put the whole transaction into question. Note that in the

typical reinsurance arrangement, the ceding party is the insurer, the insurance companythat finds that it has undertaken excessive risks in a particular context, so that it is willingto pay a premium to a reinsurer to be relieved of the risk burden.

The General Re/AIG arrangement turns that usual condition on its head, i.e., reinsurerGen Re was presumed to be paying a hefty premium to a direct-writing insurer (AIG) to

be relieved of some kind of risk.This very inversion of the typical arrangement should have sent the ‘smellers’

scurrying over to the underwriting files to see (rather than just smell) what kinds of riskswere being assumed by AIG. And, if you believe the AG, there was nothing to see,

probably also nothing even to smell.Remember, they were dealing with a transaction involving a half-billion dollars of

presumed premiums, and an even greater amount of risks presumed to have beenassumed by AIG.

More mischief

There is yet another manifestation of the ‘mischief of the virtuous’ that calls for commentat this point.

Accepting Warren Buffett as the exemplar of the highest standards of business ethics,and that it is those standards that he endeavors to sound as the ‘tone at the top’ at

Berkshire Hathaway, what is clear is that such a tone did not penetrate down into GeneralRe.

Accordingly, that failure must represent a serious disappointment to Warren Buffett,and to his fellow shareholders in Berkshire Hathaway.

But, then, what I find especially incomprehensible is that a bevy of General Reexecutives could have lent themselves to this Faustian bargain with AIG. Remember,there was naught but a panderer’s fee of a mere $5 million involved – paltry reward forthe risks of exposure undertaken by General Re and its executives.

I turn now to a consideration of the ‘mischief’ that might be attributed to AIG’sespecially virtuous independent audit committee. In this regard, a caveat included in the




committee’s report to shareholders included in the proxy material for the 2002 meeting,and essentially consistent with that included in the 2001 submission (relating to the 2001and 2000 financial statements, respectively), reads as follows:

“The role of the audit committee ... is to assist the board of directors in itsoversight of AIG’s financial reporting process. The board of directors, in its

business judgment, has determined that all members of the committee are‘independent,’ as required by applicable listing standards of the New YorkStock Exchange. ... As set forth in the audit committee’s charter, themanagement of AIG is responsible for the preparation, presentation andintegrity of AIG’s financial statements, AIG’s accounting and financialreporting principles and internal controls, and procedures designed to assurecompliance with accounting standards and applicable laws and regulations. Theindependent accountants are responsible for auditing AIG’s financialstatements and expressing an opinion as to their conformity with generallyaccepted accounting principles.”

In the performance of its oversight function, the committee has considered and discussedthe audited financial statements with management and the independent accountants. Thecommittee has also discussed with the independent accountants the matters required to bediscussed by Statement on Auditing Standards No. 61, Communication with AuditCommittees, as currently in effect. Finally, the committee has received the writtendisclosures and the letter from the independent accountants required by IndependenceStandards Board Standard No. 1, Independence Discussions with Audit Committees, ascurrently in effect, has considered whether the provision of non-audit services by theindependent accountants to AIG is compatible with maintaining their independence, andhas discussed with the accountants their independence.

It may well be that, given this abdication of responsibility by AIG’s audit committee,

the internal control system could be seen to have been lacking a critical ‘concentric ringof protection’, so that PwC should have been constrained to deny its certification of thecompany’s 2000 and 2001 financials.

We now have AIG’s Form 10-K for 2004, filed with the SEC on 27 May 2005, aswell as the company’s financial statements for the year sent to shareholders in mid-July,together with the proxy material in advance of the shareholders’ meeting scheduled for11 August 2005.

Each of these documents discourses extensively on the ‘internal examination’undertaken by the board of directors and management. This endeavour was described inthe report of the audit committee, as follows:

“In connection with the preparation of AIG’s annual report on Form 10-K forthe year ended Dec. 31, 2004, AIG’s current management initiated an internalreview of AIG’s books and records, which was substantially expanded inmid-March 2005. The review was conducted under the direction of seniormanagement with the oversight of the audit committee, and was complemented

by investigations by outside counsel for AIG and for the audit committee.PricewaterhouseCoopers LLP, AIG’s independent registered public accountingfirm, was consulted on the scope of the internal review as well as on the results.

This review culminated in the restatement of AIG’s financial results [for theyears 2003, 2002 and 2001], a delay in AIG filing its annual report on Form10-K for the year ended Dec. 31, 2004, and its quarterly report on Form 10-Qfor the quarter ended March 31, 2005, and the conclusion that there wereseveral [sic!] material weaknesses in AIG’s internal control over financialreporting.”




• evaluating alternative approaches, ensuring that hedge accounting requirements aremet

• enhancing controls over deferred tax reporting.

In my view, the changes thus wrought should have been in place as a matter of courseyears ago; thus, the supposed ‘new controls’ are of the kind that Coopers & Lybrand,even without Price Waterhouse, should have made certain were in place years before theserious deficiencies surfaced as a consequence of the prodding from the attorney general.

In short, the forensic probe of AIG should not have been implemented pursuant torules of engagement determined by AIG’s board and PwC; instead, they were, in myview, conflicted, and accordingly should have recused themselves. As already noted, anindependent forensic probe should have been pursued with appropriate vetting by thePublic Company Accounting Oversight Board.

Putting aside my impeachment of the manner in which the pathological probe of the past was initiated, implemented and concluded, we now know that there was a litany ofserious deficiencies in the application of accounting principles and the application ofauditing standards, as well as failures in the implementation of appropriate control

procedures. In fact, the aberrations and deficiencies were so serious as to require theactual restatement of previously certified financial statements.

Given that condition, how did AIG’s virtuous management and independent auditcommittee respond to the dismal past, insofar as it may have involved PwC – AIG’slongstanding independent registered public accountant? Incredibly, as I see it!

Nearly 40 years ago, Justice William O. Douglas honoured me by providing aforeword to my The Effectiveness of Accounting Communication (Praeger, 1967); thatessay concluded with the following foreboding:

“The author demands an understandably high price of the attesting accountant,who is preparing himself to fulfil this essential role. He expects him to undergoa ‘ritualistic purging’ and to forego the rewards that may be derived from therendering of management services and the other ‘peripheral services’ that hedescribes.

The burdens that Mr. Briloff puts upon the profession are substantial, but, as hedemonstrates, our economic society is in urgent need of this service. If theaccounting profession does not respond effectively to the challenges presented,there may be little alternative but to have possibly a new profession fill the

breach.”

AIG and the recurrent accounting fiascos du jour make clear that Justice Douglas’challenge to the accounting profession is still extremely appropriate – even more so.

Despite prodding from the Congress, regulators, investors, the securities industry andthe media, our leadership has succeeded in transmuting our profession into an industry,our professional organisations into trade associations.

How might we respond?As Justice Douglas observed, the circumstances might call for ‘possibly a new

profession’. Until then, I have suggested in testimony before FASB, the US Senate, andthe SEC that we consider aborting the requirement that the financial statements of

publicly owned enterprises be subject to independent audits by CPAs, and proclaimcaveat emptor.




Is there yet time for an epiphany, a rededication and recommitment to the objectivesand ideals of the profession of certified public accountancy?

Acknowledgements

I am grateful to Professor Eric Neubacher of the Baruch College Newman Library for hisvital role in ferreting out the material and data required for this critique. I am mostappreciative to Moyee Huei-Lambert, Cary Lange and Leonore Briloff for their importantassistance in the processing and editing of successive drafts of this writing over the fourmonths of its gestation.

9 - AIG – a Greek tragedy ‘Wickedness’ of the wicked.pdf

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