Yes, We Can Get Back the AIG Bonuses

03/19/2009 1:29 pm EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

The $165 million in “retention” bonuses paid to employees of American International Group’s notorious Financial Products unit have sparked a tidal wave of protest and spread panic among lawmakers and government officials in Washington, DC.

But lost among all the scapegoating and finger pointing on both sides of Pennsylvania Avenue are some simple facts about what we can do to recover the money for furious taxpayers.

In a nutshell, the retention bonuses were unnecessary, contracts are not sacred, the government has a clear legal path to challenge the bonuses, and taxing the bonuses after the fact is a very, very, very bad idea. 

Let’s first recap, briefly, what led to where we are now. Last year, AIG executives signed contracts with employees of the unit that created and sold credit default swaps and other toxic derivatives that almost brought down the global financial system last fall.

Those contracts authorized “retention” bonuses if the employees stayed in their posts through March.

Their mission, as chief executive officer Ed Liddy told a House subcommittee Wednesday: wind down their “book of business” to reduce AIG’s exposure to the toxic slime these geniuses had concocted.

The lucrative derivatives products business, based in London, was launched in 1987 under longtime chairman and CEO Maurice Greenberg. Booted in 2005 in the wake of then-New York Attorney General Eliot Spitzer’s investigations of accounting practices and other issues at AIG, Greenberg now tells all who will listen that none of this would have happened on his watch.

Whatever. But the reckless risk AIG took on by selling credit default swaps—a form of insurance that paid off when various instruments defaulted—threatened to bring down the insurer after the demise of Lehman Brothers last September.

Within days, the federal government started a series of cash infusions and loans that reached $170 billion, making AIG a far bigger ward of the state than either Citibank (NYSE: C) or Bank of America (NYSE: BAC). The US now owns slightly less than 80% of AIG.

The bonuses reportedly came to the attention of Treasury Secretary Timothy Geithner on Tuesday, March 10th. He says he spoke with CEO Liddy the next day and demanded they be renegotiated. AIG made some small changes, but began paying out the bonuses last Friday. Everybody claims their hands were tied.

For instance, Liddy testified before Congress that paying bonuses to these people was necessary to prevent much bigger losses if untrained hands had to unwind these complex positions (a line of reasoning John Gapper in the Financial Times called “internally logical but ludicrous”).

But as the Washington Post reported

Thursday, most of the heavy lifting already had been done by last December: AIG had whittled down its exposure to only $13 billion, from $78 billion, and what was left was pretty manageable. Oh, and by the way, 11 of the AIG employees who got the biggest payouts took the money and ran for the hills. So much for “retention.” (Liddy told Congress that AIG requested employees return half of the money, and some already have given back all of it.)

Also, everyone’s been saying that the government can’t violate the sanctity of a contract. That was what President Obama’s top economic adviser Lawrence Summers told ABC’s George Stephanopoulos last week.

“We are a country of law.  There are contracts.  The government cannot just abrogate contracts,” he said.

Two leading experts on securities law with whom I spoke both had the same response: rubbish.

“This ‘sanctity of contracts’ stuff is a red herring,” says Professor James A. Fanto of Brooklyn Law School.

And Professor Tamar Frankel of Boston University School of Law calls the idea that contracts are sacred “nonsense.”

Both point out that in the real world, businesses and individuals break contracts and fight it out in court all the time. Some use the threat of litigation to settle disputes or extract better deals. For some companies, it’s just part of doing business.

“There’s a lot of negotiating around the edges,” says Professor Fanto.  “I find it disingenuous to say [we can’t do anything].”

And in this case, it would have been AIG, not the government, who “broke” the contract—under pressure from the government, its controlling shareholder!

And there lies our real leverage: As a shareholder of AIG, the government has legal standing to challenge the payouts.

“The government is now a shareholder, so corporate law allows shareholders to sue directors of the corporation for corporate waste,” says Professor Frankel. “Maybe they violated their fiduciary duties.”

“You can’t take other people’s money and be generous with it,” she explains. “There is a limit to how many gifts you can give even under contract…when the company is going down the drain.”

Would that hold up in court? “I think my argument about gifts would stand,” she says.

So, the government can sue AIG and we might even win. AIG then would have to recover the bonus money from its employees. But at least we taxpayers might get some of our money back.

And it certainly would be a better route than the bill in the House of Representatives authorizing an ex post facto 90% tax on the AIG  bonuses, which might be technically legal but has to be one of the dumbest things ever proposed in Congress—and that’s saying a lot. Why use the tax code to punish individuals when there are other ways available? It might set a terrible precedent, too.

Meanwhile, New York Attorney General Andrew Cuomo has begun investigating AIG while his probe of bonuses paid to Merrill Lynch employees in the weeks before its acquisition by B of A moves forward.

Professor Fanto thinks New York state’s tough Martin Act, a 1921 law which Spitzer wielded successfully against Wall Street firms earlier this decade, might be a formidable weapon for the ambitious Cuomo, too. But remember, the Spitzer investigations were  huge embarrassments for the Securities and Exchange Commission and the federal government.

President Obama has repeatedly expressed outrage about these bonuses and has told Secretary Geithner to find ways to recover the money. But the President seems to believe the government has bigger things on its plate—like resuscitating the economy and rescuing the banking system.

Maybe so, at least in dollar terms, but I think he would be making a big mistake if he underestimated the American public’s desire to see the government at least try to get the bonus money back. If he chooses to just ride out this storm, he may find himself reaping the whirlwind.

Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own.

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