Please read the American International Group (AIG) and the Bonus Fiasco (Case 6)

What unethical business practices have you personally encountered? 

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What steps would you take as leader of the organization to prevent this behavior? 

Please read the American International Group (AIG) and the Bonus Fiasco (Case 6) in the textbook as we discuss this subject.

Case 6: American International Group and the Bonus Fiasco*

After two decades of rapid growth and expansion in an environment of very little regulatory oversight and unbounded optimism about the power of the markets to create limitless wealth, the U.S. financial system came crashing down in the second half of 2008. What started as a sudden decline in housing prices after years of speculative growth very soon snowballed into a full-fledged financial crisis. Major banking companies such as Citicorp and Bank of America found their equity base wiped out by loan losses. Investment banking firms such as Merrill Lynch and Bear Stearns, which operate largely outside the regulatory framework of the Federal Reserve, were in even bigger trouble because they were highly leveraged. Fearing a complete financial meltdown, Henry Paulson, secretary of the Treasury in the Bush administration, announced a bailout package of $750 billion on September 16, 2008, to restore confidence in the banks and to jump-start the credit markets.

What exactly does the government do in a bailout? A bailout can take many forms. For example, the government can buy stock in a troubled institution, thus shoring up its equity base.

The very fact that the government has an equity stake may be taken as an implicit government guarantee by creditors, suppliers, and clients because concerns about solvency and ability to stay in business are assuaged. Alternatively, the government can extend a loan to the institution, to be paid back when the company becomes profitable again. Another approach is for the government to buy preferred stock in the company. In this case the government is entitled to a fair return on the investment. Finally, the government can buy distressed assets of the institution, thereby helping it to clean up its balance sheet. Irrespective of the form of the bailout, all bailouts represent a temporary or, in some cases, long-term commitment of public money to private companies.

As the economic crisis gathered momentum and the credit markets came to a standstill in the fall of 2008, it became clear that banks were not the only institutions in trouble. American International Group (AIG), one of the largest and most respected insurance companies in the world, found itself in even bigger financial distress in September 2008 when the rating agencies suddenly lowered its credit rating. Not only did this cause the cost of borrowing to go up for AIG, but it also triggered the requirement that the company post collateral with its counterparties. Unable to do so, AIG approached the government for a bailout. In the next few months, the government pumped an astounding $85 billion into AIG alone to prevent it from going bankrupt. Insurance companies are generally supposed to be risk-averse and prudent. How did AIG get into such a big mess?

The primary culprit for the problems of AIG was a somewhat exotic financial product called credit default swaps (CDSs). In simple terms, these swaps represented an insurance cover to holders of mortgage-backed securities: If the value of the securities went down, AIG would make good the losses suffered by the owners. In good times, when real estate prices were climbing steadily each year, the CDSs were pure profits for AIG. Emboldened by what it perceived as negligible risk and motivated by the prospect of ever-increasing profits, AIG sold hundreds of billions of dollars’ worth of these instruments. Although insurance is a business regulated by the states, these products were outside the range of regulation.

Right from the beginning, there was considerable controversy about whether the government should try to bail out any failing firm in a market economy. Even those who were not ideologically opposed to the bailout were skeptical whether the government efforts would be enough to save the company. There were also concerns about how the company would spend the bailout money.

Immediately after the first bailout was announced, AIG attracted considerable negative press when it was reported that AIG executives attended a lavish retreat in California that featured spa treatments, banquets, and golf outings. Total tab: $444,000. Immediately thereafter, AP reported that AIG executives spent $86,000 on a luxurious English hunting trip.1 This was only days after the Fed had extended a $37.8 billion loan on top of the $85 billion mentioned earlier. The company’s response: “We regret that this event was not canceled.”2

In March 2009, it was disclosed that AIG had paid $218 million in bonus payments to employees of the financial services division, the very division that was responsible for issuing the credit default swaps that got the firm into trouble. Overall, 418 managers were the beneficiaries of these “retention” bonuses, although 53 of them were no longer with the company! The highest bonus was $6.4 million. Six managers received more than $4 million each, and 51 people received between $1 million and $2 million.

The announcement of these bonuses sparked instant outrage among the public. President Barack Obama accused the company of “recklessness and greed.” Noting that AIG had “received substantial sums” of federal aid, the president announced that he was asking Treasury Secretary Timothy Geithner “to use that leverage and pursue every legal avenue to block these bonuses and make the American taxpayers whole.”3 Andrew Cuomo, New York State’s attorney general, threatened to subpoena the executives and engage in a “name and shame” campaign C15C16by making the list of bonus recipients public.4The House even passed a bill that effectively imposed a punitive 90 percent tax on the bonuses.5

At the same time, there were others who felt that the payments represented contractual obligations and therefore populist sentiments should not be allowed to violate the sanctity of contracts. Many of the employees felt that they had every right to receive the payments they were promised and worked for. Their feelings were best expressed in the following resignation letter sent by Jake DeSantis, an executive vice president of the American International Group’s financial products unit, to Edward M. Liddy, the chief executive of AIG.

  • Dear Mr. Liddy:It is with deep regret that I submit my notice of resignation from A.I.G. Financial Products. I hope you take the time to read this entire letter. Before describing the details of my decision, I want to offer some context:I am proud of everything I have done for the commodity and equity divisions of A.I.G.-F.P. I was in no way involved in—or responsible for—the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.-F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage.After 12 months of hard work dismantling the company—during which A.I.G. reassured us many times we would be rewarded in March 2009—we in the financial products unit have been betrayed by A.I.G. and are being unfairly persecuted by elected officials. In response to this, I will now leave the company and donate my entire post-tax retention payment to those suffering from the global economic downturn. My intent is to keep none of the money myself.I take this action after 11 years of dedicated, honorable service to A.I.G. I can no longer effectively perform my duties in this dysfunctional environment, nor am I being paid to do so. Like you, I was asked to work for an annual salary of $1, and I agreed out of a sense of duty to the company and to the public officials who have come to its aid. Having now been let down by both, I can no longer justify spending 10, 12, 14 hours a day away from my family for the benefit of those who have let me down.You and I have never met or spoken to each other, so I’d like to tell you about myself. I was raised by schoolteachers working multiple jobs in a world of closing steel mills. My hard work earned me acceptance to M.I.T., and the institute’s generous financial aid enabled me to attend. I had fulfilled my American dream.I started at this company in 1998 as an equity trader, became the head of equity and commodity trading and, a couple of years before A.I.G.’s meltdown last September, was named the head of business development for commodities. Over this period the equity and commodity units were consistently profitable—in most years generating net profits of well over $100 million. Most recently, during the dismantling of A.I.G.-F.P., I was an integral player in the pending sale of its well-regarded commodity index business to UBS. As you know, business unit sales like this are crucial to A.I.G.’s effort to repay the American taxpayer.The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money. I did, however, like many others here, lose a significant portion of my life savings in the form of deferred compensation invested in the capital of A.I.G.-F.P. because of those losses. In this way I have personally suffered from this controversial activity—directly as well as indirectly with the rest of the taxpayers.I have the utmost respect for the civic duty that you are now performing at A.I.G. You are as blameless for these credit default swap losses as I am. You answered your country’s call and you are taking a tremendous beating for it.But you also are aware that most of the employees of your financial products unit had nothing to do with the large losses. And I am disappointed and frustrated over your lack of support for us. I and many others in the unit feel betrayed that you failed to stand up for us in the face of untrue and unfair accusations from certain members of Congress last Wednesday and from the press over our retention payments, and that you didn’t defend us against the baseless and reckless comments made by the attorneys general of New York and Connecticut.My guess is that in October, when you learned of these retention contracts, you realized that the employees of the financial products unit needed some incentive to stay and that the contracts, being both ethical and useful, should be left to stand. That’s probably why A.I.G. management assured us on three occasions during that month that the company would “live up to its commitment” to honor the contract guarantees.That may be why you decided to accelerate by three months more than a quarter of the amounts due under the contracts. That action signified to us your support, and was hardly something that one would do if he truly found the contracts “distasteful.”That may also be why you authorized the balance of the payments on March 13.At no time during the past six months that you have been leading A.I.G. did you ask us to revise, renegotiate or break these contracts—until several hours before your appearance last week before Congress.I think your initial decision to honor the contracts was both ethical and financially astute, but it seems to have been politically unwise. It’s now apparent that C16C17you either misunderstood the agreements that you had made—tacit or otherwise—with the Federal Reserve, the Treasury, various members of Congress and Attorney General Andrew Cuomo of New York, or were not strong enough to withstand the shifting political winds.You’ve now asked the current employees of A.I.G.-F. P. to repay these earnings. As you can imagine, there has been a tremendous amount of serious thought and heated discussion about how we should respond to this breach of trust.As most of us have done nothing wrong, guilt is not a motivation to surrender our earnings. We have worked 12 long months under these contracts and now deserve to be paid as promised. None of us should be cheated of our payments any more than a plumber should be cheated after he has fixed the pipes but a careless electrician causes a fire that burns down the house.Many of the employees have, in the past six months, turned down job offers from more stable employers, based on A.I.G.’s assurances that the contracts would be honored. They are now angry about having been misled by A.I.G.’s promises and are not inclined to return the money as a favor to you.The only real motivation that anyone at A.I.G.-F.P. now has is fear. Mr. Cuomo has threatened to “name and shame,” and his counterpart in Connecticut, Richard Blumenthal, has made similar threats—even though attorneys general are supposed to stand for due process, to conduct trials in courts and not the press.So what am I to do? There’s no easy answer. I know that because of hard work I have benefited more than most during the economic boom and have saved enough that my family is unlikely to suffer devastating losses during the current bust. Some might argue that members of my profession have been overpaid, and I wouldn’t disagree.That is why I have decided to donate 100 percent of the effective after-tax proceeds of my retention payment directly to organizations that are helping people who are suffering from the global downturn. This is not a tax-deduction gimmick; I simply believe that I at least deserve to dictate how my earnings are spent, and do not want to see them disappear back into the obscurity of A.I.G.’s or the federal government’s budget. Our earnings have caused such a distraction for so many from the more pressing issues our country faces, and I would like to see my share of it benefit those truly in need.On March 16 I received a payment from A.I.G. amounting to $742,006.40, after taxes. In light of the uncertainty over the ultimate taxation and legal status of this payment, the actual amount I donate may be less—in fact, it may end up being far less if the recent House bill raising the tax on the retention payments to 90 percent stands. Once all the money is donated, you will immediately receive a list of all recipients.This choice is right for me. I wish others at A.I.G.-F.P. luck finding peace with their difficult decision, and only hope their judgment is not clouded by fear.Mr. Liddy, I wish you success in your commitment to return the money extended by the American government, and luck with the continued unwinding of the company’s diverse businesses—especially those remaining credit default swaps. I’ll continue over the short term to help make sure no balls are dropped, but after what’s happened this past week I can’t remain much longer—there is too much bad blood. I’m not sure how you will greet my resignation, but at least Attorney General Blumenthal should be relieved that I’ll leave under my own power and will not need to be “shoved out the door.”Sincerely,Jake DeSantis

Liddy was clearly in an unwinnable situation. On the one hand, the politicians and the press were pillorying him for authorizing lavish bonuses while the company was essentially on welfare payments from the taxpayer. On the other hand, his own employees were upset at him that he was pandering to the politicians by describing these contractual payments as “distasteful.”