Accountants Missed AIG Group's Red Flags
May 31, 2005 (washingtonpost.com) For years, PricewaterhouseCoopers LLP gave a clean bill of financial health to American International Group Inc., only to watch the insurance giant disclose a long list of accounting problems this spring.
But in checking for trouble, PwC might have asked the audit committee of AIG's board of directors, which is supposed to supervise the outside accountant's work. For two years, the committee said that it couldn't vouch for AIG's accounting.
In 2001 and 2002, the five-member directors committee, which included such figures as former U.S. trade representative Carla A. Hills and, in 2002, former National Association of Securities Dealers chairman and chief executive Frank G. Zarb, reported in an annual corporate filing that the committee's oversight did "not provide an independent basis to determine that management has maintained appropriate accounting and financial reporting principles."
Further, the committee said, it couldn't assure that the audit had been carried out according to normal standards or even that PwC was in fact "independent."
While the distancing statement by the audit committee is not unprecedented, the AIG committee's statement is one of the strongest he has seen, said Itzhak Sharav, an accounting professor at Columbia University. "Their statement, the phrasing, all of it seems to be to get the reader to understand that they're going out of their way to emphasize the possibility of problems that are undisclosed and undiscovered, and they want no part of it."
Language in audit committee reports ran the gamut during those years as an economic downturn loomed and many committees rushed to add some kind of disclaimer. Some companies included the full disclaimer found in AIG's proxy; these included such blue-chips as Goldman Sachs Group Inc. and Wachovia Corp. -- but also WorldCom Inc. and other companies that later encountered big problems. Many other companies -- Lehman Brothers Holdings Inc. and Morgan Stanley, among them -- included milder disclaimers that merely said committee members relied on management and outside auditors for accurate information.
Still others -- including McDonald's Corp. and insurer Aon Corp. -- went in the opposite direction and took on more responsibility.
"There were definitely some that went closer to saying, 'Don't blame me,' as opposed to saying, 'This is the process,' " said Patrick S. McGurn, a senior vice president at the Rockville proxy advisory firm Institutional Shareholder Services. "I think that probably should set off more red flags as the language got stronger."
AIG's audit committee's disclaimer has found its way into a 224-page lawsuit filed by Ohio's attorney general accusing AIG of securities fraud and alleging that PwC disregarded key warning signs and, as a result, repeatedly issued "false and misleading" audit reports of the insurer's books.
The complaint says that PwC knew of or "recklessly disregarded" myriad "illegal" and "improper" accounting maneuvers, including the $500 million so-called finite reinsurance transactions with General Re in 2000 and 2001 that have since drawn the scrutiny of regulators.
"We cannot comment on client matters; however, that sort of proxy language was not uncommon pre-Sarbanes-Oxley [Act] and in fact was then used by many other large companies," said David Nestor, a spokesman for PwC. "Auditors would not have seen this as a 'red flag' or a scope limitation, as the board's proxy language simply described what was and what was not the responsibility of its audit committee at that time. Auditors also would not have been surprised to see that descriptive language change after the passage of the Sarbanes-Oxley Act in 2002." The act was designed to make executives responsible for their companies' accounting.
Michelle Gatchell, a spokeswoman for Ohio Attorney General Jim Petro, said the office is awaiting "more details about PwC's involvement" when AIG issues its thrice-delayed 2004 annual report, which the company says will appear by May 31 and which will include a restatement of financial results dating to 2000. This spring, AIG said it would cut its net worth by $2.7 billion, or more than 3 percent, because of a series of irregularities and mistakes.
It's an awkward moment for PwC, a global giant with more than 120,000 employees in 144 countries, which has sought to market itself as an arbiter of corporate governance. In the wake of the Enron bankruptcy, for instance, PwC chief executive Samuel A. DiPiazza Jr. co-wrote a book, "Building Public Trust," on how to improve public companies' financial reporting.
Like other major accounting firms, PwC has had a few run-ins with regulators. PwC paid $5 million to Securities and Exchange Commission regulators in 2002 for violating independence standards by engaging in business deals with audit clients between 1996 and 2001. The firm also agreed to pay the SEC $2.4 million, without admitting or denying wrongdoing, for its audits for Warnaco Group Inc. in 2004. And a PwC partner, Richard Scalzo, in 2003 agreed to a lifetime ban from auditing public companies to settle an SEC case stemming from problems at Tyco International Ltd.
Now its nearly 30-year relationship with AIG is undergoing examination. Although law enforcement sources have said PwC is not a target of any criminal investigation, the SEC has subpoenaed documents related to its work with AIG, and plaintiffs' lawyers are going through PwC's audit reports with a fine-toothed comb. Some investors and analysts say PwC has some explaining to do.
"They said everything was okay all these years," said Alain Karaoglan, an analyst with Deutsche Bank. "Now, they know everything wasn't okay. We, as investors, do rely on accountants. . . . They ought to have caught some of that stuff."
Others say the current criticism of AIG's accounting -- and PwC's review -- is a case of Monday morning quarterbacking. Dean P. Phypers, a former AIG director, said longtime AIG chief Maurice R. "Hank" Greenberg, who was forced out in March, and the company's external auditor are victims of changing standards.
"He paid more attention to internal controls, and insisted they had good internal controls, than anybody I ever worked with," said Phypers, who left the board in 1999. "If they now suddenly don't have good internal controls, either they now have new rules or everybody's lost their mind."
The relationship between PwC and AIG stretches back decades to when the firm still was called Coopers & Lybrand, before its 1998 merger with Price Waterhouse. Former AIG finance chief Howard I. Smith, who left the company earlier this year under pressure for failing to cooperate with regulators, spent almost two decades as an auditor at Coopers before joining AIG in 1984. Steven Bensinger, AIG's new chief financial officer, also started his career at Coopers & Lybrand.
In the lawsuit filed earlier this spring in U.S. District Court in Manhattan, Petro, the Ohio attorney general, alleges that PwC's independence was "impaired" by these long-standing ties and by nearly $137 million in audit and consulting fees it received from AIG between 2000 and 2003. The fees were for audit-related services, as well as for tax consulting and accounting help. The suit, for which class-action status is sought, is being brought on behalf of three Ohio public pension funds and all other pension fund and individual shareholders from 1999 to 2005.
The suit asserts that auditors should have been on high alert when reviewing the insurer's books, because Greenberg ruled with an iron fist as chief executive and chairman for 37 years, even controlling the compensation of senior managers through offshore entities affiliated with AIG. Greenberg is under investigation by New York Attorney General Eliot L. Spitzer, the U.S. attorney in the Southern District of New York and the SEC.
The Ohio suit says PwC should have looked more carefully at, among other things, the General Re deal because it had already "been put on notice about similar but equally dubious transactions" that AIG had used to help smooth earnings for other companies, including Pittsburgh's PNC Financial Services Group Inc. and Brightpoint Inc., a Plainfield, Ind., telecommunications provider. The suit says that in July 2000, months before the General Re deal, the SEC had asked AIG for records about the Brightpoint deal. AIG finally settled the PNC and Brightpoint allegations by paying the SEC and the Justice Department $126 million last year. PNC agreed to pay $115 million in penalties, while Brightpoint agreed to pay $450,000 in 2003.
The suit also cites the audit committee's disclaimers of 2001 and 2002, which were highlighted by Schiff's Insurance Observer, a trade publication, in 2002. The suit says that with the disclaimer, the committee "backed away from its support of the company's accounting practices."
Besides Hills and Zarb, the audit committee in 2002 was made up of Frank J. Hoenemeyer, retired vice chairman of a Prudential Financial Inc. predecessor; M. Bernard Aidinoff, a retired partner with Sullivan & Cromwell, the prestigious New York law firm; and the late World Bank president Barber B. Conable Jr. Hoenemeyer declined to comment. Aidinoff, Zarb and Hills did not return telephone calls.
The language was also notable because it came at time when regulators were attempting to beef up audit committee oversight. Zarb himself served on the so-called Blue Ribbon Panel to Improve Corporate Audit Committees, sponsored in 1999 by the NASD and the New York Stock Exchange in response to SEC warnings at the time about the practice of so-called earnings management and lack of director oversight. The report called audit committees "the ultimate monitor" of the financial reporting process.
Dan M. Guy, an author of books on accounting standards and a former official at the American Institute of Certified Public Accountants, said that AIG's audit committee statements read to him by a reporter seemed to say, "We're an audit committee in name only. We're not doing our job."
However, Charles Elson, director of the University of Delaware's corporate governance center, said other audit committees included similar "boilerplate" language that attempted to insulate themselves legally from corporate scandals unfolding at the time. He said external auditors wouldn't necessarily be alarmed.
In a boost to PwC, AIG in its release this spring also explicitly told investors that auditors and board members had been kept in the dark by management about some AIG accounting maneuvers, including the company's dealings with Capco Reinsurance Co. Ltd., a Barbados reinsurance firm, and Union Excess Reinsurance Co. Ltd. The company disclosed that Capco transactions involved an "improper structure created to recharacterize underwriting losses . . . as capital losses."
Georgia Institute of Technology accounting professor Charles Mulford said that in the end AIG appears to have taken myriad steps to report smooth earnings over the years.
"What it says is, the company was riskier than it appeared," he said. "I think they were doing something that was generally accepted as being done, but then the world changed."
-- Carrie Johnson and Dean StarkmanCopyright 2004 washingtonpost.com