Thursday, December 18, 2008

The Deprizio Doctrine and AIG

12 May 1989 turned the bankruptcy world upside-down with the release of Levitt v. Ingersoll-Rand, 874 F2d 1186 (7th Cir., 1989) (Easterbrook, J.). Frank Easterbrook (FE) is the second most economically literate judge on today's federal bench. He would make an excellent Supreme. FE's opinions are a joy to read. The Deprizio Doctrine, as it is commonly known, was repealed by Section 202 of 1994's misnamed Bankruptcy Reform Act, as a sop to bankers to unsecured creditors' detriment. Why go into dead bankruptcy law here? To show the "thinking" behind what AIG seems to be doing. "In 1980 V.N. Deprizio Construction Co. was awarded contracts to do $13.4 million of work on the extension of Chicago's subway system to O'Hare Airport. By 1982 the company was in trouble. ... These and other dealings by Richard N. Deprizio, the firm's president, including suspicions of affiliation with organized crime, led the [US] Attorney to open an investigation. In April 1983 Deprizio Co. filed a petition under the Bankruptcy Code of 1978. ... As the investigation continued and Deprizio's indictment was imminent, word circulated that he might 'sing'. So in January 1986 Deprizio was lured to a vacant parking lot, where an assassin's gun and the obligations of a lifetime were discharged together. Corporations are not so easily liquidated', 1187. That's how we do things in Chicago, Al Capone's ghost still stalks the city! "Payments out of the ordinary course in the 90 days before filing a bankruptcy petition may be recovered for the estate under SS 547 and 550. ... Payments to or for the benefit of an insider during the full year, not just 90 days, may be recovered by virtue of S 547(b)(4)(B). ... The Trustee reasoned that the payments made to these outside creditors were 'for the benefit' of insider co-signers and guarantors, because every dollar paid to the outside creditors reduced the insider's exposure by the same amount", 1188. "Now for the principal question: whether the Trustee may recover from an outside creditor under S 550(a)(1) a transfer more than 90 days before the filing that is avoided under S 547(b) because of a benefit for an inside creditor. ... More than language lies behind this approach. The trustee's power to avoid preferences (the 'avoiding power') is essential to make the bankruptcy case a collective proceeding for the determination and payment of debts. Any individual creditor has a strong incentive to make off with the assets of a troubled firm, saving itself at potential damage to the value of the enterprise", my emphasis, 1194. "Insiders pose special problems. Insiders will be the first to recognize that the firm is in a downward spiral. If insiders and outsiders had the same preference-recovery period, insiders who lent money to the firm could use their knowledge to advantage by paying off their own loans preferentially, then putting off filing the petition in bankruptcy until the preference period had passed. ... An alternative device is to make the preference period for insiders longer than that for outsiders. With a long period for insiders, even the prescient managers who first see the end coming are unlikely to be able to prefer themselves in distribution. ... So insiders bent on serving their own interests (few managers hold outside lenders' interests of equal weight with their own!) could do so by inducing the firm to pay the guaranteed loans preferentially. ... While concealing the firm's true financial state, they would pay off (at least pay down) the debts they had guaranteed, while neglecting others. To the extent they could use private information to do this more than 90 days ahead of the filing in bankruptcy, they would make out like bandits", my emphasis, 1195. GSG was no creditor of AIG's insurance subsidiaries. These subsidiaries should have refused Eric Dinallo's (ED) request and told AIG, "go to hell".

Metromedia v. Fugazy, 983 F2d 350 (2nd. Cir., 1992) illustrates the kind of accounting analysis involved in insolvency determinations and why AIGs' CDS counterparties cannot let a jury make an AIG insolvency determination. AIG's 30 September 2008 10-Q, states it had (billions) $73 of shareholders' equity and owed the Fed $63. However, some of its assets look questionable under current circumstances, like $10 in goodwill, $48 in deferred policy acquisition costs and $24 in prepaid commitment fees. PriceWaterhouseCoopers (PWC) should have a very interesting 2008 audit. Let's see what PWC does for $120 million, which is what it charged AIG last year. Will PWC conclude AIG is not a going concern? If not, what then? Why is PWC auditing AIG anyway?

"[PWC], the independent auditor for [AIG], will pay $97.5 million to settle a class-action securities fraud lawsuit against the insurance giant and others, according to the Ohio state attorney general. ... A federal appeals court also upheld a $182.9 million jury award that PwC will have to pay policyholders of a defunct insurance company audited by the Big Four firm's predecessror, Coopers & Lybrand", Practical Accountant, November 2008.

"Bruce West, Sr., a Texas real estate developer, experienced serious financial problems as a result of the decline in the Texas economy during the mid- to late 1980s. West eventually filed a petition in bankruptcy on April 2, 1990. This criminal case emanates from West's bankruptcy filing, with many of the charges contained in the indictment based on three transactions that West participated in shortly before his bankruptcy petition", US v. West, 22 F3d 586, 587 (5th Cir., 1994). "West was convicted of several counts of bankruptcy fraud, in violation of 18 U.S.C. S 152. Three of these counts charged West with fraudulently transferring funds to Exalter during Feburary and March 1989. West contends that transfers, which occurred more than one year prior to the filing of his bankruptcy petition, cannot provide the basis for a S 152 prosecution because the transfers were 'outside the jurisdiction of the Bankruptcy Code.' ... We disagree with West's interpretation of S 152. The plain language of S 152 certainly cannot be read to impose the requirement suggested by West", 589. "Moreover, in light of the explicit intent requirements found in S 152, we will not transplant from the Bankruptcy Code the additional requirement that a fraudulent transfer, to be prosecutable as bankruptcy fraud, must be made within one year prior to the defndants filing of his bankruptcy petition. A defendant may knowingly and fraudulently transfer property in contemplation of or with the intent to defeat the provisons of Title 11 without necessarily transferring the property within one year before filing a bankruptcy petition", my emphasis, 589-90. "Indeed, a knowledgeable defendant bent on pursuing a fraudulent course of action would effect a fraudulent transfer outside the one year period within which the bankruptcy trustee could rescind it", my emphasis, 590. Are AIG's CDS counterparties "knowledgable"? If AIG files bankruptcy say 15 months after 15 September's "ED transaction", will the SDNY US Attorney immediately indict AIG's CDS counterparties, their attorneys and senior management personnel? Or would that squelch Mike Garcia's successor's NY BigLaw partnership? Stay tuned for this saga's next installment. "For example, the financial statements prepared on West's behalf indicate that West's net worth fell dramatically after 1985. Because the deterioration of West's financial situation bears strongly on both his incentive and need to seek bankruptcy protection, such evidence is relevant not only to West's motive for hiding assets from creditors, but also indicated that it was very probable that he knew he was going to file a petition in bankruptcy long before March 1990", 595. Do AIG's CDS counterparties know enough about AIG's financial situation to be similarly criminally liable? "At trial, the only real issue in dispute involved West's intent--i.e., whether he acted in comtemplation of declaring bankruptcy or with intent to defeat the Bankruptcy Code", 597. Are AIG's CDS counterparties different? Yes. West was a nobody who concealed about $800,000 from the bankruptcy trustee, peanuts. Not tens of billions. It's Anatole of France time, my 1 September, 30 October and 9 November 2007 and 24 January 2008 posts.

"Defendant, an attorney, appeals from convictions of the crimes of concealing assets from a trustee in bankruptcy, 18 USC 152, and conspiring to transfer the assets of one corporation to another in contemplation of bankruptcy and with intent to defeat the National Bankruptcy Act, 18 USC 371 and 18 USC 152. ... There was evidence before the jury that Switzer's client, a corporation called Berkeley Jewelers, Inc., borrowed substantial sums from money lenders who also were represented by Switzer", my emphasis, US v. Switzer, 252 F2d 139, 141 (2nd. Cir., 1958). "In December 1949, Switzer, who was well aware of the corporation's financial deterioration, proposed a plan whereby the bulk of its inventory would be transferred to a new corporation to be managed for the benefit of those creditors who were also Switzer's clients. The new corporation was then to continue the profitable portion of the old corporation's business", my emphasis, 141-2. "The valuable inventory previously removed was then sold for the benefit of the favored creditors and Switzer; and the property purchased at the sale went to the newly organized corporation, which continued to pay the old corporation's debt to one of the creditors with whom Switzer was associated. ... These decisions reveal that the intent of Congress was to prevent the defeat of the bankruptcy statute and that this intent is best applied by adopting a literal reading of the statute", my emphasis, 142. "It is clear that the latter interpretation should be followed because the actual intent of Congress is best served by prohibiting either transfer or concealment for either one may defeat the purpose of the Act", my emphasis, 142-3. AIG looks like a reverse Switzer, in that Switzer created a new company to effect an inequitable distribution of the bankrupt's assets. AIG, in effect, is combining itself with its seperately incorporated insurance subsidiaries to effect an inequitable distribution of the insurance subsidiaries assets.

"The owner of a defunct Wayne-based health benefits management company pleaded guilty today to mail fraud and tax evasion, admitting he misled subscribing participants and employers about the management of premium payments, embezzled from commingled accounts and ran the business into bankruptcy, U.S. Attorney Christopher J. Christie announced. Donald Ruth, 64, formerly of Hackensack and now of Hudson, Fla., admitted that, with the diverted and commingled funds of Wayne, NJ-based Meredian Benefit, Inc., he purchased a Florida home, a boat and paid for travel and other personal expenses--in addition to receiving more than $1.5 million in income between 1999 and mid-2003, when Meridian collapsed and filed for bankruptcy, leaving approximately $15 million in unpaid insurance claims. ... Meridian was established by Ruth as a third-party administrator of health benefit plans such as those established by employers for their employees. ... The company collected close to $40 million from the participant groups. Ruth and Meridian promised and represented that funds collected from participant groups would be segregated and held in trust accounts. ... Throughout the concealment, Ruth admitted, he induced continued payments from current participants while aggessively soliciting others to further the scheme. To prevent detection, Ruth admitted that he with others did mass mailings to participants with false assurances of future payments and disseminated a roster of false explanations to customer service personnel to explain and delay claim payments", my emphasis, Department of Justice Press Release, 22 September 2005, link:

"The $50 billion privatization of Bell Canada, Canada's largest telecomminications company, was in jeopardy Wednesday after accountants said they were unable to conclude if the leveraged buyout would leave the company solvent. Bell Canada, which trades under the corporate name BCE, is among Canada's most widely held and prominent corporations. Unless the accountants change their minds, 'the transaction is unlikely to proceed,' the company said Wednesday. ... But its failure would be openly welcomed by current Bell debt holders, who say they believe their bonds will be degraded, and would provide relief at the banks that agreed to finance the takeover in a much different market climate in June 2007. ... In a brief statement, [BCE] said that the accounting firm KPMG found in a preliminary analaysis that 'the amount of indebtedness' involved in financing the deal,about $30 billion, left it unable to conclude whether the privatized company would be solvent. ... [BCE's] chief financial officer, Siim A. Vanaselja, said in that company's statement, 'The company disagees that the addition of the LBO debt would result in BCE not meeting the technical solvency definition.' ... The debt holders, however, challenged the transaction in court, saying it unfairly favored equity holders at their expense. While they were successful at a Quebec court, that ruling was overturned by the Supreme Court of Canada after an unusally swift hearing in June", my emphasis, Ian Austen, 27 November 2008 at

Francine McKenna mentions KPMG's solvency opinion at her re The Auditors, 28 November 2008, link:

"It is unusual for a merger pact to require a solvency certificate as a condition of closing. banks typically require such certificates to finance a transaction, but BCE had put this condition is place because it wanted to protect itself from complaints by existing BCE bondholders about the company's new, debt-heavy capital structure. A collapse would likely benefit the financing banks, led by Citigroup Inc., Deutsche Bank, the Royal Bank of Scotland and Toronto Dominion", my emphasis, Peter Layttman at the WSJ, 28 November 2008.

"BCE, the parent of Bell Canada, recently was hit by a preliminary solvency opinion from valuation consultants KPMG warning that the telecom operator mightn't be solvent if its $55 billion buyout by a group led by Providence Equity Partners and Ontario Teachers' Pension Plan goes through. ... Typically, with solvency opinions, they're talking about the three tests that could constitute what's called a fraudlent transfer. If you couldn't have passed the three tests prior to and subsequent to the deal, you weren't deemed solvent. Two of them have to do with the company's balance sheet. The first test would be: Do assets exceed liabilities where the assets are valued as a going concern. The second is, is the company left with adequate capital after the transaction closes, so that it there's a market hiccup after the deal happens, will it be pushed over the line, or close to it? The third is the cash-flow test, which tells whether the company can pay its debt when it comes due", Heidi Moore Interview of Rick Braun (RB) at the WSJ, 3 December 2008.

"[AIG] owes Wall Street's biggest firms about $10 billion for speculative trades that have soured, according to people familiar with the matter, underscoring the challenges the insurer faces as it seeks to recover under a U.S. government rescue plan. ... The speculative trades, engineered by the insurer's financial-products unit, represent the first sign that AIG may have been gambing with its own capital. ... An AIG spokesman characterized the trades not as speculative bets but as 'credit protection instruments.' He said that exposure has been fully disclosed and amounts to less than $10 billion of AIG's $71.6 billion exposure to derivative contracts on debt pools known as collateralized debt obligations as of Sept. 30. ... The fresh $10 billion bill is particularly challenging because the terms of the current $150 billion rescue package for AIG don't cover those debts. ... The outstanding $10 billion bill is in addition to the tens of billions of taxpayer money that AIG has paid out over the past 16 months in collateral to Goldman Sachs Group Inc. [GSG] and other trading partners on trades called credit-default swaps. ... AIG's problem: The rescue plan calls for a company funded by the [Fed] to buy about $65 billion in troubled CDO securities underlying the credit-default swaps that AIG has written, so as to free AIG from its obligations under those contracts. But there are no actual securities backing the speculative positions that the insurer is losing money on. Instead, these bets were made on the performance of pools of mortgage assets and corporate debt, and AIG now finds itself in a position of having to pay off its partners because those assets have fallen significantly in value. The Fed first stepped in to rescue AIG in mid-September with an $85 billion loan when the collateral demands from banks and losses from other investments threatened to send the firm into bankruptcy court. ... Some of AIG's speculative bets were tied to a group of [CDOs] named 'Abacus,' created by [GSG]. ... In what amounted to a side bet on the value of these holdings, AIG agreed to pay [GSG] if the mortgage debt declined in value and would receive money is it rose. ... The plan has resulted in banks in North America and Europe emerging as winners: They have kept the collateral they previously received from AIG and received the rest of the securities' value in the form of cash from Maiden Lane III. ... It also has been a double boon to banks and financial institutions that specifically bought protection on now shaky mortgage securities and are effectively being made whole on those positions by AIG and the [Fed]", my emphasis, Serena Ng, Carrick Mollenkamp & Michael Siconolfi at the WSJ, 10 December 2008.

"The fate of the C$51.7 billion ($41.3 billion) takeover of BCE Inc. took another turn after the telephone company got a positive solvency opinion from its new auditing firm, in a twist that could put the deal back on track. The Montreal-based telecom company retained PricewaterhouseCoopers LLP, which determined that the company will be solvent after the buyout, said a person familiar with the situation", Shasha Dai, at the WSJ, 9 December 2008.

"The BCE Inc. buyout is officially busted. A year and a half after it was struck, then the largest private-equity deal in history, the $41 billion leveraged buyout of the Canadian telephone company collapsed Wednesday when a valuation expert at auditing firm KPMG LLC issued a final opinion that the transaction would create an insolvent entity. ... BCE is expected to take issue with that view and sue the private-equity group over the breakup fee. ... While BCE and the private-equity firms will likely head to court, four financing banks are in a position to walk away with an early Christmas present. Citigroup Inc., Deutsche Bank AG, Royal Bank of Scotland Group PLC and Toronto Dominion Bank won't have to provide $34 billion in debt to fund the deal. Had the buyout deal closed, the banks would have absorbed as much as $12 billion in losses from selling the debt package at steep markdowns or by holding the debt on their books", Peter Lattman at the WSJ, 11 December 2008.

Here's an explanation of various bankruptcy scams, including bust-outs and bleed-outs: Strictly speaking, amongst us bankruptcy fraud cognoscenti, AIG appears to be a "bleed-out" as opposed to a "bust-out". Either one can be prosecuted under 18 USC 152.

First AIG question: is GSG an insider or an outsider? Since GSG apparently had ED authorize AIG's insurance subsidiaries to "upstream" $20 billion to AIG's parent, GSG looks like an insider to me. I think GSG should be held to be a "control person" of AIG and this should be disclosed in both companies SEC filings. Chris Cox, are you listening? What do you do anyway?

The Ruth case is a recent insurance company bust-out. These things get prosecuted from time-to-time.

Existing bondholders usually are injured by LBOs.

RB, a managing director of FTI Consulting correctly describes the three solvency tests. It is clear AIG would fail the third and possibly the second test. To be insolvent, one need fail any of the three tests.

AIG is like BCE in that creditors' relative positions are being shuffled around to benefit say, GSG, and injure AIG insurance subsidiary policy holders.

Doesn't this give to great confidence in the Big 87654's work?

I handn't thought about this before, but KPMG audits Citigroup. It should never have accepted this valuation assignment.

Step right up ladies and gentlemen, in this corner, the largest bankruptcy fraud in history. Frank Easterbrook must be laughing at this. Over 16 months. Hmm. Just get over that 12 month period for the last payment and we're home free! AIG should have filed bankruptcy in September.


Anonymous said...

IA... I'm speechless...

Independent Accountant said...

Good or bad speechless?

Anonymous said...

IA... why speechless ...

>> Breadth and depth of your analysis

>> Bleeding out the assets of AIG to GSG... yes I felt that was happening... with the complicity of the Fed/Treas...

>> Glad to see it id'd

Many thanks...

Independent Accountant said...

That's how the Bush Administration does things. Goldman Sachs rules the country.

Francine McKenna said...

Re: Your comment about conflict in KPMG taking BCE valuation assignment since they also audit Citigroup is interesting. KPMG is BCE's auditor and the opinion was supposed to come from them. Unfortunately, with only 4 large audit firms, this kind of conflict happens quite often and leave the court to decide of there was any uneven, underhanded, untoward double dealing .

Independent Accountant said...

Initially, I was of the opinion KPMG took a gutsy stand in finding BCE insolvent and effectively killing the BCE LBO. When I realized Citigroup gained billions, I changed my mind, concluding KPMG values Citigroup's business more than BCE's.
I agree, with only four large firms there are endless possibilities for conflicts of interest. You see them frequently in bankruptcies where a Big 87654 firm audits the debtor and some of the creditors. This is common in real estate bankruptcies where the debtor, say a retail chain has leases with an REIT. So it goes.