The indicting of senior General Re executives with securities fraud executed in Dublin has the potential to eclipse even the Enron trial, writes Justin O'Brien
The Bush administration's self-declared "war on corporate crime" has passed a significant watershed with the criminal indictment last Thursday of a financial intermediary's most senior executives.
The import of the securities fraud charges are magnified because the corporation in question, General Re, is a subsidiary of Berkshire Hathaway, one of the most respected names in the global insurance industry. In effect, its business model has now been branded criminal by the United States Department of Justice.
The indictment, brought by the Corporate Crime Task Force, relates to two reinsurance transactions designed and executed through General Re's Dublin-based subsidiary Cologne Re.
The transactions enabled the client, American International Group (AIG), to fraudulently book $500 million in loss reserves through a complex form of financing called finite reinsurance.
Legal if sufficient levels of risk are transferred, finite reinsurance is particularly prone to manipulation. If misapplied, it can allow insurance corporations to artificially enhance or smooth earnings, thereby distorting capital valuations.
The chief designer of the products, John Houldsworth, the former chief executive of Cologne Re in Dublin, has already pleaded guilty. He entered a plea agreement in the United States last June and pledged to help federal prosecutors and regulatory authorities secure further indictments.
He was due to be sentenced last December but that hearing was delayed in order to test the accuracy of information he provided.
AIG itself has also admitted that the transactions were improper and "were done to accomplish a desired accounting effect". It is currently involved in final stage settlement talks with the Securities and Exchange Commission and the New York State Attorney General.
The settlement is valued at more than one billion dollars, which, if approved will be the largest single fine in regulatory history.
The criminal charges against General Re signal a determination by the US Department of Justice that those providing intermediating access to the most developed securities market in the world must shoulder equal responsibility for corporate malfeasance if the products are designed to mislead and there is prior knowledge of client intentions.
Under federal sentencing guidelines, each defendant faces up to 95 years in prison if convicted. They are also personally liable for fines of up to $7 million (€5.8 million) each.
"This indictment sends a clear message to corporate America that executives will be brought to justice not only for cooking their own company's books but also for knowingly helping their counterparts at other companies do the same," said Paul McNulty, the chairman of the Corporate Crime Task Force.
The implications of this seismic change in criminal corporate enforcement priorities will reverberate around the world.
They will be acutely felt here in Dublin, which has emerged as one of the leading global centres for complex finite reinsurance financing.
The announcement was carefully choreographed for maximum impact. It coincided with the opening of the most high profile criminal case involving the implosion of Enron. Its most senior executives, Ken Lay and Jeffrey Skilling, are on trial in Houston accused of misleading the market by failing to disclose critical financial information.
Enron's collapse in 2001 radically transformed the corporate governance landscape in the United States.
The decision to concentrate criminal prosecutorial resources on the complicity of senior executives at General Re brings into sharp focus just how significant this change has been in regulatory enforcement.
The series of Enron prosecutions focused on wrongdoing within the corporation. Substantial evidence that suggested major investment banks could be complicit in the design, execution and marketing of related party transactions was not tested in a criminal court.
With the exception of a deferred prosecution involving Merrill Lynch for a small contract immaterial to the Enron failure, no investment house has faced criminal charges.
The General Re case suggests a new calculation: deviant behaviour can only be stymied if those who provide intermediating services face the reputational risk associated with having to defend a criminal prosecution.
"Executives should be wary of those who espouse the view that what happens on the accounting books of a counterparty is not your problem. When you aid and abet someone else in securities fraud, that is criminal conduct," said Alice Fisher, an assistant attorney at the Department of Justice at a briefing in Washington.
The criminal case in Virginia was accompanied by a civil case taken in the southern district federal court in Manhattan by the Securities and Exchange Commission. Both paint an unambiguous picture of a corrupted business culture.
According to the civil action in New York "the transactions had no economic substance, amounting to a round-trip of cash".
While General Re itself did not account for the transaction improperly, phone records suggest the chief executive, chief financial office and deputy general counsel conspired with Houldsworth and AIG on the assumption that gaps in regulatory oversight would obviate scrutiny.
It was also no coincidence that the General Re personnel would channel the contracts through Dublin. The Alternative Solutions Unit of Cologne Re, led by John Houldsworth, had developed considerable expertise in finite reinsurance provision.
His contractual skill in facilitating the over-valuation of FAI in Australia in 1998 had already demonstrated the potential to systematically breach accounting standards with little or no threat of sanction from regulatory authorities in either jurisdiction.
Internal corporate governance mechanisms at General Re again provided woefully inadequate protection against the reputational risk of abetting a criminal act.
"The defendants did not simply turn a blind eye to AIG's fraud. They went into this deal with their eyes wide open, understanding that they were helping AIG deceive the investing public," according to Mark Schonfeld, the regional director of the Securities and Exchange Commission in New York. They "knowingly helped AIG achieve a specific, and false, accounting effect," he added.
The case has the potential to destroy General Re. Like all financial services firms, General Re's capacity to generate premiums pivots on trust. The clear message emanating from the US Department of Justice is that the corporate model itself can no longer be trusted.
If validated by a jury, the consequences for the integrity of the markets and the regulatory systems that ostensibly police them will far eclipse the trial of allegedly corrupt executives in a failed energy corporation.
• Dr Justin O'Brien is director of the Corporate Governance programme at the School of Law, Queen's University, Belfast