UNITED STATES OF AMERICA
In the Matter of
| ORDER INSTITUTING CEASE-AND-DESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS AND A CEASE-AND-DESIST ORDER PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934 AS TO AMERICAN INTERNATIONAL GROUP, INC.|
The Securities and Exchange Commission ("Commission") deems it appropriate that public administrative proceedings be, and hereby are, instituted against American International Group, Inc. ("AIG") pursuant to Section 21C of the Securities Exchange Act of 1934 (the "Exchange Act").
In anticipation of the institution of these administrative proceedings, AIG has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and without admitting or denying the findings contained herein, except as to the Commission's finding of jurisdiction over AIG and the subject matter of this proceeding, which AIG admits, AIG consents to the issuance of this Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order Pursuant to Section 21C of the Securities Exchange Act of 1934 as to American International Group, Inc. ("Order") and to the entry of the findings and imposition of relief set forth below.
On the basis of this Order and AIG's Offer, the Commission makes the following findings:1
(1) This case involves AIG's issuance of a purported insurance policy to Brightpoint, Inc. ("Brightpoint" or "the Company") for the purpose of assisting Brightpoint to conceal $11.9 million in losses the Company sustained in 1998. As a result of this concealment, Brightpoint's 1998 financial statements, as reported in the 1998 Form 10-K, overstated Brightpoint's actual net income before taxes by 61 percent.
(2) In October 1998, Brightpoint publicly announced that in the fourth quarter ending December 31, it would recognize a one-time charge, ranging from $13 million to $18 million, arising out of losses sustained by one of its divisions in the United Kingdom ("UK"). However, by December 1998, the UK losses had mushroomed to about $29 million, and Brightpoint's corporate controller, John Delaney ("Delaney"), and its director of risk management, Timothy Harcharik ("Harcharik"), devised a scheme to cover-up these additional, unanticipated losses, rather than disclose them.
(3) In December 1998, Delaney and Harcharik turned to the Loss Mitigation Unit ("LMU") of National Union Fire Insurance Company of Pittsburgh, Pa. ("National Union"), one of AIG's principal general insurance company subsidiaries. LMU offered "insurance" products specifically designed to "smooth" the financial statement impact of losses sustained by AIG clients. Brightpoint and AIG negotiated the terms of a $15 million "retroactive" insurance policy that covered all of the extra UK losses. The parties agreed to combine this "retroactive coverage" with prospective fidelity coverage (together, the "Policy") in an effort to avoid scrutiny from Brightpoint's Auditors (the "Auditors"). The "cost" of the $15 million "retroactive coverage" to Brightpoint was about $15 million, which Brightpoint was to pay in monthly "premiums" over the prospective three-year term of the policy. The Policy, finalized in January 1999, enabled Brightpoint to record in 1998 an insurance receivable of $11.9 million, which Brightpoint netted against the total UK losses of about $29 million, bringing the net loss to within the previously disclosed $13 million to $18 million range.
(4) In fact, the "retroactive coverage" should not have been accounted for as insurance.2 It was only a mechanism for Brightpoint to deposit money with AIG - in the form of monthly "premiums" - which AIG was then to refund to Brightpoint as purported "insurance claim payments." In drafting the Policy, Delaney, Harcharik and AIG took pains to ensure that the " retroactive coverage" raised no "red flags" for the Auditors: They created a blended fidelity coverage and retroactive policy that was designed to look like traditional, non-retroactive indemnity insurance and they gave the policy an effective date of August 1998. Moreover, once the Policy was finalized, AIG issued a letter to the Auditors, which misleadingly stated that there would be a "probable" recovery under the Policy, when AIG knew that Brightpoint was, in fact, certain to recover its deposits.
(5) In October 2001, following an inquiry by the Commission's staff, the Auditors began looking more closely at the Policy and determined that it was not traditional insurance. Although the Auditors questioned whether the policy was insurance at all, they decided at the very least that the policy provided retroactive coverage and, therefore, that all premium expense associated with it should have been recorded in 1998. On November 13, 2001, Brightpoint announced a restatement, which treated the Policy as real, but retroactive, insurance (the "First Restatement"). The First Restatement expensed the full policy "premium" in the fourth quarter of 1998, amounting to $15.3 million.
(6) On January 31, 2002, Brightpoint announced that it would further restate its financial statements to reflect that the "premiums" for the "retroactive coverage" under the Policy were nothing but deposits with AIG. This second restatement came about when the Auditors learned that, one day before Brightpoint announced the first restatement, it had "cancelled" the "retroactive coverage" and obtained from AIG a refund in the full amount of premiums Brightpoint had paid over and above the "insurance claim payments" made to it by AIG under the "retroactive coverage." The cancellation transaction essentially exposed the fraud, leaving no doubt that the "retroactive coverage" was not insurance at all. As a result of the conduct summarized below, AIG violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and caused violations of Rule 13b2-2 thereunder.
(7) AIG is a Delaware corporation with its principal corporate offices located in New York, New York. AIG is a holding company that, through its subsidiaries, is engaged in a broad range of insurance and insurance-related activities in the United States and abroad. AIG's primary activities include both general and life insurance operations. AIG's securities are registered pursuant to Section 12(b) of the Exchange Act and are listed on the New York Stock Exchange.
Other Relevant Individuals and Entities
(8) Brightpoint is a Delaware corporation headquartered in Plainfield, Indiana. Brightpoint provides outsourced services such as distribution, fulfillment, customized packaging, prepaid and e-business solutions, and inventory management in the wireless telecommunications and data industry. Brightpoint's securities are registered pursuant to Section 12(g) of the Exchange Act and its common stock is listed on NASDAQ's National Market under the symbol CELL.
AIG's Development and Marketing of LMU Products
(9) In 1997, AIG developed a so-called "non-traditional" insurance product to be underwritten by a new unit called Loss Mitigation Unit, or LMU. The "LMU White Paper," which an LMU founding member distributed to 32 management level AIG and National Union employees in October 1997, including National Union's president, the President of AIG's Financial Lines Claims Division and two other senior officers, provided a guide on how to treat accounting and regulatory issues in LMU products designed to "smooth" corporate earnings. According to the transmittal memorandum, the White Paper was to be used as a general reference document for structuring LMU transactions and to provide information to assist AIG personnel when addressing "general questions" "posed by the brokerage community and clients regarding LMU deals." 3 The accounting discussion in the White Paper was written by an AIG accountant who was employed in AIG's controller's office to work on special projects.
(10) According to the White Paper, one of the principal "attributes" of non-traditional insurance was "[i]ncome statement smoothing," i.e., retroactive "insurance" could be structured to enable the "insured" to recognize losses over several reporting periods, rather than all at once in the period in which the loss occurred. This smoothing effect could be accomplished, for example, by having the retroactive "insurance" policy pay a known loss in the first year of the policy, while allowing the "insured" to reimburse the insurer over several years through "premium" payments that were, in actuality, loan repayments. Under this scenario, the insured would record only the "premium" expense as it paid the premiums over several years, rather than record the entire loss in one period.
(11) The White Paper openly acknowledged that the accounting rules were specifically designed to avoid this "income smoothing" effect. In the White Paper's own words, new accounting rules were "specifically introduced in response to abuse by insureds who did not recognize loss events as they occurred but rather as they were paid via financing arrangements." Nonetheless, the White Paper went on to set forth ways to avoid these "unintended accounting . . . consequences," most notably by not including in the insurance contract terms that might suggest the true nature of the underlying "insurance." What the White Paper proposed instead, and among other things, was that the parties rely on their "relationship" for contractual terms that, if disclosed, would require the loss to be immediately recognized. In other words, the White Paper proposed that these essential terms be contained only in an oral side agreement.
(12) AIG marketed LMU's "income smoothing" products - in those terms - to AIG's various divisions and regions on a large scale. LMU staff made at least forty-six power point presentations to various AIG divisions and regions, for the purpose of marketing the product to those divisions so that the divisions would market the product externally.
(13) AIG also marketed LMU's product directly to third parties. These third party marketing efforts were made not only by LMU staff, but also by the President of National Union, the Marketing President of National Union and eleven "field marketing representatives for LMU."
(14) AIG's internal and external marketing materials touted the following benefits of the LMU product:
(15) In other promotional documents, AIG noted Commission regulations for public disclosure of material events and that "[s]uch a disclosure if resulting from an insured event would include the probable loss amount NET of expected insurance recoveries" (emphasis in original). In the same document, AIG also presented a flow chart showing exactly how a client could pre-fund its own insurance recoveries for the "advantage [of] income statement protection in the period liability actually occurred." As will be discussed below, the LMU policy that AIG sold to Brightpoint precisely followed the blueprint described in the White Paper and in LMU marketing materials.
Brightpoint's UK Losses and the Genesis of the Policy
(16) In the spring of 1998, Brightpoint became aware that its UK operation had suffered certain losses related to the loss or devaluation of product within the Company's trading division.4 Delaney directed Harcharik to investigate and determine the amount of loss and evaluate the possible insurance recoveries available to Brightpoint under the policies Brightpoint had at the time (the "Brightpoint Policies"). Based on the information gathered during Harcharik's investigation, Delaney initially estimated the UK losses to total between $13 million and $18 million.
(17) By the end of September 1998, given all of its problems and its unprofitable history, Brightpoint decided to close the trading division in the UK. Brightpoint's Board of Directors approved the closure on October 1, 1998, and the Company issued a press release on October 2, 1998 announcing that it was eliminating the division and that the Company would recognize in the fourth quarter of 1998 a one-time charge expected to range from $13 million to $18 million relating to the closure ("One-Time Charge"). After October 2, 1998, Brightpoint continued to investigate the UK losses and gathered documentation for the purpose of making claims under the Brightpoint Policies.
(18) In early December 1998, it was clear that the amount of the One-Time Charge would be much greater than the original estimate and that Brightpoint's insurers were disputing coverage for the UK losses making it uncertain that there would be insurance recoveries under the Brightpoint Policies. At this point, Brightpoint was faced with the prospect of recording a much larger loss in the fourth quarter than it had previously disclosed, at least $12 million more.
(19) In mid-December, Brightpoint initiated contact with AIG. Harcharik had had some prior familiarity with LMU-type products designed to cover retroactive losses, and he became the point person in the discussions that ensued. From the very first discussion, Harcharik and Delaney presented Brightpoint's predicament to AIG in stark terms: That Brightpoint had issued a press release in October announcing a very specific range for the estimated loss and was now faced with a much larger loss that it did not want to disclose. Although there was initially some discussion of having AIG actually assume some of Brightpoint's risk of non-recovery under the Brightpoint Policies, and in that sense issue true retroactive insurance, discussion very quickly shifted to a deposit mechanism because AIG was unwilling to take on any risk associated with Brightpoint's UK losses.5 In the transaction eventually consummated, AIG bore no insurance risk with respect to retroactive losses; every dollar Brightpoint paid to AIG with respect to such losses was Brightpoint's money to be returned upon its demand.
Overview of Relevant Accounting Principles
(20) Under generally accepted accounting principles ("GAAP"), when it is "probable" that an insured will realize an "insurance recovery" against a specified loss, the insured is entitled to record a receivable on its balance sheet in the amount of the probable recovery and, for income statement purposes, net the amount of probable recovery against the loss, thereby reducing the loss.6
(21) In order for the insured to net an expected recovery from reportable losses, the recovery must be "probable." If recovery is only possible, the insured must recognize the loss to its full extent, without regard to insurance. Moreover, the recovery must be an "insurance" recovery. A recovery is not an "insurance" recovery for accounting purposes unless the insurance policy transfers some risk from the insured to the insurer. If a policy does not involve risk transfer, GAAP treats it as a financing arrangement, with all premiums to be accounted for as deposits.7
(22) In December 1998, as the Auditors were beginning field work for the year-end audit, Brightpoint presented the Auditors with schedules of the UK losses, which assumed that Brightpoint would be offsetting against those losses at least $11.9 million in anticipated insurance recoveries. To accomplish this offset, Brightpoint needed to satisfy the probability principle outlined above. However, at the time, it had no such coverage available because its insurers were already indicating that coverage under the Brightpoint Policies was doubtful.
(23) Brightpoint eventually used the Policy to satisfy this probability standard. In constructing the Policy, Brightpoint faced two accounting obstacles: First, the policy had to look like insurance. If it looked like a deposit, Brightpoint would not be able to net anticipated recoveries against the loss. Second, the policy could not look like retroactive insurance, i.e., insurance designed to cover a loss already quantified and known, because Brightpoint might then be required to expense the full $15 million "premium" immediately. (EITF No. 93-6, 93-14) Under GAAP, the insured is obligated to recognize the full premium expense associated with a retroactive policy at the time it recognizes the benefits of the policy. (SFAS No. 113)
(24) The Policy consists of two governing documents: The Binder of Coverage (the "Binder") and the policy itself. The Binder was executed on January 6, 1999, but was backdated to August 1, 1998. The Binder states the policy period to be the three-year period August 1, 1998 to August 1, 2001. The policy provides two separate limits of coverage: Limit A and Limit B. Limit A has an aggregate limit of $15 million, while Limit B has a per loss limit of $15 million.8
(25) Although not referred to in the policy as "retroactive," Limit A effectively provides broad retroactive coverage. The policy contains an insuring clause that provides: "The Company shall indemnify the Insured for Loss of Assets unless otherwise excluded by the terms and conditions of this policy." This insuring clause is applicable to both Limit A and Limit B. However, Limit B is subject to a laundry list of exclusions, while Limit A has no exclusions. Thus, virtually every "Loss" of "Assets" is covered under Limit A up to an aggregate amount of $15 million. Limit B, on the other hand, essentially provides prospective fidelity insurance coverage, which is severely circumscribed by the exclusions.
(26) The Binder reflects a single, indivisible premium applicable to both limits. The total premium is $15,302,400, but this aggregate figure is never set forth. Instead, the Binder provides only a list of the elements constituting the premium: It provides that the premium shall be payable as follows:
(27) Neither the policy nor the Binder states how much of the premium is applicable to Limit A and how much is applicable to Limit B. Because the policy provides for a single premium applicable to both Limits, and Limit B theoretically provides infinite coverage, i.e., $15 million per loss, the policy on its face at least appears to involve significant risk transfer. However, according to the internal LMU deal sheet, which reflected the agreement between Brightpoint and AIG, Limit A was fully pre-funded by Brightpoint: The premium Brightpoint paid for Limit A coverage was $15 million plus a $100,000 fee that AIG charged for putting the deal together. Limit B was intended to provide traditional prospective fidelity coverage. According to the deal sheet, the premium for Limit B was $202,400.
(28) The policy specifically provides that it is non-cancelable, and the Binder states that the premium "shall be fully earned as of the date of this binder agreement," meaning that AIG was entitled to be paid the full premium from the very first day of coverage. The policy also contains an acceleration clause providing that if claims made under the policy at any point exceeded the dollar amount of premium paid to that point, AIG would not be obligated to pay further claims until Brightpoint paid all remaining premiums due, except for $302,400 - an amount that coincides with the unstated Limit B premium and $100,000 fee. The acceleration provision meant that AIG could never be out of pocket under Limit A.
(29) The policy contains no express provision granting Brightpoint the right to a refund if Brightpoint ended up paying more in premiums than it was claiming in losses - a scenario that might have occurred, for example, if Brightpoint ultimately succeeded in obtaining some coverage under the Brightpoint Policies. However, there was an oral understanding between LMU and Harcharik that Brightpoint would receive such a refund, and the policy mechanism for obtaining that refund was to submit a claim under the very broad definition of coverage, which allowed Brightpoint to receive payment for just about any claim submitted under Limit A up to an aggregate maximum of $15 million.
(30) Brightpoint accounted for the Policy as if it were prospective fidelity insurance. It expensed the premiums monthly over the three-year life of the policy, and it netted "probable recoveries" under Limit A against the UK losses, purporting to rely on the probability principle outlined above.
(31) Given the true substance of the Policy, the premium attributable to Limit A should not have been accounted for as an insurance premium because there was no transfer of risk. Limit A was not even a financing arrangement because AIG was not extending credit to Brightpoint. The only money Brightpoint was entitled to receive under Limit A was money that it first deposited with AIG - deposits on which AIG paid no interest. Accordingly, the premium payments under Limit A should have been accounted for as deposits.
The Negotiations Between Brightpoint and AIG
(32) From the first discussions between Brightpoint and LMU, Delaney and Harcharik made clear to LMU that Brightpoint needed a policy to offset the One-Time Charge and that the final policy had to "pass the insurance test" with Brightpoint's auditors. Delaney explained to LMU that Brightpoint needed about $15 million in insurance coverage to bring the UK losses within the $13 million to $18 million range previously announced in October 1998. Delaney also told LMU that while Brightpoint expected to receive some recoveries for the UK losses under the Brightpoint Policies, the claims under those policies would not be resolved by the year-end. Thus, the Policy was necessary to establish for the Auditors that there was a probability of sufficient insurance recovery.
(33) Harcharik was keenly aware of the accounting issues. At the outset, he proposed to LMU that the policy contain both retrospective and prospective components. He wanted a prospective component to be part of the policy because, if Limit A stood alone, it would be too obvious that Brightpoint was paying $15 million in premiums for $15 million of coverage. In the course of the two-week negotiation, Harcharik and Delaney discussed in detail with LMU other "red flags" they wanted to avoid so as not to alert the auditors that Brightpoint should not treat the policy as insurance.
(34) One such "red flag" was the problem associated with bifurcating the premium on the face of the contract between the retroactive and prospective portions of the policy. Harcharik made clear to LMU that he did not want the premium to be explicitly bifurcated in the contract because that would show that the cost of Limit A was $15 million. Harcharik did not want the total premium amount of $15.3 million even to be tallied in the contract. Instead, Harcharik wanted the premium to be reflected simply as three untallied components, consisting of an initial down payment, 32 monthly payments, and a $7.5 million letter of credit. Harcharik did not want the $15.3 million sum to be readily apparent to the Auditors because such a substantial premium might have caused the Auditors to question the bona fides of the policy. LMU accommodated Harcharik's requests, knowing that Harcharik's purpose was to deceive the Auditors.
(35) To help structure the Brightpoint deal, LMU brought into the discussions the AIG accountant who had written the accounting guidance contained in the White Paper. This AIG employee was frequently brought in to speak with potential LMU clients about accounting issues relating to potential LMU policies. In the case of Brightpoint, the AIG employee counseled Harcharik and Delaney that the policy should contain "no reference to an experience account" and that all refunds of premium back to Brightpoint should be through loss claim payments. An experience account or commutation provision refers to an insurance mechanism by which the insured is refunded premium at the end of the policy if there were few loss experiences over the course of the contract. The AIG employee advised that such a provision would raise "red flags" with the auditors. The employee's advice was consistent with what he wrote in the White Paper.
(36) To avoid having an express refund mechanism in the policy for excess premiums paid, Harcharik and LMU reached an oral agreement, not written into the Policy, that AIG would be "extremely flexible" in refunding premiums to Brightpoint through "claim payments," requiring little to no documentation from Brightpoint on the nature of the losses.9 This type of oral side agreement is precisely what the White Paper recommended. Harcharik and AIG agreed that the retrospective coverage would be as broad as possible and there would be no exclusions to coverage in the policy for those losses. LMU documented the terms of this oral agreement with Harcharik in an internal AIG memorandum called "Loss Mitigation Unit Deal Sheet" (the "Deal Sheet").
(37) The Deal Sheet, in relevant part, states the following:
...Brightpoint had already taken a charge for the [trading] division...assuming the $15M of insurance recovery would happen. Brightpoint's auditors, . . . , wanted more evidence that an insurance recovery was possible. Otherwise, Brightpoint would be in a position to possibly restate the charge already taken...The feedback from [the Auditors] was that they wanted a letter from AIG explaining the use of the policy in case there are no proceeds paid by [Brightpoint's other insurer] ...If for some reason [Brightpoint's other insurer] pays the loss or a portion of the loss, the $15M [million] or the balance after a partial loss payment by AIG would have to be returned as well. This would be returned under a future claim submitted by Brightpoint under Sub-Limit A. THUS, SUB-LIMIT A WAS MADE TO BE EXTREMELY BROAD AND ANY PAYMENTS MADE SHOULD ALWAYS BE MADE WITHOUT LIMITATIONS BY COVERAGE; ONLY LIMITATIONS TO PREMIUM RECEIVED.
(Emphasis in original.) Along the same lines, another internal AIG memorandum to the President of AIG's Financial Lines Claims Division states:
AIG is not at risk for this arrangement and maintains the benefit of collecting cash without giving interest on the float. There were no specific required timeframes established for AIG's payments under the policy (due to the fact that the policy was purposely constructed so as to not appear as a finite risk policy for accounting reasons) and the verbal agreement was that AIG would pay within a reasonable time period.
(Emphasis in original.)
(38) January 6, 1999, AIG and Brightpoint executed the Policy by signing the Binder. The original version of the Binder had a date line, indicating that it was signed on January 6, 1999. That same day, Delaney sent Harcharik an email stating:
The binder you signed (I looked at it again) has January 6, 1999 (in one case 1998) all over it. This is not good and that copy must be destroyed and on [sic] with an August date executed.
(39) AIG and Harcharik then executed a second version with only the August 1, 1998 effective date appearing in the document. Later that day, Brightpoint issued a press release stating that the One-Time Charge was "expected to be approximately $17.6 million ... which is consistent with the previously-announced estimate."
AIG's Confirmation to the Auditors
(40) In connection with the Auditors' 1998 year-end audit, the Auditors asked Brightpoint to obtain from AIG a letter confirming the probability that Brightpoint would recover at least $11.9 million under the Policy, which was the amount Brightpoint was seeking to offset against the $29 million UK losses. After working through numerous drafts with Harcharik, AIG signed and provided a letter to Harcharik, dated January 27, 1999, which stated that "if [the insurer on the Brightpoint Policies] denies coverage or does not pay at least $11,900,000 in proceeds for the Claims...we believe it is probable that Brightpoint will recover no less than $11,900,000, net of deductibles, under the Policy, or, no less than $11,900,000 in combination of proceeds from the [Brightpoint Policies] and this Policy." LMU faxed a copy of the letter directly to the Auditors, knowing that the letter was going to be used by the Auditors as audit evidence. On the basis of this confirmation, just as Delaney, Harcharik and LMU anticipated, the Auditors approved Brightpoint's accounting for the insurance receivable and allowed Brightpoint to offset the UK losses by $11.9 million in probable insurance recoveries.
The First Restatement
(41) In September 2001, the Commission's staff issued a subpoena to the Auditors for its workpapers relating to Brightpoint's 1998 One-Time Charge. The subpoena led the Auditors to reconsider Brightpoint's 1998 accounting for the UK losses. In the course of this review, the Auditors learned for the first time that (1) the Policy had not been executed until January 1999; (2) the policy contained retroactive coverage; and (3) the policy was "non cancelable by either party and the entire premium [was] deemed earned at the inception of the policy," meaning that Brightpoint was obligated to pay the full $15.3 million in the fourth quarter of 1998.
(42) At the end of October 2001, the Auditors informed Brightpoint that Brightpoint had incorrectly accounted for the Policy and would have to restate its 1998 financial statements. However, because Brightpoint's Chief Financial Officer and its outside counsel persuaded the Auditors that there was substantial risk transfer under Limit B, the Auditors determined that Brightpoint needed to restate its 1998 financial statements by expensing the full premium on the Policy, rather than treating the premiums as a deposit.
(43) On November 13, 2001, the Company issued a press release announcing the First Restatement. The press release stated that: "Upon further review, the Company and its independent auditors now believe that premium expense should have been accrued at the date the Company entered into the [Policy], rather than over the prospective policy period because the Company could not allocate the costs of the policy between the retroactive and prospective coverage." The First Restatement expensed the full policy "premium" in the fourth quarter of 1998, amounting to $15.3 million, and reversed the monthly premium expense recorded in 1999 through 2001. While the First Restatement essentially corrected Brightpoint's bottom line for 1998, it left intact the $11.9 million in probable insurance recoveries under the Policy as an offset against the $29 million UK loss, in effect treating the Policy as real retroactive insurance.
The Second Restatement
(44) A few days before Brightpoint's November 13th press release, Brightpoint had told the Auditors that Brightpoint was in negotiations with AIG to terminate the Policy. Brightpoint represented to the Auditors that, under the anticipated termination agreement, Brightpoint would simply "walk away" from the policy without any further exchange of money between AIG and Brightpoint. The November 13 press release addressed the subject of termination, stating that "[t]he Company believes that it will recognize a gain in the fourth quarter of 2001 related to the termination of the retroactive portion of the insurance policy, which will result in the complete reversal of the remaining accrual."
(45) The termination agreement was actually executed on November 12, 2001, one day before the November 13 press release. However, Brightpoint did not notify the Auditors that the agreement had been finalized. The executed agreement essentially provided for full rescission of the Limit A part of the Policy. Under the agreement, Limit A was terminated, and AIG agreed to pay Brightpoint a refund of about $2.3 million - just about the amount of premiums Brightpoint had paid in excess of claims recovered. The agreement also provided that Limit B would continue in force for an annual premium of $97,000.
(46) The Auditors did not learn these facts until January 14, 2002 in the course of their 2001 year-end audit of Brightpoint. Upon learning of the termination agreement, the Auditors determined that Limit A was not real insurance and that Brightpoint had to restate its restatement, using the deposit method.
(47) Two weeks later on January 31, 2002, Brightpoint announced that "the Company has now determined that the appropriate accounting method for the agreement is deposit accounting... Deposit accounting requires treating the Company's payments under this agreement as deposits rather than as premiums and the Company's receipts under the agreement as withdrawals rather than claims paid by the insurance company...."
AIG's Conduct During the SEC Investigation
(48) The need for relief in this case is also affected by the manner in which AIG conducted itself during the Commission's investigation. Beginning in July 2000, the Commission's staff issued to AIG two voluntary requests and, beginning in November 2001, the Commission's staff issued various subpoenas for documents. On November 1, 2002, at the Commission's staff's request, AIG provided a sworn certification that AIG's production pursuant to all Commission subpoenas was complete. The Commission believes the certification was substantially erroneous.
(49) After AIG provided this sworn certification, the Commission's staff made various further inquiries, which led to the production of a large quantity of documents, many of which should have been produced before the certification was made. The Commission now understands that AIG's document search prior to its sworn certification did not include the files of the former LMU president or other key individuals associated with the LMU and other locations in which responsive documents were likely to be found. Nor did AIG conduct an adequate search of the LMU computer drive prior to its certification. As a result, documents that were relevant to the investigation and called for under an October 2000 voluntary request and later subpoenas were not produced until December 2002 and January 2003.
(50) AIG also had not produced the White Paper until October 29, 2002, even though the White Paper was directly relevant to a position AIG took in a Wells meeting prior to that date and in its Wells Submission in September 2002, namely, that the conduct at issue here was the result of inadequate training and support for the employee who dealt with Brightpoint. At the time AIG made these representations to the Commission's staff, AIG was aware of, but had never produced, the White Paper. 10 The White Paper demonstrates that the conduct of its employee was consistent with the guidance given in the White Paper - a document that itself had had wide circulation among management ranks.
(51) The Commission believes that AIG should have produced the White Paper in response to the voluntary requests and subpoenas. AIG disputes this point. In any event, the Commission believes that AIG should have produced the White Paper before a Wells meeting in which the subject matter of the document was put directly in issue by AIG.
AIG Violated Section 10(b) and Rule 10b-5 of the Exchange Act
(52) Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibits fraud in connection with the purchase or sale of a security. In particular, Rule 10b-5 prohibits any person from making any untrue statement of a material fact, or omitting to state a material fact, using any device, scheme or artifice to defraud, or engaging in any transaction, practice, or course of business which operates as a fraud. A misstatement or omission is material if there is a substantial likelihood that it would have been viewed by a reasonable investor as "having significantly altered the `total mix' of information made available." TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). See also Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988).
(53) To violate Section 10(b) and Rule 10b-5, a person must also act with scienter, Aaron v. SEC, 446 U.S. 680, 701-02 (1980), which is "a mental state embracing intent to deceive, manipulate, or defraud," Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976), and which can be shown by proof of intentional or reckless conduct. Novak v. Kasaks, 216 F.3d 300, 312 (2d Cir. 2000), cert. denied, 531 U.S. 1012 (2000); Press v. Chem. Inv. Serv. Corp., 166 F.3d 529, 537-38 (2d Cir. 1999). Knowledge, or reckless disregard, of the fraudulent scheme or the undisclosed information will also satisfy the scienter requirement. See, e.g., McDonald v. Alan Bush Brokerage Co., 863 F.2d 809, 814 (11th Cir. 1989); Woods v. Barnett Bank of Fort Lauderdale, 765 F.2d 1004, 1010 (11th Cir. 1985); IIT v. Cornfeld, 619 F.2d 909, 923 (2d Cir. 1980).
(54) AIG violated Section 10(b) of the Exchange Act and Rule 10b-5 by negotiating a purported insurance policy with Brightpoint, knowing that the primary purpose of the policy was to provide Brightpoint with a means for misrepresenting its losses as insured losses and for making material misstatements in its public filings. AIG further participated in the fraudulent scheme by sending a letter to the Auditors stating that there would be a "probable" "insurance recovery" under the Policy, when AIG knew that the recoveries under the policy would be merely a refund of the money that Brightpoint previously had deposited with AIG. Violations of the antifraud provisions can be based on misstatements or omissions of material fact in periodic reports or other public reports to investors. SEC v. Koenig, 469 F.2d 198 (2d Cir. 1972); SEC v. Great American Industries, Inc., 407 F.2d 453 (2d. Cir 1967), cert. denied, 395 U.S. 920 (1969); see SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968) (en banc), cert. denied, 394 U.S. 976, 89 S.Ct. 1454 (1969).
(55) In reports filed with the Commission, Brightpoint grossly overstated its operating results by 61% for the year ended 1998. It is well established that information concerning the financial condition of a company is presumptively material. Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 167 (2d Cir. 1980); see also SEC v. Blavin, 557 F. Supp. 1304, 1313 (E.D. Mich. 1983), aff'd, 760 F.2d 706 (6th Cir. 1985). Materiality judgments involve both quantitative and qualitative considerations. See Statement on Auditing Standards ("SAS") No. 47, Audit Risk and Materiality in Conducting an Audit, ¶¶ 6 and 7; Staff Accounting Bulletin ("SAB") No. 99, 64 Fed. Reg. 45150 (1999); see also Ganino v. Citizens Utilities Co., 228 F.3d 154, 163 (2d Cir. 2000) (adopting SAB No. 99 as useful guidance on materiality issues).
(56) The final element necessary to establish a violation of the antifraud provisions is that the violative activity occur in connection with the purchase or sale of a security. This requirement is construed broadly. Superintendent of Ins. of State of N.Y. v. Bankers Life and Casualty Co., 404 U.S. 6, 12 (1971). Material misrepresentations or omissions contained in annual and quarterly reports and press releases are made in connection with an order, purchase, or sale of securities. See SEC v. Benson, 657 F. Supp. 1122, 1131 (S.D.N.Y. 1987); SEC v. Jos. Schlitz Brewing Co., 452 F. Supp. 824, 829 (E.D. Wis. 1978); Softpoint, 958 F. Supp. 846, 862-863, aff'd, 159 F.3d 1348 (2d Cir. 1998). The material misstatements and omissions described above were contained in annual reports filed with the Commission, as well as in Brightpoint's press releases and registration statement. Accordingly, these material misrepresentations and omissions were in connection with the purchase or sale of Brightpoint's securities.
(57) As discussed above, Delaney, Harcharik and AIG implemented a scheme to defraud Brightpoint's investors by employing an insurance contract to hide losses and by misleading Brightpoint's auditors. AIG was aware that Brightpoint needed to provide evidence of insurance to its auditors or it would be required to restate its previously announced estimate for the UK Losses. AIG worked with Delaney and Harcharik to alter the language of the contract so that certain accounting "red flags" would be eliminated or minimized. AIG knew that these red flags pertained to potential concerns of Brightpoint auditors. AIG orally agreed with Harcharik that AIG would return all monies paid under the contract to Brightpoint. Further, AIG signed and faxed a letter to the Auditors confirming that Brightpoint was entitled to receive these "insurance proceeds" from AIG. AIG was aware that the letter served as audit evidence for the Auditors and was aware of Delaney's and Harcharik's desired accounting objectives for the transaction. AIG thus violated Section 10(b) and Rule 10b-5 of the Exchange Act.
AIG Was a Cause of Delaney's Violation of Rule 13b2-2 of the Exchange Act
(58) Rule 13b2-2 of the Exchange Act prohibits a director or officer of a public company from making, or causing to be made, materially false or misleading statements or omissions to an auditor. Delaney was an officer of Brightpoint, a public company. Delaney made, or directed others to do so, materially false and misleading statements to Brightpoint's auditors regarding the $11.9 million offset from the UK losses based upon the Policy. Delaney also failed to state material facts to Brightpoint's auditors by failing to disclose that Brightpoint did not have insurance recoveries for the UK losses and that any payments made or received by Brightpoint under the AIG transaction were merely deposits or withdrawals of money. AIG was a cause of Delaney's violation of Rule 13b2-2 by conspiring with Delaney and negotiating a sham insurance policy specifically tailored to deceive Brightpoint's auditors and by sending a confirmation letter to the auditors falsely stating that there would be a "probable" "insurance recovery" under the Policy.
1. Within 30 days of the date of this Order, AIG shall employ an independent consultant ("Independent Consultant") acceptable to the Commission staff and knowledgeable in all aspects of commercial lines insurance, including, but not limited to, the products and services offered and sold by AIG's Domestic Brokerage Group, to conduct a comprehensive review of, and report on, the internal controls, policies, practices and procedures that AIG's Domestic Brokerage Group has put in place to ensure that Insurance Products will not be structured to facilitate violations of the federal securities laws. For purposes of this Order, Insurance Products shall mean "structured," "finite," or "funded" policies and any other commercial lines product, under which coverage is being provided, in whole or in part, for a loss, claim or litigation sustained by or asserted against the insured prior to the date on which the insured purchased the policy. Such Independent Consultant will also recommend any revised or additional internal controls, policies, practices or procedures that the Independent Consultant believes are reasonably necessary.
2. AIG shall require the Independent Consultant to enter into an agreement that provides that for the period of the engagement and for a period of two (2) years from the completion of the engagement, the Independent Consultant shall not enter into any employment, consultant, attorney-client, auditing or other professional relationship with AIG, or any of its present or former affiliates, directors, officers, employees, or agents acting in their capacity as such. Any firm with which the Independent Consultant is affiliated or of which he or she is a member, and any person engaged to assist the Independent Consultant in the performance of his or her duties under the Order shall not, without prior written consent of the Commission's staff, enter into any employment, consultant, attorney-client, auditing or other professional relationship with AIG, or any of its present or former affiliates, directors, officers, employees, or agents in their capacity as such for the period of the engagement and for a period of two (2) years after the engagement.
3. AIG shall promptly provide the Independent Consultant with any and all requested documents and other information pertaining to AIG's Insurance Products, and permit the Independent Consultant to meet with and interview any officer, agent, and employee of AIG or any of its divisions or subsidiaries.
4. No later than six months from the date that AIG employs the Independent Consultant, the Independent Consultant will submit, in writing, to AIG, with a copy to the staff of the Commission, his or her report detailing his or her findings regarding AIG's internal controls, policies, practices and procedures as described above, and his or her recommendations, if any, for revised or additional measures.
5. Upon good cause being shown, the staff of the Commission may grant the Independent Consultant such additional time as the staff deems necessary to submit his or her report regarding AIG's internal controls, policies, practices and procedures, and his or her recommendations, if any, for revised or additional measures.
6. Within 30 days after the date of the issuance of the Independent Consultant's report, AIG shall remedy any deficiencies in its internal controls, policies, practices or procedures identified by the Independent Consultant and adopt, implement, and maintain any revised or additional measures recommended by the Independent Consultant, or alternatives recommended in writing by AIG and accepted in writing by the Independent Consultant or the staff of the Commission.
7. No later than 30 days from the date of the issuance of the Independent Consultant's report, AIG, through an officer, shall submit an affidavit to the staff of the Commission stating that AIG has remedied any deficiencies in its internal controls, policies, practices and procedures identified by the Independent Consultant (stating the means by which such remedy has been accomplished), and stating further that AIG has adopted, implemented and will maintain any revised or additional internal controls, policies, practices or procedures recommended in the Independent Consultant's report, or alternatives acceptable to the Independent Consultant or the staff of the Commission. Upon written request and good cause being shown, the staff of the Commission may grant AIG such additional time as the staff deems necessary to submit such affidavit.
8. If, after 30 days from the date of the issuance of the Independent Consultant's report, or such additional time as allowed by the staff in writing, AIG fails to remedy the deficiencies in its internal controls, policies, practices and procedures identified by the Independent Consultant, or such alternatives recommended in writing by AIG and accepted in writing by the Independent Consultant or the staff of the Commission, the Commission may move to enforce this Order.
In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to by AIG in its Offer.11
Accordingly, it is hereby ORDERED:
A. Pursuant to Section 21C of the Exchange Act, AIG shall cease and desist from committing or causing any violations, or committing or causing any future violations, of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and from causing any violations or any future violations of Exchange Act Rule 13b2-2.
B. IT IS FURTHERED ORDERED that AIG shall, within 10 days of the entry of the Order, pay disgorgement in the amount of $100,000 and prejudgment interest in the amount of $37,535.47 to the United States Treasury. Such payment shall be: (1) made by United States postal money order, certified check, bank cashier's check or bank money order; (2) made payable to the Securities and Exchange Commission; (3) hand-delivered or mailed to the Office of Financial Management, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Alexandria, Stop 0-3, VA 22312; and (4) submitted under cover letter that identifies AIG as a Respondent in these proceedings, the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to Mark K. Schonfeld, Associate Regional Director, Securities and Exchange Commission, 233 Broadway, New York, NY 10279.
C. IT IS FURTHER ORDERED that AIG shall comply with the undertakings enumerated in Section III. above.By the Commission.
Jonathan G. Katz
1 The findings herein are made pursuant to AIG's Offer and are not binding on any other person or entity in this or any other proceeding.
2 For state law insurance regulatory and other purposes, the entirety of a contract that transfers risk (as the prospective fidelity coverage did here) may be regarded as a single insurance policy, even though the proper accounting treatment or financial reporting obligation of the insured may require the insured to treat the contract in part or in whole as creating a depository relationship.
3 Organizationally, the LMU is a unit within National Union. However, LMU products were marketed by various AIG divisions and subsidiaries.
4 The trading division was involved in the purchase of wireless handsets from sources other than manufacturers or network operators and in the sale of those handsets to other trading companies dealing in the secondary market.
5 In this respect, Harcharik proposed that AIG and Brightpoint share in the litigation risk associated with Brightpoint's anticipated insurance coverage litigation under the Brightpoint Policies, with both AIG and Brightpoint splitting the proceeds if the litigation was successful. However, AIG was unwilling to pursue this proposal.
6 Statement of Financial Accounting Standards ("SFAS") No. 5; Emerging Issues Task Force ("EITF") No. 93-5 (concerning environmental insurance); Statement of Position ("SOP") 96-1 (concerning environmental insurance).
7 When a policy affords retroactive coverage, it is not regarded as insurance for the policyholder's accounting purposes unless there is either an underwriting risk or a timing risk associated with the policy. When a loss has occurred and is known at the time the policy is written, there can be underwriting risk if the dollar amount of the loss is not fully known. Alternatively, if at the time the policy is written the dollar amount is both known and fixed, there can still be a timing risk if the actual payout may be delayed for many years. In such circumstances, the insurer might set the premium on the assumption that it will not have to pay for ten or twenty years. The risk is that payment may actually become due at an earlier time.
8 The insurer identified in the Binder and the policy is American International Specialty Lines Insurance Company, which is 70% owned by National Union and 30% owned by two other AIG subsidiaries: Birmingham Fire Insurance Company of Pennsylvania and the Insurance Company of the State of Pennsylvania. The Binder is written on the letterhead of "American International Companies" and the "AIG" logo appears in the bottom right-hand corner of each page. The Binder was executed by the LMU officer who negotiated the Brightpoint transaction. He signed it in his capacity as "Assistant Vice President" of "American International Companies." American International Companies is a brand name used by AIG's general insurance subsidiaries.
9 Over the life of the policy, Brightpoint's "claims" were paid upon the submission of a letter, saying simply that a loss had been sustained. AIG paid the claims without requiring further documentation.
10 AIG admittedly was aware of the White Paper in the fall of 2000.
11 AIG has agreed to pay a $10 million civil penalty in a parallel civil action.
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