Introduction II. Credit Default Swaps A. Default Swaps--Their Origin B. Default Swaps--From Protection Against Risk to Speculation 1. Insurable Interest 2. Synthetic CDO 3. Multiple Swaps for Debt Securities 4. Credit Events and Escalating Exposure III. Default Swaps Business at AIG, 2002-07 A. Disclosures and Statements on Credit Derivatives, 2002-07 1. 2002 2. 2003 3. 2004 4. 2005 5. 2006 6. 2007 B. Credit Default Swaps: The Economic Justification IV. Corporate Governance at AIG--A Review. A. Corporate Governance and the Structure at AIG B. Lifting the Corporate Veil 1. The Role of Joseph Cassano 2. Oversight by CEO/Senior Management 3. Board Committees--Their Level of Involvement 4. Monitoring by the Board of Directors V. Director Oversight--The Issues with Corporate Theory A. Boards--A Case for Expanding Their "Service" Function B. Board Composition and Director Independence C. The Standard of Care VI. Conclusion. I. Introduction
The recent events at American International Group, Inc. (AIG) are significant from the perspective of corporate governance. They raise important questions about the contemporary model of governance, which is based on management by the executives and oversight by the directors. To facilitate effective monitoring by the directors, the recent decades have seen an increased emphasis on directors' independence. (2) In addition, there is the requirement of extensive disclosures under U.S. securities law. (3) The theory is that these mechanisms would ensure transparency and accountability and, in turn, promote the good governance of public corporations. (4)
Referring to AIG's statutory disclosures, media reports, and the statements of its senior executives, this Article traces the credit derivatives business of the company that led to its implosion. The experience with AIG and other financial corporations in the credit crisis offers valuable clues on shaping corporate governance policies for the future, particularly in fine-tuning the concept of monitoring boards. The AIG episode illustrates the limitations of the current "bare-bones" governance model that stops with placing the directors under a largely undefined duty to monitor. The concern of corporate theory is essentially with whom the directors will monitor, and very little about what they should monitor. (5)
Without a clear definition of the functional responsibilities of the directors, it is not possible to come to conclusions about the oversight of AIG's default swaps business. The following are some major conclusions drawn in this Article from the case-study of AIG:
a. The recent emphasis on the monitoring role of boards and director independence can potentially impede effective business oversight by the directors.
b. The broad-brush standard of care applicable to directors, obfuscated by the business judgment rule, indemnity, and professional insurance, further undermines board oversight and directorial accountability.
To learn from the experience and to make board oversight more efficient, this Article proposes the following:
a. A clear definition of the role of corporate boards and guidance on the mix of executive and non-management directors; and
b. Developing a standard of care that balances the imperatives of accountability for the directors of public corporations with the need for affording them protection.
These measures would streamline the functioning of corporate boards and potentially improve the efficacy of director oversight. The result, hopefully, would be fewer instances of governance failures of the variety seen recently in the credit crisis.
This Article is divided into five Parts. Credit default swaps were at the center of the debacle at AIG, and part I provides an overview of these instruments and their characteristics. part II traces the credit derivatives business of AIG from 2002, when the company made the first reference to default swaps in its statutory report until 2007 when it reported a loss of over $11 billion from the business, sparking the meltdown. Part III examines the governance structure of AIG and its credit derivatives business from the perspective of contemporary corporate theory. Part IV discusses the issues highlighted in the case-study--namely, board composition and functions and directors' duty of care.
Part V concludes with proposals for better articulation of the functions of boards, regulatory guidance on the mix of executive and outside directors and an effective standard of care for the directors of public corporations. These measures would strengthen the law's role in corporate governance that began recently with the Sarbanes-Oxley Act of 2002, (6) and its requirements of audit committees and independent directors. The conclusion advocates an interdisciplinary approach to reform that promotes convergence between management theory and corporate theory.
Credit Default Swaps
In the annual report for 2007, AIG reported "an unrealized market valuation loss of $11.5 billion on [the] super senior credit default swap portfolio" held by its subsidiary, AIG Financial Products. (7) This triggered a meltdown and ended AIG's life as an independent and successful company. (8) This Part provides a brief overview of credit default swaps, which proved to be the undoing of AIG.
Default Swaps--Their Origin
Collateralized Debt obligations (CDos) and Credit Default Swaps (CDSs) are the major credit derivatives devised by the financial industry in the last two decades. (9) Between the two, credit default swaps--which are similar in principle to credit insurance--were the causal factor in the AIG debacle. (10) In turn, it was AIG's stature as an insurance company that generated significant volumes in its default swaps business. (11)
Default swaps are issued towards consolidated pools of debt securities, designated as CDOs. (12) The idea of pooling risky and safe debt as CDOs and marketing them among investors came, apparently, from Drexel Burnham Lambert, the now defunct investment banking firm. (13) This was in 1987. It represented the first step towards CDOs, which soon gave rise to CDSs.
The financial instruments, designated as derivatives, have been constantly in the news in the last two decades. They were dogged by controversy derivatives from the beginning. In the early 1990s, efforts were made in the U.S. Congress to understand the risks in these derivatives. (14) Regulatory interest in credit derivatives continued later in the 1990s as well. (15) It was only in the recent years that the idea of consolidated debt, or CDOs, really took off. The growth in their popularity can be attributed to two significant innovations--credit rating and default swaps.
The debt securities comprising CDO pools could range from residential mortgages to automobile loans and credit card balances. Getting them rated by professional rating agencies would provide independent assessment of the credit risk in them. With such independent assessment, it would be easier to market the derivatives among investors. The theory is that chances of default by the borrowers would be low in CDOs that have been professionally assessed. (16)
The other innovation--default swaps--would guarantee payment by the seller of the swaps in the unlikely event of default by the borrowers. When a large insurance company provides default swaps, as AIG did, (17) it can be interpreted as near-complete elimination of the risk in CDOs. These are, apparently, the assumptions on which the actors in the financial market based their calculations for their credit derivatives business.
In substance, there is little distinction between default swaps and credit insurance, (18) which is a longstanding feature of the insurance industry landscape. (19) understood in these terms, credit default swaps are quite innocuous. They are merely a variant of credit insurance, which offers protection to lenders against the risk of default by the borrowers. However, a number of other features that have been added to default swaps deprive them of their simple character as instruments that offer protection against credit risk. The process by which default swaps turned into instruments of speculation is outlined below.
Default Swaps--From Protection Against Risk to Speculation
A series of market developments have carried default swaps away from their simple conception as instruments that offer protection against credit risk. These include the neglect of insurable interest in the default swaps framework, the rise of synthetic CDos, and the sale of multiple swaps for a single underlying pool of debt. The following is an account of the process by which default swaps were transformed from their position as risk protection devices into instruments of speculation and agents of instability.
Insurance is always about future events and uncertainty. Hence, an element of speculation is inherent in insurance. (20) The law of insurance, as it has developed, steered insurance contracts away from their speculative foundation and shaped them as instruments for protection against risk. A number of rules have been developed to undermine speculation and promote the integrity and legitimacy of insurance contracts. 21 These rules stress the character of insurance as a device for protection against risk and weaken the speculative element.
Principal among the rules is the requirement that persons seeking insurance coverage must have "insurable interest" in the subject of insurance. (22) The concept of insurable interest requires the holder of a policy to have substantial economic interest in the subject of insurance. For example, the interest that the owner of a house property has in the safety and security of the building would be insurable.
Default swaps were originally devised as instruments that offered protection to lenders against default by borrowers. (23) In their case, the insurable interest would be with the lenders or in persons claiming under...
Default swaps and director oversight: lessons from AIG.
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