Dissecting the AIG Bonus Contract

Washington is filled with outrage over the $165 million in bonuses given out by the American International Group. Yet, as I said in my post on Tuesday, “Seven Sad Truths About A.I.G.,” the real concern over the insurance giant should be about the $170 billion in government bailout money it received and and A.I.G.’s subsequent payments of tens of billions to a myriad of banks.

All of this appears to have been done without any attempt to bargain or otherwise obtain government recompense from these third-party banks. Congress should hold hearings to find out why this was done and if it was appropriate, instead of concentrating on the more minor compensation issue.

Nonetheless, if you are not tired of this issue yet, a review of the now-infamous bonus contract, released Wednesday by Representative Barney Frank, will generate its own anger or maybe disappointment.

First, the contract opens the kimono and details A.I.G.’s share of profits from the company’s financial products division. A.I.G. itself received 70 percent of the distributable income, with the employees of the financial products division taking home the remaining 30 percent. The definition of distributable income was not in the agreement itself, but it does appear to be profits. So, if I am right and if you think about the financial products division as a hedge fund (and it was), this is quite a fee they were taking home.

Hedge fund managers typically only receive 20 percent of the profits and a 2 percent administrative fee. If the funds have losses, the managers receive nothing and they lose substantially because they have a significant amount of money invested directly in the funds. The managers are not then paid until they make back these losses.

In A.I.G.’s case, however, employees got 30 percent with very little personal risk (we don’t know how much of their compensation was in stock) and their overhead covered. The arrangement shows the cavalier attitude of A.I.G. management and the power the financial products division had.

Second, back to that risk part and the hedge fund analogy. The agreement confirms that A.I.G. indeed flipped this notion on its head. It also confirms what was publicly disclosed. These bonuses are payable regardless of performance and are calculated at 100 percent of 2007 compensation for all employees except senior management, who receive 75 percent of 2007 compensation. The amount is payable unless they are fired with good cause, resign without good reason or fail to meet performance standards. For those hoping that these employees could now be fired, “good cause” is defined in the agreement as a very high standard. This is normal for these agreements.

The agreement states that “’cause’ means conduct involving intentional wrongdoing, fraud, dishonesty, gross negligence, material breach of the AIG Code of Conduct or other policies of AIG-FP or AIG, or conviction of or entry of a plea of guilty or no contest to a criminal offense.”

Similarly, failure to meet performance standards is another hard test to meet. If you could meet this latter standard, the contract provides that the employee still keeps his or her 2008 payments, just not next year’s. So even if the employee fails to meet performance standards this past year, they still keep the money paid this past weekend.

The contract also appears as inviolable as it states. Of course, this is not to say that it cannot be broken some other way, such as through bankruptcy, taxation or perhaps legislation. And there are many contract doctrines that allow for abrogation of contracts that might apply here. It’s against public policy, it was based on a mistake, it becomes impracticable, and so on.

But as Andrew Ross Sorkin has pointed out, we may not even want to do that as we need these people. Of course, this contract should have been better written to align pay with going-forward performance (in this case money saved in unwinding these trades). This leads to my final point:

This was not a boilerplate contract. Rather, it was highly negotiated. And it was highly negotiated to pay retention fees at high levels without regard to performance. This is obviously shocking. But it makes me wonder: perhaps one area of direction here should be actually looking at who negotiated this and why?

It strikes me that the A.I.G. financial products division received an unbelievably sweet deal. Did its managers slip it under the radar? Did the managers act in good faith? And who at A.I.G. signed off on this and did they focus on the risks and rewards? Yet more avenues for possible litigation.

But of course, this is all merely a diversion for what should be the main focus: Where did the $170 billion go that taxpayers spent on A.I.G and why, and what we are going to do with A.I.G. going forward?