Accountants Missed AIG Group's Red Flags

It's an awkward moment for PWC, a global giant with more than 120,000 employees in 144 countries, which has sought to market itself as an arbiter of corporate governance. In the wake of the Enron bankruptcy, for instance, PWC chief executive Samuel A. DiPiazza Jr. co-wrote a book, "Building Public Trust," on how to improve public companies' financial reporting.

Like other major accounting firms, PWC has had a few run-ins with regulators. PWC paid $5 million to Securities and Exchange Commission regulators in 2002 for violating independence standards by engaging in business deals with audit clients between 1996 and 2001. The firm also agreed to pay the SEC $2.4 million, without admitting or denying wrongdoing, for its audits for Warnaco Group Inc. in 2004. And a PWC partner, Richard Scalzo, in 2003 agreed to a lifetime ban from auditing public companies to settle an SEC case stemming from problems at Tyco International Ltd.

Now its nearly 30-year relationship with AIG is undergoing examination. Although law enforcement sources have said PWC is not a target of any criminal investigation, the SEC has subpoenaed documents related to its work with AIG, and plaintiffs' lawyers are going through PWC's audit reports with a fine-toothed comb. Some investors and analysts say PWC has some explaining to do.

"They said everything was okay all these years," said Alain Karaoglan, an analyst with Deutsche Bank. "Now, they know everything wasn't okay. We, as investors, do rely on accountants. . . . They ought to have caught some of that stuff."

Others say the current criticism of AIG's accounting -- and PWC's review -- is a case of Monday morning quarterbacking. Dean P. Phypers, a former AIG director, said longtime AIG chief Maurice R. "Hank" Greenberg, who was forced out in March, and the company's external auditor are victims of changing standards.

"He paid more attention to internal controls, and insisted they had good internal controls, than anybody I ever worked with," said Phypers, who left the board in 1999. "If they now suddenly don't have good internal controls, either they now have new rules or everybody's lost their mind."

The relationship between PWC and AIG stretches back decades to when the firm still was called Coopers & Lybrand, before its 1998 merger with Price Waterhouse. Former AIG finance chief Howard I. Smith, who left the company earlier this year under pressure for failing to cooperate with regulators, spent almost two decades as an auditor at Coopers before joining AIG in 1984. Steven Bensinger, AIG's new chief financial officer, also started his career at Coopers & Lybrand.

In the lawsuit filed earlier this spring in U.S. District Court in Manhattan, Petro, the Ohio attorney general, alleges that PWC's independence was "impaired" by these long-standing ties and by nearly $137 million in audit and consulting fees it received from AIG between 2000 and 2003. The fees were for audit-related services, as well as for tax consulting and accounting help. The suit, for which class-action status is sought, is being brought on behalf of three Ohio public pension funds and all other pension fund and individual shareholders from 1999 to 2005.

The suit asserts that auditors should have been on high alert when reviewing the insurer's books, because Greenberg ruled with an iron fist as chief executive and chairman for 37 years, even controlling the compensation of senior managers through offshore entities affiliated with AIG. Greenberg is under investigation by New York Attorney General Eliot L. Spitzer, the U.S. attorney in the Southern District of New York and the SEC.

The Ohio suit says PWC should have looked more carefully at, among other things, the General Re deal because it had already "been put on notice about similar but equally dubious transactions" that AIG had used to help smooth earnings for other companies, including Pittsburgh's PNC Financial Services Group Inc. and Brightpoint Inc., a Plainfield, Ind., telecommunications provider. The suit says that in July 2000, months before the General Re deal, the SEC had asked AIG for records about the Brightpoint deal. AIG finally settled the PNC and Brightpoint allegations by paying the SEC and the Justice Department $126 million last year. PNC agreed to pay $115 million in penalties, while Brightpoint agreed to pay $450,000 in 2003.

The suit also cites the audit committee's disclaimers of 2001 and 2002, which were highlighted by Schiff's Insurance Observer, a trade publication, in 2002. The suit says that with the disclaimer, the committee "backed away from its support of the company's accounting practices."

Besides Hills and Zarb, the audit committee in 2002 was made up of Frank J. Hoenemeyer, retired vice chairman of a Prudential Financial Inc. predecessor; M. Bernard Aidinoff, a retired partner with Sullivan & Cromwell, the prestigious New York law firm; and the late World Bank president Barber B. Conable Jr. Hoenemeyer declined to comment. Aidinoff, Zarb and Hills did not return telephone calls.

The language was also notable because it came at time when regulators were attempting to beef up audit committee oversight. Zarb himself served on the so-called Blue Ribbon Panel to Improve Corporate Audit Committees, sponsored in 1999 by the NASD and the New York Stock Exchange in response to SEC warnings at the time about the practice of so-called earnings management and lack of director oversight. The report called audit committees "the ultimate monitor" of the financial reporting process.

Dan M. Guy, an author of books on accounting standards and a former official at the American Institute of Certified Public Accountants, said that AIG's audit committee statements read to him by a reporter seemed to say, "We're an audit committee in name only. We're not doing our job."

However, Charles Elson, director of the University of Delaware's corporate governance center, said other audit committees included similar "boilerplate" language that attempted to insulate themselves legally from corporate scandals unfolding at the time. He said external auditors wouldn't necessarily be alarmed.

In a boost to PWC, AIG in its release this spring also explicitly told investors that auditors and board members had been kept in the dark by management about some AIG accounting maneuvers, including the company's dealings with Capco Reinsurance Co. Ltd., a Barbados reinsurance firm, and Union Excess Reinsurance Co. Ltd. The company disclosed that Capco transactions involved an "improper structure created to recharacterize underwriting losses . . . as capital losses."

Georgia Institute of Technology accounting professor Charles Mulford said that in the end AIG appears to have taken myriad steps to report smooth earnings over the years.

"What it says is, the company was riskier than it appeared," he said. "I think they were doing something that was generally accepted as being done, but then the world changed."