A leading figure from Dublin's financial services centre faces a jail sentence in the US for masterminding a global securities fraud network from Sydney to New York. Justin O'Brien assesses a case that has profound implications for Ireland's business reputation.
Six months after admitting the orchestration of a multi-billion dollar securities fraud, Dublin-based reinsurance supremo, John Houldsworth, faced a scheduled sentencing hearing in Alexandria, Virginia, last month. At the last minute, the case was unexpectedly adjourned.
The decision staves off the day of reckoning for Houldsworth. Formal adjudication by a US federal court that transactions designed and executed through the Alternative Solutions Unit in Dublin of a company known as General Cologne Re amounted to a criminal conspiracy marks the final ignominy for him. As part of his plea agreement he has already accepted a ban from the US securities market. This adds to a similar ban on practising in Australia following a series of disparate investigative, regulatory and criminal processes.
Each has concluded that loopholes in the governance of the reinsurance industry created systemic risks. Each has identified Dublin as the weakest link in the enforcement firmament.
This has profound implications for Ireland's ambition to maintain its position as the fastest growing financial services centre in the EU. Off the record briefings with senior regulators in Dublin suggest recognition that perceived enforcement weakness represents a major problem but palpable relief at the lack of domestic media and political traction.
This approach has gained explicit sanction from the highest echelons of the EU. In October, the Commissioner for Internal Markets, Charlie McCreevy, returned to Dublin to pass verdict on the performance of the Irish Financial Regulator: "Don't try to protect everyone from every possible accident. Concentrate on the big things that really matter. And leave industry with the space to breathe and investors with the freedom to learn from their mistakes," he said.
This insouciance stands in marked contrast with regulators and enforcement agencies in the jurisdictions where market integrity was undermined by the business model developed and marketed by the Alternative Solutions Unit.
In Australia, reinsurance contracts developed by the Alternative Solutions Unit fundamentally distorted the valuation of FAI General Insurance Company. Its subsequent purchase by HIH Insurance led to the corporation's eventual collapse in 2001 as one of Australia's largest corporate bankruptcies. A Royal Commission of Inquiry set up to investigate the failure proclaimed that the scandal brought into doubt "the integrity of the market system itself".
Deploying a metaphor from the property market, a highly placed source from the commission equated those responsible with "skillful interior designers. Underneath the paper were cracks. In fact there were gaping holes rather than cracks".
The Royal Commission and subsequent regulatory and criminal investigations also highlighted, however, Australia's relative powerlessness to influence the behaviour of financial groups operating outside the jurisdiction. This subjugated position was made manifest by the behaviour of the ultimate owners of General Cologne Re, Berkshire Hathaway, one of the most influential insurance conglomerates in the world, which upheld the right of senior executives in the Alternative Solutions Unit to disregard requests to give evidence to the Royal Commission. "It is fair to say that the reinsurance aspects probably disturbed [Justice Neville Owen] more than any individual issue that arose during the Royal Commission. They had such a capacity to distort the accounts and they did distort the accounts and did it in a way that the regulators had not a clue," he said.
Two senior investigating counsels to the commission maintain that the primary problem to be addressed is one of supply.
According to one, it was clear from the e-mail evidence that the contracts were constructed with "consummate ease. You got the sense that they were writing these every day of the week". The second argues that if one were to transpose the case to the criminal arena, the Alternative Solutions Unit, "would equate to the drug dealer, with the user akin to drug addicts dependent on the next financial fix to survive".
John Houldsworth was one of the leading global figures in finite reinsurance design. He was far from being a rogue trader. His capacity for business alchemy had attracted the attention and overt support of the corporate hierarchy in the United States.
His location offshore in Ireland minimised the risk of contamination. For a number of years the bifurcation paid handsome dividends for little demonstrable risk.
Its unravelling is embarrassing for Berkshire Hathaway. Houldsworth has provided the authorities with considerable evidence of corporate complicity to minimise his own culpability. The delay in sentencing is linked to testing the veracity of his claims.
The proceedings, when linked with previous action in Australia paint a more disturbing picture of regulatory incapacity in Ireland that has the potential to be catastrophic to its reputation for probity.
Legal if there is a genuine risk of loss, so-called "finite reinsurance" is a complex form of financial engineering. For corporations facing significant distress it can artificially create or sustain share price valuations. The capacity to "smooth" earnings rests on two interlocking mechanisms.
First, the terms can exceed one calendar year. This protects the receiver against any sudden upsurge in claims provision arising from cyclical, climatic or financial shock. It also serves to mask loss-provisioning levels by giving the appearance that any liability claim could be offset by recovery under the reinsurance contract. The difficulties of ascertaining the material reality of the insurance contract are made more acute because the public terms of the transaction can be nullified by separate confidential side-letter agreements.
Complexity, the lack of enforcement capacity, resolve or co-ordination and the extensive use of offshore havens to act as circuit breakers, play key enabling roles in restricting both transparency and accountability. It also makes it exceptionally difficult to secure a criminal conviction.
The criminal case in Sydney against Australia's FAI directors involved in the reinsurance scandal collapsed in November because the prosecution failed to prove that an oral sidebar agreement existed. The fact that the designer of both products - John Houldsworth - has now pleaded guilty in the United States undermines this corporate defence. It also renders the Irish lack of interest in the substance of its export market hard to justify.
IN the autumn of 2000, Hank Greenberg, the chairman of American International Group faced a delicate problem. Despite posting better than expected results, the corporation's share price fell 6 per cent. He needed to arrest the decline and protect his own personal investment.
Greenberg approached his opposite number in Dublin of General Re, the parent of General Cologne Re. He wanted to book $500 million to provide a cushion against future earnings fluctuations and required a finite reinsurance deal to achieve it. Greenberg explicitly stated, however, that he did not want to transfer risk.
From the beginning the executives at General Re knew not only what was expected by its largest single customer but also the underlying purpose. General Re headquarters also knew exactly who to approach: John Houldsworth, head of the Alternative Solutions Unit.
Telephone records between Richard Napier, the vice-president at General Re responsible for handling relations with AIG, Elizabeth Monrad, the reinsurers' chief financial officer and Houldsworth make clear that the critical question was not whether the deal shouldbe consummated but how it could be.
Houldsworth: "There is clearly no risk transfer. You know there is no money changing hands."
Monrad: "[ AIG] may have a tough time getting the accounting they want out of the deal that they want to do . . . They are not looking for real risk . . ."
Napier: "[ W]hat would happen if we just did this where there was no risk. I mean we just charge them a fee for doing this deal?"
Houldsworth: ". . . I think to give them a deal with no risk in it and just charge them a fee, you can assume their auditors are being pushed in one direction, but I think that's going too far. [ Without introducing some risk] I would be staggered if they get away with that."
Napier: "Then the way to do this, if there is a risk in this, the way to become whole requires [ the AIG chairman] and [ the General Re CEO] to have a handshake."
E-mail records provide prima facie evidence that the transaction had the explicit sanction of senior management in General Re headquarters in the United States. Specific guidance from the General Re chairman, Ronald Ferguson, stated that the file was to be "confidential and consequently kept in a locked desk at all times".
The thoughts of the chief financial officer, Elizabeth Monrad, are recorded in a damning telephone conversation with Houldsworth.
Monrad: "I will tell you any way we structure it it's got to look more like deposit because they are not really looking to take risks. Well I think if we spend a lot of time trying to figure out how to transfer $500 million of risk, we won't get this deal done in the time they want."
Houldsworth: "Yeah, it means as you say, if there's enough pressure on their end, they'll find ways to cook the books won't they."
[ Monrad laughs]
The interlinked criminal and civil complaints lodged in the United States paint a graphic picture of corporate malfeasance.
"This case is not about the violation of technical accounting rules," says the complaint, lodged in New York by the Security and Exchange Commission.
"It involves the deliberate or extremely reckless efforts by senior corporate officers of a facilitator company (General Re) to aid and abet senior management of an issuer (AIG) in structuring transactions, having no economic substance, that were designed solely for the unlawful purpose of achieving a specific, and false, accounting effect on the issuers financial statements."
In Australia, excessive deference, misplaced trust in the illusion of probity cultivated by the sector and lack of insight about the functional purpose of finite reinsurance has been replaced by systemic risk evaluation.
For Ross Jones, the recently appointed director of enforcement, in the identification and examination of risk, APRA recognises that it needs "to be much more discerning when people come through the door".
In Ireland, however, the response to the systemic risk posed has been much more muted by both the regulatory authorities and the business community.
The critical question is why?
Globalisation and financial liberalisation in the late 1980s and 1990s facilitated the emergence of networked centres to rival traditional offshore havens. Relative success was dependent on capacity to attract the critical mass to sustain the "network advantage" of accounting and legal services.
None has been more successful than Ireland in attracting leading banking and insurance concerns to base operations at the International Financial Services Centre.
By 2003, 10 per cent of the reinsurance market was underwritten through Dublin, the vast majority of the operation outside of direct regulatory oversight.
The success of the IFSC is predicated on a triangulated model based on light touch regulation, low corporation tax and the reputational advantage of providing a trading domicile at the heart of the European Union.
Faced with the possibility that an anchor tenant at the IFSC could be responsible for massive fraud, the response of the regulator in Dublin has been unconvincing - to say the least - in the face of emerging evidence.
Despite the fact that the transactions at the heart of the HIH investigation in Australia involved a US subsidiary operating in Ireland, the regulatory enforcement priorities in the Republic did not extend to intensive consultation with either APRA or the Australian Securities and Insurance Commission.
This is doubly surprising given that another transaction involving General Cologne Re's dealings with Zurich Financial Services Australia led to a stringent enforceable regulatory undertaking in 2005.
When Eliot Spitzer, the crusading state attorney general of New York launched a separate investigation into how the Alternative Solutions Unit manipulated the earnings of the insurance colossus American International Group, the silence from Dublin was equally puzzling.
Speaking last April, Liam O'Reilly, the chief executive of Ifsra - the Irish financial regulator - said of its approach:"We find out the facts before we act. We're not a regulator that reaches for the gun and shoots people down before we know what the real situation is."
This leaves unanswered the question of just what evidence the Irish regulatory authorities need to deal with a systemic risk to global markets.
It may also prove acutely embarrassing that the former Irish minister for finance - Charlie McCreevy - chose to use his visit to the Financial Regulator in October to call for a relaxation in regulatory oversight. As European Commissioner for Internal Markets, McCreevy is charged with ensuring global co-operation to combat corporate and financial malpractice through supervision and law enforcement. Significantly, in his Dublin speech he made no reference to the reinsurance scandal. Instead, he harked back to a more uncomplicated time.
"Many of us in this room are from the generations that had the luck to grow up before governments got working and lawyers got rich on regulating our lives. We were part of the 'unregulated generation' - the generation that has produced some of the best risk takers, problem solvers, and inventors. We had freedom, failure, success and responsibility and we learned how to deal with them all," he said.
Outside Ireland, and, indeed, the EU a much less sanguine view is coming into clear focus.
The charge in The New York Times that Dublin is fast becoming the "wild west of European finance" resonates with off-the-record briefings provided to me by senior regulators in Australia and the United States.
One expressed "shock and dismay that Ireland had abdicated its responsibilities for short-term advantage".
Another suggested that behind the scenes pressure was being exerted on the Irish regulatory authorities through international networks, such as the International Association of Insurance Superintendents. According to this source "good luck to Ireland if it thinks it is going to get away with it, but it won't".
By contrast, Commissioner McCreevy argued that "the benefits [ of regulation] are sometimes more imaginary than real". The EU commissioner stated that rather than advocating the "excessive gold-plating" of regulatory restrictions, he favoured a political philosophy "based on giving people freedom. That includes freedom to make money and freedom to lose it".
He concluded with a rousing call for further expansion of financial services reform, which, if captured, could position Ireland at the forefront of change.
More problematic is the perception that the regulatory system has itself been captured.
Significant industry actors, including the Dublin International Insurance and Management Committee, have been lobbying the Irish Government not to accede to European Commission Directorate proposals to introduce mandatory regulatory standards for the reinsurance industry.
Given the preferences outlined by Commissioner McCreevy, it is likely that they will continue to receive a sympathetic hearing.
Whether the wider regulatory community, which now perceives Dublin as a rogue market, will accept this is another matter entirely.
Justin O'Brien is the director of the corporate governance programme at the School of Law, Queen's University, Belfast. His book Trading at the Frontier, based on the reinsurance scandals, will be published next year by Gill&Macmillan.