Clawbacks can't scratch AIG

Treasury's reticence to use its clawback authority has left legislators to devise a tax workaround.

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NEW YORK (Fortune) -- The latest spectacle in the AIG circus is a supposedly tough federal rule on executive compensation that has drawn no blood.

The troubled insurer has provoked another round of outrage by paying out $165 million in bonuses -- to the employees of a subsidiary that caused AIG's (AIG, Fortune 500) near collapse, no less.

The payments to workers at AIG's derivatives-happy financial products group have been widely condemned in Washington. President Obama told Treasury Secretary Tim Geithner to explore legal avenues to block the so-called retention bonuses.

Late Tuesday night, Geithner said would force AIG to pay back the government an amount equal to the bonuses.

And New York Attorney General Andrew Cuomo subpoenaed AIG to find out who is getting how much and why.

With AIG having received $170 billion in federal funding altogether, the bonus case - in which 73 workers got at least $1 million each, after a year in which AIG lost $99 billion - would seem to be a perfect test for the clawback provisions inserted in the bailout legislation Congress passed last fall and updated last month in the stimulus bill.

Those provisions allow firms receiving federal aid to demand repayment of disputed funds from employees in certain circumstances. Since Treasury Secretary Henry Paulson first asked Congress for $750 billion in bailout funds last September, policymakers have been saying clawback provisions would help to protect the taxpayers.

But it seems that the clawback provisions were written so narrowly -- they apply primarily to the top executives at firms receiving federal funds and for cases in which those executives appear to have misled investors -- that the government has concluded it should not use the rules to go after the previous AIG bonuses.

Geithner did say late Tuesday night that he would use these provisions to limit future AIG bonus payments. But there is still anger about the bonuses that AIG has already agreed to pay.

So some legislators find themselves looking to treat AIG as if it were Al Capone -- the gangster who was brought to justice when he was convicted for tax evasion instead of murder -- and proposing to use tax policy to fix their unpopular taxpayer-funded bonus problem.

Senate Finance Committee Chairman Max Baucus, D-Mont., is expected to propose a special tax for the bonuses and Sen. Bill Nelson, D-Fla., said the tax could be as high as 90%.

Not everyone is on board. Rep. Charles Rangel, D-N.Y., said Tuesday he doesn't agree with calls to tax the bonuses.

"It is tough to me to think of the tax code as a political weapon," he told reporters in Washington. "The tax code is not sacred, but it should have enough credibility so people can depend on it."

Still, the fact that lawmakers are discussing possible changes to tax rules is proof of how little teeth the clawback rules have - something foreseen by some skeptics of the bailout.

"I've communicated with members of Congress already that I think the clawback provision, the severance provision ... and compensation -- they all could have been much stronger," Lynn Turner, the former chief accountant of the Securities and Exchange Commission, told the House Committee on Oversight and Government Reform back on Oct. 7.

Still, some tax experts think Treasury is not using the full extent of its bonus-busting authority.

Henry Oehmann, the director of national executive compensation services at Grant Thornton in Raleigh, N.C., said provisions in the stimulus bill could give the government the right to review bonuses whose payment impairs the value of firms receiving federal aid. It wouldn't be hard to make the case that the bonus case at AIG has done just that, Oehmann said.

"It seems to me they have some tools here," he said of the Treasury's ability to influence bonus payments at AIG. "Who would argue that this whole mess hasn't hurt shareholder value?"

But it appears Treasury has decided that it doesn't want to pick a fight with AIG, and instead let Congress levy taxes on the unpopular bonuses. And after years of watching traders rake in obscene profits with their escapades, some observers say why not.

"There are no constitutional obstacles to taxing this money at very high rates," said Lee A. Sheppard, a tax attorney and contributing editor at the tax journal Tax Notes. "What's remarkable here is just how tone deaf Wall Street can be."