Last month's Update focused on pension protection proposals.¹ This month, we take the opposite tack (would that be pension invasion?) and look at a recent proposal to recapture pension payouts to management employees in the year before bankruptcy.

Days before Enron filed bankruptcy in December 2001, 292 executives received bonuses totaling $73 million, and others got $53 million more in deferred compensation. Those payouts are now the targets of lawsuits filed by the Enron Employee Committee, as authorized by Bankruptcy Judge Arthur Gonzalez in August 2002. Letting the official employees' committee try to recover the payments was part of a settlement between the employees, with help from the AFL-CIO and the Rainbow Push Coalition, and Enron and its other creditors, to allow immediate severance payments of $13,500 to thousands of laid-off Enron workers.² These "David-and-Goliath" lawsuits³ pitting lower-level employees against top executives have not been going well, but such suits could get a powerful push from bills pending in Congress.

"Executives shouldn't be lining their own pockets while ordinary workers lose their jobs, health care and pensions."⁴ With those words, Senator and presidential candidate John Edwards (D-N.C.) introduced S. 1343, the Equal Treatment of Pensions and Bankruptcy Act of 2003.⁵

The bill's loose drafting raises the question: "What's the real agenda here?" Sen. Edwards's press release sounds as if the only targets are top executives who bail out of failing firms or lead them into bankruptcy after "squirreling away pension funds for themselves."⁶ However, the bill could be read to allow organized labor and other creditors to file suits to recapture every dollar the debtor paid into defined benefit or defined contribution plans, within a full year before bankruptcy, for each and every "management employee." If that's the intended reading, the bill would give unions much greater power in plan negotiations pre- and post-petition. Of course, such a reading would also increase the costs to administer standard retirement benefit plans and discourage employers from offering these benefits to their employees.

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[T]he bill could be read to allow organized labor and other creditors to file suits to recapture every dollar the debtor paid into defined benefit or defined contribution plans, within a full year before bankruptcy, for each and every "management employee."

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The bill has two parts. First, it would create a new class of per se preferences: transfers to fund "supplemental retirement benefits or other deferred compensation" within a year before bankruptcy for insiders and other management employees. No proof of insolvency would be required, and none of the standard exceptions to avoidance would apply. Of course, the DIP's managers won't rush to file adversaries to retake their own perks. The bills would cure that problem by derivative standing; that is, letting courts allow creditors' committees or others to file avoidance and surcharge adversaries for the estate. Express authorization of this practice would put to rest uncertainties raised by the Supreme Court's Hen House decision.⁷

I. S. 1343's Powerful New Pension Preference Seek-and-destroy Tool

The bill would add a new subsection to Code §547 on preferences:

(h) Notwithstanding subsections (b) and (c), the trustee may avoid a transfer of a debtor's...property to any trust or similar arrangement to fund supplemental retirement benefits or other deferred compensation for the benefit of an insider or other management employee...within one year before...the filing of the petition.

This clearly would create a new subset of avoidable preferences with few defenses, but that's all that's clear. Do the words "supplemental retirement benefits and other deferred compensation" include qualified plans? Which trusts and similar arrangements are covered? Why dispense with proof of insolvency and insider status? Who is a management employee for this purpose? Why make all the §547(c) exceptions inapplicable?

The bill does not define either "supplemental retirement benefits" or "transfers into...trusts." That's a problem, for the words could stretch to fit even qualified plans, the defined benefit and defined contribution plans that "supplement" Social Security benefits for a wide range of employees. However, qualified plans have relatively low limits on contributions and are closely regulated under the Internal Revenue Code and ERISA. They do not lend themselves easily to the eve-of-bankruptcy insider manipulation described in Edwards's press release. If qualified plans are not the bill's intended quarry, the bill should be revised to make that clear.

A narrower reading of "supplemental retirement benefits" is found in some discussions of executive compensation. There, those words often mean perks offered only to top executives and other key personnel, perks different from those offered under qualified plans.⁸ These special perks, with nicknames like "top-hat plans" and "golden parachutes," help recruit and retain key personnel, giving them contractual protection from change of control, mergers and, now, bankruptcy. Their more formal name is "non-qualified deferred compensation arrangements" (NQ plan) because they do not qualify for favorable tax treatment. The employer gets no deduction until the employee is taxed on NQ plan benefits, and benefits are ordinary income to participants. On the other hand, there are few statutory limits on amounts payable under these plans. Limits are matters of private corporate governance, not public law.

NQ plans normally are not funded, for funding would trigger constructive receipt and recognition of ordinary income for participants. Thus, NQ plan participants are usually unsecured creditors. Unlike most other unsecured creditors, however, these insiders can improve their status very rapidly. NQ plan participants will be the first to know of their firm's financial distress. Constructive receipt looks much better than non-receipt and discharge when bankruptcy looms. So, they have both the strong incentive and the power to (1) quickly fund the plan by transferring assets to their benefit and (2) postpone a bankruptcy filing until at least 91 days after that transfer, making preference avoidance more difficult. Insiders can quickly pull large sums out of the firm, dollars that could have been used to pay other unsecured creditors.

In theory, these transfers are avoidable under current §547, but there are real obstacles. Under §547(b), the trustee has the burden of proving insolvency of the debtor at the time of transfer—a difficult issue. Transfers more than 90 days pre-petition are avoidable only if they benefit "insiders," defined in Code as the directors, officers and "persons in control" of a corporate debtor.⁹ Finally, the beneficiaries of golden-parachute transfers may still control the debtor-now-turned-DIP. If so, they will not rush to recover assets from themselves.

The bill would remove all of these obstacles. The need to prove insolvency and insider status is eliminated, along with all exceptions to avoidance under §547(c), by the first four words of the proposed new subsection: "Notwithstanding subsections (b) and (c), the trustee may avoid..." Who would file the case is discussed in Part II below. The trustee could avoid those pension funding transfers by proving five simpler elements:

1. a transfer of the debtor's property;
2. within one year before the petition was filed;
3. to a trust or similar arrangement;
4. to fund supplemental retirement benefits or other deferred compensation; and
5. for the benefit of an insider or other management employee.

It is item 5's reference to "other management employee" that raises questions as to the real agenda here. Is it, as advertised, just to stop a small cabal of insiders from looting a failing firm? If so, why add non-insiders to the target list? The bill makes transfers even to non-insider mid- and lower-level managers vulnerable for a full year before filing. Since the bill is not expressly limited to NQ plans, transfers into qualified plans for any and all management employees might be avoidable. NQ plans are the more appropriate target, and it should not be unduly difficult to show that participants therein are insiders. The reference to other management employees is overkill for that purpose. On the other hand, if the intent is to give the rank and file and their representatives much greater leverage in the employers' bankruptcy, putting all of management at risk would do the job.

Under current law, regular employer contributions to non-discriminatory qualified plans could be ordinary-course transfers protected from avoidance under §547(c)(2). However, the bills make each and every subsection (c) exception inapplicable to this new avoiding power. If only insiders and their NQ plans are the targets, there is little need to rule out subsection (c)'s exceptions. Suddenly shifting millions into previously unfunded plans would not be ordinary course, and the other standard exceptions are unlikely to apply. Putting qualified plans at risk runs counter to the strong federal policy of protection of retirement savings.

A final complaint as to this part of the bills: They do not state whether this revised preference power would affect pending cases or prospective only. So large a change should be purely prospective.

II. Is There Life after Hen House? Derivative Standing for Surcharge and Avoidance Actions

If transfers into insiders' and other managers' pension plans could be avoided, the next question is who would file the action. It won't be the debtor-in-possession's (DIP's) insiders, who got some or all of the targeted transfers. Someone else will need the power. The bill answers this by authorizing the court to allow persons other than the trustee or DIP to file avoidance and surcharge actions on behalf of the estate. The bill proposes to add yet another new subsection to §547:

If the trustee consents or fails to commence a proceeding...under §506, 543, 544, 545, 547, 548, 549, 550, 552, 553 or 724, on request of a party in interest or a committee of creditors...after notice and hearing, the court may authorize such party...or committee...to commence and prosecute such proceeding if the court finds...[it] is in the best interest of the estate and for the benefit of the estate.

One technical quibble before we get to substance. Section 547 is the wrong place. The new subsection would apply not only to preferences, but also to a wide array of actions under §§506, 543, 544, 545, 548, 549, 550, 552, 553 and 724. If this is enacted, put it in §546, entitled "Limitations on Avoiding Powers."

Now for substance. For more than 100 years, courts have allowed creditors' committees or other parties in interest to bring avoidance actions on behalf of the estate if the trustee/DIP unjustifiably fails to act and the court authorizes the action.¹⁰ The procedure is useful where management of the DIP received the transfers that creditors seek to avoid. Authorizing the creditors' committee or another party to bring the action on the estate's behalf may be less disruptive than appointing a trustee, an alternative the Third Circuit has described as akin to replacing "a scalpel with a chainsaw."¹¹

While the practice has a long history, its validity is in doubt due to the Supreme Court's decision in Hartford Underwriters' Ins. Co. v. Union Planters Bank (In re Hen House),¹² better known as Hen House, that an administrative claimant lacked standing to file a surcharge suit in a chapter 7, where the court did not authorize the action and the creditor acted for its own benefit rather than for the estate. The crucial words in §506(c) are "the trustee may," which the Court read to mean "only the trustee (and DIP) may...." Justice Scalia, writing for a unanimous court, said the statute's language was plain, so "the sole function of the courts...is to enforce it according to its terms" if that result is not absurd.¹³ "Had Congress intended the provision to be broadly available, it could simply have said so,"¹⁴ as it did in other sections that expressly allow a party in interest to take various actions.

However, Justice Scalia also included footnote 5, which appears to limit the Hen House holding to its peculiar facts of no court authorization and no benefit to the estate.¹⁵ This leaves the validity of derivative standing in other cases unclear.

The Second and Seventh Circuits were the first to look at derivative standing after Hen House. Both found the practice survived where recovery was for the estate and the court authorized the action.¹⁶ Last year, however, a Third Circuit panel saw it differently. In In re Cybergenics, that panel read Hen House as extending to a fraudulent transfer action that the court had authorized. They held that a court had no power to authorize a creditors' committee to bring such an action on behalf of the estate.¹⁷ Early this year, the Cybergenics panel opinion was vacated, and the Third Circuit heard the case en banc. The majority opinion for the court en banc upheld derivative standing, finding that a bankruptcy court may use "its equitable powers to craft a remedy when the Code's envisioned scheme [of having the debtor-in-possession pursue avoidance actions] breaks down."¹⁸ The en banc majority found that Code §§503(b)(3)(B), 1103(c) and 1109(b) empower the court to let creditors' committees or others act on the estate's behalf. The Third Circuit distinguished Hen House, since the claimant in that case acted without court approval and sought recovery for itself rather than for the estate. Four judges joined in a dissent.

The bill would settle this question by clearly authorizing derivative standing where the trustee/DIP either refuses to file or consents to another party's filing an adversary under the long list of sections set forth above. With that settled, the new power to recapture transfers to fund supplemental retirement benefits and other deferred compensation for insiders and other management employees could be put into action

So far, Sen. Edwards and Rep. Conyers are the sole sponsors of this proposal, which languishes in the Judiciary Committees of both houses. Their bills bear watching, however, because their brief words mask changes of uncertain scope. Maybe they would only capture dollars from "CEOs [who] have used tricks and gimmicks to give themselves huge benefits while cutting pensions for workers."¹⁹ Conversely, they could threaten a full year's worth of employer contributions to retirement funds for managers at every level, and end by bringing an end to benefits for all employees.

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Footnotes

¹ Culhane, M., "Pensions and Bankruptcy: Recent Developments," ABI Journal (November 2003). Return to article

² Pacelle, Mitchell, "Despite Lawsuit, Enron Bonuses Haven't Been Returned," Wall Street Journal, Nov. 3, 2003; Berger, Eric and Murphy, Bill, "Finally, Checks Will Be in the Mail," Houston Chronicle, Aug. 29, 2002. Return to article

³ The quoted phrase is from Mitchell Pacelle's Wall Street Journal article, supra note 2 at C1. Return to article

⁴ "Senator John Edwards Would Ground Golden Getaways for Executives," Press Release, Sen Edwards web site, edwards.senate.gov (June 25, 2003). Return to article

⁵ John Conyers (D-Mich.)is the sponsor of an identical bill in the House, H.R. 2609. Since they are identical, we'll refer to them in the singular here. Return to article

⁶ Edwards Press Release, note 1 supra. Return to article

⁷ Hartford Underwriters Ins. Co. v. Union Planters Bank NA (In re Hen House), 530 U.S. 1 (2000). See Part II of this article. Return to article

⁸ See, e.g., Mancoff & Weiner, Nonqualified Deferred Compensation Arrangements, §11.15 (Westlaw online treaties, updated October 2003). Return to article

⁹ Code §101(31). Return to article

¹⁰ See, e.g., Chatfield v. O'Dwyer, 101 Fed. 797 (8th Cir. 1900). Return to article

¹¹ In re Cybergenics, 330 F.3d 548 (3d Cir. 2003) (en banc). Return to article

¹² 530 U.S.1 (2000). Return to article

¹³ Id. at 6. Return to article

¹⁴ Id. at 7. Return to article

¹⁵ Id. at 13, footnote 5. Return to article

¹⁶ See Term Loan Holder Comm. v. Ozer (In re Caldor Corp.), 303 F.3d 161 (2d Cir. 2002); Fogel v. Zell, 221 F. 3d 955 (7th Cir. 2000). Return to article

¹⁷ 310 F.3d 785 (2002). For brief and lively comments on both opinions in Cybergenics, see Joel Gluckman's two Cracking the Code articles posted on ABI's World on May 2, 2003, and May 30, 2003 (www.abiworld.org/talkback/). Return to article

¹⁸ In re Cybergenics Corp., 330 F.3d 548 (3rd Cir. 2003) (en banc). Return to article

¹⁹ Press Release, supra note 2. Return to article