Legislative Update S. 2820 Would Increase Wage Priority Recover Unjust Compensation
S. 2820 Would Increase Wage Priority, Recover "Unjust Compensation"
Prof. G. Ray Warner
ABI Robert M. Zinman Resident Scholar
A bill introduced by Sen. Jean Carnahan (D-Mo.) and co-sponsored by Sens. Edward Kennedy (D-Mass.) and Patrick Leahy (D-Vt.) on July 30, 2002, would increase the dollar amounts for the §507(a)(3) and (4) wage and employee benefits priorities to $13,500 from the current cost of living adjusted amount of $4,650. This is the same change proposed by the pending Employee Abuse Prevention Act of 2002 (S. 2798 and H.R. 5221) that was introduced by Sen. Richard Durbin (D-Ill.) and Rep. William Delahunt (D-Mass.). The current limit has come under attack recently in such high-profile cases as Enron and WorldCom. In Enron, the bankruptcy court approved priority wage payments that exceeded the current $4,650 limit, and a similar motion is pending in the WorldCom case.
In addition to increasing the wage and employee benefits priority, the bill would also amend the §547 preference provision to permit recovery of transfers of "compensation" made within 90 days before bankruptcy to present or former employees, officers or directors. In order to be recoverable, such compensation must be shown to be either "out of the ordinary course of business" or "unjust enrichment." Although this provision would be added to the preference section, it would not technically be a preference since the section would permit recovery of compensation even if the debtor was solvent and even if there was no pre-existing debt owed to the employee, officer or director. Although the Durbin-Delahunt bill also would allow recovery of excessive compensation, its provisions are substantially different from the provisions of S. 2820.
Since the term "compensation" limits the class of transfers that can be recovered under S. 2820, and since that term is not defined, it is not clear whether this provision would apply to transactions such as sweetheart loans to executives and the forgiveness of such loans that have recently drawn scrutiny.
Similarly, it is unclear how the avoidance standards would apply. The non-ordinary course test, if applied strictly, might result in the avoidance of payments made to rank and file employees, such as the non-ordinary course payment of all earned but unpaid wages on the eve of bankruptcy. It might also result in the avoidance of completely proper compensation arrangements merely because the debtor's financial condition required it to resort to unusual compensation schemes as its condition worsened.
It is unclear whether the alternative "unjust enrichment" standard is meant to incorporate the common-law contract doctrine of unjust enrichment or to provide wide discretion to bankruptcy judges to avoid compensation deemed excessive. If it merely allows recovery of compensation in cases where the compensation was excessive, it adds little to the §548 power to avoid constructively fraudulent transfers where the debtor received less than a reasonably equivalent value. Unlike §548, the amendment would allow recovery even if the debtor was solvent and might allow recovery where excessive compensation was paid pursuant to a contract entered into before the one-year look-back period under §548.
The bill has been referred to the Committee on the Judiciary.
S. 2901 Would Recover "Excessive Payments"to Insiders
A bill introduced by Sen. Charles Grassley (R-Iowa) on Sept. 3, 2002, would permit the recovery of excessive compensation paid to insiders, officers or directors of the debtor during the year prior to bankruptcy. In addition, in cases involving securities law violations or accounting irregularities, the look-back period would be expanded to allow avoidance of both compensation transfers and of obligations incurred for compensation within four years prior to bankruptcy. The bill has been referred to the Committee on the Judiciary.
S. 2901 is drafted to amend both the §547 preference provision and the §548 fraudulent transfer provision. The amendment to §547 creates a one-year look-back period and allows recovery of transfers made within the year prior to bankruptcy to insiders, officers or directors of the debtor if those transfers were for "any bonuses, loans, nonqualified deferred compensation or other extraordinary or excessive compensation." Although this provision would be added to the preference section, it would not technically be a preference since the section would permit recovery of compensation even if the debtor was solvent and even if there was no pre-existing debt owed to the insider.
It is not clear whether the phrase "other extraordinary or excessive compensation" is meant to modify the listed terms. For example, would all bonus and loan transfers be avoidable, or only those that are either unusual or excessive? Further, with respect to a "transfer...made...for any...loan," it is unclear whether the section is limited to loans that are "compensation." If not, this language would permit recovery of all loan payments made to insiders (a term that includes affiliated corporate entities) within the year prior to bankruptcy, even if the loan transaction was legitimate and not related to compensation. The provision is not limited to publicly traded companies and would apply in all cases.
Finally, since the provision establishes "excessive" and "extraordinary" as alternative grounds for avoidance, it might result in the avoidance of completely proper bonus arrangements merely because the debtor's financial condition required it to resort to unusual compensation schemes as its condition worsened. For example, if a turnaround professional were employed as an officer on terms that were unusual for the debtor company, the compensation arrangement might be at risk even if the terms were not excessive.
The bill would also add a new subsection to the §548 fraudulent transfer provision establishing a four-year look-back period for the recovery of compensation in certain cases. The compensation recovery provision applies only to officers, directors or employees of an "issuer of securities" who have engaged in securities law violations or improper accounting practices. The provision applies both to transfers made and obligations incurred and thus would allow the debtor to negate a compensation agreement made within four years before bankruptcy as well as the payments made pursuant to such an agreement. Note that unlike true fraudulent transfers, this provision would permit avoidance even though the debtor was not insolvent or in financial difficulty at the time the transfer was made or the obligation incurred.
The provision targets the same types of transfers as the amendment to the preference provision and raises similar interpretive difficulties. The targeted class of persons is both broader and narrower than the related preference provision. While the inclusion of "employees" expands the section's scope, it does not apply to insiders who are not officers or directors of the debtor, and thus would not apply to a controlling shareholder or an affiliated company. Further, unlike the preference amendment, this provision only applies to issuers of securities that are registered under §12 of the Securities and Exchange Act of 1934, or that are required to file reports under §15(d) of the Act.
The subject transfers and obligations are avoidable if the officer, director or employee committed (1) a violation of state or federal securities law or any regulation or order issued thereunder; (2) fraud, deceit or manipulation in a fiduciary capacity or in connection with the purchase or sale of any security registered under §12 or 15(d) of the Securities and Exchange Act of 1934 or under §6 of the Securities Act of 1933; or (3) illegal or deceptive accounting practices. This section potentially has a very broad sweep. The securities violation provision could be read to apply to technical violations or violations resulting from negligence that might not involve intentional improper conduct. The accounting practices prong could also be interpreted broadly, since the term "deceptive" apparently covers practices that are not illegal.
In addition, the provision does not appear to require that the defendant's improper action relate to the compensation that would be avoided—either by causation, or by time. Presumably, a securities violation committed shortly before bankruptcy could be the basis for the recovery of bonuses paid years earlier.