S. 2901 Would Recover Excessive Payments To Insiders

A bill introduced by Senator Grassley (R-Iowa) on September 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 (4) years prior to bankruptcy. The bill has been referred to the Committee on the Judiciary.

S. 2901 is drafted to amend both the section 547 preference provision and the section 548 fraudulent transfer provision. The amendment to section 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 which are either unusual or excessive? Further, with respect to a "transfer … made …for any … loan," 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 sub-section to the section 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 section 12 of the Securities and Exchange Act of 1934, or that are required to file reports under section 15(d) of the Act.

The subject transfers and obligations are avoidable if the officer, director, or employee committed: (i) a violation of state or federal securities law or any regulation or order issued there under; (ii) fraud, deceit, or manipulation in a fiduciary capacity or in connection with the purchase or sale of any security registered under section 12 or 15(d) of the Securities and Exchange Act of 1934 or under section 6 of the Securities Act of 1933; or (iii) 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.

Prof. G. Ray Warner, ABI Resident Scholar, Professor of Law at the University of Missouri-Kansas City.