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Uncle Sam should claw back Wall Street bonuses

By Harvard Law School Program on Corporate Governance

(Editor’s Note: For a related piece published in the San Francisco Chronicle by Professor Jesse Fried, the author of this post, see here.)

Warren Buffett aptly called the credit-related derivatives invented, marketed, and held by Wall Street firms “financial weapons of mass destruction.” These weapons have now gone off, putting the economy at risk. The Bush administration has cobbled together a $700 billion taxpayer-financed plan to bail out Wall Street firms and, it is hoped, avoid a larger economic disaster.

Unfortunately, While Wall Street executives have already pocketed large profits from the reckless business decisions that made the bailout necessary in the first place. Over the last two years, Wall Street financiers took home more than $60 billion in bonuses, much of it in cash. Lehman Bros. alone shelled out almost $6 billion in bonuses in 2007; it recently filed for bankruptcy.

If the government ends up losing money on the bailout, it should make a serious effort to “claw back” at least part of the bonuses paid to Wall Street executives before the meltdown. The cost of cleaning up this mess must not fall entirely on taxpayers’ shoulders; those who profited from the derivatives casino should chip in directly. Clawing back executives’ bonus pay will also make future decision-makers think twice before taking similar financial gambles, reducing the likelihood that another generation of Americans will be asked to bail out Wall Street.

The challenge would be finding legal authority to recover pre-meltdown bonuses. If a bailed-out firm were to file for bankruptcy, several provisions of the Bankruptcy Code could be used to recover pre-bankruptcy bonus payments to its executives. But if the rescue plan is successful, most of these bailed-out firms won’t be forced to file for bankruptcy. Is there a way to attack the bonuses paid by the firms that, thanks to government assistance, are able to steer clear of bankruptcy?

One possible source of authority is New York’s “fraudulent conveyance” statute, which applies to all firms in that state, including those that have not filed for bankruptcy. The statute gives creditors the right to recover a payment to an insider if, for example, the paying firm (1) did not receive fair consideration for the payment and (2) at the time had unreasonably small capital for its business operations. Some courts have held that managerial services do not constitute fair consideration for purposes of this type of statute. The statute may thus permit the government, to the extent it is considered an unpaid creditor of a bailed-out firm, to recover a bonus payment to one of that firm’s executives.

Will the federal government be able to recoup bonuses paid to Wall Street executives before the meltdown? We won’t know for sure until the government litigates these cases. But if the government loses money on the bailout, bringing these cases is the least the government can do for taxpayers - both those on the hook for the $700 billion rescue plan and those who may be asked to pay for a future bailout.

Full post as published by The Harvard Law School Corporate Governance Blog on October 04, 2008 (boomark / email).