Bankruptcy

AIG Bonuses as Fraudulent Transfers

By Adam Levitin

We?ve heard Fed Chairman Bernanke and Treasury Secretary Geithner say that there are no legal avenues to clawing back the AIG bonuses.  I?m not so sure that?s true.  What about good old fraudulent transfer law?  That?s a cornerstone of creditor-debtor law.  Would fraudulent transfer law apply?

Every state in the union has a fraudulent transfer law.  But there is also a special (and virtually unknown) federal fraudulent transfer statute just for the United States government, as creditor.  The federal government could, of course, proceed under a state fraudulent transfer law (I?m not sure which state?s law would apply to AIG), but why bother when it could proceed under its own law?

So would the government be able to clawback AIG?s bonuses with a fraudulent transfer action? 

Maybe.  As far as I know AIG has received loans from the Federal Reserve Bank of New York and the US Treasury has purchased preferred shares in AIG, but not made any loans directly.  The government?s argument would be that AIG made the transfers when it was thinly capitalized and/or insolvent or likely to become so and that AIG did not receive ?reasonably equivalent value.?  Discretionary bonuses are also per se not reasonably equivalent value. 

But there are some potential problems for the federal government.  First, the federal fraudulent transfer statute only applies to the United States as a ?creditor.?  Creditor is defined to include the holder of contingent claims, so to the extent the US is a guarantor, it should have standing to bring an action.  I?m less certain that this would hold for being a second-tier guarantor, e.g., Treasury guarantees the Fed, which guarantees AIG, much less if the guarantee of the Fed is implicit.

If the United States is not a guarantor, what about bringing an action as a preferred shareholder? Preferred stock is a hybrid debt-equity security.  It has some characteristics of debt and some of equity.  While preferred shares are nominally equity, there are many circumstances (tax, bankruptcy, corporate governance) in which courts have recharacterized preferred shares as debt, including cases in which preferred shareholders have been successful in bringing fraudulent transfer actions.  (If preferred stock is equity, there is still a state corporate law claim for ?waste.?) 

It is difficult to generalize about preferred stock because there are many possible variations, including whether it is perpetual, cumulative, voting, convertible, redeemable at will or on or after date certain, whether dividends are automatic or must be declared, and whether a dividend has in fact been declared and come due.  There is no case law directly on point regarding the federal fraudulent transfer statute. 

There is, however, case law on whether preferred shareholders have standing to bring fraudulent transfer actions under various state statutes. The case law is mixed.  While most decisions indicate that preferred shareholders lack standing, the decisions are highly dependent on the particular characteristics of the preferred stock.  So it?s uncertain whether the federal government as preferred shareholder could bring a fraudulent transfer action.

It is important to note that while the standing question is unresolved for preferred stock, the Treasury Department?s March 2, 2009 stock exchange agreement with AIG likely weakened any argument the federal government had for standing to bring fraudulent transfer litigation under 28 U.S.C. § 3304 as a preferred shareholder.  The agreement provided for Treasury to exchange cumulative, quarterly compounding, automatic dividend Series D AIG preferred stock for non-cumulative Series E AIG preferred stock on which a dividend must be declared.  Non-cumulative preferred shares without an automatic dividend are more like equity than cumulative, compounding, automatic dividend shares.  This makes standing as a creditor less likely.

AIG is clearly a debtor to the Federal Reserve Bank of New York. (Let's put aside the part of the deal in which AIG ?lent? the NY Fed a bunch of toxic assets, presumably on a non-recourse basis, and the Fed posted good ?cash? collateral).  The Federal Reserve Bank of New York is not part of the federal government.  Although authorized under federal law, it is a privately-owned institution, owned by its member banks.  So the FRBNY can't use the federal fraudulent transfer statute, but it should be able to bring a fraudulent transfer action against AIG under state law, and surely Treasury could persuade the FRBNY to do so.  (I?m uncertain where the Federal Reserve Board fits in here, either in terms of AIG transactions or government/private classification, but the Board might also be able to bring an action.) 

There?s also a question about whether the transfer was made by the relevant debtor.  I am not sure how AIG is structured, but the bonuses might have been paid by a subsidiary of the debtor holding company, which is not itself a co-debtor.  For example, if the United States or FRBNY is a creditor solely of AIG?s holding company, AIG?s Financial Products Division is a separately incorporated subsidiary of the AIG holding company, and the transfer being challenged was made by the Financial Products Division, the United States might not be able to challenge the transfer on the basis of insolvency and lack of reasonably equivalent value because it lacks a creditor relationship with the entity actually making the transfer.  Lastly, as Angie Littwin has noted, the bailout of financial institutions might save AIG from having committed a fraudulent transfer because the bailout arguably rectified the institutions? insolvency

The FRBNY could almost certainly bring a fraudulent transfer action against AIG and maybe the US government could as well.  Whether the action would ultimately be successful is uncertain, but there?s certainly a colorable litigation route to take with AIG, and I?d bet there are lots of law firms that would gladly take this on on a contingency fee basis. 

We?re seeing a lot of interesting twists as the federal government becomes a market participant in distressed investment and lending situations.  From questions of priority in the GM and Chrysler credit agreements to fraudulent transfers with AIG, the government?s market activities are really a primer in the risks involved in distressed situations.  The government's position is complicated because it has political, as well as economic considerations, and those often argue for taking actions that if unsuccessful leave the government poorly protected down the road. There is a real tension between the attempts to avoid economic failure and the attempts to shield the taxpayers from the impact of such failure.  If the government aims for the former and is unsuccessful, public funds are much more exposed as a result.  

Full post as published by Credit Slips on March 27, 2009 (boomark / email).