Legislative Update S. 2820 Would Increase Wage Priority Recover Unjust Compensation

<i>This month's Update includes an analysis by ABI Resident Scholar G. Ray Warner of
two recently introduced bankruptcy bills. Both bills are pending in the Senate
Judiciary Committee at press time.</i>

</p><h3>S. 2820 Would Increase Wage Priority, Recover "Unjust Compensation"</h3>

<p><i>Written by:<br>
Prof. G. Ray Warner<br>
ABI Robert M. Zinman Resident Scholar</i><br>
<a href="mailto:gwarner@abiworld.org">gwarner@abiworld.org</a&gt;

</p><p>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 <i>Enron,</i> the bankruptcy court approved priority wage payments that exceeded the current
$4,650 limit, and a similar motion is pending in the WorldCom case.

</p><p>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.

</p><p>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.

</p><p>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.

</p><p>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.

</p><p>The bill has been referred to the Committee on the Judiciary.

</p><h3>S. 2901 Would Recover "Excessive Payments"to Insiders</h3>

<p>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.

</p><p>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.

</p><p>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.

</p><p>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.

</p><p>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.

</p><p>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.

</p><p>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.

</p><p>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.