AIG Bonuses as Fraudulent Transfers

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. 

What about the potential double damages issue that Chairman Bernanke suggested scared off the Fed?  My understanding is that is a matter of Connecticut state employment law and is triggered if an employer wrongfully withholds wages.  Even if it covered bonuses, it just doesn't come up as an issue with fraudulent transfer actions, regardless of whether state or federal fraudulent transfer law applies. With fraudulent transfer actions, the bonuses are paid, and then clawed back.  There's no withholding whatsoever, so the double damages issue for an unsuccessful suit doesn't arise.  Instead just the traditional rule that parties bear their own costs. 

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.  

Comments

[CathyG]

Clawing back the bonuses is important if for no other reason than as a symbolic stand against a financial industry that seems to consider itself immune to suffering any hardship from the chaos it has caused.

But there are bigger areas of fraudulent activity going on here. AIG wrote the CDS that are now causing so much trouble and so much expense to the taxpayer - $180B and counting - and did so without anything close to the capital reserves necessary to make good on the policies. Isn't this fraud?

If I pay a year's worth of premiums to Allstate and my house burns down, they're not allowed to say "oops, so sorry but we don't have the money." That would be insurance fraud. So why do my husband and I have to make good on AIG's fraudulently made CDS contracts? They clearly never had any ability or intention of making good on these contracts, so why can't the US Treasury say that we won't honor fraud?

[max]

(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 way I understood when I read it was AIG put up the control of the shares plus some assorted assets as collateral on the loan, and as an additional guarantee, added in that in the event of default, FRBNY had sole title as first claimant in line. It was a strange hybrid, but it clearly seems that AIG put itself up as collateral on the loan, which is characterized as loan, since it has a repayment schedule, plus conditions attached.

The way I read the other deals was that Treasury legally treating those shares as equity, so they do not appear to matter. The whole thing appears to boil down to the Trust owned by the Treasury, which is run for the benefit of the Treasury.

It seems to me Treasury could claim standing as beneficiary of the trust, and that might fly or it might not, but since the Federal Reserve board, rather than FRBNY is the Trustee, I think FRBoard has the immediate standing to sue. Would UST need to sue the Trustee AND AIG to make a fraudulent claim, since the Trustee won't act?

OK. It appears the trust has got 100% of the equity in AIG Trading Group which merged somehow with FPU, so, in the event of default, the Trust owns FPU.

Honestly, I don't think the Fed or the Treasury would sue ever.

max
['I don't think they're willing to do anything.']

[anon]

Analysis is generally good withthe following comments:

First it overlooks that payments under pre-existing contracts are normally not considered fraudulent transfers, because the definition of "value" in ft law includes satisfaction of an antecedent obligation. Plenty of cases on that. Further, your characterization of these as "discretionary bonuses" is not accurate. They were retention bonuses and according to the press the amount of each bonus was the amount of the person's prior year compensation. Effectively the deal sounds like, we'll pay you the same as last year if you stay the full year. So the payment was not discretionary as it was tied to an event beyond the company's discretion and the amount was similarly determined. One can disagree that it was reasonably equivalent but to make the case stick one would be ill-advised to misstate the facts. Finally, although I see that people like to make their thinking easy by lumping everyone into the same class, in reality, there would be a triable issue as to each recipient on the question of the value of his or her individual services. Other than the psychic income that would flow from pleasing the crowd in the Colosseum, it seems like an inefficient use of government legal resources on a net basis.

[Adam Levitin]

Anon raises an important point--were the bonuses discretionary? If not, then the case that AIG did not receive "reasonably equivalent value" is quite weak. I haven't been able to figure out from news reports whether the bonuses were in fact discretionary and to what degree. My impression of how they work is different from Anon's, but I would reserve judgment until seeing the actual deal language. The mere fact that they are called "retention bonuses" surely isn't dispositive, and I think it's a bit much to say that there is a misstating of the facts. We just don't know the details of these bonuses yet.

Anon is also right that there would be separate triable issues as to each recipient. But it doesn't follow that every one of them would go to trial. It's just not cost efficient for anyone. My guess is that there might be one bonus that gets tried and the rest stipulate based on that outcome.

Finally, Anon is of course right about the questionable value of pursuing _any_ of the AIG bonuses, and I've blogged about it before. The systemic costs are the real worry. But the narrow cost-benefit of recovering any individual bonus is a different matter; for the larger ones, it probably is cost effective; the small fry, maybe not, but if done on contingency, who cares? Max's comment gets to the heart of this: it doesn't look like Treasury or the Fed _want_ to sue. They have colorable, if not perfect, legal claims. There's enough to act on if the motivation is there. I just don't think it is. Whether it should be depends on whether the political benefits now outweigh the systemic costs of undermining confidence in government deals down the road.

[AMC]

I think the AIG execs would have a very good chance of beating a fraudulent conveyance action based upon having given 'reasonably equivalent value'. I am not familiar with the federal statute you reference, but I've litigated (from both sides) my fair share of constructively fraudulent conveyance issues under state law and Section 548 of the Bankruptcy Code.

In addition to the points made by "anon", the payments made for similar services in the past are at least evidence that the values exchanged were 'reasonably' equivalent, for fraudulent transfer purposes. In other words, the salaries and bonuses given to similar executives prior to the crash are going to be evidence of the 'going rate' for those services.

Also, unlike in a preference action, past consideration is good consideration for fraudulent conveyance purposes.

As for one trial being dispositive for all - that's just not in the executives best interest. If I were defending an AIG executive, I might agree that we'd be bound by the finding that AIG was insolvent, but there is no way in hell I'd stipulate to being bound re: reasonably equivalent value.

However, I might not demand a jury trial on that issue.... I might leave that issue to be decided by the judge. :-)

[Thomas Perkins]

The better remedy may be a stockholder's derivative suit against the officers and the board for breach of fiduciary duties. Instead of prudently funding a loss reserve account from the enormous profits AIG made on the risky credit default swaps, they orchestrated the payout of most of those profits in bonuses, thereby rewarding and encouraging more of the same. If you want to get your blood boiling, read the best article I have seen on the CDS mess: http://www.rollingstone.com/politics/story/26793903/the_big_takeover.