Flawed Corporate Bankruptcy Law

Organized Crimes
By Carlton Meyer
Nov/03/2008
As the American investment bank Lehman Brothers faced bankruptcy two months ago, executives at one of its subsidiaries sent an e-mail to headquarters suggesting that all executives forgo bonuses this year. A member of Lehman's executive committee and a cousin of President Bush, George H. Walker, sent a reply e-mail to senior executives disagreeing with the suggestion: "Sorry team. I'm not sure what's in the water at 605 Third Avenue today. … I'm embarrassed and I apologize."

Lehman CEO Richard Fuld, who was paid $485 million in salary, bonuses and options between 2000 and 2007, also mocked the suggestion.[1]

Because of the dismal leadership of people like Bush and Fuld, Lehman was forced into bankruptcy. Lehman bosses sent a terse e-mail to most employees that Lehman had filed for bankruptcy; they would be laid off; and Lehman hadn’t the funds to meet payroll so they should clean out their desk immediately and go home. Meanwhile, Lehman defaulted on $160 billion dollars in uninsured bonds that were owned by European pension funds. Lehman had also sold these to thousands of individual Asian workers, insisting that their reputation and high credit rating was so strong that insurance was unnecessary. Since Lehman was a member of the S&P 500, nearly all American pension funds suffered losses from Lehman’s demise.

Flawed Corporate Bankruptcy Law
While there is much discussion and taxpayer funding to deal with the symptoms of the meltdown on Wall Street, there is little concern about addressing the root cause. Senior executives can loot their companies through outrageous pay packages while a corporation heads toward bankruptcy. Of the many reforms the U.S. Congress needs to make, it must rewrite corporate bankruptcy law to prevent the frequent looting of dying companies by their own executives.

In personal bankruptcy, the judge demands all financial records to ensure that person is truly bankrupt and has not hidden assets. This logic should become part corporate bankruptcy law. Judges must ensure that those responsible for the bankruptcy, best defined as the senior executives for the previous four years, refund excessive compensation. Refunds should also be required when taxpayers bailout corporations to prevent bankruptcy.

Fair Compensation
Long-time stock analyst Stephen McClellan recently authored a book about the financial industry "Full of Bull" that provides great insight. McClellan states that people on Wall Street are vastly overpaid. Their educational requirements are no greater than doctors or top civil engineers, yet they earn several times more. The Institute for Policy Studies calculated that last year the CEO's of the nine banks now receiving federal bailout funds took home on average, $32.2 million each, nearly triple the average CEO pay at the 500 biggest US companies.[2]

Last year Merrill Lynch's chairman Stan O'Neal retired after announcing losses of $8 billion, taking a final pay deal worth $161 million. Citigroup boss Chuck Prince left last year with a $38 million in bonuses, shares, and options after multibillion-dollar write-downs. In Britain, Bob Diamond is Barclays’ president, and one of the few investment bankers whose pay is public. Last year his total pay, including bonuses, reached £36 million.[3]

The weak explanation of “free market capitalism” falls apart when banks file for bankruptcy and default on billions of dollars in bonds, while equity investors are wiped out. Either bank executives were incompetent and didn’t earn their pay or they defrauded people. Whatever the reason, there must be a mechanism to recover what they took. Creditors in bankruptcy court can attempt to have money paid to executives within the past year recovered, but that is at the discretion of the judge. Millions of dollars looted in previous years is untouchable.

Hold Executives Accountable
The solution is to require four year look-back period to recover money looted from bankrupt corporations in the form of excessive executive compensation or unwarranted payouts to friends and relatives posing as consultants or lawyers. “Excessive” is difficult to define. Senator John McCain suggested that executives at banks receiving federal bailout money be limited to what the U.S. President earns -- $400,000 annually.

Americans should agree that executives deserve no more $1 million in total annual compensation in the four years prior to the date a corporation files bankruptcy. The obvious benefit of recovering funds is to help compensate bondholders and unpaid employees. However, this would affect the attitude of corporate America in other ways.

Roll the Dice Strategy
The bankruptcy of many American investment firms in recent years was caused by gambling in the futures market. Executives made risky bets because of their bonus structure. For example, a 32-year old senior trader at the hedge fund Amaranth, Brian Hunter, was given great latitude and allowed to pocket 15% of whatever he earned trading energy futures. This allowed him to collect $75 million in 2005 after Hurricane Katrina disrupted the Gulf coast energy complex.

He tried the same strategy in the summer of 2006, yet bet wrong and lost 70% of the funds assets. Amaranth declared bankruptcy, 400 employees lost their jobs, and investors lost billions. Hunter lost his job too, but still kept the $75 million bonus from 2005.[4] This bonus model is common throughout Wall Street, so it is no surprise that traders take great risks with other people’s money when there is everything to gain and little to lose. Making risky bets shouldn’t be criminalized, but it should not be profitable for insiders if it eventually bankrupts a company.

Excessive compensation recovery as part of corporate bankruptcy law would lessen this malfeasance. If a risky bet pushed a firm into bankruptcy, executives would not only lose their jobs, but any bonuses from risky bets that paid off in the four previous years. In this case, Hunter would have to refund his 2005 bonus to help cover investor losses. Moreover, the existence of bankruptcy recovery laws would mean that traders like Hunter would not take high risks if their money was at stake. In addition, fund managers would keep a tight leash on traders knowing that high risks may not only hurt investors, but personal profits they already banked.

Bankruptcy Strategy
Corporate bankruptcy is designed to allow a judge to void all contracts and debts as part of the corporation’s reorganization plan. This normally involves layoffs and closing some operations while selling others. Ideally, these actions put the corporation on track to a profitable future within a year. Otherwise, the judge declares it a failure and orders a liquidation of assets to pay creditors some of what they are owed.

In recent years, some corporations abused the intent of bankruptcy law to shed their pension plans. This occurred in the airline industry where they dumped their pension plans to become profitable. These are insured by the federal government, so taxpayers were left with the bill. Employees who had paid into the plan received a small reimbursement, while retirees had their benefits slashed since federal insurance only pays a small portion. These airlines emerged from bankruptcy in a stronger position to compete. Meanwhile, other airlines may dip into bankruptcy and shed their pension plans to stay competitive.

This will soon become a national crisis as more corporations adopt the strategy of using bankruptcy filings to shed pension plans. General Motors has blamed its pension costs and related health care costs for its losses in recent years. GM and Ford executives will find it easier to glide into bankruptcy and dump their pensioners rather than make a serious effort to build small cars, or electric cars that have been in high demand for years.

The threat of bankruptcy has been used for years as part of negotiations with unions and creditors. This is understandable if a corporation truly faces bankruptcy, but it is often the result of lazy management. If a change in corporate bankruptcy law requires executives to repay most of their compensation from the past four years, executives would find the idea of using bankruptcy as a management tool appalling.

Rats Jumping Ship
It has become common for senior executives to resign once it becomes apparent their firm is heading for bankruptcy. Others are forced to resign, and happily collect a huge “golden parachute” bonus as they depart. This happens as the corporation nears bankruptcy, and the talent that these executives supposedly possess is needed to keep afloat. If new executives are hired, they often demand huge pay packages to board a sinking ship, and arrive unfamiliar with the corporations’ problems.

On the other hand, if executives see bankruptcy as a threat to their personal wealth, they will work hard to save the corporation, lest they must refund millions of dollars. This will cause a drastic change in attitude in corporate America. Senior executives now earn millions of dollars at corporations that are obviously heading toward bankruptcy. They may quietly offer suggestions on strategic direction, but fear upsetting their lucrative position by rocking the boat. However, if they are subject to a four-year look-back period in which a bankruptcy judge will order them to repay most of their fat paychecks, they will become more active and argumentative.

For example, many failing companies continue to pay hefty dividends to shareholders while the company loses money for years leading up to bankruptcy. This practice is unwise, yet senior executives fear upsetting major shareholders who might threaten their lucrative jobs. In other cases, friends, relatives, or conflicts of interest deter them from closing unprofitable operations or laying off workers. However, a change in bankruptcy law that threatens the personal wealth of executives would result in decisive leadership and probably cut the number of corporate bankruptcy filings in half.

Ban Legal Looting
While the American people are divided on important issues, they will unite on the idea of limiting the legal looting of corporations. An excellent example recently occurred when Washington Mutual paid a $7.5 million signing bonus to incoming CEO Alan Fishman, who ran the bank for 18 days before it failed.[5] Four days before Lehman filed for bankruptcy, CEO Richard Fuld recommended that Lehman's compensation committee give three departing executives over $20 million in "special payments."[6] None of this is illegal. In contrast, if a personal bankruptcy judge learned that someone had transferred millions of dollars out of his bank just before filing, he would be arrested for fraud and spend years in prison.

Corporate executives would attempt to evade bankruptcy law by collecting money indirectly though law firms and consultants, so bankruptcy law should require the review and recovery of such payments as well. Congress could avoid lengthy court challenges by wealthy executives by imposing a retroactive 100% tax on excessive compensation during the four years preceding a corporate bankruptcy. This immediately involves the IRS in seizing and recovering money and places lawyers before unfriendly tax court judges.

It should surprise no one that the Bush administration has taken no action to address this looting. Both Bush and Cheney made their millions through excessive executive compensation schemes thanks to their insider connections. They would never suggest forgoing ill gotten riches that would embarrass President Bush’s cousin. Hopefully, the next President will “drink the water at 605 Third Avenue” and take action to curtail corporate looting and improve corporate leadership.

[1] “Lehman Brothers Boss Defends $484 Million in Salary, Bonus”, ABC News, Oct. 6, 2008.
[2] “For Whom the Bailout Tolls”; Truthout, Oct. 25, 2008.

[3] “Wall Street Banks in $70 billion Staff Payout”, Guardian UK, Oct. 18, 2008.

[4] "Amaranth's $6.6 Billion Slide Began With Trader's Bid to Quit”, Bloomberg, Dec. 6, 2006.

[5] “WaMu creditors could challenge payments to Killinger, others”, Seattle Times, Oct. 1, 2008.

[6] “Lehman Brothers Boss Defends $484 Million in Salary, Bonus”, ABC News, Oct. 6, 2008.