Last December Lehman Brothers announced that its employees would be rewarded handsomely. Bonuses generally comprise 60 percent of an employee’s compensation at the bank, and in 2007 Lehman paid out $5.7 billion, a 10 percent increase from the year before. Richard Fuld, Lehman’s CEO, was awarded $35 million in additional stock.
Now that Lehman has declared bankruptcy, its past performance and financial statements will face new scrutiny from creditors, who may attempt to recoup those bonuses if they can prove that the bank was not as solvent as it seemed.
“There is a possibility that creditors might launch a legal battle to reclaim some of the bonuses that were paid out last year,” says Paul Hodgson, a senior researcher at The Corporate Library. “Their argument would be that the bonuses were for short-term achievements that were not based on reality.”
Hodgson noted that Lehman does not have a clawback provision in place that would force executives to reimburse the firm for incentive payments, or profits from the sale of stock, awarded in the year prior to an accounting restatement that reflected misconduct. Bonuses that paid for completing specific transactions would be difficult to recoup, Hodgson said, but those relating to earnings or mortgage-backed securities would be more accessible.
“The key question is whether Lehman was solvent when it paid out the bonuses,” wrote Adam Levitin, a law professor at Georgetown University, on his bankruptcy blog Credit Slips. “On an equity basis, almost assuredly yes, but on a balance sheet basis, that might be a closer call, depending on how things like MBS and CDOs are valued.”
If the bank was not solvent when the bonuses were awarded, Levitin explained, the payout could be considered a “fraudulent transfer.” One successful claim could challenge all of the bank’s bonuses. A Lehman spokesperson could not be reached for comment.
The Lehman bonuses likely will be scrutinized under bankruptcy rules that govern constructive fraudulent conveyance or preference payments. In 2005, Congress passed The Bankruptcy Abuse Prevention and Consumer Protection Act, allowing trustees and creditors to examine bonus pay under those two scenarios.
Rules related to constructive fraudulent conveyance allow creditors to examine two years worth of bonus pay in determining whether executives will have to return the payouts to the bankrupt company’s trustee, says Jack Williams, a managing director at BDO Consulting and a bankruptcy professor at Georgia State University’s College of Law.
Preference-payment rules allow creditors to look back one year if the executive or officer receiving the bonus is considered an “insider” under bankruptcy rules, says Hal Schaeffer, president of D&H Credit Services. Otherwise, preference claims extend back only about three months.
Preference claims are meant to prevent an insolvent company from favoring one creditor at the expense of another. In practical terms, the bankrupt company has the right to sue vendors to force them to return payments that were made within 90 days of the bankruptcy filing.