Wednesday, October 29, 2008

Fraudulent Transfers to Employees

Shenwick & Associates has recently received calls from employees of struggling businesses inquiring whether bonuses paid to employees are recoverable in bankruptcy. These inquiries stem from recent articles in the New York Times, CFO.com, and Creditslips.org that discuss the possibility that the Bankruptcy Code may allow Lehman Brothers as a debtor-in-possession to "claw back" some of the $5.7 billion in bonuses that were paid out to its employees and executives in the past year.

Under section 548 of the Bankruptcy Code, a trustee in bankruptcy can recover fraudulent transfers made prior to bankruptcy. Specifically, section 548(a)(1)(B) of the Bankruptcy Code allows recovery by the debtor-in-possession if constructive fraud exists. Constructive fraud exists if the debtor: (1) made a transfer within 2 years of the filing of its bankruptcy petition; (2) received less than "reasonable equivalent value" in exchange for the transfer; and (3) either was insolvent at the time the transfer was made, made insolvent by the transfer, or the transfer was made to the benefit of an insider under an employment contract and not in the "ordinary course of business."

In a post on Creditslips.org, Adam Levitin, a professor of law at Georgetown University, stated that the third element would likely be the deciding factor if a fraudulent transfer claim was filed in the Lehman Brothers bankruptcy case. He reasoned that the first two elements were easily established because the bonuses being challenged were made within one year of the bankruptcy petition and generally, bonuses that are paid in addition to a salary are clearly transfers made for less than reasonable equivalent value.

It is this author's experience that in these cases the third factor is always the key factor. The defenses available to an employee who seek to retain his or her bonus are that the company was solvent when the bonus was paid or the bonus was made in the ordinary course of business.

Accordingly, regardless of insolvency, Lehman Brothers may succeed in a fraudulent transfer claim if it can establish that the bonuses were made to insiders and were not made in the ordinary course of business.

For more information about the recovery of bonuses under the Bankruptcy Code, please contact Jim Shenwick.

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