Uncle Sam should claw back Wall Street bonuses

Editor’s Note: For a related piece published in the San Francisco Chronicle by Professor Jesse Fried, the author of this post, see here.

Warren Buffett aptly called the credit-related derivatives invented, marketed, and held by Wall Street firms “financial weapons of mass destruction.” These weapons have now gone off, putting the economy at risk. The Bush administration has cobbled together a $700 billion taxpayer-financed plan to bail out Wall Street firms and, it is hoped, avoid a larger economic disaster.

Unfortunately, While Wall Street executives have already pocketed large profits from the reckless business decisions that made the bailout necessary in the first place. Over the last two years, Wall Street financiers took home more than $60 billion in bonuses, much of it in cash. Lehman Bros. alone shelled out almost $6 billion in bonuses in 2007; it recently filed for bankruptcy.

If the government ends up losing money on the bailout, it should make a serious effort to “claw back” at least part of the bonuses paid to Wall Street executives before the meltdown. The cost of cleaning up this mess must not fall entirely on taxpayers’ shoulders; those who profited from the derivatives casino should chip in directly. Clawing back executives’ bonus pay will also make future decision-makers think twice before taking similar financial gambles, reducing the likelihood that another generation of Americans will be asked to bail out Wall Street.

The challenge would be finding legal authority to recover pre-meltdown bonuses. If a bailed-out firm were to file for bankruptcy, several provisions of the Bankruptcy Code could be used to recover pre-bankruptcy bonus payments to its executives. But if the rescue plan is successful, most of these bailed-out firms won’t be forced to file for bankruptcy. Is there a way to attack the bonuses paid by the firms that, thanks to government assistance, are able to steer clear of bankruptcy?

One possible source of authority is New York’s “fraudulent conveyance” statute, which applies to all firms in that state, including those that have not filed for bankruptcy. The statute gives creditors the right to recover a payment to an insider if, for example, the paying firm (1) did not receive fair consideration for the payment and (2) at the time had unreasonably small capital for its business operations. Some courts have held that managerial services do not constitute fair consideration for purposes of this type of statute. The statute may thus permit the government, to the extent it is considered an unpaid creditor of a bailed-out firm, to recover a bonus payment to one of that firm’s executives.

Will the federal government be able to recoup bonuses paid to Wall Street executives before the meltdown? We won’t know for sure until the government litigates these cases. But if the government loses money on the bailout, bringing these cases is the least the government can do for taxpayers – both those on the hook for the $700 billion rescue plan and those who may be asked to pay for a future bailout.

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  1. Randy Picker
    Posted Saturday, October 4, 2008 at 10:21 am | Permalink

    Yes, on 9/23, I suggested for these reasons that we should build a phantom bankruptcy regime into the bailout bill. See http://uchicagolaw.typepad.com/faculty/2008/09/bailouts-and-ph.html

  2. Francine McKenna
    Posted Saturday, October 4, 2008 at 11:29 am | Permalink

    There is a provision in Sarbanes-Oxley for clawing back ill-gotten bonuses. Just get the SEC to do their job. I wrote about it here. http://www.retheauditors.com/2007/12/hey-sec-clawback-those-stolen-bonuses.html

  3. Bruce Porter
    Posted Sunday, October 5, 2008 at 1:18 am | Permalink

    Get over it! The chain of financial malfeasance runs from originators of “liar loans” through the banks, rating firms, investment firms, hedge funds, etc. To single out only executive compensation is short sighted, stupid and childish.
    Review the system, incorporate judicious fixes and move on. If criminal actions are discovered then proscecute.

  4. oliver jin
    Posted Sunday, October 5, 2008 at 12:51 pm | Permalink

    damn right! get our money back from those bastards

  5. Leonard Gehl MD
    Posted Thursday, December 18, 2008 at 8:55 pm | Permalink

    I’m not a lawyer but: the claw back provision under section 304 of sarbanes-oxley act to recover CEO and CFO bonuses based on bogus profits from the scam credit default swaps may just be the tip of the iceberg. Caveat Venditor (seller beware) law could show there is a duty of care. Thus creating a product that is really not a mortgage-backed security but a loan made by buyers, held by a brokerage house, financed through short positions and linked to a possible mortgage default was obviously not eplained to the buyers. Nobody would buy that.

  6. Jeff Parsons
    Posted Saturday, March 7, 2009 at 4:52 pm | Permalink

    In my opinion SOX 304 doen’t go far enough to prevent what is a growing pattern of bonuses paid based on short term profits at the expense of ignoring risk (eg.AIG). We need new SEC/Bankruptcy regulation allowing courts and regulators to claw back officer bonuses for a multi year (3-5) period prior to a public company bankruptcy. Give shareholders the weapons to keep executive robbery of corporate value in check.

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  1. By Bailouts, Bonuses and Clawbacks | The D&O Diary on Thursday, January 30, 2014 at 6:56 pm

    […] should clawback financiers’ prior compensation has been a rallying cry for academics (here) and commentators (here) […]