Discretionary Bonuses: Per Se Fraudulent Conveyances?

Joe Foster Headshot
Joseph A. Foster
Director, Corporate Department
Christopher M. Dube
Director, Corporate Department
Published: New Hampshire Bar News
July 17, 2019

The Bankruptcy Code does not treat all unsecured creditors equally; public policy concerns dictate otherwise. Workers, for example, benefit from a priority given to payment of certain wages. Frequently, the statute and facts are interpreted in a manner to protect workers and avoid interference with timely payment of wages during a Chapter 11 case. However, workers are not immune to the risk many other creditors face of being owed money and also being asked to pay money back to the estate. Take, for example, a situation in which executives authorize payment of employee bonuses shortly before the filing; on its face this appears to be at the detriment of other unsecured creditors. Creditors who believe the bonuses are improper may have a remedy — to bring an action to claw the bonus payments back into the bankruptcy estate as a fraudulent transfer.

What is a Fraudulent Transfer?

The Bankruptcy Code and N.H. Rev. Stat. Ann. Ch. 545-A, the Uniform Fraudulent Transfer Act (UFTA), permit the recovery of transfers made: (1) with the actual intent to hinder, delay or defraud creditors — so-called “actual fraud”; or (2) at a time when the debtor was insolvent or was rendered insolvent by the transfer and the debtor did not receive “reasonably equivalent value” in exchange – so called “constructive fraud.” This article focuses on a claim brought under the constructive fraud prong of the statute.

Insolvency, the first prong of constructive fraud, can be proven by reference to a debtor’s balance sheet; by establishing the debtor is not paying its debts as they become due; or by showing that following the challenged transfer the debtor was left with unreasonably small capital.

If insolvency is established, then the remaining inquiry will focus on whether the debtor received “reasonably equivalent value” for the transfer made. While the Code and UFTA do define “value,” neither defines “reasonably equivalent.”

Does Absolute Discretion in the Payment of a Bonus Eliminate the Possibility of an Exchange of Value?

To determine if an employee has an enforceable right to receive a bonus, courts have generally focused on the hallmark characteristics of a valid contract: exchange of valuable consideration and definiteness of terms.

If a bonus is based on future achievement of metrics (e.g., sales goals) or service for a specified period, then upon satisfaction of the conditions a contractual obligation to pay the bonus arises and a “debt” becomes due. In that case, a payment of the agreed-to amount satisfies the debt, an exchange of value is completed, and no fraudulent transfer has occurred.

What about discretionary bonuses? Can an exchange of value occur when management pays a bonus without any contractual obligation to do so? This question was recently addressed in In re F-Squared Management, LLC, et al., 600 B.R. 294 (Bankr. D. Del. 2019). The debtor, once a successful investment management firm, filed for Chapter 11 protection in July 2015 about six months after its settlement of a cease and desist administrative proceeding brought by the U.S. Securities and Exchange Commission. Between December 2014 and March 2015, the company had paid a discretionary bonus to certain employees. Contracts with some, but not all, employees mentioned the opportunity for a discretionary bonus and the company’s employee handbook noted that the company “has a discretionary annual cash bonus for all employees in good standing.”

In July 2017, the liquidating trustee filed fraudulent transfer actions against the employees alleging the debtor was insolvent when the bonus payments were made and that they were not for reasonably equivalent value because the company had no obligation to make the payments. The Trustee did not allege the bonuses were above market, excessive, or that the work was not honestly performed. Instead, the Trustee grounded his claim solely on the theory that bonus payments, as a matter of law, conferred no value on the company because they were discretionary in nature.

The Court rejected the Trustee’s argument and dismissed the complaints. Pointing to Third Circuit precedent, it first concluded even if there is a slight chance that a benefit (tangible or intangible) might be conferred by the transferor, value is given. See, In re: R.M.L., Inc., 92 F.3d. 139, 153 (3d Cir. 1996). It then held it could not conclude “as a matter of law that the payment of a bonus pursuant to an entirely discretionary bonus plan that does not contain any pre-enunciated performance or incentivizing metrics can never be for ‘value’.” Noting “normal experience and common sense suggest that the reasonable inference drawn from awarding and payment of a bonus, discretionary or not, is that the employer paying the bonus believes it confers value on the employer” it called self-evident that, “[r]ewarding your best employee(s) with a discretionary bonus…undoubtedly helps to build the loyalty of the employee and increase morale, generally, if nothing else.”

The upshot: discretionary bonuses made prior to a bankruptcy proceeding are not automatically recoverable. Note, however, they remain subject to scrutiny. The opinion notes the Trustee made no claim other than a pure legal one. Had he alleged that the bonuses bore no relation to performance and was willing to introduce that evidence through a trial, the claims likely would not have been dismissed. If there is evidence payments were made without regard to market norms for bonuses or performance, those facts can still be developed and claims pursued.