Enron Judge Rules Employee Bonuses Are Voidable Transfers

A Texas bankruptcy judge has ruled that more than $44 million in bonuses hurriedly distributed to Enron traders and other high-level employees on the eve of bankruptcy—sometimes delivered via air flight—are voidable transfers.

In a 100-page opinion, Official Employment-Related Issues Committee of Enron Corp. v. Arnold (In re Enron Corp.), Case No. 03-5522 (Bankr. S.D. Tex. Dec. 9, 2005), U.S. Bankruptcy Judge Robert McGuire of the U.S. Bankruptcy Court for the Southern District of Texas described in detail the circumstances surrounding the bonuses. The decision that the bonuses could be voided was not a close call; the judge rejected nearly all of the defendants’ defenses.

The Arnold case, combined with a second case referred to as the Lavorato case, was brought by a creditors’ committee formed specifically to address employment-related avoidance actions. The Employment Committee brought the Arnold action to recover bonuses extended to a group of high-ranking energy traders, and the Lavorato case to recover bonuses paid to other employees who had been deemed necessary to support Enron’s operations during bankruptcy. The latter group included employees in the areas of information technology, operations, credit, market risk, research fundamentals, human resources, accounting, and legal support.

The defendants received bonuses that ranged from more than $8 million for named defendant John D. Arnold to $5,000. Most of the 300-plus defendants settled; 36 went to trial.

The dispute over the bonuses was intertwined with the demise of Enron.

News in October 2001 of former Chief Financial Officer Andrew Fastow’s undisclosed partnerships was followed by announcements from the credit rating agencies that Enron’s credit would be downgraded, increasing Enron’s required collateral and margin deposits needed to conduct its wholesale trading while limiting the company’s ability to borrow to meet those heightened requirements. Then the company announced it would be filing restated financial statements for 1997 through 2000, and the first half of 2001.

As Enron’s financial situation deteriorated to the point where the company no longer could conduct its core energy trading business, the traders became concerned that they might not receive bonuses for 2001. In the company’s pay-for-performance culture, bonuses comprised most of their salary. To appease the traders, the company in October

2001 awarded guaranteed annual 2001 calendar year performance bonuses, payable in February 2002.

These bonuses were contrary to Enron’s stated compensation policy because the amounts were not: 1) contingent, 2) based upon market surveying, and 3) negotiated, according to Judge McGuire’s decision.

Following an announcement of an intended merger/acquisition by competitor Dynegy, Inc., Enron issued a new memorandum in November, voiding the previously awarded bonuses and offering new ones. Under the terms of the second memo, employees had to forfeit and repay the bonus if they left the company before February.

Enron began having difficulty paying creditors, and company executives placed the bonus pool into a grantor trust established to distribute bonuses to identified traders. This group became the subject of the Arnold suit.

When Dynegy backed out of the merger, credit agencies downgraded Enron’s credit ratings to junk status and bankruptcy became inevitable.

The chairman of Enron’s compensation committee then recommended establishing a bonus plan to retain other key people, and such a plan was developed for 528 non-trader employees deemed key to the trading business. This group became the subject of the Lavorato suit. The terms of the plan were similar to those for the traders, and the plan was similarly executed via a memorandum issued in November.

The creditors’ Employment Committee sought to avoid the bonuses distributed to both groups as: 1) voidable postpetition transfers, 2) voidable preferences, and fraudulent transfers.

In determining whether the bonuses were prepetition or postpetition transfers, the court noted that a judge previously hearing the Enron case had granted summary judgment holding that the Arnold transfers were made prepetition. In support of this finding, the court noted that even though the Arnold defendants were paid with bank trust checks, which cleared postpetition, the transfers already had been perfected at the time the employees accepted the terms of the November memoranda.

As to the Lavorato defendants, "it is undisputed that they received their payments by cashier’s checks from Enron, delivered to them prepetition," the judge stated. "Enron’s management went to extraordinary lengths to try to deliver the bonuses prepetition," Judge McGuire noted. "Enron employees delivered checks by plane in order to avoid the effect of the bankruptcy filing. Defendants were given only one day to accept the terms of the agreement, and the bonuses were paid immediately thereafter."

Turning to the issue of preferences, the court addressed whether, under § 547 (b) of the Bankruptcy Code, the bonuses qualified as "antecedent debt" that could be avoided for being distributed while the debtor was insolvent.

The judge noted that the bonuses, agreed to by both groups in November, served as a liquidation for past performance in 2001.

The defendants argued the bonuses were a contemporaneous exchange for new value because they were given with the condition that employees remained with the company until February.

The court utterly rejected this defense, citing the amount of the bonuses, as well as testimony that retention bonus agreements normally extend for longer than 90 days and that typical 90-day retention bonuses would be expected to be lower than past performance bonuses.

In contrast, the court stated, "[a]s a group, the Defendants in this case received over $44 million for 90 days of work, and that is in addition to their normal salaries, stock options, and other forms of compensation."

Defendant Arnold (who settled his case before trial) had a salary of $160,000, yet received a performance bonus of more than $8 million, Judge McGuire noted. "According to the defendants’ theory, Arnold is assumed to have provided new value in the allegedly promised 90-days to justify payments of … more than $2 million a month. Arnold, of course, was never compensated like that in his prior seven years at Enron."

In addition, Judge McGuire concluded that the evidence strongly indicated Enron was insolvent and not a "going concern" when it made the bonus payments.

The company was carrying a debt load of more than $38 billion, had ceased paying many creditors, had publicly announced that it had ceased making all payments other than those necessary to maintain its core operations, and had suffered credit downgrades that made it impossible to conduct its most profitable business—energy trading.

The judge further cited 38 conclusions from government reports detailing the massive accounting fraud at Enron, which the judge stated supported the finding that Enron was insolvent at the time it distributed the disputed bonuses.

The judge therefore concluded the bonuses were voidable preferences under § 547 (b).

Examining whether the bonuses at issue also qualified as fraudulent transfers, the judge concluded that "[t]here was undisputed evidence of intent to hinder or delay" creditors in the distribution of the bonuses.

"When payments were requested and distributed, Enron knew it was going to file bankruptcy immediately thereafter," Judge McGuire wrote. "The payments were made in direct anticipation of the imminent filing of the Enron bankruptcy and to avoid the perceived delays in timely obtaining authority from the bankruptcy court…."

The judge rejected the defense that the defendants had accepted the bonuses for value and in good faith. He concluded that having determined the transfers are voidable under § 547, which governs preferences, "by express exclusion" § 548 (c), which governs fraudulent transfers, "would furnish no defense."

Nonetheless, the court also substantively addressed the good faith defense, pointing out that the defendants were well aware of the company’s likely, or even imminent, bankruptcy at the time they accepted the bonuses.

The Arnold decision is highly fact-specific, and the recent amendments to the Bankruptcy Code now provide that prepetition retention bonuses to key employees are presumed to be voidable transfers, expressly subject to bankruptcy court approval.

Nevertheless, practitioners note that Arnold is instructive on a number of points. The case contains extensive analysis of issues that include the interplay of antecedent debt and preferences, the "new value" defense, and the standards to be applied in determining whether a debtor is insolvent when a transfer takes place.

This article is presented for informational purposes only and is not intended to constitute legal advice.