Justin Fox has been asking how we might make the miscreants pay (and here). I have two ideas to throw out.

My first thought is an old doctrine. If we could get the people who supposedly represent the people to formally acknowledge the insolvency of the institutions we are bailing out, there is a wide-ranging doctrine known as "fraudulent conveyance" that might help. Payments by a bankrupt firm during the period preceding the bankruptcy are subject to challenge and reversal, under the theory that preferential transfers by insolvent firms to some parties rather than others are inequitable. I don't know, from a legal perspective, how far back and how broadly the doctrine of fraudulent transfer could be applied to insolvent financials, but it's possible that a formal insolvency (e.g. a nationalization or receivership) could put a lot of people who got paid by banks during the boom at risk.

Yves Smith pointed this out a while back. I think it's worth taking a moment to wonder whether and how much the political resistance to formal nationalization is due to fears on the part of well-connected executives of being clawed-back via this doctrine. (Has fraudulent conveyance been aggressively pursued with respect to the Lehman bankruptcy? If not, why not?)

I hasten to add that I know very little about the legal details of fraudulent conveyance, whether it could in fact be applied to large, insolvent financials, what if any legislative action would be required to make the doctrine bite effectively, etc. I do know that even good-faith sellers of firms into leveraged buyouts are quite terrified of fraudulent conveyance, since even healthy firms become risky after the levering up and capital extraction that often followed these deals, and the former owners of previously viable firms can be made to take a serious hit. People who might know stuff about this (Buce?) are encouraged to weigh in. If we treated nationalizations as insolvency for the purpose of fraudulent conveyance, could we do some clawing back? Or is this a ridiculous idea?

Another way we could claw back is to simply enact a special tax on all recipients of income from firms receiving public support. Again, we are partially screwed by Hank Paulson's cynical strategy of encouraging healthy firms to camouflage the rotten ones by accepting TARP funds. But we might set a deadline for the return of public capital, to encourage the healthy trend of banks returning unneeded public support. People who received income as an employee or contractor of banks requiring continued public support during 2004-2007 could be subject to a special, retroactive tax on that income. The IRS presumably has W-2s and 1099s by which they can identify those who would be liable.

This is obviously mean and unfair to many innocent bank employees, and cuts against the America tradition of eschewing collective justice. To diminish the meanness, the special tax could be progressive in the amount of income collected, so that janitors and tellers at Citibank wouldn't be unduly hit. It could be spread over several years, to help people finance the unexpected charge. But, however imperfect, this sort of tax would be far better targeted than future taxes that penalize Americans broadly, or even forward looking tax levies on financials that (if we get our act together) might be very different from the dinosaurs and innocent of their sins. (Should prosper.com pay for the excesses of Citibank?) Administration of the tax should be straightforward and comprehensive, as even the sharkiest of sharks working for putrescent financials wouldn't have seen this one coming a few years ago and contrived to hide the source of paychecks from Citi.

Of course, it would set a precedent going forward, so highly-paid agents of firms capable of forcing a bail-out might seek get paid via squirrelly networks of special-purpose vehicles in order to evade future clawbacks. But that is a feature, not a bug. One problem with our financial system is that it was easy for basically decent people to engineer rapacious and fraudulent practices while persuading themselves it was respectable work. Acting in a manner that yields private short-term profits in exchange for catastrophic risk to taxpayers and the economy is not respectable work. People who find they have to launder their paychecks like drug dealers are less likely to get confused about that (and less likely to be dealt with mildly if they push us to the edge again).

If we do this kind of thing, we should make it clear that its purpose is to cover actual rescue costs, not to arbitrarily discourage risk-taking. (I'd view it as similar to how people who get stuck on mountains are sometimes billed for the cost of their search-and-rescue.) Agents of firms that are clearly small enough to fail could rest assured that the taxman would have no claim against people caught in private tragedies. Fear of such a tax might discourage managers and executives from building up large or insidiously interlinked firms and then capitalizing on an implicit "too big to fail" guarantee. Firms may be too big to fail, but the people who make them that way needn't be invulnerable.

Update: Reader Paul Morelli directs us to the excellent Adam Levitin at Credit Slips on the subject of fraudulent conveyance and bonuses. See also the comments, in which Tom Grey suggests a "windfall bonus tax".

Update 2: Skeptical CPA has a great deal about bankruptcies and fraudulent transfers, for example here. He also points to this interesting summary of bankruptcy scams. To reiterate the connection between this stuff and current events, if the government bails out an insolvent bank by making creditors and counterparties whole, that is like a bankruptcy, except the government steps into the shoes of creditors and takes the hit they otherwise would take. Conduct that would harm private creditors in a bankruptcy harm the taxpayer in a bailout, and in theory should be litigated just as aggressively by the aggrieved party, which is all of us. However, by preventing any formal declaration of insolvency, bailouts enable scavengers to avoid the whole skein of case law surrounding bankruptcy, which tends to put people who extract benefits from a firm while it is foreseeably bust in jeopardy.

Update 3: Buce weighs in on fraudulent transfer (and distinguishes them usefully from preferential transfers) in the comments. His conclusion? "...maybe less here than meets the eye." Thanks Buce! Not too many comments on the tax idea, which I thought the more incendiary of the two proposals...

Update History:
  • 8-Mar-2009, 4:40 a.m. EDT: Added update re creditslips post.
  • 8-Mar-2009, 12:15 p.m. EDT: Updated with stuff from Sketical CPA.
  • 8-Mar-2009, 5:15 p.m. EDT: Added update re comment from Buce.
Steve Randy Waldman — Saturday March 7, 2009 at 10:32pm permalink
Isn't this comprehensive approach somewhat inconsistent with the "Black Swan" explanation, which after all translates to a theory of risk management incompetence, as opposed to fraudulence per se?
3.8.2009 8:59am
rmark (mail):
"This is obviously mean and unfair to many innocent bank employees, and cuts against the America tradition of eschewing collective justice. To diminish the meanness, the special tax could be progressive in the amount of income collected, so that janitors and tellers at Citibank wouldn't be unduly hit. "

I don't think wages paid to employees counts a fraudulent conveyance - they were paid for services they provided. Bonuses paid after it was evident the company was failing might be viewed differently.
3.8.2009 9:41am
mistah charley, ph.d. (mail) (www):
While experience shows that "all property is theft" is too general a generalization, Balzac's saying that "Behind every great fortune lies a great crime" is probably true more often than not.

In an ultimate sense, which extends to the next life (and the one after that) "You only own that which is safe in a shipwreck." In a more proximate and practical sense, it is society which guarantees property. We have a right to be secure in our persons and effects, but society also has a right to protect itself against those whose family motto is "homo homini lupus" - man is a wolf to man.

Right now the wolves - the banksters, the elites of the MICFiC -control society - not only through bribery, but the guns and the mechanisms of mass distraction (i.e. the corporate media). See James Galbraith's The Predator State for details.

This will not change by elections until campaign financing - "one dollar, one vote" - changes. Since our laws are made by the legislators selected under the current system, ("We have the best Congress that money can buy" - Will Rogers), we will probably need more direct, mass action - not just legislative reform - to change course as a society. This implies organizing, but not necessarily mass killing - non-cooperation might be enough to dislodge those now at the top, or help them to see that it is time to change. Our situation here resembles 1789 (in France) more than 1776, but let's hope we can avoid the the paths of idealism and violence that the French followed.

In the longer run, if we ever get back a government that is in a substantial sense by and for the people, it should include

a)progressive income taxation [of course - and in practice, not just in theory]
b)taxes on all financial transactions
c)wealth taxes [some serious thought would need to be given to the issue of 'charitable foundations']

After the Labour Party took over in the UK after WWII, the landed gentry had to disgorge some of the wealth their ancestors had stolen from the people. After the coming cataclysm, I hope something similar will happen here - probably not in the Obama Administration, but the next, or the one after that.
3.8.2009 10:44am
Funcity (mail):
doesn't have to be actual fraud -- just a payment by an insolvent firm to a creditor of that insolvent firm -- key is insolvency thats not a secret -- there's also the notion of constructive insolvency in bankruptcy within a given time frame and/or with re to the bankrupt's insiders (as defined)

so, for ex, the $$$ recently conveyed to AIG's counter-parties could be viewed in that light

I think harder with re bonuses
3.8.2009 11:00am
Blissex (www):
«Acting in a manner that yields private short-term profits in exchange for catastrophic risk to taxpayers and the economy is not respectable work.»

That sounds like you are being a Communist -- any Real American knows that making money is all that matters, even if it is especially sweet if someone else gets screwed too.

Why should Real Americans worry about what happens to losers if they make a lot of money fast? Real America is a land of rugged individualists, not of Communists who worry about the collective consequences of private profits.

3.8.2009 11:35am
Blissex (www):
«doesn't have to be actual fraud -- just a payment by an insolvent firm to a creditor of that insolvent firm -- key is insolvency thats not a secret -- there's also the notion of constructive insolvency in bankruptcy within a given time frame and/or with re to the bankrupt's insiders (as defined) »

But why invoke bankruptcy law? It usually does not cover compensation to employees, only payments to creditors.

However, most or all of those bonuses were conditional, usually profit related as they were payable only if specific targets were met.

Now the targets weren't met because the reported profits were illusory. It depends a bit on whether the bonus awards were worded as being dependent on actual or reported targets.

But the banks are now bust because most of the income and profits reported were the fruit of incorrect (or fraudulent) accounting, where sales were booked early (via securitization) and expenses were booked late (via underprovision against future losses).

What the people receiving those enormous bonuses got was in effect a large chunk of the capital of their employers, not of the profits thereof; so those bonuses are simply not owed to them.
3.8.2009 11:41am
Buce (www):
Fraudulent transfer basics: there are two routes. Creditor/trustee may avoid

1) A transfer made with the /intent/ to hinder, delay or defraud creditors.

2) A transfer made for less than reasonably equivalent value while insolvent.

Fraudulent transfer is bottom-fisher's law; usually messy and expensive, with lots of he-said she-said. Note that for type #1, you have to prove intent, and very few transferors go around saying "I herewith intend to commit a fraud." For type #2, you have to prove solvency, often hard though perhaps less so for so-called grownup financial institutions. "Reasonably equivalent value" can be a sticking point--and some transferees may be able to keep the swag via a defense of good faith.

Distinguish "preference" law, where the payer favors one creditor over another. You can set aside preferences in bankruptcy but there is a short time fuse and it has probably long since expired for all the money we'd want to get.

So maybe less here than meets the eye.
3.8.2009 12:17pm
Anonymous (mail):
maybe bottom fisher law but it is reasonably a law invoked in a shareholder action where less than equivalent value may reasonably proven and actual bankruptcy filing not necessary in all cases

the corporation is the damaged party ie the shareholders

preference law requires actually being in bankruptcy court and belongs to other creditors who were not preferred
3.8.2009 3:11pm
A more immediate question is how to stop the bleeding, how to get rid of Geithner, Summers, and Bernanke.
3.8.2009 10:48pm
inherently hard to make intermediaries take the rap. inherent in the word 'intermediary'.
3.9.2009 5:21pm
RueTheDay (mail):
As much as I would love to see all of those bogus bonuses clawed back, I don't see it happening. We need to start thinking more about preventing a future recurrence.

1. Going forward, bonuses have to be paid on performance over a much longer horizon. Maybe 5 years, maybe even a little more. None of this "leverage 30 times and bet the farm, pocket an enormous bonus this year, walk away when it all collapses next year". I'm not sure how to legislate this, though financial services being a highly regulated industry with existing licensing arrangements means this should be simpler than in an unregulated industry. We just need regulators with spines.

2. As another poster mentioned - a financial transaction tax ala Tobin. Tax ALL transactions, have the rate be progressive with regard to some sort of potential systemic risk rating by instrument. Going forward, if we can't avoid bailouts, we can at least make them self-funding.

At the end of the day, as Taleb said, financial services have to become regulated utilities.
3.9.2009 5:26pm
The Epicurean Dealmaker (mail) (www):
For what it's worth, Steve, I don't like the retroactive tax idea at all. First of all, it is confiscatory and backward-looking, rather than prospective. Second, it is too blunt an instrument: you will catch thousands of fish in that net who had nothing to do with making the bad decisions which got us here in addition to a few (presumably) bad apples. The spirit of fraudulent conveyance--with which I agree by the way--does not jibe with employment and business decisions made in good faith which turn out in retrospect to have been bad. Third, this idea is a very slippery slope. Where would you stop: real estate brokers, politicians, economists? No-one is completely free of complicity in this pile up. No-one.

Full disclosure: I do not have any dog in this fight. I just think it is a lousy idea. Punishment is fine. I'm all for punishment, especially for bad guys. But in our society, punishment takes a long time, is difficult, and is expensive. This is good, since it discourages the sort of retrospective, politically motivated scapegoating which your tax idea would enable. Let's keep the search for justice where it belongs: in the courts.
3.9.2009 7:45pm
so wait a minute on this. wouldn't you want the trader whose book did NOT implode during a systemic crisis to get paid a good bonus? if your answer is no, please explain UNDER WHAT CIRCUMSTANCE you would allow a trader to get paid a good bonus.
3.9.2009 9:19pm
Steve Randy Waldman (mail) (www):
TED — Thanks for the comment. I'm actually pretty sympathetic to your view, although I have some rebuttals. I threw out the tax idea not because I'm sure it's the right thing, but because I think ideas like this should be out there.

Anyway, the rebuttals: You can draw a pretty clear line, if you restrict such taxation to employees of institutions that are deemed systemically important and that are expensively rescued by taxpayers. The little bad apples — the mortgage brokers and real estate boosters etc — never billed the US Treasury, directly, Of course, indirectly they did, by selling this stuff onto banks and other institutional investors that do require rescue. But that's part of the point. Systemically important institutions have systemic obligations. Ones actions are private to the degree their scope and scale are limited. Going forward, part of the rationale for this sort of thing is to provide disincentives to scale, and where scale is economically efficient to create active demand for regulation by agents who are capable of perceiving and identifying competitive spirals towards unmanageable complexity faster than outside regulators.

Looking backwards, a lot of the injustice of this sort of scheme could be mitigated by setting a high income floor. And, one way or another, a lot of people are going to end up paying for this mess who are relatively innocent of the bad decisions. At a personal level, if I were caught by such a tax, and knew I'd worked terribly hard (as most of bank employees have), I would feel it was terribly unjust. But the scale of harm and injustice of this event is pretty dramatic, and the sense that the beneficiaries of a lot of bad action are completely untouchable is corrosive. Recipients of stolen goods can be required to disgorge them, even if they bought them in good faith. And many of the better paid employees of these banks were aware of the risks at some level, even if they underestimated them, believed the new finance story, etc.

There are two ways of looking at the social effect of this kind of tax. On the one hand, it might encourage ever more witchhunts and scapegoating, as you fear. On the other hand, it might salve some of the public outrage that robbing a liquor store will get you jail-time but banditry by financial engineering can be arranged in such a manner that punishment is impossible, it would be uncivilized. In the scheme of things, a thing quite analogous to the windfall taxes we've periodically mooted for oil companies is a pretty mild remedy for such a large and often self-serving catastrophe.

All of that said, I may very well agree with you overall. But I do think the issue deserves serious discussion. I don't think it's open and shut that this is a bad idea.

I appreciate the comment.
3.9.2009 9:48pm
Steve: "Going forward, [...] to create active demand for regulation by agents who are capable of perceiving and identifying competitive spirals towards unmanageable complexity faster than outside regulators."

I can't think of an effective way to do this that doesn't also include allowing creditors to lose when they bet wrong. As I argued in another thread, waiting for "next time" to do so is tantamount to never.
3.9.2009 11:29pm
RebelEconomist (mail) (www):
With all due respect to RTD, I actually think that it is more important to act retrospectively to take some money away from those who did well out of the boom than to make rules to prevent a recurrence. Partly this is because it seems right to me that those who benefitted and probably still have plentiful resources should bear a large fraction of the cost of the clean up, but the main reason is to set a timeless example. I suspect that unless this crisis is managed extremely badly, experience alone will ensure that it is not repeated for perhaps two generations. By that time, any rules that are introduced about regulation, incentives, market structure etc, will have begun to seem outdated and unnecessarily restrictive, and, like Glass-Steagall, will have been neutered or repealed. Then, the best protection against reckless and cynical gambling will be the knowledge that, whatever the letter of the law may say at the time, society will not let you to keep egregious gains from breaching its spirit in a destructive way.
3.10.2009 11:27am
RueTheDay (mail):
RE - I don't disagree that it would be the right and fair thing to do and would help instill a lesson about greed and its consequences. I just don't see how it can be done within the present legal framework. The fraudulent conveyance case is very difficult to prove and even then, only applies to companies that have actually gone bankrupt (and still further would only likely affect a few people at the very top of the organization).
3.10.2009 12:15pm
RebelEconomist (mail) (www):

Can't it be done as a windfall tax (I suggested this myself back when there was talk of a windfall tax on oil companies)?
3.10.2009 12:54pm
RueTheDay (mail):
RE - I suppose you could do that going forward, but if the issue is recouping 2007-2008 bonuses, wouldn't that be an unconstitutional ex post facto law?
3.10.2009 1:42pm
RebelEconomist (mail) (www):

I am no lawyer, and I cannot speak for the USA, but I do know that the utility post-privatisation tax introduced by the incoming Labour government in the UK in 1997 applied to profits in previous years. The UK does not have an explicit constitution, but I believe UK and US laws are generally similar.
3.10.2009 3:20pm
Miguel Barbosa (mail) (www):
Mr. Wadman,

This post is exactly what I had in mind expect articulated much better. What can I say I love your blog. Keep up the great posts. I will be linking to your two latest articles on SimoleonSense. Thanks again.

Best Regards,
Miguel Barbosa
3.11.2009 4:33am
Note: You don't have to register to comment! Just use the pull-down menu to comment as "Guest".

Post as: [Register] [Log In]

Remember info?