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 [ 21 comments | 0 Trackbacks ] permalink

Rep. Carolyn Maloney is circulating a bill that would try to claw back bonuses taken by employees of firms that had to be bought by Uncle Sam. I'd quibble with the terms of her proposal, and, although I've suggested something like it myself, I'm not sure this is a road we want to start down.

I am sure, though, that this idea — levying a special tax on people who were paid very large sums of money in recent years by firms that have been expensively rescued by the Treasury — deserves to be a part of the mainstream debate. Let it be thoroughly vetted, then enacted or rejected after careful consideration.

Conor Clarke suggests that such a bill would be unconstitutional on its face. I think he's wrong about that. He cites the following line from the US Constitution:

No Bill of Attainder or ex post facto Law shall be passed.

I am not a lawyer, but I don't think this prohibition would much apply, as long as the tax is civil and remedial in nature, rather than criminal and punitive. Consider the so-called "Superfund" law, which made polluters liable for cleaning up environmental messes, even though that liability may not have been written into law at the time when the polluting was done. The current banking crisis strikes me as quite analogous to the Superfund situation: A large class of private actors have caused harms that must be remedied. While the state has no choice but to pick up some of the tab, it also identifies the responsible party and holds them partially liable for the mess they have made. We even use the same words: It's all about "toxic waste".

Thanks to Google books, I can quote Daniel E. Troy, of all people, the former chief counsel of George W. Bush's FDA. (There's something fitting and ironic about that. Look him up.) In Troy's book Retroactive Legislation (1998), he writes

Carefully assessed, the argument that CERCLA [Superfund] is unconstitutional is in tension, at least, with the Supreme Court's current interpretation of the ex post facto and bill of attainder clauses. It may also be at odds with the original understanding of those clauses.

A Bill of Attainder? The contention that CERCLA violates the bill of attainder clause may be dispensed with easily. Under the Supreme Court's current case law, the class "responsible parties" is almost certainly not sufficiently small to warrant treatment as a bill of attainder. The Court, which has not struck down a law under the bill of attainder clause in thirty years, is not likely to consider CERCLA a "legislative punsihment . . . of specifically designated persons or groups." Moreover, as we have seen, the bill of attainder clause was originally understood to prohibit laws that affected life and liberty only.

An Ex Post Facto Law? Because the ex post facto clauses do not apply to civil laws, Superfund therefore would have to be characterized as punitive in nature to be classified as an ex post facto law. The current Court, though, has suggested that unless a law is exclusively punitive, it will not come within the scope of the ex post facto clauses. Although CERCLA certainly has a punitive element, it is hard to contend, under the relevant Supreme Court test, that it "may not be fairly characterized as remedial, but only as a deterrent or retribution." [emphasis original]

Speaking personally, I might prefer that Clarke's naive interpretation of the Constitution were binding. Again, I don't like the taxback approach, it puts us on a slippery slope to a lot of things I'd find disagreeable. But then I also dislike it when idealistic protections apply to the wealthy and well-connected while ordinary people have their vehicles forfeited 'cuz the cop said he smelled pot. And the scale of the injustice to be remedied here viz the financial system is immense. I think we should carefully consider all our options, and hire very good lawyers. We certainly oughtn't take the CEO of AIG's word for it that nothing can be done.

I would point out that effectively ex post changes to civil law are quite common. Greg Mankiw is teasing Larry Summers today for supporting ex post changes in contracts with respect to so-called mortgage cramdowns. But the 2005 bankruptcy law also amounted to an ex post change in the terms of nearly all debt contracts, as did the original prohibition of cramdowns on a principal residence, which had fallen within the ordinary powers of a bankruptcy judge until the late 1970s.

The law may be the law, but it is also a battlefield upon which people play to win and hypocrisy is everywhere. I'd like to be idealistic, but if that means a kind of "unilateral disarmament" under which the least idealistic run roughshod, we'd better try a different strategy.

Update: Marc Ambinder (ht Clusterstock) reports on a tax clawback proposal by Rep. Gary Peters.

A suggestion for Congress: Tax clawback proposals should be written to apply to a rational and preferably large class of people — singling out AIG bonus recipients won't fly. I'd suggest setting specific support criteria for firms (e.g. firms to which at least $2B of Treasury funds were provided or $10B of assets guaranteed, with support not returned or relinquished prior to September 20, 2009), income floors for individuals (e.g. applies only to income over $1M in any year between 2004 and 2009), a high but not outrageous tax rate (maybe 50% of earnings above $1M, not 100%), and a generous repayment schedule (payment of taxes under the act due can be spread over a five-year period). All in all, a proposal should be a reasonable means of identifying agents who benefited extensively from activities that induced a government bailout and asking them to contribute alongside taxpayers to a remediation effort.

Update 2: The excellent and widely read Kevin Drum writes about an ex post tax on bonuses, and seems broadly supportive. This idea may yet get a mainstream, public vetting. Drum quotes a Washington Post story

In the House, Reps. Steve Israel (N.Y.) and Tim Ryan (Ohio) introduced the "Bailout Bonus Tax Bracket Act" to create a 100 percent tax on bonuses over $100,000 that are distributed to employees of financial firms receiving federal bailout funds.

This is the most sensible variant so far pursued, but I think going for 100% is too aggressive if the good Representatives are not just grandstanding. Senators Harry Reid and Max Baucus would tax 98% of AIG bonuses only, which I think is not a good idea. (It's narrow and punitive, so it might not pass constitutional muster, and it scapegoats AIG employees only rather than getting the gatekeepers of systemically important financial institutions broadly, the group that should really be held responsible.)

Update 3: Conor Clarke responds, and gets an opinion from Harvard law prof Laurence Tribe to boot. I think it's safe to say that this idea is under consideration in mainstream policy circles. Megan McArdle expresses some concerns. Felix Salmon turns populist.

Update History:
  • 17-Mar-2009, 4:50 a.m. EDT: Added bold update re Marc Ambinder/Clusterstock story and "suggestion for Congress".
  • 17-Mar-2009, 5:15 a.m. EDT: Added title "Rep." before Carolyn Maloney's name.
  • 17-Mar-2009, 4:15 p.m. EDT: Added Update 2 in response to Kevin Drum's post.
  • 17-Mar-2009, 5:00 p.m. EDT: Added Update 3 re Conor Clarke / Larry Tribe / Megan McArdle.
  • 17-Mar-2009, 5:20 p.m. EDT: Added Felix as populist to Update 3.
Steve Randy Waldman — Monday March 16, 2009 at 10:07pm [ 15 comments | 0 Trackbacks ] permalink

Monday night, when I wrote about tax clawbacks, I was afraid that the idea would be written off too quickly based on an oversimplistic view of the law. Two days later, it's like a movement. At least six members of Congress are on record as trying to craft some sort of tax clawback, Conor Clarke has Larry Tribe opining that a well-crafted clawback would be Constitutional, and widely read bloggers like Kevin Drum and Felix Salmon have considered the idea supportively. Tonight Bloomberg reports that

The senior members of the Senate Finance Committee from both parties proposed taxes totaling 70 percent on bonuses at AIG and other companies getting federal money during the U.S. financial meltdown. House Speaker Nancy Pelosi directed committees there to draft several alternatives and said her chamber may consider a bill as early as this week.

If we're going to do this, and it looks like we might, we had better get it right. Regardless of the legal technicalities, a tax clawback does represent a kind of escalation. It sits awkwardly with norms and ideals that are less a matter of law than we think but that are nevertheless an important part of American political culture. In our better moments, we dislike "collective punishment" and try not to change the rules of the game out from under people midstream. On balance, I think the benefits of a well designed tax clawback could exceed its costs. But a poorly designed clawback would set a corrosive precedent for no other purpose than to salve and misdirect public rage.

The main benefit of a tax clawback would not be to punish bankers for the looting they have already done, but to set a precedent. Many commentators (e.g. Surowiecki) have pointed out that during the credit bubble, market discipline failed not so much because shareholders expected to be bailed out, but because the employees who run financial firms could cash out short-term gains regardless of long-term costs to shareholders and taxpayers. The precedent of a tax clawback would put future employees of systemically important financial institutions in jeopardy. They would know that if their mistakes provoke a taxpayer bailout, their personal wealth would be on the line. Eliminating their sense of inviolability, making it impossible for bankers to simply walk away from the losses they impose on investors and taxpayers, would, I think, result in structural changes to financial institutions. Risk-takers would congregate in definitely-small-enough-to-fail boutiques and hedge funds. Managers of systemically important banks would lobby for regulation to prevent competition from forcing them into risky practices that might provoke a clawback of their personal net worth when things go bad.

The dumbest possible tax clawback would be a punitive one-off designed to recoup the AIG bonuses. The brazenness of those bonuses has galvanized public anger, and served usefully as a tipping point, but in the scheme of things recovering less than half a billion dollars of a multitrillion dollar bailout will not matter very much. In order to set a useful precedent, a tax clawback needs to be broadly and rationally targeted. That is, employees of any and all institutions whose weakness necessitates a public bailout must be subject to the clawback. The Paulson Treasury, as a matter of insidious policy, made it difficult to distinguish between failing and healthy banks by forcing solvent banks to suck up TARP money along with the zombies. A good clawback proposal would encourage healthy banks to return any public assistance they've received over a period of several months, and then claw back funds only from employees of banks that are unable to return the funds without violating capital or liquidity requirements. (The law would have to address wrinkles like how to let banks "return" noncash assistance such as asset guarantees.)

A good tax clawback would not have to be very punitive. While getting back the money is an important purpose of a clawback, establishing the principle that the people who run financial institutions will be made responsible for cleaning up their own messes is far more important. Levying a 100% tax on bonuses might be satisfying, but so draconian a law would only pass if it were uselessly addressed to a single scapegoat rather than applied to financial institutions broadly. I'd recommend a 50% tax on compensation above maybe $200,000 in any year during the four years prior to the public assistance. Since this tax would represent an unexpected expense to the people it would affect, I'd allow the liability to be spread out over a period of several years. In general, the law should be structured and justified as a means of having the parties responsible for a financial disaster bear part of the cost of the cleanup, not as punishment.

One might worry that if the tax is too mild, future bankers might not be discouraged from taking foolish risks at critical institutions. If a big bet can get you a $10M bonus this year, but you'd have to return $5M if things go wrong next year, it might still be worth taking the bet. I think there's less to this than meets the eye. Once a firm precedent is established that previous years' compensation is fair game to pay for a taxpayer bail out, bankers would have to keep in mind that tax rates can always change, and that legislators might be less reticent next time around, when the use of clawbacks would not be novel and controversial. The law might even establish a higher tax rate for future failures.

In order for an ex post tax to be Constitutional, it should apply broadly and have some legitimate purpose besides just punishing someone. Kevin Drum gets a bit sardonic about this:

So it looks like the answer here is simple: even though the purpose of this tax would pretty clearly be punitive with extreme prejudice, we need to carefully pretend that it's not. And we need to make sure the legislative history shows that it's not (it should be "manifestly regulatory and fiscal" Tribe says). Then everything is kosher! We can tax their socks off!

While a lot of us might want to be "punitive with extreme prejudice", this is too cynical a view. The requirements of the Constitution seem perfectly consistent with imposing a clawback that permanently alters the incentives of the people who run systemically important banks. A good law would be both retrospective and prospective. It would help defray the costs of the current crisis while firmly establishing the principle that the individuals who run critical financial institutions can be decompensated if they let those institutions melt down on their watch. The analogy to Superfund is quite close, I think. If we do this, we oughtn't conceptualize what we're doing as finding a loophole we can use to shaft the f@kers. We should craft a good law that lets us to recoup some of the cost of cleaning up existing messes, and that defines a framework for sharing the cost any future messes with the people most responsible for them.

Steve Randy Waldman — Wednesday March 18, 2009 at 5:41am [ 16 comments | 0 Trackbacks ] permalink

The most troubling thing about trying to tax back jackpots paid by firms that are now on public assistance is that an effective measure would have to apply retrospectively. That is, the people who are responsible for the terrible decisions made at systemically important financial institutions have already been handsomely paid for their mistakes. Nearly all of them were paid well before December 31, 2008. A measure that only interferes with current and future pay would simply teach the next generation of "rational agents" that if they cash out fast and early, nothing can be done to them. That was precisely what the current crop of malefactors expected. The whole point of a tax clawback would be to violate that expectation, and to eliminate it going forward.

The House has passed a very poor tax clawback bill (ht Conor Clarke). It is almost prospective — the law would apply only to payments made from January 1, 2009 forward. But almost prospective is like half pregnant. The bill is retrospective for just long enough to clawback the politically fetishized AIG bonuses, while leaving those who made out during the thick of the toxic credit bubble completely untouched. It has all of the philosophical distastefulness of an ex post law, and no offsetting benefit whatsoever, other than punishing a few trophy miscreants from AIG. I would support a well-designed tax clawback, but this ain't it. Hopefully the Senate comes up with something better.

I think a good tax clawback

  • would apply to employees of all firms that have received public capital and that are unable to repay that capital prior to some reasonable deadline several months in the future (so that healthy banks persuaded by Paulson to accept money can be excluded).

  • would tax compensation paid (or accrued) to individuals during the period of the credit bubble, maybe from January 1, 2004 to December 31, 2008.

  • would apply to all forms of compensation (not just bonuses), but only above some fairly high floor. (In a previous post I suggested $200K, but I think that's too low. $500K or $1M would be better.)

  • would apply at a high rate, but one that is arguably not confiscatory or punitive. 50%, maybe 60%, would be reasonable. 90%? No.

  • would be justified in terms of cost-sharing between taxpayers and highly compensated employees when weakness of a systemically important firm occasions public financial assistance.

Future compensation at firms already on life support oughtn't be regulated via so roundabout an instrument as a tax clawback. Henry Blodget has an excellent post on how dumb the House measure is looking forward. If we want to control pay levels at zombie firms, the government should put them into receivership and manage them properly. Setting compensation policy via the IRS no way to run even a very bad bank.

Update: Oh, one other thing that Congress really needs to do already is to restrict the ability of systemically important firms, somehow defined, to file for bankruptcy without first providing an opportunity for the government to intervene. Obviously, a broader regime for resolving sick uberbanks (as called for by Ben Bernanke) would be ideal, but at the very least, firms ought not have the power to play chicken with the government by threatening a disorderly collapse. This is not a new problem, but it's relevant here because if a serious tax clawback were to be passed, a ruthless CEO wishing to avoid the tax could return the TARP money and take a troubled firm into bankruptcy, provoking a large-scale panic.

Update History:
  • 20-Mar-2009, 3:25 a.m. EDT: Added bold update re preventing systemically important firms from petitioning for bankruptcy.
  • 20-Mar-2009, 3:40 a.m. EDT: Clarified and substantially changed the last sentence of the bold update.
  • 20-Mar-2009, 3:45 a.m. EDT: Clarified the last sentence of the bold update yet again.
  • 20-Mar-2009, 12:05 p.m. EDT: Added a missing "to".
  • 21-Mar-2009, 3:05 a.m. EDT: Added a missing "is".
Steve Randy Waldman — Friday March 20, 2009 at 1:17am [ 23 comments | 0 Trackbacks ] permalink