Bankruptcy Before Government Bailouts

There has been tremendous anger over government money being used to pay bonuses to executives in many of the companies receiving government bailouts. We saw this recently in the cases of American International Group (AIG) and Merrill Lynch. The amounts become massively larger when you consider creditors, such as the Credit Default Swap counter-parties in the case of AIG.

How do you handle such a situation? The current solution seems to be to enact a special tax to recover the bonuses. However, this presents a problem for several reasons:

  • Such a tax may be unconstitutional as the law prohibits targeting specific people.
  • The nature of the tax concerns the business community, which is rightly concerned that similar statutes (if this one is deemed legal) could be enacted to confiscate wealth on an arbitrary basis.
  • This tax does very little to establish a workable framework to address similar FreePasser problems.

Thus, this may solve one problem but creates even more in the process. What can we do to resolve the situation?

Recognize the Insolvency First

I believe that the answer lies in existing bankruptcy law. When a company declares bankruptcy, there are opportunities to go back in the past to reclaim assets that have been unlawfully conveyed. This provision was created to prevent looting of the company.

Bankruptcy Provides a Framework

We are currently seeing this in the Madoff case, and in similar situations in the past. Investors as well as employees may be forced to return money that was paid to them previously. No one is arguing this concept, although they disagree about the legal ability to collect the funds.

Although the AIG bonus problem and similar situations are slightly different, this framework could be modified to deal with these issues. However, it does require us to deal with AIG’s underlying insolvency. Like a 12-Step program, we must first admit that the problem exists. Although the current bankruptcy framework may cause too much market disruption, we must admit that the government’s intervention represent a new form of receivership, not just a temporary liquidity injection.

Admit Insolvency Before Providing Cash

Recognizing this insolvency is the first step toward solving the problem. By doing so, we have a framework which gives us an established structure to deal with it on a more logical and valid legal basis.

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