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Feature

Jay D. Adkisson
Partner
Riser Adkisson LLP

The 2005 Bankruptcy Reform Act: Impact on Directors
Pouring salt into the wound of Sarbanes-Oxley, the new bankruptcy legislation significantly erodes a director’s ability to protect his or her personal assets. (First of two parts).

By Jay D. Adkisson

The Sarbanes-Oxley Act dramatically expanded the duties and responsibilities–and thus the potential liabilities–of corporate officers and directors. There were no shortages of securities class-action lawsuits even prior to SOX, but after its passage that litigation became much more personal, especially for outside directors.

To settle their liability on the accounting fraud claims alone, ten outside directors of WorldCom agreed to pay $18 million from their personal assets, which represented an estimated 20% of their net worth, with another $36 million to be paid from their D&O insurance. Similarly, 10 former Enron directors agreed to personally pay $13 million as part of a $168 million settlement for fraudulent accounting practices.

Stung by large claims against the D&O policies issued to these unfortunate directors, the insurance carriers have tightened up their policies and expanded their exclusions. Future corporate officers and directors who are caught up in similar circumstances may have to litigate with their own insurance carriers to provide defense and coverage. Also, a sustained series of financial collapses, such as occurred during the savings & loan crisis of the 1980s, might challenge the solvency of a particular insurance carrier and its ability to timely pay claims.

Officers and directors now face the specter of personal liability unrecompensed by their company or its insurance carrier for shareholder losses, whistleblower claims, and similar types of liabilities. Such liability in the past would have been met with personal bankruptcy--or, with little foresight or strategy, one suspecting difficulties could simply move to Texas or Florida where the creditor exemption for homestead was unlimited. It was also easy for corporate officers to load millions into their ERISA-protected pension plans knowing that those would be protected from any future creditors as well.

Not any more.

Targeting Directors
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 seemed to specifically target corporate officers and directors so that they would not be able to protect any significant assets in bankruptcy. While the new bankruptcy act significantly pared down the exemptions available to all debtors, it virtually eliminated any meaningful protection for those who are successfully sued for securities fraud or breach of fiduciary duty.

The key provision is the new section 522(q), which limits any exemption existing under state law to $125,000 for several types of debts including those arising from:

(i) any violation of the federal securities laws (as defined in section 3(a)(47) of the Securities Exchange Act of 1934), any state securities laws, or any regulation or order issued under federal securities laws or state securities laws;

(ii) fraud, deceit, or manipulation in a fiduciary capacity or in connection with the purchase or sale of any security registered under section 12 or 15(d) of the Securities Exchange Act of 1934 or under section 6 of the Securities Act of 1933; and

(iii) any civil remedy under section 1964 of title 18 (this is the civil RICO remedy provision).

These are, of course, three of the most common avenues to the personal liability of a corporate officer or director.

$250,000 Is All
For persons who are successfully sued under one of these theories, the effect is that they will not be able to protect more than $125,000 in their house, regardless of how much the state allows, nor will they be able to protect more than $125,000 in their pension or similar types of retirement plans.

In other words, if you are successfully sued for securities fraud, breach of fiduciary duty, or civil RICO, you will not be able to protect much more than $250,000 in your combined home and retirement plans, and a few personal effects.

If all this isn’t bad enough, prospective debtors are also limited in the type of pre- bankruptcy planning that they can do. A new section 522(o) creates a 10-year period during which the bankruptcy trustee can claw back nonexempt assets that were converted to exempt assets to avoid creditors.

Other provisions of the new bankruptcy act create numerous other limitations for debtors to protect assets.

So how about those asset protection trusts that you read about all the time? Form one in the Cook Islands, or even in Alaska or Delaware these days, and your assets in them will be bulletproof from creditor claims, right?

Wrong.

The ‘Claw Back’ Threat
Stung by criticism in a New York Times article about a “loophole for the rich” in the new bankruptcy act, Congress passed a new section 548(e) that allows a bankruptcy trustee to claw back assets that were transferred to an asset protection trust within 10 years of the filing of the voluntary or involuntary bankruptcy petition, if the transfer was meant to diminish the rights of creditors.

Since the very purpose of an asset protection trust is to diminish the rights of creditors, the import is that assets transferred to such trusts can be easily backed out by the bankruptcy trustee.

There is an old adage that “As the laws get tighter, the lawyers get smarter.” Asset protection will not go away, but it will necessarily become more complex and sophisticated to meet such evolutions in debtor-creditor law as the new bankruptcy act.

Ed. Note: In Part 2 of this article, which will appear in the January e-Briefing, the author will provide additional guidance on personal financial planning for directors to address the provisions of the 2005 bankruptcy reform act.

Jay D. Adkisson is a partner in the Atlanta-based law firm of Riser Adkisson LLP (http://www.risad.com) and admitted to practice law in Oklahoma and Texas. He is a co-author of Asset Protection: Concepts and Strategies, published by McGraw-Hill & Co., and numerous articles on debtor-creditor law issues. He has twice been an expert witness to the U.S. Senate Finance Committee regarding abusive tax schemes. He is also the director of Private Client Services of Select Portfolio Management Inc., an investment advisory firm in California. He can be contacted at jay@risad.com.