At the outset, the answer to the question posed in this article seems simple: employers should just pay their employees as much as is reasonably possible.  However, when a corporation finds itself in Chapter 11 reorganization, the Bankruptcy Code restricts the use of some traditional motivational methods.  Simultaneously, competitors might make tempting job offers to quality employees, inducing them to leave the business.  This combination of factors can distract employees from the main task of getting the debtor through the reorganization process. 

To provide sufficient compensation and persuade employees to remain with the business, a debtor can attempt to adopt a key employee retention plan (KERP for short), also known as a “pay to stay” arrangement.  This is in contrast to a “Produce Value for Pay” plan that provides incentives for strong corporate performance.

Years ago, bankruptcy courts commonly approved new KERPs, or permitted debtors to assume existing KERPs, if the debtor could show that it used “proper business judgment in making its decision to do so.” In re U.S. Airways, Inc., 329 B.R. 793, 797 (Bankr. E.D. Va. 2005).  However, Congress was concerned that the “pay to stay” arrangements were simply a way to give executives excessive bonus packages, even when those individuals had developed the strategies leading to the debtor’s bankruptcy.  As a result, it passed the Bankruptcy Abuse Prevention and Consumer Protection Act (the “BAPCPA”).  The BAPCPA modified Section 503 of the Bankruptcy Code section 503, adding stringent requirements that a debtor must satisfy in order to obtain bankruptcy court approval of an executive KERP or severance arrangement.  

Now, in order to approve an executive compensation plan, a bankruptcy court must first determine whether it is a KERP subject to section 503(c)(1) by considering whether: (1) it is for the benefit of an insider and (2) it is for the purpose of retaining his or her employment during the pendency of the case.  11 U.S.C. § 503(c)(1).  The Bankruptcy Code defines “insiders” as including directors, officers, or other persons in control of the debtor.  11 U.S.C. §101 (31).  Insiders also include relatives of other insiders. 

If the court determines that section 503(c) applies to the proposed plan, then the debtor must present evidence that it has met the statutory requirements.  First, the debtor must show that “the transfer or obligation is essential to retention of the person because the individual has a bona fide job offer from another business, at the same or greater rate of compensation.” 11 U.S.C. § 503(c)(1)(A).  In addition, the debtor must show that the services provided by the individual “are essential to the survival of the business” and the size of the payment does not exceed technical caps established by the statute.  11 U.S.C. §§ 503(c)(1)(B) and (C). 

While section 503(c)(1) does not forbid the implementation of a KERP per se, it plainly has a limiting effect on the debtor’s ability to use this tool to retain quality employees.  A firm, good-faith offer from another employer is a prerequisite for approval of an executive KERP, and it is not hard to imagine the disruption resulting from a key employee’s announcement that she has secured alternative employment at a higher rate of pay.  In addition, any counteroffer the debtor may wish to make to the employee will then be subject to the rigors of section 503(c)(1) and require court approval.  The delay required to obtain the requisite approval may well defeat the debtor’s ability to retain the employee. 

Since it is best to keep the individuals tasked with crafting the debtor’s reorganization focused on the work at hand instead of actively seeking alternative employment, a debtor needs to have a plan for compensating its employees while avoiding the need for relief under section 503(c).  From the cases discussing section 503(c)(1), it is possible to find a balance for a debtor who wishes to adopt incentive compensation for its employees to prevent defections during the reorganization. 

For example, in Dana’s bankruptcy, the debtor asked the Bankruptcy Court for the Southern District of New York to consider a compensation package for the debtor’s key executives.  In that case, the compensation package would have provided substantial bonus payments to insiders when the company emerged from Chapter 11.  The insiders would receive “incentive” payments even if the debtor’s performance actually declined by as much as 23%.  Finding that the plan was a “pay to stay” arrangement under the statute, the court held that it did not comply with section 503(c)(1).  In concluding, the court noted that all compensation has the effect of retaining employees; therefore, it is “possible to formulate a compensation package that passes muster under the section 363 business judgment rule [as a “Produce Value for Pay” plan] or section 503(c) limitations [as a KERP], or both.”  In re Dana Corp., 351 B.R. 96, 103 (Bankr. S.D.N.Y. 2006).

Subsequent cases have approved plans that focus on incentive pay as opposed to retention pay.  The Bankruptcy Court for the District of Delaware listed the following factors to determine whether a proposed compensation plan meets the business judgment test:

  1. Is there a reasonable relationship between the plan proposed and the results to be obtained, i.e., will the key employee stay for as long as it takes the debtor to reorganize or market its assets, or, in the case of a performance incentive, is the plan calculated to achieve the desired performance?
  2. Is the cost of the plan reasonable in the context of the debtors’ assets, liabilities and earning potential?
  3. Is the scope of the plan fair and reasonable; does it apply to all employees; does it discriminate unfairly?
  4. What were the due diligence efforts of the debtor in investigating the need for a plan; analyzing which key employees need to be incentivized; what is available; what is generally applicable in a particular industry;
  5. Did the debtor receive independent counsel in performing due diligence and in creating and authorizing the incentive compensation?

In re Global Home Products, LLC369 B.R. 778, 786 (Bankr. D. Del. 2007).