The Bankruptcy Abuse and Consumer Protection Act of 2005 (BAPCPA) purported to eliminate the ability of chapter 11 debtors in possession to pay bonuses to management through Key Employee Retention Plans. However, in recognition of the fact that a real need often exists to incentivize key employees to remain with a reorganizing or liquidating business, bankruptcy courts have approved incentive plans providing for payments to insiders and other employees. Such plans must be carefully crafted to avoid the restrictions on retention bonuses post-BAPCPA.

Executive Compensation and the 2005 Bankruptcy Act

Prior to BAPCPA, debtors would routinely seek authority to implement payment plans for key personnel, usually including the debtors' CEO, CFO, General Counsel and other executives. These plans (typically called Key Employee Retention Plans or KERPs) often included one or more of the following: (i) retention payments to those employed through a particular date, (ii) additional bonuses paid upon confirmation of a reorganization plan or sale of the business, and (iii) severance payments in the event of termination.

Debtors sought approval of KERPs based upon the argument that such payments were necessary to induce management to continue working for the struggling business rather than moving to more financially stable competitors. Prior to BAPCPA, bankruptcy courts typically approved KERPs where the debtor exercised proper business judgment, established a sound business purpose and the plan was fair and reasonable.

As a result of the perceived excesses contained within KERPs, Congress, through BAPCPA and an amendment offered by the late Sen. Edward Kennedy, included a new provision in the Bankruptcy Code - § 503(c). This section contains limitations in the allowance or payment of amounts to "an insider of the debtor for the purpose of inducing such person to remain with the debtor's business" as well as limitations on severance payments and other payments to officers, managers or consultants that are outside of the ordinary course of business. Under the Bankruptcy Code the term "insider" includes the officers and directors of a chapter 11 debtor.

Employee Incentive Plans Post-BAPCPA

The language of § 503(c) makes paying retention bonuses to officers and directors insiders almost impossible. However, the need to stem the exodus of talented managers in chapter 11 cases remains high. Accordingly, courts have approved payments to insiders through incentive plans and other contracts that avoid "pay to stay" provisions. In addition, retention plans may still be approved for those employees that do not qualify as "insiders" under the Bankruptcy Code.

The most common approach to maintaining key personnel post-BAPCPA is for a debtor to propose an "incentive" plan rather than "retention" plans in order to obtain approval under the traditional "business judgment standard." Courts have rejected plans that only require the employee to remain on the job in order to receive payments, while approving plans that require certain performance standards and benchmarks. However, bankruptcy judges and other parties in interest continue to carefully examine all plans providing for payments to executives. Where incentive plans contain easily achievable targets, benchmarks or milestones, courts have ruled such plans to be impermissible end-runs around the requirements of § 503(c). For example, the bankruptcy court in the Dana Corporation bankruptcy case rejected a proposed incentive plan that contemplated payment of bonuses to the debtor's Chief Executive Officer and other executives upon, among other things the effective date of a reorganization plan and the total enterprise value of the debtor upon emergence from chapter 11.

Unlike certain incentive plans which have been approved by bankruptcy courts post-BAPCPA, the plan proposed by Dana Corporation did not have the support of the creditors' committee. Subsequently, the debtor proposed a modified plan which did have the support of the creditors' committee. This new plan included assumption of executives pension plans, payment of lower bonus amounts which complied with restrictions in § 503(c), execution of non-compete agreements, and payment of incentive bonuses with ceilings imposed. This revised plan was approved by the court.

In recent cases, debtors have designed incentive plans using milestones such as confirmation of a plan of reorganization or sale of substantially all assets to determine the amount and timing of any bonus. Financial incentives and productivity measures are also used as benchmarks to determine whether a bonus is earned and warranted. More complex arrangements have also been used with multiple targets and bonus calculations. Often, a sliding scale is utilized to modify the bonus amount based upon the results and the relevant target. In addition, debtors have in certain cases proposed separate plans or "tiers" for executives and lower level employees. Rewarding rank and file employees is often more palatable for creditors committees and the United States Trustee than plans which only cover senior management, and such proposals typically fall outside the ambit of § 503(c). As corporate bankruptcy filings continue at a rapid pace, incentive plans continue to evolve within the confines of § 503(c).

Other Agreements Related to Management Compensation

Debtors have also used other means by which to ensure the retention of management and other key personnel such as the assumption of employment or consulting contracts, the inclusion of incentives in reorganization plans, or having a non-debtor fund the bonuses. Many companies also enter into employment contracts with certain executives in the ordinary course of business. The assumption of a pre-petition employment contract that includes target bonuses or other incentives may allow the company to retain qualified employees during its reorganization. In addition, a post-petition employment or consulting contract may provide an avenue to retain the services of current or former management. For example, in the Pilgrim's Pride bankruptcy case, the bankruptcy court authorized the debtor to enter into consulting agreements with its former CEO and COO. These agreements were approved under § 503(c)(3), which requires that any transfers to officers managers or consultants outside of the ordinary course of business be justified by the facts and circumstances of the case.

Section 503(c) only restricts payment of administrative expenses of the estate, therefore, where payments are not being made by the bankruptcy estate, § 503(c) does not apply. Thus, bankruptcy courts have approved incentive plans that are included in chapter 11 reorganization plans due to, among other things, the fact that the payments will not be made by the bankruptcy estate but by the reorganized debtor or third party purchaser. Similarly, where a secured creditor or other non-debtor party funds the retention plan, § 503(c)(1) is not implicated. However, incentive plan payments under reorganization plans may in some instances be subject to review under a reasonableness standard pursuant to § 1129(a)(4).

Conclusion

With layoffs continuing in many troubled industries, public interest in the level of executive compensation is at an all-time high. Despite being titled a KERP or an incentive plan, bankruptcy judges and other parties will carefully scrutinize any plan to pay bonuses to executives, particularly in light of the current economic climate. However, where such plans are genuinely designed to reward performance tied to objective benchmarks and result in demonstrable benefits to the estate, courts are more likely to grant approval. In contrast, where plans appear to simply reward maintaining employment with the debtor, courts will typically be hesitant to bless the arrangement. The law regarding compensation plans continues to evolve as do the types of plans proposed by debtors. Bankruptcy professionals must continue to review developing caselaw in order to effectively represent their clients, whether debtors, creditors, committees or other parties in interest.

This article appeared on the Bankruptcy Law360 website on October 1, 2009.