Limiting the Effect of BAPCA

The adoption of BAPCA strictly curtailed a Chapter 11 debtor's ability to retain top executives throughthe use of a KERP. Specifically, ' 503(c)(1) of the Bankruptcy Code now prohibits the use of a KERP to retain 'insiders' (as defined in ' 101(31) of the Bankruptcy Code, which often includes all members of senior management) unless: 1) the insider has a bona fide offer for another job at the same or greater rate of compensation; 2) the insider's services are essential to the survival of the Chapter 11 debtor's business; and 3) the payments to be made to such insider do not exceed the statutory caps set forth in the Bankruptcy Code. 11 U.S.C. ' 503(c)(1). A debtor's ability to award severance payments to key employees of a liquidating company similarly was abridged under ' 503(c)(2) of the new Bankruptcy Code. 11 U.S.C. ' 503(c)(2). Under revised ' 502(c)(2), no insider may receive a severance payment unless such payment: 1) is part of a program generally applicable to all full-time employees; and 2) does not exceed ten times the amount of the mean severance pay given to non-management employees during the calendar year in which the payment is made. 11 U.S.C. ' 502(c)(2). Finally, Congress further tied the hands of Chapter 11 debtors by limiting any other payments outside the ordinary course of business (i.e., those not motivated primarily by retention or in the nature of severance) to those payments 'justified by the facts and circumstances of the case.' 11 U.S.C. ' 503(c)(3).

Few courts have interpreted ' 503(c) since the adoption of BAPCA in October 2005. Those courts that have addressed the provision have found themselves bound by the plain language of the new Bankruptcy Code and without the ability to maneuver their way to a resolution of the problem before them. This article first discusses In re Dana Corp., 351 B.R. 96 (Bankr. S.D.N.Y. 2006) ('Dana I'), in which the Southern District of New York bankruptcy court denied a debtors' proposed employee 'incentive' program. The article then highlights the differences between the program proposed in Dana I and the program approved by the Southern District of New York in In re Dana Corp., 2006 WL 3479406 (Bankr. S.D.N.Y. 2006) ('Dana II'). Finally, this article proposes options other than those utilized in the foregoing cases that might be available to bankruptcy practitioners in need of a way to ensure that their clients' top executives do not walk out the door.

Dana I

The plan proposed by the debtors in Dana I (the 'Dana I Program') provided benefits to the debtors' chief executive officer and five other members of senior management (collectively, the 'Executives'), all of whom were employed by the debtors as of the petition date. Dana I, 351 B.R. at 98. The benefits to be provided were divided into five categories: base salary, annualized incentive bonus payments ('AIP Payments'), completion bonus payments, severance payments conditioned upon the execution of a non-compete agreement by each executive, and a senior executive retirement program (the 'SERP'). Id. at 99. The completion bonus portion of the Dana I Program was divided into two components: fixed and variable. Id. Under the fixed component, payments were capped at a certain amount and were conditioned exclusively upon the executive being employed by the debtors as of the effective date of a plan of reorganization. Id. Payments due under the variable component were uncapped, but were tied to the debtors' 'Total Enterprise Value' six months after the effective date of a plan of reorganization. Id. at 99-100. Under the severance component of the Dana I Program, the debtor's CEO's prepetition severance entitlement would be reduced from two years to one year in the event the CEO was terminated without cause or resigned for 'good reason.' Id. at 100. No other limitations were imposed upon the CEO's severance payments.

The first challenge addressed by the court was the UST's allegation that because the executives impacted by the Dana I Program were prepetition employees of the debtors, the court could not examine the program under the more expansive requirements of ' 503(c)(3) (which specifically identifies 'postpetition hires' as an example of persons affected thereby) and must examine it under sections 502(c)(1) and (2) only. Dana I, 351 B.R. at 101. The court rejected this argument, stating that 'the plain language of the statute does not prohibit the [c]ourt from analyzing transfers to prepetition hires expansively under [section 503(c)(3)].' Id.

The court then turned to the two most troublesome components of the Dana I Program: the completion bonus and the severance payments. In analyzing the completion bonus, the court held that because the fixed component of the completion bonus was conditioned only on the executive remaining with the company until the effective date of a plan of reorganization, it could not be categorized as an incentive bonus. Dana I, 351 B.R. at 102. Because it could not be categorized as an incentive bonus, the court implied that the fixed portion of the completion bonus must be reviewed under the standards articulated by ' 503(c)(1) of the Bankruptcy Code (which relate to 'retention' payments made to insiders). Id. In discussing the severance component, the court declined to adopt the debtors' view of the payments as 'payments made in exchange for non-compete agreements.' Id. The court instead looked to the expansive definition of severance utilized in the Second Circuit ' which includes any amounts due whenever termination of employment occurs ' and found that the debtors had failed to meet their burden of demonstrating that the payments were not severance payments merely because they were made in exchange for a non-compete agreement. Id. at 102-3. The court then held that because no showing had been made that the payments complied with the requirements of section 502(c)(2) (relating to severance payments made to insiders), this portion of the Dana I Program must be denied. Id. at 103.

In its conclusion, the court held that the Dana I Program failed to pass muster under ' 503(c)(1), (2), or (3) of the Bankruptcy Code as amended by BAPCA. Dana I, 351 B.R. at 103. The court did, however, take pains to state that 'incentivizing plans that have some retentive effect [do not] necessarily violate section 503(c)' of the Bankruptcy Code. Dana I, 351 B.R. at 103.

Dana II

The debtors moved for reconsideration of the court's denial of their executive compensation program in Dana I, while simultaneously negotiating with their creditors and other constituents to formulate a more acceptable proposal. Dana II, 2006 WL at *1. Prior to the hearing on the debtors' motion for reconsideration, the debtors proposed a 'wholly different' program (the 'Dana II Program') that was supported by the Official Committee of Unsecured Creditors and the Official Committee of Equity Security Holders. Id. Under the Dana II Program, the executives were to be provided with base salaries, AIP Payments, assumption of their prepetition pension benefits (conditioned upon the assumption of the debtors' non-management pension obligations), a modified severance package that complied with the requirements of ' 502(c)(3) of the Bankruptcy Code, payments under a separately approved long-term incentive plan (the 'LTIP') (which payments were tied to the debtors' ability to meet certain revenue targets) and certain allowed prepetition and post-effective date claims against the debtors' estates. Id. at *3-4. Because the debtors had proposed a new program acceptable to its constituents and the court, the court treated the debtors' motion for reconsideration as moot.

Prior to approving the Dana II Program, the court was careful to note that, unlike the Dana I Program, the Dana II Program contained 'no guaranteed payments to the ' Executives other than base salary ' .' Dana II, 2006 WL at *4 (emphasis in original). The court then considered and approved each potentially objectionable provision of the Dana II Program. With regard to assumption of the pension obligations, the court declined to find that such obligations were severance payments (as argued by the debtors' unionized employees and the UST) and instead held that any retentive aspect of the pension program was 'merely incidental to the terms of the pension plans and are ordinary and customary in such plans.' Id. In so holding, the court again noted its holding in Dana I that plans with some retentive effect do not necessarily violate ' 503(c) of the Bankruptcy Code. Id. The court focused on the fact that the assumption of such obligations was tied to the assumption of the debtors' non-management pension obligations, thereby ensuring parity of treatment between the executives and the debtors' non-management employees. Id. (Presumably, in focusing on the parity of treatment between senior management and non-management employees, the court was relating back to ' 502(c)(2) of the Bankruptcy Code). In approving the executives' allowed prepetition claims, the court held that ' 503(c) of the Bankruptcy Code by its terms applies only to the allowance of administrative claims and, therefore, does not apply to allowance of prepetition claims. Id. Accordingly, allowance of the executives' prepetition claims was not scrutinized under ' 503(c).

In considering the AIP Payments, the court agreed with the debtors that the AIP program was merely a continuation of the debtors' long-standing, ordinary-course incentive program, adjusted to reflect 'current business conditions and a reduction in the number of participants.' Id. at *8. As such, the AIP Payments standing alone would not have required court approval. Id. at *10. In the context of the Dana II Program, however, the court held that the AIP Payments must be considered as part of the overall proposal under section 503(c)(3). Id. Finally, the court examined the LTIP and found that the debtors' ability to meet the revenue benchmarks established thereunder was 'uncertain, at best,' thereby rendering the executives' right to LTIP payments likewise uncertain Id. The court concluded by considering the possible AIP Payments to be earned by the executives combined with the possible LTIP payments and held that these programs could be approved under ' 503(c)(3) of the Bankruptcy Code, provided that an appropriate yearly ceiling was placed on the total compensation to be earned by each of the executives during the Chapter 11 cases. Id. at *11.

Possible Solutions to Key Employee Retention Problems Posed by BAPCA

The most important practical points to be gleaned from Dana I and Dana II are that: 1) incentive-based programs with some retentive effect do not necessarily violate ' 503(c) of the Bankruptcy Code; 2) prepetition claims should not be subject to review under ' 503(c); and 3) a continuation of ordinary course programs and policies does not invoke ' 503(c) review.

From these practical points, several options for establishing workable plans to help retain key employees are apparent. The most obvious option, of course, is to establish an incentive-based plan that incidentally encourages key employees to remain with the debtor. For example, debtors may establish attainable (albeit not artificially low) benchmarks for earning an incentive payment. In reorganization cases, such a benchmark may be an EBITDA or revenue target, while in liquidation cases, the benchmark might be a net sales number related to liquidation of a certain asset or category of assets. In order to incentivize key employees to remain with the debtor as well as maximize value, however, benchmarks should be measured as of a date or dates on which the debtor expects or needs the employee to remain with the company. Finally, the plan should provide that a key employee may not earn an incentive payment if it is not employed by the debtor as of the benchmark date.

Alternatively, because prepetition claims are not subject to review under the strict standards of ' 503(c), such claims may be liberally allowed as part of any compensation program. To incentivize a key employee to stay with the debtor, the allowance of such claims may be conditioned upon the key employee remaining with the debtor through a date certain. Prepetition claims for benefits, wages, terminated retirement programs, lost bonuses and other incentives, severance and damage claims for rejection of lucrative employment agreements all are types of prepetition claims that may be deemed 'allowed' as part of a compensation program. Although not ideal, large enough claims may incentivize key employees to remain with a debtor for some period of time.

Alternatively, a board of directors may consider giving its key employees ordinary-course compensation adjustments (i.e., raises) during the course of the Chapter 11 cases. Raises of this nature can be justified under almost any compensation guidelines given the increased workload imposed upon key employees related to the Chapter 11 filing. Rather than actually paying the increased salary amount to the key employee, however, such payments could be escrowed during each pay period for the benefit of the key employee to be released to the key employee on a date certain (the date through which the debtor is attempting to retain the employee). If bankruptcy professionals are concerned about this approach, authority to continue giving ordinary-course raises could be sought preemptively in the company's otherwise largely prophylactic first-day employee wage motion.

Conclusion

Notwithstanding Congress's best attempt, BAPCA has not completely destroyed a Chapter 11 debtor's ability to retain its key employees and top executives through the complicated and often uncertain reorganization process. To the contrary, corporate officers and bankruptcy professionals will continue to find new and creative ways to incentivize key employees and executives to remain with a Chapter 11 debtor. The proposals described above are just a few of the many options available to companies and professionals striving to ensure that corporate debtors successfully emerge from Chapter 11 with strong, properly-compensated management intact.

Rebecca L. Booth is an attorney in the Business and Finance Practice of Morgan, Lewis & Bockius LLP in Philadelphia. Her practice focuses on corporate bankruptcy, restructuring and other insolvency related matters. Ms. Booth has been involved in the representation of debtors, lenders, formal and informal committees, and other significant parties in large bankruptcy cases.

I once knew a senior executive of a debtor client who was well known within our bankruptcy practice for wanting nothing more from his/her company's Chapter 11 case than court approval of the company's key employee retention program. That is not to say that this particular executive was in any way unique. To the contrary, he/she was merely illustrative of the running joke among many bankruptcy practitioners that the first question asked by an executive of any new Chapter 11 debtor is, 'Have the petitions been filed?' And the second question is, 'Who's negotiating the executive bonus program?'

Lurking behind the smile of every attorney who laughed at that joke, however, lies a very real concern: namely, that retaining key employees and talented executives through the course of a Chapter 11 case is no easy task. Working for a Chapter 11 debtor provides an executive with substantial career uncertainty. In exchange for such uncertainty, the executive is asked to take on substantially increased responsibility, deal with angry creditors and equity holders, and respond daily (if not hourly) to attorneys and financial advisers for any number of often unfriendly constituents ranging from the official committee of unsecured creditors to the Office of the United States Trustee (the 'UST'). In order to pacify fearful and overworked executives and to incentivize qualified executives to remain employed by Chapter 11 debtors, creative professionals and Chapter 11 executives developed what has become known as a key employee retention program, or KERP. These programs provide bonuses to executives and other key employees if they remain employed by the debtors through a date certain (often consummation of a plan of reorganization or similar benchmark). Additionally, these programs often offer severance payments to employees who are expected to be terminated without cause during the course of a Chapter 11 liquidation. Until the adoption of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ('BAPCA'), KERPs were widely and successfully utilized by Chapter 11 debtors to ensure that top talent did not leave for greener, more certain, and usually less demanding pastures.

Section 503(c) Under BAPCA

The adoption of BAPCA strictly curtailed a Chapter 11 debtor's ability to retain top executives throughthe use of a KERP. Specifically, ' 503(c)(1) of the Bankruptcy Code now prohibits the use of a KERP to retain 'insiders' (as defined in ' 101(31) of the Bankruptcy Code, which often includes all members of senior management) unless: 1) the insider has a bona fide offer for another job at the same or greater rate of compensation; 2) the insider's services are essential to the survival of the Chapter 11 debtor's business; and 3) the payments to be made to such insider do not exceed the statutory caps set forth in the Bankruptcy Code. 11 U.S.C. ' 503(c)(1). A debtor's ability to award severance payments to key employees of a liquidating company similarly was abridged under ' 503(c)(2) of the new Bankruptcy Code. 11 U.S.C. ' 503(c)(2). Under revised ' 502(c)(2), no insider may receive a severance payment unless such payment: 1) is part of a program generally applicable to all full-time employees; and 2) does not exceed ten times the amount of the mean severance pay given to non-management employees during the calendar year in which the payment is made. 11 U.S.C. ' 502(c)(2). Finally, Congress further tied the hands of Chapter 11 debtors by limiting any other payments outside the ordinary course of business (i.e., those not motivated primarily by retention or in the nature of severance) to those payments 'justified by the facts and circumstances of the case.' 11 U.S.C. ' 503(c)(3).

Few courts have interpreted ' 503(c) since the adoption of BAPCA in October 2005. Those courts that have addressed the provision have found themselves bound by the plain language of the new Bankruptcy Code and without the ability to maneuver their way to a resolution of the problem before them. This article first discusses In re Dana Corp., 351 B.R. 96 (Bankr. S.D.N.Y. 2006) ('Dana I'), in which the Southern District of New York bankruptcy court denied a debtors' proposed employee 'incentive' program. The article then highlights the differences between the program proposed in Dana I and the program approved by the Southern District of New York in In re Dana Corp., 2006 WL 3479406 (Bankr. S.D.N.Y. 2006) ('Dana II'). Finally, this article proposes options other than those utilized in the foregoing cases that might be available to bankruptcy practitioners in need of a way to ensure that their clients' top executives do not walk out the door.

Dana I

The plan proposed by the debtors in Dana I (the 'Dana I Program') provided benefits to the debtors' chief executive officer and five other members of senior management (collectively, the 'Executives'), all of whom were employed by the debtors as of the petition date. Dana I, 351 B.R. at 98. The benefits to be provided were divided into five categories: base salary, annualized incentive bonus payments ('AIP Payments'), completion bonus payments, severance payments conditioned upon the execution of a non-compete agreement by each executive, and a senior executive retirement program (the 'SERP'). Id. at 99. The completion bonus portion of the Dana I Program was divided into two components: fixed and variable. Id. Under the fixed component, payments were capped at a certain amount and were conditioned exclusively upon the executive being employed by the debtors as of the effective date of a plan of reorganization. Id. Payments due under the variable component were uncapped, but were tied to the debtors' 'Total Enterprise Value' six months after the effective date of a plan of reorganization. Id. at 99-100. Under the severance component of the Dana I Program, the debtor's CEO's prepetition severance entitlement would be reduced from two years to one year in the event the CEO was terminated without cause or resigned for 'good reason.' Id. at 100. No other limitations were imposed upon the CEO's severance payments.

The first challenge addressed by the court was the UST's allegation that because the executives impacted by the Dana I Program were prepetition employees of the debtors, the court could not examine the program under the more expansive requirements of ' 503(c)(3) (which specifically identifies 'postpetition hires' as an example of persons affected thereby) and must examine it under sections 502(c)(1) and (2) only. Dana I, 351 B.R. at 101. The court rejected this argument, stating that 'the plain language of the statute does not prohibit the [c]ourt from analyzing transfers to prepetition hires expansively under [section 503(c)(3)].' Id.

The court then turned to the two most troublesome components of the Dana I Program: the completion bonus and the severance payments. In analyzing the completion bonus, the court held that because the fixed component of the completion bonus was conditioned only on the executive remaining with the company until the effective date of a plan of reorganization, it could not be categorized as an incentive bonus. Dana I, 351 B.R. at 102. Because it could not be categorized as an incentive bonus, the court implied that the fixed portion of the completion bonus must be reviewed under the standards articulated by ' 503(c)(1) of the Bankruptcy Code (which relate to 'retention' payments made to insiders). Id. In discussing the severance component, the court declined to adopt the debtors' view of the payments as 'payments made in exchange for non-compete agreements.' Id. The court instead looked to the expansive definition of severance utilized in the Second Circuit ' which includes any amounts due whenever termination of employment occurs ' and found that the debtors had failed to meet their burden of demonstrating that the payments were not severance payments merely because they were made in exchange for a non-compete agreement. Id. at 102-3. The court then held that because no showing had been made that the payments complied with the requirements of section 502(c)(2) (relating to severance payments made to insiders), this portion of the Dana I Program must be denied. Id. at 103.

In its conclusion, the court held that the Dana I Program failed to pass muster under ' 503(c)(1), (2), or (3) of the Bankruptcy Code as amended by BAPCA. Dana I, 351 B.R. at 103. The court did, however, take pains to state that 'incentivizing plans that have some retentive effect [do not] necessarily violate section 503(c)' of the Bankruptcy Code. Dana I, 351 B.R. at 103.

Dana II

The debtors moved for reconsideration of the court's denial of their executive compensation program in Dana I, while simultaneously negotiating with their creditors and other constituents to formulate a more acceptable proposal. Dana II, 2006 WL at *1. Prior to the hearing on the debtors' motion for reconsideration, the debtors proposed a 'wholly different' program (the 'Dana II Program') that was supported by the Official Committee of Unsecured Creditors and the Official Committee of Equity Security Holders. Id. Under the Dana II Program, the executives were to be provided with base salaries, AIP Payments, assumption of their prepetition pension benefits (conditioned upon the assumption of the debtors' non-management pension obligations), a modified severance package that complied with the requirements of ' 502(c)(3) of the Bankruptcy Code, payments under a separately approved long-term incentive plan (the 'LTIP') (which payments were tied to the debtors' ability to meet certain revenue targets) and certain allowed prepetition and post-effective date claims against the debtors' estates. Id. at *3-4. Because the debtors had proposed a new program acceptable to its constituents and the court, the court treated the debtors' motion for reconsideration as moot.

Prior to approving the Dana II Program, the court was careful to note that, unlike the Dana I Program, the Dana II Program contained 'no guaranteed payments to the ' Executives other than base salary ' .' Dana II, 2006 WL at *4 (emphasis in original). The court then considered and approved each potentially objectionable provision of the Dana II Program. With regard to assumption of the pension obligations, the court declined to find that such obligations were severance payments (as argued by the debtors' unionized employees and the UST) and instead held that any retentive aspect of the pension program was 'merely incidental to the terms of the pension plans and are ordinary and customary in such plans.' Id. In so holding, the court again noted its holding in Dana I that plans with some retentive effect do not necessarily violate ' 503(c) of the Bankruptcy Code. Id. The court focused on the fact that the assumption of such obligations was tied to the assumption of the debtors' non-management pension obligations, thereby ensuring parity of treatment between the executives and the debtors' non-management employees. Id. (Presumably, in focusing on the parity of treatment between senior management and non-management employees, the court was relating back to ' 502(c)(2) of the Bankruptcy Code). In approving the executives' allowed prepetition claims, the court held that ' 503(c) of the Bankruptcy Code by its terms applies only to the allowance of administrative claims and, therefore, does not apply to allowance of prepetition claims. Id. Accordingly, allowance of the executives' prepetition claims was not scrutinized under ' 503(c).

In considering the AIP Payments, the court agreed with the debtors that the AIP program was merely a continuation of the debtors' long-standing, ordinary-course incentive program, adjusted to reflect 'current business conditions and a reduction in the number of participants.' Id. at *8. As such, the AIP Payments standing alone would not have required court approval. Id. at *10. In the context of the Dana II Program, however, the court held that the AIP Payments must be considered as part of the overall proposal under section 503(c)(3). Id. Finally, the court examined the LTIP and found that the debtors' ability to meet the revenue benchmarks established thereunder was 'uncertain, at best,' thereby rendering the executives' right to LTIP payments likewise uncertain Id. The court concluded by considering the possible AIP Payments to be earned by the executives combined with the possible LTIP payments and held that these programs could be approved under ' 503(c)(3) of the Bankruptcy Code, provided that an appropriate yearly ceiling was placed on the total compensation to be earned by each of the executives during the Chapter 11 cases. Id. at *11.

Possible Solutions to Key Employee Retention Problems Posed by BAPCA

The most important practical points to be gleaned from Dana I and Dana II are that: 1) incentive-based programs with some retentive effect do not necessarily violate ' 503(c) of the Bankruptcy Code; 2) prepetition claims should not be subject to review under ' 503(c); and 3) a continuation of ordinary course programs and policies does not invoke ' 503(c) review.

From these practical points, several options for establishing workable plans to help retain key employees are apparent. The most obvious option, of course, is to establish an incentive-based plan that incidentally encourages key employees to remain with the debtor. For example, debtors may establish attainable (albeit not artificially low) benchmarks for earning an incentive payment. In reorganization cases, such a benchmark may be an EBITDA or revenue target, while in liquidation cases, the benchmark might be a net sales number related to liquidation of a certain asset or category of assets. In order to incentivize key employees to remain with the debtor as well as maximize value, however, benchmarks should be measured as of a date or dates on which the debtor expects or needs the employee to remain with the company. Finally, the plan should provide that a key employee may not earn an incentive payment if it is not employed by the debtor as of the benchmark date.

Alternatively, because prepetition claims are not subject to review under the strict standards of ' 503(c), such claims may be liberally allowed as part of any compensation program. To incentivize a key employee to stay with the debtor, the allowance of such claims may be conditioned upon the key employee remaining with the debtor through a date certain. Prepetition claims for benefits, wages, terminated retirement programs, lost bonuses and other incentives, severance and damage claims for rejection of lucrative employment agreements all are types of prepetition claims that may be deemed 'allowed' as part of a compensation program. Although not ideal, large enough claims may incentivize key employees to remain with a debtor for some period of time.

Alternatively, a board of directors may consider giving its key employees ordinary-course compensation adjustments (i.e., raises) during the course of the Chapter 11 cases. Raises of this nature can be justified under almost any compensation guidelines given the increased workload imposed upon key employees related to the Chapter 11 filing. Rather than actually paying the increased salary amount to the key employee, however, such payments could be escrowed during each pay period for the benefit of the key employee to be released to the key employee on a date certain (the date through which the debtor is attempting to retain the employee). If bankruptcy professionals are concerned about this approach, authority to continue giving ordinary-course raises could be sought preemptively in the company's otherwise largely prophylactic first-day employee wage motion.

Conclusion

Notwithstanding Congress's best attempt, BAPCA has not completely destroyed a Chapter 11 debtor's ability to retain its key employees and top executives through the complicated and often uncertain reorganization process. To the contrary, corporate officers and bankruptcy professionals will continue to find new and creative ways to incentivize key employees and executives to remain with a Chapter 11 debtor. The proposals described above are just a few of the many options available to companies and professionals striving to ensure that corporate debtors successfully emerge from Chapter 11 with strong, properly-compensated management intact.

Rebecca L. Booth is an attorney in the Business and Finance Practice of Morgan, Lewis & Bockius LLP in Philadelphia. Her practice focuses on corporate bankruptcy, restructuring and other insolvency related matters. Ms. Booth has been involved in the representation of debtors, lenders, formal and informal committees, and other significant parties in large bankruptcy cases.