Key Employee Retention under BAPCPA

The Enactment of ' 503(c)

The Act introduced a subsection of the Bankruptcy Code, ' 503(c), that for the first time addressed expressly the criteria for court approval of KERPs ' and, significantly, imposed severe limitations on the use of KERPs as they then existed. Section 503(c) contains three components. Section 503(c)(1) prohibits transfers to, or the incurrence of obligations for the benefit of, 'insiders' ' defined in ' 101(31) as including directors, officers and persons in control of the debtor ' unless the insider has a bona fide job offer from another business at the same or greater rate of compensation, the services provided by the insider are essential to the survival of the business, and the transfer or obligation falls within statutory limits. Section 503(c)(2) prohibits severance payments to an insider unless the payment is part of a program that is generally applicable to full-time employees and falls within statutory limits. Finally, ' 503(c)(3) is a 'catch-all' provision that prohibits transfers or the incurrence of obligations that are outside the ordinary course of business and not justified by the facts and circumstances of the case, including transfers made to, or obligations incurred for the benefit of, officers, managers or consultants hired after the petition date.

Section 503(c) was a last-minute addition to the Act proposed by Sen. Edward M. Kennedy (D-MA). There is scant legislative history regarding the amendment. In a statement, Kennedy cited 'an epidemic of abuse in recent years [in the area of corporate bankruptcy], the worst corporate misconduct since before the Great Depression.' Press Release with Attached Statement, Senator Edward M. Kennedy Fights to Protect Americans from a Flawed Bankruptcy Bill (Feb. 17, 2005). Noting the examples of Enron Corp., Worldcom Inc. and others, he urged the passage of '[a] bill that cracks down on corporate executives who loot their companies at the expense of workers, retirees, creditors, and stockholders.' Id. Despite this focus, the amendment as proposed did not mention corporate fraud and, indeed, other statements appeared to be aimed at the broader issue of excessive executive compensation. For example, testimony offered before the Senate Judiciary Committee urged Congress to grapple with 'the notorious 'KERPs,” stating that 'These are 'golden parachutes' payable to the executives of a reorganizing company and rewarding them handsomely often after they have cut workers' pay, reduced or eliminated retiree benefits, shuttered plants, and sold them off.' Bankruptcy Revision: Hearing on S. 256, Before the S. Judiciary Committee, 109^th Cong. 1 (2005) (statement of Dave McCall, Director, United Steel Workers of America). Other members of Congress, concerned that section 503(c) would impair responsible companies' ability to reorganize by preventing them from retaining key employees, proposed language that would have prevented payments to insiders only in the event of fraud, mismanagement or other conduct contributing to a debtor's insolvency; however, this language was not included in the final bill. See In re Dana Corp., 358 B.R. 567 (Bankr. S.D.N.Y. 2006). Indeed, a proposed amendment to section 503)(c) was introduced in September 2007 that would extend the reach of section 503(c)(1) to 'a bonus of any kind' paid to an insider and would impose new, more stringent, requirements in section 503(c)(3) that would be virtually impossible to satisfy. H.R. 3652, 110^th Cong. (2007).

Whatever the exact motives of Congress in enacting ' 503(c), the text of the statute suggests that the underlying premise of ' 503(c) is strikingly different from that supporting the approval of pre-Act KERPs. Whereas a fundamental purpose of KERPs was to ensure that senior management would remain with the troubled company through the bankruptcy, this purpose is expressly prohibited in ' 503(c)(1) unless an extremely onerous ' in most cases impossible ' test is met. It is likely that any executive of a debtor who obtains an offer at equal or greater pay from another (presumably non-bankrupt) company would accept that offer rather than make public in the bankruptcy court both the pending offer and the executive's efforts to use that offer to leverage her current employer. Thus, the requirement under ' 503(c)(1) that the insider already possess such a job offer appears to encourage the very risks that KERPs sought to avoid: key employees conducting job searches when their time and energies are needed on matters of critical importance to the debtor, and perhaps being lured by the promise of an equal or superior position at a more solvent competitor. The requirement that the insider's retention be necessary for the 'survival' of the debtor is likewise at odds with the usual focus in Chapter 11 on reorganizing successfully and enhancing value for creditors, and is likely to be met only in rare circumstances. In several published opinions since the enactment of ' 503(c), bankruptcy courts have undertaken the dual (and, at times, dueling) tasks of deciphering the intentions of Congress in this section and overseeing debtors' efforts to achieve a successful reorganization.

Post-Act Compensation Plans

Not surprisingly, there have been no published cases in which a debtor has sought to meet the three-part test of ' 503(c)(1) for the approval of retention payments to insiders. Instead, debtors have sought approval for a variety of compensation plans structured as something other than retention plans ' most often, management 'incentive' plans ' which they have argued fall outside the limitations of ' 503(c)(1). In analyzing these plans, bankruptcy courts, particularly in Delaware and the Southern District of New York, have begun to develop guidelines for the approval of payments to key employees that both comply with the strictures of ' 503(c) and address the need in bankruptcy to offer sufficient financial incentives to high-level employees.

The following cases are illustrative. In a case decided shortly after the enactment of ' 503(c), In re Nobex Corp., 2006 Bankr. LEXIS 417 (Bankr. D. Del. Jan. 19, 2006), the debtor sought court approval to pay its senior management bonuses tied to the price achieved in a ' 363 sale of substantially all the debtor's assets. The plan provided for payment only if the gross sale price exceeded the proposed stalking horse bid, and did not link the payment to management's continued employment. In approving the plan under ” 363 and 503(c)(3), the court found that the plan was neither a retention nor a severance plan and was within the appropriate exercise of the debtor's business judgment.

In In re Dana Corp., 358 B.R. 567 (Bankr. S.D.N.Y. 2006) ('Dana II'), the court approved a management compensation plan for the debtors' senior management, after denying a prior application. In its earlier opinion, the court found that the plan initially presented, while denominated an incentive plan, in fact was properly characterized as a retention or severance plan. In re Dana Corp., 351 B.R. 96, 102-103 (Bankr. S.D.N.Y. 2006) ('Dana I'). In particular, the court found that a provision entitling executives to 66% of their bonus even if the debtors lost 23% of their value was not a success-based initiative, and that the debtors had failed to demonstrate that certain 'non-compete' payments were not 'severance' payments under section 503(c)(2). Id. The court noted, however, that incentivizing plans with 'some components that arguably have a retentive effect' do not necessarily violate section 503(c).' Id. at 103 (emphasis in original). In Dana II, 358 B.R. at 584, the court found that the debtors' revised executive compensation package 'properly incentivizes [senior management] to produce and increase the value of the estate' and that the payments either complied with
' 503(c)(2) or were non-severance in nature. Citing Nobex for the proposition that 'section 503(c)(3) gives the court discretion as to bonus and incentive plans, which are not primarily motivated by retention or inthe nature of severance,' Id. at 576 (internal citation omitted), the court granted debtors' motion under ” 503(c)(3), 363(b) and 365, subject to a cap on total yearly compensation during the bankruptcy.

More recently, in In re Global Home Products, LLC, 396 B.R. 778 (Bankr. D. Del. 2007), the debtor sought court approval for two employee compensation plans, a management incentive plan and a sales bonus plan. In approving the plans over the objections of unionized employees, the court, relying on the analysis in Dana II, focused its inquiry on whether the plans were 'pay to stay' plans (i.e., KERPs) or 'pay for value' plans created to incentivize key employees, and found that the plans were performance-based and thus not subject to the restrictions of sections 503(c)(1) and 503(c)(2). Id. at 787. The court found 'that the Plans are primarily incentivizing and only coincidentally retentive because Debtors employed virtually identical plans prepetition when retention was not the motive. The fact ' that all compensation has a retention element does not reduce the Court's conviction that Debtors' primary goal [sic] to create value by motivating performance. All companies seek to retain employees they value by fairly compensating them.' Id. at 786. Notwithstanding its lengthy discussion of ' 503(c), the court ultimately found that, because similar plans had been in place prepetition, the plans were within the debtors' ordinary course of business. The court therefore approved them under section 363. Id. at 787.

As indicated in these cases, the general trend in the case law is that, where benefits to insiders can be characterized as primarily for the purpose of 'incentivizing' employees rather than simply 'retaining' them, and the payments are non-severance in nature, courts have held that ” 503(c)(1) and (2) do not apply. In such cases, the plan may be approved under ' 503(c)(3) if the facts and circumstances of the case warrant its approval ' although, as noted above, some courts have found ' 503(c)(3) to be inapplicable and relied on ' 363. That distinction may be irrelevant, however; as noted in Dana II, the test under ' 503(c)(3) appears to be no more stringent than the ordinary course of business test under ' 363 or the requirement under ' 503(b)(1) that administrative expenses be 'actual, necessary costs and expenses of preserving the estate.' 11 U.S.C. ' 503(b)(1); Dana II, 35 B.R. at 576 (citing Nobex, 2006 Bankr. LEXIS 417).

Conclusion

Given that the raison d'etre of KERPs was to retain top management, it is perhaps ironic that debtors now must show that a compensation plan is not retentive ' or at least that retention is not its primary purpose ' in order to obtain bankruptcy court approval. If Congress' intention in ' 503(c) was to eliminate bonus compensation plans in bankruptcy, then neither the text of the Act nor the courts' interpretation reflects that goal. Assuming, however, that Congress' goal was to rein in undeserved or excessive bonuses, the approach courts have adopted fulfills that objective while enabling debtors to take necessary steps toward their successful reorganization.

Douglas P. Bartner is a partner at Shearman & Sterling LLP and is head of the Bankruptcy & Reorganization Group. He regularly represents debtors and creditors and acquirers of assets in Chapter 11 bankruptcies and out-of-court restructurings. Lynette C. Kelly is counsel in the Group. She has substantial experience in reorganizations and liquidations of U.S. and foreign corporations, as well as in bankruptcy litigation and complex commercial litigation. The authors gratefully acknowledge the assistance of associate Gloria Huang in the preparation of this article.

In 2005, Congress purported to address the hot-button issue of executive compensation in bankruptcy by severely limiting Key Employee Retention Programs ('KERPs') that were then common in reorganization cases. These limitations on KERPs were set forth in Bankruptcy Code ' 503(c), added by the Bankruptcy Abuse and Consumer Protection Act of 2005 (the 'Act'). Although billed as a response to recent abuses of the bankruptcy system by executives of corporate giants like Enron Corporation, the amendment as drafted applied absent any Enron-type fraud or mismanagement, prompting concern that it would impede successful reorganizations by preventing necessary retention payments to debtors' executives. As post-Act case law shows, the Act in practice has not had the dramatic effect on executive compensation in bankruptcy that was perhaps intended. This is good news, however, for companies facing reorganization, which need to provide appropriate compensation to their employees in order to negotiate the difficult terrain of Chapter 11 and emerge successfully.

Background: Pre-Act Use of KERPs

Prior to the Act, KERPs were used routinely by debtors in Chapter 11 cases in an effort to retain key employees, principally senior management, who might otherwise seek employment at another, more financially stable, company. Underlying the widespread use of KERPs was the premise that the retention of knowledgeable and experienced personnel, particularly at senior levels, is often critical to enabling a troubled company to reorganize successfully, ultimately maximizing value to creditors. Although compensation packages varied from case to case depending on the debtor's needs, typical components of a KERP included: performance-based incentive bonuses; retention bonuses; success bonuses upon meeting bankruptcy benchmarks; discretionary bonuses for rank and file employees; severance benefits; and assumption of existing employment or severance agreements. Because no Bankruptcy Code provision specifically addressed KERPs, bankruptcy courts considered whether to approve a KERP against the standards for non-ordinary course use of property of the estate under ” 105(a), 363(b) and 365(a) of the Bankruptcy Code: whether the program was fair and reasonable and within the debtor's sound business judgment. This standard afforded a debtor substantial flexibility in formulating a KERP.

The Enactment of ' 503(c)

The Act introduced a subsection of the Bankruptcy Code, ' 503(c), that for the first time addressed expressly the criteria for court approval of KERPs ' and, significantly, imposed severe limitations on the use of KERPs as they then existed. Section 503(c) contains three components. Section 503(c)(1) prohibits transfers to, or the incurrence of obligations for the benefit of, 'insiders' ' defined in ' 101(31) as including directors, officers and persons in control of the debtor ' unless the insider has a bona fide job offer from another business at the same or greater rate of compensation, the services provided by the insider are essential to the survival of the business, and the transfer or obligation falls within statutory limits. Section 503(c)(2) prohibits severance payments to an insider unless the payment is part of a program that is generally applicable to full-time employees and falls within statutory limits. Finally, ' 503(c)(3) is a 'catch-all' provision that prohibits transfers or the incurrence of obligations that are outside the ordinary course of business and not justified by the facts and circumstances of the case, including transfers made to, or obligations incurred for the benefit of, officers, managers or consultants hired after the petition date.

Section 503(c) was a last-minute addition to the Act proposed by Sen. Edward M. Kennedy (D-MA). There is scant legislative history regarding the amendment. In a statement, Kennedy cited 'an epidemic of abuse in recent years [in the area of corporate bankruptcy], the worst corporate misconduct since before the Great Depression.' Press Release with Attached Statement, Senator Edward M. Kennedy Fights to Protect Americans from a Flawed Bankruptcy Bill (Feb. 17, 2005). Noting the examples of Enron Corp., Worldcom Inc. and others, he urged the passage of '[a] bill that cracks down on corporate executives who loot their companies at the expense of workers, retirees, creditors, and stockholders.' Id. Despite this focus, the amendment as proposed did not mention corporate fraud and, indeed, other statements appeared to be aimed at the broader issue of excessive executive compensation. For example, testimony offered before the Senate Judiciary Committee urged Congress to grapple with 'the notorious 'KERPs,” stating that 'These are 'golden parachutes' payable to the executives of a reorganizing company and rewarding them handsomely often after they have cut workers' pay, reduced or eliminated retiree benefits, shuttered plants, and sold them off.' Bankruptcy Revision: Hearing on S. 256, Before the S. Judiciary Committee, 109^th Cong. 1 (2005) (statement of Dave McCall, Director, United Steel Workers of America). Other members of Congress, concerned that section 503(c) would impair responsible companies' ability to reorganize by preventing them from retaining key employees, proposed language that would have prevented payments to insiders only in the event of fraud, mismanagement or other conduct contributing to a debtor's insolvency; however, this language was not included in the final bill. See In re Dana Corp., 358 B.R. 567 (Bankr. S.D.N.Y. 2006). Indeed, a proposed amendment to section 503)(c) was introduced in September 2007 that would extend the reach of section 503(c)(1) to 'a bonus of any kind' paid to an insider and would impose new, more stringent, requirements in section 503(c)(3) that would be virtually impossible to satisfy. H.R. 3652, 110^th Cong. (2007).

Whatever the exact motives of Congress in enacting ' 503(c), the text of the statute suggests that the underlying premise of ' 503(c) is strikingly different from that supporting the approval of pre-Act KERPs. Whereas a fundamental purpose of KERPs was to ensure that senior management would remain with the troubled company through the bankruptcy, this purpose is expressly prohibited in ' 503(c)(1) unless an extremely onerous ' in most cases impossible ' test is met. It is likely that any executive of a debtor who obtains an offer at equal or greater pay from another (presumably non-bankrupt) company would accept that offer rather than make public in the bankruptcy court both the pending offer and the executive's efforts to use that offer to leverage her current employer. Thus, the requirement under ' 503(c)(1) that the insider already possess such a job offer appears to encourage the very risks that KERPs sought to avoid: key employees conducting job searches when their time and energies are needed on matters of critical importance to the debtor, and perhaps being lured by the promise of an equal or superior position at a more solvent competitor. The requirement that the insider's retention be necessary for the 'survival' of the debtor is likewise at odds with the usual focus in Chapter 11 on reorganizing successfully and enhancing value for creditors, and is likely to be met only in rare circumstances. In several published opinions since the enactment of ' 503(c), bankruptcy courts have undertaken the dual (and, at times, dueling) tasks of deciphering the intentions of Congress in this section and overseeing debtors' efforts to achieve a successful reorganization.

Post-Act Compensation Plans

Not surprisingly, there have been no published cases in which a debtor has sought to meet the three-part test of ' 503(c)(1) for the approval of retention payments to insiders. Instead, debtors have sought approval for a variety of compensation plans structured as something other than retention plans ' most often, management 'incentive' plans ' which they have argued fall outside the limitations of ' 503(c)(1). In analyzing these plans, bankruptcy courts, particularly in Delaware and the Southern District of New York, have begun to develop guidelines for the approval of payments to key employees that both comply with the strictures of ' 503(c) and address the need in bankruptcy to offer sufficient financial incentives to high-level employees.

The following cases are illustrative. In a case decided shortly after the enactment of ' 503(c), In re Nobex Corp., 2006 Bankr. LEXIS 417 (Bankr. D. Del. Jan. 19, 2006), the debtor sought court approval to pay its senior management bonuses tied to the price achieved in a ' 363 sale of substantially all the debtor's assets. The plan provided for payment only if the gross sale price exceeded the proposed stalking horse bid, and did not link the payment to management's continued employment. In approving the plan under ” 363 and 503(c)(3), the court found that the plan was neither a retention nor a severance plan and was within the appropriate exercise of the debtor's business judgment.

In In re Dana Corp., 358 B.R. 567 (Bankr. S.D.N.Y. 2006) ('Dana II'), the court approved a management compensation plan for the debtors' senior management, after denying a prior application. In its earlier opinion, the court found that the plan initially presented, while denominated an incentive plan, in fact was properly characterized as a retention or severance plan. In re Dana Corp., 351 B.R. 96, 102-103 (Bankr. S.D.N.Y. 2006) ('Dana I'). In particular, the court found that a provision entitling executives to 66% of their bonus even if the debtors lost 23% of their value was not a success-based initiative, and that the debtors had failed to demonstrate that certain 'non-compete' payments were not 'severance' payments under section 503(c)(2). Id. The court noted, however, that incentivizing plans with 'some components that arguably have a retentive effect' do not necessarily violate section 503(c).' Id. at 103 (emphasis in original). In Dana II, 358 B.R. at 584, the court found that the debtors' revised executive compensation package 'properly incentivizes [senior management] to produce and increase the value of the estate' and that the payments either complied with
' 503(c)(2) or were non-severance in nature. Citing Nobex for the proposition that 'section 503(c)(3) gives the court discretion as to bonus and incentive plans, which are not primarily motivated by retention or inthe nature of severance,' Id. at 576 (internal citation omitted), the court granted debtors' motion under ” 503(c)(3), 363(b) and 365, subject to a cap on total yearly compensation during the bankruptcy.

More recently, in In re Global Home Products, LLC, 396 B.R. 778 (Bankr. D. Del. 2007), the debtor sought court approval for two employee compensation plans, a management incentive plan and a sales bonus plan. In approving the plans over the objections of unionized employees, the court, relying on the analysis in Dana II, focused its inquiry on whether the plans were 'pay to stay' plans (i.e., KERPs) or 'pay for value' plans created to incentivize key employees, and found that the plans were performance-based and thus not subject to the restrictions of sections 503(c)(1) and 503(c)(2). Id. at 787. The court found 'that the Plans are primarily incentivizing and only coincidentally retentive because Debtors employed virtually identical plans prepetition when retention was not the motive. The fact ' that all compensation has a retention element does not reduce the Court's conviction that Debtors' primary goal [sic] to create value by motivating performance. All companies seek to retain employees they value by fairly compensating them.' Id. at 786. Notwithstanding its lengthy discussion of ' 503(c), the court ultimately found that, because similar plans had been in place prepetition, the plans were within the debtors' ordinary course of business. The court therefore approved them under section 363. Id. at 787.

As indicated in these cases, the general trend in the case law is that, where benefits to insiders can be characterized as primarily for the purpose of 'incentivizing' employees rather than simply 'retaining' them, and the payments are non-severance in nature, courts have held that ” 503(c)(1) and (2) do not apply. In such cases, the plan may be approved under ' 503(c)(3) if the facts and circumstances of the case warrant its approval ' although, as noted above, some courts have found ' 503(c)(3) to be inapplicable and relied on ' 363. That distinction may be irrelevant, however; as noted in Dana II, the test under ' 503(c)(3) appears to be no more stringent than the ordinary course of business test under ' 363 or the requirement under ' 503(b)(1) that administrative expenses be 'actual, necessary costs and expenses of preserving the estate.' 11 U.S.C. ' 503(b)(1); Dana II, 35 B.R. at 576 (citing Nobex, 2006 Bankr. LEXIS 417).

Conclusion

Given that the raison d'etre of KERPs was to retain top management, it is perhaps ironic that debtors now must show that a compensation plan is not retentive ' or at least that retention is not its primary purpose ' in order to obtain bankruptcy court approval. If Congress' intention in ' 503(c) was to eliminate bonus compensation plans in bankruptcy, then neither the text of the Act nor the courts' interpretation reflects that goal. Assuming, however, that Congress' goal was to rein in undeserved or excessive bonuses, the approach courts have adopted fulfills that objective while enabling debtors to take necessary steps toward their successful reorganization.

Douglas P. Bartner is a partner at Shearman & Sterling LLP and is head of the Bankruptcy & Reorganization Group. He regularly represents debtors and creditors and acquirers of assets in Chapter 11 bankruptcies and out-of-court restructurings. Lynette C. Kelly is counsel in the Group. She has substantial experience in reorganizations and liquidations of U.S. and foreign corporations, as well as in bankruptcy litigation and complex commercial litigation. The authors gratefully acknowledge the assistance of associate Gloria Huang in the preparation of this article.