Introduction
Creditors in mega-bankruptcies and people in general are up in arms over the ridiculous bonuses companies are giving their “key” employees and executives — styled as “retention bonuses.”
Pre-Bankruptcy Retention
For practical reasons, companies facing financial uncertainty need to retain key employees. Therefore, the Bankruptcy Code enacted a pay-to-stay program otherwise referred to as the key employee retention program (KERP) under Section 503(c) of the Bankruptcy Code. The purpose of the KERP is to provide stable leadership and management while the debtor is in bankruptcy and, in doing so, provide key employees with a supplemental compensation program.
Yet, the KERP is subject to bankruptcy court approval and thus, as a way to avoid seeking bankruptcy court approval of a KERP under Section 503(c), many companies choose to award bonuses to key employees prior to the bankruptcy filing. Afterall, such action eliminates the need for negotiations with courts and creditors, it keeps the focus on employees who may consider leaving the company, and it provides flexibility to develop a plan that meets the company’s needs. Moreover, it is difficult to claw back the bonuses once the bankruptcy is filed. To do so, creditors would be required to file adversary proceedings alleging the bonuses were fraudulent conveyances or preferences or a breach of a fiduciary duty. These lawsuits are often expensive and time consuming and not worth it when a debtor is struggling to survive.
Bankruptcy Court Approval Under Section 503(c)
After the bankruptcy is filed, if the debtor wants to bonus its key employees, it must prove up the elements under Section 503(c) of the Bankruptcy Code.
First, Section 503(c) has significant limitations on retention and severance programs for “insiders” of the debtor, which as defined in the Code includes, but is not limited to, officers, directors, or persons in control of a business debtor.
Insider Limitations Under Section 503(c)(1)
Section 503(c)(1) prohibits a court from approving a KERP, severance payment, allowance, or payment of retention bonuses to insiders unless the debtor can satisfy the following three requirements:
- First, the debtor must demonstrate that the KERP is essential to retention of an insider 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).
- Second, the services that the officer or director provides must be determined to be essential to the survival of the debtor’s business. 11 U.S.C. § 503(c)(1)(B).
- Third, the KERP amount must not be more than 10 times the amount of the mean transfer or obligation of a similar kind the debtor has given to non-management employees for any purpose during the calendar year. If the company has not made a similar bonus payment to a non-management employee during that period, the KERP cannot be greater than 25-percent of the amount of any similar transfer made or incurred for benefit of an insider within the calendar year before the enactment of the KERP. 11 U.S.C. § 503(c)(1)(C)(i) and (ii).
Capping Severance Payments Under Section 503(c)(2)
Under Section 503(c)(2), severance packages generally must be applicable to all full-time employees. The amount of the severance payments cannot be greater than 10 times the amount of the mean severance pay given to non-management employees during the calendar year in which the payments are made.
Severance and Incentive Plans for Non-Insiders and Other Employees Under Section 503(c)(3)
Section 503(c)(3) is a catchall provision not limited to insiders and has been used to cover incentive payments and severance to both insiders and non-insiders such as earnings, cost control, and the outcome of a Chapter 11 plan or sale process. In other words, Section 503(c)(3) is used as an inducement to increase the funds available to creditors and is more attractive due to the restrictions imposed by KERPs. If the plan is incentive-based, then such a plan is known as a Key Executive Incentive Plan (KEIP). The proposed transfers have to be in the ordinary course and justified by the facts and circumstances of the case. Generally speaking, ordinary course transactions are subject to the business judgment test. The incentives have to be tied to financial metrics, restructuring goals, or a combination of both. That said, the incentives/performance goals cannot be a lay-up, so to speak, but instead must be a challenge to achieve.
In In re Dana Corp., 358 B.R. 567, 576-77 (Bankr. S.D.N.Y. 2006), the court denied the debtor’s initial compensation program, the debtor modified the plan to include incentives that ironically had been offered by the debtor pre-bankruptcy. The court approved the plan as being an incentive plan and therefore within the ordinary course of business. In doing so, the court applied the following factors:
- 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 for 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? (emphasis added)
- Is the cost of the plan reasonable in the context of the debtor’s assets, liabilities, and earning potential?
- Is the scope of the plan fair and reasonable; does it apply to all employees; does it discriminate unfairly?
- Is the plan or proposal consistent with industry standards?
- 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?
- Did the debtor receive independent counsel in performing due diligence and in creating and authorizing the incentive compensation?
KERPs v. KEIPs
Courts will address whether the proposed KEIP was a disguised KERP. In this regard, courts will deny a motion to approve a KEIP where most of the work required to earn payments is performed prior to the bankruptcy filing date and the business goals are not difficult to achieve. Thus, when approving a KEIP, courts will be asked to find that the performance metrics are challenging to attain. Otherwise, there is no incentive and the KEIP should not be approved.
Conclusion
There is no doubt that financially-troubled debtors need to retain key employees and some of those will fit within severance plans and others within incentive plans. Though creditors would prefer that these issues be addressed by a bankruptcy court following the filing of bankruptcy, the realities reflect that there are times when debtors need to address such issues pre-bankruptcy or risk losing key employees.
