Feature: Executive Compensation Issues under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA)
by: Gary M. Kaplan
Howard Rice Nemerovski Canady Falk & Rabkin, PC; San Francisco
BAPCPA significantly modified federal bankruptcy law, imposing significant restrictions on the payment of retention bonuses, severance pay and other amounts to executives of a company in bankruptcy. These new statutory provisions apply to bankruptcy cases commenced on or after Oct. 17, 2005. In addition, BAPCPA works to undo certain executive compensation programs implemented prior to a bankruptcy filing. This article discusses the changes to prior law made by BAPCPA with respect to executive retention and severance payments, early case experience under BAPCPA and pending legislation to close perceived loopholes that have emerged in post-BAPCPA cases.
Key Employee Retention and Similar Compensation Programs under BAPCPA
Legislative Response to Routine Approval of KERPS in Bankruptcy Cases
Particularly in recent years, retention programs for senior management, often referred to as key employee retention plans (KERPs), have become common in chapter 11 bankruptcy cases. KERPs typically provide for the payment of bonuses to certain “key employees” for remaining with the company during the course of its reorganization or liquidation in bankruptcy.
The widespread implementation of KERPs in bankruptcy cases has led to considerable controversy, as many large companies have approved generous retention plans in the midst of massive layoffs or while seeking major wage and benefit concessions under §§1113 and 1114.1 In response to perceived KERP abuse, legislation was introduced in Congress, which was later included in BAPCPA, in an effort to severely restrict the use of KERPs by chapter 11 debtors. Such provisions significantly curtail a bankruptcy court’s discretion to approve KERPs, particularly those benefiting senior management without providing commensurate protection to rank-and-file employees.
The relevant provisions of BAPCPA prohibit a court from approving KERP, severance or similar payments unless certain specific factors are met. BAPCPA provides for a new §503(c)(1), which prohibits payment of retention bonuses and similar liabilities to “insiders”2 of the debtor unless the court finds all of the following:
- such payment is essential to the person’s retention based on a bona fide job offer from another business at the same or greater pay;
- The person's services are essential to the survival of the business; and
- The amount of such payment does not exceed either (I) 10 times the mean amount of similar transfers paid to nonmanagement employees for any purpose during the same calendar year, or (II) if there are no such transfers, 25 percent of the amount of any similar transfer to the insider for any purpose during the preceding calendar year.
BAPCPA also established a new §503(c)(2), which prohibits severance payments to insiders of the debtor unless the court finds both that:
- such payment is part of a program generally applicable to all full-time employees; and
- the amount of such payment is not greater than 10 times the mean severance pay paid to nonmanagement employees during the same calendar year.
In addition, BAPCPA provides for a new §503(c)(3), which prohibits payments that are outside the ordinary the course of the debtor’s business and not justified by the circumstances of the case, including amounts paid to officers, managers or consultants hired after the bankruptcy filing.
Comparison of BAPCPA Provisions Regarding KERPs to Prior Law
Prior to BAPCPA, bankruptcy courts generally established a two-pronged test for determining whether to approve a KERP,3 requiring both that a sound business purpose justified the KERP and that the KERP was “fair and reasonable.”4 The debtor company generally could carry its burden of showing that the retention plan was based on sound business judgment and was reasonable by demonstrating that there was a significant risk that the debtor would lose valued employees without such a program, and that the program was reasonably designed to achieve desired results without unduly burdening the bankruptcy estate. Once the debtor had articulated a rational business justification, a presumption attached that the decision was made on an informed basis, in good faith and in the honest belief that the action was in the best interest of the debtor.5 In order to rebut the presumption of the valid exercise of the debtor’s sound business judgment, a party objecting to a KERP was required to produce evidence demonstrating otherwise.6 The debtor’s business judgment generally was given considerable deference, “unless it [was] shown to be ‘so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, or whim or caprice.’”7
The relevant factors that a bankruptcy court must consider in approving KERP, severance or similar payments under the new BAPCPA provisions are generally comparable to the factors that courts have previously considered in the reported case law. However, the BAPCPA provisions deprive bankruptcy courts of their discretion in determining which factors to consider and the relative weight to be given to the various factors when deciding whether to approve a retention or severance program. Furthermore, BAPCPA imposes rigid numerical caps limiting the amount of retention and severance payments that company executives may receive.
Potential Pre-Bankruptcy Implementation of KERPS and Severance Programs
The stringent limitations governing the implementation of KERPS and similar programs by a company in bankruptcy under BAPCPA suggests that a company can avoid the impact of such provisions by establishing such programs prior to filing for bankruptcy.8 However, another BAPCPA provision is designed to curtail such a strategy.
Specifically, this BAPCPA provision amends §548 to allow for the avoidance – essentially the unwinding – of a pre-bankruptcy transfer or obligation to or for the benefit of an insider under an employment contract and not in the ordinary course of business, if the debtor received less than a “reasonably equivalent value” in exchange for such transfer or obligation. Unlike the requirements for avoidance of other pre-bankruptcy transfers or obligations under §548, a showing of insolvency is not necessary to avoid such a transfer or obligation to an insider.
On its face, this provision does not apply to retention or severance payments made pursuant to long-standing or common arrangements between the company and its executives, such that they would not be considered outside the ordinary course of business. In addition, based on the text of the new law, it apparently would not affect payments made through policies or programs applicable to a number of executives, rather than through an individual’s particular employment agreement. As discussed below, there is pending legislation in Congress to close these potential loopholes in the BAPCPA provision.
Post-BAPCPA Practice and Additional Proposed Legislation Regarding Executive Compensation Issues in Bankruptcy
Early Case Experience under BAPCPA
In the post-BAPCPA world, some companies in bankruptcy have attempted to implement enhanced compensation programs for senior management while avoiding the severe restrictions under the relevant BAPCPA provisions. For example, debtors have based executive bonuses on the company’s performance or other criteria such as confirmation of a reorganization plan or a successful asset sale, rather than on the executives remaining with the company, in an effort to sidestep the strict limitations of §503(c)(1). In such an event, the more flexible standard of §503(c)(3) applies, which allows payments outside the ordinary the course of the debtor’s business if justified under the circumstances of the case.
Although §503(c)(3) contains no guidance regarding how this standard should be applied, early decisions under BAPCPA appear to adopt the business judgment test utilized under prior law. For example, in February 2006, the judge presiding over the bankruptcy proceedings of Delphi Corp. and related entities approved an executive bonus plan linked to the company’s earnings involving payments totaling approximately $20 million for a six-month period to several hundred senior managers. The bankruptcy court applied the deferential business judgment standard in rejecting the arguments of the company’s unions and creditors based on Delphi’s simultaneous efforts to reject its collective-bargaining agreements in order to drastically reduce compensation of rank-and-file employees. Similarly, in January 2006, the judge in the Nobex Corp. bankruptcy case approved under §503(c)(3) the debtor’s motion to provide certain senior managers with an incentive to increase the sale price of the debtor's assets by paying them specified percentages of the sale price in excess of a pending “stalking horse” bid, applying the business-judgment test.
Pending Legislation to Close BAPCPA Loopholes
Legislation has been recently introduced in Congress to close perceived loopholes reflected in post-BAPCPA cases allowing executives to continue reaping generous bonuses. Introduced in April 2006, the Fairness and Accountability in Reorganizations Act of 2006 (S. 2556/H.R. 5113) would expand the types of compensation subject to the strictures of §503(c)(1) to include any performance, incentive, or other bonus or compensation enhancement, rather than being limited to payments to remain with the debtor’s business. In addition, §503(c)(3) would be amended to prohibit any payments to officers, managers or consultants retained by the debtor, whether or not outside of the ordinary course of business, in the absence of a finding by the court (and without deference to the debtor's request for such payments) that such obligations are essential to the survival of the business or to the orderly liquidation and maximization of value of the assets of the debtor because of the essential nature of the services provided, and then only to the extent that the court finds such obligations reasonable under the circumstances of the case.
The proposed legislation is expressly based on congressional findings that “it is becoming more common for corporations that file for bankruptcy protection under chapter 11 of title 11 of the Code to ask for great sacrifices from workers, retirees, creditors and former shareholders, while executives provide themselves with generous bonuses and other forms of lucrative compensation,” and notes that “in the case of one company, an executive-pay package for key employees would have given executives and managers $510 million in compensation, while rank-and-file workers were asked to take large wage cuts or forced to lose their jobs” (a clear reference to the debtor's original proposed plan in the Delphi case, before it was scaled back to the $20 million plan noted above). It remains to be seen whether this legislation, which would be retroactive to any bankruptcy case filed or pending on or after Oct. 1, 2005, will be adopted.
1 Unless otherwise noted, all statutory citations are to the Bankruptcy Code, Title 11, U.S. Code.
2 Pursuant to §101(31), an “insider” is defined to include, with respect to a corporation, a director, officer or person in control of the corporation, or a relative of such person.
3 See, e.g., In re Orion Pictures Corp., 4 F.3d 1095, 1099 (2d Cir. 1993); Dai-Ichi Kangyo Bank, Ltd. v. Montgomery Ward Holding Corp. (In re Montgomery Ward Holding Corp.), 242 B.R. 147, 154 (D. Del. 1999); In re Aerovox, Inc., 269 B.R. 74, 80-81 (Bankr. D. Mass. 2002); In re America West Airlines, Inc., 171 B.R. 674, 678 (Bankr. D. Ariz. 1994); In re Interco Inc., 128 B.R. 229, 234 (Bankr. E.D. Mo. 1991).
5 See, e.g., Official Comm. of Subordinated Bondholders v. Integrated Res., Inc. (In re Integrated Res., Inc.), 147 B.R. 650, 656 (S.D.N.Y. 1992) (citing Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985)).
6 See Montgomery Ward, 242 B.R. at 155 (affirming bankruptcy court's approval of debtor's proposed retention plan because the objectors failed to produce any evidence rebutting the debtor's evidence, which showed that plan was a result of sound business judgment).
8 For example, just three days before filing for bankruptcy in March 2006, Dana Corp. adopted a performance-based incentive program for senior executives providing for bonuses of up to 200 percent of annual salary.