Third Quarter 2006

BAPCPA’s Treatment of KERPs: A Prime Example of Why Leaving It to the Courts Would Have Been the Right Idea

Holland & Knight Newsletter
John J. Monaghan

Congress used to recognize its limitations. The legislative history regarding the 1978 Bankruptcy Code is replete with references to the need to leave filling in the details of the concepts set forth in the Bankruptcy Code to the situation-specific judgments of a specialized tribunal attuned to the facts of each case – the Bankruptcy Court.1

With the Bankruptcy Code and Consumer Protection Act of 2005 (BAPCPA),2 Congress forgot that previously observed and salutary concept. In BAPCPA’s treatment of key employee retention programs, Congress ventured into a realm about which it, as an institution, knows passing little, and impacted the outcome of bankruptcy cases, as well as the businesses and livelihoods of many in ways that it is not capable of understanding or foreseeing.

Although a few high profile cases involving phonebook-sized numbers in retention benefits provided political grist for the Congressional mill, the new restrictions on key employee retention payments set forth in BAPCPA’s amendment of Section 503 evidence Congress’ misunderstanding of the Bankruptcy Code and the bankruptcy process, as well as Congress’ ineffectiveness in remedying that which it does not understand. Newly minted Section 503(c) of the Bankruptcy Code3 purports to carve back the previously exercised discretion of bankruptcy courts to determine the appropriateness of incentive compensation by imposing formulaic limits on severance or retention payments that a debtor can promise its employees during Chapter 11 proceedings. Billed as a means of ending abuses in the Chapter 11 mega-cases of debtors funneling millions of dollars to highly paid executives, as drafted Section 503(c) missed its mark, and neither debtors nor courts have had much difficulty in working around the new restrictions to accomplish largely the same results as were obtained pre-BAPCPA. A recent decision by the Bankruptcy Court for the Southern District of New York, however, makes clear that while 503(c)’s provisions can be overcome, they cannot be ignored.

KERPs and Other Forms of Employee Compensation Pre-BAPCPA

In its purest form, a key employee retention program (KERP) is a pay-to-stay program that affords highly valued employees compensation in addition to their pre-Chapter 11 salary to stay with the company for a defined period of time. Faced with the prospect of suffering a slow death through employee exodus to higher paying and financially more stable competitors, Chapter 11 debtors learned to stem the tide of brain drain the old fashioned way – they bribed their employees with the promise of retention bonuses. Under the stated premise of providing stability to leadership and management of a Chapter 11 debtor, debtors often seek bankruptcy court approval to implement KERPs that provide supplemental compensation programs for key employees.4

Prior to enactment of BAPCPA’s Section 503(c) provision, bankruptcy courts would analyze KERPs and other forms of key employee compensation, such as severance packages, applying a “sound business judgment” standard under the statutory umbrella of Sections 105(a) and 363(b).5 Courts generally afforded considerable deference to the business judgment of the debtors’ board of directors in its design and suggested implementation of the KERP. As long as the court determined that the compensation program was fair and reasonable, and that the debtor’s business decision was sound and not based on “bad faith, or whim or caprice,” the compensation program generally would be approved.

Applying this somewhat non-descript standard, courts approved some form of KERP in most large Chapter 11 cases. Presumably, a few such approvals, involving eight and nine figure administrative liabilities in cases of companies that had been the subject of highly publicized corporate scandals, caught Congress’ eye and led to the reforms of Section 503(c).

In the Chapter 11 cases of Enron Corporation and its affiliated debtor entities, the debtors sought bankruptcy court approval to pay retention bonuses and severance benefits to key employees. The debtors stated that the proposed plan was a result of the exercise of “proper business judgment in formulating the KERP” to “motivate all Key Employees to work diligently and productively not only to maximize enterprise value but also to achieve a successful conclusion of the chapter 11 cases.” The Enron KERP consisted of three components: (1) a retention program that awarded employees for remaining with the debtors until a date certain, (2) a liquidation incentive pool which rewarded employees that assisted in the liquidation of the debtors’ trading assets and non-core businesses, and (3) a severance benefit that was generally restricted to employees who were not eligible for benefits under the two other KERP components. The debtors estimated that their potential liability under the KERP would be between $47.4 million and $130 million.

In the WorldCom Chapter 11 cases, the affiliated debtors filed a motion seeking approval of a KERP that the debtors characterized as being “the most cost-effective manner in which to protect against attrition and to improve employee morale.” The proposed KERP was estimated to cost approximately $25 million, and included a stay bonus, plan progress bonus and a discretionary pool to cover unforeseen events, and to “send a positive message to employees other than Key Employees.”

To the extent large KERPs in cases tainted by corporate scandal were not enough to catch Congress’ eye, the management/rank and file dichotomy evidenced by similarly sized retention programs for the benefit of airline industry executives in Chapter 11 cases commenced largely to shed legacy labor costs likely contributed to a sense of political opportunity. United Airlines and its affiliated debtor entities moved for approval of a KERP and an executive severance program that it described as being needed to retain those employees with “mission critical” skills and competencies needed for a successful reorganization. The KERP was comprised of two parts: (1) a retention component; and (2) a severance component. In their motion seeking approval of the KERP, the debtors estimated that the KERP would cost approximately $32 million for the retention portion and as much as $75 million for the severance portion depending on the extent of downsizing of the debtors’ operations. The court approved the motion as being “essential to continued operation of the Debtors’ businesses and in the best interest of the Debtors’ estates and creditors” over the objection of several parties.

Similarly, in the U.S. Airways bankruptcy case, the court approved in part and denied in part portions of a KERP program estimated to cost as much as $28 million. The court approved a severance program for nearly 2,000 management employees, but deferred packages for certain executives, stating that given “the magnitude of the proposed severance payments for the officers, the lack of any provision for mitigation, and the ability of the officers at the most senior level to collect severance (although at a reduced amount) simply because they might not want to move to Arizona, the court agrees with the United States Trustee that approval of new employment agreements for the officers should await plan confirmation.”6

New Section 503(c): Limiting Judicial Discretion

New Section 503(c)7 provides explicit guidelines to bankruptcy courts regarding the scope and magnitude of retention bonuses and severance payments contemplated by a Chapter 11 debtor. Specifically, the provision places significant limitations on retention and severance programs for “insiders” of the debtor, defined in the Bankruptcy Code as including an officer, director or person in control of a business debtor.8 That listing, however, is not exhaustive and one may safely assume that Section 503(c) provides a new incentive to litigate the scope of the insider definition.9

Section 503(c)(1): Altering Retention Payment Standards

BAPCPA restricts bankruptcy court approval of retention bonuses (payments to induce certain employees to stay with the debtor) under Section 503(c)(1) of the Bankruptcy Code. 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:

1) 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).

2) Second, the services 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).

3) 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).

Case law suggests that the first two requirements were generally points of consideration for the bankruptcy court before the adoption of Section 503(c), although admittedly not requisite factual findings. The analysis regarding the amount of the KERP, however, had previously been left to each court’s discretion on a case-by-case consideration.

Whatever failures may appropriately be viewed as having been committed by bankruptcy courts in their efforts to assess the reasonableness of a few case-specific KERPs in a few high profile mega-cases, Congress’ attempt at a universal formulaic definition of relative reasonableness constitutes a greater failure to address the KERP conundrum by many multiples. While a textual analysis alone could provide fodder for the bulk of a critical legal studies text book, a few examples of the problems arising from the retention benefit specific provisions will demonstrate why KERP assessment would have been best left to the bankruptcy courts presiding over the cases in which a financially challenged debtor was struggling to retain its key employees.

First, Congress missed the mark at which it was taking aim. Due to the limitation on the KERP restrictions to “insiders,” the main target of the legislative undertaking, the multiple layers of vice presidents, senior vice presidents and executive vice presidents in large publicly traded companies, are not even impacted. To be sure, the new KERP restrictions impose limits on payments to the presidents and CEOs of the large corporate world, but the greater direct impact is on the small, closely held corporation where, unlike in a large publicly traded company, a high percentage of the management team has sufficient control to be considered an “insider.”

Second, the various percentage restrictions on amounts present practical difficulties that could threaten a debtor’s reorganization prospects. For example, will debtors risk the cash flow constraints of providing substantial retention bonuses for non-management level employees so that the statutory 10 multiple will afford a large enough base line to retain highly compensated executives? Put in concrete terms, if a board of director’s business judgment is that it needs to provide a $150,000 retention bonus to ensure the continued service of a single, critical management level insider-employee, the board has to implement a program for its $30,000 per year rank and file employees so that the mean payment of such a program is $15,000. What if there are 100 such employees – does the debtor need to undertake a $1.5 million total obligation to the rank and file? If you exclude 50 of those employees, are they counted as zero dollars for the purpose of calculating the mean so that the other 50 have to receive a $30,000 KERP benefit, or are they not counted at all so that a KERP that includes only one non-management employee with a single $15,000 payment right can establish the mean?

Finally, the various calendar year references present difficult planning issues. The statute envisions that a debtor can wholly exclude non-management employees from KERP benefits, but if the debtor does so then its insiders can receive no more than 25 percent “of the amount of any similar transfer or obligation made to or incurred for the benefit of such insider for any purpose during the calendar year before the year in which such transfer is made or obligation is incurred.” Will the level of pre-bankruptcy planning increase to include giving substantial pre-petition bonuses in the calendar year immediately preceding the filing so that the 25 percent threshold provides a meaningful number, and, if so, can these payments survive the scrutiny of a fraudulent transfer analysis under the amendments to Section 548 of the Bankruptcy Code?10

Section 503(c)(2): Capping Severance Payments

Congress did not limit its misguided efforts to retention benefits. New Section 503(c)(2) of the Bankruptcy Code alters the landscape regarding severance benefits, limiting the amount payable to insiders of the debtor as severance. To pass scrutiny under Section 503(c)(2), severance packages must now be part of a program that is generally applicable to all full-time employees and the amount of the payment 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 payment is made. 11 U.S.C. § 503(c)(2).

While it is clear that the intended impact of this new provision was to limit large golden parachutes for executives,11 Section 503(c)(2) raises its own set of questions and strategy issues. For example, is the placement of this provision in Section 503, the Bankruptcy Code section relating to administrative claims, an implicit suggestion that claims under pre-petition severance packages are entitled to administrative priority if there is a post-petition termination? Because the cap on payment to insiders is 10 times the “severance pay given to nonmangement employees during the calendar year,” can a debtor escape any severance pay obligation to an insider by firing him or her on January 1 at 12:01 a.m.? At minimum, new Section 503(c)(2) suggests that drafting severance plans will be no small task. Whereas the traditional severance plan provides for a certain number of weeks’ or months’ salary, Section 503(c)(2) speaks in terms of “amounts.” Therefore, a textual analysis of the new Bankruptcy Code would suggest that a $250,000 per year senior executive – terminated in a year when the only other severance benefit paid was two week’s pay to a $500 per week staff person – would receive no more than a $10,000 severance payment.

Section 503(c)(3): Non-Insiders And Others Did Not Escape

BAPCPA also provides a catchall provision applicable to situations that fall through the chasm-sized cracks left by the retention and severance provisions. Section 503(c)(3) prohibits any other transfers or obligations outside of the ordinary course that are not justified by the facts and circumstances of the case. Unlike the subsections devoted to retention and severance payments, Section 503(c)(3) is not limited to just insiders of the debtor, but is broadly applicable to all transfers outside of the ordinary course specifically mentioning officers, managers, and consultants.

While the provision was undoubtedly thought to be applicable to compensation-like payments to non-insiders, the statute arguably impacts a much broader array of transactions already governed by a long-standing Bankruptcy Code provision that is the subject of extensive case law interpretation. Section 363(b)(1) of the Bankruptcy Code conditions any out of the ordinary course transaction on court approval. Case law has established a paradigm for considering whether or not a proposed transaction is within a debtor’s ordinary course of business and, if not, whether the proposed transaction should be approved. As a general matter, out of the ordinary course transactions are subject to the business judgment test. Section 503(c)(3)’s language appears to establish a presumption against approval of all out of the ordinary course transactions, prohibiting them unless justified by the facts and circumstances of the case. Whether or not this arguably broad shift away from business judgment is limited to compensation-like issues that Section 503(c)(3)’s statutory placement suggests was intended, it does seem evident that at least consideration of incentive payments and severance to non-insiders will be subjected to an analysis of whether the proposed payments are justified by yet to be identified facts and circumstances of the case.

Characterizing Payments as Success Fees: An Alternative?

While BAPCPA provisions appear to have changed the KERP landscape in bankruptcy for insiders, similar incentive plans based on performance targets, such as earnings, cost control and the outcome of a Chapter 11 plan or sale process, appear to escape the formulaic limitations on KERPs. Instead, they are governed by the general “facts and circumstances of the case” provision of new Bankruptcy Code Section 503(c)(3). This dichotomy of statutory treatment between KERPs and other forms of post-petition payments has been seized upon, and Chapter 11 debtors have restructured what were once KERPs that provided bonuses for mere longevity to incentive programs affording bonuses based on performance or a successful exit from Chapter 11. Some bankruptcy courts have supported this creative solution to Congressional meddling.

For example, in In re Nobex Corporation, the Bankruptcy Court for the District of Delaware applied Section 503(c)(3) and entered an order authorizing the payment of sale-related incentive pay to senior management of the debtor. In re Nobex Corp., No. 05-20050 (Bankr. D. Del. Jan. 20, 2006) (order authorizing payment of sale-related incentive pay to senior management). Rather than afford insiders additional payment for their continued employment, the compensation at issue in Nobex would only be paid if an asset sale garnered more than the original bid received by the debtor-company. The Court found that restrictions on KERPs did not apply because the pay was not proposed to induce the senior management to stay with the debtor, nor was it a severance payment. Instead it was an inducement to increase the funds received upon consummation of a sale and, therefore, made available for distribution to creditors.

A recent decision of the United States Bankruptcy Court for the Southern District of New York, however, may limit a debtor’s ability to draft around the more restrictive provisions of Section 503(c), or at least mandate that the compensation package proposed be something other than a KERP in more ways than just the title on the document. In re Dana Corp., 2006 WL 2563458 (Bankr. S.D. N.Y. Sept. 5, 2006). On September 5, 2006, the Dana court denied the debtor’s proposed compensation plan for its executives, consisting of base salary payments, annual incentive bonuses, completion bonuses, a severance/non-compete package, and a Senior Executive Retirement Program, determining that the compensation scheme was more like a “Pay to Stay” compensation plan than an “incentivizing ‘Produce Value for Pay’ plan.” Rejecting the notion that a change in title alone would result in escaping the recently enacted restrictions on KERPs, the Court noted that “[i]f it walks like a duck (KERP), and quacks like a duck (KERP), it’s a duck (KERP).” Id. at *5 n.3. Accordingly, the Court analyzed the compensation under the stricter standards relating to retention plans and concluded that the debtor was not able to meet its burden under those provisions. The Court, however, did leave open the possibility that an incentive-based compensation plan with “some components that arguably have a retentive effect,” could pass scrutiny, but gave little guidance as to how such a plan would be structured.

BAPCPA’s provisions relating to key employee retention programs and severance packages evidence the difficulties of translating broad policy to small details, and why that task is best left where the Bankruptcy Code, when originally implemented in 1978, assigned it – to the bankruptcy courts. Congress’ efforts to address the broad and politically fashionable topic of perceived excessive executive compensation in bankruptcy cases resulted in legislation that must have appeared sensible to the drafters at their mile-high vantage point, but which is simply unworkable when applied to actual cases by counsel and courts seeking to invoke the broader Bankruptcy Code mandate favoring reorganization of companies. Fortunately, the same drafting shortfalls that cause the KERP and severance benefit provisions of BAPCPA to be problematic also render drafting around those provisions less than problematic.

For more information, e-mail John Monaghan or Diane Rallis at or, respectively, or call toll free 1.888.688.8500.

1 The legislative history to Section 361’s provisions relating to adequate protection are a prime example, stating the following: “There are an infinite number of variations possible in dealings between debtors and creditors, the law is continually developing, and new ideas are continually being implemented in this field. The flexibility is important to permit the courts to adapt to varying circumstances and changing modes of financing.”

2 See generally, Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, 119 Stat. 23, codified in various sections of 11 U.S.C., 15 U.S.C., 18 U.S.C. and 28 U.S.C. (enacted April 20, 2005). BAPCPA became effective on October 17, 2005, except that certain provisions, not relevant to this discussion unless specifically so stated, became effective on certain other dates, including the date of enactment.

3 References herein to the Bankruptcy Code refer to Title 11 of the United States Code, 11 U.S.C. §§101 et seq.

4 KERPs usually provide for a bonus payment to “essential” employees to induce them to remain with the debtor until a specified date or event. In bankruptcy cases, the specified date or event is often the confirmation of a plan of reorganization plan or sale of the business. See, e.g., Aerovox, Inc., 269 B.R. 74, 77 (Bankr. D. Mass. 2001).

5 See, e.g., In re Aerovox, 269 B.R. at 80.

6 In re U.S. Airways, Inc., 329 B.R. 793, 801 (Bankr. E.D. Va. 2005).

7 Section 503(c) provides as follows:

(c) Notwithstanding subsection (b), there shall neither be allowed, nor paid – (1) a transfer made to, or an obligation incurred for the benefit of an insider of the debtor for the purpose of inducing such person to remain with the debtor’s business, absent a finding by the court based on evidence in the record that –

(A) the transfer or obligation is essential to the retention of the person because the individual has a bona fide job offer from another business at the same or greater rate of compensation;

(B) the services provided by the person are essential to the survival of the business; and

(C) either –

(i) the amount of the transfer made to, or obligation incurred for the benefit of, the person is not greater than an amount equal to 10 times the amount of the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose during the calendar year in which the transfer is made or the obligation is incurred, or

(ii) if no such similar transfers were made to, or obligations were incurred for the benefit of, such nonmanagement employees during such calendar year, the amount of the transfer or obligation is not greater than an amount equal to 25 percent of the amount of any similar transfer or obligation made to or incurred for the benefit of such insider for any purpose during the calendar year before the year in which such transfer is made or obligation is incurred;

(2) a severance payment to an insider of the debtor, unless –

(A) the payment is part of a program that is generally applicable to all full-time employees; and

(B) the amount of the payment is not greater than 10 times the amount of the mean severance pay given to nonmanagement employees during the calendar year in which the payment is made; or

(3) other transfers or 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 date of the filing of the petition

11 U.S.C. § 503(c).

8 See 11 U.S.C. § 101(31).

9 Section 102(3) of the Bankruptcy Code states that the terms “includes” and “including” are not limiting.

10 New subsection (a)(1)(B)(ii)(IV) under Section 548 of the Bankruptcy Code permits the avoidance as a fraudulent transfer of a prepetition transfer or obligation to or for the benefit of an insider of the debtor “under an employment contract and not in the ordinary course of business” if the debtor received less than reasonably equivalent value. 11 U.S.C. § 548(a)(1)(B)(ii)(IV)

11 In In re U.S. Airways, the court noted the following regarding the intention of Congress in enacting Section 503:

All too often [KERPs] have been used to lavishly reward-at the expense of the creditor body – the very executives whose bad decisions or lack of foresight were responsible for the debtor’s financial plight. But even where external circumstances rather than the executives are to blame, there is something inherently unseemly in the effort to insulate the executives from the financial risks all other stakeholders face in the bankruptcy process. Congressional concern over KERP excesses is clearly reflected in changes to the Bankruptcy Code that will become effective for cases filed after October 17, 2005.

In re U.S. Airways, Inc., 329 B.R. at 797.

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