Looming Bankruptcy & Compensation Ramifications – Part Two

In our second issuance to the trilogy of transaction-based compensation actions, our team has outlined the complicated world of executive compensation in light of bankruptcy. Unlike other types of actions, bankruptcy for an organization is an incredibly tenable moment in an organization’s history.

When bankruptcy is in full force, the human element truly appears on a large scale. Employees are rightfully worried about fielding questions from their loved ones on how it will impact their daily lives, concerned coworkers with equal or less information, friends, and, in some more extreme cases, media members. When these moments meet, fight-or-flight senses will likely engage.

The flight mechanism will lead to a mass exodus of employees to more certain employment opportunities. Those who are left will now pick up the added work of the newly departed coworkers with little security of their ability to have gainful employment, further compounding the strenuous moment.

The Larger Impact of Bankruptcy

Looking more globally, when a company files for bankruptcy, it lights the fuse on a comprehensive restructuring process that will touch all aspects of its financial and operational obligations. Among the critical issues scrutinized during this process are executive compensation structures and agreements.

These arrangements, in most cases, draw intense scrutiny from outside investors and stakeholders, as they must strike a delicate balance between retaining and motivating key executives and addressing the realities of the financial status. This article explores the many perspectives and outcomes from legal, practical, and, just as important, reputational considerations that surround executive compensation during bankruptcy proceedings.

Key Legal Framework: The Bankruptcy Code

The U.S. Bankruptcy Code imposes strict limits on executive compensation during bankruptcy to ensure fairness and prevent misuse of funds that could otherwise go to creditors or employees. Specifically:

1. Section 503(c): Restrictions on Payments to Insiders

This section outlines limitations on three types of payments:

• Retention Bonuses: Payments made solely to retain executives are heavily restricted. For a retention bonus to be approved, the company must demonstrate that:
  • The executive has a “bona fide” job offer from another company at the same or higher compensation level.
    • A bona fide offer is a genuine and legitimate job offer that meets specific criteria established by the court. The offer must, at a minimum, demonstrate that the executive has a credible alternative employment opportunity, typically at a comparable or higher level of compensation.
  • The payment is essential to retain the executive.
  • The amount is reasonable and necessary for the company’s needs.
• Severance Payments: Severance for insiders is capped at 10 times the mean severance pay provided to non-management employees during the preceding calendar year.
• Incentive-Based Compensation: Payments tied to specific performance goals (often through Key Employee Incentive Plans, or KEIPs) are allowed but must be structured to reward measurable achievements rather than mere retention.

Balancing Incentives and Stakeholder Interests

During bankruptcy, companies often face a duality; they must first retain and, secondly, properly incentivize key executives to navigate the complex and tremendously time-consuming restructuring process while ensuring that compensation arrangements are fair and reasonable.

The methods by which companies are able to achieve solutions to this duality is through two key compensation elements. A Key Employee Incentive Plan (KEIP) and a Key Employee Retention Plan (KERP) are programs nearly always used by companies. However, they differ in purpose and design elements:

1. Key Employee Incentive Plan (KEIP)

• Purpose: Designed to motivate key employees to achieve specific performance milestones or goals that are critical to the success of the company during its restructuring or operational improvement phase.
• Criteria: Compensation payouts are tied to performance-based outcomes, such as achieving desired financial targets, completing a successful sale of the company, or meeting pre-determined restructuring milestones.
• Structure: Incentive payments are contingent on meeting clearly defined benchmarks or goals. It rewards employees for exceeding expectations, not just for staying with the company. In general, compensation terms are more similarly related to an annual incentive plan (KEIPs can potentially cover a period longer than 12 months depending on the emergence/sale timelines).

2. Key Employee Retention Plan (KERP)

• Purpose: Designed to retain key employees during periods of uncertainty, such as bankruptcy or restructuring, to ensure continuity and prevent disruption caused by employee departures.
• Criteria: Compensation is typically tied to an employee’s continued employment with the company for a specific period, regardless of the company’s financial or operational performance.
• Structure: Payments are retention-based, meaning employees receive compensation if they remain with the company through a specific date or event, like the conclusion of a bankruptcy case.

Aspect Comparison: KEIP vs. KERP