CHAPTER 5, C. The World of Bankruptcy Compensation for Key Employees

• Jurisdiction: United States

C. The World of Bankruptcy Compensation for Key Employees

ABI Journal

January 2019

Brian L. Cumberland

Alvarez & Marsal

Dallas, Texas

J.D. Ivy

Alvarez & Marsal

Dallas, Texas

Achapter 11 debtor's executives might find little motivation to remain employed at a company as annual bonus plans become compromised and long-term incentive vehicles (e.g., stock options, restricted stock) become virtually worthless. As a result, it is imperative that an organization in chapter 11 implement an alternative-compensation arrangement in order to retain key executive talent and incentivize them toward the level of performance that is necessary to achieve a successful restructuring.

Overview of Bankruptcy Law

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) imposed the most significant changes to U.S. bankruptcy law in 35 years, affecting both consumer and business bankruptcies. Section 503(c) of the revised law imposed several restrictions on the use of retention plans for insiders in the context of a bankruptcy proceeding. If a company's key employee retention plan (KERP) does not provide for incentive compensation (performance-based) and is solely based on the employee's retention, it is subject to the restrictions under § 503(c)(1). This section prohibits retention payments to "insiders" (defined in more detail below) unless the following criteria are satisfied:

1. The services provided by the employee are vital to sustaining the business;
2. The payment is essential to the retention of the employee due to a bonafide job offer from another company of equal or greater compensation (inclusive of commissions, benefits, equity and all wage equivalents or supplements); and
3. The amount of the payment is no greater than 10 times the average payment to similar non-management employees in the same calendar year or (in case the previous, similar payments do not exist) no greater than 25 percent of any similar payment made to the "insider" during the previous calendar year.

Because of these onerous restrictions, retention programs are rarely utilized for "insiders." BAPCPA also placed similar restrictions on severance payments to "insiders." Section 503(c)(2) prohibits severance payments to "insiders" unless the following criteria are met:

1. The severance payment is part of a program that is generally available to all full-time employees; and
2. The severance amount is not greater than 10 times the average severance payment to non-management employees during the same calendar year.

As a result of these limitations, the value of severance programs to "insiders" is extremely limited or nonexistent. Finally, § 503(c)(3) serves as a catch-all provision prohibiting any other payments that are outside the ordinary course of business and are not justified by the facts and circumstances presented in the case. These BAPCPA restrictions apply only to "insiders" and are not imposed on noninsiders.¹

Key Employee Retention Plans for Noninsiders

The hurdles established by BAPCPA under § 503(c)(1) often render KERPs unworkable as a mechanism to retain insiders. However, KERPs can still be effectively used to incentivize noninsider employees to remain with a company during a bankruptcy period. KERPs for noninsiders usually take the form of cash bonuses to employees, are often expressed as a percentage of each relevant employee's base salary, and are distributed throughout the corporate transition period, with the final (and typically largest) payment generally linked to the process resolution (e.g., emergence, liquidation).

Key Employee Incentive Plans for Insiders

While § 503(c)(1) does not prohibit the use of KERPs for insiders altogether, the challenges to and...