CHAPTER 5, A. What Changed After KERPs Were Banned by Congress?

• Jurisdiction: United States

A. What Changed After KERPs Were Banned by Congress?

Evidence from an Empirical Study

ABI Journal

November 2019

Prof. Jared Ellias

UC Hastings College of the Law

San Francisco, Calif.

In 2005, the perception that wealthy executives were being rewarded for failure led Congress to ban chapter 11 debtors from paying "retention" bonuses to senior managers. Prior to the reform, which was tucked into the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), chapter 11 debtors routinely paid retention bonuses to senior managers through key employee retention plans (KERPs). Debtors justified these bonuses as necessary to keep talented executives working hard to turn the firm around.

However, many critics at the time viewed these bonuses as signs that managers were abusing their control of chapter 11 debtors to extract excessive levels of compensation. After the amendment became effective, bankruptcy judges could only authorize bonuses for senior managers if they were linked to specific performance goals, such as increasing revenue or moving the firm through the bankruptcy process. Thus, key employee incentive plans (KEIPs) became an important part of the chapter 11 landscape, displacing the earlier era of KERPs.

In a recent article,¹ the author offered the first comprehensive analysis and empirical study of how the 2005 law changed corporate bankruptcy practice. The data suggest that the reform appears to have had little substantive effect on executive compensation. The evidence suggests that this is primarily due to two flaws that undermined the reform.

First, the new law only regulated payments characterized as bonuses during the period that firms are in chapter 11. Firms could easily sidestep the new law by paying managers before or after the bankruptcy case, and many appear to have done so.

Second, the institutions of bankruptcy law have struggled to administer the law. A rule that bans retention bonuses while allowing incentive bonuses requires the bankruptcy judge to make a fact-intensive determination about the "challengingness" of a proposed bonus plan. Although creditors would appear to be well situated to assist the judge and scrutinize executive compensation themselves, they have little economic incentive to quibble over relatively small bonuses when doing so might anger the managers with whom they need to negotiate over more important chapter 11 issues.

The author's study draws on a sample of large chapter 11 debtors that filed for bankruptcy between 2001 and 2012. The author examined the pay practices of all major corporate bankruptcies during that period and closely examined a period prior to the reform from 2003-05, then a period after the reform was well entrenched, from 2009-10.

For each of these cases, the author, along with a team of research assistants, examined all of the significant pleadings filed in the case, with special attention to the pleadings discussing bonus plans, as well as the firm's financial statements and subsequent filings in the bankruptcy case and with the Securities and Exchange Commission to determine whether the bonus goals were achieved. The larger sample consists of 408 debtors that filed for bankruptcy between 2001 and 2012. The sample that was studied more closely consisted of (1) 41 firms that filed for bankruptcy and sought permission to pay retention bonuses to senior managers between Jan. 1, 2004, and April 20, 2005, immediately prior to BAPCPA becoming effective (the "pre-BAPCPA sample"); and (2) 57 firms that filed for bankruptcy between Jan. 1, 2009, and Dec. 31, 2010, when the new...