Jessi D. Herman, Pay to Stay, Pay to Perform, or Pay to Go?: Construing the Threshold Terms of Sec. 503(c)(1) and (2)

• Publication year: 2011

PAY TO STAY, PAY TO PERFORM, OR PAY TO GO?: CONSTRUING THE THRESHOLD TERMS OF

Sec. 503(C)(1) AND (2)

INTRODUCTION

On April 20, 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA").¹This extensive legislation revising the United States Bankruptcy Code ("Bankruptcy Code" or "Code")²was primarily aimed at preventing abuse of the consumer bankruptcy system under chapters 7 and 13 of the Code. In the years leading up to the enactment of the BAPCPA, however, a growing trend in business bankruptcies led some to perceive a need to prevent corporate abuse of the bankruptcy system as well. The odious trend that was the cause of such public disillusionment with the bankruptcy system was the institution, by business debtors in chapter 11 reorganization, of court-approved key employee retention programs, commonly known as KERPs.

Debtors in chapter 11 reorganization propose KERPs to adopt bonus and termination pay programs for certain "critical" or "key" employees, often insider executives, to induce them to continue their employment with the debtor's business through the uncertainty of reorganization.³The odiousness of the trend toward KERPs lies in the disparity that results when corporate debtors obtain court approval to pay rich bonuses or termination payments to their executives while pressuring, in the name of reorganization, their nonmanagement employees to accept lower wages and reduced benefits, and while laying off hundreds or thousands of nonmanagement employees with vast reductions in both severance, vacation, and sick-leave payments as well as pension and insurance plan contributions.

Polaroid is an example of a corporate debtor that has provided fuel for public fury in recent years. On October 12, 2001, Polaroid filed chapter 11 bankruptcy while executive vice president Neal D. Goldman wrote to former employees to inform them of the company's termination of all severance payments and funding for medical, dental and life insurance plans.⁴Goldman wrote:

[Today] Polaroid Corp. took the painful but necessary step of voluntarily filing for reorganization under Chapter 11 of the U.S. Bankruptcy Code. . . . As a result of the filing, absent court approval, Polaroid is precluded from paying any obligations to creditors that existed prior to the filing. This includes former employees currently collecting severance.⁵

Six months later, a bankruptcy judge approved Polaroid's plan to pay $4.5 million in retention bonuses to forty executives.⁶Under the plan, Goldman and fellow executive vice president William Flaherty would be eligible to receive bonuses equal to 62.5% of their base pay as well as severance payments also equal to 62.5% of their base pay. Other executives would be eligible to receive bonuses and severance payments equaling 25 to 50% of their base salaries.⁷This was Polaroid's scaled-down plan. Originally, Polaroid had proposed a plan to pay Chief Executive Officer ("CEO") Gary DiCamillo approximately $1.5 million in retention incentives,⁸which the company later withdrew in response to public outrage.⁹

Shortly after filing its chapter 11 petition in January 2002, Kmart became another major contributor to the public ire. On March 9, 2002, the company announced that it would close 284 stores and fire 22,000 employees without severance pay.¹⁰Three days later, Kmart announced the resignation of CEO Chuck Conaway, who would walk away with a court-approved $9.5 million-

$4.5 million in severance plus forgiveness for a $5 million loan Kmart had made to the CEO a year earlier.¹¹

From toy merchants to steel companies, there have been many other similar corporate offenders in recent years.¹²Recently, just before the BAPCPA went into effect, major automotive parts company Delphi Corporation filed its chapter 11 petition and KERP.¹³With a pension plan underfunded by $11 million and proposals on the table to cut up to two-thirds of workers' pay and to make substantial reductions in retiree benefits, Delphi proposed an incentive bonus program to pay $21.5 million to executives in the first six months and

$88 million more in cash to the company's top 500 employees upon emergence from bankruptcy.¹⁴From the $88 million, the company's top four executives would receive $8.9 million.¹⁵

In the face of this growing disparity in corporate debtors' treatment of nonmanagement employees and their executive counterparts, Congress added an amendment to the BAPCPA that was aimed at curbing corporate bankruptcy abuse. The BAPCPA added a new provision to the Bankruptcy Code that now limits corporate debtors' ability to pay large retention bonuses and severance payments to their executives. The new Sec. 503(c) limits debtors' ability to make or promise payments to insiders of the company to induce them to remain with the business, to pay severance to insiders, and to make any other payments or promises to pay outside the ordinary course of business and not justified by the facts and circumstances of the case. ¹⁶Debtors can no longer make retention payments to an insider without first making a showing that the insider has "a bona fide job offer from another business at the same or greater rate of compensation" and that the insider's services are "essential to the survival of the business."¹⁷Moreover, the allowable amount of an insider payment is now capped.¹⁸The payment must not be greater than ten times the mean amount of similar payments given to nonmanagement employees during the same calendar year.¹⁹If no such payments were made or promised to nonmanagement employees during the calendar year, then the amount of the retention payment is limited to twenty-five percent of any similar payment made or promised to the insider during the previous calendar year.²⁰Similarly, debtors cannot make a severance payment to an insider unless it is part of a program applicable to all full-time employees.²¹Insider severance payments are also capped.²²The payment must not be greater than ten times the mean severance pay given to nonmanagement employees during the same calendar year.²³

These new restrictions on debtors' ability to institute KERPs are quite strict. Section 503(c) creates detailed qualifications for judicial approval of programs that were hitherto a matter of the debtor in possession's ("DIP") business judgment and a bankruptcy judge's discretion. Moreover, Sec. 503(c) places monetary caps on bonuses and severance payments where there had previously been none. Critics predict that Sec. 503(c) will "effectively eliminate all companies' ability to ever receive court approval for a KERP."²⁴Others believe that Sec. 503(c) at least spells the end of KERPs as a common element of chapter 11 cases.²⁵Furthermore, critics of Sec. 503(c) complain that the amendment is poorly drafted, creating a great deal of ambiguity over how it will be interpreted in application.²⁶

This Comment will not attempt to resolve every ambiguity raised by

Sec. 503(c)²⁷but will address, rather, the two most pressing questions of interpretation-those which will determine the scope of application for the strict limitations of Sec. 503(c). First, application of Sec. 503(c)(1) will demand an answer to the threshold question: what kinds of incentives should be considered "for the purpose of inducing [an insider] to remain with the debtor's business?" Only the approval of those transfers and obligations which are inducements to remain will be subject to the bona fide job offer requirement, the requirement that the recipient is essential to the survival of the business, and the monetary caps imposed by Sec. 503(c)(1). Bonus programs, for example, which are intended to create incentives that motivate employees toward superior performance may be beyond the reach of Sec. 503(c)(1). Similarly, application of Sec. 503(c)(2) will require an answer to the threshold question: what kinds of termination payments should be considered "severance"? Only those termination payments which are considered "severance" will trigger the requirement of a severance program for all full- time employees or the monetary caps imposed by Sec. 503(c)(2). Some have argued for an interpretation implying a significant exception to Sec. 503(c)(2) that excludes from its coverage claims for termination payments arising from individual employment contracts.²⁸

This Comment contends that these threshold questions of Sec. 503(c) application must be answered in light of the public policies which underlie the bankruptcy system and which motivated Congress to enact Sec. 503(c). Part I of this Comment provides background information on how KERPs fit into the chapter 11 business reorganization process before the enactment of Sec. 503(c). By comparing the priority afforded KERP claims under the pre-BAPCPA Code with the priority afforded other employee wage and benefit claims, this Part explains why chapter 11 business debtors have been able to obtain court approval for supergenerous KERPs while cutting off employment, severance, and a multitude of other benefits to nonmanagement employees. Part II draws on the legislative history of the Bankruptcy Code, and, particularly, the legislative history of Sec. 503(c) and other employment-related amendments enacted by the BAPCPA to show that Congress's purposes in enacting

Sec. 503(c) were to restore protection for employees of bankrupt companies under the Code and to eliminate the ability of debtors to gain court approval for corporate practices that invoke a deep sense of unfairness. Part III argues that in applying Sec. 503(c)(1), courts need to make a distinction between retention bonuses and performance-motivating incentives in order to avoid needlessly restricting incentives that have independent value to the estate beyond simply inducing an insider to remain. This Part shows that exempting legitimate performance incentives from the restrictions of Sec. 503(c)(1) is consistent with Congress's purposes in enacting Sec. 503(c). In...