Paying for performance in bankruptcy: why CEOS should be compensated with debt.

Author:Listokin, Yair

While managerial performance always plays a critical role in determining firm performance, a manager's importance is elevated during bankruptcy. A manager in bankruptcy both runs the firm and helps form a plan of reorganization. In light of this critical role, one would expect that bankruptcy scholarship would place considerable emphasis on the role of CEO compensation in incentivizing managerial performance in bankruptcy; however, the opposite is true. Bankruptcy scholars and practitioners tend to emphasize other levers of corporate governance, such as the role of debtor-in-possession financiers, rather than the importance of CEO compensation. This Article seeks to revive CEO compensation as an important governance lever in bankruptcy. First, the Article examines current ideas and practices of managerial compensation in bankruptcy and finds them wanting. The Article next proposes a novel bankruptcy compensation plan--debt compensation--that provides better incentives for managers to perform efficiently. By granting managers a fixed proportion of unsecured debt in the bankrupt firm, debt compensation creates value-enhancing incentives similar to the incentives created by the stock grants and stock options that are heavily employed by solvent firms to compensate managers.

INTRODUCTION I. A HYPOTHETICAL FIRM IN BANKRUPTCY II. EXISTING MANAGERIAL COMPENSATION ARRANGEMENTS IN BANKRUPTCY A. Debtor-in-Possession Financing B. Managerial Compensation 1. Pay-To-Stay Bonuses 2. Rapid-Reorganization Bonuses 3. Percentage-of-Assets Compensation Plans a. Skewed Incentives b. Low-Powered Incentives 4. Percentage of Equity Compensation Plans a. Inefficient Capital Structure b. Skewed Incentives for Getting a Plan of Reorganization Confirmed C. Enron as an Example of the Deficiencies of Current Methods of CEO Compensation in Bankruptcy III. DEBT COMPENSATION FOR MANAGERS A. Unsecured Creditors and Chapter 11 Bankruptcies B. Debt Compensation for Managers C. Why Debt Compensation Is an Improvement upon Existing Means of Managerial Compensation in Bankruptcy 1. Improvement over Pay-To-Stay Bonuses 2. Improvement over Rapid-Reorganization Bonuses 3. Improvement over Percentage-of-Assets Plans 4. Improvement over Equity Compensation Plans 5. Improvement of the Functioning of the Creditors' Committee IV. WEAKNESSES OF DEBT COMPENSATION AND POTENTIAL RESPONSES A. Debt Compensation's Expense 1. Opt-out for Senior Unsecured Creditors 2. Debt Compensation Is a Voluntary Plan B. Conflicts Between Creditors Caused by Debt Compensation 1. Conflicts Among General Unsecured Creditors 2. Conflicts Between Secured Creditors and Unsecured Creditors 3. Conflicts Between Senior Unsecured Creditors and General Unsecured Creditors 4. Conflicts Between Equity and Unsecured Creditors C. Joint Administration D. Manager Has Debt in Reorganized Company 1. Problems with Debt Holding by Managers 2. Responses to These Concerns 3. Possible Modifications to Debt Compensation E. Change in Pre-bankruptcy Incentives 1. Debt Compensation's Impact on the Propensity To File 2. Debt Compensation's Impact on Managers' Treatment of Creditors Before Bankruptcy F. Cautious Implementation Should Prevent the Worst Abuses of Debt Compensation CONCLUSION INTRODUCTION

While managerial performance always plays a critical role in determining firm performance, a manager assumes a heightened role in bankruptcy. In bankruptcy, the manager in control of the debtor-in-possession makes all the decisions that the manager of an ordinary firm must make regarding firm operations and strategy; however, the manager's role does not end there. Instead, the manager also plays an essential role in forming a plan of reorganization or liquidation. This task involves many responsibilities, including weighing the choice of liquidation versus reorganization, mediating between different classes of creditors, and selecting the optimal capital structure for the reorganized firm.

How unfortunate, then, that managerial compensation in bankruptcy is so restricted. While managers of ordinary firms receive a wide array of incentive compensation devices, compensation for a manager in bankruptcy is far more ineffectual and limited. (1) In addition, managerial interests tend to be "closely aligned with the shareholders," (2) making it unlikely that a manager will design a reorganization plan that maximizes value for the creditors of an insolvent firm. The limitations of executive compensation in bankruptcy are echoed by the lack of scholarly attention to the subject. While the question of executive compensation is the subject of a vast literature in both finance and law, (3) analyses of corporate governance in bankruptcy tend to give the subject short shrift. (4) In an important exception to the pattern of downplaying the role of executive compensation in bankruptcy, Professor David Skeel details some managerial compensation schemes that are prevalent in bankruptcy. (5) These include "pay-to-stay" agreements to retain key managers in the wake of a bankruptcy declaration (6) and managerial bonuses for speedy reorganization. In addition, Professor Skeel mentions proposals for improving these compensation schemes. Skeel states that the ideal solution would be to "base the managers' pay on the overall value of the debtor's assets at the conclusion of the Chapter 11 case." (7) Skeel explains that because of uncertainties regarding valuation, however, this solution will only be attainable when firm value is reasonably well established, such as in liquidation. (8) Instead, Skeel proposes granting stock in the reorganized company to managers; in this way, managers will have incentives to maximize value. (9)

Unfortunately, pay-to-stay agreements, rapid-reorganization bonuses, and the Skeel proposals all contain significant flaws. (10) Pay-to-stay agreements may enable the debtor to retain key managerial personnel, but they do nothing to ensure that a manager will attempt to maximize value. Rapid-reorganization bonuses incentivize a speedy reorganization, not a value-maximizing one. Granting a manager a percentage of liquidation proceeds works well if liquidation is the obvious choice. When liquidation is not the efficient option, however, the prospect of a percentage of the asset return in liquidation may encourage a manager to push for liquidation even when reorganization would create more value. Finally, granting stock in the reorganized company skews managerial incentives in a number of ways. First, it may encourage a manager to prefer reorganization when liquidation is a more efficient option. Second, owning stock in the reorganized company means that a manager has an incentive to ensure that the equity of the reorganized company is of the utmost value. This encourages the manager to propose reorganization plans wherein the reorganized company has little or no debt, even if the company would have a higher total valuation with some debt in its capital structure. (11)

All of these problems stem (at least in part) from a fundamental difficulty of granting incentive compensation in bankruptcy as compared to incentive compensation in an ordinary solvent firm. In an ordinary solvent firm, a manager's fiduciary duty is associated with the residual claimants--the equity holders. (12) As a result, equity-based incentive compensation plans, such as stock options, are relatively easy to adopt. (13) By granting equity to the manager, incentive compensation aligns managerial incentives with those of the equity residual claimants--when the residual claimants benefit, so does the manager. The manager's pecuniary incentives accord with her fiduciary duties. In bankruptcy, by contrast, the residual claimants (and the manager's fiduciary responsibilities (14)) are harder to identify. Most frequently, the residual claimants, and those owed fiduciary obligations, are unsecured creditors. (15) In response, the executive compensation proposals described above use some proxy for residual claimants when awarding compensation. This process is subject to errors. For example, granting the manager equity in the reorganized firm works well if the residual claimants in bankruptcy also will hold equity in the reorganized firm. If, however, some of the residual claimants in bankruptcy hold debt in the reorganized entity, then there may be a conflict of interest between the manager and the residual claimants. (16)

To remedy these defects and reorient the scholarly debate in bankruptcy toward the problem of executive compensation rather than focusing almost exclusively on other means of corporate governance, this Article proposes a novel form of managerial incentive compensation for publicly traded corporations in bankruptcy. The unsecured creditors' committee should be granted a new (conditional) right--the right to grant the manager a percentage of the unsecured debt (a "vertical strip" of unsecured debt) currently held by the creditors of the firm. (17) This right would be subject to several conditions, as described below. Because unsecured creditors are the most common residual claimants in bankruptcy, (18) this right would enable the residual claimants to align the incentives of the manager with their own. When the value of a bankrupt firm rises, it is typically the unsecured creditors who obtain the greatest benefit because they are the most common residual claimants. Granting a manager debt in the bankrupt firm allows the creditors to share these gains with the manager and ensures that the manager has the appropriate incentive to pursue these gains.

Granting the manager a percentage of unsecured debt solves many of the inefficient incentive problems generated by the plans described above. If a rapid reorganization increases the total value of the firm and thereby the total recovery for unsecured debt, then a manager receiving a percentage of this debt will have a greater incentive to reorganize rapidly because a rapid reorganization...

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