Key Employee Retention Programs (KERPs) are a ubiquitous feature of the modern corporate bankruptcy. The term covers a wide variety of benefits (or sins, depending on one's perspective) ranging from success bonuses to severance pay, retention bonuses and the assumption of pre-petition golden-parachute agreements. To their supporters, they are a crucial tool to retaining the crucial presence, knowledge and experience needed to bring a troubled entity through the stormy waters of bankruptcy to the safe harbor of a confirmed plan with a high payout to creditors. To their critics, they are a way for overpaid, incompetent executives that mismanaged a company into bankruptcy to continue skimming the cream for as long as possible, imposing huge administrative costs with little proven benefit to the company or the creditors.

The Government's Interest

Taxing authorities are among those most concerned with these programs. Most taxes will be pre-petition priority taxes or post-petition administrative expenses. The other priorities are either inapplicable to corporations (such as domestic support obligations), relatively small (the $2,225 allowed for consumer deposit claims), or were paid at the beginning of the case (wages and benefits) and so, for better or worse, are no longer an issue. Thus, if the debtor's solvency is questionable, the conflict will frequently devolve into one between the government's priority and administrative tax claims and the administrative claims for the debtor's management and the professional fees. Because taxes may not be payable until months after the end of a fiscal year, administrative taxes can easily be incurred and may go unpaid if the estate is insolvent.

The problem will be exacerbated if the payments are made during the case, rather than on plan confirmation (or later), as with most non-ordinary-course-of-business expenses, since once they are made, disgorgement will be difficult. The result may be that post-petition taxes with equal priority will never be paid. Such payments can also result in reduced cash flow with a greater need for borrowing (with the lender receiving superpriority status) and increased likelihood that a plan will never be confirmed or will fail shortly thereafter. Further, insiders will often have substantial equity interests, and depending on the corporate-governance structure, payments raise serious questions about equity's fiduciary duties to creditors and the "absolute priority" rules.²

Are Compensation Experts the Answer?

Proponents of KERPs often come to court armed with impressive studies from "experts" documenting that the programs being suggested are reasonable and necessary when compared to "average" programs in similar bankruptcies or paid by solvent companies that are competing to hire these employees. The assumption that persons employed by companies in bankruptcy should receive as much as those not in that unfortunate state is one of the primary places where bankruptcy realities run directly counter to the instinctive views of the rest of the world. When confronted with economic difficulties outside of bankruptcy, we usually assume we must spend less on ourselves and cannot afford the same amount of professional assistance. Only when one enters bankruptcy (at least after 1978) does that assumption become reversed, and it is thought normal that debtors should hire the best and pay appropriately, even while creditors receive little or nothing.

That assumption and the policy rationales for it, as applied to professional fees, continues to be a staple for much discussion, not to mention consternation, on the part of creditors who watch fees in cases such as Enron soar toward three quarters of a billion dollars in relatively short order. The same concern occurs even more urgently when the persons who led the company into bankruptcy now wish to be paid at the same rate as their more successful colleagues. The issue is somewhat different when the issue is what to pay new management that is put into place by the turnaround specialists, but there is still much angst when one finds managers being given large compensation packages while rank-and-file employees and creditors are losing much or all of what they are owed. However, so the analysis goes, there are many places in bankruptcy where what "should" happen collides with economic realities of the even worse results that purportedly "will" happen if the payments are not made, and so the programs go forward.

One might think that the use of outside experts and other procedural measures, such as only having independent directors propose such plans, might obviate the concerns. We suggest, though, that such measures are not necessarily as effective as one might hope. First, those experts are presumably competent to analyze the question of "how much" but not necessarily the question of "whether." That is, the commissioning of the study already largely presupposes the result since a report that comes back saying "don't do anything" seems somewhat unlikely. But moving beyond the inherent pressure to come up with a recommendation to do something, there is perhaps another, more insidious bias—the "Lake Woebegon Syndrome," named for that famous small town where "all of the children are above average."³

What we refer to here is the inherent ratcheting effect that comes from using average figures to decide what shall be paid at a particular company. We say "inherent" because, just as the decision to hire a compensation expert presupposes that improvements need to be made, the desire to retain particular personnel tends to carry with it the assumption that these people are worth keeping because they are "above average." To be sure, sometimes independent directors might concede privately that management isn't great, but the costs of bringing in someone better are simply too high. But who would want to say that publicly—or to those managers directly? Indeed, doesn't everyone believe that they and their employees are "above average?" Indeed, a board of directors would likely feel quite virtuous if they only proposed to pay the "average."

However, even such decisions will move the average up over time. "Averages" must have people below that level, as well as above it. So if each succeeding company merely pays the "average," then each succeeding calculation will find the average moving higher, because there are no below-average payments to balance the above-average ones. Proposing a below-average KERP, though, seems counterintuitive and counterproductive to its success. If one is trying to convince others that these employees are truly crucial, then proposing a sub-par retention agreement would seem to contradict the basic premise. Moreover, while proposing a bonus should improve morale, proposing a mediocre bonus could backfire. Thus, the pressures are surely there to have all KERPs, like all children in Lake Woebegon, be "above average."

The same is surely true outside of bankruptcy, and the constant ratcheting up of executive compensation there is equally problematic and equally difficult to uproot. Shareholder revolts are increasing, and opposing votes on proposed bonus and incentive packages for executives are as well, but few if any have actually broken through to become the majority position.

An even greater problem may be the issue of whether either the compensation experts or the directors on corporate boards are truly independent. A recent article in the New York Times suggests that the same conflicts that existed with respect to accounting firms that audited a company's books while also giving more lucrative business advice also exists for compensation experts.⁴ That article details how firms that provide such advice, may also be hired to do far more extensive (and profitable) work administering aspects of the benefit programs for those same companies or similar matters. The potential for conflict on their "independent" advice then is obvious. Moreover, the article notes, the "independence" of the outside directors may also be questioned in view of the overlapping nature of such boards and the potential for reciprocal back-scratching among directors and executives. Thus, one may well doubt the validity of the system that exists outside of bankruptcy, much less the wisdom of using that model as the basis for making compensation decisions in bankruptcy.

The BAPCPA Amendments

In such a "broken" system, it may be the case that only an outside intervention that sets the terms of engagement and levels the playing field for all can alter the results. Congress tried to do that when it included the KERP amendments in the recent Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). How well did it succeed?

It is worth noting that the new amendments, like many others in BAPCPA, display a substantial distrust of judicial discretion in reviewing these proposed plans. Many critics of BAPCPA have focused on the limitations on judicial discretion with respect to consumer debtors; this provision, though, came from the other side of the aisle, but displays many of the same characteristics. Rather than provide a more detailed list of factors or standards for the courts to use where none existed before, the amendments instead lay out very specific requirements, but only for certain types of payments.

The politics of its inclusion are interesting and informative. No such language was included in the prior bills that repeatedly passed both Houses at various times between 1997 and 2004, nor did it appear in the version of S. 256 that was introduced on Feb. 1, 2005. The Senate Judiciary Committee markup of that bill took place on Feb. 17, 2005, with Sen. Orrin Hatch (R-Utah) presiding in place of Sen. Arlen Specter (R-Pa.), who had recently been diagnosed and hospitalized with lymphoma. Those attending (including one of the authors) watched as Sens. Edward Kennedy (D-Mass.) and Russ Feingold (D-Wis.) pushed for a laundry list of proposed amendments, each of which was duly defeated. During the process, Sen. Hatch made at least two "Let's pass this one for the Gipper" speeches, noting that he had promised Sen. Specter that he would get the bill passed out of the committee. He eventually offered the minority their choice—have all of the amendments voted down, or pick a couple that would be included, and let the rest be voted upon on the Senate floor. That compromise was agreed to, and the KERP amendments were among those Sen. Feingold picked, a result that occasioned some grumbling on the majority side. However, they were included as written, as §331 of BAPCPA and now §503(c) of the Bankruptcy Code.

The new section has several interesting aspects. First, it bars all payment (not just administrative expense status) for certain obligations—"retention" payments, "severance" payments and "other" payments. Retention payments to "insiders" of the debtor may be made only upon findings that (1) the payment is "essential...because the individual has a bona fide job offer from another business at the same or greater rate of compensation and (2) the person's services are "essential to the survival of the business." If those criteria are met, the amount of the payment may be up to 10 times the mean payment of a "similar kind" given to "nonmanagement" employees for any purpose during that calendar year. If no such payments were made, then the amount is limited to 25 percent of the amount of any similar transfer to the insider for any purpose during the prior calendar year.

Severance payments may only be made to insiders if the program is applicable to all full-time employees, and the payments to such insiders do not exceed 10 times the mean severance pay given to non-management employees during the calendar year in which the payment is made. Finally, any other transfers or obligations "outside the ordinary course of business and not justified by the facts and circumstances of the case" are also barred.

The section raises many drafting and policy questions. For instance, "insider" payments are limited, but the comparison group is "non-management employees." How do payments to non-insider management employees then fit into the calculus? Are they also limited by this "10 times" provision, or not? Second, the provisions refer to payments of a "similar kind" made to non-management employees, but then say that the payments may be given "for any purpose." Is the "any purpose" language meant to expand the scope of what is "similar?" If so, in what way?

Third, with respect to retention bonuses, the two options will often be worthless. The first choice will rarely exist; it is doubtful that more than a handful of companies pay retention bonuses to non-management employees outside of bankruptcy. Ten times nothing is nothing. The second option may likewise prove extremely limiting. It only counts a bonus paid to the particular insider in the prior calendar year, so even a well-established program of paying retention bonuses will not count unless this executive had received a payment, and even then, only in the prior year (not the current year or any other prior years).

Even golden parachute agreements would often not count because such agreements typically provide for payments up front or after the manager leaves, but not during the term of employment. Thus, this provision in most cases may well block any retention payments to insiders, no matter how well justified (and of course, it is not clear where the 25 percent limit came from or why it would be appropriate). The section does not, on the other hand, apparently place any limits on such payments for non-insiders, even if they are management, as long as they are not "insiders." The severance-pay provision is less demanding, although the use of the calendar year, rather than a rolling 12-month period, may well be subject to manipulation.

Even assuming one navigates the dollar limitations, the two "essential" requirements may also prove difficult to administer and may be problematic in terms of a debtor's needs. First, the insider must have actually received a job offer, which would make it difficult to create a predictable retention program that will provide present assurances about the future, rather than an idiosyncratic series of bonus reviews. And even assuming that the debtor can obtain approval for future payments, the need to show that this employee received a job offer will surely encourage all employees to start looking for other jobs—exactly the sort of distraction that these payments are supposed to discourage.

Moreover, if the only way to obtain a bonus is to obtain an actual attractive job offer, there surely is then a strong temptation to just take that offer, rather than to remain in bankruptcy limbo (or to anger the other company by using it as a bargaining ploy, when the manager may eventually need to come back looking for a job for real). While turnover and attrition are surely relevant issues, it is unclear that they work well on a person-by-person basis. That is particularly true when considering how to enforce this: Must the judge review each job offer and bonus, and allow other parties to object thereto and attack the need for that executive? Such a process is surely likely to exacerbate, rather than alleviate, the pressures on the best employees to leave.

In any event, since the limit only covers pure "retention" programs, the most likely result appears to be that programs in the future will be structured as anything else but "retention," most likely being changed to "success" payments. Many such programs already have aspects of that nature in that they provide for payments if the employee is still employed when milestones in the case are reached. It is not difficult to imagine that one can recast the language of the programs to simply refer to employees being rewarded for that "success," rather than being paid to be "retained" until those dates.

Cases, Past and Present, and Some Thoughts on Proper Structuring

Despite the somewhat draconian nature of the new provisions, they arose for good reason in view of some of the prior cases that approved KERPs, and the lack of any standards in the Code for analyzing such proposals. Most bankruptcy courts reviewed such agreements under the bankruptcy court's authority under §363 to allow the use of property "outside the ordinary course of business." As such, bankruptcy courts often analogized these programs to other measures authorized under that section, such as the sale of property or the borrowing of money. If the Code authorized debtors to operate the business, bankruptcy courts could not be in the business of micromanaging a debtor's decisions. Even for non-ordinary course decisions where court approval was needed, deference would still be given; if not warranted, management should be removed under §1104(a)(1)—not left in place but then subjected to constant scrutiny.

Such a standard works reasonably well where the insider is not on both sides of the transaction. But KERPs, by definition, do allow insiders to personally benefit from programs that they may well be promoting. Thus, to use the test stated in In re Aerovox, 269 B.R. 74 (Bankr. D. Mass. 2001) (decision will be upheld unless "so manifestly unreasonable that it could not be based upon sound business judgment, but only on bad faith, or whim or caprice"), could plainly lead to abuse. Another issue is whether the bankruptcy court should require the debtor to demonstrate a "reasonable prospect of successfully reorganizing" before offering the bonuses. In In re Montgomery Ward Holding Co., 242 B.R. 147 (D. Del. 1999), the court held that there was no absolute requirement to show that, although that issue should inform the bankruptcy court's exercise of discretion.⁵

A further issue is whether payments should be tied to the success of the case. This concept is undoubtedly valuable, since the point of making these payments is to make a reorganization more likely. The bankruptcy court in In re U.S. Airways Inc., 329 B.R. 793 (Bankr. E.D. Va. 2005), for instance, distinguished between lower-level management, for which it approved a severance package before the plan was voted on, and upper management, as to which it required that the plan address the issue so that creditors could vote thereon. In the Matter of Allied Holdings Inc., 337 B.R. 716 (Bankr. N.D. Ga. 2005), the bankruptcy court reviewed a program that provided for bonuses paid in installments upon achieving "milestones" in the case. The bankruptcy court placed those milestones somewhat further down the road than the debtor proposed, requiring, for instance, that payments not be made until an actual plan was proposed, not just a "restructuring strategy."

This "success bonus" strategy appears to be appropriate, especially since it is akin to the use of management performance bonuses outside of bankruptcy. The problem arises, though, if the bar for "success" is set too low. "Proposing a plan" or even confirming one, in these days of "pre-pack" liquidations, is not always much of an accomplishment—or one that requires the retention of existing management. At the session on "Turnarounds after BAPCPA: Should We All Become Liquidators?" at the recent ABI Annual Spring Meeting, Kenneth Frieze, president of Gordon Brothers Asset Advisors, discussed what changes, if any, needed to be made in valuing assets for store-closing sales. For most assets, his analysis concluded that "[t]he company's officers, who may be lost due to the revised KERP restrictions, are not essential to the sale process" (emphasis added).

This is not to say that "key employees" are irrelevant in true reorganizations, but it is important for courts to recognize the difference between a plan that puts an operating business back on track versus one that merely completes a liquidation in the guise of a chapter 11 plan. Moreover, the analysis should also take into account how successful the plan truly is, both on an absolute and a relative scale. A plan that pays 100 cents on the dollar to unsecureds merits higher bonuses than a 10-cent plan, and managers that increase a projected 15-cent plan to a 50-cent plan are deserving of more compensation than those who merely confirm a plan that pays less than what was in the till when the case was filed. In that regard, the plan in In re Teligent, 282 B.R. 765 (Bankr. S.D.N.Y. 2002), which was confirmed with a payout to administrative claimants of about 10 percent, is perhaps the best example of "success" that warrants no bonus.

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[M]anagement should be required to tie its fate to the success of the reorganized debtor, not just to getting it out of bankruptcy, particularly when many creditors' only compensation will be in company stock. If that stock quickly becomes worthless after the plan is confirmed, the creditors should not be the only ones that suffer.

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What then might an appropriate KERP look like, and how should it be analyzed? First, one can assume that, for insiders, at least, it will be set up on the "success bonus" model, since pure retention bonuses will be very difficult to have approved, although noninsiders may still have them. The limits on severance payments—10 times the non-management level may actually be relatively workable in the severance area, since it at least allows everyone to receive something—and a 10 to 1 ratio is not an unreasonable "absolute" for Congress to place upon executives who lead their companies into bankruptcy, so they will not likely face much debate.

In any case, however characterized, a great many bonus packages will end up being reviewed under the catch-all provision in §503(c)(3). That language gives bankruptcy courts the same leeway that they had before since the only limit is that payments must be "justified by the facts and circumstances of the case," which presumably goes without saying. Thus, that requirement provides little more guidance to the bankruptcy courts than they had before. There is still much need for the bankruptcy courts to adopt adequate criteria that balances the needs of the debtor, the creditors, and the rank and file employees who are asked to make sacrifices rather than receive added compensation.

An early case actually had one of the more stringent KERP programs and is a possible model. In In re Interco Inc., 128 B.R. 229 (Bankr. E.D. Mo. 1991), the KERP, rather than being tied merely to meeting bankruptcy milestones, was based on projected business performance goals and tied the bonuses to achieving those goals, with higher bonuses resulting from higher performance. Payments moreover were primarily made at and after the end of the fiscal year, and performance goals had to be met even with the payment of the bonuses. The two most senior officials would receive nothing until after confirmation; moreover, if the plan was not confirmed by a set date, their potential bonuses would be reduced for each month of delay.

A package of guidelines should include at least the following: First, the level of scrutiny should be based on the degree to which insiders and management (as opposed to employees generally) that benefit from the program are involved in making the decisions and a meaningful review of the independence of those making the recommendations. Second, the amount and terms of payments should be correlated to the level of persons receiving the benefits; upper management and officers are more responsible for the success or failure of the bankruptcy case, so their compensation should be more closely tied to progress in the case, while lower-level recipients may need to be compensated more quickly and with more certainty if they must be convinced to stay. Third, higher-level management should be paid for success, which should be graded both on progress in the bankruptcy and business operations, and on meeting meaningful goals, not just on getting to the end of the year or confirming a plan, no matter how meager.

Fourth, the analysis should take into account the total amount of the benefits, both as an absolute amount of revenue and as it relates to the payments to be received by creditors in the case, and the sacrifices being sought from rank-and-file employees. In the Fruehauf case, the court noted that the testimony was that such plans normally entailed about .4 to .5 percent of revenues to obtain commitments to stay for 12-18 months. A plan that is more generous, or that provides large benefits to management while employees lose out, should be closely scrutinized.

Finally, the form of compensation for upper-level employees should also be made at least partially in the form of stock options or warrants that will vest over time post-confirmation. Confirmation orders are required to include a finding that the case will not likely soon result in liquidation or the need for further financial reorganization. Thus, management should be required to tie its fate to the success of the reorganized debtor, not just to getting it out of bankruptcy, particularly when many creditors' only compensation will be in company stock. If that stock quickly becomes worthless after the plan is confirmed, the creditors should not be the only ones that suffer. Such stock might be convertible to cash after certain periods or based on the reorganized debtor's performance. There should also be "default provisions" that terminate or subordinate such payments if the plan goes into default. Other administrative and priority creditors should not see their losses compounded by paying for successes that are merely illusory. Keeping "key employees" tied to the company during the critical phase of post-confirmation performance and spreading out payments both assists in cash flow and ensures that those needed to foster further growth and development after confirmation stay around—and avoid a chapter 22 filing.

Further Legislative Developments

A final note of interest is that these provisions may not be the last word. Alarmed, perhaps, by the realization that the current language has many exceptions, Sen. Evan Bayh (D-Ind.) and Rep. John Conyers (D-Mich.) introduced additional legislation on April 6 to further amend the Code. These bills (S. 2556 and H.R. 5113, respectively, titled the Fairness and Accountability in Reorganization Act of 2006) would close those perceived loopholes with a vengeance. The bill proposes, in §3, to amend §1129(a)(5) to add an additional requirement that the court rule that the disclosed post-confirmation compensation proposed for any insider be "reasonable." In §4, the bill amends the current §503(c)(1) dealing with retention bonuses to make any payment of a "performance, incentive or other bonus, or any other compensation enhancement" also subject to its limitations. In addition, the current §501(c)(3) would be replaced with:

other transfers or obligations, whether or not outside of the ordinary course of business, to or for the benefit of officers, managers or consultants retained by the debtor, before or after the filing of the petition, in the absence of a finding by the court based upon evidence in the record and without deference to the debtor's request for such payments, that such transfers or obligations are essential to the survival of the business or (in the case of a liquidation of some or all of the debtors' assets) essential to the orderly liquidation and maximization of value of the assets of the debtor, in either case, because of the essential nature of the services provided, and then only to the extent that the court finds those transfers or obligations are reasonable under the circumstances of the case (emphasis added).

As law professors are wont to say, "you can run through your study groups" the impact of those far-reaching proposals on the possibility of retaining competent management officials should they ever be enacted into law.

Footnotes

1 The views expressed herein are those of the authors. They should not be taken as expressing the views of attorneys general or any of their staff.

2 Granting oneself increased pension or severance benefits to the detriment of creditors during the pre-bankruptcy period can be attacked as a fraudulent transfer. In re Fruehauf Trailer Corp., 2006 WL 933404 (3rd Cir. 4/12/06). Such payments should not meet a better fate merely because they are paid in bankruptcy.

3 In fact, the statement, while seeming paradoxical, can be true, depending on the composition of the group from which the "average" is derived. All of the children in Lake Woebegon could be above the average of all Minnesota children. That points up the powerful effects from being able to choose one's own peer group.

4 "Gilded Paychecks: Troubling Conflicts; Outside Advice on Boss's Pay May Not Be So Independent," New York Times, April 10, 2006, Section 3, Page 1, Column 4.

5 This of course was in Montgomery Ward's first bankruptcy filing, where its reorganization plan failed within less than two years, sending the company back into bankruptcy to liquidate. One would assume that the court's somewhat sanguine view of spending money with no assurance of success would be more tempered in Montgomery Ward's second case.