Approving Insider Compensation Under Section 503(c)(3) Court Discretion or Business Judgment Standard

By: Cameron Fee
St. John’s Law Student
American Bankruptcy Institute Law Review Staff
Recently, the United States Bankruptcy Court for the Northern District of Texas, in In re Pilgrim’s Pride Corp., held that certain consulting agreements negotiated by chapter 11 debtors with former executives were not the type of insider compensation agreements proscribed by section 503(c).[1] After filing for chapter 11, Pilgrim’s Pride Corporation entered into resignation agreements with its CEO Rivers and COO Wright. The debtors filed a motion pursuant to section 503(c) for “court authority to purchase time-limited noncompetition agreements,” to prevent Rivers and Wright from soliciting the company’s customers.[2] The trustee argued that the proposed consulting agreements violated section 503(c)(1) because the payments were meant to induce Wright and Rivers to remain with the business. The court, however, found that the agreements were meant to induce Rivers and Wright not to work for a competitor for a limited time and therefore the consulting agreements did not implicate either section 503(c)(1)[3] or 503(c)(2).[4] The court also found—after determining an independent assessment of the circumstances was the appropriate standard of review—that the agreements did not violate section 503(c)(3) because they were justified given the facts and circumstances of the case.[5] 
Section 503(c)(3) is narrow and has limited applicability.[6]  Section 503(c)(3) bars an otherwise valid transfer or obligation when two conditions are met: (1) the transaction is outside the ordinary course of business; and (2) the transaction is not justified by the facts and circumstances of the case.[7] The court applied these conditions, and emphasized that section 503(c)(3) conditions transfers and obligations on “the facts and circumstances of the case.”[8] The issue before the court was what standard of review should be used for a motion under section 503(c)(3). 
The court rejected the debtors’ argument that the second condition of 503(c)(3) should be evaluated using the business judgment standard.[9] The business judgment standard gives deference to the debtor or trustee: If a valid business reason is proffered for a transaction, it will be presumed appropriate.[10] The court in In re Pilgrim’s Pride was concerned that such deference might permit conflicts of interest among insiders and the estate.[11] Executives may be responsible for devising and approving a transaction. Indeed, these executives may focus on self-serving interests rather than interest of the estate. The court recognized that such conflicts of interest weaken the reasoning “underlying application of the business judgment rule (that officers and directors will fulfill their fiduciary responsibilities).”[12] The court also noted that Congress intended the courts “to play a more critical role in assessing transactions” given the plain language of 503(c)(3).[13] Only subsection (3) of 503(c) uses the language “justified by the facts and circumstances of the case.” The court concluded that Congress’s specific adoption of this language requires courts to independently determine whether the motion best serves all interested parties.[14] 
The In re Pilgrim’s Pride decision illustrates the split for the standard of review under a section 503(c)(3) motion. Some bankruptcy courts use the business judgment rule as the standard for granting relief.[15] In contrast, the court in In re Pilgrim’s Pride used an independent evaluation, which seemingly ameliorates many of the potential problems of relying on a corporation’s own business decisions. Although the standard of review may still be an issue in forthcoming decisions, the appropriate standard resonates in Congress’s purpose for promulgating section 503(c)(3): “to limit a debtor’s ability to favor powerful insiders economically.”[16]

[1] In re Pilgrim’s Pride Corp., 401 B.R. 229, 237 (Bankr. N.D. Tex. 2009); see 11 U.S.C. § 503(c)(3) (2006).
[2] In re Pilgrim’s Pride Corp., 401 B.R. at 233.
[3] 11 U.S.C. § 503(c)(1) (“[T]here shall neither be allowed, nor paid—a transfer made to or an obligation incurred . . . for the purpose of inducing such a person to remain with the debtor’s business . . . .” (emphasis added)).
[4] 11 U.S.C. § 503(c)(2) (barring severance payments to insiders with two limited exceptions).
[5] In re Pilgrim’s Pride Corp., 401 B.R. at 237.
[6] See 4 Collier on Bankruptcy, ¶ 503, at 503.17[3] (Alan N. Resnick et al. eds., 15th ed. rev. 2006) (discussing limited application of section 503(c)(3)).
[7] 11 U.S.C. § 503(c)(3) (“[T]here shall neither be allowed, nor paid—other transfers or obligations that are outside the ordinary course of business and not justified by the facts and circumstances of the case . . . .” (emphasis added)).
[8] In re Pilgrim’s Pride Corp., 401 B.R. at 236 (quoting 11 U.S.C. § 503(c)(3)).
[9] Id. (citing In re Dana Corp., 351 B.R. 96, 102–03 (Bankr. S.D.N.Y. 2006)).
[10] In re Pilgrim’s Pride Corp., 401 B.R. at 233.
[11] 237.
[12] 237.
[13] See id. at 237.
[14] See id. at 237–38 (noting cost of agreements is minimal compared to lost revenues from diverting one major customer).
[15] See, e.g., In re Global Home Products, LLC, 369 B.R. 778, 783–84 (Bankr. D. Del. 2007) (“Compensation issues are normally governed by the business judgment standards, i.e., proof that there is a broad business purpose for an action.”); In re Nobex, No. 05-20050(MFW), 2006 WL 4063024, at *2 (Bankr. D. Del. Jan. 19, 2006) (finding debtors had sound business purpose and did not violate section 503(c)(3)).
[16] In re Pilgrim’s Pride Corp., 401 B.R. at 237.