Vol 4 (2007) - Issue 3

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Executive Compensation and the Recent US Bankruptcy Code Amendments: Fundamental Change or an Invitation to Negotiate?

On 20 April 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (‘BAPCPA’). BAPCPA made substantial amendments to the Bankruptcy Code and Rules, creating significant changes for business and consumer bankruptcy cases. One of the most high-profile corporate issues addressed in BAPCPA is how executive compensation is treated in a chapter 11 case.

Compensation for CEOs in the United States has soared over the past decade, far exceeding inflation and wage gains of ordinary workers. The increasing pay for executives has garnered much attention and led to debates in Congress, front-page headlines, cover stories and stories on television news shows. In addition, federal and state prosecutors have looked into the propriety of executive pay outside of bankruptcy. Notably, the newly appointed Attorney General of the State of New York, Andrew Cuomo, appointed chief trial counsel to handle the case against former New York Stock Exchange chief executive Richard A. Grasso to give back over USD 100 million in compensation.

In an effort to address perceived abuses associated with executive compensation, effective in October 2005, Congress formulated section 503(c) of the Bankruptcy Code to curb bonuses paid to executives in a chapter 11 case. In light of this change to the Bankruptcy Code and recent court rulings, this article will focus on how to craft an executive compensation plan that will withstand scrutiny from the court and not violate the new section 503(c).

Bankruptcy court authorisation for KERPs pre-BAPCPA

Companies frequently provide compensation to certain employees as an incentive for the employee to remain with the company during uncertain times, such as a period of downsizing, merger, reorganisation or similar activity. Such payments are designed to compensate the employees for risks associated with remaining with the company for a specified period.

In bankruptcy, management incentives contained in programs known as key employee retention programs or ‘KERPs’ became an integral part of almost all large chapter 11 cases over the past decade. KERPs typically provided for the payment of bonuses to certain ‘key employees’ for remaining with the debtor company during the course of its chapter 11 case. The key employees were typically the company’s senior management, including the chief executive officer, chief financial officer and chief operating officer. A KERP generally included one or more of the following types of payments: (1) retention payments to eligible employees who remain employed by the debtor through a certain date or event; (2) success payments made to eligible employees upon the occurrence of a specified event; (3) severance payments to eligible employees who are involuntarily terminated; and (4) bonuses payable to eligible employees in the event that their employment is terminated after a change in control of the company.

A debtor company will typically seek approval from the bankruptcy court to implement a KERP shortly after the bankruptcy petition is filed. Prior to BAPCPA, a debtor usually sought approval of a proposed KERP under section 363(b)(1) of the Bankruptcy Code, requiring bankruptcy court approval for use of property of the bankruptcy estate ‘other than in the ordinary course of business’. Bankruptcy courts established a two-part test for determining whether to approve a KERP: (1) that there was a sound business purpose for approval of the KERP; and (2) that the KERP was ‘fair and reasonable’.