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Execs should be held firmly to standard of proof before getting additional compensation

By STEVEN M. WALLACE and AMANDA R. MCQUAID
p05 WallaceWallace    Chapter 11 bankruptcy is frequently the vehicle used for dismantling businesses. Chapter 11 “reorganizations” are most often court-supervised liquidations. Shareholders’ investments are wiped out, vendors receive pennies on the dollar, if that, and employees lose jobs. Nonetheless, some bankrupt entities believe it is appropriate to pay “incentive” bonuses to senior management. When shareholders, vendors and employees are being shellacked and there is no demonstrable benefit to be received from the continued services of management, businesses in Chapter 11 should not be permitted to heap additional compensation on officers and directors who presided over the company’s demise.
    Historically, bankruptcy courts routinely approved so-called retention bonuses (key employee retention programs or “KERPs”) to officers and directors of bankrupt companies without much evidence that their services were essential to the success of the business. Congress perceived the routine approval of those bonuses as abusive, and, in 2005, p05 McQuaidMcQuaidamended the Bankruptcy Code to require evidence in support of what are now referred to as “incentive” payments (key employee incentive programs or “KEIPs”). Specifically, in order for a KEIP to be approved, there must be proof that (a) the individual to receive the compensation has a bona fide offer for other employment, (b) the services the individual provides are essential to the business’ survival, and (c) either (i) the amount is no more than 10 times similar payments given to non-management employees or (ii) no more than 25 percent the amount that individual received in the previous calendar year.
    Congress also prohibited payments outside the ordinary course of business unless they were justified by the “facts and circumstances of the case.” Clearly, Congress intended to put a halt to the practice of handing out bonuses to officers and directors merely to retain them and in the absence of evidence that their services were essential. To pass muster a proposed KEIP must revolve around incentivizing the affected officers and directors. The basis for the program must be “pay for value” as opposed to “pay to stay.”
    Which brings us to the case of Sports Authority, which filed a Chapter 11 bankruptcy case on March 2. Initially, Sports Authority tried to sell its business. It eventually decided to close all its stores and sell its retail inventory. The dismantling was virtually complete by July 31. In mid-July, Sports Authority filed its first KEIP motion, to which the United States Trustee (an arm of the Justice Department which oversees Chapter 11 bankruptcies) and the committee of unsecured creditors objected. They contended that the proposed KEIP ran afoul of the Bankruptcy Code, in part, because there was no discernible benefit from the continued services of the beneficiaries of the KEIP and because it appeared that that proposed KEIP was nothing more than a disguised retention plan. The Bankruptcy Court agreed with the U.S. Trustee and the committee, and refused approval.
    Undaunted, Sports Authority returned to court with a new proposal, predicated on “performance” metrics that included (1) a value based on the sharing of proceeds from inventory liquidation, and (2) a value based on any excess savings made to projected controllable costs, for a total maximum aggregate sum of $1,425,000 divided among three people. The debtors asserted that the modified KEIP satisfied the “facts and circumstances” standard and should be approved because it was a sound exercise of business judgment. Once again, the United States Trustee objected, claiming that the supposed metrics were illusory: (a) the liquidation was complete, and there was no evidence what the KEIP beneficiaries had to do with it and (b) there was no evidence of any influence on the controllable costs. In short, the performance metrics on which the KEIP was based were either “baked in” or had nothing to do with the tasks to be performed by the KEIP beneficiaries. Nonetheless, the Bankruptcy Court approved the modified KEIP, and the order the court entered is silent as to the rationale.
    The Sports Authority KEIP appears to be nothing more than a disguised retention program for management personnel who oversaw the demise of the entity. The record does not reveal a basis in evidence to conclude that the executives who benefitted were providing any essential or unique services or that the metrics were anything but illusory. In the context of a complete liquidation, especially a case in which the bulk of the assets have already been sold or where the liquidation process is purely market driven, there is little, if any, justification for a KEIP. A request for implementation of KEIP in such a situation should be accompanied by substantial evidence that the officers and directors who will benefit are uniquely suited to the task of completing the liquidation and that their services will enhance the return to all creditors.  
    Certainly, there are situations in which KEIPs are appropriate. For example, if a business is engaged in genuine efforts to reorganize, management’s vigorous participation is essential to restructuring, and the officers and directors are uniquely qualified to lead the company’s efforts, incentive payments tied to performance may be entirely appropriate. Likewise, if a business is attempting to liquidate as a going concern and management can play an active role in mustering the highest and best price and potentially confer a benefit on multiple constituencies, i.e., shareholders, vendors, creditors, and employees, officers and directors should receive incentives based on the ultimate sale price. However, in cases such as Sports Authority (and there are many like it), KEIPs should receive the strictest of scrutiny, and parties proposing “incentive” pay should be held firmly to the standard of proof prescribed in the Bankruptcy Code.
    Steve Wallace is a partner with HeplerBroom, LLC, in Edwardsville. Amanda McQuaid is an associate with the firm.