POINT: Should courts look favorably at bonuses in Chapter 11 bankruptcies?
Yes, Congress has implemented measures to protect creditors, incentivize the executive team
By ROBERT E. EGGMANN and BECKY R. EGGMANN
Chapter 11 business filings are on the increase. According to data compiled by the Administrative Office of the United States Courts, 5,594 Chapter 11 business bankruptcies were filed in the 12-month period ending June 30, 2015, while 6,782 business Chapter 11 cases were filed for the same period ending June 30, 2016.
The latest headlines reveal payouts oftentimes in the millions of dollars in executive bonuses for companies such as Peabody Coal, Alpha Natural Resources, PacSun and Radio Shack.
Why should these executives receive anything at all from a business clearly strapped for cash? Because through recent changes to the bankruptcy law, Congress has ensured that certain measures are in place to protect creditors while incentivizing the executive team to work toward the company’s successful emergence from bankruptcy.
In 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act, which amended the Bankruptcy Code by adding, among other provisions, Section 503(c)(3). This statutory provision limits the circumstances in which transfers, such as bonuses, may be made to executives while a bankruptcy case is pending. While payments made solely to retain an individual are restricted, bonuses which serve primarily to incentivize the key employee to achieve certain goals during the pendency of the bankruptcy case are permitted. A committed management team, guiding the company through the bankruptcy process, is often the ultimate catalyst to an effective reorganization.
Debtor companies must show that bonuses are part of a “pay for value” plan that offers incentives for performance, rather than a “pay to stay” approach that merely rewards showing up for work. A management incentive plan is generally acceptable if it is justified by the facts and circumstances of the case, with consideration given to the following factors: (1) is the plan calculated to achieve the desired performance? (2) is the cost of the plan reasonable, given the debtor company’s assets, liabilities and earnings potential? (3) is the scope of the plan is fair and not discriminatory against certain employees? (4) is the plan is consistent with industry standards? (5) what were the due diligence efforts used by the company in investigating the need for the plan, analyzing which key employees are needed and what funds are available for them? and (6) did the company use independent counsel to perform the due diligence and also create and authorize the incentive compensation structure?
In 2013, the U.S. Bankruptcy Court sitting in St. Louis carefully examined all of these factors in ruling on an executive cash bonus proposal in the Patriot Coal case. In the nine months preceding the court’s decision, over 30 key executives left Patriot for other employment. The incentive plan proposed by Patriot Coal offered bonuses beyond base salary provided that five performance metrics were reached, including financial, environmental, safety and individual goals. Chief Judge Kathy Surratt-States determined that all of the necessary guidelines had been met and ruled in favor of the $6.9 million plan, finding it to be primarily incentive. That figure constituted only 0.36 percent of Patriot’s total annual revenues at the time.
“Given (Patriot’s) volatile situation, and the undisputed fact that the price of coal has decreased, the court cannot conclude that the (executives) merely have to show up to work to achieve the targets,” she wrote.
Similar bonus award structures have been approved by bankruptcy courts across the country. The court in the Alpha Natural Resources, Inc. case accepted the company’s proposed key employee incentive plan, agreeing that it encouraged company executives to “minimize their cash bleed while simultaneously cutting expenses and maintaining their safety and environmental standards.” Because the proposal was primarily contingent on the performance of the business (as opposed to mere retention of the management group), it met the standards promulgated by the bankruptcy act.
Requests for executive bonuses do not receive rubber-stamp approval by the bankruptcy courts. Sports Authority made received national attention this past August when the bankruptcy court in Delaware denied its motion for approval of an executive incentive program. The U.S. Trustee, an industry watchdog, argued against the bonus plan, labeling it “clearly retentive” with vague or meaningless performance targets.
Guiding a corporation through a Chapter 11 bankruptcy case is lengthy and oftentimes arduous. Bonus programs such as that adopted in the Patriot Coal case are essential to the bankruptcy process, in order to ensure that incentivized key employees are working toward the maximum return for the company’s creditors. The ultimate goal of any bankruptcy case is the debtor’s successful emergence for a fresh start. Executive merit awards that are not unreasonable in light of the company’s assets and liabilities and which recognize the need for consistency in key management resources provide the best opportunity to achieve that end.
Attorneys Robert E. Eggmann and Becky R. Eggmann are with the law firm Desai Eggmann Mason LLC with offices in Clayton and Edwardsville.