Fighting a Management Bonus Plan

By Peter D. DeChiara

pdechiara@cwsny.com

Posted July 2016

After a financially distressed company files for Chapter 11 bankruptcy protection, it typically asks the bankruptcy court to allow it to pay big bonuses to the company’s top executives.  To those unfamiliar with the world of bankruptcy, this may seem odd.  Why reward those executives under whose watch the company went bankrupt?  To the company’s rank-and-file employees, who may face wage and benefit cuts during the Chapter 11, such bonus plans — typically called “key employee incentive plans” or KEIP’s — often seem grossly unfair.  This post offers some tips on how a union might oppose a company’s motion for approval of a KEIP.  (The union may not be alone in this opposition.  The U.S. Trustee’s office, or the Committee of Unsecured Creditors, two important players in a Chapter 11 case, sometimes also raise objections to a proposed KEIP).

The starting point for a challenge to a KEIP is Section 503(c)(1) of the Bankruptcy Code, 11 U.S.C. §503(c)(1).  That 2005 addition to the Code makes it all but unlawful for a bankrupt debtor to pay a bonus to an “insider” of the debtor “for the purpose of inducing such person to remain with the debtor’s business.”  (Section 503(c)(1) does permit retention bonuses for insiders in certain very narrowly defined circumstances, but those exceptions are exceedingly hard to meet and debtors almost never try).  The debtor moving for approval of a KEIP will argue that Section 503(c)(1) creates no bar because the executives to receive the bonuses aren’t insiders, or, if they are, the proposed bonus plan does not aim to induce them to remain at their jobs, but seeks to incentivize them to achieve certain performance goals (hence, the self-serving label “key employee incentive plan”).

In attacking a proposed KEIP, a union might first consider challenging the company’s claim that those eligible to receive the bonuses are too low in the corporate hierarchy to be considered insiders.  The Bankruptcy Code’s definition of a corporate “insider,” which includes an officer, director or “person in control,” see 11 U.S.C. §101(31)(B), is non-exhaustive, and job titles are not determinative.  One helpful case defines a corporate insider simply as someone “taking part in the management of the debtor.”  In re Foothills Texas, Inc., 408 B.R. 573, 579 (Bankr. D. Del. 2009).  A union opposing a KEIP might consider seeking information to show that at least some of the plan participants are insiders.

Often, a debtor’s initial motion papers contain just a sketch of the proposed KEIP’s terms, without providing actual plan documents or even a list of all those eligible to receive the bonuses.  Fortunately, the bankruptcy rules allow for pre-hearing discovery.  See Fed. R. Bankr. P. 7026-7037, 9014(c).  While depositions may be costly, a simple document request asking for the companies’ organizational charts, pay scale data and job descriptions (as they existed before the bankruptcy filing) may yield valuable information about where a particular executive fits in the corporate hierarchy.  To make a case that an executive is an insider, the union should seek evidence that he or she reports to top management, enjoys pay toward the top of the corporate pay scale, and either has discretion to set at least some company policy or to authorize the expenditure of non-trivial sums from the corporate treasury.  See, e.g., In re Global Aviation Holdings, Inc., 478 B.R. 142, 148-49 (Bankr. E.D.N.Y. 2012) (finding employees not to be insiders but providing a discussion of the factors relevant to the analysis).  Remember that the debtor, as proponent of the plan, bears the burden of proving compliance with Section 503(c).  If the union can present some evidence suggesting an executive may be an insider, the company then has the burden of coming forward with sufficient evidence to the contrary.

(In addition to proposing KEIP’s, bankruptcy debtors also often propose separate bonus plans for lower-level managers, called “key employee retention plans” or KERP’s.  Because a KERP is admittedly a tool to keep management officials on the job during the Chapter 11, the debtor must, to comply with Section 503(c)(1), prove that all those covered by it are not insiders).

A union opposing a KEIP motion should also consider challenging the company’s claim that the plan seeks to incentivize extraordinary performance.  Cases hold that a KEIP only passes muster as a true incentive plan if it awards bonuses to executives for performance targets that are difficult to achieve.  See GT Advanced Technologies, Inc. v. Harrington, 2015 WL 4459502, at *5 (D.N.H. 2015) (discussed on this blog in September 2015).

Successfully challenging a KEIP thus often requires scrutinizing the performance metrics that would trigger bonuses, looking for evidence that an executive may stand to reap an award without extraordinary effort.  For example, a KEIP that rewards work already done can hardly be described as providing an incentive to extraordinary future performance.  A KEIP proposed, say, in December would be suspect if it provided a bonus based on the company achieving a certain profit in that calendar year; most of the work to achieve that target would already have taken place.  Similarly, a KEIP would be suspect if it provided an executive a bonus upon the company achieving a certain level of sales if that executive’s job — say in IT or finance — has no direct connection to sales and his or her performance would not affect the company’s sales levels.

Another possible sign that a KEIP is really a retentive, not an incentive, plan:  if the plan provides that to get their bonuses, executives — regardless of the quality of their performance — have to stay on the job until a defined moment, such as the closing on the sale of the business or upon confirmation of a plan of reorganization.  See, e.g., In re Hawker Beechcraft, Inc., 479 B.R. 308, 314 (Bankr. S.D.N.Y. 2012).  A KEIP should also not reward company officials for doing what the Bankruptcy Code already requires them to do, such as file a plan of reorganization “as soon as practicable.”  11 U.S.C. §§1106(a)(5), 1107(a).

Even if a proposed KEIP passes muster under Section 503(c)(1), it must also comply with Bankruptcy Code Section 503(c)(3), which prohibits a management bonus plan not “justified by the facts and circumstances of the case.”  11 U.S.C. §503(c)(3).  Debtors almost always argue that 503(c)(3)’s “facts and circumstances” test requires the same deference to company decision-making as the business judgment rule, and thus, in their eyes, constitutes barely a speed bump on the road to approval of the plan.  The better interpretation of Section 503(c)(3), however, holds that it requires independent judicial scrutiny, not deference to a self-interested decision by management to pay itself bonuses.  See, e.g., In re Pilgrim’s Pride, 401 B.R. 229, 236-37 (Bankr. N.D. Tex. 2009).

Even those courts that apply the business judgment rule under Section 503(c)(3) nonetheless ask a host of questions, including whether the proposed KEIP discriminates unfairly; whether its cost is reasonable; whether it is consistent with industry standards; and whether the debtor received independent counsel regarding it.  See In re Dana Corp., 358 B.R. 567, 576-77 (Bankr. S.D.N.Y. 2006).  A union challenging a KEIP should probe whether the company satisfied these factors.

The union may argue, for example, that by limiting bonus recipients to top executives, the KEIP unfairly discriminates against others, not least the company’s rank-and-file workers who face losses in the bankruptcy.  On this point, the language of now-retired bankruptcy judge Stephen Mitchell in In re U.S. Airways, Inc., 329 B.R. 793 (Bankr. E.D. Va. 2005), is worth quoting.  After noting that management bonus plans in bankruptcy “have something of a shady reputation,” Judge Mitchell goes on to point out that “[a]ll too often they have been used to lavishly reward—at the expense of the creditor body—the very executives whose bad decisions or lack of foresight were responsible for the debtor’s financial plight. But even where external circumstances rather than the executives are to blame, there is something inherently unseemly in the effort to insulate the executives from the financial risks all other stakeholders face in the bankruptcy process.”  Id. at 797.

While unfairness goes to the heart of the matter, a union challenging a KEIP may also seek to cast doubt on its validity in other ways.  For example, the proposed KEIP may aim to give bonuses similar in size to those given to management pre-bankruptcy, but companies often file bankruptcy when their industry is in financial distress.  Does the size of the proposed bonuses ignore the now depressed state of the industry?  An outside financial firm may claim to have counseled the company regarding the proposed KEIP, but did it in fact just bless what management had already decided to pay itself?  And is the outside firm really independent, or is it one long retained by the company for other matters?

Challenging a KEIP isn’t easy.  Many ultimately receive bankruptcy court approval, particularly if crafted with the help of sophisticated counsel and if the debtor, in response to objections, displays a willingness to engage in a bit of plan trimming and tucking to reduce potential legal risks.  Yet challenging a KEIP may be a battle worth fighting.  These bonus plans for top management almost invariably exacerbate existing inequities within the firm, and almost inevitably demoralize the rank-and-file workforce on whose labor the debtor critically depends for a successful reorganization.