If you think a bankrupt company that has spent the past year laying off 3,000 employees, cutting severance packages, and freezing salaries would adopt frugal executive compensation packages, think again.
On January 27, 2010, chief judge of the Delaware Bankruptcy Court, Kevin J. Carey, approved a $45.6 million incentive program for "top executives and managers of the Tribune Company," a household media conglomerate that filed for Chapter 11 in December 2008. Explaining his ruling, Judge Carey stated that "there is a reasonable relationship between the plan and its objective to restore profitability," and that the plan provides "incentives [to Tribune's executives] designed to improve the company's chances to survive."
Bonus proponents emphasized that the plan was needed to motivate top executives at Tribune not only to stay with the firm, but also to perform well. As Tribune's chief operating officer Randy Michaels stated, "incentivizing employees is essential to Tribune's future success. We must continue motivating our people to overcome obstacles, achieve our performance goals and take the company to the next level." Opponents, however, find the bonuses excessive and a drain on the company's cash flow. Bill Salganik, president of The Newspaper Guild--a media union that filed an initial objection to Tribune's bonus request--stated, "if Tribune has [$45.6] million available to spend, we think it would be better spent on providing more and better news and service for readers and viewers and advertisers."
In light of recent debates in Washington and on Wall Street over appropriate levels of compensation for top corporate executives, Tribune's incentive program raises this question: How does the Bankruptcy Code allow a company to dole out millions in bonuses while simultaneously laying off thousands of employees. The answer, in short, is that the Code is not meant to.
Originally, the Bankruptcy Code required court approval for bonus plans that were considered outside the ordinary course of a company's business. Under Lionel, a debtor had to show some business justification for requesting that bonuses be paid to the company's top executives. This weak test, however, allowed companies, post-Lionel, to distribute large bonuses to executives, justifying the payouts--known as Key Employee Retention Plans (KERPs)-- as necessary to retain their executives during the companies' Chapter 11 reorganizations.
The KERPs, however, often rewarded the very managers who drove the debtor into bankruptcy. As one bankruptcy judge stated, "All too often, [executive retention plans] have been widely used to lavishly reward . . . the very executives whose bad decisions or lack of foresight were responsible for the debtor's financial plight."
To prevent such perverse situations, the late Senator Edward Kennedy pushed for inclusion of a new Code provision, § 503(c), in the 2005 Bankruptcy Act. Under § 503(c)(1)--known as the KERPs provision--a company is prohibited from paying retention bonuses to its executives unless (1) the bonus is "essential" to the retention of the individual because he has a bona fide job offer from another company paying the same or a higher rate of compensation, and (2) the individual is "essential" to the survival of the debtor's business. If a bonus plan is not deemed to be retention-based, however, the court will then apply § 503(c)(3), which is the functional equivalent of Lionel's toothless business judgment test.
At first blush, § 503(c)(1)'s language appears to severely limit a company's ability to pay out retention bonuses to its executives. The problem, however, is that companies can easily circumvent the restrictive § 503(c)(1) test, and thus come under the less stringent § 503(c)(3) test. As companies have discovered, courts will approve bonus plans under § 503(c)(3) that are de facto retention payments, so long as the plans, as a whole, are not clear "pay to stay" compensation. In Dana Corporation, for example, the defendant Dana's bankruptcy bonus plan was originally rejected under § 503(c)(1) because its provisions were deemed too retention-based. The court, however, eventually approved Dana's modified plan--now under § 503(c)(3)--which "arguably contained some similar provisions to the previous [bonus plan]" by applying a "holistic approach," rather than focusing on specific retention-based provisions in the bonus plan. As former Congressman Chris Cannon stated before the Committee on the Judiciary, "[The Dana decision] shows [how] experienced bankruptcy courts . . . are straining to interpret the [C]ode in a way that would help keep Chapter 11 companies from becoming Chapter 7 economic shipwrecks."
Reaching a similar conclusion to that of Dana, Judge Carey found that "[Tribune] need only show that the proposed plan is an exercise of their business judgment." If such bonus payments, however, are, as Judge Carey phrased it, "incentives designed to improve the company's chances to survive," the question, then, is really: What are they incentivizing?
Tribune's lawyers argued that the bonuses are needed to keep executives motivated during rough economic times. Almost sarcastically, The Newspaper Guild responded, "We think more highly of our bosses. While we sometimes disagree with them, we think they're dedicated professionals who would do their best with or without bonuses--just as thousands of non-executive employees are working hard for Tribune every day with no bonuses." It seems, though, that a plan that incentivizes retention--a proposition implied in the Guild's statement--cannot in good conscience be considered an incentive to work harder.
Whether retention bonuses are needed to give Chapter 11 companies the best chances of emerging from bankruptcy--as many in Washington and on Wall Street believe--is an interesting debate best left for another day. But have no illusions: The current "holistic" approach to § 503(c) is failing to fully fulfill Congress's original intent to prohibit KERPs and other forms of retention-based bonuses.
Originally posted at the Columbia Business Law Review