Sidestepping Proposed Bankruptcy Legislation: Examining the Power of Corporations to Set Executive Compensation through KERPs, KEIPs, & Other Compensation Tactics

Posted on by Dillon Jones

In the wake of COVID-19 and its impact on the American economy, compensation for executives of bankrupt corporations has been heavily scrutinized by laid off employees and the public.1 While executive compensation was already a hot topic of focus for the public and investors in the past decade, recent bankruptcy activity due to COVID-19 has shed even greater light on executive compensation2

Before considering new legislative proposals, one must examine the current legislation, its goals, and its effectiveness. The most recent amendments to executive compensation in bankruptcy regulation came through the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCA”)3. Specifically, BAPCA amended § 503(c) of the Bankruptcy Code “[t]o expand the authority of bankruptcy courts to limit retention bonuses and severance pay to corporate insiders.”4

Section 503(c)(1) restricts retention payments through three key features when the payment is made “for the purpose of inducing such a person to remain with the debtor’s business.”5 First, an executive must have a job offer from another company with the same or greater compensation before the debtor can pay that executive a bonus.6 Second, the debtor must prove that the services provided by the person are “essential to the survival of the business.”7 Third, the retention bonus cannot be “greater than an amount equal to 10 times the amount of the mean transfer or obligation of a similar kind given to nonmanagement employees” or, if no such similar transfers are made, an amount which does exceed “25 percent” of “any similar transfer or obligation” made “for any purpose” during the preceding calendar year.8

However, it is important to note that bankrupt corporations do not face the § 503(c)(1) hurdles every time they pay executives. Rather, they only are required to obey § 503(c)(1) when the compensation is paid “for the purpose of inducing such person to remain with the debtor’s business.”9 Therefore, if the payment plan is interpreted to not be a retention payment (i.e., the payment is an incentive payment), § 363 of the Bankruptcy Code, which offers the business judgment rule to such payments, applies.10

Thus, corporations have sidestepped § 503(c) mainly through two ways. First, they have changed key employee retention plans (“KERPs”) to key employee incentive plans (“KEIPs”).11. Second, they have offered executives retention payments prior to and after recovering from bankruptcy to evade court approval.12

Due to corporations side-stepping executive compensation decisions and the widespread light on the issue in the wake of the COVID-19 bankruptcies, there has been a renewed call to implement further legislative measures to hinder executive compensation decisions by corporations. Professor Jared Ellias offers multiple proposals to accomplish more controls on executive pay. First, he states that legislation should “move away from distinguishing ‘incentive’ and ‘retention’ bonuses and force Chapter 11 firms to justify all executive compensation with data on historic practice and prevailing market conditions.”13 Second, he maintains that “Congress (or bankruptcy judges) should consider creating new post-bankruptcy reporting requirements to force post-bankruptcy Chapter 11 debtors to report their overall level of senior management compensation for a period of two years after bankruptcy.” 14 This Congressional action of requiring additional disclosure “would curtail the ability of managers to extract promises from creditors in bankruptcy that lead to excess compensation once the firm leaves bankruptcy court.”15

In addition to the proposals of Professor Ellias, members of Congress have made proposals to amend executive compensation. In 2019, Senator Elizabeth Warren’s Stop Wall Street Looting Act16 sought to include performance-based pay, incentive compensation, and any other type of bonus in § 503(c)(1)(C)’s retention bonus restriction.17 In 2020, a proposal like the Stop Wall Street Looting Act was made in the House of Representatives. The Protecting Employees and Retirees in Business Bankruptcies Act of 2020 (the “PERBB”) requires that compensation for “insiders” employed by the company upon emergence from bankruptcy be capped to no more than the amount “corresponding to the 50th percentile of the compensation” of similarly situated personnel at comparable companies.18  Also, the compensation cannot be “excessive or disproportionate in light of economic losses of the nonmanagement workforce of the debtor.”19 However, the PERBB does not address how long the executive compensation restrictions need to stay in place.20

Even if the previously mentioned proposals were to be implemented, they would likely diminish firms’ power over executive compensation very little. First, if legislation were to force firms to justify their compensation based on historic practice and prevailing market conditions, firms and industries who have historically paid their executives well, especially if they paid them well during other periods of economic downturn, could likely easily justify a generous executive compensation package. Particularly if the prevailing market conditions cause executives from a specific industry to consider leaving the industry (i.e., Hertz and the rest of the rental car industry during COVID-19), the prevailing market conditions could potentially justify an even higher compensation than prior to the enactment of the proposed legislation. For example, firms could point to executives who have either already left or are threatening to leave because the long-term prospects of the firm or the industry are grim compared to employment they could obtain elsewhere.

Although Professor Ellias’ second proposal of requiring additional disclosure for a period of two years for firms emerging from bankruptcy may sound like a good idea to limit executive compensation in theory, additional disclosure for executive compensation has backfired in practice. In 1993, the SEC required detailed public disclosures about compensation of their top five corporate officers to increase transparency and dampen CEO compensation.21 However, the mandated disclosures actually increased CEO compensation as Professors William Allen and Reinier Kraakman explain: 

Typically, compensation committees would want to pay their CEO at roughly the 75th percentile among comparable companies, reflecting the fact that their CEO is (of course) above average. But if all boards are aiming to pay their CEO at the 75th percentile, then we get a general ratcheting up of CEO pay levels along the lines of what is documented in the chart above. The 1993 disclosure requirement fueled this trend by creating greater visibility on the pay of (arguably) comparable CEOs.22

If pay for executives in corporations emerging from bankruptcy were to be disclosed, the accessible information would likely spur higher payments. With the justification that firms who are emerging from bankruptcy need to keep or hire the top executives in the industry to develop long-term profitability, those firms will aim to pay executives above the industry median. Thus, if this idea were to be enacted and post-bankruptcy data from nonpublic industry competitors were to be accessible, the “general ratcheting up” would likely occur in this setting just like it did after the 1993 SEC reform.

Furthermore, both legislative pieces, the Stop Wall Street Looting Act and the PERBB, fail to address glaring holes in the current legislation which firms utilize to sidestep legislation. Payments before and after the bankruptcy period can still be offered. For example, to avoid bonus restrictions on both incentive and severance payments, firms can increase salaries of executives in the years prior to bankruptcy instead of offering bonus payments. They can do so because courts give strong deference to firms to set executive salaries.23 Also, if the PERBB were to be enacted, the legislative proposal still fails to directly address payments on the eve of bankruptcy.24 Therefore, pre-bankruptcy KERPs can continue to be the norm.

The bill’s restrictions on post-bankruptcy executive pay will likely be ineffective, too. The PERBB’s text does not make clear how long courts or judges will monitor the 50th percentile threshold. If the post-bankruptcy compensation restrictions last, for example, one year, firms could just wait to give bigger bonuses or bigger severance payments (e.g., American Airlines’ severance payment to Tom Horton) in year two.25 Besides, it may be difficult to identify pay for comparable positions at comparable companies if comparable companies are private companies who refuse to release their compensation data. Lastly, when one considers the requirement that compensation cannot be “excessive or disproportionate in light of economic losses of the nonmanagement workforce of the debtor,” the proposal not only offers little insight as to what that vague standard means, but it also “will have little practical effect in industries where the market for executive compensation is already generous.”26

Even though Congress enacted § 503(c) to reduce corporate fraud and fix the disparity in bankruptcy between executive gains and employee losses, it has failed to do either. Because the proposed legislation from Professor Ellias and Congress is subject to many of the same faults and walkaround tactics, it will likely be ineffective, too. Whether or not one thinks that pay disparity is a problem, § 503(c) and its proposed amendments are clearly not a solution to the alleged problem; corporations have, and will continue to have, the power to set executive compensation in the face of this legislation.

  1. See Michael Sainato, US Corporations File for Bankruptcy and Lay Off Workers. Why Do Execs Still Get Bonuses?, The Guardian (Sept. 16, 2020 5:00 PM), https://www.theguardian.com/business/2020/sep/16/us-corporations-file-for-bankruptcy-and-lay-off-workers-why-do-execs-still-get-bonuses. ↩

  2. See Mike Spector & Jessica DiNapoli, On Eve of Bankruptcy, U.S. Firms Shower Execs with Bonuses, Reuters (July 17, 2020 7:05 AM), https://www.reuters.com/article/us-health-coronavirus-bankruptcy-bonuses/on-eve-of-bankruptcy-u-s-firms-shower-execs-with-bonuses-idUSKCN24I1EE. ↩

  3. Amend. No. 5202 to S. 256, 109th Cong. (2005) (enacted ↩

  4. Id. ↩

  5. 11 U.S.C. § 503(c)(1). ↩

  6. Id. § 503(c)(1)(A). ↩

  7. Id. § 503(c)(1)(B). ↩

  8. Id. § 503(c)(1)(C). ↩

  9. Id. §503(c)(1). ↩

  10. See Dorothy Hubbard Cornwell, To Catch a KERP: Devising a More Effective Regulation than 503(c), 25 Emory Bankr. Dev. J. 485, 506 (2009). ↩

  11. Id. at 506-14 ↩

  12. See Spector & DiNapoli, supra note 2. ↩

  13. Jared Ellias, Bankruptcy Pay Evasion, The Hill (May 26, 2020 4:00 PM), https://thehill.com/opinion/finance/499449-bankruptcy-pay-evasion-during-financial-crisis?amp. ↩

  14. Jared A. Ellias, Regulating Bankruptcy Bonuses, 92 S. Cal. L. Rev. 653, 697 (2019). ↩

  15. Id. ↩

  16. S. 2155, 116th Cong. (2019). ↩

  17. Id. at § 304(2)(B). ↩

  18. H.R. 7370, 116th Cong. § 301(2)(C)(ii) (2020). ↩

  19. Id. at § 301(2)(C)(iii). ↩

  20. Shmuel Vasser & Eric Hilmo, The Protecting Employees and Retirees in Business Bankruptcies Act of 2020: A Sign of the Times, Dechert LLP (Oct. 5, 2020), https://www.dechert.com/knowledge/onpoint/2020/10/the-protecting-employees-and-retirees-in-business-bankruptcies-a.html. ↩

  21. William T. Allen & Reinier Kraakman, Commentaries and Cases on the Law of Business Organization (5th ed. 2016), reprinted in Corporate Law & Ethics 746-747 (Vikramaditya Khanna & Adam Pritchard ed., 2019). ↩

  22. Id. ↩

  23. See, e.g., Brehm v. Eisner, 746 A.2d 244, 263 (Del. 2000) (“It is the essence of business judgment for a board to determine if a particular individual warrant[s] large amounts of money.”) (internal quotation marks omitted). ↩

  24. Vasser & Hilmo, supra note 20. ↩

  25. See Susan Carey, How Tom Horton Shaped American Airlines, Wall St. J. (May 30, 2014 5:04 PM), https://www.wsj.com/articles/how-tom-horton-shaped-american-airlines-1401483124. ↩

  26. H.R. 7370, 116th Cong. § 301(2)(C)(iii) (2020); Vasser & Hilmo, supra note 20. ↩

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