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A Fresh Obstacle to Retaining Key Employees

A bid to prevent insiders from profiting by a company's breakup leaves some room to maneuver

March 1, 2006, Laurie L. Silverstein

Reprinted with permission from the March 06, 2006 edition of
The National Law Journal (c) 2006 ALM Properties, Inc.
All rights reserved.
Further duplication without permission is prohibited.


Since the early 1990s, key employment-retention plans (KERPs) have been commonplace in Chapter 11 bankruptcy cases.  These plans, which often provide hefty compensation to induce managers to remain with the struggling company, historically have been approved under §363 and §105 of the U.S. Bankruptcy Code.  In the absence of a statute directing a specific standard for review of KERPs, courts applied the general §363 standard and looked to whether a sound business purpose justified the plan, and/or whether the debtor properly exercised its business judgment.  See, e.g., In re Montgomery Ward Holding Corp., 242 B.R. 147 (D. Del. 1999).  Various courts have approved KERPs when they were fair and reasonable under the circumstances.  See In re Georgetown Steel Co., 306 B.R. 549, 555-56 (Bankr. D.S.C. 2004) (collecting cases).

It has been suggested that Congress believed that judges had too much discretion in this area.  With the recently passed Bankruptcy Abuse Prevention and Consumer Protection Act, Congress now has attempted to specifically delineate the magnitude of retention and severance payments that may be made to "insiders" -- typically, officers and other senior management employees with significant decision-making authority.  New §503(c) is a limitation on the allowance or payment of a transfer "for the purpose of inducing [an insider] to remain with the debtor's business;" severance payments to insiders; or "other transfers or obligations outside the ordinary course" to, among others, insiders.

The legislative history, such as it is, confirms the broad scope of §503(c). Sen. Edward M. Kennedy, D-Mass., proposed the amendment as a last-minute addition to the bankruptcy bill, and it received little comment at the time.  While there does not appear to be a transcript of his oral comments, in his written "Statement on Bankruptcy Cloture Vote" released on March 8, 2005, Kennedy expresses his concern over the "glaring abuses of the bankruptcy system by the executives of giant companies like Enron Corp. and WorldCom Inc. and Polaroid Corp., who lined their own pockets, but left thousands of employees and retirees out in the cold."

Its detractors were concerned that Kennedy's amendment would prevent responsible companies from successfully reorganizing, and advanced that §503(c) should only prevent payments to insiders in the event of fraud, mismanagement or conduct contributing to insolvency.  Cong. Rec. S2341 (March 9, 2005) (statement of Sen. Orrin G. Hatch); Cong. Rec. H2050-51 (April 14, 2005) (statement of Rep. Chris Cannon).  A letter from the directors of the Association of Insolvency and Restructuring Advisors to that effect was also placed in the Congressional Record.  In the end, the amendment was adopted in its original, broad-brush form.

Whether judges have lost all discretion with respect to key management compensation is up for debate, however.  While there have not been many cases addressing §503(c), attorneys and judges are coming up with creative approaches to address compensation issues consistent with the statute and their sense of fairness and with an eye toward the policies of the Office of the United States Trustee (UST).  At least in the context of liquidating cases, judges have not hesitated to find a way to approve plans they determined were appropriate under the circumstances.


As set forth above, §503(c)(1) prohibits transfers to insiders "for the purpose of inducing such person to remain with the debtor's business."  Such transfers are allowed only when the court makes a series of findings, one of which is that the services provided by the insider are "essential to the survival of the business."  Picking up on this theme, at least one debtor has argued that a KERP was permissible in the context of a Chapter 11 liquidation because §503(c)(1) simply did not apply.

In In re FLYi Inc., No. 05-20011 (Bankr. D. Del. Feb. 2, 2006), the debtor, a regional airline, decided to cease operations and implement a wind-down plan in its Chapter 11 proceedings after a failed sale process.  The wind-down plan included the immediate cessation of operations and the implementation of a "Wind-Down Employee Plan" that would encourage employees to stay with the company to complete specified tasks, i.e., liquidating the remaining assets, reviewing and resolving proofs of claim and preparing required reports.  The 180 employees who were part of the wind-down employee plan were grouped by length of task (one week to "6 months and beyond") and were entitled to a specified "Completion Bonus" upon completing their assigned task.  Of the 180 employees who were part of the plan, FLYi Inc. suggested that only 10 were arguably insiders.

FLYi advanced the position that §503(c)(1) did not apply to the wind-down employee plan because if the court were to grant FLYi's request to immediately cease operations, there was no "business" remaining. FLYi reasoned that the term "business" in §503(c)(1) must be construed to be a viable commercial business, and that a liquidation by definition was not a "business."  FLYi also argued that even if a "business" existed after cessation of operations, the wind-down employee plan was not designed to induce the insiders to remain with that business.  Rather, FLYi maintained that there was a fundamental difference between being paid to continue to work as part of a team in a growing business, and being rewarded for performing nonoperational tasks designed to wind down the business.  In essence, FLYi argued, the insiders were working themselves out of a job.

Ultimately, the court did not have to rule on this issue.  After discussions with the UST, FLYi determined that all but two of the insiders would fall under the §503(c)(2) cap, and the parties agreed to characterize the program as a severance program.  As to those two insiders, FLYi and the UST agreed that they would be paid the maximum severance allowed, with the right to seek more in the future.

U.S. Bankruptcy Chief Judge Mary F. Walrath approved the modified wind-down employee plan over the objection of the Association of Flight Attendants.  In so doing, she rejected the argument that under §503(c)(2) the debtors had to include in their calculation severance paid (or not) to employees who previously had been severed.  Rather, the court ruled that §503(c)(2) contemplated a new severance program for employees remaining after a debtor has gone through initial cost-cutting measures.

In re Refco Inc., No. 05-6006 (Bankr. S.D.N.Y. Jan. 10, 2006), another liquidating Chapter 11 case, also presented an issue under §503(c).  In that case, the Refco debtors sought an order permitting them to implement a key employee compensation program.  The debtors (supported by the official committee of unsecured creditors and the trustee appointed in certain affiliated Chapter 7 cases), posited that §503(c)(1) did not apply because none of the employees in the program were insiders. U.S. Bankruptcy Judge Robert D. Drain agreed, and ruled that while some of the employees may have had decision-making authority prepetition, they currently did not have that authority and therefore no longer were insiders.  Moreover, the judge noted that the employees were not included in the KERP because they were insiders, but because they were productive employees critical to the efficient and economic administration of the estate.  Finally, embracing the theme raised in FLYi, Drain noted that these employees were working themselves out of a job by facilitating an orderly liquidation.  For these reasons, among others, the judge approved the proposed KERP.


Section 503(c)(3) also may assist in retaining insiders.  It prohibits other types of transfers if they are outside the ordinary course of business and not justified by the facts and circumstances of the case.  This subsection does not have a formulaic approach to compensation.  Accordingly, if a compensation plan falls into this third category (nonretention and nonseverance), the court has much more flexibility.

Walrath recently relied upon §503(c)(3) to approve an incentive plan over the objection of the UST in In re Nobex Corp., No. 05-20050 (Bankr. D. Del. Jan. 20, 2006).  In Nobex, the debtor, a biopharmaceutical company, entered bankruptcy to pursue a §363 sale of substantially all of its assets.  The court quickly approved a sale procedure, and eight days after the petition was filed, the debtor filed a motion seeking authorization to pay "sale-related incentive pay" to two of its senior managers.

The compensation was couched as a percentage of the sale proceeds over certain benchmarks, and Nobex sought permission to pay each of the executives up to the amount approved by the court subject to the "board's ultimate conclusions about the post-petition contributions of each to successful implementation of the sale procedure, including obtaining approval of and closing a Sale."  As authority, Nobex cited §363, as well as §503(c)(3).  Nobex took the position that the incentive pay plan was not intended or structured as either a retention plan or a severance plan, but rather was "designed and intended to ensure complete implementation of the sale procedure."

The UST made multiple arguments in opposition to the motion.  First, it argued that §503(c)(3) applies only in the narrow situation in which insiders are hired after the petition date.  Alternatively, the UST argued that semantics should not govern, and that §503(c)(3) cannot be used to undermine the more specific subsections addressing retention and severance.  Noting that artful counsel can almost always couch a retention or severance plan as something else, the UST asserted that the plan was nothing more than a disguised retention program in that it was an inducement provided so the managers would remain.

Walrath overruled the objection.  Recognizing that this new language was not entirely clear, the judge held that §503(c)(3) is a "catch-all" provision that applies to insiders hired prepetition.  She also held that the standard set forth in §503(c)(3) was "nothing more than a reiteration of the standard under 363" -- namely, whether the plan reflected the debtor's sound business judgment based on the circumstances of the case.

Applying her conclusions, Walrath first held that the incentive plan was not a disguised retention plan in that it did not provide payment to senior management "solely for being retained," nor was it a disguised severance plan because the employees could leave the day after the sale and still receive the incentive payment under the plan.  Placing great weight on the support of the creditors' committee, and the fact that the formula gave managers incentives to improve upon a stalking-horse bid, she found that the plan was designed to maximize recoveries to unsecured creditors, and thus approved the plan.

It is premature to say that KERPs are entirely a thing of the past when it comes to insiders; as evidenced above, there may still be vehicles by which debtors can ensure that necessary employees remain with the company.  Liquidating debtors may have an easier burden, but even in the case of a reorganizing debtor, bankruptcy courts may be inclined to take a narrow view of the limitations on the plans circumscribed by BAPCPA.  Ultimately, debtors may be able to compensate their management by complying with the specific requirements of §503(c)(1) or (2), or by proposing an "other transfer" justified by the facts and circumstances of the particular case.


*   Laurie Selber Silverstein leads the restructuring and bankruptcy practice at Potter Anderson & Corroon in Wilmington, Del.  Associate Theresa V. Brown-Edwards assisted in the preparation of this article.  The views or opinions expressed in this article are those of the authors alone and do not necessarily represent the views or opinions of Potter Anderson & Corroon LLP or its clients.