New York Bankruptcy Court Labels Management Bonuses An Impermissible Retention Plan

Friday, December 1, 2006 - 01:00

On September 5, 2006, Judge Burton R. Lifland of the United States Bankruptcy Court for the Southern District of New York denied Dana Corporation's motion to implement an executive compensation program, ruling that the proposed program violated Section 503(c) of the Bankruptcy Code. That section, which was added as part of the recent Bankruptcy Code amendments (the '2005 Amendments') restricts payments for the purpose of inducing insiders 'to remain with the debtor's business,' as well as 'severance payments' to insiders. The decision marks the first substantial interpretation of the newly added Section 503(c) in a contested proceeding and has important implications for future Chapter 11 cases.

The 2005 Amendments - Bankruptcy Code Section 503(c).

Until 2005, bankruptcy courts routinely approved key employee retention plans (KERPs) and severance plans intended to induce certain key executives to remain with a debtor in the face of the uncertainty that resulted from a company's bankruptcy filing. Notwithstanding the increasingly generous payments proposed under these programs, they were judged under the comparatively deferential 'business judgment' standard.

Creditors, and especially labor unions, became more and more frustrated with the routine approval of generous KERPs. David McCall of the United Steelworkers testified against such programs before the Senate Judiciary Committee in early 2005 and Senator Kennedy insisted on KERP restrictions as the price for allowing the 2005 Amendments out of Committee for a vote on the Senate floor. The result was new section 503(c) of the Bankruptcy Code. The new section provides that payments made 'for the purpose of inducing' an insider 'to remain with the debtor's business' are permitted only upon a showing that: (i) the insider has a bona fide job offer at the same or greater rate of compensation, (ii) the proposed retention payment is essential to the retention of the employee, and (iii) the services of the insider are 'essential to the survival of the business.' See 11 U.S.C.503(c)(1)(A) and (B). Even if a debtor is able to make these threshold showings, no retention payments can exceed ten times the average bonus paid to non-management employees. See 11 U.S.C.503(c)(1)(C). In addition, any severance payment to an insider must be part of a program that is generally applicable to all full-time employees and may not be greater than 10 times the amount of the mean severance pay given to non-management employees during the calendar year in which the payment is made. See 11 U.S.C.503(c)(2).

Dana's Executive Compensation Plan

Approximately three months after filing under Chapter 11, Dana Corporation filed a motion seeking authority to enter into modified employment agreements with six key executives. Among other things, Dana sought authority to pay the executives 'completion bonuses' (in amounts of up to $6.2 million) if they remained employed through consummation of a plan of reorganization or a sale of substantially all of Dana's assets and 'termination payments' (in amounts of up to $7 million) in the event the executive was terminated without cause. Although not tied to any standard performance goals, Dana argued that the completion bonuses 'incentivized' management to confirm a plan or sell the business in an expeditious manner. Because the 'completion bonuses' and 'termination payments' were not expressly labeled 'retention' or 'severance' payments, Dana asserted that neither section 503(c)(1) nor 503(c)(2) applied and therefore the bonuses were permissible so long as they met the 'business judgment standard' under section 363.

The Official Committee of Unsecured Creditors, represented by Kramer Levin, objected and was joined by every other major party in the case. Dana then amended the motion to, among other things: (i) reduce the guaranteed completion bonuses by 50%; (ii) provide that the remainder of the completion bonuses would be payable if Dana's Total Enterprise Value ('TEV') reached certain thresholds after the effective date; and (iii) recharacterize the 'termination payments' as consideration for the executives to enter into non-compete agreements. Dana continued to take the position that the requirements set forth in sections 503(c)(1) and (2) were not applicable because they were proposing an 'incentive' plan. The objectors found these modifications to be inadequate to address their concerns and comply with the statute, and Judge Lifland agreed.

Judge Lifland's Decision:If It Walks And Quacks Like A KERP, It's A KERP

In rejecting the Debtor's proposed plan, Judge Lifland noted Congress' frustration with excessive KERPs, and held that to the extent Dana's program sought authorization to pay retention or severance payments, 'then the business judgment rule does not apply, irrespective of whether a sound business purpose may actually exist.'

While a properly designed incentive program might be approved under section 503(c)(3), the court emphasized that the 'minimum' bonus was payable without regard to any recognized performance metric. 'Without tying this portion of the bonus to anything other than staying with the company until the Effective Date, this Court cannot categorize a bonus of this size and form as an incentive bonus.' The Court went on to find that 'if it walks like a duck (KERP), and quacks like a duck (KERP), it's a duck (KERP.) . . .' Accordingly, the Court declined to approve a compensation scheme that 'walks, talks and is a retention bonus.'

The court also declined to approve Dana's proposal to make millions of dollars of 'noncompete payments.' Dana, the court held, had failed to meet its burden of showing that the noncompete payments fell outside the general definition of what constituted 'severance' or that the payments might otherwise meet the requirements of Section 503(c)(2).

In rejecting Dana's proposed compensation plan, Judge Lifland rejected as precedent unpublished opinions which had approved management bonus plans in the absence of material opposition.The Judge, however, left the door open for consideration of alternative plans: '[w]hile it may be possible to formulate a compensation package that passes muster under the section 363 business judgment rule or section 503(c) limitations, or both . . . I do not find that incentivizing plans which may have some components that arguably have a retentive effect, necessarily violate section 503(c)'s requirements.'

Implications For The Future

By adopting a common sense reading of the new Section 503(c), Judge Lifland appears to have enforced Congressional intent regarding retention plans. At the very least, the decision supports the view that creditors should be consulted in the creation of any executive compensation plan, because the ability of a debtor to implement such a plan may in part depend on the support it is able to garner from its creditor constituencies, as well as the reasonableness of any incentive targets proposed by the debtor. The decision should give creditors more power to ensure that executives are properly incentivized to achieve the most successful reorganization of the debtor's estate and shows the debtor should not try to implement management bonuses over the concerted objection of its creditor constituencies. Future cases are likely to see negotiations and disputes over the appropriate performance thresholds for management bonuses, with creditors seeking higher targets and debtors advocating graduated and more 'realistic' performance milestones. In the process, debtors may be forced to disclose their predictions about future economic performance much earlier than they have in the past.

Thomas Moers Mayer and P. Bradley O'Neill are partners at Kramer Levin Naftalis & Frankel LLP. Associate Matthew Williams contributed to this article. Mr. Mayer specializes in representing investors in claims against, and interests in, financially distressed businesses. He is the leading scholar on the law of trading claims and taking control of corporations in Chapter 11, having authored or co-authored (with Chaim J. Fortgang) five published articles and the Collier Bankruptcy Practice Manual chapter on that topic. He can be reached at (212) 715-9169. Mr. O'Neill's practice focuses primarily on bankruptcy litigation and other complex commercial litigation. He has handled numerous litigations and investigative matters on behalf of trustees, debtors, creditors' committees and individual creditors. He can be reached at (212) 715-7583. Kramer Levin Naftalis & Frankel represents the Official Committee of Unsecured Creditors in the Dana bankruptcy case.

Please email the authors at tmayer@kramerlevin.com or boneill@kramerlevin.com with questions about this article.