ARTICLE
11 April 2007

Employee Compensation Programs: A Study Of Judicial Interpretation Under BAPCPA

When I decided to write an article regarding the judicial interpretation, thus far, of Congress’s 2005 amendments to the United States Bankruptcy Code (known affectionately to bankruptcy lawyers as BAPCPA), affecting key employee retention programs (or KERPS), I did what any diligent researcher would do, I read other articles, written by some of the finest, astute bankruptcy lawyers in the country.
United States Insolvency/Bankruptcy/Re-Structuring

When I decided to write an article regarding the judicial interpretation, thus far, of Congress’s 2005 amendments to the United States Bankruptcy Code (known affectionately to bankruptcy lawyers as BAPCPA), affecting key employee retention programs (or KERPS), I did what any diligent researcher would do, I read other articles, written by some of the finest, astute bankruptcy lawyers in the country. Most of the articles I read on the subject provide an excellent, well rounded synopsis of pre-BAPCPA law (statutory and judicial interpretation), the initiatives to amend pre-BAPCPA law, BAPCPA itself, including the infamous, somewhat newly enacted § 503(c), and finally, a summery of the judicial interpretation thus far.

This article is not intended to provide such a broad scope of § 503(c) and its affect on KERPS. Rather, this article assumes that the reader is familiar with pre-BAPCPA law, the initiatives to amend pre-BAPCPA law, and BAPCPA itself. This article focuses solely on the judicial interpretation of BAPCPA that has taken place thus far and attempts to go beyond a review of the relief requested, granted and denied, and attempts to get inside the minds of the courts by additionally examining the comments and dialogue that took place at the hearings on the pleadings, but which did not necessarily make it into an order or written opinion. Such comments and dialogue, I believe, in these unchartered waters, is invaluable to today’s commercial bankruptcy lawyer.

Keep in mind, the terms "key employee retention program" and "KERP" are, for all intents and purposes, terms of the past. In our post-BAPCPA world, no bankruptcy attorney in his or her right mind, who has studied the opinions and transcripts interpreting § 503(c) thus far, would include such terms in their filing papers or even utter such words out loud (at least not in public). Rather, as a review of the cases below shows, bankruptcy lawyers have been quite creative and savvy in not only crafting new names for employee compensation programs, but in arguing the inapplicability of § 503(c) and its strict requirements, all with one final goal: to obtain the relief that their clients require. The bankruptcy judges are listening.

This article examines cases before the United States Bankruptcy Courts for the District of Delaware and the Southern District of New York. Although other jurisdictions have considered employee compensation programs under BAPCPA, the cases decided in the District of Delaware and the Southern District of New York provide a fair representation of the issues considered nationwide. The format of this article is simple. First, this article summarizes the relief sought by the respective debtors to give the reader an understanding of the types of programs that have been proposed to courts under BAPCPA. Second, this article summarizes the orders entered by the courts, providing the reader with an understanding of the precedent that is being created. Third, this article provides a summary of the hearings on the pleadings, to the extent that hearing transcripts are available. Lastly, through a comprehensive review of the pleadings, the orders, and the hearing transcripts, this article provides comments and insight regarding the ramifications of the cases studied herein. Hopefully the information provided herein is helpful the next time you are filing, or faced with an employee compensation program in chapter 11.

With that introduction, let’s begin.

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THE DELAWARE CASES

In re: Nobex Corporation, Case No. 05-20050 (Bankr. D. Del. 2005).
(J. Walrath)

The Program: Retention Plan

The Motion:

On December 9, 2005, the debtor filed a Motion for Order Authorizing Payment of Sale-Related Incentive Pay to Senior Management Pursuant to 11 U.S.C. §§ 105, 363(b) and 503(c)(3), pursuant to which the debtor requested authority to make incentive payments to two officers during the implementation of its sale procedures. The debtor argued that during the efforts to sell its assets, it was imperative for senior management to undertake every effort to support the due diligence process and the marketing of the debtor’s assets. The debtor further argued that such sale efforts were essential to meet the burden imposed pursuant to § 363 of the Bankruptcy Code.

The requested payments were contingent upon the total gross price received in a sale of substantially all of the debtor’s assets. In support of the motion, the debtor relied upon §§ 105 and 363(b) of the Bankruptcy Code and argued that § 503(c) was satisfied to the extent that the participants were deemed insiders.

The Order:

On January 20, 2006, the court entered an Order Authorizing Payment of Sale-Related Incentive Pay to Senior Management Pursuant to 11 U.S.C. §§ 105, 363(b) and 503(c)(3).

The Hearing:

At the January 12, 2006 hearing, the court noted that the program was not just a retention program. In fact, the court noted that "the structure’s based on not just being here, but getting a successful conclusion to the sale; that is, an upside price." The court further noted,

I think in this case it is clear that from structure [sic] of the plan that this is not a retention plan. It is not providing payment to the employees or senior management solely for being retained, staying on the job. In fact, they can stay on the job all they want if the criteria are not meant [sic]. That is, if the sale does not produce sufficient funds, they will not get anything. Similarly, they can leave the day after the sale and get the incentive if in fact the sale produces more than the minimums required under this. So I see it as not a retention plan and therefore not subject to the (c)(1) strictures.

Transcript at p. 87.

In distinguishing the program before her from the traditional retention programs that perhaps offended Congress and caused it to enact § 503(c), the court noted that "an incentive program that is based on a sale, an increase in sale price, does not seem to be or to fit in with what 503(c)(1) was meant to do . . . ." It is worth noting, however, that the court did state that such a program could fit into § 503(c) if the debtor had been selling its assets prepetition and there were plans in place to provide payments based on that sale.

In approving the compensation program before her, the court applied § 503(c)(3) and stated as follows:

So I do read (c)(3) to be the catch-all and the standard under (c)(3) for any transfers or obligations made outside the ordinary course of business are those that are justified by the facts and circumstances of the case. Nothing more – no further guidance being provided to the Court by Congress, I find it quite frankly nothing more than a reiteration of the standard under 363 and – well, 363 under which courts had previously authorized transfers outside the ordinary course of business and that is, based on the business judgment of the debtor, the court always considered the facts and circumstances of the case to determine whether it was justified. And I’ll do the same in this case.

Transcript at p. 86.

In discussing the requirements of § 503(c)(3), the court addressed the debate regarding whether the language, "including transfers made to, or obligations incurred for the benefit of, officers, managers, or consultants hired after the date of the filing of the petition," is inclusive or exclusive, i.e., whether "hired after the petition date" applies to officers, managers, and consultants, or only consultants. In respect thereof, the court noted, "I agree that the including transfers made to officers, managers or consultants hired after the petition date is not exclusive. That’s clear from other provisions in the Bankruptcy Code." Transcript at p. 86.

Finally, it is noteworthy that the court placed "great weight" in the fact that the program was presented and negotiated with the creditors committee, who as well as the debtor, has a fiduciary duty to all creditors, but has a particular interest in assuring that general unsecured creditors get some recovery.

Author’s Comment: This case makes clear that there is a real distinction between retention programs and incentive programs, with § 503(c)(1) and its strict requirements, applying solely to the former and § 503(c)(3) applying to the latter. Section 503(c)(3) allows employee compensation outside of the ordinary course if it is "justified by the facts and circumstances of the case." As this court noted, in drafting (c)(3), Congress did not provide any guidance as to what facts or circumstances would justify approval of compensation under this subsection. This case provides some clarity in this regard through the court’s application of the business judgment standard set forth in § 363 of the Bankruptcy Code. Congress has made approval of retention programs to insiders so difficult, vis-à-vis § 503(c)(1), that compensation programs will likely take the form, more often than not, of incentive programs, rather than retention programs, in which case the debtor need only satisfy the business judgment rule, to the extent that courts agree with Judge Walrath’s interpretation.

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In re: FLYi, Inc., et al., Case No. 05-20011 (Bankr. D. Del. 2005).
(J. Walrath)

The Program: Wind-Down Employee Plan

The Motion:

On January 2, 2006, the debtors filed an Emergency Motion of the Debtors for an Order (I) Authorizing Them to Discontinue Their Scheduled Flight Operations and Take Certain Actions in Connection Therewith; (II) Approving a Wind-Down Employee Plan; (III) Approving the Payment of Certain Severance, Vacation and Other Benefits and Amounts to Terminated or Furloughed Employees; and (IV) to the Extent Necessary, Authorizing the Modification of Collective Bargaining Agreements Pursuant to Section 1113(e) of the Bankruptcy Code in Connection Therewith. By the motion, the debtors requested authority to pay termination benefits to certain terminated and furloughed employees, as well as to compensate employees that would remain with the debtors to assist in the wind down.

Under the program, the debtors provided each participant with a wind-down task. The length of time required to complete such task determined the amount of additional compensation to such employee. The debtors argued that the program should be approved pursuant to § 363(b). In addressing § 503(c), the debtors asserted that the program did not conflict with § 503(c)(1) because that section only applies to entities continuing as a viable commercial enterprise. The debtors, however, were in the process of liquidating their estates, and as such, there would be no business remaining. Hence, the employees’ services would not be essential to the survival of a business. In the alternative, the debtors argued that the program was not intended to induce the participants to stay in their employ; but rather it was intended to create incentives to wind down the debtors’ affairs.

In the motion, the debtors noted that if the court found that the program contravened § 503(c) with respect to participating insiders, the debtors intended to either: (i) seek authority to enter into post-petition employment agreements with such insiders otherwise covered by § 503(c)(1) at base salaries equal to the amount payable under the program; (ii) terminate the employment of such insiders and enter into consulting agreements with such employees as independent contractors; (iii) demote such employees so that they were no longer insiders; or (iv) establish incentive based bonuses on the assumption that they would not fall within the ambit of § 503(c) that would be satisfied by such insiders.

The debtors also sought authority to pay, among other things, severance to employees terminated or furloughed as a result of the discontinuation of scheduled flight operations. With respect to non-union employees, the debtors sought to modify their prepetition severance plan to provide a flat severance payment of two weeks pay to such employees and asserted that such payments would create administrative expenses of the estate. The debtors estimated that the total cost of compensation for non-union employees, including severance, would be $6,040,000.

With respect to union employees, the debtors sought to honor the respective collective bargaining agreements (CBA) in place prior to the bankruptcy filing. The CBA’s provided one week severance payments for full time employees with at least one full year of service and two weeks for full time employees with at least two full years of service. The debtors estimated that the total cost of compensation to union members, including severance, would be $5,260,000.

The Orders:

On January 5, 2006, the court entered an Order (I) Authorizing the Debtors to Discontinue Their Scheduled Flight Operations and Take Certain Actions in Connection Therewith; (II) Approving a Wind-Down Employee Plan; (III) Approving the Payment of Certain Severance, Vacation and Other Benefits and Amounts to Terminated or Furloughed Employees; and (IV) to the Extent Necessary, Authorizing the Modification of Collective Bargaining Agreements Pursuant to Section 1113(e) of the Bankruptcy Code in Connection Therewith. In this order, the Court found that the debtors articulated a sound business purpose for the approval and implementation of the wind-down employee plan and payment of termination benefits pursuant to § 363 and approved the program with respect to non-insiders only. The court found that the debtors could, in consultation with the creditors committee, modify the program, provided that total compensation would not exceed $4.4 million.

On February 6, 2006, the Court entered an Order Approving Wind-Down Employee Plan Pursuant to Section 503(c)(2) of the Bankruptcy Code With Respect to Certain Officers of the Debtors, pursuant to which the court approved the program, pursuant to §§ 363(b) and 503(c)(2), with respect to the six respective insiders. The court approved an agreement between the debtors and the United States Trustee (UST) that no bonus would be paid to any officer exceeding $118,385.96, such that the order complied with the requirements of § 503(c)(2).

The Hearing:

As the January 6, 2006 order approved the program with respect to non-insiders, the January 12, 2006 hearing pertained solely to the approval of payments to the participating insiders. At the hearing, the debtors and the UST presented an agreement to the court to treat the proposed payments to the insiders as severance payments pursuant to § 503(c)(2). Accordingly, such payments could not be more than 10 times the severance payments to non-insiders. The parties reserved their rights with respect to any incentive payments for which the debtor may seek future approval.

At the hearing, counsel for the Association of Flight Attendants (AFA) argued that the debtors misinterpreted § 503(c)(2)(B), specifically the language requiring that "the amount of the payment [to insiders] is not greater than 10 times the amount of the mean severance pay given to nonmanagement employees during the calendar year in which the payment is made." Counsel for the AFA argued that the debtors’ calculation was based on the 171 non-insider employees participating in the program and erroneously failed to include employees that were not terminated. Counsel for the AFA argued that under the debtors’ interpretation, a debtor could implement a wind-down plan with one non-insider receiving severance and multiply that number by 10 to calculate the amount of severance payable to insiders, with everybody else receiving no compensation.

In response, the court stated,

I think the prior (c)(1)(C) talks about payments being equal to ten times amounts made during the prior calendar year or the calendar year in which it was made and then applicable to a prior period. But this doesn’t have any of that prior language, and I think that it does contemplate creating a severance payment for remaining employees after the debtor has gone through its cost cutting and does not mean that because you’re now proposing to do severance payments for employees you have to go back … and retroactively give severance payments for terminated employees … I think this contemplates a new severance program, if you will.

Transcript at p. 11

Author’s Comment: This case is insightful in that it explains how § 503(c)(2) severance payments to insiders should be calculated. Furthermore, this case provides some options to consider when seeking approval of employee compensation programs for insiders. In the motion, the debtors noted that if the court found that the program contravened § 503(c) with respect to the insiders they would either: (i) seek authority to enter into post-petition employment agreements with such insiders otherwise covered by § 503(c)(1) at base salaries equal to the amount payable under the program; (ii) terminate the employment of such insiders and enter into consulting agreements with such employees as independent contractors; (iii) demote such employees so that they were no longer insiders; or (iv) establish incentive based bonuses on the assumption that they would not fall within the ambit of § 503(c) that could be satisfied by such insiders. The extent to which any of these options would pass muster with the courts is uncertain. Nevertheless, these are options that should at least be considered.

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In re: Aphton Corporation, Case No. 06-10510 (Bankr. D. Del. 2006).
(J. Sontchi)

The Program: Sale-Related Incentive Pay

The Motion:

On June 9, 2006, the debtor and the creditors committee filed a Joint Motion of Debtor and of Official Committee of Unsecured Creditors for Order Authorizing Payment of Salary Deferral and Sale-Related Incentive Pay to Debtor’s Employees Pursuant to 11 U.S.C. §§ 105, 363(b) and 503(c)(3). Prior to the filing of the motion, the

debtor began efforts to sell substantially all of its assets and was having liquidity problems. The committee proposed to all of the debtor’s employees, and certain employees accepted, an arrangement whereby the employees would defer taking their salary in return for receipt of their salary with a deferral bonus upon the sale of the debtor’s assets. The total bonus to be paid to the three participating employees was $50,250.

The debtor and the committee argued that the relief should be granted in accordance with §§ 105 and 363(b) of the Bankruptcy Code and to the extent that § 503(c) was applicable, as a result of the status of the employees as insiders, the facts and circumstances justified the requested relief thereunder.

The Order:

On June 15, 2006, the court entered an Order Authorizing Payment of Salary Deferral and Sale-Related Incentive Pay to Debtor’s Employees Pursuant to 11 U.S.C. §§ 105, 363(b) and 503(c)(3), pursuant to which the debtor was authorized to pay a gross amount of no more than $102,416 to the deferring employees, payable upon the closing of the sale for their efforts in achieving such sale. However, the order provided that in order to receive the salary deferral and sale-related incentive pay, the deferring employees were required to remain employees of the debtor from the date of the entry of the order through and including the date of the closing of the sale.

Author’s Comment: This case provides another option to consider when seeking approval of an employee compensation program in the face of opposition: deferral of compensation, payable with a bonus, upon consummation of the respective transaction. This case is noteworthy in that the court approved the compensation program, which was clearly a retention based program, pursuant to § 503(c)(3), which this court had begun to utilize when approving incentive based compensation programs.1

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In re: Werner Holding Co. (DE), Inc., Case No. 06-10578 (Bankr. D. Del. 2006).
(J. Carey)

The Programs: Business Optimization Bonus Plan & Chicago Plan Transition Bonus Plan

The Motion:

On June 30, 2006, the debtor filed a Motion for Entry of Order Authorizing Debtor to Honor Prepetition Incentive-Based Bonus Plans Pursuant to Sections 363 and 105 of the Bankruptcy Code, pursuant to which the debtor sought approval of its Business Optimization Bonus Plan (BOB Plan) and its Chicago Transition Bonus Plan (the Chicago Plan), both crafted by the debtor’s management with the assistance of an outside consultant prior to the petition date.

The BOB Plan sought to reward employees by providing bonuses equal to a percentage ranging from 10% to 75% of the respective employee’s annual salary upon meeting certain individual and collective goals. By the motion, the debtor proposed to make BOB Plan payments in 4 installments. Approximately 116 employees were eligible to participate in the BOB Plan and the debtor estimated that the total maximum cost would be $4,000,000, with the average amount payable to each employee being approximately $35,000.

The Chicago Plan was crafted to motivate employees deemed critical to the transition of the debtor’s operations to Juarez, Mexico. The Chicago Plan bonuses ranged from 8% to 100% of an employee’s annual base salary and the bonuses were payable in one lump sum within 15 days of the participating employee’s meeting performance objectives. Approximately 81 employees were eligible for the Chicago Plan and the debtor estimated that the total maximum cost would be $2,600,000, with the average amount payable to each employee being approximately $32,000.

The Orders:

By July 28, 2006 and August 23, 2006 orders, the court approved the BOB Plan and the Chicago Plan. With respect to the 10 executive participants of the BOB Plan, the court limited the relief granted to the debtor. One of the executives could not receive payment if he was terminated for cause. Another executive’s payment was subject to disgorgement if he voluntarily terminated his employment before a certain date.

Furthermore, the order required the debtor to complete written evaluations of each executive’s entitlement to payment, providing copies to the committee. The committee thereafter had an opportunity to object to any payments made. Whereas most orders approving incentive programs grant administrative expenses to the participants, this order purposefully did not create an obligation on the debtor, but rather gave the debtor discretion as to whether and when to pay.

The Hearing:

At the July 25, 2006 hearing, although the court shared some of the objectors’ reservations concerning payment to the nine executives, the court sensed a consensus that the rank and file supervisors who were key to the continued operation of the business should receive payments under the BOB Plan and the court was willing to give interim approval for the July payment to those individuals.

Author’s Comment: This case provides further options to consider when seeking approval of an employee compensation program in the face of opposition. Whereas most orders approving employee compensation programs grant such payments administrative priority, this order purposefully did not. Furthermore, the creditor’s committee had an opportunity to object to the payments prior to the debtor’s making such payments. These bargaining options may assist a debtor in garnering committee support of a proposed employee compensation program.

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In re: Radnor Holdings Corporation, et al., Case No. 06-10894 (Bankr. D. Del. 2006).
(J. Walsh)

The Program: Management Incentive Plan (MIP)

The Motion:

On August 31, 2006, the debtors filed a Motion for Order Under Bankruptcy Code Sections 105 and 363(b) Authorizing Payment of Sale-Related Incentive Pay to Senior Management. The program was intended to provide participants with greater compensation in the event that they obtained greater value for the debtors’ estates. The debtors proposed that upon the closing of a sale or alternative transaction, a pool of funds would be made available to the program participants. The incentive compensation pool would increase only as the value of the transaction increased.

The debtors proposed that the initial amount of the incentive compensation pool be $700,000, which was the amount of incentive compensation that the purchaser of substantially all of the debtors’ assets agreed to assume upon consummation of the sale. Under the program, the minimum incentive pool would not increase unless and until the debtors received aggregate consideration sufficient to pay the lenders under the debtor-in-possession facility.

Pursuant to the program, four members of the debtors’ senior management were designated as participants. The debtors also requested that a portion of the pool be made available to pay junior members of management that provided significant benefits to the restructuring process and requested that upon consummation of the sale, the pool of $700,000 be divided as follows: $625,000 to senior management and $75,000 to the junior executives. The debtors argued that the program did not conflict with § 503(c), which only applies to payments meant to induce insiders to remain with the debtors’ business. The debtors argued that the program was not intended to induce anyone to remain with the debtors’ business. Although participants were required to be employed on the date of sale or alternative transaction, the debtors argued that such requirement was not intended to induce any participant to remain in the debtors’ employ. Rather the payments were intended to ensure that the participants continue their efforts to solicit/facilitate the consideration of alternative transactions.

The Order:

On October 4, 2006, the court entered an Order Under Bankruptcy Code Sections 105 and 363(b) Authorizing Payment of Sale-Related Incentive Pay to Senior Management, pursuant to which the court approved the MIP.

The Hearing:

At the October 4, 2006 hearing, the United States Trustee argued that because § 503(c)(1) and (c)(2) apply to insiders, the court should find that § 503(c)(3) does as well. In response, the court made clear that "well, I would agree with you if 503(c)(3) said other transfers or obligations with respect to insiders. But Congress didn’t say that."

Author’s Comment: Similar to the Aphton Corporation case, this court approved the respective program as an incentive based program under § 503(c)(3), notwithstanding the requirement that the participants remain in the debtors’ employ through a specified period of time. These rulings, coupled with the court’s statements in Musicland Holding Corp., have the potential to muddy the waters in distinguishing between a retention program subject to (c)(1) and an incentive program subject to (c)(3). This could be an issue that may ultimately require clarification by Congress or the Supreme Court. With respect to the court’s interpretation of § 503(c)(3), although it may seem obvious that (c)(3) does not only apply to insiders, this case certainly provides clarity to the extent necessary.

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THE NEW YORK CASES

In re: Refco, Inc., et al., Case No. 05-60006 (Bankr. S.D.N.Y. 2005).
(J. Drain)

The Program: Key Employee Compensation Program

The Motion:

On December 21, 2005, the debtors filed a Motion for Order Under 11 U.S.C. §§ 105 and 363 Authorizing Implementation of Key Employee Compensation Program. The debtors stated that the program was designed to retain certain employees key to the successful wind-down of the debtors’ business operations by providing a financial incentive for them to remain. None of the key employees held officer or director positions with the debtors. The program was part of a larger effort to retain certain employees of non-debtor affiliates that were also conducting wind-down operations and covered 17 employees of the debtors and 15 employees whose work benefited both debtor and non-debtor entities.

Under the program, key employees would be eligible to receive (i) a year-end bonus consistent with the debtors’ historical policy; and (ii) a performance bonus based on a successful and timely sale and wind-down of the debtors’ businesses. Additionally, key employees would remain eligible to receive severance benefits consistent with the debtors’ severance policy, which provided for two weeks’ salary per year of service, capped at six months’ salary.

The program divided key employees into two tiers. The first tier included employees with knowledge and expertise necessary to lead the wind-down and maximize the value of the debtors’ estates. The debtors proposed to provide these employees with a year-end bonus equal to four months’ salary and a performance bonus equal to one month base salary for each month they worked during a four month period. The second tier included employees who would support the efforts to wind-down the debtors’ businesses and maximize value for their estates and who had the institutional knowledge and expertise to assist in these efforts. The debtors proposed to provide these employees with a year end bonus equal to two months’ salary and a performance bonus equal to one-half month of their base salary for each month they worked in the same four month period. The proposed maximum payable amount to all key employees was approximately $1.4 million.

The debtors proposed to pay 50% of the year-end bonus in the first paycheck of 2006 if the employee did not resign prior to January 1, 2006. The debtors proposed to place the remaining 50% in escrow, to be paid after the earlier of March 31, 2006 or the covered employee’s separation date. Furthermore, in order to receive the full year-end bonus, employees would have to be employed by the debtors on December 31, 2005 and the earlier of March 31, 2006 or the date on which the employee’s services were no longer needed.

A covered employee’s performance bonus would accrue monthly and would be placed in escrow, to be paid after the earlier of March 31, 2006 or the covered employee’s separation date. The performance bonus would be pro-rated for those employees whose last date of employment fell before the end of the month. In order to receive a performance bonus, a covered employee needed to remain actively employed by the debtors through and including the earlier of March 31, 2006 or such employee’s separation date. Any key employee who voluntarily left the debtors’ employment before the target dates would forfeit their rights to future payment under the program. Any amounts that would have otherwise been payable, but were not paid due to voluntary resignation, would be returned to the estate.

The Order:

On January 18, 2006, the court entered an Order Under 11 U.S.C. §§ 105 and 363 Approving Implementation of Key Employee Compensation Program. The order granted administrative priority to the payments to be made under the program pursuant to §§ 503(b)(1)(A) and 504(a)(2) of the Bankruptcy Code. The order was without prejudice of a subsequent determination within 60 days after entry of the order that the costs of the program should be allocated to debtor or non-debtor entities other than as identified in the motion. The order provided protection to the creditor’s committee by enabling it to inform the debtors of any particular employee that it believed failed to cooperate adequately and should therefore be removed from the debtors’ consideration for payment.

The Hearing:

At the January 10, 2006 hearing on the motion, the court found that the respective employees did not fall within the purview of section 503(c), as none of them were "insiders" as defined in 11 U.S.C. § 101(31). Although the employees may have had certain decision making authority prepetition, they did not have any such authority during the bankruptcy. The Court stated:

"[b]ased upon the current status of this debtor which is – or these debtors – which is that they are not operating but are in liquidation mode, I do not believe that they have the type of decision making authority that was addressed by section 503(c), or that there is a basis to assume that they are being offered this KERP because they are insiders. Rather, it’s clear to me they’re offered the KERP because they are productive employees, and more importantly, critical to the efficient administration of the estate and the economical administration of the estate going forward."

Transcript at p. 30. The court further noted that,

"I generally have been reluctant to approve KERP’s even before BAPCPA, but one circumstance in my mind clearly justifies the KERP, and that is where the employees are working themselves out of a job in facilitating an orderly liquidation and that is clearly what’s happening here."

Transcript at p. 30.

Author’s Comment: This case is insightful because it addresses some of the issues raised in Flyi, Inc., supra, that were not ultimately addressed by the court in light of debtors’ and the United States Trustee’s settlement. In Flyi, Inc., the debtors argued in their motion that their compensation program did not conflict with § 503(c) because that section only applies to entities continuing as viable commercial enterprises. As the Flyi, Inc. debtors were in the process of liquidating their estates, they argued that there would be no business remaining, and thus § 503(c) was inapplicable. Although the Flyi, Inc. court never addressed this argument, in finding that § 503(c) was inapplicable, the Refco, Inc. court appeared to rely on that very argument. This ruling is important as it provides a basis for liquidating debtors to avoid application of § 503(c) and an ability to utilize the more lenient business judgment standard set forth in § 363 and described by the court in In re: Nobex, supra.

Additionally, in Flyi, Inc., the debtors noted that if the court found that the program contravened § 503(c) with respect to the participating insiders, they intended to, inter alia, demote such employees so that they were no longer insiders. Although those efforts never occurred in Flyi, Inc., in finding that the respective employees were not insiders within the definition set forth in § 101(31) of the Bankruptcy Code, the Refco, Inc. court noted that although the employees may have had certain decision making authority prepetition, they did not have any such authority during the bankruptcy. This is an important finding as it legitimizes efforts to strip insider status away from a plan participant in order to avoid applicability of § 503(c).

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In re: Musicland Holding Corp., et al., Case No. 06-10064 (Bankr. S.D.N.Y. 2006).
(J. Bernstein)

The Programs: Shrink Plan, Severance Plan, Corporate Management Incentive Plan

The Motion:

On January 12, 2006, the debtors filed a Motion for Order Authorizing, But Not Directing, Debtors to Pay Certain Prepetition Employee Obligations and Related Claims, to Continue Providing Employee Benefits in the Ordinary Course of Business, to Continue and Modify Severance Programs and Incentive Plans, and Granting Related Relief. By the motion, the debtors requested authority to implement or continue the following programs:

Shrink Plan – Prepetition, the debtors initiated a retention and severance program in connection with GOB sales to retain store managers and incentivize them through store closing dates. Under the Shrink Plan, each store manager was eligible to receive a $500 bonus depending on the results of the GOB sales. The debtors estimated the cost of continuing this program to range between $150,000 and $186,000.

Severance – Prepetition, the debtors offered severance benefits to certain employees in the event of involuntary termination. Benefits were determined by years of service and position. The debtors requested authority to continue the program and pay severance obligations to employees terminated post-petition. The debtors estimated that between the petition date and the first week of February (approximately three weeks) severance payments would total approximately $2.2 million to more than 125 employees who had been employed with the debtors between one to 24 years.

Corporate MIP - Shortly before the petition date, the debtors increased base salaries to market competitive levels for approximately 35 employees (less than $480,000 on an aggregate annual basis). The debtors also compensated corporate employees under a Management Incentive Program (MIP) for performance meeting various profitability or operational goals. Under the MIP, if certain target metrics were met, individualized bonuses would be paid based on a percentage of employees’ salaries. The debtors sought to continue and honor any prepetition obligations owed under the Corporate MIP and also sought to enhance the Corporate MIP for 2006 to reward certain officers, directors, and managers that would continue to play a critical role in the debtors’ restructuring.

Modified Corporate MIP – the debtors proposed to pay 25% of the current Corporate MIP 2006 target bonuses. The debtors proposed to create a discretionary pool of $665,000 to be paid in one installment following the close of fiscal year February 28, 2006. The debtors argued that the modified Corporate MIP was critical to properly incentivize eligible employees.

The debtors sought approval of the motion pursuant to §§ 105 and 363 of the Bankruptcy Code and asserted that the payments were in the ordinary course of business pursuant to § 363(c). The debtors asserted that none of the programs resembled a retention program; rather, the debtors merely sought to continue their prepetition practice of rewarding employees’ performance. The debtors asserted that § 503(c) was inapplicable.

The Orders:

By orders dated January 17, 2006, February 1, 2006, February 22, 2006, and March 27, 2006, the court approved the various programs. With respect to the Modified Corporate MIP, the court authorized the debtor to pay $368,144 to 94 employees. The debtors withdrew their request for the remaining $171,138 from the Modified Corporate MIP payable to 5 additional employees.

The Hearing:

At the March 1, 2006 hearing, the court expressed concern as to whether the programs were actually disguised retention plans. In questioning debtors’ counsel as to whether a participant would receive a bonus if they resigned immediately after entry of an order, with a sale occurring a month after, the court noted, "I would think they’d have to stay around. It sure looks like a retention plan to me." Transcript p. 29.

When debtors’ counsel argued that the effect of every performance program is to prevent employees from leaving, the court responded, "not necessarily. Somebody could have done enough on the sale that they’ve earned their money now and they can leave. And if the sale goes forward they get paid. You know, when I read it, it certainly sounded like a retention program to me. Unless you’re telling me that they don’t have to stay around to get the money. And then I question you, why, you know, why would the debtor do that." Transcript p. 30. In response thereto, the debtors’ counsel argued that the plans were performance based. The court, however, made clear that, "I understand that it’s performance-based, but they still have to stay around to get it, don’t they? Debtors’ counsel replied in the affirmative but argued that the Bankruptcy Code does not provide that if one of the impacts of a program is to keep people, or one of the terms is that they are staying, that it is an impermissible retention program. The Court concluded, "well it’s -- it just sounds like a KERP to me. It’s not permissible or impermissible. You just have to satisfy the requirements of the code." Transcript at p. 31.

Author’s Comment: This case presents an important issue that must be considered when seeking approval of an employee compensation program. In In re: Nobex, supra, Judge Walrath appeared to provide debtors with a way to avoid the applicability of § 503(c) by structuring programs as incentive programs, as opposed to retention programs. Incentive programs are by definition performance based. In Musicland Holding Corp., the court raises the issue that performance based programs may nevertheless be retention programs subject to § 503(c). Accordingly, in structuring employee compensation programs, this case makes clear that it is important to understand the interplay between retention based and incentive based programs. As noted above, the inconsistency between the comments made by this court and the holdings in Aphton Corporation and Radnor Holdings Corp., may require further explanation or reconciliation.

The Program: Supplemental Incentive Plan

The Motion:

The debtors also filed, on January 20, 2006, a Motion for Order Approving Debtors’ Supplemental Incentive Plan. By this motion, the debtors sought to implement an incentive plan to further incentivize those employees who the debtors characterized would be working at a "feverish pace." Under this program, five senior management employees would be eligible to receive success payments from a pool of $1 million. A separate pool of $200,000 would be established for additional management employees.

Payments under this supplemental program were to be conditioned upon the earlier to occur of (a) a closing of a sale of substantially all of the debtors’ assets through one or more § 363 sales or GOB sales; and (b) the consummation of a chapter 11 plan of reorganization. Based on the results of the sale or restructuring of the debtors, the portion of the $1 million pool that was allocated to the CEO and CFO would be subject to upward adjustment to the extent agreed to by the Informal Committee of Secured Trade Creditors. The debtors sought approval of this program pursuant to §§ 105 and 363 of the Bankruptcy Code and argued that § 503(c) was inapplicable as the program did not resemble a retention program.

The Order:

On August 11, 2006, the court entered an Order Approving, and Authorizing Payments Under Debtor’s Incentive Plan, approving the Supplemental Incentive Plan and allowing $816,200 of the $26,000,000 proceeds of the secured trade creditor’s collateral to be paid to the respective employees. The secured trade creditor was not entitled to a replacement lien, a § 507(b) claim, or an administrative priority claim.

Author’s Comment: This case provides yet another option when seeking approval of an employee compensation program: tying the program into the cost of a sale. It is not clear whether the fact that the program was funded by the purchaser of the debtors’ assets, as opposed to the estate, affected the applicability of § 503(c).

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In re: Plusfunds Group, Inc., Case No. 06-10402 (Bankr. S.D.N.Y. 2006).
(J. Peck)

The Program: Sale-Related Incentive Plan (SRIP)

The Motion:

On March 27, 2006, the debtor filed a Motion for Order Under 11 U.S.C. §§ 105 and 363 Authorizing Continuation of the Sale-Related Incentive Plan. The debtor sought approval of an incentive plan for six senior officers and managers that the debtor believed were key to the transaction and who were not part of a certain severance plan previously approved by the court for full-time employees.

The debtor was in the process of selling substantially all of its assets and entered into a sale agreement with a stalking horse bidder. Pursuant to the proposed program, the senior managers would share in a bonus pool starting at $300,000, which could increase by 3% of the amount by which the ultimate total gross purchase price reserved from the sale of substantially all of the debtor’s assets exceeded $5,000,000.

The Order:

On April 19, 2006, the court entered an Order Authorizing Sale-Related Incentive Plan, approving the SRIP, pursuant to §§ 105, 363, and 503(c) of the Bankruptcy Code. The order provided that in the event of a successful sale of substantially all of the debtor’s assets as a going concern, the debtor would be authorized to pay the incentive bonuses; provided, however, that no individual payment could exceed $72,220. The court accorded the payments under the SRIP administrative expense priority under §§ 503(b)(1)(A) and 507 (a)(2) of the Bankruptcy Code.

The Hearing:

At the April 18, 2006 hearing, the court had a concern that the program was actually a disguised retention plan. In referring to In re: Nobex, supra, the court noted that, "Judge Walrath approved a plan that … that claim was purely contingent on a successful sale in which the proceeds exceeded the stalking horse’s baseline number and this plan is predicated on timing benchmarks such that as I understand it … As I understand it, there’s a vesting of entitlements purely as a result of the passage of time through the sale process without a demonstration that an individual who is participating in the program has added value and the nature of the value added." Transcript at p. 53. The court further stated, "I would be interested in knowing with particularity the role played by each beneficiary of this plan in the sale process … I would like to know in particular how the individual was critical to the sale which we’re about to approve and to understand … In approving the plan that has been fashioned here I need to be satisfied notwithstanding the fact that you’ve reached an agreement with the UST’s office."

In presenting the program to the court, the debtor advised the court that it had reached a settlement with the United States Trustee to treat the payments as severance payments under § 503(c)(2). Nevertheless, while recognizing that the program could be interpreted as a severance plan, the court ultimately approved the plan pursuant to § 503(c)(3) because it was

designed to retain key employees whose services are critically needed by the debtor in its efforts to stabilize itself pending a sale and to provide reassurances to the investor community … I think a more accurate cubbyhole in which to place this is the broad catchall of 503(c)(3) which allows the Court to approve this kind of a program where the showings made … where the showings made demonstrate that the facts and circumstances of this case justify the approval of such transfers

Transcript at p. 71-72. The court further explained:

I also believe that this broad catchall is consistent with the general provisions of Section 502 which allow the Court to authorize transfers and payments that are actual and necessary expenses and the showings made here … demonstrate that these expense which are in relationship to the severance plan reasonable are also even without regard to the severance plan reasonable in order to achieve the debtor’s business purpose [sic].

Transcript at p. 72.

Author’s Comment: Notwithstanding the debtor’s and the United States Trustee’s agreement to treat the program as a severance program under § 503(c)(2), and the court’s acknowledgement that the program could be interpreted as a severance program, the court approved the program pursuant to § 503(c)(3), the catch-all. The curious and unexplainable part of the court’s ruling is that it found that the plan was a retention plan but did not require satisfaction of § 503(c)(1). This ruling is particularly curious in light of the court’s concern and comments at the hearing.

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In re: Calpine Corporation, et al., Case No. 05-60200 (Bankr. S.D.N.Y. 2005).
(J. Lifland)

The Program: Calpine Incentive Plan

The Motion:

On April 6, 2006, the debtors filed a Motion for an Order Authorizing the Implementation of the Calpine Incentive Program. The debtors claimed that the purpose of the Calpine Incentive Program was to return the overall compensation opportunity for certain of the debtors’ key employees to market competitive levels in order to ensure the continued effective job performance necessary for the debtors’ ongoing business operations and successful reorganization. The motion requested approval of the following programs:

Emergence Incentive Plan (EIP) – this program would provide cash awards, payable only at emergence to selected senior employees in the positions most capable of influencing the success of the debtors’ ongoing business and reorganization efforts. The award level would be tied to value creation. Compensation for eligible employees would increase proportionately to the value created for the debtors and their creditors. There were 20 senior employees eligible for this program, which would begin with an incentive pool of $5.4 million earned for the successful consummation of a plan and a threshold adjusted enterprise value (AEV) of at least $5 billion. There would be an increase of $285,000 for each incremental increase of $100 million to AEV;

Management Incentive Plan – this program was similar to traditional bonus programs utilized by the debtors prepetition. There were 600 eligible employees for this program. Payments would only be made to the extent that performance objectives were achieved. The debtors estimated that if targets were met, the program would cost $23.5 million for 2006;

Supplemental Bonus Plan – this program was designed to address the immediate potential for the loss of key human capital in functions that were critical to the debtors’ ongoing businesses. Persons identified by the debtors as performing critical functions and being at risk of being hired away would be provided with a supplemental cash award. None would be insiders. Payment would be made in two equal installments, the first upon court approval, and the second at year end. The aggregate cost would be $6 million;

Discretionary Bonus Plan – this program would provide a pool in the amount of $500,000 to be created annually, from which individual bonus payments of no more than $25,000 per employee, per year, could be awarded.

The debtors argued that the motion was authorized pursuant to §§ 363(b) and 503(c)(3) of the Bankruptcy Code. The debtors further argued that neither § 503(c)(1) nor (c)(2) were applicable because the programs did not include retention payments to insiders or severance payments of any kind. Even to the extent that payments made pursuant to the EIP would be to insiders, the debtors argued that any such awards would not be retention payments.

The Order:

On May 15, 2006, the Court entered an Order Authorizing the Implementation of the Calpine Incentive Program, pursuant to which the Calpine Incentive Program, including the Emergence Incentive Plan, the Management Incentive Plan, the Supplemental Bonus Plan, and the Discretionary Bonus Plan, were all approved in all respects.

The Hearing:

At the April 26, 2006 hearing, the court addressed the ability of two of the program’s participants to resign and still receive compensation. Specifically, the court stated:

I have one problem, Mr. Cantor before I rule. There is one provision for the CEO and Mr. David, I believe, to receive some compensation if they leave for a good reason. I don’t know what good reason is. It’s a very subjective term that I can anticipate good reason being something very favorable to Mr. May and Mr. David but not favorable to others. It’s very subjective and I don’t know, unless you can define it better, I would have a problem with that because the trigger for the payment for good reason could be a good reason being bad health, that’s one thing. A good reason could be an opportunity to take over General Motors, and that’s another thing.

Transcript at p. 81

Author’s Comment: This case is a good example of the need to keep employee compensation plans clear and objective. Subjective criterion may create problems, especially with respect to a participant’s discretion to resign and continue to receive payments. The court’s concern regarding a participant’s ability to resign while still receiving program payments should be considered in respect of the line of cases distinguishing between retention based plans and incentive based plans. Although the program was approved as an incentive plan, pursuant to § 503(c)(3), the court nevertheless had concern regarding the lack of required retention of certain participants.

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In re: Portrait Corporation of America, Inc., et al., Case No. 06-22541 (Bankr. S.D.N.Y. 2006).
(J. Hardin)

The Program: Employment Agreement

The Motion:

On August 31, 2006, the debtors filed their Motion for an Order Pursuant to Section 365 of the Bankruptcy Code Authorizing the Debtors to Assume Certain Prepetition Employment Agreements. By the motion, the debtors sought entry of an order pursuant to § 365 of the Bankruptcy Code authorizing the debtors to assume employment agreements entered into prepetition with certain key employees, who were officers of the company. Under the agreements, all of the respective employees were entitled to termination payments of amounts equal to up to 100% of their salaries. While some of the agreements were entered into years before the petition date, others were entered into on the eve of the bankruptcy filing.

The Order:

On September 27, 2006, the court entered an Order Pursuant to Section 365 of the Bankruptcy Code Authorizing the Debtors to Assume Certain Prepetition Employment Agreements, authorizing the debtors to assume the agreements as of the date of the order.

Author’s Comment: This case is noteworthy in that it provides yet another alternative in avoiding the application of § 503(c). By executing an employment agreement prior to the bankruptcy filing (even on the eve of bankruptcy), this case exemplifies a debtor’s ability to provide the same relief that would otherwise be in a retention/incentive program, so long as the debtor satisfies § 365 of the Bankruptcy Code and the assumption of the agreement is within the debtor’s business judgment. In this case, the assumed employment agreements provided termination payments to officers that would otherwise have been deemed severance payments subject to § 503(c)(2).

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In re: Dana Corporation, et al. Case No. 06-10354 (Bankr. S.D.N.Y. 2006).
(J. Lifland)

The Program: Employment Agreements

The Motion:

On June 29, 2006, the debtors filed a Motion of Debtor Dana Corporation, Pursuant to Sections 363, 365 and 105 of the Bankruptcy Code, for an Order Authorizing Dana Corporation to (A) Enter Into Employment Agreements with Michael J. Burns, Its President and Chief Executive Officer, and Five Key Executives of His Core Management Team, and (B) Assume Certain Change of Control Agreements, As Amended (as subsequently supplemented). By the motion, the debtors sought an order pursuant to §§ 363(b), 365 and 105(a) to enter into employment agreements with their president and CEO and five other executives, and assume certain change of control agreements with three of the executives.

Pursuant to the proposed employment agreements, the base salaries ranged from $500,000 to $1,552,500. The CEO and the executives would also be eligible to participate in an annual incentive plan (AIP), which was conditioned upon debtors’ short-term financial performance, the size of which would depend on whether the debtors met threshold target or superior performance goals. The 2006 AIP bonuses ranged from $336,000 to $2,070,000 and the 2007 amounts would be determined by the debtors’ board of directors, in consultation with creditors’ committee.

The CEO and the executives would also be eligible to participate in a completion bonus, which was comprised of two components. The first component was fixed, and awarded without regard to performance or creditor recovery, payable in cash on the effective date of a plan of reorganization, if such participants remained in the debtors’ employ. The first component ranged from $400,000 to $3,100,000. The second component was uncapped, and variable, based on the debtors’ total enterprise value six months after the effective date. Originally, the form of payment for this component was cash; however, under the debtors’ supplement to the motion, any amount in excess of the minimum completion bonus would be payable in common stock of the reorganized debtors, as long as the stock was listed and readily tradable or subject to repurchase by the reorganized debtors, if the participants were not employed by the reorganized debtors after the effective date. Otherwise, the amounts would be payable in cash.

The CEO was also eligible to receive severance payments. If he was terminated without cause or resigned for a good reason, or if he failed to complete a replacement employment agreement, he would execute an eighteen month non-compete agreement in exchange for payments of $166,666.67 per month. Furthermore, he would be eligible to receive a pro rata payout of his completion bonus if the business plan was completed, but the effective date had not yet occurred. If the effective date had occurred, he would receive his full completion bonus.

Finally, the debtors proposed to assume the CEO’s senior retirement programs under § 365 of the Bankruptcy Code. If assumed, the CEO would receive a administrative claim against the estate in the amount of $6 million.

The Order:

On September 5, 2006, the court issued its Extract of Bench Ruling Denying Motion of Dana Corporation for an Order Authorizing Dana to Enter into Employment Agreements with its President and Chief Executive Officer and Five Key Executives of His Core Management Team. In its ruling, the court stated that the basic issue of the case was "is this a ‘pay to stay’ compensation plan (also known as a Key Employee Retention Program or KERP) subject to the limitations of Section 503(c), or can it be construed to be an incentivizing ‘Produce Value for Pay’ plan to be scrutinized through the business judgment lens of Section 363."

In examining the proposed programs at issue, the court noted that the completion bonus included an amount payable to the participants upon the debtors’ emergence from chapter 11, regardless of the outcome of the cases. The court held that "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. Using a familiar fowl analogy, this compensation scheme walks, talks and is a retention bonus."

With respect to the severance bonuses, the court found that the "debtors try to circumvent the requirements of § 503(c)(2) by characterizing the amounts being paid to the executives upon involuntary dismissal or resigning for good cause as payments in exchange for non-compete agreements … The Debtors have failed here to meet their burden of demonstrating that the payments in exchange for signing a non-compete agreement and other payments do not constitute ‘severance’ for purposes of § 503(c)(2), or that the evidentiary requirements have been satisfied."

The court did note, however, that contrary to the contentions of several of the objectors, that the language of § 503(c)(3) does not prevent the court from considering a program using the business judgment rule. "While it may be possible to formulate a compensation package that passes muster under the § 363 business judgment rule or § 503(c) limitations, or both, this set of packages does neither. In so holding, I do not find that incentivizing plans which may have some components that arguably have a retentive effect, necessarily violate §503(c)’s requirements."

The Hearing:

At the September 5, 2006 hearing, debtors’ counsel argued that the program was tied to incentive benchmarks and that § 502(c)(1) did not apply. In response, the court stated:

I take it then that you agree that the incentives per se is [sic] not condemned or limited under 503, but your main argument, among other things, is that the metrics that have come out of two opposing camps are improper to be utilized for purposes of incentives … And to the extent you make that observation, I also observe that those metrics come our of [sic] parochial interests on both sides of the equation, and perhaps in some future program should be discarded completely as not giving any kind of real barometer of an incentive program for compensation … It’s clear to me that the metrics that have been put on the table on both sides are born of parochial interests, and I don’t know that that should be the driving mechanism.

Transcript at p. 36

Author’s Comment: In respect of the ongoing distinction between retention based programs and incentive based programs, the court’s holding that "incentivizing plans which may have some components that arguably have a retentive effect, necessarily violate §503(c)’s requirements," is noteworthy. It is not clear, however, whether the court was referring to § 503(c)(1) or § 503(c) in general. The court did, however, clearly identify the distinction between the two types of programs when it stated that the basic issue of the case was whether it was a "pay to stay"’ compensation plan (also known as a Key Employee Retention Program or KERP) subject to the limitations of Section 503(c), or an incentivizing "Produce Value for Pay" plan to be scrutinized through the business judgment lens of Section 363.

The Motion:

Following the court’s entry of the September 5, 2006 order denying the motion, the debtor re-commenced negotiations with parties-in-interest in an attempt to garner approval of a modified employee compensation program. In respect thereof, on November 6, 2006, the debtors filed a Motion of Debtor Dana Corporation, Pursuant to Sections 105, 363, 365, 502 and 503 of the Bankruptcy Code, for an Order, (A) Authorizing Assumption of Employment Agreements, as Modified, (B) Approving Long-Term Incentive Plan and (C) Granting Related Relief.2 In addition to base salary and an annual incentive plan, the motion sought approval of the following terms:

Pension Benefits – the debtors sought to assume 100% of the executives’ pension plans (ranging between $999,000 and $2.7 million) and 60% of the CEO’s pension plan (60% of 5.9 million) with the remaining 40% being allowed as a general unsecured claim.

Severance – the debtors sought authority to pay severance to the executives, should the need arise, in an amount that complies with § 502(c)(2). To quell the fears of objecting parties, the debtors agreed to submit a statement detailing the calculation, allowing sufficient notice of such proposed payments.

Non-Disclosure Agreement and Pre-Emergence or Post-Emergence Claim – in consideration for the assumption of the employment agreements and receipt of payments under the long term performance based incentive plan (LTIP), the CEO and the executives would execute new non-compete, non-solicitation, non-disclosure and non-disparagement agreements. In the event that the CEO was terminated prior to the debtors’ emergence from chapter 11, he would receive a pre-emergence claim, in the form of a general unsecured claim, in the amount of $4 million (with recovery limited to $3 million, less any severance actually paid). In the event of a post-emergence termination, a claim of $3 million would be paid ratably.

LTIP – under the LTIP, the executives would be eligible for a long-term incentive bonus if the company reached a certain EBITDAR. The amount of the incentive payment would increase if additional, higher EBITDAR benchmarks were reached. In order for the CEO to qualify for the minimum amount of the LTIP ($3 million), the company needed to achieve a 2007 EBITDAR of $250 million. The CEO would earn an additional $750,000 for each $100 million increase in EBITDAR, with a maximum payout of $4.5 million for 2007.

The debtors contended that the compensation provided was necessary and appropriate, and represented a reasonable exercise of the debtors’ business judgment pursuant to §§ 363, 365, and 502 of the Bankruptcy Code, and was permissible under § 503(c) of the Bankruptcy Code.

The Orders:

On November 30, 2006, the court issued its Memorandum Opinion Approving, in Part, Debtors’ Motion for Authorization to Assume Employment Agreements, for Approval of a Long Term Incentive Plan and Related Relief. In respect of its prior denial of the debtor’s proposed program and its distinction between retention based programs and incentive based programs, the court noted that "[r]ecognizing the potential limitations of section 503(c) of the Bankruptcy Code as it applies to those employee retention provisions that are essentially ‘pay to stay’ key employee retention programs (‘KERPS’), yet viewing compensation packages holistically, a true incentive plan may not be constrained by 503(c) limitations." Id.

In respect of the objecting parties’ argument that the proposed pension benefits were retentive in nature, the court noted that "to the extent these conditions have any retentive impact, it is merely incidental to the terms of the pension plans and are ordinary and customary in such plans." The court found that the pension benefits were not retentive in nature and were not severance payments and their assumption was subject to the debtors’ business judgment.

The objecting parties also contended that the pre-emergence claim and post-emergence claim violated § 503(c). In respect of the pre-emergence claim, the court noted that it was a general unsecured claim and § 503(c) only limits the allowance and payment of administrative claims. With respect to the post-emergence claim, the court noted that it could not guarantee that payment of the such claim would ultimately be approved.

Ultimately, the court held that the LTIP was not a KERP, but was "a program designed to incentivze the CEO and Senior Executives, and may be assumed by the Debtors if it is fair and reasonable exercise of business judgment." However, the court found that the program could result in a windfall and conditioned approval of the plan upon the debtor placing a yearly ceiling on each participant

After the debtor negotiated proper ceilings on the program, on December 18, 2006, the Court entered an Order, Pursuant to Sections 105, 363, 365, 502 and 503 of the Bankruptcy Code (A) Authorizing Assumption of Employment Agreements, as Modified, (B) Approving Long-Term Incentive Plan and (C) Granting Related Relief, which implemented the memorandum opinion and the ceilings agreed to by the parties. On December 28, 2006, the objecting parties noted their appeal of this order. The appeal is presently pending before the United States District Court for the Southern District of New York.

Author’s Comment: In furtherance to the distinction between incentive based programs and retention based programs, it is noteworthy that the court approved the program at issue as an incentive based program, notwithstanding the retentive effect that the program had.

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CONCLUSION

The cases studied herein exemplify the departure from retention based compensation programs in favor of incentive based programs. However, as the cases indicate, the distinction between the two types of programs is not very clear and may require further review. The extent to which an incentive based program may have a retentive affect, without requiring application of § 503(c)(1) is the key issue. Until that issue is confronted, debtors seeking approval of compensation programs for insiders have their options.

Footnotes

1 See In re: Musicland Holding Corp., et al., infra, in which Judge Bernstein, notes that an incentive based program which calls for the participants’ continued retention, may be subject to the purview of § 503(c)(1).

2 Following the entry of this order, the debtors also filed their Motion of Debtor Dana Corporation for Clarification and Reconsideration, Pursuant to Rules 9023 and 9024 of the Federal Rules of Bankruptcy Procedure, of Order Denying Executive Compensation Motion, which was subsequently deemed moot by the court.

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