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Bankruptcy Courts Continue to Approve Performance-Based Bonuses for Executives of Companies in Chapter 11

(August 2007, Bankruptcy Bulletin)

Edward E. Neiger

A critical consideration at the outset of most chapter 11 cases is the retention of key employees. Certain recent amendments to the Bankruptcy Code, enacted by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, directly impact employee benefits and executive compensation, and specifically, impact a company’s ability to award its executives lucrative bonuses.

Section 503(c)(1) of the Bankruptcy Code places considerable limits on retention bonuses by providing that retention bonuses may not be paid unless (i) the payment is essential to retaining an employee because that person has a “bona fide job offer from another business” with equal or greater compensation and (ii) the services provided by that person are “essential to the survival of the business.” Section 503(c)(1) also places caps on the amounts of such bonuses. It limits retention bonuses to an amount equal to ten times the amount of similar payments given to nonmanagement employees for any purpose (during the year in which such payment is made) or if no such similar payments were made during the year, the amount of the retention bonus cannot be greater than an amount equal to twenty-five percent of the amount of any similar payments made to such insider for any purpose during the year preceding the year in which the payment is made. Finally, section 503(c)(3) prohibits payments to management or consultants that are made outside the ordinary course of business absent justification by the facts and circumstances of the case.

The purpose behind such restrictions, as one court explained, is to “eradicate the notion that executives were entitled to bonuses simply for staying with the Company through the bankruptcy process.” With this view generally in mind, bankruptcy courts have continued to give much deference to the business judgment of companies in chapter 11 with respect to approving bonus plans for their executives. Below is a summary of recent cases dealing with issues relating to executive compensation, and in many of the cases, the bankruptcy court allowed debtors to reward their executives with bonuses and other compensation, often over the objection of other interested parties.

In re Calpine Corp.

Calpine Corp. filed for bankruptcy protection in the United States Bankruptcy Court for the Southern District of New York on December 20, 2005. Soon after, Calpine proposed two separate compensation packages, one for certain insiders and other key employees and the other for its chief executive officer, chief financial officer/chief restructuring officer, and a key executive vice president. The first compensation package was comprised of an “Emergence Incentive Plan” (granting bonuses based on a valuation of the company upon successful emergence), a “Management Incentive Plan” (granting bonuses for completion of management goals), a “Supplemental Bonus Plan” (providing retention bonuses for non-insiders), and a “Discretionary Bonus Plan” (providing bonuses from a limited pool of money to be paid out at the CEO’s discretion). The second compensation package called for:
  • an annual cash performance bonus for the chief executive officer, chief financial officer/chief restructuring officer and the executive vice president so long as they remain employed by the company on the last day of the applicable fiscal year, with the amount of the bonuses set by the board and/or the chief executive officer (for the executive vice president);
  • a “Base Emergence Incentive Payment” for the chief executive officer and the chief financial officer/chief restructuring officer payable upon effectiveness of a confirmed plan of reorganization;
  • an “Additional Emergence Incentive Payment” for the chief executive officer and the chief financial officer/chief restructuring officer based on the achievement of a certain adjusted enterprise value (total enterprise value less project debt); and
  • an additional potential emergence incentive (up to $4 million for the chief executive officer and $1.3 million for the chief financial officer/chief restructuring officer), payable at the sole discretion of the creditors’ committee.

The proposals drew objections from several interested parties, which argued, among other things, that the proposed awards were retention payments designed to induce the continued employment of the recipients and were not performance-based incentive payments. In response to these objections, Calpine adjusted the first compensation package (the performance metric that was to be used to calculate the Emergence Incentive Plan was modified to incorporate the post-emergence market value of Calpine’s securities, making it more objective). Calpine also modified the second compensation package significantly by eliminating the Additional Emergence Incentive Payment and modifying the method of calculating adjusted enterprise value to make it a more objective measure of value by incorporating the post-emergence market value of Calpine debt and equity securities distributed as part of a plan of reorganization.

As a result of these modifications, the court approved the compensation plans and found that the proposed plans were not retention-based, and therefore, did not need to comply with section 503(c)(1).

In re Musicland Holding Corp.

Musicland Holding Corp. filed for bankruptcy protection in the United States Bankruptcy Court for the Southern District of New York on January 12, 2006. Soon after, Musicland filed a motion for the approval of a management incentive plan, which proposed payment of over $1 million in bonuses to several high-level executives for successfully winding down Musicland’s businesses or selling substantially all of its assets. The proposed bonuses would be based upon the company’s performance (measured by EBITDA) with annual target payouts of 8.5% to 50% of the executives’ salaries. Musicland contended that section 503(c)(1) was inapplicable because the proposed plan was designed to motivate personnel to maximize value, not to induce insiders to remain in the company’s employ, and that section 503(c)(3) was inapplicable because the proposed bonus payments were being made in the ordinary course of business.

The creditors’ committee objected to the proposed plan, arguing that it was not in compliance with section 503(c) because the plan’s payments were conditioned only upon either the closing of the sale or consummation of the plan, and thus, the plan only motivated management to consummate a deal as quickly as possible, not to maximize value. Ultimately, the creditors’ committee agreed to withdraw its objection after the company reduced the bonus amounts to less than $1 million (due to the departure of certain management employees who received severance payments in lieu of incentive payments) and the secured trade committee agreed to pay the incentive bonus payments out of its collateral proceeds, thereby eliminating any impact such payments would have on general unsecured creditors. The bankruptcy court approved the incentive plan, as modified.

In re Nellson Nutraceutical, Inc.

Nellson Nutraceutical, a manufacturer of nutritional bars and powders, filed for bankruptcy protection on January 28, 2006 in the United States Bankruptcy Court for the District of Delaware. Nellson had in place an Ordinary Course Employee Bonus Compensation Program, which set aside $2.1 million to be awarded to employees, including management level officers, operational directors, and managers, who achieved high levels of sales. Specifically, employees who achieved their targeted EBIDTA for the year 2006 would receive bonuses of up to 50% of their base salary. No bonuses were paid, however, because targeted EBIDTA for 2006 was not achieved. In January 2007, Nellson adopted modifications to the plan, which lowered the bonus targets, allowing all eligible employees under the plan to receive bonuses, and requested that the bankruptcy court approve the modifications. The United States Trustee opposed the approval request, arguing that although the plan was said to be based on achievement, employees would receive the bonuses even if targets were not achieved, and thus, the plan was, in essence, a retention plan not an incentive plan.

In May 2007, the court approved the modified plan over the United States Trustee’s objections. In approving the modified plan, the bankruptcy court took a more holistic view and accepted the rationale of setting aspirational goals and rewarding hard work even if, in the end, those goals were not reached. The court also took note of the fact that during the three years prior to 2006, the debtor had a similar incentive program, and thus, the court concluded that the modifications were made in the ordinary course of business. The court held that the modified plan was in the ordinary course of business from a “horizontal” perspective, because comparable companies have adopted similar plans, and from a “vertical” perspective, because Nellson had made similar prepetition reductions in bonus targets in previous years. The court concluded that as long as a proposed bonus plan represents “a business judgment made in good faith upon a reasonable basis and within the scope of authority under the Bankruptcy Code,” it would not disturb the business decision.

The court explained that for purposes of determining whether the goal of a plan is retentive in nature under Bankruptcy Code section 503(c)(1), courts must apply a “materiality” standard because all bonus payments will have, at a minimum, some incidental retentive purposes. The court quoted the court in In re Dana Corp., which stated that “merely because a plan has some retentive effect does not mean that the plan overall, is retentive rather than incentivizing in nature.” Following this reasoning, the court in Nellson concluded that despite the modified plan’s retentive qualities, retention was not its primary purpose, and consequently, the restrictions of section 503(c)(1) did not apply.

In re Dana Corp.

Dana Corp. filed for bankruptcy protection in the United States Bankruptcy Court for the Southern District of New York on March 3, 2006. Dana and its affiliated debtors sought authority to enter into employment agreements with their chief executive officer and five key executives, which provided the executives with their prepetition annual salaries, their regular annual bonus, and a long-term bonus. The long-term bonus would be awarded in two parts: (1) a flat bonus for remaining in the debtors’ employ as of the effective date of a plan of reorganization and (2) a variable component based on the total enterprise value of the debtors six months after the effective date of the debtors’ plan of reorganization.

Dana argued, among other things, that the contemplated bonuses were incentive-based because they were tied to the company’s emergence from bankruptcy and were scaled against a valuation of the company post-emergence. The company also contended that it needed assurance that its executive team would remain in place to work through a “difficult and demanding restructuring effort and that [the] management team will be sufficiently protected so that members can dedicate themselves to the objectives of maximizing values for all of the Debtor’s competing constituents without distraction from the imminent risk to their futures.”

The objecting parties, which included the creditors’ committee and the United States Trustee, argued that the bonuses were not incentive-based because the performance bar was set so low that to be entitled to their compensation, the executives did not have to do anything other than wait for confirmation.

The court denied Dana’s motion, reasoning that the compensation scheme was designed primarily to retain executives and not to reward performance, that it was subject to the requirements of section 503(c), and that to the extent a compensation arrangement falls within subsection (c)(1) or (c)(2), the business judgment rule attendant to non-ordinary course transactions under section 363 does not apply “irrespective of whether a sound business purpose may actually exist.” Judge Lifland colorfully reasoned that “if it walks like a duck (KERP) and quacks like a duck (KERP), it’s a duck (KERP).”

On November 6, 2006, with the support of the creditors’ committee and after extensive discussions with the parties that had objected to the first executive compensation motion, Dana filed a revised motion for authority to assume prepetition employment agreements with its chief executive officer and certain senior executives. Assumption would take place upon emergence from bankruptcy or the senior executives’ involuntary termination without cause, and with respect to the chief executive officer, voluntary termination for good reason. The revised motion also sought approval of a long-term performance-based incentive plan for the company’s chief executive officer and five senior executives and approval of an annual incentive plan. Under the revised plan, if all EBITDAR goals were reached, over a three-year period, the long-term incentive plan would provide for an $11 million payment in total to six executives: $5 million in cash and the remainder in stock. In consideration for the assumption of the employment agreements, the senior executives and the chief executive officer agreed to execute noncompete, nonsolicitation, and nondisclosure agreements.

Dana contended that the revised executive compensation motion was necessary and appropriate and represented a reasonable exercise of business judgment, and thus, was permissible under section 503(c). The company pointed out that the long-term performance-based portion of the plan was tied to the achievement of certain levels of EBITDAR that represented significant operational improvements to the status quo.

On November 30, 2006, the bankruptcy court approved the long-term incentive component of the plan, subject to an annual cap on the total compensation to be earned by the executives. In its opinion, the court stated that “generally, courts take a holistic view of and measure acceptability of compensation packages through the prism of several factors including: - whether the amount of cost or expense is reasonable and in the best interest of the estate; - whether the services to be provided are likely to enhance a successful reorganization or liquidation of the debtor; - whether the debtor exercised appropriate business judgment in implementing any application for continuing, resuming, or retaining the executive.” The court also noted that “a true incentive plan may not be constrained by 503(c) limitations . . . . [M]erely because a plan has some retentive effect does not mean that the plan, overall, is retentive rather than incentivizing, in nature.”

In re Dura Automotive Systems, Inc.

Dura Automotive Systems, Inc. filed for bankruptcy protection on October 30, 2006 in the United States Bankruptcy Court for the District of Delaware. In February of 2007, Dura proposed a bonus plan that would award its top executives up to $7 million. The plan was tied to the executives’ success in outsourcing the jobs of 2,000 of Dura’s employees to sites outside the United States. Dura also stated that the bonus plan was needed to keep the company’s salaries competitive.

The United Auto Workers opposed the plan, arguing that the plan would harm workers and exacerbate economic instability. According to the UAW, it was improper to implement a bonus plan that would result in job loss rather than job retention. The United States Trustee also opposed the plan on the grounds that it did not provide enough information about how Dura would allocate the bonus money. In response to pressure from the UAW and the United States Trustee, Dura agreed to request a reduced bonus amount and deferred seeking approval of a portion of the bonus to a later date, and the court approved the plan.

On May 8, 2007, the court again approved approximately $2 million to be distributed to executives as bonuses after Dura and the creditors’ committee agreed that certain amounts would be withheld until the executives achieved certain benchmarks. On June 28, 2007, the court approved a $1.3 million bonus plan for seven of Dura’s top employees as an incentive for them to sell one of Dura’s product units. Dura argued that the bonuses were meant to motivate managers to procure the best sale price. Under the plan, each manager was to receive up to 50% above his or her annual base salary when the sale closed.

In re Global Home Products, LLC

Global Home Products, LLC filed for chapter 11 protection on April 10, 2006 in the United States Bankruptcy Court for the District of Delaware. On March 6, 2007, the bankruptcy court approved Global’s two incentive plans: the Management Plan and the Sales Bonus Plan. The Management Plan called for senior management to receive quarterly incentive payments upon achieving earnings and cash flow objectives at the end of specified periods. The total amount that Global would distribute under this plan was $2.7 million. Under the Sales Bonus Plan, specifically intended for sales managers, the managers would receive up to 30% of their annual salaries based on the annual percentage increase of annual sales for their division calculated at the end of the 2007 fiscal year over the prior year and a 15% target bonus percentage payment, governed by the same terms and conditions as the Management Plan.

The United Steel, Paper and Forestry, Rubber, Manufacturing, Energy, Allied Industrial and Service Workers International Union objected to both plans. The union argued that the plans ran afoul of section 503(c)(1) because despite their label as “incentive” plans, they were actually retention plans. The union further objected because Global sought approval of the bonus plans at the same time it requested concessions from employees and retirees, which the union represented.

The bankruptcy court approved the bonus plans, explaining that section 503(c) “was not intended to foreclose a chapter 11 debtor from reasonably compensating employees, including insiders, for their contribution to the debtors’ reorganization.” The court did not delve into whether the employees covered by the plan were “insiders,” because “the Plans are not governed by § 503 and the determination is not relevant to the holding.” The court also stated that the plans complied with the business judgment standard of section 363 because the same or similar plans were in place prepetition.

In re New Century Financial Corp.

New Century Financial Corp. filed for chapter 11 protection on April 2, 2007 in the United States Bankruptcy Court for the District of Delaware. On April 11, 2007, in anticipation of selling off its assets, New Century filed an emergency motion with the bankruptcy court requesting approval of an Executive Incentive Plan (“EIP”) and a Key Employee Incentive Retention Plan (“KEIRP”). Under the EIP, certain employees, including the CEO and seven individuals from the executive management team, would receive up to 90% of their annual base salaries after each asset sale closed. New Century argued that the bonus plan was essential to keeping senior management motivated throughout the sale process, and as such, the EIP was not a retention plan under section 503(c)(1). New Century asserted that the EIP, unlike a retention plan, directly tied management’s compensation to success in completing asset sales and that the EIP did not provide management with any form of compensation if their employment with New Century was discontinued.

The KEIRP provided bonuses to key employees for remaining with New Century as the company worked toward completing its asset sales. The KEIRP divided employees under the plan into five tiers, and depending on the tier, would pay out incentive payments of up to 45% of the employee’s base salary. New Century argued that KEIRP was important to retain key employees because at least one pending asset sale required a certain number of employees. New Century also argued that retaining the employees under the KEIRP was important because those individuals possessed a great deal of knowledge about the company. It argued that section 503(c)(1) did not apply to the KEIRP because section 503(c)(1) only applies to insiders, and the employees under the KEIRP were not insiders. The United States Trustee objected to the KEIRP, arguing that some of the individuals under the KEIRP were, in fact, insiders because they were designated as “officers” under the company’s by-laws, and that the KEIRP was outside the “ordinary” course of business. The bankruptcy court convened a hearing on the issue, and on May 29, 2007, entered an order approving the EIP and KEIRP, over all objections.


Although the limitations of section 503(c) on insider executive compensation have not precluded significant bonuses for executives of chapter 11 debtors, bankruptcy courts have exercised greater scrutiny over the terms and amounts of such bonuses. Specifically, the bonus plans approved have been performance-based rather than purely retentive. Once a debtor shows that the plan is performance-based, bankruptcy courts, for the most part, have given considerable deference to the business judgment of companies in chapter 11 with respect to approving the proposed bonuses.

In re Calpine Corp., No. 05-60200 (BRL) (Bankr. S.D.N.Y. May 15, 2006).

In re Musicland Holding Corp., No. 06-10064 (SMB) (Bankr. S.D.N.Y. Aug. 11, 2006).

In re Nellson Nutraceutical, Inc., No. 06-10072 (CSS), 2007 WL 1502169 (Bankr. D. Del. May 24, 2007).

In re Dana Corp., 358 B.R. 567 (Bankr. S.D.N.Y. 2006).

In re Dura Auto. Sys., Inc., No. 06-11202 (KJC) (Bankr. D. Del. May 8, 2007).

In re Dura Auto. Sys., Inc., No. 06-11202 (KJC) (Bankr. D. Del. June 28, 2007).

In re Global Home Prods., LLC., No. 06-10340 (KG), 2007 WL 689747 (Bankr. D. Del. Mar. 6, 2007).

In re New Century TRS Holdings, Inc., No. 07-10416 (KJC) (Bankr. D. Del. May 29, 2007).
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