Bankruptcy Code Changes Affecting Compensation: Can You Keep What You Have, and Will They Pay You What They Promised?

May 31, 2007Cole Schotz Docket

People who receive bonuses or severance packages pursuant to employment agreements do not customarily view themselves as potential law suit targets.  However, recent changes to the Bankruptcy Code that generally took effect last October 17 (with some exceptions) may change that.  Under a new subsection regarding fraudulent transfers and obligations, if a company makes a payment or incurs an obligation to or for the benefit of an “insider” pursuant to an employment contract and not in the ordinary course of business within one year before the company files for bankruptcy, the payment or the obligation becomes avoidable whether or not the company was insolvent at the time, or was made with actual intent to hinder, delay or defraud any creditor.

Two key points here are whether the person is an “insider” and if the transaction was in the ordinary course of business.  If the individual is a director, officer, person in control of the debtor, or is a relative of: the debtor’s general partner, director, officer or person in control of the debtor, that person is an “insider”.  One key benchmark to determine if the transaction was in the “ordinary course of business” is whether the contract and the transaction being challenged were both routine and did not place an unusual burden on the company.

Another important change to the fraudulent transfers and obligations section is that the so-called one (1) year before bankruptcy “reachback” period will be two (2) years, effective for bankruptcy cases filed on or after April 21, 2006.  The reachback period will stay one (1) year for all cases filed before then.

Other new language in this same section explicitly includes transfers or obligations made to or incurred for the benefit of an insider under an employment contract as being avoidable if they were made or incurred with actual intent to hinder, delay or defraud any creditor, or if the debtor received less than a reasonably equivalent value in exchange and was insolvent or became insolvent as a result of the transaction.  This invites arguments that the size of a payment or obligation incurred to or for an insider under an employment contract was excessive, perhaps making it easier to recover routine bonus payments if the company files for bankruptcy within two years thereafter.

Companies operating in Chapter 11 must often place heavy demands on their employees during a critical and very stressful period.  Companies often propose Key Employee Retention Programs to provide financial incentives to keep these employees on board, but perceived abuses led to new limits on these programs.  Companies who file for bankruptcy after October 17, 2005 cannot make payments to or incur obligations for the benefit of insiders to induce them to remain employed unless the court finds that it is essential to retaining this person because they have a bona fide job offer from another business at the same or a greater rate of compensation, the person provides services that are essential to survival of the business, and the amount to be paid (or obligation incurred) does not exceed ten times the amount of a similar transfer to a non-management employee during the calendar year of the proposed transfer.  If no such similar transfers (or obligations) were made or incurred to non-management personnel during the calendar year, then it may not exceed 25 times the amount of any similar transfer to that insider for any purpose in the calendar year before the year in which the transfer is proposed.

Severance payments to insiders are also limited.  They must be part of a program that is generally applicable to all full-time employees and the amount paid may not exceed ten times the mean severance pay given to non-management employees during the calendar year in which the payment is made. 

Under the new subsection, payments or transfers that are outside the ordinary course of business and not justified by the facts and circumstances of the case, including transfers to or obligations incurred for the benefit of officers, managers, or consultants hired after a bankruptcy petition is filed are also prohibited.  This prohibition is not absolute.  For example, on January 20, 2006, a Delaware bankruptcy judge entered an order authorizing payment of sale-related incentive pay to the debtor’s senior management with the consent of the Creditors’ Committee. The court specifically found that the proposed incentive plan was not a retention bonus or severance pay, and that it was designed to encourage two people with unique experience and skill to work above and beyond their normal fiduciary duties.  The court was satisfied that this was an appropriate exercise of the debtor’s business judgment, a routine issue in deciding bankruptcy sale motions.  These provisions are likely to continue to be tested in the future as debtors and creditors try to maximize the returns available from the assets of bankruptcy estates.


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