KERP Or KEIP: Fireworks Continue On Keeping Key Employees At The Helm In Chapter 11

Changes made to the Bankruptcy Code in 2005 raised the bar considerably for providing "pay to stay" incentives that had been offered routinely to management and other key employees of a chapter 11 debtor, such as a severance or key employee retention plan ("KERP"). Sections 503(c)(1) and 503(c)(2) now place strict limitations on severance and KERP payments to "insiders." In addition, section 503(c)(3) of the Bankruptcy Code mandates that transfers or obligations outside the ordinary course of business to any person or entity, including officers, managers, or consultants hired post-petition, be "justified by the facts and circumstances of the case."

Several notable court rulings have been handed down already in 2012 concerning the propriety under section 503(c) of—or the application of that subsection to—payments to key employees. Many of these decisions concern the increasing frequency with which chapter 11 debtors have characterized proposed payments to personnel as a key employee incentive program ("KEIP") rather than a KERP. Bankruptcy courts, U.S. Trustee watchdogs, and creditor groups have collectively cast a critical eye on these efforts to ensure that payments to key employees do not run afoul of the purpose underlying section 503(c). Other issues that have recently come under scrutiny include the criteria applied under section 503(c)(3) to proposed payments and, further peeling back the onion, whether all KERPs or KEIPs proposed by a chapter 11 debtor are even subject to section 503(c). The latter was addressed by a Delaware bankruptcy court in In re Blitz U.S.A., Inc., 475 B.R. 209 (Bankr. D. Del. 2012).

LIMITATIONS ON PAYMENTS TO KEY EMPLOYEES

Section 503(c) was intended to limit the scope of KERPs and similar plans designed to induce management personnel to remain with a company during its bankruptcy case. Prior to the 2005 amendments, key personnel were frequently given bonuses in addition to their regular compensation as part of a KERP, with the resulting obligations treated as administrative-expense priority claims under section 503 of the Bankruptcy Code.

Section 503(c) limits the allowance and payment of such administrative-expense claims, reflecting in part the growing disfavor of giving what some characterized as preferential treatment to a debtor's "insiders" (including, among others, directors, officers, and other controlling individuals or entities) at the expense of the bankruptcy estate. It provides that, notwithstanding the general rule stated in section 503(b) regarding the allowance of administrative expenses:

there shall neither be allowed, nor paid—

a transfer made to, or an obligation incurred for the benefit of, an insider of the debtor for the purpose of inducing such person to remain with the debtor's business, absent a finding by the court based on evidence in the record that— the transfer or obligation is essential to retention of the person because the individual has a bona fide job offer from another business at the same or greater rate of compensation; the services provided by the person are essential to the survival of the business; and either— the amount of the transfer made to, or obligation incurred for the benefit of, the person is not greater than an amount equal to 10 times the amount of the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose during the calendar year in which the transfer is made or the obligation is incurred; or if no such similar transfers were made to, or obligations were incurred for the benefit of, such nonmanagement employees during such calendar year, the amount of the transfer or obligation is not greater than an amount equal to 25 percent of the amount of any similar transfer or obligation made to or incurred for the benefit of such insider for any purpose during the calendar year before the year in which such transfer is made or obligation is incurred; a severance payment to an insider of the debtor, unless— the payment is...