Restructuring

Key Employee Retention Plans (KERPs) and Key Employee Incentive Plans (KEIPs) are often the subject of intense interest, either because a distressed company’s management is focused on developing such programs to retain valuable talent during a time of great uncertainty within its organization or because certain creditor constituencies or parties in interest take issue with the payments a company intends to make under the programs.  The debtor’s experience in In re American Eagle Energy Corporation was no different.  There, the U.S. Trustee and a secured creditor objected to the debtor’s proposed KEIP, arguing it was a disguised, prohibited KERP.  The Bankruptcy Court for the District of Colorado, however, found otherwise and approved the plan. 
KERPs are programs designed to retain a select group of employees and typically incorporate the payment of a fixed lump sum, either on a one-time basis or a fixed, regular basis.  The payments are usually contingent simply on an employee remaining with the company through the expected payment date.  In contrast, KEIPs are programs designed to incentivize certain performance from a select group of employees and typically incorporate performance targets that the employees need to meet before a payout is earned.  Such performance targets can include the completion of certain tasks, like the consummation of the sale of substantially all the assets of a company, or, more commonly, the satisfaction of certain financial metrics, like positive EBITDA or cash flow in X amount for Y period of time.
KERPs and KEIPs can be contentious because the Bankruptcy Code places limitations on the types of payments a debtor can make to its employees under such plans.  Specifically, section 503(c)(1) of the Bankruptcy Code sets stringent limitations on the types of retention plans that a debtor can adopt for an “insider,” which limitations effectively prohibit a debtor’s ability to successfully implement a plan in most circumstances.  The Bankruptcy Code defines an “insider” to include directors and officers and “persons in control” of the debtor.  Typically, courts will find that senior management with significant decision-making authority over a debtor’s affairs are insiders.
Because of section 503(c)(1)’s limitations on retention plans to insiders, a debtor will often instead seek to implement an incentive plan for its senior management.  Incentive plans are not subject to the restrictions of section 503(c)(1).  Rather, incentive plans are governed by the more general provisions section 363(b)(1) and section 503(c)(3) of the Bankruptcy Code.  Section 363(b)(1) allows a debtor in possession to transact outside the ordinary course of business with court approval.  Courts will apply the deferential business judgment test to analyze such transactions.  The business judgment test asks whether the debtor has proved that the transaction at issue is within the fair and reasonable business judgment of the debtors and thus within the zone of acceptability.
Payments under an incentive plan must, however, also satisfy section 503(c)(3), which prohibits transfers to employees “that are outside the ordinary course of business and not justified by the facts and circumstances of the case.”  Different courts apply different tests to determine whether a KEIP is justified by the facts and circumstances, and some courts hold that the facts and circumstances test of section 503(c)(3) is identical to the business judgment test under section 363(b)(1).  A key issue in dispute when a debtor proposes KEIPs to insiders is often whether they are actually retention plans disguised as KEIPs solely to avoid the stricter (and nearly impossible to meet) standards of section 503(c)(1).
In American Eagle, the U.S. Trustee and a certain secured creditor objected to the debtor making two lump sum payments to two specific individuals pursuant to its KEIP:  (1) a payment of $60,000 to the individual who served as the debtor’s VP of Marketing and Strategy, CFO, and Treasurer (the “CFO”) and (2) a payment of $7,500 to another individual who served as the debtor’s in-house counsel and Secretary.  Under the KEIP, the payments were to be earned upon the consummation of a sale of substantially all of the debtor’s assets or the confirmation of a plan of reorganization or liquidation, and the debtor exceeding its cash collateral budget.  Any proposed bonus to be paid would be limited to twenty-five percent (25%) of the total amount of actual excess cash on the date of the closing of the asset sale over the projected cumulative cash balance as listed in the budget.  The objectors argued that these goals were so easy to attain as to provide little incentive to the individuals to perform, and instead constituted a disguised KERP.
The Bankruptcy Court disagreed.  It reviewed applicable case law, the evidence and argument presented on the record and concluded that the KEIP, while possessing certain “retentive” elements, was indeed an incentive plan.  It distinguished the KEIP from other plans where the same management that “rode the company into a [c]hapter 11 filing is now proposing through the [debtor-in-possession] to pay themselves bonuses and golden parachutes merely for remaining with the [d]ebtor and performing all or most of their same duties for a given time period.”  Instead the Bankruptcy Court applied the nine factor test in In re Alpha Natural Resources, Inc. and concluded the following:
(1) Considering all facts and circumstances the scope of the KEIP was reasonable:  The court noted that the CFO was performing parts of two or three jobs previously performed by other employees who were now no longer with the company.  The court also noted that the in-house counsel took on new or increased duties involving HR and creation and maintenance of a data room for interested buyers.  Moreover, had the plan solely meant to retain the CFO, as opposed to incentivize him, the Board could have simply paid the CFO the raise he requested.  Additionally, the Bankruptcy Court believed that the facts and circumstances at the time the plan was adopted were not simple or clear cut, such that a bonus was a guarantee.  At the time the debtor filed its petition, oil and gas prices were experiencing unprecedented volatility and decline and a successful sale of the debtor’s assets to a cash purchaser was not a certainty.  Accordingly, the Bankruptcy Court concluded that the KEIP sufficiently incentivized both employees to remain and find a potential cash buyer to challenge the stalking horse credit bid.
(2) Suitable due diligence was undertaken for adoption of the KEIP by an Independent Compensation Committee:  The Bankruptcy Court noted that the debtor relied upon a Bonus Committee to help develop the KEIP, and that none of the Board members or the Committee members received a bonus.
(3) The targeted management team of the KEIP was appropriate:  The Bankruptcy Court observed that the two employees were the “worker bees” responsible for shuttling forward the marketing/sales process.  The CFO provided the financial reports for parties in interest and prospective purchasers and generated the modelling for management’s analysis of the purchase offers.  The in-house counsel maintained the data room.
(4) The cost of the KEIP was reasonable in the context of the Debtor’s assets, liabilities and earnings potential:  The Bankruptcy Court highlighted that, initially, the CFO had requested a 50% raise to a $300,000 annual salary, but the Board instead offered him a $230,000 base salary with a $60,000 cash bonus if cash balances were maintained or improved as of the time of the closing of the asset sale.  In the court’s opinion, had the Board sought to simply retain the CFO, it could have easily given him the raise.  Finally, the court noted that the aggregate payout of $67,500 was modest in light of the cash purchase price of $36.75 million offered by the winning bidder.
(5) The KEIP was properly designed to achieve performance standards: Again, the Bankruptcy Court reiterated its view that there was no certainty during the sale process that the two employees would earn bonuses.  The initial stalking horse bid provided for a credit bid by the debtor’s noteholders would have only left a small, fixed pool of cash to satisfy all administrative expenses (including the bonuses to the extent the cash amount was sufficient to do so).  The debtor’s employees were thus incentivized to find a competing bidder willing to purchase the debtor’s assets for cash to ensure sufficient funds to earn the bonus.
(6) The KEIP was consistent with industry standards:  The parties did not submit evidence on this factor, but the Bankruptcy Court did note that the Board’s approach to developing the KEIP was consistent with past practice and the payouts were “quite modest.”  Thus, it concluded this factor was neutral or tended in favor of the debtor.
(7) The KEIP fell well within the fair and reasonable business judgment of the debtor:  The Bankruptcy Court concluded that the use of bonus payments to incentivize the key employees while protecting the continuity of the debtor’s operations and sale process was worth the expense in light of all the factors discussed.
(8) The KEIP was not a disguised KERP:  The Bankruptcy Court referred to the reasons expressed in its analysis of the other factors that supported this finding.
(9) The KEIP satisfied the heightened-scrutiny standard set forth in Pilgrim’s Pride:  The Bankruptcy Court found the debtor met the higher bar of the “facts and circumstances” test.  It noted that although the two employees held officer titles, they did not participate in the Compensation Committee or Board decisions to award bonuses and were not the ultimate decision makers on the goal of the chapter 11 case, although they did provide key services.  The Bankruptcy Court in particular highlighted the performance of the employees themselves and noted that, according to the court’s direct observations and the testimony presented, the two employees had discharged their duties responsibly and competently and, therefore, earned their bonuses.
Ultimately, although the KEIP approved by the Bankruptcy Court may have fallen on the less-challenging end of the spectrum as performance goals go, it appears the debtor presented persuasive evidence to support the primary incentive purpose of the program.  That evidence, coupled with the modest payouts under the program and the successful outcome of the sale process, was weighted heavily by the Bankruptcy Court in approving the KEIP.  Debtors seeking to implement their own incentive programs for senior management would do well to keep these facts in mind when fashioning their own programs.
Jessica Liou is an Associate at Weil Gotshal & Manges, LLP in New York.