Executive Compensation in Bankruptcy: The Fairness and Accountability in Reorganizations Act

Executive Compensation in Bankruptcy: The Fairness and Accountability in Reorganizations Act

Order Code RS22427
April 20, 2006
CRS Report for Congress
Received through the CRS Web
Executive Compensation in Bankruptcy:
The Fairness and Accountability
in Reorganizations Act
Robin Jeweler
Legislative Attorney
American Law Division
Summary
S. 2556 and its companion bill, H.R. 5113, 109th Congress, 2nd Sess. (2006),
introduced by Senator Bayh and Representative Conyers, respectively, are entitled the
Fairness and Accountability in Reorganizations Act of 2006. The legislation, according
to its sponsors, is intended to “ensure that workers are treated more fairly during
[bankruptcy] reorganizations by limiting executive compensation deals and requiring
corporations to provide a more accurate picture of their holdings before attempting to
modify collective bargaining agreements or promised health benefits.”1 This report
surveys the bill’s provisions.
Background. When a corporate debtor files for reorganization under chapter 11
of the U.S. Bankruptcy Code, 11 U.S.C. § 1101 et seq., corporate management oversees
the reorganization. Although a trustee is always appointed in chapter 7, chapter 11 is
premised on the supposition that a reorganization is most likely to be successful and
creditors and the public are most likely to benefit from continued operation of the
business by existing management.2 Under chapter 11, management may be removed “for
cause, including fraud, dishonesty, incompetence, or gross mismanagement[.]”3 Thus,
1 Bayh, Conyers Introduce Legislation Ensuring Greater Fairness for Workers in Corporate
Bankruptcy Proceedings, Press Release (April 6, 2006) at [http://bayh.senate.gov/releases/2006/
04/06APR06pr.htm]. See also 152 CONG. REC. E545 (daily ed., April 6, 2006) (statement of Rep.
Conyers).
2 H.Rept. 95-595, 95th Cong., 1st sess. 233 (1977), comprising part of the legislative history of the
1978 bankruptcy law. “Moreover, the need for reorganization of a public company today often
results from simple business reverses, not from any fraud, dishonesty, or gross mismanagement
of the part of the debtor’s management.”
3 11 U.S.C. § 1104. Pursuant to amendment by the BAPCPA, the U.S. Trustee shall seek
appointment of a trustee if “there are reasonable grounds to suspect that current members of the
(continued...)
Congressional Research Service ˜ The Library of Congress

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when a company files for reorganization, all of its operations may be subject to the court’s
oversight. But by practice and design, the court holds hearings to review only those
activities outside of the ordinary course of business or that by statute requires court
authorization, such as sales of assets or the assumption or rejection of executory contracts.
One treatise states that “[t]he discretion to act with regard to ordinary business matters
without prior court approval has been said to be ‘at the heart’ of the powers of a trustee
or debtor in possession, and courts have shown a reluctance to interfere, or to permit other
parties in interest to interfere, in the making of routine, day-to-day business decisions.”4
So, when a debtor files under chapter 11, it receives permission, pursuant to 11 U.S.C.
§ 503, to continue its operations, including the payment of management and non-
management employees. Permission to continue operations in bankruptcy is granted as
part of “first-day orders.”5
Recent high-profile bankruptcy reorganizations, such as those in the airline and auto
industries, however, frequently result in significant reductions in a wide spectrum of jobs
and employee benefits, including wages, retirement, and health benefits. In a climate of
employee financial loss, there has been increasing scrutiny of the compensation of the
executives who seek a bankruptcy court’s permission to reduce employee compensation,
especially through the rejection of collective bargaining agreements (CBAs).6 Indeed, the
general issue of the growth of executive compensation in relation to value provided and
non-managerial employee compensation is one that receives considerable scrutiny outside
of bankruptcy.7
Post-filing expenses incurred in the operation of the business may be considered
administrative expenses. With respect to an individual executive’s claim for any non-
routine compensation, like all bankruptcy claims, its disposition may depend upon many
factors, such as when and how it was earned and/or paid, that is, before or after the
bankruptcy filing. Non-routine postpetition payments are generally subject to greater
scrutiny by the court, and prepetition payments, to a more limited extent, may be subject
to avoidance. Nevertheless, retention bonuses and similar compensation for executives
are commonly sought and approved by the courts.8 But they may be challenged by parties
3 (...continued)
governing body of the debtor...participated in fraud, dishonesty, or criminal conduct in the
management of the debtor or the debtor’s public financial reporting.” § 1104(e).
4 7-1108, COLLIER ON BANKRUPTCY (15th ed. rev.), ¶ 1108.07. (Footnotes omitted.)
5 Part of the transition into bankruptcy involves court permission to ensure that the employees
receive their unpaid prepetition salary and do not miss a paycheck. The priority status for
prepetition wages at 11 U.S.C. § 507 enables courts to authorize continuity in payments.
6 11 U.S.C. § 1113.
7 The issue of executive compensation is not necessarily linked to bankruptcy. See CRS Report
96-187, A Comparison of the Pay of Top Executives and Other Workers, by Linda Levine. See
also Eric Dash, Executive Pay: A Special Report, Off to the Races Again, Leaving Many Behind,
and C.E.O. Pay Keeps Rising, and Bigger Rises Faster, both posted April 9, 2006, at
[http://www.nytimes.com/2006/04/09/business/businessspecial/09pay.html] and
[http://www.nytimes.com/2006/04/09/business/businessspecial/09payside.html].
8 For more background on executive compensation in bankruptcy, see CRS Report RL33138,
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to the bankruptcy proceeding and denied in whole or part. In the reorganization of Delphi
Corporation, the largest U.S.-based automotive parts manufacturer, which filed on
October 8, 2005,9 the bankruptcy court has, for example, authorized both an executive
incentive compensation program and an early retirement incentive plan for 13,000
employees.
Amendments to Executive Compensation in the Bankruptcy Abuse
Prevention and Consumer Protection Act (BAPCPA). Enacted on April 20,
2005, and taking effect on October 17, 2005, the BAPCPA imposed new limitations on
non-routine executive compensation.10 Amendments to 11 U.S.C. § 503(c) limit both the
circumstances under which severance and retention payments may be made to a debtor’s
officers and directors, as well as the amount of such payments. Subject to court approval
based on evidence in the record, retention payments may only be made when essential to
retain the individual because he or she has a bona fide job offer from another business at
the same or a greater salary; the services are essential to the survival of the business; and
the payment is less than 10 times the amount paid to similar non-management employees
in the preceding year, or if no retention bonuses were paid in the preceding year, then no
more than 25% of any similar executive benefit in the preceding year. § 503(c)(1).
Severance payments may not be made unless the payment is part of a program
generally applicable to full time employees and is limited to 10 times the average amount
of severance payments made. § 503(c)(2).
Other payments outside the ordinary course of business, including payments to
executives, officers, managers, and consultants who are hired after the bankruptcy filing,
may not be made unless they are justified by the facts and circumstances of the case.
§ 503(c)(3).
The statute, as amended by the BAPCPA, imposes the highest burden of proof on
retention payments, i.e., the individual must be found to be essential to the business and
have another job offer, which must be supported by evidentiary findings introduced into
the record. Severance payments are capped and must be available to all non-management
employees as well. Other payments outside the ordinary course of business must be
justified.
S. 2556/H.R. 5113: Limitations on Compensation. Section 4 of the
proposed bills would amend 11 U.S.C. § 503(c)(1) to broaden the requirements imposed
on retention payments to include “a performance, incentive, or other bonus or any other
compensation enhancement.” Thus, any bonus or incentive would require an evidentiary
finding that the executive had another job offer and that his or her services are essential
8 (...continued)
Employment-Related Issues in Bankruptcy, by Robin Jeweler.
9 For more background on Delphi and the automotive industry, see CRS Report RL33169,
Comparing Automotive and Steel Industry Legacy Cost Issues, by Stephen Cooney.
10 P.L. 109-8, § 331, 119 Stat. 23, 102-03.

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to the survival of the business. These payments would also be subject to the 10-times
multiplier or 25% cap in Subsection (c)(1)(C).11
Section 4 would replace the requirement in Subsection (c)(3) that payments outside
the ordinary course of business be justified by the facts and circumstances of the case.
The new standard would disallow all pre- and postpetition “transfers or obligations” for
the benefit of officers, managers and consultants, whether within or without the ordinary
course of business, unless the court makes an evidentiary finding on the record, without
deference to the debtor’s request, that the payments are essential to the survival of the
business, or, in a liquidation, essential to maximize the value of the estate, and in either
case because the services provided are essential and the payments are reasonable under
the circumstances.
Under current law, the court may authorize, pursuant to § 503(b)(1), the payment of
wages, salaries and commissions for services rendered after commencement of the case.
Subsection (c)(3) disallows “other transfers outside of the ordinary course of business”
unless justified by facts and circumstances of the case. The revised language would
disallow “other transfers or obligations, whether or not outside the ordinary course of
business.” There is some ambiguity as to whether that language includes wages and
salaries referred to in subsection (b), which are generally considered to be obligations in
the ordinary course of business.
The amendments are very broad in nature and appear to repudiate the underlying
theory that the debtor’s management is best positioned to reorganize it. Instead of
overseeing the on-going operations of the debtor, the bankruptcy judge would be charged
with holding hearings to determine an appropriate level of compensation for the debtor’s
executives. The standard by which the judge would determine the appropriate level of
executive compensation is not specified in the provision.12
Proponents of the bill are likely to support a new, increasingly adversarial approach
to establishing, and possibly limiting, executive compensation for the reorganizing debtor.
Many will view this approach as more equitable given the financial sacrifices that many
non-management employees are required to make. Some may feel that bankruptcy courts’
oversight of executive compensation has often been inadequate and/or ineffective, and
that the growth in executive compensation in relation to the value of services provided is
simply not justified, within or without of bankruptcy. These changes would be consistent
with a view that corporate bankruptcy is not a result of business conditions beyond
managerial control and that they should be required to have a greater financial stake in the
11 Broadening the scope of compensation enhancements subject to § 503(c) may make sense,
since one treatise predicts that “[t]he narrow scope of subsections 503(c)(1) and (c)(2) will
basically result in the elimination of programs that provide compensation to officers for
remaining employed with the debtor or that provide severance when such persons leave.” It
speculates that different methods of inducing managers to stay with the debtor will need to be
found. 4-503 COLLIER ON BANKRUPTCY (15th ed. rev.), ¶ 503.17[4].
12 For example, would the judge look to executive compensation at comparable businesses
outside of bankruptcy, or mandate comparable management and non-management benefit
reductions for the individual debtor?

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business’ success or failure. Stricter limitations on compensation may free more of the
debtor’s assets for other business purposes, including distribution to the debtor’s creditors.
Like many vexing problems, such as pension underfunding and health insurance
costs, many will question whether perceived imbalances in executive compensation are
best addressed in bankruptcy. Opponents are likely to object on the ground that lengthy
compensation proceedings will substantially increase the costs of bankruptcy
administration. The specter of these proceedings may diminish managerial zeal for
reducing non-management employee benefits in the course of reorganization. Whether
that will actually benefit or hinder the likelihood of a successful reorganization is
impossible to predict. Some will argue that talented managerial executives will simply opt
out of troubled businesses to avoid the bankruptcy process all together. That could leave
the struggling business enterprise in the hands of those who have few options. The greater
philosophical and policy questions are whether, if debtors avoid reorganization, they will
have a greater or lesser likelihood of maintaining solvency and staying in business, and
which is a more desirable outcome.
Treatment of Foreign Affiliates. Section 5 of the bill(s) would require the
bankruptcy court to specifically consider, in two situations, the ongoing impact on the
debtor of the debtor’s relationship with all subsidiaries and affiliates regardless of whether
they are domestic or foreign, or whether they are in bankruptcy. The first would be in the
determination of whether to permit a debtor to reject a collective bargaining agreement
under 11 U.S.C. § 1113. The second is in connection with a debtor’s application to
modify retiree health benefits under 11 U.S.C. § 1114.
The law generally accepts a corporation as a free-standing legal entity. Although
there is a large body of law that considers when and where it is appropriate to “pierce the
corporate veil” and view separately incorporated entities as sharing assets and/or
liabilities, a general discussion of this body of law is beyond the scope of this report.13
The language of the bill does not suggest that the assets (or liabilities) of affiliates and
subsidiaries be considered those of the debtor.14 Hence, how the court is to evaluate the
impact of the debtor’s relationship with subsidiaries and affiliates for purposes of
deciding matters before it is not explained.
The specific operation of this provision, though not immediately apparent, may be
developed as the legislation wends its way through the legislative process.
13 See Hector José Miguens, Liability of a Parent Corporation for the Obligations of an Insolvent
Subsidiary Under American Case Law and Argentine Law, 10 AM. BANKR. INST. L. REV. 217
(2002), discussing the evolution of the theory of the corporation as an individual “entity” into a
conglomerated “enterprise” and its implications in case law.
14 Cf. 11 U.S.C. § 524(g), assigning liability for and third-party protection to subsidiaries and
affiliates as an element of asbestos-related bankruptcy trusts.