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September 9, 2014

2014-Issue 36—It is critical for distressed companies to retain and motivate key talent both during the bankruptcy process and upon emergence from bankruptcy. The implementation of key employee incentive plans (KEIPs) during the bankruptcy process and the granting of equity compensation upon (or shortly following) emergence from bankruptcy are two ways in which companies may accomplish these retention and motivation goals. This edition of Tax Advisor Weekly briefly highlights certain key considerations that may be of interest to companies contemplating such arrangements.

Overview of KEIPs
Companies in bankruptcy want to retain key executives because their substantial industry experience and company-specific knowledge are necessary to continue the operation of the company’s business and to support the company’s turnaround. On the other hand, such executives have very little incentive to remain with the company during bankruptcy in the midst of job instability and where annual bonuses and other compensation may no longer offer attractive payouts. As the key executives' long-term incentive awards often are deemed to be worthless as a result of the bankruptcy, it is generally accepted to target executives' bankruptcy compensation higher than compensation actually realized pre-bankruptcy. 

To address these conflicting interests, prior to 2005, companies typically retained executives by implementing key employee retention plans (KERPs) whereby executives were paid for simply remaining on the job through specified dates during the bankruptcy process. However, as a result of perceived abuses involving substantial payments to executives in bankruptcy, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) added restrictions on payments to “insiders.” Bankruptcy Code Section 503(c)(1) prohibits payments “to an insider of a debtor for purposes of inducing such person to remain with the debtor’s business” unless the following stringent requirements are met:

  • The payment is essential to the retention of the employee because he or she has a bona fide job offer from another business at the same or greater rate of compensation;
  • The services provided by the employee are essential to the survival of the business; and
  • The amount of the payment is not greater than 10 times the average payment of a similar kind given to non-management employees during the same calendar year. If no similar payments are made to non-management employees in the same calendar year, the amount of the payment must not be greater than 25 percent of the amount of any similar payment made to the insider during the previous calendar year.

The severe restrictions imposed by Section 503(c)(1) effectively ended the use of key employee retention plans for top management. As a result, many companies today implement KEIPs, which are performance-based plans that are essentially designed to fall outside the scope of Section 503(c)(1). A KEIP that is able to avoid the restrictive treatment of Section 503(c)(1) may instead be subject to the more liberal business judgment standard under which a plan may be approved by the bankruptcy court based on business judgment and an analysis of the facts and circumstances of the case.

So the question arises, under what circumstances may a KEIP avoid Section 503(c)(1) and thereby increase its chance for bankruptcy court approval?

Who Is an “Insider?”
One of the first items to understand is whether the plan’s participants are “insiders.” To the extent a bankruptcy court determines that plan participants are not “insiders” covered by Section 503(c)(1), the plan will not be subject to the Section 503(c)(1) restrictions. In other words, non-insiders may participate in retention plans which are not subject to the onerous limitations of section 503(c)(1) of the Bankruptcy Code.

Section 101(31)(B) of the Bankruptcy Code provides the definition of “insider,” which includes a director, an officer, a person in control or a general partner of the debtor, or a relative thereof, as well as a partnership in which the debtor is a general partner. However, because the list in Section 101(31)(B) is not exhaustive and the terms “director” and “officer” are not defined, a bankruptcy court’s determination of insider status is often based on the facts and circumstances of each case.

Although there are no bright-line rules, some courts have found that a person with an officer title is, per se, an insider as he or she satisfies the definition, while other courts have found that a person’s title is not determinative and it is necessary to investigate the extent to which the individual exerts control over the company. While investigating an individual’s level of control, some courts have considered as significant an individual’s involvement with the management of the company (e.g., influence or authority over company policies or budget) and connection with the company’s board of directors (e.g., attendance at board meetings, reporting to the board or appointment/election by the board).

So, the KEIP Covers “Insiders”….Now What?
KEIPs covering “insider” participants may avoid the restrictions of Section 503(c)(1) if it can be established that the primary purpose of the KEIP is to incentivize such persons and not simply to induce them to remain employed. Courts have found that a KEIP that is shown to be primarily incentivizing will not be subject to Section 503(c)(1) restrictions even if it has some retentive effect.

Consequently, KEIPs should be structured to pay out based upon the achievement of performance metrics and goals determined by the company. Common performance metrics used by companies include:

  • Financial metrics (EBITDA, cash flow, operating income, liquidity);
  • Sale of assets;
  • Confirmation of plan of reorganization/emergence from bankruptcy (usually by a specified time);
  • Cost reduction/expense control;
  • Creditor recovery; and
  • Product sales.

Such performance metrics, however, must be carefully chosen and structured to be sufficiently challenging based on the circumstances of the particular company. Bankruptcy courts have denied KEIPs where performance metrics are too easy to satisfy, and have also required that performance metrics be closely tied to any payout under the plan.

Bankruptcy courts will likely view plans with performance metrics that are too easily attained and not tied to payment as disguised KERPs. For example, in a seminal case called In re Dana Corp.(Dana I), 351 B.R. 96 (Bankr. S.D.N.Y. 2006) a company sought approval of a completion bonus plan with two components: (i) a fixed component that would be paid on the effective date of a plan of reorganization without regard to performance or creditor recovery as long as the executive was still employed and (ii) an uncapped, variable component based on the “total enterprise value of the debtors” six months after the effective date of the reorganization plan. The court found the completion bonus to be a retention bonus because (i) the fixed component was not tied to anything other than staying with the company until the effective date of the plan of reorganization and (ii) the thresholds for the variable component were so artificially low that they guaranteed that the bonuses would be paid. The court famously observed “this compensation scheme walks, talks and is a retention bonus.”

Not surprisingly, bankruptcy courts have generally disapproved of KEIPs where the majority of the work required to earn payments is performed prior to the court hearing date. However, several courts have approved KEIPs despite the fact that the sale of a company’s most valuable assets had already been approved and therefore a majority of the KEIP performance metric had been achieved by the time the motion for KEIP approval reached the court. In one case, while acknowledging concerns about the timing of the motion for KEIP approval, the court gave substantial deference to the fact that the debtors had provided the creditor’s committee with the opportunity to consider the KEIP and that the committee ultimately supported the plan. The outcome in these cases highlights the importance of providing creditors’ committees with the opportunity to consider a KEIP and, if possible, obtaining its support when seeking approval of the plan.

Post-Emergence Incentive and Retention
Unfortunately, the battle to retain and motivate key employees does not end upon exit from bankruptcy. When emerging from bankruptcy, most pre-bankruptcy company stock, along with unvested equity awards held by employees, is cancelled or virtually worthless. Lack of meaningful equity ownership in the go-forward entity, coupled with an uncertain company future, leads to difficulties retaining and motivating key executives post-emergence. Consequently, emergence equity grants are a way to ensure that companies retain motivated personnel who are vital to a successful post-emergence entity.

Some important considerations for emergence grants include:

  • What percentage of the new company’s equity should be reserved for employee equity awards?
  • What portion of the equity pool should actually be granted at emergence?
  • Who should receive emergence grants (officers, middle management, all employees)?
  • How will the emergence grants be structured (i.e., type of award, vesting, etc.)?

Most companies emerging from bankruptcy reserve a portion of the new company’s shares in order to provide equity compensation to employees. In our experience, the typical share reserve at emergence is around 10 percent of outstanding equity, but companies with smaller market capitalization tend to reserve a larger percentage of shares. Most emerging companies grant no more than one-third to one-half of the reserved shares upon emergence, with the majority of the awards going to the company’s top officers. Any shares remaining in the equity pool can be used for grants to new employees and/or grants in future years. Equity grants are typically made in the form of stock options, restricted stock and/or performance shares. Depending on the company’s needs post-emergence, the awards can be structured as a retention vehicle (vesting based on time), to incent specific results (vesting based on performance) or a combination of the two.

As the creditors will generally become a significant shareholder, companies work closely with the creditor committee in determining which executives are key during the post-emergence time frame and accordingly who should be granted post-emergence grants. The discussing of the post-emergence grants either comes up as part of the confirmation plan or shortly after the company exits from bankruptcy. 

Alvarez & Marsal Taxand Says:
Companies entering or exiting bankruptcy protection are especially challenged with retaining and motivating key employees. KEIPs, when properly structured, can help bridge the compensation gap between the time in bankruptcy and the successful go-forward organization. If implementing a KEIP, it is vital to structure the plan to avoid the stringent restrictions of Section 503(c)(1) and to ensure that the plan properly incentivizes participants to achieve the desired results. Time is of the essence for KEIPs — as a company draws closer to emerging from bankruptcy, it becomes increasingly difficult to get the all-important buy-in from the creditors' committee, other key constituents and, ultimately, the court.

Just as KEIPs may be effective tools during the bankruptcy process, emergence equity granted by companies upon emergence from bankruptcy is useful in motivating and retaining employees after the bankruptcy process has concluded. Key considerations include the size of the post-emergence equity pool, the amount of equity to grant at emergence, the determination of who will receive emergence grants and the structure of awards.

As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.   

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.

Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.

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