In 2005, the perception that wealthy executives were being rewarded for failure led Congress to ban Chapter 11 debtors from paying ‘retention’ bonuses to senior managers. Prior to the reform, retention bonuses for senior managers had become a ubiquitous part of the Chapter 11 landscape, with most large debtors choosing to pay their executives to stay at the beginning of the bankruptcy case. These bonuses were justified as necessary to keep talented executives working hard to turn the firm around. However, many commentators feared that managers were abusing their control of Chapter 11 debtors to extract excessive levels of compensation. After the amendment became effective, Chapter 11 debtors could only pay executive bonuses through court-approved ‘Key Employee Incentive Plans,’ which required managers to earn their pay by accomplishing specific performance goals, such as increasing revenue or moving the firm through the bankruptcy process.
In a recent article, forthcoming in the Southern California Law Review, I use newly collected data on the compensation practices of Chapter 11 debtors between 2002 and 2012 to examine how the reform changed bankruptcy practice. I find that relatively fewer firms—as a proportion of all large firms filing for Chapter 11 bankruptcy—used court-approved bonus plans after the reform. However, this finding is ambiguous for two reasons. First, the overall level of executive compensation does not appear to be different after the reform. Second, I find significant evidence of regulatory evasion, as firms found other channels through which to pay senior managers, which could explain why the overall level of executive compensation appears to be similar.
I hypothesize that three problems may have undermined the efficacy of the reform. First, the 2005 law asks bankruptcy judges to police the line between ‘incentive’ bonuses and ‘retention’ bonuses, which is extremely hard to do—judges are poorly equipped to assess the ‘challenging-ness’ of a proposed performance goal. Second, creditors have limited incentives to police executive compensation themselves and help bankruptcy judges perform their inquiry, and the Department of Justice’s US Trustee program, while vigilant, lacks expertise in executive compensation. This means that judges are essentially on their own when it comes to adjudicating whether a bonus plan is a bona fide incentive plan that will require management to earn their pay by accomplishing a challenging goal, or a ‘disguised retention plan’ that rewards managers for staying employed at the firm. Third, gaps in the new regime make it easy for firms to bypass the 2005 law and pay managers without the judges’ permission. I support each of these hypotheses with empirical evidence. Further, there is suggestive evidence that the reform significantly increased the litigation and, unsurprisingly, the attorneys’ fees surrounding bonuses plans, the latter appearing to nearly triple in constant 2010 dollars for the bonus plans in my sample that were approved after the reform became effective.
In many ways this paper examines what happens when Congress tries to change the balance of bargaining power between managers and creditors. The result appears to be that firms find ways to get around a poorly written rule.
Jared A. Ellias is Associate Professor of Law at the University of California Hastings College of the Law.