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ANALYSIS: Executive Pay Is Problematic for Companies in Distress

Nov. 16, 2020, 11:27 AM

Executive compensation has long been a hot-button issue for investors. Throughout 2021, the Covid-19 pandemic and the economic downturn will focus attention on the pay of executives in struggling companies. Furthermore, companies seeking bankruptcy relief will probably encounter heightened scrutiny of their executive compensation requests.

Companies facing bankruptcy may encounter restrictions on incentive bonuses and other forms of compensation. Issuers might also expect adverse “say on pay” advisory votes from shareholders, and even campaigns from activist investors if compensation is perceived as misaligned with performance. In addition, under the federal securities laws, public companies may claw back executive compensation in the event of an accounting restatement.

Bankruptcy Concerns for Executive Pay

A company filing bankruptcy is not necessarily without money. Obviously, a corporate debtor will need significant resources to provide for repayment to creditors, but it will also need to pay attorneys’ fees, continued operating expenses (including wages) and — sometimes controversially — additional bonuses to encourage key employees to remain and shepherd the debtor through reorganization.

Prior to changes to the law in 2005, corporate debtors would frequently adopt pre-bankruptcy key employee retention plans (KERPs). KERP payments often continued beyond the petition date and received administrative expense priority, meaning that executives were getting bonuses before some creditors were getting payments. Infamously, in the Enron case, the Bankruptcy Court for the Southern District of New York approved $140 million in payments to the debtor’s executives, notwithstanding the more than half billion in bonuses and other compensation that the company shelled out in the year leading up to the bankruptcy filing.

Congress to the Rescue?

Not quite. In 2005, Congress attempted to address unconscionable bonuses with the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA). With the enactment of BAPCPA came amendments 11 U.S.C. § 503(c) and 11 U.S.C. § 548(a)(1)(B)(IV) to expressly address exorbitant executive bonus payments head-on. Bankruptcy Code Section 503(c) finally provided a standard set of strict criteria for courts to consider in evaluating post-petition retention payments.

These amendments to the U.S. Code presented merely a temporary obstacle for determined debtors. As a result of the new restrictions on retention payments, debtors turned to carefully crafted key employee incentive plans (KEIPs) that linked bonuses to certain performance milestones. The executives kept their bonuses and the debtors, theoretically, benefited from more motivated employees who would work diligently to increase the probability of a successful reorganization.

Are We Back Where We Started?

Not at all. While the BAPCPA amendments did not eradicate executive bonuses from bankrupt companies, some debtors seem to have taken the lesson to heart, and have significantly curtailed bonus payments on the eve of the bankruptcy. For example, earlier this year, in the days leading up to their imminent bankruptcies, Hertz Global Holdings Inc. paid a total of $16.2 million to 340 employees and J.C. Penney Co. paid out about $10 million. But while Hertz requested approval of an additional $14.6 million in post-petition incentive payments, it later reduced its request, cutting 20% from bonuses to vice presidents and senior VPs to address the court’s concerns —and, probably, a public backlash — over an additional round of bonuses in short order. J.C. Penney’s KEIP request was higher, seeking approval of $47 million in incentive pay, but it sought to compensate non-executives. Those bonuses are by no means pennies, and are more strategic than altruistic, but they pale in comparison to amounts paid by Enron.

Bankruptcy law changes slowly, but the surge in high-profile Chapter 11s could make 2021 a busy year for KEIP litigation. However, even as our nation grapples with record unemployment and lingering economic hardship for average Americans, it is not likely that multimillion-dollar KEIPs will disappear altogether. These key employees do, after all, possess critical institutional knowledge and play an essential role in successful bankruptcies.

Corporate and Securities Law Issues

Provisions of the federal securities laws also might have an impact on executive compensation at distressed companies. SEC rules adopted under the Dodd-Frank Act require public companies to conduct an advisory shareholder vote on the compensation of the company’s most highly compensated executives (the “say on pay” vote). While the vote must be held at least every three years, most companies do so annually. Companies must disclose (usually in the proxy statement) how they have factored the results of the votes into their compensation policies and decisions.

While the votes are not binding, a lack of investor support for pay programs is significant. Proxy advisory firms factor the vote results into their corporate governance scores and recommendations. Companies frequently modify their pay plans in response to a negative vote, and often shift to more performance-based pay metrics.

A misalignment of executive pay with performance may also prompt activist investors to challenge underperforming companies. A failed vote or a narrow majority may indicate investor dissatisfaction that activists could exploit to make demands for pay program modification or seek board seats and participation in the compensation committee.

The Consequences of Misconduct

The most drastic impact on executive pay results from flawed financial reporting related to misconduct. Section 304 of the Sarbanes-Oxley Act contains a clawback provision triggered by a restatement of a public company’s financial statements. If a company issued a restatement resulting from misconduct, the statute requires CEOs and CFOs to disgorge several forms of compensation and profits from company stock sales received within a year of the reporting date.

The restatement must result from material noncompliance with the financial reporting requirements of the federal securities law, and must be rooted in misconduct. The statute does not define misconduct, and does not state that the CEO or the CFO must be implicated in the wrongdoing. Court decisions indicate that a clawback may be required even if there is no personal culpability on the part of the subject officers.

Companies may, subject to state corporate and contract law, adopt clawback policies that expand beyond the statutory requirements. These policies could expand the number of covered employees, or widen the scope of factors triggering a clawback.


Companies in bankruptcy will likely see changes to executive bonus pay. The deep economic hardship caused by the pandemic has shone a new spotlight on economic inequities, and ordinary citizens are paying attention. The BAPCPA amendments resulted from a previous crisis, and neither debtors nor judges exist in a vacuum. In the coming year, courts will likely continue to push back on post-petition executive bonuses even in the absence of objection. Likewise, debtors will probably make every effort to control the optics with more modest retention and incentive bonuses.

Few companies will likely face compensation clawbacks in 2021. However, companies in distress will have to face their investors with their “say on pay” vote. Lucrative compensation packages will also draw the attention of activists, as struggling companies with declining stock prices make for attractive targets.

Access additional analyses from our Bloomberg Law 2021 series here, including pieces covering trends in Litigation, Transactions & Markets, the Future of the Legal Industry, and ESG.

Bloomberg Law subscribers can find related content on our Bankruptcy Practice Center.

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