Bankruptcy Bonuses: What’s There Not to Like?

Late in 2009, 20 senior Canwest officials were given bonuses as part of a “key employee retention plan” (KERP) worth nearly $9 million; the sweeteners were designed to keep them with the failing company as it moved through bankruptcy restructuring. This at a time when many Canwest workers were laid off without severance.

The move touched off a firestorm of criticism in Canada, yet it was hardly an isolated occurrence. The last decade has seen many large companies in bankruptcy protection offer bonuses to senior operating officers who had steered their ships toward rocky shoals. The thinking has been that management departures deal a heavy blow to companies trying to restructure and avoid the loss of human capital.

Yet there is no shortage of commentators harshly critical of retention and incentive plans that, they believe, enrich failed and entrenched managers at the expense of creditors. The bad optics of such plans were so bad that, in 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act was passed in the U.S. to restrict KERPs.

Yet bankrupt companies continue to award executives rich incentive plans to keep them in the fold, which got Queen's School of Business assistant professor Wei Wang thinking. “If it doesn’t make economic sense, why would [bankruptcy court] judges approve these plans for so many companies?” said Wang during a School of Business research presentation in October 2012. “There must be a reason why they’re offering bonuses to these executives.”

Creditors benefit when executives stay on

The reason, as Wang found out from his research, is that such plans often significantly improve the outcomes for creditors. Working with Vidhan Goyal of Hong Kong University of Science and Technology, Wang showed that firms with such plans in place move through restructuring faster and are more likely to be successful after emerging from Chapter 11.

Wang and Goyal looked at 417 public companies that filed for bankruptcy between 1996 and 2007. Wang painstakingly built the database over the course of more than a year with hard-copy documents sourced from bankruptcy courts and the National Archives in the U.S. He and his colleagues hand-coded the documents to make them searchable by key markers.

Of the companies studied, 39 percent offered KERPs to key employees, paying out bonuses of 30 to 70 percent of the employees’ base salaries. For many, a portion of the bonus was tied to minimum stay of, on average, nine months.

But that’s not all. As Wang and Goyal note in their working paper, 78 percent of KERPs paid out incentive bonuses contingent on bankruptcy resolution, and almost half allowed for bonuses contingent on the firm's emergence from Chapter 11. Another 30 percent paid out bonuses on the sale of assets or the firm's liquidation.

Creditor control is key

Given that incentive bonuses provided by bankrupt companies tend to be closely tied to creditors' claims and bankruptcy outcomes, do they actually work?

Wang says yes.

“Overall, the findings suggest that incentive plans improve outcomes for creditors by aligning managers' interests with those of creditors, shortening bankruptcy duration, and limiting stockholders' ability to extract concessions from creditors.”

Not only that, the likelihood of a firm's emergence from bankruptcy is greater when key employees are paid incentive bonuses.

Wang saw no evidence to suggest senior leaders are simply enriching themselves. In fact, a strong predictor of KERPs being offered is when there is strong creditor control, in the form of a court-approved creditors’ committee and debtor-in-possession financing.

Given the positive findings about KERPs, Wang is at a loss to explain why they have such a bad reputation.

“One thing I found surprising was that the total cost devoted to these plans in the 417 companies studied was less than 1 percent of the firms’ pre-bankruptcy petition assets,” says Wang. “So why are people so skeptical about these plans? If you think of legal fees, lawyers account for eight to 10 percent of assets, but people don’t argue about legal fees.”

— Alan Morantz