Incentivizing Executives to Stay Through a Chapter 11 Asset Sale (Part I): Key Employee Retention Programs for Insiders

The best — and sometimes only — option for a financially troubled company to avoid a piecemeal liquidation may be to seek an acquirer for itself or its assets. While a distressed company may prefer an out-of-court sale transaction, the risks inherent in buying distressed company assets sometimes foreclose that possibility. Where there are significant historic liabilities, undesirable contracts or lease obligations, regulatory complications, or concerns about successor liability or fraudulent transfer risk, buyers may insist on executing the sale through a Chapter 11 bankruptcy case, which allows a buyer to acquire assets free and clear of liens, claims, interests, and encumbrances, including successor liability and fraudulent transfer claims, and leave behind contracts and leases that are not necessary for the go-forward business. In many cases, the advantages afforded to buyers purchasing assets with Chapter 11’s protections yield higher proceeds for sellers, even after taking into account the costs of Chapter 11.¹ 

Retention of senior management and other key employees during the pendency of a sale process is critical to preserving the assets’ value. Absent such retention programs and/or assurances that the employees will have jobs with the buyer post-closing, attrition is a significant risk that may harm the company’s value. Outside of bankruptcy, sellers have tools to mitigate this risk — they may implement key employee retention programs (KERPs) to pay bonuses to certain employees in exchange for their agreement to remain with the seller through closing of the sale. But once a company files for Chapter 11, its options are more limited, particularly for “insiders.”² In Chapter 11, KERPs require bankruptcy court approval, and the requirements of section 503(c) of the Bankruptcy Code are so restrictive that — as a practical matter — debtors typically cannot implement KERPs for insiders during a bankruptcy case.³  

Part I of this series discusses retention by Chapter 11 debtors of insiders under KERPs, while Part II will discuss using post-bankruptcy KERPs to motivate non-insiders, as well as the use of key employee incentive programs (KEIPs) in Chapter 11 for insiders and non-insiders.

As a result of the Bankruptcy Code’s restrictions on retention payments to insiders, most distressed companies contemplating a Chapter 11 filing implement KERPs and make all retention payments prior to the bankruptcy filing.⁴ In approving a pre-bankruptcy KERP, a board must make several key decisions, including the identity of KERP participants; the length of the KERP; and the size of KERP payments. 

• In determining which employees will participate in the KERP, the board will consider a number of factors, including the importance of the employee to preservation of value through the sale closing, the risk that the employee might leave if not included in the KERP, the impact that such employee leaving will have on the company, the liquidity available to make payments, and lenders’ willingness to provide any necessary consents for the use of cash for KERP payments. 
• The KERP will require that recipients stay through a defined period during the bankruptcy (typically, the earlier of a defined date or closing of the asset sale) and repay some or all KERP payments if they quit or are fired for cause before the end of the stay period. The board determines the length of the stay period based on when it expects a sale to close. Typically, all KERP participants will have the same stay period.
• In contrast, the size of retention payments in a KERP may vary significantly and is usually tailored to each KERP participant. Factors in sizing the payments include the board’s view of the size of payments necessary to motivate participants to stay, the company’s available liquidity, market standards, and lenders’ willingness to provide any required consents. 
• A board may consult with a compensation consultant for advice on the board’s key decisions and a comparison of the proposed stay period, KERP payments, and KERP participants to KERPs of comparable companies.

In short, if a company makes all KERP payments before entering Chapter 11, its KERP will not be subject to the Bankruptcy Code’s restrictions on the approval of such plans or otherwise require court approval. But pre-bankruptcy KERPs are not entirely risk free from bankruptcy court oversight. KERP payment recipients run some risk that the debtor’s estate (or creditors on behalf of the estate) will try to avoid the pre-bankruptcy KERP payments as fraudulent transfers, which would require the recipients to repay the amounts to the debtor’s estate. In practice, however, debtors’ estates rarely seek to avoid pre-bankruptcy KERP payments. As a result, this risk does not typically undermine the retentive effects of pre-bankruptcy KERPs. Additionally, a board’s decision-making in connection with a pre-bankruptcy KERP can and often is subject to hindsight review, potentially including allegations of breaches of the fiduciary duties of care and/or loyalty. As a result, careful consideration must be given to the proposed KERP to ensure that it is narrowly tailored to achieve its goals and consistent with market standards.

Part I of this series explores the use of pre-bankruptcy KERPs to incentivize key insider employees to remain with Chapter 11 debtors through a sale’s closing. But there are other tools that Chapter 11 permits a debtor to use to retain key employees: KERPs for non-insiders and KEIPs for insiders and non-insiders. Part II will explore these tools.

^[1] See “Top 10 Questions About Bankruptcy Sales – A Primer on Sales Under Section 363 of the Bankruptcy Code,” Goodwin (May 29, 2024).
^[2] The Bankruptcy Code defines insiders of a corporate debtor to include, among others, directors, officers, persons in control of the debtor, affiliates, and insiders of affiliates. In practice, it often is not clear which employees are insiders, and the issue is frequently litigated. But a seller planning for bankruptcy should expect that, at a minimum, C-suite employees will be considered insiders.
^[3] Section 503(c)(1) of the Bankruptcy Code only permits retention payments to an insider if (i) the insider already has a job offer with the same or equal compensation, (ii) the insider’s services are essential to the survival of the business, and (iii) the payment amount is no more than (x) 10 times the mean of retention payments made to nonmanagement employees in the calendar year in which the retention payment is made to the insider or (y) if no such payments were made, 25% of the amount of retention payments made to the insider in the calendar year prior to the year in which the retention payment is made to the insider.
^[4] Sometimes the KERP will include more junior key employees, but companies sometimes instead wait to implement a KERP in bankruptcy for more junior employees since the Bankruptcy Code does not impose the same restrictions on retention payments to non-insiders.

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