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Limiting the Role of Business Judgment in Authorizing KERP Payments

Changes made to the Bankruptcy Code in 2005 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”) raised the bar for providing incentives that had been offered routinely to management of a chapter 11 debtor by way of a severance or key employee retention plan (“KERP”) designed to ensure that vital personnel would be willing to steward the company through its bankruptcy case, whether it involved reorganization or liquidation. Sections 503(c)(1) and 503(c)(2) place strict limitations on severance and KERP payments to “insiders.” In addition, section 503(c)(3) of the Bankruptcy Code mandates that transfers or obligations outside the ordinary course of business be “justified by the facts and circumstances of the case.” However, courts applying section 503(c)(3) have not been able to settle on a clear standard to evaluate the payments. Earlier this year, a Texas bankruptcy court examined the issue and articulated its own standard. In In re Pilgrim’s Pride Corp., the court ruled that, under section 503(c)(3), a payment to an insider that is not in the ordinary course of business may be granted administrative expense priority only if the court finds, independent of the debtor’s business justification, that the payment is in the best interest of the parties.

 

Limitations on Priority Claims of Key Employee Insiders

 

Enacted as part of BAPCPA’s sweeping reforms, section 503(c) was intended to limit the scope of KERPs and other similar plans to attract managers to remain with the company during its chapter 11 bankruptcy case. Prior to the amendments, managers were frequently given lucrative compensation packages as part of a KERP, with the resulting obligations treated as administrative expense priority claims under section 503 of the Bankruptcy Code. Administrative status for such claims gave insider managers a great deal of leverage, particularly because a chapter 11 plan cannot be confirmed unless either such claims are paid in full or the claimant agrees otherwise. 

Section 503(c) limits the allowance and payment of such administrative expense claims, reflecting the general disfavor of giving preferential treatments to a debtor’s “insiders” (which include, among others, directors, officers, and other controlling individuals or entities) at the expense of the bankruptcy estate. It provides that, notwithstanding the general rule stated in section 503(b) regarding the allowance of administrative expenses:

 

there shall neither be allowed, nor paid -

 

(1) a transfer made to, or an obligation incurred for the benefit of, an insider of the debtor for the purpose of inducing such person to remain with the debtor’s business, absent a finding by the court based on evidence in the record that -

 

(A) the transfer or obligation is essential to retention of the person because the individual has a bona fide job offer from another business at the same or greater rate of compensation;

 

(B) the services provided by the person are essential to the survival of the business; and

 

(C) either -

     

(i)  the amount of the transfer made to, or obligation incurred for the benefit of, the person is not greater than an amount equal to 10 times the amount of the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose during the calendar year in which the transfer is made or the obligation is incurred; or

 

(ii) if no such similar transfers were made to, or obligations were incurred for the benefit of, such nonmanagement employees during such calendar year, the amount of the transfer or obligation is not greater than an amount equal to 25 percent of the amount of any similar transfer or obligation made to or incurred for the benefit of such insider for any purpose during the calendar year before the year in which such transfer is made or obligation is incurred;

 

(2) a severance payment to an insider of the debtor, unless -

 

(A) the payment is part of a program that is generally applicable to all full-time employees; and

 

(B) the amount of the payment is not greater than 10 times the amount of the mean severance pay given to nonmanagement employees during the calendar year in which the payment is made; or

 
(3) other transfers or obligations that are outside the ordinary course of business and not justified by the facts and circumstances of the case, including transfers made to, or obligations incurred for the benefit of, officers, managers, or consultants hired after the date of the filing of the petition.

 

Sections 503(c)(1) and 503(c)(2) deal with KERP payments and severance payments, respectively. In addition, section 503(c)(3) imposes a general catchall limitation with respect to payments or obligations that are both outside the ordinary course of business and not justified by the facts and circumstances of the case. Lawmakers did not enunciate detailed criteria governing the strictures of section 503(c)(3), reserving for the bankruptcy courts the discretion to determine whether the provision’s conjunctive requirements have been satisfied.

 

Before BAPCPA, courts generally applied the business judgment rule to determine whether nonordinary-course payments to insiders under KERPs or similar programs should be permitted. This meant that debtors only had to provide a legitimate business justification for the payments, which was a low threshold. In the relatively brief period since 2005, only a handful of courts have analyzed the catchall provision of section 503(c)(3), with mixed results as to whether the business judgment rule or a different test is the appropriate standard to evaluate a proposed expenditure or obligation that falls thereunder.

 

For example, in In re Nobex Corp., a Delaware bankruptcy court in 2006 endorsed the business judgment rule and went so far as to conclude that section 503(c)(3) merely reiterates the standard under section 363(b) of the Bankruptcy Code, pursuant to which courts authorize the use, sale, or lease of estate property outside the ordinary course of business based on the business judgment rule. Later in the same year, a New York bankruptcy court suggested in In re Dana Corporation that the “sound business judgment test” is the appropriate test for evaluating proposed payments governed by section 503(c)(3). This test derives from pre-BAPCPA cases and takes into account, in addition to business judgment, whether a KERP is financially reasonable and fair and conforms to industry standards and the level of due diligence the debtor exercised in formulating the program. More recently, the bankruptcy court in Pilgrim’s Pride considered the appropriate standard for evaluating a payment to an insider under section 503(c)(3).

 

Pilgrim’s Pride

 

Pilgrim’s Pride Corp. and its affiliates (the “debtors”), the nation’s second-largest chicken producer for the consumer market, filed for chapter 11 protection in December 2008 in Texas. On December 16, 2008, the debtors’ chief executive officer, J. Clinton Rivers (“Rivers”), and chief operating officer, Robert A. Wright (“Wright”), agreed to resign from their respective positions. On January 2, 2009, the debtors sought court authority to employ Rivers and Wright as consultants for three- and four-month terms, respectively, at essentially their pre-resignation salaries. The United States Trustee (the “U.S. Trustee”) objected to the motion, contending that the consulting agreements violated section 503(c).

 

At the hearing on the motion, the debtors’ chief restructuring officer testified that the debtors did not require consulting services from Rivers and Wright, but that the consulting agreements were necessary to prevent Rivers and Wright from soliciting the debtors’ customers on behalf of the debtors’ competitors. Thus, the debtors were seeking court approval of the agreements to purchase “time-limited non-competition agreements.”

 

The Bankruptcy Court’s Ruling

 

The court evaluated the motion in two stages: (i) whether the noncompetition consulting agreements violated any of the various subsections of section 503(c); and (ii) if not, whether such nonordinary course of business expenditures should be allowed as administrative expenses. According to the court, section 503(c)(1) does not apply because the purpose of the consulting agreements was not to retain Rivers and Wright, but to prohibit them from working with the debtors’ competitors. The bankruptcy court also rejected the U.S. Trustee’s argument that payments under the consulting agreements were tantamount to severance as part of the debtors’ termination of Rivers and Wright and should therefore be evaluated under section 503(c)(2).

 

The court concluded that, although payments under the consulting agreements did not fall under sections 503(c)(1) and (c)(2), section 503(c)(3) applied because the proposed payments under the agreements represented transfers to an insider outside the ordinary course of business. Notably, in reaching this conclusion, the court expressly refrained from ruling on whether section 503(c)(3) extends beyond transactions with insiders.

 

The bankruptcy court then examined what standard should govern proposed payments or obligations under section 503(c)(3). The court rejected the debtors’ argument that the business judgment standard should apply, reasoning that if it did, section 503(c)(3) would be redundant, given that section 363(b)(1) already governs transfers made outside the ordinary course of business. In addition, the court noted, the text of section 503(c)(3) requires debtors to demonstrate that a transfer or obligation is justified by the “facts and circumstances of the case.” This “justification” clause, the bankruptcy court explained, suggests that Congress intended the court to “play a more critical role in assessing transactions” under section 503(c)(3), as opposed to deferring to the business judgment of the debtor or a bankruptcy trustee.

 

The court in Pilgrim’s Pride declared that, consistent with lawmakers’ goal to have the bankruptcy courts assess the value to the debtor of a proposed payment or obligation, under section 503(c)(3), “even if a good business reason can be articulated for a transaction, the court must still determine that the proposed transfer or obligation is justified in the case before it.” This standard, the court emphasized, requires the court to play a greater role by making its own determination that the transfer serves the interests of the creditors and the estate, regardless of a debtor’s business judgment:

 

Given the obvious conflict of interest between a debtor’s estate and insiders—who may themselves have been responsible in whole or part for devising and internally approving the proposed transaction—the argument underlying application of the business judgment rule (that officers and directors will fulfill their fiduciary responsibilities) lacks its usual weight.

 

Applying this standard, the court held that the obligations under the consulting agreements should be authorized under section 503(c)(3) as administrative expense claims. According to the court, the debtors not only provided valid business reasons for entering into the agreements, but demonstrated that the consulting agreements were in the best interests of creditors and the estate. Specifically, the debtors presented evidence that Rivers and Wright were knowledgeable about the debtors’ customers, had contacts with those customers, and were likely to use such knowledge and contacts to divert those customers to one of the debtors’ competitors, at a potential cost of hundreds of millions of dollars. Weighed against the $500,000 in aggregate to be paid to Rivers and Wright under the agreements, the cost to the estate was small. The bankruptcy court, however, reserved for another day any ruling on the U.S. Trustee’s contention that administrative priority for claims arising under the consulting agreements was unjustified because Rivers and Wright were already obligated not to compete under their respective resignation agreements. The court observed that it was confident that the debtors and their counsel were justified in seeking additional assurance of noncompetition by entering into the consulting agreements.

 

Outlook

 

Pilgrim’s Pride provides another court’s view concerning how Congress may have intended section 503(c)(3) to apply. The bankruptcy court’s conclusion that the inquiry into justification should involve an independent examination by the court of the best interests of the estate notwithstanding the debtor’s business judgment is undeniably a departure from the approach taken by other courts. Such an independent evaluation will necessarily be fact-specific, and any bankruptcy court taking this approach will have broad discretion to determine which transfers and obligations are “justified.”

 

The additional examination by the court under the Pilgrim’s Pride approach would appear to make section 503(c)(3) more restrictive. It bears noting, however, that in Pilgrim’s Pride, the bankruptcy court ultimately deferred to the debtors’ business judgment. Thus, a debtor’s business judgment may not end the inquiry under section 503(c)(3), but even under a standard similar to that adopted in Pilgrim’s Pride, the debtor’s business judgment continues to play a significant role in the assessment of whether payments will be authorized under that subsection.

 

_______________________________________

 

In re Pilgrim’s Pride Corp., 401 B.R. 229 (Bankr. N.D. Tex. 2009).

 

In re Nobex Corp., 2006 WL 4063024 (Bankr. D. Del. Jan. 19, 2006).

 

In re Dana Corporation, 358 B.R. 567 (Bankr. S.D.N.Y. 2006).

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