NFPCC Original Article: Process for Pay in “BK” (Bankruptcy)
FINANCIAL RESTRUCTURINGS, WHILE NOT AN ENJOYABLE PROCESS, ARE SOMETIMES A NECESSARY STEP TO ENSURE FUTURE FINANCIAL SUCCESS.
In order to achieve a successful restructuring, companies need to deploy the right compensation strategies in this volatile environment that will retain and motivate key talent to see the process through. In this article, we review the tools available to companies going through restructuring and how to approach determining values.
What happens to current compensation plans?
Unfortunately, all of the work and effort that went into developing a market competitive compensation program gets thrown out when a restructuring occurs. Annual incentive or cash bonus plans become obsolete as companies have to shift strategic direction to focus on completing a restructure. Long-term incentives typically become worthless, as current stockholders’ holdings go to zero value (or in some instances are replaced for pennies on the dollar in emerging entity stock). And employees that paid taxes on equity awards that are now worthless, don’t get reimbursed.
To ensure a company considering a restructuring has a fighting chance for success, alternative compensation structures that best reflect market competitive compensation opportunities need to be established. The following sections lay out the general decision process companies should undertake when creating bankruptcy-related compensation programs.
Given changes to bankruptcy law that went into effect in the early 2000’s, it is important to first perform due diligence on which incumbents are deemed to be “insiders.” The reason being the compensation tools available to companies get restricted materially for those individuals that are “insiders.” We recommend companies narrow the group of employees to be classified as “insiders” during a restructuring process as tightly as possible to maximize the flexibility they have to appropriately motivate and reward their workforce. This will be one of the primary “battlegrounds” with creditors and the court, so it is key to have this thought out in advance.
Without the retention of a company’s most critical asset, its human capital, restructuring endeavors carry little chance of success. Disruption to a company’s normal operating environment can create uncertainty for employees, so it’s best not to layer on added concerns when normal compensation programs get suspended. Rest assured, every search firm worth their salt will be calling and pitching the benefits of leaving.
To stave off poaching efforts from competition or employee attrition, companies should establish a retention bonus compensation program. These are created via one of two paths, pre-filing or post-filing. Note that pre-filing programs are becoming increasingly popular as they carry a number of advantages, most importantly that they are outside of the sphere of influence of the courts and its more restrictive bankruptcy code. This allows for the opportunity to include “insiders” in a retention program which they would otherwise be ineligible to receive. That said, it is important to ensure retention value delivered, no matter the method, carries appropriate competitiveness to external compensation opportunities that may be available to key talent.
Note that if a company seeks to establish a retention bonus program within the court setting, certain conditions must apply if the person is an “insider”:
- The bonus must be essential to the retention of an “insider” (see above discussion) because the “insider” has a bona fide job offer from another business at the same or greater rate of compensation;
- The services provided by the “insider” are essential to the survival of the business; and
- The amount of the bonus cannot exceed more than 10 times the mean retention bonus paid to other employees during the year in which the bonus is paid to the “insider”, or if no such bonuses are paid to other employees during the year, the value cannot be greater than 25% of the amount of any similar payment to the “insider” in the preceding calendar year.
It is important to conduct the necessary due diligence to determine appropriate values of retention awards, whether they be under the purview of the courts or not. Be sure to assess market competitive total compensation levels for the company’s competitive market (try to compare to companies that will have similar profiles to the emerged entity), discounting where necessary, the levels of compensation opportunity typically provided via variable pay programs to reflect eliminated risk of value loss.
With key talent retained through the use of retention awards, companies must then focus on motivating the right behaviors through the restructuring process to achieve a successful outcome. This is typically done by establishing a key employee incentive plan, or KEIP.
KEIPs are metric-driven pay programs that are intended to drive achievement of certain financial and operational performance hurdles selected due to their perceived impact on the outcome of the restructuring process. KEIPs sometimes get a bad reputation from external observers who may view the performance hurdles to be “sandbagged” or to lack efficacy on the overall restructuring plan for a debtor. To combat this, performance metrics established within a KEIP should tie to a company’s goals and objectives so that incentive payments are only made to key employees when they achieve these goals. Commonly used metrics within KEIPs recently analyzed include the following:
- Financial metrics, including EBITDA, liquidity measures, cash flow, etc.;
- Asset divestitures; and
- Targeted date for emergence.
While there are a number of examples of case law highlighting different reasons KEIPs got rejected by the courts, they generally fall under the following:
- Is the plan designed to achieve desired performance?
- Is the cost of the plan reasonable given size of assets, liabilities and earnings potential?
- Is the scope of the plan fair and equitable?
- Does the plan comply with industry standards?
- Is there proper due diligence done with respect to the plan?
Companies must ensure proper retention and motivation of key staff after completing a restructuring process. Even with a restructuring completed, there is likely to be continued uncertainty around the future of the business for some time. Case in point – a number of companies in the oil and gas industry, which saw a substantial wave of bankruptcies in 2015 – 2018, are again being flagged as potential returning customers to the restructuring process thanks to sustained low commodity pricing and operational challenges. Noting that competitive compensation practices in today’s market include strong long-term incentive opportunities, the elimination of value of employee equity awards (vested/held and unvested) puts restructured companies at a considerable disadvantage to their competitive market.
To rectify this issue, companies should design an equity compensation award structure to go into effect post-emergence. There are a number of considerations to think through when designing these awards:
- Who is eligible?
- What percentage of “new equity” should be reserved for employee incentives?
- How much of the share pool should be granted in conjunction with emergence?
- What is the appropriate value for each recipient?
- Should the awards be retention focused (time vesting only) or should they carry some element of performance measurement?
After the establishment of post-emergence equity awards, companies should review cash compensation program alternatives and likely return to normal course structures. Be mindful of the impact of retention awards on employee expectations while ensuring go-forward compensation plans support the strategic plan of the newly restructured entity.
It is key to have the right advisors – legal, financial and compensation – that can all work as one, toward a common goal. Restructurings are part of the business, and if done correctly and thoughtfully, can prove to be worth the journey.
Longnecker & Associates has arguably worked on more restructurings than anyone in our field and is ready to assist if your organization is facing this challenge.
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