The Financially Troubled Company

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Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Signs Of A Turn In The Private Equity Buyout Market?

Last week saw what may prove to be early signs of a turn in the robust market for the debt that finances private equity buyouts. In just a week’s time, The New York Times reported on a possible cooldown in the buyout market, and the Financial Times published a commentary on signs of a possible "bondholder revolt" against issuer-favorable debt terms (including low debt coverage ratios mentioned in an earlier post) that have prevailed for the past several years. In addition, the DealBook Blog‘s post entitled "Buyout Boom Could Slow As Investors Push Back" discussed how several buyout debt offerings were recently curtailed or modified, a first in this previously strong debt market.

Then, in a separate but interesting move, the former co-head of investment banking at UBS, Jeff McDermott, left last week to start a new private equity firm, Stony Lane Partners. Stony Lane’s focus? Buying and turning around distressed businesses. When asked by the Financial News why he’s making the move, McDermott answered:

I think a credit crunch will play out over time, and it will be like a slow rolling wave. It’s won’t be a one-day cataclysmic event. I think there will be double leverage in the system. I think CDOs are buying margin leverage and are buying corporate credits, which are priced like there’s no end to economic growth in the future. Of course, there are economic cycles.

If he’s right, a rise in defaults, restructurings, and Chapter 11 bankruptcy filings may be coming down the road.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

New Case Addresses Whether A Security Interest In A Patent Can Be Perfected With Just A PTO Filing

When a debtor grants a security interest in a patent issued by the U.S. Patent and Trademark Office (PTO), the creditor must take steps to perfect that security interest. Given that the PTO issues patents but the Uniform Commercial Code (UCC) generally governs perfection of security interests, creditors have often filed both a UCC-1 financing statement and made a filing in the PTO to cover all the bases.

Perfection By UCC Filing. In 2001, the Ninth Circuit held that a creditor who filed a UCC-1 financing statement properly perfected a security interest in a patent even if it did not also make a filing with the PTO. The decision in the In re Cybernetic Services, Inc. case, officially Moldo v. Matsco, Inc., 252 F.3d 1039 (9th Cir. 2001), rested on the Ninth Circuit’s determination that the federal Patent Act does not cover liens on patents and does not preempt the UCC with respect to perfection of security interests. This seemed to settle the question of whether a UCC filing alone was enough to perfect a security interest in a patent, at least in the Ninth Circuit.

Does A PTO Filing Alone Perfect? Judge William C. Hillman of the U.S. Bankruptcy Court for the District of Massachusetts faced the opposite question in the In re Coldwave Systems, LLC case. There the creditor sought to rely on a PTO filing alone to perfect its security interest in a patent because the Bankruptcy Court avoided as a preference a tardy UCC filing made long after the security interest was granted but within 90 days of the bankruptcy petition. The creditor’s much earlier PTO filing of a Recordation Form Cover Sheet, recording the conveyance of the security agreement between the debtor and the creditor, was not subject to avoidance as a preference. The creditor argued that the PTO filing was sufficient to perfect its security interest, even in the absence of a UCC filing.

UCC Perfection Or Bust. In his 14-page decision issued on May 15, 2007, Judge Hillman held that the PTO filing was insufficient to perfect the creditor’s security interest because the Patent Act (specifically Section 261 of Title 35), did not create a system for the perfection of security interests in patents. After first concluding that "[t]he Federal statute does not protect holders of security interests," Judge Hillman held as follows:

There is nothing in §261 that addresses in any way the conflict between one who is not a holder of an interest by way of assignment, grant, or conveyance and a bankruptcy trustee. We must look to other law for the answer. 

That other law was the UCC. Holding that a patent is a general intangible, the Court ruled that nothing in the UCC excepts general intangibles from the rule requiring perfection by a UCC filing. Since no valid UCC filing perfected the creditor’s security interest, it was unperfected and the Chapter 7 trustee prevailed.

The Bottom Line. The Coldwave Systems decision is consistent with the Ninth Circuit’s earlier Cybernetic Services ruling. Together they teach creditors that the only way to perfect a security interest in a patent is by an unavoidable and proper UCC filing. Any creditor relying on a PTO filing alone will end up unperfected and unsecured. While there may be other reasons for a creditor to make a PTO filing, such as potentially protecting against an improper assignment of the patent, perfection of a security interest is not one of them.

Want More? For more on the Coldwave Systems and Cybernetic Services decisions, be sure to read Warren Agin’s excellent post on the Tech Bankruptcy blog, entitled "An Expert Builds On Cybernetic Services." Warren also gets special thanks for first posting on Judge Hillman’s interesting decision.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Third Circuit Holds Contemporaneous Exchange Defense To Preference Claim Is Available Even For Credit Transactions

On June 7, 2007, the U.S. Court of Appeals for the Third Circuit issued a decision in the In re Hechinger Investment Company case holding that the "contemporaneous exchange for new value" defense to preference claims can apply even if the payments were made in the context of a credit arrangement. The key is whether the parties intended the payments involved to be contemporaneous exchanges for new value, the linchpin of this particular preference defense. A copy of the Third Circuit’s decision is available here.

Bankruptcy Preferences. As a reminder, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

The Contemporaneous Exchange Defense. This defense, found in Section 547(c)(1) of the Bankruptcy Code, is short and to the point:

(c) The trustee may not avoid under this section a transfer–

(1) to the extent that such transfer was–

(A) intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor; and

(B) in fact a substantially contemporaneous exchange.

In interpreting this language, the Bankruptcy Court held that a "credit relationship is inconsistent with the intent required in order to sustain" the defense. Essentially, under its view the defense would presumably be limited to situations in which no credit was allowed to remain outstanding but instead a C.O.D. purchase or other similarly immediate "goods for cash" swap was involved.

The Third Circuit’s Focus On Intent. The Third Circuit reversed the Bankruptcy Court’s ruling, explaining its reasoning as follows:

The Bankruptcy Court found that the disputed transfers were not intended by the parties to be contemporaneous exchanges because the transfers were credit transactions. In reaching this result, the Court relied upon several factually distinguishable cases, none of which stand for the proposition that parties can never intend credit transactions to be contemporaneous exchanges under § 547(c)(1)(A). We disagree with the Bankruptcy Court’s conclusion. Indeed, it would appear that § 547(c)(1) covers little other than credit transactions. The § 547(c)(1) defense applies only to transfers that the debtor has shown are payments on an “antecedent debt” under § 547(b). See 11 U.S.C. § 547(b)(2) (definition of avoidable transfers). If there is no delay between when the debt arises and payment of the obligation, then the transfer is outside the scope of § 547(b), and § 547(c)(1) is not implicated. The existence of a delay between the creation of a debt and its payment is a hallmark of a credit relationship, which is, by definition, a relationship in which the creditor entrusts the debtor with goods without present payment. OXFORD ENGLISH DICTIONARY (2d ed. 1989) (defining “credit” as “[t]rust or confidence in a buyer’s ability and intention to pay at some future time, exhibited by entrusting him with goods, etc. without present payment.”).

We do not think that the District Court’s interpretation of the Bankruptcy Court’s order – namely, as concluding that the parties intended to have a credit relationship – necessarily resolves the question. The inquiry still remains: even if a credit relationship was intended, was it nonetheless their intent that the ongoing payments would be contemporaneous exchanges for new value? A court may find the parties intended a contemporaneous exchange for new value even when the transaction is styled as a “credit” transaction. See In re Payless Cashways, Inc., 306 B.R. 243 (8th Cir. BAP 2004), aff’d, 394 F.3d 1082 (8th Cir. 2005). The question is one of intent, and although a delay between the incurrence of the debt and its payment can evidence that the exchange was not intended to be contemporaneous, the passage of time does not necessarily negate intent.

(Footnotes omitted.)

The Bottom Line. Under this decision, a contemporaneous exchange defense to a preference is available even if the defendant has extended credit to the debtor. Nevertheless, to prevail the defendant will have to prove that it and the debtor actually intended the payments to be contemporaneous exchanges for new value and they were, in fact, substantially contemporaneous with the exchange of goods or services.

A Final Note. The Third Circuit decision covered other issues as well, including the ordinary course of business defense and whether prejudgment interest is available for preference claims. For more on those issues, plus a copy of the Bankruptcy Court’s decision below, be sure to read the detailed post on the case by the Delaware Business Bankruptcy Report.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Who Gets The Benefit Of A D&O Policy’s Proceeds, The Directors And Officers Or A Bankruptcy Trustee?

On June 8, 2007, Delaware Bankruptcy Judge Kevin Gross issued a decision in the World Health Alternatives, Inc. bankruptcy case that corporate directors, officers, attorneys, and bankruptcy professionals alike will find of interest. A copy of the Court’s 13-page decision and short order is available here.

The Three-Sided D&O Policy. The issue in the case was whether a Chapter 7 bankruptcy trustee could get an injunction to prevent directors and officers from using the proceeds of a Director and Officer (D&O) liability policy to settle a shareholder lawsuit pending in another court (known as the Consolidated Action). The underlying question centered on who owns the proceeds of a D&O policy when the policy provides:

  • Side A coverage for directors and officers;
  • Side B coverage for the corporation’s expenses in indemnifying directors and officers; and
  • Side C coverage for the corporation’s own exposure for securities litigation claims.  

As is true with many D&O policies, the policy involved in this case also had a "Priority of Payments" endorsement that gave payments under the Side A coverage for the directors and officers priority over both the Side B and Side C coverages.

Does The Automatic Stay Stop Use Of A D&O Policy’s Proceeds? The Chapter 7 trustee sought to block the use of the D&O policy’s limited proceeds to settle the shareholder lawsuit, arguing that they were property of the bankruptcy estate and that the effort to use them to settle this Consolidated Action violated the automatic stay of bankruptcy.  The Chapter 7 trustee had his own lawsuit pending against the directors and officers and he wanted to keep the "wasting" D&O policy (called "wasting" because the policy proceeds also had to cover defense costs) available to cover his claims. The debtor corporation had been dismissed from the shareholder litigation so no Side C coverage was implicated, and because no indemnification had been or was likely to be paid, the Side B coverage had not been triggered.

In denying the Chapter 7 trustee an injunction, the Delaware Bankruptcy Court held that although the policy was property of the bankruptcy estate since the debtor corporation had purchased it, the policy’s proceeds were not. Although acknowledging that some other courts had ruled differently, Judge Gross followed an earlier Delaware Bankruptcy Court decision in In re Allied Digital Technologies Corp., 306 B.R. 505 (Bankr. D.Del. 2004), and held as follows:

Applying the rulings in the cases cited above to the case at hand, it appears that the proceeds of the Debtor’s insurance policy are not property of the estate. The Court arrives at this conclusion from its review of the ‘language and scope of the [P]olicy at issue.’ Allied Digital, 306 B.R. at 509. The Policy proceeds which are being used to fund the Settlement and are being held in escrow by Lead Counsel are from the Policy’s Coverage A. World Health, and now the Trustee as successor, has no right to any Coverage A proceeds, which insures only World Health’s officers and directors. World Health must look to Coverage B which insures it for indemnification claims. There are no such claims against World Health. If the Trustee is seeking to recover for the wrongs of the defendants in the Trustee’s Action pending in this Court, it is not entitled to preference over the settlement of the Consolidated Action. As the Court held in Allied Digital:

The Trustee’s real concern is that payment of defense costs may affect his rights as a plaintiff seeking to recover from The D&O Policy rather than as a potential defendant seeking to be protected by the D&O Policy. In this way, Trustee is no different than any third party plaintiff suing defendants covered by a wasting Policy.

Id. at 512.

Judge Gross ruled that the automatic stay did not apply to the policy proceeds at issue and, as a result, the Chapter 7 trustee was not entitled to an injunction to stop them from being used to settle the other litigation. 

The Take-Aways. When D&O policy proceeds are being used by insured directors and officers to fund a defense or settlement of a covered claim, a bankruptcy trustee generally will not be able to interfere if none of the other coverages — specifically the Side B and C coverages — has been invoked.

  • If claims have been made against the Side B or Side C coverages, the outcome could very well be different.
  • A Priority of Payments endorsement, which gives priority to the Side A coverage for directors and officers, is one tool to consider to help ensure that the D&O policy is available for directors and officers first. However, the law is not clear whether that endorsement would trump the automatic stay if the other coverages were invoked.
  • These issues are complicated and those with a stake in these questions should be sure to get legal advice on both the bankruptcy and insurance coverage issues involved.

For more discussion of the decision and the insurance issues raised, be sure to read Kevin M. LaCroix’s excellent post at The D&O Diary. Special thanks to Francis G.X. Pileggi of the Delaware Corporate and Commercial Litigation Blog for highlighting Kevin’s post.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

New Article Examines What Might Happen To Private Equity Buyouts In A Downturn

The Globe And Mail has a story on its Report On Business.com site entitled "Private equity’s high-wire act: Can leveraged buyout artists build firm foundations on soft money?" The article discusses the current low default rate on the debt that has been financing private equity buyouts and considers who will get hurt when the default rate rises.

The article makes a number of interesting observations about the risks in the current buyout market, including the following:

  • Banks hold a smaller percentage of leveraged debt, having sold off debt to hedge funds and others though pooling vehicles such as collateralized loan obligations, known as CLOs.
  • This trend has put some banks in something of a loan broker role, making the initial acquisition loan but later selling the position.
  • The free cash flow to interest expense ratios are now in the 1.7 range, a noticeable reduction from the 2.6 average three years ago.
  • Toggle bonds, which allow borrowers to issue new bonds, often at higher rates, to finance interest costs on the existing bonds, have become more common.

The article concludes with a discussion of what might bring this private equity cycle to an end, a question on many people’s minds these days. For more on this issue, you may find interesting three past posts on the general subject, available here, here, and here.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Ninth Circuit Clarifies Earmarking Defense To Preference Claims

On June 4, 2007, the U.S. Court of Appeals for the Ninth Circuit brought some additional clarity to the earmarking defense to preference claims in its decision in Metcalf v. Golden, an adversary proceeding within the In re Adbox, Inc. Chapter 7 case. In this post, I’ll give a little background on preferences and the earmarking defense and then discuss how the defense works in the Ninth Circuit.

Preferences And Earmarking. Before reaching its decision on the earmarking issues, the Court set the legal context by discussing what preferences are and how earmarking can sometimes be a defense to a preference claim.

Under 11 U.S.C. § 547 the bankruptcy trustee may recover certain transfers made by the debtor within 90 days before filing for bankruptcy, if the trustee proves:

(1) a transfer of an interest of the debtor in property;

(2) to or for the benefit of a creditor;

(3) for or on account of an antecedent debt;

(4) made while the debtor was insolvent;

(5) made on or within 90 days before the date of the filing of the petition; and

(6) one that enables the creditor to receive more than such creditor would receive in a Chapter 7 liquidation of the estate.

In re Superior Stamp & Coin Co., Inc., 223 F.3d 1004, 1007 (9th Cir. 2000) (citing 11 U.S.C. § 547(b)). Such a transfer is known as an ‘avoidable preference’ or a ‘preferential transfer.’ Id. at 1007-09. The ‘earmarking doctrine’ is a courtmade exception to this rule that applies when a third party advances funds to the debtor subject to an agreement requiring the debtor to use the funds to pay off another creditor. Id.; In re Sierra Steel, Inc., 96 B.R. 271, 274 (B.A.P. 9th Cir. 1989). In such circumstances, the funds are deemed ‘earmarked’ and are not considered part the debtor’s estate. Sierra Steel, 96 B.R. at 274.

For more information on preferences, and some tips on how creditors can protect themselves when dealing with a financially troubled customer, you may find this post of interest.

Is Earmarking An Affirmative Defense? One previously unresolved issue involving the earmarking defense was whether it is a true "affirmative defense," which would mean that to assert it a preference defendant would have to include it in its answer to the preference complaint. In Metcalf, the Ninth Circuit said no:

Earmarking is not one of the affirmative defenses enumerated in Rule 8, and we decline to construe it as such under Rule 8’s residuary clause for ‘any other matter constituting an avoidance or affirmative defense.’ Properly understood, the earmarking doctrine is not an affirmative defense under Rule 8, but rather a challenge to the trustee’s claim that particular funds are part of the bankruptcy estate under 11 U.S.C. § 547. See Libby Int’l., 247 B.R. at 467 [In re Libby Int’l., Inc., 247 B.R. 463 (B.A.P. 8th Cir. 2000)]. Thus, the Metcalfs did not waive their earmarking defense by failing to plead it in their answer in the preference action.

Who Has The Burden Of Proof? With the affirmative defense issue out of the way, the Ninth Circuit then tackled the even more important question of whether the trustee or the defendant has the burden of proof on the earmarking defense. The Court held that although the trustee has the burden to prove that the funds at issue came from the debtor’s account, the real burden of proof to establish the actual earmarking defense shifts back to the defendant:

As the district court noted, there is ‘substantial confusion’ over who bears the burden of proof on an earmarking defense. The Ninth Circuit Bankruptcy Appellate Panel addressed this question in Sierra Steel, where it denied an earmarking defense because the defendant ‘ha[d] not traced the funds to money received by the debtor from [the lender].’ 96 B.R. at 275. While the Sierra Steel court started from the general principal that the trustee has the burden of establishing that property is part of the bankruptcy estate, it also noted that the funds in question were disbursed from the defendant’s general account. Id. at 274 n.5. The source of the funds raised the presumption that the funds were property of the bankruptcy estate and the burden of proof accordingly shifted from the trustee—to establish that the funds were part of the estate —to the defendant—to show that they were not. Id. (citing In re Bullion Reserve of N. Am., 836 F.2d 1214, 1217 n.3 (9th Cir. 1988)).

We follow well-established law in holding that the trustee bears the initial burden of establishing that a transfer is an avoidable preference under § 547. See Sierra Steel, 96 B.R. at 274. If, however, the trustee establishes that the transfer of the disputed funds was from one of the debtor’s accounts over which the debtor ordinarily exercised total control, we follow the approach of Sierra Steel and find that the trustee makes a preliminary showing of an avoidable transfer “of an interest of the debtor” under § 547(b). The burden then shifts to the defendant in the preference action to show that the funds were earmarked.

In the Metcalf case, the Court ultimately held that the defense was not established. The defendants could not prove the existence of an agreement between the debtor and the lender that had advanced the funds requiring them to be paid to the defendants. Since the debtor could have used those funds for another purpose, the payment to the defendants was a preferential transfer from the debtor’s estate.

Where Does This Leave The Earmarking Defense? The Ninth Circuit’s decision reaffirmed the existence of the earmarking defense and resolved two important procedural questions about how the defense may be asserted. The decision also highlighted the level of proof needed to make a successful earmarking defense. If a creditor is getting paid with loaned funds and hopes to use the defense, it should make sure that there is an actual agreement requiring the debtor to use the newly loaned funds to pay that creditor. Without proof of such an actual agreement, the earmarking defense will fail. 

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Delaware Bankruptcy Court Considers Whether Key Employee Incentive Plan Milestones Can Be Lowered Without Triggering The Restrictions On Retention Plans

One of the significant changes made by the Bankruptcy Code amendments that took effect in October 2005 was the imposition of severe restrictions on "key employee retention plans," known in the bankruptcy world as KERPs.  In this post I’ll discuss how several courts have handled these issues in the year and a half since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, known as BAPCPA, became effective. The most recent decision, issued late last week by the Delaware Bankruptcy Court in the Nellson Nutraceutical case, gives debtors added flexibility when trying to craft plans consistent with these new restrictions.

Changes Aimed At Curbing KERPs. Prior to BAPCPA, KERPs were a very popular way of making sure that a company could retain its most important officers and employees to guide it through bankruptcy. Citing perceived abuses, however, Congress added language in BAPCPA that requires debtors to satisfy nearly impossible standards before courts would be permitted to approve payment of retention bonuses (or severance payments) as administrative claims to officers and other insiders of a bankrupt company. The restrictions apply only to insiders; no similar limitations have been placed on payment of retention bonuses and severance to non-insiders.

The New Law’s High Hurdles. To give you a flavor of the restrictions BAPCPA added to Section 503(c) of the Bankruptcy Code, a debtor company must now prove the following before it can gain approval for payment of a retention bonus to an insider:

  • 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;
  • the services provided by the person are essential to the survival of the business; and

  • either

  • 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
  • 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.

The requirement of a bona fide job offer in particular has led some to observe that if an officer of a company in Chapter 11 really had such an offer he or she would probably just take it, mooting the entire retention issue. In any event, these provisions have had their desired effect. It is now rare to find a debtor proposing a KERP that seeks to make retention payments to officers or other insiders.

Debtors Opt For Plan B. Despite these restrictions, debtors still usually want to keep their key officers and may worry that they will leave for more stable companies absent some incentives to remain with the debtor. So what are debtors doing? Since October 2005, they have shifted gears and are proposing not retention plans but incentive plans instead. To date, only a few decisions, discussed below, have addressed what is necessary for an incentive plan to pass muster. In other instances, incentive plans have been approved with little or no opposition. Perhaps the earliest such approval came in May 2006 when Judge Burton R. Lifland approved one in the Calpine Corporation Chapter 11 case.

The Dana Corporation Case. The first significant contested plan motion came shortly after the Calpine incentive plan’s approval. Dana Corporation, whose Chapter 11 case was also pending before Judge Lifland, filed a motion seeking approval of a plan similar to that approved in the Calpine case. After considering objections filed by various creditors and others, however, in September 2006 Judge Lifland refused to approve Dana Corporation’s proposed plan, finding that it was a prohibited retention plan. For an excellent and entertaining discussion of the circumstances leading to denial of that first effort in the Dana Corporation case, including why the Calpine plan was approved while the first Dana plan was not, be sure to read Steve Jakubowski’s detailed post on the Bankruptcy Litigation Blog.

A few months later, on Dana Corporation’s second try, Judge Lifland approved the revised incentive plan. In his second ruling, he found that with certain modifications the debtor’s revised proposals met the sound business judgment test required for approval. In addition, he ruled that the new plan incentivized the key officers "to produce and increase the value of the estate" and, because the benchmarks in the plan were difficult targets to reach and not easy "lay-ups," the proposal was an actual incentive plan and not a retention plan in disguise.

Evaluating Incentive Plans. In evaluating whether the Dana plan represented the exercise of sound business judgment, Judge Lifland considered the following factors:

  • Is there a reasonable relationship between the plan proposed and the results to be obtained, i.e., will the key employee stay for as long as it takes for the debtor to reorganize or market its assets, or, in the case of a performance incentive, is the plan calculated to achieve the desired performance? (emphasis added)
  • Is the cost of the plan reasonable in the context of the debtor’s assets, liabilities and earning potential?
  • Is the scope of the plan fair and reasonable; does it apply to all employees; does it discriminate unfairly?
  • Is the plan or proposal consistent with industry standards?
  • What were the due diligence efforts of the debtor in investigating the need for a plan; analyzing which key employees need to be incentivized; what is available; what is generally applicable in a particular industry?
  • Did the debtor receive independent counsel in performing due diligence and in creating and authorizing the incentive compensation?

These factors provide useful guidance not only to bankruptcy courts but also to boards of directors of financially troubled companies, whether in or out of bankruptcy, when considering proposals for retention or incentive plans.

The Global Home Products Decision. In March 2007, Judge Kevin Gross of the Delaware Bankruptcy Court approved two incentive plans in the Global Home Products case. In that decision, as the Delaware Business Bankruptcy Report described here, the court followed the analysis Judge Lifland used in the Dana Corporation case and approved the two incentive plans. Specifically, Judge Gross found that the plans were true incentive plans, which he called "pay for value" plans and were not KERPs, or "pay to stay" plans. For this reason, Judge Gross evaluated the plans under the business judgment standard of Section 363 of the Bankruptcy Code, holding that the strict Section 503(c) limitations simply did not apply.

The Nellson Nutraceutical Decision. On May 24, 2007, Judge Christopher S. Sontchi of the Delaware Bankruptcy Court issued a decision in the Nellson Nutraceutical Chapter 11 case approving revisions to a previously-approved incentive plan. There, the debtors’ first incentive plan provided for certain performance milestones based on target levels of EBITDA, or earnings before interest, taxes, depreciation, and amortization. Unfortunately, the debtors did not achieve those EBITDA milestones and sought to lower them to align with what they considered to be more realistic performance goals. After receiving testimony that the debtors had made similar reductions in bonus targets in the past, Judge Sontchi concluded that the debtors’ current proposal was in the ordinary course of business and involved a good faith business judgment.

On the issue of whether Section 503(c)’s retention payment restrictions applied, Judge Sontchi found that the lowering of the incentive plan milestones did not turn the plans into retention plans. He held that if the primary purpose of a plan is to incentivize insiders and other employees, rather than merely retain them, it remains an incentive plan:

Under the facts of this case, although the modification of the 2006 bonus program has some retentive effect, it is for the primary purpose of motivating employees and, thus, the limitations of section 503(c)(1) are not applicable.

*     *    *

The [United States Trustee] argues with some force that if an incentive plan is based on achievement of EBITDA targets and those targets are not achieved, yet the bonus is still received, that the plan cannot be an incentive plan but must, in fact, be solely a retention plan.

*   *    *

While the Court agrees that the payment of bonuses under the modified 2006 [plan] has some retentive effect, the Court disagrees with the [United States Trustee’s] argument that its sole or primary purpose is retention. Consistent with the Debtors’ pre-petition practice, the 2006 [plan] must be considered as a whole. It consists of two parts: the establishment of ‘aspirational goals’ in the early part of the year; and a review at the end of the year to consider whether those goals have been met and, if not, why. In this case, the Debtors did just that and determined that the 2006 [plan] served its purpose by motivating the employees to do a ‘great job’ in connection with the matters that those employees could reasonably be expected to influence. As such, the Debtors seek to award bonuses at a reduced level to compensate the employees for their success (albeit somewhat limited) in 2006 and to motivate the employees in 2007.

Finally, Judge Sontchi held that Section 503(c)(3)’s additional limitations, which among other things prohibit transfers to insiders that are "outside of the ordinary course of business and not justified by the facts and circumstances of the case," by its terms apply only to payments outside of the ordinary course of business. Given his earlier holding that the debtors’ plans and their modifications were made in the ordinary course of business, Judge Sontchi concluded that Section 503(c)(3)’s requirements did not apply at all.

Conclusion. BAPCPA has effectively ended the use of KERPs for officers and other insiders of a debtor. However, more than a year and a half after BAPCPA became effective, bankruptcy courts in New York and Delaware, and perhaps elsewhere, are willing to approve incentive plans for insiders. The Nellson Nutraceutical decision goes further and, in the right circumstances, will allow the incentive plan’s performance milestones themselves to be lowered without jeopardizing the "incentive" character of the plan. This area of the law is plainly evolving, so stay tuned for more developments.