Fair is fair
Amid the chaos of the Delphi Corporation bankruptcy, there has been an intriguing development of interest to anyone involved in setting or critiquing executive pay. Following a hearing, federal bankruptcy Judge Robert Drain of New York’s Southern District agreed to approve Delphi’s bankruptcy exit plan only if the company significantly slashed executive incentives from $87 million to $16.5 million. It was a rare example of a court cutting executive pay in a Chapter 11 context, and fits with a developing legislative push to distribute the burden of bankruptcy losses more evenly across all levels of a company.
The company agreed to the cuts, which were proposed by organized labor, and the decision grabbed headlines around the world. Gretchen Morgensen of The New York Times called the original incentive package ‘a wonderful example of unshared sacrifice that has become deplorably common in Corporate America.’ Andrew Clark, writing in the UK’s Guardian newspaper, said Drain had ‘struck a blow against America’s culture of telephone number-sized corporate bonuses.’
Is the Drain decision a demand for c-suite executives to say goodbye to all that? Lawyers agree that the decision does not establish a precedent that mandates bankruptcy courts’ review of executive compensation in reorganization plans. Rather, they say, it exerts judicial authority provided for under the Bankruptcy Code, which Drain exercised in consideration not only of the code, but also of agreements between management and labor in this particular case. The extent to which labor-management negotiations and labor concessions played into the decision limits its applicability to future cases.
Lawmakers in synch
At the same time, however, existing and proposed legislative changes in Congress are converging to create a legal environment in which it will be more difficult, if not impossible, for companies to sustain old-style executive compensation packages through a bankruptcy reorganization and exit. One such bill, sponsored by Rep John Conyers and by Sen Richard Durbin, is the ‘Protecting Employees and Retirees in Business Bankruptcies Act, ’ which seeks to spread concessions in bankruptcy proceedings more evenly between management and employees.
Some important legislative changes actually occurred between the time Delphi began its reorganization and the Drain ruling in January. Richard Kremen, a bankruptcy lawyer at DLA Piper and chairman of the legislation subcommittee of the American Bar Association’s Business Bankruptcy Committee, notes that any interpretation of the ruling has to take into account the fact that the Delphi filing occurred before the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which made several significant amendments to the Bankruptcy Code, was passed into law.
‘These amendments changed certain key provisions of the Bankruptcy Code, particularly Section 503, which dealt with compensation arrangements,’ Kremen says. ‘The 2005 amendments changed the landscape dramatically in terms of how compensation and severance arrangements had operated in the bankruptcy world.’
Although the amendments had no direct bearing on the decision, since the Delphi filing predated their coming into law, Drain obviously was aware of them and of the ‘notorious cases’ (Enron, Global Crossing, WorldCom and so forth) that had sparked the changes, he adds. ‘So when you look at what the judge said in this case, you have to understand that it was not based on what the amendments said, because if the case would have been controlled by the amendments, the basis for the judge’s ruling would have been dramatically different.’
Kremen explains that the Drain ruling was based on the judge’s analysis of the confirmation standards. In order to get its bankruptcy plan approved, a company must demonstrate that it has satisfied all the requirements of what is known as Section 1129, addressing the question of whether payments for a proponent of the plan are reasonable. ‘That was the hook that he used to go back and really criticize the [compensation] consultants’ findings, which he obviously thought were not persuasive,’ he says.
The judge examined such factors as industry standards, claims against the estate, if the plan discriminated unfairly among constituencies of the bankruptcy, how the provision applied to employees, and what due diligence was performed. ‘He did a global analysis,’ Kremen says. ‘He really went through all of the factors and concluded that the senior management group was not going to get $87 million, that $16 million was fair given the totality of the circumstances.’
Edward Morrison, a law professor at Columbia University, concurs that the decision reflects Delphi’s particular circumstances. He notes that agreements reached by management and labor had considerable impact on the judge’s decision in this case, making the ruling much more specific to Delphi’s situation and much less likely to be applied globally: ‘It probably would seem somewhat unusual to strike down executive compensation so aggressively using only that provision of the bankruptcy code, because once you go down that road, you go down the road of micromanaging the case, and the Bankruptcy Code was drafted in 1978 with the specific goal of getting judges out of the business of micromanaging cases.’
Sharing the pain
But Drain didn’t rely solely on the Bankruptcy Code; he also took into account a specific Memorandum of Understanding (MOU) between management and labor at Delphi. ‘My understanding was that this MOU contained language that employees and management would be treated fairly and equitably … that if salaries are cut, if benefits are cut, that the cuts would be fair and equitable across employees and managers,’ Morrison says. ‘And judge Drain read that as another foundation to review the reasonableness of the executive compensation, because the executives had agreed with the union that whatever cuts the line workers suffered would not be disproportionate, that there would be a sharing of the burden of the reorganization process.’
Because the MOU played such an important role in determining the judge’s decision in this case, Morrison says, it’s unlikely that the case will prompt other bankruptcy judges to routinely review executive compensation agreements in future bankruptcy reorganizations. However, there are provisions in the bankruptcy code that say that during the bankruptcy case itself, executive compensation cannot be excessive. The concept of fair and equitable treatment is built into the bankruptcy code, and the language in which the concept is expressed is similar to the language in the MOU.
Mark Roe, who teaches corporate bankruptcy and reorganization, corporate finance and corporate law at Harvard University, expresses the idea more colloquially: ‘It sounds like what’s going on in the opinion is, this just doesn’t pass the smell test. Here are company executives taking huge amounts of money while the employees are being told to cut back X percent.’
He adds that the Delphi ruling seems to say that the proposed levels of executive compensation were not good for the enterprise – and that had Drain allowed the proposed executive compensation structure to stand, the business would not have been run as well following its exit from bankruptcy.
Delphi executives may not have accepted that rationale, but they had few options aside from accepting the ruling in order to get their plan approved and allow the company to move forward. Experts say that had Delphi’s management team attempted to appeal the decision, the company’s legal and financial options would have been limited. Kremen explains that a successful appeal would have depended on a finding ‘that the judge made an error in the way he applied the facts of the law.’
There are also economic constraints on a company in the midst of a reorganization. As Morrison points out, a company’s ability to appeal successfully would depend in part on its chances of surviving as a going concern through the appeal process – a gamble many companies in Chapter 11 are not in a position to take.
Looking ahead, Kremen, Morrison and Roe agree that while the Drain decision itself is unlikely to attain landmark status, the landscape for executive compensation during a bankruptcy reorganization is changing. Corporations must be aware of those changes and the extent to which Congress and organized labor can exert influence on them, they agree.
‘Organized labor has obviously been very vocal in terms of these statutes. My experience is that’s where you see most of these issues coming from,’ Kremen explains. ‘You don’t see these issues to any great extent if you’re not in the large bankruptcy cases where labor is very active. You just don’t see it if you look at the smaller Chapters 11s; these are not issues that would normally surface.’
Morrison echoes his comments: ‘Whenever a union is present and the union members are being asked to make sacrifices, that’s going to have bearing on executive compensation.’
As far as legislative action is concerned, Morrison notes that while Congress has taken action to promote disclosure of executive compensation outside the context of bankruptcy, it has sought to use the Bankruptcy Code as a vehicle not just for disclosure but, in a more activist sense, to limit compensation. ‘It’s actually a neat area of law,’ he says. ‘During a bankruptcy case, management compensation is now regulated under the code. And now we see, with judge Drain’s decision, an example — it’s not clear how generalizable it is, but at least an example — of management compensation upon exit from bankruptcy being regulated as well, or at least scrutinized.’
And while judges in future bankruptcy cases won’t be held to a Drain precedent, continued legislative initiatives could give more teeth to similar decisions or even reconstruct the law in such a way that it instructs others to issue similar decisions. The Conyers-Durbin bill, Roe says, tells judges: ‘There’s a range of things where you can’t even decide whether this is a reasonable business practice or not. It’s not giving the judge or managers discretion. This is potentially tougher than the Delphi decision.’