Regulating Bankruptcy Bonuses

By Jared Ellias (University of California, Hastings)

In 2005, the perception that wealthy executives were being rewarded for failure led Congress to ban Chapter 11 firms from paying retention bonuses to senior managers. After the amendment became effective, Chapter 11 debtors could only pay executive bonuses through court-approved “Key Employee Incentive Plans,” which required managers to earn their pay by accomplishing specific performance goals, such as increasing revenue or moving the firm through the bankruptcy process.

In my article, I use newly collected data on the compensation practices of Chapter 11 debtors between 2002 and 2012 to examine how the reform changed bankruptcy practice. I find that relatively fewer firms used court-approved bonus plans after the reform, but the overall level of executive compensation appears to be similar. I hypothesize that three problems undermined the efficacy of the reform. First, the 2005 law asks bankruptcy judges to police the line between “incentive” bonuses and “retention” bonuses, which is extremely hard to do – judges are poorly equipped to assess the “challenging-ness” of a proposed performance goal. Second, creditors have limited incentives to police executive compensation themselves and help bankruptcy judges perform their inquiry, and the Department of Justice’s US Trustee program, while vigilant, lacks expertise in executive compensation. Third, gaps in the new regime make it easy for firms to bypass the 2005 law and pay managers without the judges’ permission. I support each of these hypotheses with empirical evidence. Further, there is also evidence that the reform significantly increased the litigation surrounding bonuses plans and, unsurprisingly, the attorneys’ fees associated with them. In many ways this paper examines what happens when Congress tries to change the balance of bargaining power between managers and creditors, and the result appears to be that firms found ways to get around a poorly written rule.

The full article is available here.

 

The Effect of Executive Compensation on Recoveries

posted in: Valuation | 0

By Andrea Pawliczek, Leeds School of Business, University of Colorado – Boulder

 

The structure of executive compensation will influence an executive’s behavior. For debt holders, this influence becomes especially important when a firm nears bankruptcy because this is when the debt holders’ value is at risk.

 

Consider the actions of an executive of a financially distressed firm depending on his compensation. As bankruptcy becomes likely, an executive with only equity compensation (i.e. stock and options) is likely to gamble for solvency as his wealth is entirely dependent on the firm’s stock price. For example, RadioShack, whose CEO had no debt-like compensation, undertook such a strategy, purchasing a 2014 Super Bowl ad for $4 million when the company was already in significant financial distress. Although the ad was popular and resulted in a 12% jump in the firm’s stock price the next morning, it did not help the fortunes of the company, which declared bankruptcy just over a year later on February 15, 2015.  Alternatively, an executive with debt-like compensation (e.g., pensions and deferred compensation) does not lose everything in the case of bankruptcy. This executive would have incentives to preserve firm value (i.e. assets that have value in liquidation or more value to the reorganized firm) to generate higher recoveries for himself and other debt holders in the event of bankruptcy.

 

While this prediction is established theoretically, there is no prior empirical evidence supporting this idea. Using a sample of 104 Chapter 11 bankruptcies of large public firms, I find that debt-like compensation – specifically Supplemental Executive Retirement Plans (SERPs) – is associated with higher recoveries to unsecured debt in bankruptcy. (SERPs are in almost all cases a form of unsecured debt that is at risk in bankruptcy. The only exception is if SERP assets are held in a secular trusts. Secular trusts are rarely used in compensation of executives at large public firms, however, because they result in the loss of tax deferral.) Recoveries to unsecured debt are 22% higher for a firm whose CEO holds sample mean levels of debt-like compensation compared to a firm whose CEO holds no debt-like compensation. I also document that debt-like compensation is associated with efforts to preserve more liquid assets prior to bankruptcy (e.g., cuts to research and development expenses).

 

The complete paper can be downloaded here.