Management Compensation: Primer on Aligning Incentives in Bankruptcy

Welcome to the 114th Pari Passu newsletter,

Today we are going to be digging deep into management compensation and incentive structures in distressed businesses.

Founders and CEOs are the faces of corporations when they succeed – Steve Jobs with Apple, Elon Musk with Tesla, and Brian Niccol with Chipotle. They are also the first to blame when they fail – Adam Neumann with WeWork and Ken Lay with Enron. Choosing and properly incentivizing the right leadership teams is crucial. So, how do companies motivate successful and valuable talent to help ballast a sinking ship? How does the Bankruptcy Code prevent managers from enriching themselves using creditor assets?

In this newsletter, we will begin by exploring the importance of corporate management in distressed businesses and then provide an overview of the typical incentive structures key employees receive in a Chapter 11 scenario. To bring it all together, we will examine surgical implant and healthcare tools manufacturer Exactech’s 2024 bankruptcy and the debates surrounding its executive compensation structure. Let’s dive right in.

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Introduction

At its core, a business is just a collection of people that produce goods or provide services. A company’s operating metrics and financing structure can be reorganized into neat financial statements and kept track of using accounting systems, but the essence of a business is always driven by its people. The economic contribution of an organization’s culture, leadership, and management is difficult to quantify; in good times, it can be the key intangible differentiator between a successful company and a struggling one. In distress, it can be the difference between a going concern and a liquidation. Managing a company heading for bankruptcy can be very different from leading a startup or spearheading a new product launch. 

The Role of Managers: Healthy vs Distressed Companies

Healthy Company: In a healthy company, the role of the executive is to find ways to continue to grow. Classic financial economic theory dictates that a corporation should provide returns (r) above its cost of capital (k). If this happens, the excess value should accrue to shareholders because their ownership of the company is worth more. To ensure that r>k, healthy companies are constantly investing in capital expenditures, making acquisitions, and expanding their operations. The decision-making structure for corporations is from the top-down. At the top is a corporation’s board of directors which acts as the organization’s “governing body”. These individuals have the power and responsibility to enact company policy and set executive compensation targets. Perhaps most importantly, they hire and fire corporate officers, who actually operate the business day-to-day [12]. It is not uncommon for individuals to serve on both the board of directors and as officers in their company. In a healthy company, both the board of directors and the officers they elect to operate the company are direct representatives of shareholder interests. In other words, they have a fiduciary duty, or the legal and ethical obligation to act in the best interests of the owners of the company. Practically speaking, shareholders enforce this legal and ethical ideal using economic incentives to “align” management’s interest with their own. Management is generally compensated in one of three ways for their work [1]:

Stock options: Participants are given the opportunity to purchase an agreed number of shares at a set price at some point in the future.

Restricted stock units: Participants are given a specified number of shares or their cash equivalents in accordance with a pre-determined “vesting” schedule.

Cash-based performance bonuses: If a series of operational or financial targets are achieved, participants receive a cash bonus or pre-determined percentage of the incremental operational improvement.

Strictly speaking, public companies also provide officers incentives for achieving short-term earnings targets which do not always have long-term benefits. Earnings-per-share can be artificially inflated through non-economic share-repurchases, deferred R&D and capex, or through bolt-on acquisitions. While management incentive structures can vary greatly from company to company, the theoretical concept remains the same: if the company is able to make r>k, the manager shares in the equity upside with the other shareholders of the business. For the typical executive, most of their compensation comes from their incentive-based pay. For example, in 2023 Chipotle ex-CEO Brian Niccol took home ~$22.5mm in total compensation, of which ~98% was incentive-based pay [13].

Distressed Company: In a distressed company, by definition, r<k. Perhaps there was an economic downturn, a structural trend the company missed out on, or an unexpected liability that jeopardized the earning potential of the business going forward. As trouble mounts, the expected incentive pay for a senior manager can be non-existent. Several considerations complicate the company’s options going forward. 

First, the shareholders of the business may still have control over the operations of a company, but they may not be the economic owners of the business. To provide an illustration of this scenario, imagine a company with a large loan coming due in one year. It cannot refinance or pay down its debt using operating cash, but it has enough liquidity to service the debt in the interim. When that loan comes due, the company will likely default and be forced to file for bankruptcy, and the value of the equity will be deemed worthless. While the creditors are the economic owners of the business (they will be paid first in bankruptcy), the shareholders (management) still have control of the operations of the company. Practically, what does this mean? In this scenario, management has the incentive to invest in high-risk, high-reward options to try and turn the business around and retain the value of their equity ownership of the company. From a creditor’s perspective, these actions could be viewed as destroying value – setting up a confrontational dynamic between managers and its creditors in court. Later in the article we will learn about the provisions in the bankruptcy code to “claw back” any of these destructive decisions.

Second, technical insolvency can change management’s fiduciary duties from shareholders to all beneficial stakeholders including creditors. Once a company declares bankruptcy, creditors can file lawsuits against directors and officers alleging misconduct – asking to be made whole for the damages these actions inflicted. To determine insolvency, courts generally use one of two methods: 

The Balance Sheet Test: Examines if a corporation’s liabilities exceed the reasonable market value of its assets.

The Equitable Insolvency Test: Also known as the “Cash Flow Test”, this examines whether a corporation can pay its debts when they become due.

Courts use these tests to determine eligibility for a company to file bankruptcy, or to evaluate litigation alleging impropriety. When a company is determined to be within this “zone of insolvency”, managers are often confronted with choosing between their own financial interests and the best interests of the company [2].

Because of these factors, the role of a manager in a distressed company is fundamentally different from a healthy company. Instead of making sure r>k, management of a distressed company should be focused on preventing asset deterioration and serving the best interests of all stakeholders. Unfortunately, the traditional compensation structure of a healthy company fails to “align” to these new objectives and creates issues for retaining company leaders. In this case, executives generally take the following steps:

Quit / take jobs elsewhere: If someone has a good track record and is not economically incentivized to stay, there is a good chance they will find another job which will pay better and be less work than managing a company about to enter bankruptcy.

Retain advisors: If a company is in trouble, its first call is often to its lawyer to receive advice on how to proceed. If recommended, a turnaround consultant or investment banker can also be hired to help review options for maximizing operational performance or increasing liquidity.

Purchase D&O insurance: Directors and officers insurance (D&O) protects personal assets of corporate directors and officers in the event they are personally sued for wrongful acts while managing the company [3].

Ultimately, because of how different managing a healthy company and a distressed company can be, turnaround professionals generally end up leading distressed businesses through the deleveraging process.

Retaining Key Talent in Bankruptcy

While hiring a lawyer, turnaround consultant, or investment banker can be a prudent business decision, it is temporary and insufficient. These professionals do not know the industry as well as the original management team and cannot create a lasting culture at a reemerging company. For that, a company needs to retain key employees which are instrumental to the organization’s long-term strategy. While creditors may be skeptical about executives who led a company into bankruptcy staying on, it is undeniable that the industry relationships, institutional knowledge, and external legitimacy of the right leadership team is crucial to maximizing value. Indeed, after a successful restructuring, some of the former creditors are likely to be the new reorganized equity owners, making them keen to reaccelerate growth. There are two major ways a company in distress can attempt to retain its key employees during a restructuring:

Pre-petition: Remember our example from earlier, when our hypothetical business was going to declare bankruptcy in a year, but shareholders still controlled the company. As an executive in that scenario, it is very tempting to increase your salary to offset your worthless equity-based compensation. These payments are not subject to bankruptcy court approval and might be overlooked in the later filing. Legally, however, these actions can be “clawed back” by the bankruptcy estate if they occur within a year of declaring chapter 11. Additionally, these payments can be extremely inflammatory and controversial. For example, 6 months before its 2012 bankruptcy, Hostess Brands raised its CEO’s salary to $2.5mm from $750k and gave large raises to at least 9 other executives. Understandably outraged, creditors went to the press and leaked details of the pay packages to coerce Hostess to roll back the raises. They did. Additionally, you might be tempted to transfer or sell assets hastily to extend the option in your equity. Sometimes these actions can be construed as a “fraudulent conveyance” in a bankruptcy context. Asset transfers can be classified as “fraudulent conveyances” if i) they were executed “with actual intent to hinder, delay, or defraud” ii) the business receives “less than a reasonably equivalent value in exchange for such transfer or obligation” and the business is insolvent at the time, the business believed it would incur debts it would be unable to pay, or the transfer was made for the benefit of an insider [11]. In other words, if the manager recklessly uses their position as a decisionmaker to prioritize shareholder interests once a business is in that “zone of insolvency”, there is a high chance it will be litigated in bankruptcy court and potentially unwound. For these reasons, pre-petition retention compensation strategies are risky and rarely used [4]. 

Part of the Plan of Reorganization: Most commonly, companies identify key employees they wish to incentivize to stay with the company and approve these packages after the chapter 11 petition is filed. For decades, executives could negotiate extremely generous compensation packages just to stay at the company regardless of the restructuring outcome. Then, in 2005, congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act (BACPA) which added section 503(c) to the Bankruptcy Code.

Pre-2005: Before BACPA and 503(c), the most common motion for key employee retention was called the Key Employee Retention Program (KERP). In exchange for staying with the company, executives would receive cash bonuses as a percentage of their base salary. Crucially, these bonuses were treated as administrative claims in chapter 11, meaning they enjoyed higher priority than creditors and had to be paid in full for the company to exit bankruptcy. This system was controversial because bankruptcy often forced pension concessions and pay cuts for junior employees [5].

Post-2005: After BACPA was passed, section 503(c) of the Bankruptcy Code restricted the type of employee eligible for KERP payments given their preferential treatment as “administrative claims”. 503(c) flatly prohibits retention payments for insiders (executives, directors, or shareholders with more than 10% of the equity). It also severely restricts any benefits to insiders that are deemed “outside the ordinary course of business” and subjects these payments to court approval. Practically, these extremely narrow restrictions on KERPs for insiders made them an unviable method for retaining key executives. It is important to note that KERPs remain the primary distressed compensation structure for non-insider key employees. In certain cases, like the one we will examine later, approval of the KERP has hindged on the court’s interpretation of the term “insider”. In place of KERPs, a new type of compensation structure emerged, the Key Employee Incentive Program (KEIP). KEIPs are different from KERPs in one regard: payments are performance-based instead of being granted for retention regardless of performance. In this way, KEIPs avoid the provisions in 503(c) and maintain their administrative priority [5].

While legally different, it is easy to see how the line between a KERP and a KEIP can sometimes be blurred. For example, in re Residential Capital, LLC, executives stood to earn ~$7mm in KEIP bonuses upon plan confirmation. After closer examination, the performance goals governing 63% of this bonus had already been achieved before the KEIP had even been proposed [5]. The court denied the plan and forced the company to rework its KEIP. In addition to ensuring that performance goals are sufficiently difficult to achieve, companies must also ensure that KEIPs do not violate the absolute priority rule in bankruptcy. This is relevant in situations when executives are large pre-petition equity holders and are offered reorganized equity incentives in their KEIP. If these equity incentives are deemed to be offered “on account” of management’s previous equity ownership – this violates the payment waterfall where creditors are compensated first. In other words, a CEO being a large shareholder before the bankruptcy should not have any influence on their potential equity ownership after the bankruptcy. To avoid being accused of granting shares on account of pre-petition ownership, the company must demonstrate the executive’s value to the business and provide a list of comparable managers being paid a similar amount [6].

Ultimately, compensation should be a tool for aligning incentives of company stakeholders and management. In healthy companies, this means giving executives equity ownership and shared profits of the enterprise as it grows. For companies in distress, these incentives diverge because the equity options no longer have any value. To solve this, companies create management incentive plans to retain valuable employees and re-align their incentives with the reorganized owners.

Exactech: A Case Study in Zero-Sum Bankruptcy

Exactech is a leading developer and manufacturer of surgical implants and surgical imaging devices. The company is best known for its artificial joints used to help alleviate arthritis and osteonecrosis symptoms. Exactech was bought by TPG Capital in 2018 for ~$737mm. Despite strong operational results, the company faced significant litigation stemming from recalls of several of its surgical implant products. Without certainty regarding the resolution of these liabilities, the company was unable to refinance its maturing 2024 and 2025 debt. With no out-of-court solution attainable, the debtor negotiated a restructuring support agreement (RSA) with its ad-hoc group of first-lien lenders who agreed to fund the DIP loan and provide a stalking horse bid for the company’s assets. In plain English, the company pre-negotiated a sale to its most senior lenders before filing for bankruptcy on October 29^th , 2024 [7]. 

Given the company’s “strong” operating results, the debtors are hoping for a quick chapter 11 restructuring that will minimize value leakage. Their strategy is to classify the litigation claims as unsecured, sell the business to the pre-petition senior lenders, and distribute the proceeds to the bankruptcy estate (where the litigation claims will be paid last). The first-lien lenders, or the implied equity owners of a reorganized Exactech, want the business to continue to operate strongly once it exits bankruptcy. 

To maintain Exactech’s operational strength and retain the employees instrumental to its success, the debtors filed a KERP motion just 15 days after filing for bankruptcy. In the KERP, the company acknowledges that despite including KERP participants with titles of “senior director”, “senior manager”, or “vice president”, these individuals are not insiders. Remember, this nuance would allow Exactech to use a KERP rather than a KEIP, and in the process designate KERP payments as administrative claims. Indeed, the company went further to argue that these employees sit one level below the senior executive team – as such they are not responsible for “overseeing and managing the various functional groups critical to the operation of the Debtor’s business” [8]. In sum, they were pushing to avoid the 503(c) restrictions imposed by BACPA using a technical loophole. The terms of the KERP were as follows: The average KERP participant would receive an immediate $63,400 cash bonus. This amounted to a ~30% increase to the employee’s annual salary. In exchange, the employee agreed to remain with the company until either the assets of Exactech were sold or one year had passed.

Given this unorthodox classification of vice-presidents and senior directors as non-insiders, the US Trustee objected to the KERP motion. It argued that precedent rulings had established titles of “vice president” and “senior director” as insider titles. As such, the debtor had a much higher burden to prove that its KERP participants should not be bound by the 503(c) restrictions [9]. Unfortunately for the trustee, the court ultimately ruled to authorize the KERP motion and justified its decision by saying the motion was “appropriate under the circumstances” [10]. 

While notionally small in value in this case (the KERP payments totaled ~$1.3mm), Exactech’s proceedings demonstrate how contentious bankruptcy can be. Every dollar sent to management is a dollar not recovered by impaired creditors. Despite its zero-sum nature, the utility of Chapter 11 as a corporate restructuring mechanism for all stakeholders is why it is so important to our market-based system. 

Conclusion

In sum, compensation structures are key for guiding corporate managers’ actions. When misaligned, economic incentives can lead to litigious bankruptcy proceedings, value destruction, and chronic underperformance. However, when used correctly, they are a tool that can drive focused leadership and maximize enterprise value. In this newsletter, we learned about the differences between stakeholder dynamics as performance deteriorates, and the tools the bankruptcy code provides to allow transfers to be undone and incentives to be realigned.

[1], [2], [3], [4], [5], [6], [7], [8], [9], [10], [11], [12], [13]

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