💥Toys R Us & Executive Compensation in Bankruptcy💥
Does Section 503 Need Revising?
The fine folks at law firm Cravath Swaine & Moore LLP have been busy.
Last month, Partner Paul Zumbro made an appearance on Capitol Hill arguing in favor of the “Texas Two-Step” — the legal ploy used by Johnson & Johnson ($JNJ) to siphon off and dump its potential talc liabilities into a newly created independent entity and pump it through chapter 11. In a nutshell, he said that divisional mergers effectuated via the TTT are an appropriate use of bankruptcy and that section 524(g) of the Bankruptcy Code is an efficient and fair mechanism for addressing all tort claims (not just asbestos claims). A bankruptcy judge in New Jersey agreed: shortly after Zumbro’s testimony, Judge Michael Kaplan denied motions by talc claimants alleging that J&J instigated its new affiliate’s bankruptcy filing in bad faith. That decision will, no doubt, see an appeal.
Zumbro’s advocacy doesn’t stop there. In an ABI Journal article co-written with colleagues Eric Hilfers and George Zoblitz, Zumbro lobbies for changes to Bankruptcy Code section 503(c) — the code provision that addresses employee (i) retention plans, (ii) severance plans, and (iii) incentive plans. Added in 2005 as a response to executives getting paid massive golden parachutes despite driving some of the country’s largest bankruptcies in history, section 503(c) is a relatively new-yet-impactful provision; because of all kinds of onerous requirements, it all but kicked insider retention and severance pay to the curb — leaving incentive plans as the sole viable economic option for directors and officers (and/or other controlling parties) in bankruptcy.
What kind of requirements? Glad you asked! Here is a quick rundown:
📍Retention Payments (501c1) = limited to employees who (i) have “bona fide” job offers at equal or higher pay and (ii) are essential to the survival of a debtor’s business and (iii) subject to caps of 10x the average payment to non-management employees in the same calendar year or, if there’s no such payment in the current calendar year, 25% of any similar payment in the prior calendar year.
📍Severance Payments (502c2) = must be made (i) pursuant to a program applicable to all full-time employees and (ii) subject to cap of 10x the average payment to non-management employees in the same calendar year.
Both must also be justified by the facts and circumstances of a case.
10x cap, huh? You could see why certain members of management would want no part of that limitation.
And so restructuring professionals advising debtors and company management teams have basically flicked a monstrous middle finger at these provisions in the last few years.
Indeed, the Cravath team highlights a recent Government Accountability Office (GAO) finding that not one of the 7.3k companies that filed for BK in ‘20 attempted to get a key employee retention plan approved and that, instead, 42 companies — including Hertz Global Holdings Inc. ($HTZ), JC Penney, and the soon-to-merge Whiting Petroleum Corp. ($WLL) — awarded 223 executives close to $165mm in retention-bonus payments in the lead-up to a filing (a practice they dub “payday before mayday” — love it!). Many people, of course, yell and scream about how this is a perversion of the bankruptcy system and evades judicial and creditor review. And this is one thing on a menu of things that the former management of Toys R Us are getting sued for (more on this in a moment). Because section 503 hasn’t had the desired effect of curbing D&O comp abuses, the Cravath team says various amendments are in order. These include: