Replacing key employee retention plans with incentive plans in bankruptcy
Introduction
Executive compensation literature examines how compensation contracts and their accounting-based performance benchmarks help alleviate moral hazard and adverse selection problems that arise between managers and shareholders in going-concern firms (e.g., Armstrong, Guay, & Weber, 2010; Bushman & Smith, 2001; Lambert, 2001). In this paper, we focus on the compensation of key employees in firms undergoing court-supervised restructurings.
Compensation and retention of insiders in bankrupt firms (debtors) have been the subject of controversy in North America, where pay-to-stay contracts are commonly used during restructurings. This is especially true in the United States (US), where bankrupt corporations can be restructured through court-supervised Chapter 11 reorganizations. The public sees little benefit in giving extra compensation to the bankrupt firms’ managers, whom it typically blames for the bankruptcy. This concern comports with the managerial power hypothesis (Bebchuk & Fried, 2003, 2006), as Chapter 11 allows the management to propose the reorganization plan and retain control over the firm. Such a debtor-friendly process could aggravate agency conflicts between creditors, equityholders, and managers and may destroy value (Weiss & Wruck, 1998). US legislators have expressed worry that executive and other key employee bonus plans in distressed firms are used to extract rents (Suhreptz, 2009).
The academic evidence on the management's role in firm failures is, at best, mixed (Khanna & Poulsen, 1995). Contrary to the management-power and rent-extraction arguments, researchers have found that providing the management with the right compensation can reduce information asymmetries and agency conflicts and lead to more efficient restructurings (e.g., Evans, Luo, & Nagarajan, 2014; Laffont & Martimort, 2002). These studies posit that key employees, whose firm-related knowledge can be critical during restructuring, are unlikely to stay unless they are compensated for the higher risk of working for a reorganizing firm (e.g., Hambrick & D'Aveni, 1992; Chang, Hayes, & Hillegeist, 2016; Eckbo, Thorburn, & Wang, 2016).
We bring new evidence to this debate by examining the design of executive compensation in bankruptcy. In particular, we add to research on the role of compensation contracts in Chapter 11 reorganizations. Evans et al. (2014) analyze retention and incentive plans from the 1990s and observe an association with improved operating performance. Goyal and Wang (2017) find that Chapter 11 compensation plans are correlated with shorter bankruptcies and fewer deviations from absolute priority. These findings suggest that executive bonuses in bankruptcy do not extract rents but rather contribute to optimal contracting. Our conclusions differ from theirs, as we explain below.
We analyze the implementation and consequences of the introduction of Section 503(c)(1) into the US Chapter 11 by the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005. Since early 1990s, American bankruptcy courts had allowed both key employee retention plans (KERPs, which are also known as “pay-to-stay contracts”) as well as performance incentive plans (PIPs, also known as “pay-to-perform” or “key employee incentive plans”). Before 2005, when proposed by the debtor's management, both types of contracts were almost always approved by bankruptcy courts under the “sound business judgment rule” (see Section 2 below). The introduction of Section 503(c)(1) changed this practice, as it restricted the adoption of KERPs but not PIPs. The 2005 reform allows us to examine the law's effects on the adoption of these bonus contracts as well as on bankruptcy efficiency and performance during Chapter 11.
To conduct our analysis, we hand-collect KERP and PIP contract details using the Public Access to Court Electronic Records (PACER) database (see Section 4 for details). We find that, after it became more difficult to award retention bonuses, KERP adoptions decreased and so did these plans' coverage (their size for the firm and its employees).1 This first set of findings suggests that BAPCPA's Chapter 11-related changes have been successfully implemented, as adoption of KERPs waned. We also find that the propensity to adopt PIPs increased after the reform and so did these plans' coverage. However, these changes have been accompanied by a weakening of PIP performance incentives. Incidences of zero-performance thresholds for performance-related payments and managerial discretion over the distribution of bonuses increased after the reform. We also find that both the efficiency of the Chapter 11 process and firm operating performance worsen for PIPs post reform. Our results show that this reduced performance is linked to the adoption of zero-performance thresholds and debtor discretion over bonuses.
Our findings contrast with those of Evans et al. (2014) and Goyal and Wang (2017). These two papers' results suggest that Chapter 11 bonus plans improved bankruptcy outcomes and consequently are inconsistent with a rent-extraction story. Our work differs in several ways. First, unlike Evans et al. (2014) and Goyal and Wang (2017), we clearly separate retention contracts from performance incentive ones.2 Second, we use the adoption of BAPCPA-introduced Section 503(c)(1) restrictions on KERPs as a setting in which to examine the changes in bonus contracting and their effects. Evans et al. (2014) do not examine post-BAPCPA bankruptcies (their data stop in 2004), while Goyal and Wang (2017) do not analyze changes brought by the 2005 bankruptcy reform in the United States. These two differences allow us to make a number of contributions. First, we empirically establish that, before reform, Chapter 11 firms that adopted PIPs had positive operating performance during the reorganization, whereas we find no evidence that firms that adopted KERPs did better than companies with no bonus contracts. This finding is consistent with the argument that KERPs were used to extract rents. Second, our findings indicate that the 2005 reform has led to statistically significant drops in the absolute and relative numbers of retention contracts as well as these bonus programs' adoption propensities (which decreased) and coverages (which also decreased along the two of the three dimensions indicated in footnote 1). Despite these changes, we see no post-reform improvement in the efficiency of the bankruptcy process (measured by the proceeding's duration) or firm operating performance during reorganization when much more restrictive KERPs are adopted.
We observe, however, statistically significant increases in the adoption, propensity, and coverage of PIPs and a decline in the operating performance of bankrupt firms adopting these contracts after the reform. Thus, we show the unintended consequences of regulating retention bonuses in Chapter 11. We also examine how PIPs have become a means of rent extraction. Our tests reveal that, after BAPCPA, debtors make changes that weaken the pay-for-performance sensitivity of PIPs. These changes negate some of the benefits that the plans had before reform.
The paper proceeds as follows. In the next section, we provide background on KERPs, PIPs, and the BAPCPA. In Section 3, we use managerial power theory and information from congressional hearings to develop our six hypotheses. In Section 4, we describe the archival data, their sources, and our variables. In Section 5, we present the results of our analysis. In section 6, we discuss the results and provide suggestions for future research.
Section snippets
Background
Corporate bankruptcy in the United States is regulated by the 1978 federal Bankruptcy Code, which allows firms in distress or their creditors to file for Chapter 11 reorganization under the protection of a federal bankruptcy court. This debtor-friendly procedure, which tries to avoid costlier liquidation, gives significant leeway to the management. The code allows the debtor to remain in possession of its assets and continue to operate under the protection of the court. Once the firm petitions
Hypothesis development
Information asymmetry and agency problems, which could lead to self-dealing by managers in going-concern firms, do not necessarily decrease during a formal reorganization, even if the restructuring is conducted under the auspices of a bankruptcy court. This is, in part, because the US corporate bankruptcy code is debtor-oriented. That is, the management retains control over the failed firm and has a clear priority in proposing a restructuring plan to the court. During this process, the judge
The data sources, sample construction, and variables used
To conduct our empirical analysis, we collect a sample of 575 bankruptcy filings from publicly accessible data sources (see below). These include 321 cases with a retention or incentive plan or both in the 1993–2015 period and for which we hand-collect data on contract specifics from court documents.
The starting point for our sample construction is the Altman-NYU Salomon Center Bankruptcy database, which provides a list of all large US bankruptcies (with liabilities larger than $100 million at
Conclusion
We add to the accounting research on incentive contracting by studying the consequences of the 2005 BAPCPA reform that regulated key employee retention plans for firms in court-supervised restructurings. This regulation restricted the use of pay-to-stay plans in bankruptcies while leaving pay-to-perform plans unregulated. First, we test whether the new law was successfully implemented. We find a decrease in the number, likelihood of adoption, and coverage of KERPs after the reform. These
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