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.