In 2005, popular disgust with several high-profile cases of bankrupt firms paying top executives large “retention” bonuses led Congress to prohibit such bonuses for firms in Chapter 11. In a forthcoming article in the Southern California Law Review, Regulating Bankruptcy Bonuses, Professor Jared Ellias suggests that firms have found ways to evade this prohibition, so that the overall-compensation patterns for top executives of bankrupt firms have not materially changed. Despite good intentions, the ultimate benefits of the reform have thus been minimal or nonexistent. At the same time, firms must incur real costs—for example, in legal fees—to remain compliant with the ban. The reform has therefore failed the cost-benefit test, Professor Ellias suggests, and Congress should repeal it.
With a deeply informed dive into bankruptcy caselaw and deftly framed empirical tests, Professor Ellias paints a rich, compelling picture of why the reform failed. It turns out it is relatively easy for firms, with a bit of expert help, to comply with the letter (but not the spirit) of the ban. One way firms have done this is to pay what amounts to a retention bonus but to structure it so that the payment falls outside the period during which the firm is in Chapter 11 proceedings, so that it is not technically within the scope of the prohibition. Another way is for them to take advantage of the fact that while retention bonuses are forbidden, incentive bonuses are not: with court approval, firms in Chapter 11 can pay bonuses to top executives conditional on the achievement of challenging performance objectives. There is evidence, however, that firms routinely create objectives that are not, in fact, challenging to meet, so that what appears to be an incentive bonus in compliance with the 2005 reform is in reality a disguised retention bonus. What is more, the various gatekeepers that could prevent this subterfuge often lack appropriate expertise or incentives to do so. Bankruptcy judges and the US bankruptcy trustee are generally ill-equipped to assess the difficulty of attaining bonus-plan milestones; and creditors often find it not worth their while to alienate management by challenging bonuses that, while large to most individuals, are small relative to the amounts at stake in bankruptcy litigation.
Professor Ellias’s analysis has direct implications for the regulation of executive bonuses in bankruptcy, but it also serves as an invitation to ponder the challenges of regulatory approaches to stamping out abuse in a world full of unintended consequences and of highly paid regulatory arbitrageurs. While he makes a few gestures toward what a better-structured reform might look like, the focus and force of this article is in its diagnosis of the challenges. Awareness of how difficult these challenges are is a necessary first step toward effective reform, and Regulating Bankruptcy Bonuses serves a valuable function in promoting such awareness.