Approving Insider Compensation under § 503(c)(3): Court Discretion or Business-Judgement Standard?

The Bankruptcy Code strives to reach a balance between giving the debtor flexibility in making daily business decisions while at the same time limiting those activities which are deemed to be outside the ordinary course of business. [1] This limitation generally comes in the form of judicial oversight. Indeed, courts exercise varying degrees of scrutiny depending on the applicable Code provision. Curiously, one area where courts are using different standards of relief within the same provision is § 503(c)(3): [2] Some courts make an independent determination while others use the business-judgment test as the standard for granting relief under § 503(c)(3). Recently, the U.S. Bankruptcy Court for the Northern District of Texas, in In re Pilgrim’s Pride Corp., [3] confronted this wavering standard in evaluating the propriety of consulting agreements between a debtor and former executives, and held that an independent court determination is the proper standard under § 503(c)(3). [4]

This article will first discuss the relevant Code provisions involved with insider compensation motions and the In re Pilgrim’s Pride decision, then it will assess the two standards of review under § 503(c)(3) and the policy implications of both approaches.

Relevant Code Provisions
Section 503(c) applies to administrative expenses of the estate and generally restricts a debtor’s ability to pay insiders of the estate. It was enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) to prevent executives in chapter 11 from using their influence to receive significant compensation at expense of the estate.[5] Section 503(c) covers three categories of administrative expenses. First, § 503(c)(1) prohibits a debtor from paying or incurring an obligation for the purpose of retaining an insider of the debtor. [6] Second, § 503(c)(2) generally forbids severance payments to an insider of the debtor. [7] Under § 503(c)(1) and (c)(2), courts typically apply the business judgment standard. [8] Lastly, § 503(c)(3) bars “other transfers or obligations” when two conditions are met: (1) the transaction is outside the ordinary course of business, and (2) the transaction is not justified by the facts and circumstances of the case.[9]

The construction of a compensation plan during a chapter 11 changes the applicable Code section. For instance, debtors may craft a compensation plan to avoid § 503(c)(1) by including only some retentive components, thereby not implicating § 503(c)(1) because the “primary purpose” was not to induce the insider “to remain with the debtor’s business.”[10] Similarly, debtors may avoid the restrictive conditions of § 503(c) entirely by creating a Key Employee Retention Program (KERP)—if the plan intends to be an incentive plan to management, such as providing bonuses if the company meets certain financial thresholds, courts will apply the “more liberal business judgment review under § 363” rather than § 503(c). [11] Thus, debtors might consider crafting compensation packages as incentives for performance because courts will apply the business judgment standard.

Factual Background of In re Pilgrim’s Pride
Pilgrim’s Pride Corp. was the second largest producer of chicken when it voluntarily filed for chapter 11. After filing, the debtors entered into resignation agreements with its CEO Clinton Rivers and COO Robert Wright. The debtors filed a motion pursuant to § 503(c)(3) for “court authority to purchase time-limited non-competition agreements.” [12] The proposed consulting agreements agreed to compensate Rivers and Wright at roughly their pre-resignation salaries for a period of four and three months, respectively. The court conducted a hearing where William Snyder, the chief restructuring officer, testified about the company’s purpose in effectuating such agreements. He admitted that the debtors did not require Rivers’ and Wright’s consulting services, but rather needed the consulting agreements to prevent them from soliciting the company’s customers. [13]

The Bankruptcy Court’s Decision
In considering the motion to employ Rivers and Wright as consultants, the bankruptcy court began by analyzing each provision under § 503(c). The court first ruled that § 503(c)(1) did not apply because the purpose of the consulting agreements was to induce Rivers and Wright to not solicit competitors for a limited time, and therefore was not meant to induce them “to remain with the debtor’s business.” [14] The court also found that § 503(c)(2) did not apply because the payments from the consulting agreements were not intended as severance. The trustee argued that the court should follow In re Dana Corp., [15] where the bankruptcy court ruled that payments for non-competition agreements were tied to the employee’s severance and consequently were barred by §503(c)(2).[16] The court reasoned that contrary to the facts in In re Dana, the debtors met their burden of proof that the payments were not for severance. [17]

Next, the court analyzed whether § 503(c)(3) barred the proposed consulting agreements. The issue before the court was the standard of review under § 503(c)(3). The debtors argued that the business-judgment rule, as applied under § 363(b), should be the standard. The court rejected this argument and ruled that a “court must make its own determination that the transaction will serve the interests of the creditors and the debtor’s estate.”[18]
           
The court explicitly rejected using the business-judgment test for three primary reasons. First, using the business-judgment standard would render § 503(c)(3) redundant. Payments made outside the ordinary course of business would fall within the ambit of § 363(b) without § 503(c)(3), and therefore § 503(c)(3) would add nothing to the Bankruptcy Code.[19] Second, the court stressed that Congress intended for the courts “to play a more critical role in assessing transactions” given the plain language of § 503(c)(3).[20] Finally, the court opined that the business-judgment standard might permit conflicts of interest among insiders and the estate.[21] The court observed that executives could focus on self-serving interests rather than interests of the estate because they can be responsible for devising and approving a transaction.[22] The court recognized that such conflicts of interest weaken the reasoning “underlying application of the business-judgment rule (that officers and directors will fulfill their fiduciary responsibilities).”[23]

The court approved the § 503(c)(3) motion and held that the consulting agreements were justified by the facts and circumstances of the case.[24] The court noted that without the agreements the debtors could be subject to potential competition by Rivers and Wright. The court was particularly concerned that “diversion of even one of the Debtors’ largest customers could cost the Debtors hundreds of millions of dollars.” [25] The court balanced the cost of the agreements with the potential damages if the motion was not granted: The cost of agreements was miniscule compared to the harm to the overall estate if a major customer was diverted. [26]

The Two Standards of Review under § 503(c)(3)
Not all courts agree that an independent court determination is the proper standard under § 503(c)(3). In fact, many courts apply the business-judgment test as the standard under § 503(c)(3). Prior to BAPCPA, insider compensation was generally evaluated using the business-judgment test. [27] However, after these amendments the appropriate standard under § 503(c)(3) became an issue given Congress’s purpose in amending § 503(c) and the statutory language of § 503(c)(3). [28]

The business-judgment test applied under § 503(c)(3) is essentially the same standard used in § 363(b). [29] Under the business-judgment standard, courts defer to the debtors’ business decisions as long as a minimum level of care was exercised in reaching those decisions.[30] Courts will further assume that, in arriving at a business decision, the debtors “‘acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.’” [31] Although courts give deference if a business’s reason is proffered, they will nevertheless consider numerous factors to assess whether the business reason is sound. [32]
           
The most expansive decision endorsing the business-judgment test as the standard under § 503(c)(3) is In re Dana. In that case, the chapter 11 debtors moved for an order authorizing assumption of pre-petition employment agreements for its CEO and other senior executives. The court found that neither §§ 503(c)(1) or 503(c)(2) applied, [33] and thus was left to consider § 503(c)(3).

The court approved the proposed employment agreements under § 503(c)(3) using the business-judgment test. The court reasoned that the standard under § 503(c)(3) “appears to be no more stringent a test than the one courts must apply in approving any administrative expense under section 503(b)(1)(A).” [34] Section 503(b)(1)(A) permits any administrative expense that is necessary in preserving the estate. [35] The court determined that § 503(c)(3) therefore “gives the court discretion as to bonus and incentive plans.” [36] Because the proposed assumption of employment agreements involved bonus plans, the court exercised its “discretion,” and decided to apply the business-judgment test. [37] After finding that this was the appropriate standard, the court listed numerous factors that courts should consider when applying the business-judgment test.[38] The court applied these factors and concluded that the debtors “exercised fair and reasonable business judgment in determining to assume the Employment Agreements of the CEO and Senior Executives.” [39]
           
Policy Implications of Both Approaches
Debtors are beginning to craft compensation plans that avoid the strict conditions of §§ 503(c)(1) and 503(c)(2)[40] in an effort to fall under § 503(c)(3). Debtors have generally had a difficult time passing muster under § 503(c)(1) if there is some retentive effect because the strict conditions under § 503(c)(1). [41] Section 503(c)(2) might be even more difficult to satisfy because the severance payments must be “generally applicable to all full-time employees.”[42] This certainty requirement imposes a serious hurdle for a debtor of any size. Compared to §§ 503(c)(1) and 503(c)(2), § 503(c)(3) is considerably more liberal. Thus, the applicable standard will become increasingly more critical as more debtors take attempt to take refuge under §503(c)(3).

Congress promulgated § 503(c) in 2005 to protect the interest of company workers and retirees. [43] The corporate scandals and subsequent bankruptcies of companies such as Enron, Worldcom, Polaroid and Adelphia, provided the impetus for Congress to address the pervading concern of corporate executives who create compensation packages at the expense of their employees. [44] Specifically, under § 503(c), Congress sought “[t]o prevent unfair and unnecessary retention bonuses to insiders in chapter 11 companies.” [45]
           
Applying the business-judgment standard to a proposed transaction between debtors and its insiders might permit conflicts of interest. Although the court will assess the reasoning for a proposed transaction, “courts are adjured to defer to the debtor in possession or trustee if a valid business reason is shown.”[46] Moreover, the investigation by the court regarding the rationale for adopting a proposed compensation plan will be minimal given the transaction is presumed appropriate under the business-judgment standard. [47] Thus, as the In re Pilgrim’s Pride court pointed out, the business-judgment standard could permit executives to devise a self-serving compensation package.[48] Additionally, the business-judgment standard seems contrary to the intent of § 503(c)(3). Congress probably intended a greater level of scrutiny because § 503(c)(3) was promulgated to prevent debtors from favoring powerful insiders.
           
An independent determination by the court might provide debtors problems in constructing insider compensation packages. When will a § 503(c)(3) motion be “justified by the facts and circumstances of the case”?[49] This standard of review is necessarily fact-specific: Courts will have broad discretion to determine whether transfers or obligations are justified. Consequently, debtors might have issues in crafting compensation packages because courts will look to different factors. Even under an independent-determination standard, courts may nevertheless have to defer to some degree on the debtors’ business judgment, given that the only statutory guideline under § 503(c)(3) is whether the motion is “justified by the fact and circumstances of the case.”[50]

Conclusion
The In re Pilgrim’s Pride decision illustrates a split between the courts on the standard of review under a § 503(c)(3) motion. The standard set forth In re Pilgrim’s Pride—an independent examination by the court of the best interests of the estate—ameliorates many of the potential problems with an insider creating compensation packages. Although the standard of review may still be an issue in forthcoming decisions, the appropriate standard resonates in Congress’ purpose for promulgating § 503(c)(3): “to limit a debtor’s ability to favor powerful insiders economically.”[51]