Provision of Management Incentives in Bankrupt Firms

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1 Provision of Management Incentives in Bankrupt Firms Vidhan K. Goyal Wei Wang August 8, 2012 Abstract We examine the use of key employee retention plans (KERPs) in bankrupt firms. Our results do not support the common view that retention bonus plans enrich managers at the expense of creditors. On the contrary, creditor control of bankruptcies increases the likelihood that bankrupt firms offer retention and incentive bonuses to managers. Retention bonus plans are also more common when there is a greater risk of employee turnover. We find that incentives provided under such plans improve bankruptcy outcomes for creditors along several dimensions: they increase the likelihood of emergence, reduce bankruptcy duration, and result in fewer violations of the absolute priority rule. JEL classification: G30, G32 Keywords: Key employee retention plans (KERPs); Chapter 11; compensation; retention bonuses; creditor control of bankruptcies; management incentives in bankrupt firms We acknowledge the helpful comments of Paul Oyer, and workshop participants at Concordia, National Chengchi, Singapore Management, and Yuan Ze. We thank Wenhan Lin, Matt Murphy, Remya Neela, and Nikhil Wadhwa for excellent research assistance, and Lynn LoPucki, Parcels Inc., and National Archives at various locations for their help with data collection. Vidhan Goyal thanks the Research Grants Council for financial support (RGC Project #64110). Wei Wang thanks the CA Queen s Center for Governance for financial support. c 2012 by Vidhan K. Goyal and Wei Wang. All rights reserved. The Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong, [email protected] Queen s School of Business, Queen s University, Kingston, Ontario, Canada, K7L 3N6, [email protected]

2 The bankruptcy court has become a place where corporate executives go to get permission to line their pockets and break their promise to workers and retirees. Senator Edward Kennedy 1 1 Introduction Bankrupt firms often pay retention and incentive bonuses to their key employees to persuade them to stay with the firm through the restructuring process. Worldcom Inc., for example, filed for bankruptcy in July 2002 and offered 329 of its key employees retention bonuses that paid between 35% to 65% of their annual salary. Half of this bonus was paid if the employees under the plan remained with the company for at least 5 months. The remaining amount was payable 60 days after confirming a plan of reorganization. Retention bonus plans are commonly viewed as schemes through which managers enrich themselves. Critics claim that retention bonuses reward failed and entrenched managers at a time when the firm is slashing pensions, reducing wages for lower-level employees, closing factories, and laying off workers with little severance benefits. Excerpts from various business press articles confirm that many critics have adopted a rent extraction view of bankruptcy-related bonuses: In this year s unforgiving economy, managers in most industries are expecting sharply lower bonuses. But there is at least one sector where pay is rising: busted telecommunications and high-tech companies Ann Davis, Wall Street Journal, October 31, About 20 senior Canwest officials will share $8.9 million in bonuses as part of the company s creditor protection plan, but recently departed rank-and- 1 Statement of Senator Edward Kennedy to U.S. Congress (151 Congress Record S1990, March 3, 2005). Congress eventually introduced provisions in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), provisions which made it difficult for companies in Chapter 11 to pay retention bonuses. 1

3 file employees are finding their severance packages gutted Martin Cash, Winnipeg Free Press, October 24, On the way to bankruptcy court, Lear Corp., a car-parts supplier, closed 28 factories, cut more than 20,000 jobs and wiped out shareholders. Still, Lear sought $20.6 million in bonuses for key executives and other employees, including an eventual payout of more than $5.4 million for then chief executive Robert Rossiter Mike Specter and Tom McGinty, Wall Street Journal, January 27, Defending these bonuses, companies have taken the position that retention plans prevent critical employees from leaving when they are most needed. Management departures in distressed firms are very common. Such departures are highly disruptive to the successful and expeditious resolution of bankruptcy, as they result in a loss of continuity and high search and training costs. As a result, the costs incurred through delays in bankruptcy resolution and management changes could often be far greater than the cost of pay-tostay bonuses to key employees. According to firms using these plans, retention bonuses are an efficient contracting solution to the problem of high turnover in bankrupt firms. To examine the two starkly different views the rent extraction view and the efficient contracting view we assembled a comprehensive database of key employee retention plans (KERPs) at large public firms that filed for Chapter 11 between This database provides us with a first detailed look at the structure of retention and incentive bonus plans in bankrupt firms. Of the 417 firms in the sample, 39% adopt KERPs. Most plans offer retention bonuses tied to a minimum stay of, on average, 9 months. The plans cover about 2% of the firm s employees and pay bonuses that are between 30 and 70% of their base salaries. About half of these plans offer additional incentives tied to the resolution of bankruptcy (either through emergence from bankruptcy or sale of assets), speed of restructuring, 2

4 debt recovery, and specific targets based on financial performance at plan confirmation. 2 A reading of these plans suggests that incentives provided by bankrupt firms closely tie bonuses to creditors claims and bankruptcy outcomes. One of the key findings of our paper is that retention and incentive bonuses are common in bankrupt firms that exhibit a large amount of creditor control. Specifically, bankrupt firms with an approved creditors committee and with debtor-in-possession financing more often pay retention and incentive bonuses. This evidence is consistent with senior-secured lenders exerting control over bonus plans through loan documents in debtor-in-possession financing while other unsecured lenders acting through a creditors committee. 3 KERPs are also more common among bankruptcies in which there is a greater likelihood of employee turnover. Employees are more likely to change jobs when there are many other potential employers in the same industry located in the same geographical area as the Chapter 11 firm. We find that KERPs are more frequently adopted by firms headquartered in such areas. In addition, KERPs are more frequently adopted in industries in which senior executives benefit from greater growth in cash compensation. In such industries, KERPs reduce the threat of employee turnover resulting from large pay disparities at the bankrupt firm. Finally, firms in distressed industries exhibit a lower likelihood of adopting these bonus plans presumably because there are fewer outside job opportunities in such industries. The only CEO characteristic that appears to be important in explaining CEO participation in bonus plans is whether or not the the CEO is a newly-hired turnaround specialist. Such CEOs are more frequently paid retention bonuses. None of the other 2 The passage of BAPCPA in 2005 led to a precipitous decline in retention bonus plans and many firms completely switched to offering incentive bonus plans. 3 Similarly, Eckbo et al. (2012) show that creditors are actively involved in CEO replacement decisions and in designing the compensation of existing and new CEOs. 3

5 CEO characteristics appears to matter. Moreover, governance variables have no predictive ability in determining CEO participation in these bonus plans. Overall, there is no evidence that entrenched CEOs initiate these plans to pay themselves large bonuses. We also examine the effect of KERPs on bankruptcy outcomes. We distinguish between KERPs that are retention-only plans from those that provide incentive bonuses (with or without retention bonuses). The retention-only plans pay bonuses contingent on a minimum stay or stay until plan confirmation and do not include an incentive component tied to specific outcomes. In our tests, we use employees outside job options to identify exogenous variation in the use of bonus plans. The results show that incentive plans significantly improve outcomes for creditors. The likelihood of a firm s emergence from bankruptcy is greater when key employees are paid incentive bonuses. Importantly, the outcome depends on the specific nature of incentives in these plans. When key employees are offered bonuses that are tied to firm reorganization or firm performance upon reorganization, firms are more likely to reorganize. By contrast, when employees are paid bonuses tied to asset sale, firms are more likely to liquidate. Furthermore, incentive bonuses affect both the duration of bankruptcy and deviations from the absolute priority rule (APR). Firms that provide incentive bonuses spend significantly less time in bankruptcy and have a significantly lower likelihood of deviating from the APR. Overall, the findings suggest that incentive plans improve outcomes for creditors by aligning managers interests with those of creditors, shortening bankruptcy duration, and limiting stockholders ability to extract concessions from creditors. Relative to KERPs, standard compensation contracts are less relevant, perhaps even suboptimal, when the fiduciary obligations of managers shift towards creditors as creditors 4

6 take control of the bankruptcy process. The results of the paper show that incentives provided to executives of bankrupt firms become more closely aligned with the interests of creditors. More broadly, the paper examines whether managers control the pay-setting process in bankrupt firms, where agency problems are likely to be more severe. We find no evidence consistent with the rent extraction view. In fact, our results suggest that retention and incentive bonuses in bankrupt firms are the outcome of an optimal contracting process. Finally, the fact that bankrupt firms provide retention and incentive bonuses to key employees at all levels of corporate hierarchy suggests that the restructuring of troubled companies requires more decentralized decision-making. The paper is organized as follows. Section 2 provides a review of the literature on CEO compensation in bankrupt firms and a review of our hypotheses. Section 3 describes our data sources and the construction of key variables, and provides a summary of the key features of retention and incentive bonus plans. Section 4 employs logit regressions to predict the use of KERPs in bankrupt firms. Section 5 provides results from regressions that examine the effect of KERPs on bankruptcy outcomes. Section 6 concludes the paper. 2 Background In a standard principal-agent framework, firms design compensation contracts to align the interests of managers with those of stockholders. However, when firms become insolvent, the fiduciary duties of managers shift from stockholders to creditors. How do incentive structures evolve for firms in distress? What determines the payment of retention bonuses in bankruptcies? How do bonus payments affect bankruptcy outcomes? This paper explores these questions. 5

7 Much of what we know about the compensation of managers in distressed firms comes from Gilson and Vetsuypens (1993), who examine the compensation policies of 77 publiclytraded firms that filed for bankruptcy or privately restructured their debt between 1981 and Gilson and Vetsuypens found that CEOs in these firms suffer large personal losses. Importantly, their results highlight the fact that firms often rely on compensation policy to deal with financial distress. About 20% of firms in Gilson and Vetsuypens sample based their CEO s compensation on the outcome of the firm s financial restructuring. In about 17% of the cases, bonuses were tied to a minimum length of stay with the firm, and in another 10% of the cases, compensation plans were restructured to increase the interdependence of the wealth of the CEO and that of creditors. Two relatively recent papers also examine the compensation of CEOs in bankruptcy. Henderson (2007) examines 76 large bankruptcies between and finds that the compensation of CEOs does not significantly change during distress situations. On the contrary, Kang and Mitnik (2009) examine 99 bankruptcies over the 1992 to 2005 period and arrive at the opposite conclusion. Specifically, they find that the CEOs of distressed firms experience a significant reduction in their overall compensation, and that much of this reduction is due to the decreased value of new grants of stock options. This paper is unique in that it examines the retention and incentive bonus payments offered to a larger group of employees identified as critical or key employees. The payment of bonuses to key employees via KERPs grew in popularity in the early 2000s. Skeel (2003) and Ayotte and Morrison (2009) argue that the increasing trend in the use of KERPs in bankruptcies coincides with greater creditor control. Creditors are becoming increasingly active in bankruptcies and are often instrumental in CEO replacement decisions and in determining the design and structure of senior executives compensation. Eckbo et al. 6

8 (2012) find that creditor control is directly responsible for CEOs personal losses from bankruptcy. The changing nature of the bankruptcy process has significantly affected bankruptcy outcomes. For example, Bharath et al. (2010) show that the increasing use of debtorin-possession financing and key employee retention plans are associated with a declining trend in APR deviations. While we find similar results with respect to the use of KERPs and APR deviations, our focus is on understanding the use of KERPs in bankrupt firms and in examining the effects of KERPs on a number of other bankruptcy outcomes. 4 It is important to understand the role that creditors play in a firm s decision to offer its key employees retention bonuses. If retention bonuses are a symptom of agency conflicts between managers and creditors, greater creditor control should result in fewer instances of retention bonuses to managers. However, if retention bonuses are offered as part of creditors value-maximizing strategy, creditor control should increase the likelihood of KERP adoptions. The two views also yield different predictions regarding how KERPs affect bankruptcy outcomes. If KERPs align employee incentives with those of creditors, creditor outcomes should improve with KERPs. Thus, KERPs should influence reorganization versus liquidation decisions, time spent in bankruptcy, and absolute priority deviations. The controversy surrounding retention bonuses led Congress to amend the U.S. bankruptcy law in The new legislation known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) introduced section 503(c) 4 In a related paper, Crutchely and Yost (2008) examine KERP programs and show that firm size increases the likelihood of KERPs. They also show that firms with KERPs spend longer in bankruptcy. Since KERPs are adopted in large and complex bankruptcies, it is unclear if KERPs actually cause bankruptcy duration to increase. We deal with such endogeneity issues by examining employees outside options as instruments and find that incentive plans result in a quicker restructuring process, although retention plans do not. Our study covers a larger sample of bankruptcies and a longer period in examining why firms adopt KERPs and the effect that such plans have on bankruptcy outcomes. 7

9 into the Bankruptcy Code: a bankruptcy court is not to authorize payments to an insider for the purposes of inducing the person to stay with the debtor unless the court determines that (a) he or she has a bona fide job offer from another company at the same or higher compensation, (b) the individual provides services that are essential to the survival of the business, and (c) the retention payment is less than 10 times the average compensation of a similar kind given to nonmanagement employees during the calendar year. These new rules have dramatically changed the nature of bonus plans that bankrupt firms now offer. As we will show later, BAPCPA resulted in retention plans becoming less common while incentive plans gained popularity. In these performance-based pay plans, firms offer bonuses which are contingent on their achieving a predetermined milestone. These milestones are typically related to bankruptcy outcomes (reorganization versus liquidation), speed of reorganization, debt recoveries, EBITDA, and enterprise value at emergence. Bonus plans that are intended to provide incentive compensation to management employees are subject to a more liberal review process under Bankruptcy Code 363. Given the new legislation restricting the payment of retention bonuses, it has become even more important to distinguish retention plans from those that provide incentive bonuses in improving creditor outcomes. 3 Data Sources and Sample Description 3.1 Data The present study begins with a sample of all Chapter 11 bankruptcy filings included in the UCLA-LoPucki Bankruptcy Research Database (BRD) during the period from 8

10 1996 to The 497 Chapter 11 filings in the UCLA-LoPucki database include the bankruptcies of all public firms with reported assets in excess of $100 million (in 1980 constant dollars) as of the last Form 10-K filed with the SEC pre-bankruptcy petition. The filings are cross-checked with New Generation Research s BankruptcyData.com to verify their Chapter 11 status. Filings that were dismissed by the court (11 cases), cases still pending as of December 31, 2008 (12 cases), financial firms (37 cases), utilities (11 cases), and firms headquartered outside of the U.S. (9 cases) are excluded. 5 The resulting sample of 417 firms in Chapter 11 is matched to Compustat in order to obtain firmlevel financial data. If information is missing in Compustat, it is filled in manually using information from 10-Ks (obtained from EDGAR). We identify firms with KERPs through a search of Bankruptcydata.com, 8-K filings, reorganization/liquidation plans, and Factiva News Retrieval, using keywords that are related to the use of retention and incentive bonus plans. 6 The court documents related to KERP approvals are obtained from bankruptcy courts (specifically, through their respective Public Access to Court Electronic Records (PACER) websites). 7 The court documents provide detailed information on KERPs, including the identity of the key employees to be covered, the purpose of the retention program, bonus amounts, and other plan details. 5 Financial firms and utilities are excluded because of differences in regulations and accounting standards for these industries. Firms headquartered outside the U.S. are excluded because we require information on other firms located around the headquarter of the Chapter 11, and such location information is only available for U.S. firms. Of the nine firms headquartered outside the U.S., one is in Argentina, two are in Canada, and another six are in Bermuda. 6 The keywords that we use include retention plan, bonus plan, incentive plan, retention bonus, pay-to-stay, bankruptcy pay, managerial incentive, key employee, KERP, KEIP, KMIP, and KECP. 7 Every bankruptcy court maintains a PACER website, which contains the docket sheet for a bankruptcy case. KERP motions and approvals for Chapter 11 firms are obtained through PACER in about two-thirds of the cases. For another 30% of the cases, we retrieve motions and orders directly from U.S. bankruptcy courts, National Archives, and Parcels, Inc. For the remaining 4% of the cases, we collect as much information as possible from company filings with SEC and news articles. 9

11 The Bankruptcy Research Database and Bankruptcydata.com are our primary sources for basic information about bankruptcy filings, including the type of filing, the outcome of the Chapter 11 process, and the months spent in restructuring. Bankruptcydata.com also provides reorganization and liquidation plans with information on the classes of claims, the dollar amount of allowed claims, recovery, and whether cash or security was given to each class of claimant. In the event that a plan is not available in this database, we obtain the information from the relevant 8-K filings or purchase the reorganization plans directly from U.S. bankruptcy courts. Information about debtor-in-possession financing and top management turnover is obtained mainly from Bankruptcydata.com, PACER, and Factiva/LexisNexis. The institutional ownership data are obtained from 13F filings provided by the Thomson Reuters Ownership Database. We identify CEOs at the time of KERP approval and determine the CEO s founder status, age, and tenure from proxy statements and 10-K filings. We further determine whether the CEO is an incumbent or newly hired. Newly-hired CEOs are defined as those who are hired during a period starting three years before Chapter 11 filing and ending with KERP approval. In cases of CEO changes, we determine whether new CEOs are internal promotions or external hires. Through a perusal of news articles around CEO appointments, we also identify whether or not the newly-hired CEO is a turnaround specialist. The governance variables (including board size and the fraction of independent directors) are collected from the firm s last 10-K or proxy statements before bankruptcy filing. 10

12 3.2 Summary Statistics Table 1 provides an annual distribution of firms adopting KERPs. Column (1) provides an annual distribution of all Chapter 11 filings in our sample. Consistent with the wellknown relation between business cycles and financial distress, we observe a clustering of bankruptcies in the early 2000s, a period that coincides with the U.S. recession. Column (2) provides a distribution of firms using KERPs. About 39% of Chapter 11 firms in our sample adopt KERPs. Consistent with the trends reported in Skeel (2003), Bharath et al. (2010), and Jiang et al. (2012), we find more firms adopting KERPs in the more recent period; in the mid-to-late 1990s, less than one-third of the Chapter 11 firms adopt KERPs, yet this number increases to over 50% in the later part of the sample period. We classify KERPs into those which offer only retention bonuses, those which offer both retention and incentive bonuses, and those which offer only incentives bonuses. Retention bonuses are a common feature of the bonus plans adopted by firms in bankruptcy. Among firms with KERPs, approximately 88% offer retention bonuses. In about half of these cases, firms additionally pay incentive bonuses. There is a dramatic decline in the use of retention bonus plans after 2005, which coincides with the enactment of BAPCPA. As described in Section 2, BAPCPA placed severe restrictions on the payment of retention bonuses which, in turn, resulted in an almost complete shift wherein firms developed a preference for incentive bonuses over retention bonuses. Panel A of Table 2 provides mean and median values of firm characteristics in the pre-filing year. The sample firms are large, with average assets of $2 billion (in constant 2008 dollars) and a median asset value of $0.7 billion. The large sizes of bankrupt firms in the sample are unsurprising, as BRD includes only large filings. Chapter 11 firms are substantially overlevered, as one would expect; their average total liabilities to assets ra- 11

13 tio is 1.02 (the median is 0.92). The industry-adjusted leverage is 0.44, which indicates significant distress. 8 Firms are not only overlevered; they are also unprofitable. The average industry-adjusted operating performance (measured as earnings before interest, taxes, depreciation and amortization (EBITDA), scaled by assets, and adjusted for industry performance) is (the median is -0.05). Secured debt represents about 42% of assets. Institutions own about 27% of the firm s stock at the time of filing. Panel B reports descriptive statistics on bankruptcy filings. About 29% of the Chapter 11 filings are prepackaged bankruptcies in which reorganization plans are negotiated and voted on by shareholders and creditors before bankruptcy filing. The simultaneous filing of both the bankruptcy petition and the reorganization plan considerably shortens the time that companies spend in bankruptcy. 9 About 67% of the bankrupt firms obtain debtor-in-possession financing. Roughly 44% of the bankruptcies are filed in Delaware. Creditors committees are common; about 85% of firms have such committees approved by court. By contrast, equity committees are less common and exist in only 11% of bankruptcy cases. The priority of claims is sometimes violated in Chapter 11 bankruptcy when a junior claimant receives some payment (which is often equity) even though senior claimants are not paid in full. Many bankruptcy scholars argue that deviation from APR happens because Chapter 11 is debtor-friendly, resulting in shareholders (or the managers supporting them) having a significant ability to impose costs on creditors through tactics designed to 8 We obtain the industry-adjusted characteristic by subtracting the median-industry characteristic (based on the two-digit SIC code) from the comparable characteristic for each firm. 9 Tashjian et al. (1996) provide descriptive information on a sample of 49 prepackaged Chapter 11 bankruptcies. They show that prepackaged bankruptcies incur lower direct cost of bankruptcy, result in higher debt recoveries than traditional Chapter 11 filings, and the distressed firms spend less time in bankruptcy. 12

14 delay the resolution of bankruptcy. These tactics are costly to creditors and, as a result, senior claimants sometimes agree to accept less than the contractual value of their claims. To estimate the APR deviation, we obtain information about the type and amount of new securities various claimant classes receive in the final reorganization plan approved by court. The recovery to each class is estimated by adding up the values of cash and new securities each class receives. Except for debt (for which we use the face value) other securities are valued using traded prices that most accurately post date the firm s emergence from bankruptcy. These traded prices are obtained from various sources, including CRSP, Bloomberg, Datastream, and the Bankruptcy DataSource. An APR deviation is deemed to have occurred if equity holders receive a payment before other senior claims are paid in full. 10 We use this information about APR deviation to construct an indicator variable that takes a value of one if there is any APR deviation, and a value of zero otherwise. APR deviations are not commonplace and occur in about 17% of bankruptcy cases. The literature shows that APR deviations were much more common in the 1980s and in the 1990s (see Weiss (1990) and Adler et al. (2006)). Our observation of the decline in APR violations is consistent with the findings of Bharath et al. (2010). Panel C shows the mean and the median of the three governance variables and CEO characteristics at the time that KERPs are adopted. The average board has 7 members, 71% of which are classified as independent directors. In about half of the cases, the CEO is also the chairman of the board. Founder-CEOs are present in 15% of the cases. CEOs are, on average, 53 years old and have worked in their current position for about 4 years. Consistent with the substantial turnover commonly observed in distressed firms, only about 41% of the CEOs are incumbent (i.e., they have not been replaced in the last three 10 See, for example, Eberhart et al. (1990), Betker (1995), and Jiang et al. (2012). 13

15 years before Chapter 11 filing). A little more than half of the new CEOs are external hires. About 20% (48 of 239) of the new hires are turnaround specialists. Panel D provides a distribution of Chapter 11 outcomes. An outcome is classified as a reorganization if there is evidence that the firm has reorganized and emerged from Chapter 11 status. Similarly, an outcome is classified as a liquidation if the firm s assets are sold piece-meal, and as an acquisition if all of the firm s assets are acquired by another firm. Firms reorganize and emerge from Chapter 11 in about 60% of the cases. Liquidations happen in about 29% of the cases and the remaining 11% of the firms are acquired. The last two columns of Panel D provide the mean and median time spent in bankruptcy, measured as the number of months between the filing date and the confirmation date of the plan. Across all cases, the average duration from the month of filing bankruptcy to reorganization, acquisition, or liquidation is about 17 months (the median is 13.5 months). The average duration of bankruptcy decreases from 21 months at the beginning of our sample period to 12 months in the more recent period. The decrease in average bankruptcy duration is also evident in the literature. Frank and Torous (1994) report an average duration of 30 months during the 1983 to 1988 period; Bharath et al. (2010) report an average duration of 18 months for the more recent period. Firms that reorganize spend less time in bankruptcy than firms that are liquidated or acquired. Table 3 provides summary statistics of KERPs. The average plan covers about 2% of the firm s employees. The employees are classified into three tiers: the highest tier consists of a few top managers being paid larger bonuses, while the lowest tier consists of a greater number of managers being paid smaller bonuses. In the highest tier, a median of 6 employees receive retention bonuses that represent about 75% of their salaries. Conversely, in the lowest tier, a median of 46 employees receive retention bonuses that represent about 30% of their salaries. 14

16 Incentive bonuses are offered to even fewer employees; a mere 1% of the employees receive them. The employees covered by incentive plans are similarly divided into three tiers. CEOs are included in about 80% of these plans. The plans almost always include other senior managers (99% of retention plans and 95% of incentive plans include non- CEO executives). Other mid-level employees are also included frequently. About 85% of retention plans tie retention bonuses to a minimum-stay (i.e., a firm pays a bonus if the executive stays with the firm for a pre-determined period). The typical plan requires managers to stay for at least 9 months following the KERP initiation date in order to qualify for bonuses. About 52% of retention plans promise additional bonuses tied to plan confirmation. In 97 of the 417 Chapter 11 filings (or 23%), key employees compensation is explicitly tied to the successful resolution of the firm s bankruptcy and/or other outcomes directly affecting payoffs to creditors. By comparison, far fewer firms tied executive compensation to creditor s wealth in the 1980s (Gilson and Vetsuypens, 1993). A large proportion of KERPs make incentive bonus payments contingent on bankruptcy resolution (78%). Roughly 48% of these plans offer bonuses contingent on the firm s emergence from Chapter 11 and another 30% pay bonuses upon the sale of assets or the firm s liquidation. Incentive plans that offer bonuses that are tied to EBITDA and enterprise value targets are also common. Less common are incentive plans that tie employee payments to the speed of restructuring or to debt recovery (about 13% of the incentive bonus plans include these features). The overall cost of the average plan is about $8.5 million for retention bonuses and about $7 million for incentive bonuses. The maximum financial pool allocated for bonus plans averages about $9 million for retention plans and $16 million for incentive plans. These plan costs, representing about 0.4% of pre-filing assets, appear small when com- 15

17 pared to professional legal fees paid in bankruptcy, which, according to LoPucki and Doherty (2004), could be as large as 2% (in a sample of 48 large public company bankruptcies from 1998 to mid-2002). 4 Explaining the Use of KERPs in Chapter Logit Results We begin by examining the effect of creditor control on KERP adoption. Ayotte and Morrison (2009) suggest that creditors, in the most recent decade, have come to dominate the Chapter 11 process. If bonus plans benefit creditors, then the greater influence of creditors in Chapter 11 should result in the more frequent adoption of KERPs. We employ two measures of creditor power: (a) the presence of a creditors committee, and (b) the presence of debtor-in-possession financing. The existence of a creditors committee indicates that unsecured creditors have an influence on bankruptcy restructuring. According to Henderson (2007), creditors committees are often involved in negotiating employment agreements and determining managerial pay. Jiang et al. (2012) show that the managers of hedge funds often seek representation on a creditors committee to enforce governance. The active role of creditors in bankruptcies suggests that they are likely to reject bonus packages that do not improve creditor outcomes. We use debtor-in-possession (DIP) financing as our second measure of creditor control, as Skeel (2004) argues that DIP financing has become a new tool of governance in Chapter 11. Through DIP financing, creditors gain a significant amount of control through loan agreements and subsequently exert control over the restructuring decisions of bankrupt firms. 16

18 Table 4 presents results from logit regressions where the dependent variable takes a value of one if the firm adopted a KERP and zero otherwise. The results show that both measures of creditor control have the predicted positive relation with KERPs and both are statistically significant. The strong positive coefficients on the presence of creditors committee and the DIP financing suggest that greater creditor control is associated with higher likelihood of key employee retention plans in Chapter 11. The estimates suggest that the probability of KERP adoption is 34% higher in firms with a creditor s committee than those without such a committee. Similarly, the probability of KERP adoption is 24% higher in firms that receive DIP financing compared to those that do not. In Column (2), we additionally include variables that measure employees outside job opportunities. We expect firms that face a greater threat of employee turnover to have a higher likelihood of adopting KERPs. Previous research shows that bankruptcies result in a significant increase in CEO turnover. We expect high turnover among non-ceo executives as well. 11 Since key employee departures affect a firm s ability to reorganize or sell the firm, retention bonuses are more likely when there is a greater threat of employees leaving the firm. The propensity of employees to switch firms depends on the ease with which they can find alternative employment. Geographic considerations are important because managers find moving disruptive and costly (Almazan et al., 2007). With many potential employers in a local market, employees have fewer concerns about the loss of earnings from leaving their current firm. Consistent with this argument, Kim (2011) finds that wage losses are greater in labor markets with fewer potential employers in the local industry. Following Lazear (2009), we label employment markets where there are many same-industry firms in the same geographic area as thick employment markets 11 Fee and Hadlock (2004) show that non-ceo turnovers are elevated around CEO dismissals. 17

19 (T hickemplm arkets). In the context of such markets, managers enjoy greater job opportunities, and suffer smaller wage losses from switching employers while bankrupt firms find it more difficult to retain employees unless they provide explicit pay-to-stay or incentive bonuses. The variable T hickemplmarkets takes a value of one if there are at least twenty other firms in the same two-digit industry within a 100-kilometer radius from the sample firm s headquarter. 12 Alternative cutoffs, based on both the number of firms and the size of the geographic area, yield similar results. The positive and statistically significant coefficient for the T hickemplmarkets variable is consistent with the argument that the availability of alternative job options increases retention bonus payments. The effects are also economically large. The probability of KERP adoption is 33% higher for bankrupt firms operating in thick employment markets than for firms not operating in such markets. As another proxy for employees propensity to change jobs, we include the median industry cash compensation growth (IndCompGrowth). 13 A higher growth in cash compensation in comparable firms implies greater pay disparities between the pay of executives at the bankrupt firm and the pay of those at comparable firms. Consistent with our prediction, we find that a higher cash compensation growth in the median industry firm positively affects the likelihood of KERP adoption. A one standard deviation increase in median industry cash compensation growth increases the probability of KERP adoption by about 6%. 12 The distance of a company s headquarter to all other Compustat firm headquarters is estimated using the Haversine formula. See distance. 13 We focus on cash compensation rather than total compensation because equity-based compensation is less relevant for firms in bankruptcy. Cash compensation is tied much more closely to short-term performance targets. For example, Yahoo s 2012 proxy statement states that their annual cash bonus is intended to focus on, and reward the achievement of short-term goals that are important to the Company. Cash compensation is estimated as the average salary and bonus payments for the topfive paid non-ceo executives. We use firms in Execucomp to calculate the annual growth rate of cash compensation of senior executives for all 2-digit SIC industries (excluding the firm in question). 18

20 Yet another proxy for employee outside job options is whether the industry is in distress. Fewer jobs are available in distressed industries. As such, the presence of such industry-wide distress reduces a firm s incentives to offer retention bonuses. We follow Acharya et al. (2007) in classifying an industry as distressed if the industry median stock return for the year before the Chapter 11 filing is -30% or less. The coefficient for the distressed industry dummy is negative, although its significance level is weak (p=0.11). The results suggest that firms operating in distressed industries have a marginally lower likelihood of using KERPs. In Columns (3) to (5) we add the three governance variables: the fraction of independent directors, CEO-chairman duality, and board size. If KERP adoption is a reflection of agency problems we should observe that firms with weaker boards and powerful CEOs have a higher likelihood of adopting KERPs. We find no such evidence. Both the fraction of independent directors and CEO-Chairman duality variables are insignificant. Only the board size variable carries a positive sign and is statistically significant at the 5% level. The board size variable does not have a unique interpretation. Larger boards could be a proxy for greater firm complexity, which, in turn, could explains why firms with larger boards are more likely to adopt KERPs. 14 The regression specifications control for firm size, the pre-packaged bankruptcy indicator, the Delaware filing indicator, and industry-fixed effects. 15 We find that firm size significantly affects the propensity of a firm to adopt KERPs. A one standard deviation change in firm size increases the likelihood of KERP adoption by 10% (with all other variables held at their means). The positive relation between firm size and the likelihood 14 The board literature shows that complex firms have larger boards. See, for example, Coles et al. (2008) and Lehn et al. (2009). 15 In unreported tables, we find that bankruptcies are relatively more common in manufacturing, telecommunications, and in wholesale and retail industries while they are less common in oil and gas, chemical, and healthcare industries. 19

21 of KERP adoption has two alternative interpretations. If firm size is a proxy for agency problems, then one could infer that managers of large firms boost their wealth by paying themselves retention bonuses. However, firm size could also be a proxy for bankruptcy complexity, where this complexity increases the demand for management continuity. The coefficient for the pre-packaged filing indicator is negative and statistically significant at the 1% level. The estimates suggest that firms opting for pre-packaged bankruptcies have an 18% lower likelihood of KERP adoption than those sticking to regular bankruptcies. The pre-packaged nature of these filings means that plans are prenegotiated to include less flexibility for managers. Thus, in these cases, there are fewer incentives to provide retention and incentive bonuses. The coefficient for the Delaware dummy is statistically insignificant. In Table 5, we extend these results to a multinomial logit framework that examines a firm s decision to offer retention-only bonuses separately from its decision to offer incentive bonuses (with or without retention bonuses). The results from these additional tests are generally consistent with those presented above. Overall, we find that firms are more likely to adopt both types of plans where there is a creditors committee and where lenders provide DIP financing. The results show that creditors committees more strongly predict the adoption of retention-only plans, while the presence of DIP lenders more strongly predicts plans with incentive bonuses. While T hickemplm arkets positively predicts adoption of both types of plans, the other two measures of employees outside options only affect the plans with incentives. Another difference between the results in this table and those in Table 4 is that board size does not affect the likelihood of adoption of retention-only plans, whereas it positively affects the adoption of plans with incentive bonuses. 20

22 4.2 Explaining Plan Features Table 6 presents Tobit estimates from regressions that relate bonus plan features to various firm and bankruptcy characteristics. These regressions examine whether or not the firm and bankruptcy characteristics explain the size of these plans along a number of dimensions, including the fraction of key employees covered in the bonus pool, the size of the bonus paid to the highest tier, and plan costs as a fraction of pre-filing assets. 16 Columns (1) to (4) present results for retention bonuses, while columns (5) to (8) present results for incentive bonuses. The results show that larger firms include more employees in the plan, offer bonuses which are a larger fraction of employees salaries, and commit more financial resources (as a fraction of assets) to the plan. The pre-packaged plans, on the other hand, offer smaller bonuses and commit a smaller fraction of their assets to the bonus pool. Both DIP financing and greater creditor control result in a larger percentage of employees receiving retention bonuses, more retention bonuses, and higher retention plan costs. However, the effects documented for incentive bonuses in Columns (5) to (8) suggest that creditor control has no effect on incentive bonus amounts and plan costs. T hickemplmarkets positively affect the plan sizes and plan costs for the payment of retention bonuses but not for incentive bonuses. On the other hand, IndCompGrowth positively affects plan sizes and costs for incentive bonuses but not for retention bonuses. 16 The motions and orders for KERP adoption provide either target percentage bonus or the dollar value paid to key employees. We use the percentage value directly if it is quoted in court documents. If the documents provide dollar amounts, we convert them to a percentage by dividing the bonus amounts by CEO salary in the last fiscal year before Chapter 11 filing. The percentage bonus paid to top tier executives in our sample ranges between 4 percent and 200 percent for retention plans, and between 7 percent and 844 percent for incentive plans, respectively. 21

23 4.3 CEO Participation in KERPs We examine CEO participation in KERPs to test if failed and entrenched CEOs use retention bonus plans for self-serving purposes. If the use of KERPs reflects agency problems, then we would expect to see that entrenched top executives are a part of retention plans. Furthermore, weak governance will make it more likely that CEOs participate. However, if KERPs are an equilibrium response to contracting problems in bankruptcy, we expect to see no relation between CEO characteristics, governance, and CEO participation in KERPs. Table 7 presents logit estimates predicting CEO participation. In columns (1) to (4), we examine CEO participation in all KERPs regardless of whether they are retention-only plans, or plans with both retention and incentive features, or plans with just incentive bonuses. Thus, in these columns, the dependent variable takes a value of one if the CEO participates in a KERP, and is zero otherwise. In columns (6) to (8), we focus on CEO participation in plans with incentive bonuses to examine if the effect differs when we exclude retention-only bonus plans. Here, the dependent variable takes a value of one if the CEO receives incentive bonuses, and is zero otherwise. The independent variables include various CEO characteristics: CEO age, CEO tenure, CEO founder status, and the dummy variable for an incumbent CEO. In the specification reported in column (2), we consider CEOs who are promoted internally and those who are hired externally, and CEOs who are turnaround specialists. Additional specifications include governance variables and firm characteristics. The results reported in Table 7 show that, of all CEO characteristics, only turnaround specialists have a higher likelihood of receiving retention bonuses. However, turnaround specialists are not any more likely to receive incentive bonuses (as seen from estimates in 22

24 Columns (5) to (8)). This reflects the importance of retaining turnaround specialists to the distressed firms that hire them. There is also some evidence that old managers are less likely to be included in incentive bonus plans. Overall, the findings are contrary to the media perception that KERPs are used to enrich failed managers. Among the governance variables, only board size predicts CEO participation in KERPs. Once again, it is not clear if governance is weak in firms with bigger boards. Greater board size most likely reflects bankruptcy complexity, and bonuses to CEOs in such cases may be optimal from a creditor s perspective. Other than the board size variables, creditor control measures are the only measures that are statistically significant in these regressions. The results suggest that greater creditor control increases the likelihood that CEOs are covered by KERPs. Overall, our inability to explain the inclusion of CEOs in the bonus plans as a function of CEO characteristics suggests that firms make optimal decisions regarding CEO participation in KERPs. 5 KERPs and Bankruptcy Outcomes In the previous section, we show that creditor control has predictive power for KERP adoptions by bankrupt firms. This raises the question of whether or not KERPs improve bankruptcy outcomes for creditors. Estimating the effect of KERPs on outcomes is not straightforward, since firms optimally determine when to use bonus plans. A firm s decision regarding the use of KERP can be specified as a function of the X variables below. 23

25 KERP i = X i β + ɛ i (1) Firms adopt KERPs if X i β + ɛ i is positive. 1 if KERPi > 0, KERP i = 0 if KERPi 0 (2) The bankruptcy outcome is a function of the Z variables and whether or not the firm has adopted a KERP. Outcome i = Z i γ + µkerp i + η i (3) The outcome variables we focus on include bankruptcy resolution (emergence versus liquidation), time spent in bankruptcy, and deviation from APR. Econometrically, a selection problem amounts to a non-zero correlation between the error disturbances in equations (1) and (3). To identify the outcome models, we rely on two instrumental variables that predict the adoption of KERPs but not bankruptcy outcomes. Both of our instruments are related to employees outside options. We know from Section 4 that KERPs are adopted more frequently in bankrupt firms with greater employment options for employees (measured by T hickemplm arkets). We do not expect a geographic concentration of same-industry firms to affect bankruptcy outcomes directly except through their influence on KERP adoption. Our second instrument is the median industry cash compensation growth (IndCompGrowth), which affects the propensity of employees to change jobs because of an increasing wage gap between the bankrupt firm and its peers. Our results reported in Section 4 suggest that a higher growth in industry cash compen- 24

26 sation increases the likelihood of KERP adoption. However, with this variable, there is a concern that industry cash compensation growth may be correlated with industry outcomes which may somehow affect bankruptcy outcomes. Thus, in discussing our results, we place a greater emphasis on our first instrumental variable (T hickemplmarkets) than the second. The Z i variables include firm size, leverage, profitability, the prepack indicator, Delaware-bankruptcy indicator, the industry-in-distress indicator, the secured debt scaled by assets, and variables measuring creditor control. All of these variables are known to affect the likelihood of emergence from bankruptcy (Lemmon et al., 2009; Jiang et al., 2012). In the regressions, the X i variables contain the two instrumental variables in addition to a full overlap with Z i variables. With binary-outcome variables and binary-endogenous explanatory variables, the appropriate estimation method is a bivariate probit model (see Woolridge (2002 Chapter )). With continuous-outcome variables, the appropriate estimation method is a treatment regression model (see Maddala (1983)). All of the models are estimated using the maximum-likelihood estimation method. In Columns (1) to (3) of Table 8, we examine the effect of KERPs on the bankruptcy outcomes. However, KERPs include both retention-only plans and plans that provide incentive bonuses. Since incentive bonus plans more directly tie the bonuses to outcomes, we expect the effect of incentive bonus plans on outcomes to be stronger. We, therefore, examine the effect of plans that include incentive bonus plans on outcomes in Columns (4) to (6). Column (1) presents result from bivariate probit regressions that explain the likelihood of a firm s emergence from bankruptcy. The dependent variable is an indicator variable that takes a value of one if the firm reorganizes and zero if the firm liquidates or is acquired. The predictions on how bonus plans affect the likelihood of bankruptcy 25

27 reorganization are complex and nuanced. KERPs provide retention bonuses that compensate managers to stay at the firm until a specified date (or until plan confirmation). In many bankruptcies, creditors prefer the firm to reorganize. But in others, creditors prefer the firm to liquidate. There are no clear predictions on how the provision of pay-to-stay bonuses will affect emergence since in both reorganizations and liquidations, creditors will want key employees to stay at the firm until the bankruptcy is resolved. The results in column (1) show no relation between the existence of bonus plans and the probability of a firm s emergence. In column (2), we present the treatment regression results that examine the effect of KERPs on the duration of bankruptcy. Bankruptcy costs are a function of the time spent in bankruptcy. Thus, we expect creditors to be sensitive to, and invested in, the expeditious resolution of bankruptcy. 17 The question we pursue here is whether or not KERPs affect the duration of bankruptcy. Retention plans that pay bonuses contingent on managers staying for a minimum length of time should have no effect on bankruptcy duration. However, retention plans that pay bonuses at plan confirmation should provide incentives for managers to speed up bankruptcy (assuming that managers have positive discount rates). However, the results show no significant relation between KERPs and bankruptcy duration. While the coefficient estimate on KERP adoption is negative, it is statistically indistinguishable from zero. The results in Section 4 show that greater creditor control is associated with an increased use of KERPs. In light of these findings, a logical question to ask is whether or not the use of KERPs reduces the ability of shareholders to obtain payoffs from creditors 17 LoPucki and Doherty (2004) provide estimates suggesting that doubling the time a case remains pending increases fees by about 57%. 26

28 (as evidenced in APR deviations). Furthermore, Bharath et al. (2010) recently show that APR deviations have been declining since the early 1990s. Bharath et al. attribute this decline to increasing creditor control in bankruptcies, since an increase in creditor control coincides with an increase in DIP financing and the adoption of key employee retention plans. The increase in DIP financing and KERPs during the 1990s is also documented by Skeel (2003). In Column (3), we examine the extent to which KERPs mitigate absolute priority deviations. If bonus plans are promoted by creditors, then such plans would strengthen creditor rights and reduce the costs that the bankruptcy process imposes on creditors, including deviation from the absolute priority rule. The coefficient on the KERP indicator is negative but the estimate is not statistically significant. Overall, we conclude that KERPs do not materially improve outcomes for creditors. The likelihood of emergence from bankruptcy is unrelated to the provision of retentiononly bonuses; the time spent in bankruptcies in firms offering such plans is no different, and the plans have no effect on APR violations. Since much of the criticism of KERPs is about retention-only plans, we next examine if results differ when we examine the effect of incentive bonus plans relative to firms that offer no bonuses or offer only retention bonuses. The incentive bonuses are often contingent on the firm achieving a certain outcome or the firm reaching a pre-determined milestone. These objectives are more frequently aligned with the interests of creditors. Thus, contrary to the findings above, we expect incentive bonus plans to significantly improve outcomes. Columns (4) to (6) of Table 8 examine the effect of incentive bonus plans on the three bankruptcy outcomes. The incentive-plan indicator takes a value of one if plans include 27

29 incentive bonus payments to key employees, and a value of zero otherwise. As described earlier, many KERPs include incentive bonuses together with retention payments, while a small number of plans include only incentive bonuses. In both cases, the incentive-plan indicator is coded as one. As before, the regressions control for firm and bankruptcy characteristics that are important in determining outcomes. Incentive bonus plans frequently tie the compensation of key employees to a firm s emergence from Chapter 11, or to performance indicators that are tied to either EBITDA or the enterprise value at emergence. Since incentive plans more frequently tie bonuses to emergence rather than to liquidation, we expect the overall effect of incentive bonuses on emergence to be positive. The bivariate probit estimates reported in column (4) confirm this prediction. In Table 9, we separately examine the effect of these objectives on the likelihood of emergence. In column (5), we examine how the presence of incentive bonus plans affect the time spent in bankruptcy. Many incentive bonus plans directly tie bonuses to the speed with which a bankruptcy is resolved. Specifically, managers are offered larger bonuses if the plan is confirmed early; the firm will gradually reduce bonus payments as the plan confirmation date moves into the future. The estimates show that the use of incentive bonuses significantly reduces time spent in bankruptcy. The effect of incentive plans on bankruptcy duration is much stronger compared to that in Column (2) where we examined all plans (including the retention-only plans). In column (6), we examine the effect of incentive bonus plans on the likelihood of APR violation in Chapter 11. As discussed earlier, if bonus plans improve outcomes for creditors, then they should reduce the costs that the bankruptcy process imposes on creditors, including deviation from the APR. Consistent with this prediction, we find that the coefficient on the incentive plan indicator is significantly negative. 28

30 The coefficient estimates on control variables have the predicted signs. The coefficient estimate on Ln(assets) in emergence regressions is positive, although it is not statistically significant. 18 We expect leverage to affect positively the probability of emergence because high leverage indicates that the firm suffers from financial, rather than economic, distress. In addition, creditors of highly-levered firms are likely to favor continuation, given that the claims of highly-levered firms are more risky. Consistently, we find that firms are more likely to emerge if they have high leverage. Furthermore, we expect firms to have a higher likelihood of emergence in pre-packaged bankruptcies, as a plan of reorganization often accompanies a bankruptcy petition at filing. The results strongly support this prediction as the coefficient estimates on pre-packaged bankruptcy are positive and significant at the 1% level in Columns (1) and (4). The Delaware filing dummy is negatively associated with emergence. We find that the presence of a creditors committee, a measure of bankruptcy complexity, is associated with a longer time spent in bankruptcy. As expected, pre-packaged bankruptcies are resolved more quickly. The only other variable that is significant in the duration regressions is the presence of an equity committee, which is associated with longer time spent in bankruptcy. Finally, the results suggest that APR violations are more common in pre-packaged bankruptcies. These results are consistent with those reported in Tashjian et al. (1996). Table 9 examine whether specific objectives in retention and incentive plans differently affect the probability of emergence. We focus on those plan objectives which appear most frequently in KERPs. The logit estimates presented in Columns (1) and (2) show that 18 Larger firms are more likely to be reorganized because larger firms are more costly to liquidate due to the financing constraints faced by potential buyers (Shleifer and Vishny, 1992; Aghion et al., 1992). Larger firms also have a considerably larger scope when reorganizing assets through restructuring and operating improvements (Denis and Rodgers, 2007; Barniv and Agarwal, 2002; Lemmon et al., 2009). 29

31 specific plan objectives in retention plans have no predictive ability in explaining a firm s emergence from bankruptcy. This finding is not surprising, since retention bonuses are based on a minimum stay or on the length of stay until plan confirmation (which could be either through a reorganization or liquidation). Columns (3) to (6), on the other hand, examine the three specific objectives that are commonly observed in incentive bonus plans. As described earlier, many of the bonus plans link incentive payments to the firm s emergence from Chapter 11. Many other plans link bonuses to asset sales. These two objectives are likely to have opposite effects on the likelihood of a firm s emergence. In column (3), we examine the likelihood of emergence when firms offer incentive plans that tie bonuses to emergence. The expected positive coefficient on the emergence objective indicator suggests that emergence is more likely when bonuses are linked to emergence. Conversely, results in column (4) show that when the plan objective is to sell assets, emergence is less likely. Overall, the results strongly suggest that incentive bonuses are important in explaining a firm s emergence from bankruptcy. In column (5), the effect of incentive bonus plans that link incentive bonuses to targets based on firms EBITDA upon emergence is examined. The presence of such plans is likely to once again positively affect emergence. The positive coefficient on the EBITDA objective indicator is consistent with this prediction. Overall, the findings suggest that bonus plans that offer incentive bonuses to key employees increase the likelihood of a firm s emergence from bankruptcy, reduce the time that firms spend in bankruptcy, and lower the likelihood that APR is violated. The fact that specific plan objectives differently affect the likelihood of a firm s emergence suggest that the nature of incentives matters significantly in bankrupt firms. The stronger findings on the effect of incentive plans on outcomes suggest that provision of incentive bonus payments significantly improves outcomes for creditors. 30

32 6 Conclusion This paper examines the determinants of retention and incentive bonus plans in cases of Chapter 11 bankruptcy and the effect that such plans have on bankruptcy outcomes. Many perceive that retention bonus plans simply transfer value from creditors to managers. The perception that managers are enriching themselves through such plans while lower level workers are laid off has generated immense controversy in the media and the Congress. However, companies have defended the use of these plans by arguing that key employee retention plans are important to dissuade mission-critical employees from leaving the firm. We find that measures of creditor power, such as the presence of creditors committees and debtor-in-possession financing, significantly increase the likelihood of a bankrupt firm implementing retention and incentive bonus plans. Similarly, these plans are more likely to be used when employees have increased outside employment options. Overall, the evidence generated through our study suggests that KERPs are more likely to be used when creditors have increased control over the bankruptcy process and when there is a greater risk of employees leaving the firm. We do not find evidence that entrenched incumbent CEOs are more likely to be covered by KERPs. On the contrary, turnaround specialists hired to improve and reorganize troubled companies are more likely to be covered by these plans. Furthermore, we examine the effect of KERPs on bankruptcy outcomes and find that it is important to distinguish between plans that provides only retention bonuses and those that provide both retention and incentive bonuses. While KERPs, in general, do not have material effect on a firm s likelihood of emergence from bankruptcy, plans that provide incentive bonuses significantly increase the likelihood of a firm s emergence. 31

33 Furthermore, incentive plans significantly reduce the time a firm spends in bankruptcy and the likelihood of absolute priority rule deviation. The nature of such incentives matters. When incentive plans tie bonuses to a firm s emergence or provide incentive bonuses contingent on EBITDA targets at emergence, the likelihood of emergence increases. On the contrary, when incentive bonuses are tied to asset sales, it becomes more likely that firms will, in fact, sell their assets. Overall, the evidence in this study casts doubt on claims that KERPs are adopted because creditors are ineffective in preventing managers from enriching themselves through the payment of these bonuses. On the contrary, we find that creditor control is critical in the payment of retention and incentive bonuses and that such plans generally improve outcomes for creditors. 32

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35 Gilson, S.C., and M.R. Vetsuypens, 1993, CEO compensation in financially distressed firms: An empirical analysis, Journal of Financial Economics 48, Henderson, M.T., 2007, Paying CEOs in bankruptcy: Executive compensation when agency costs are low, Northwestern University Law Review 101, Jiang, W., K. Li, and W. Wang, 2012, Hedge funds and Chapter 11, Journal of Finance 67, Kang, Q., and O.A. Mitnik, 2009, CEO power and compensation in financially distressed firms, Working Paper, University of Miami. Kim, H., 2011, Does human capital specificity affect employer capital structure? evidence from a natural experiment, working paper, Duke University. Lazear, E.P., 2009, Firm-specific human capital: A skill weights approach, Journal of Political Economy 117, Lehn, K., S. Patro, and M. Zhao, 2009, Determinants of the size and composition of US corporate boards: , Financial Management 38, Lemmon, M., Y.-Y. Ma, and E. Tashjian, 2009, Survival of the fittest? financial and economic distress and restructuring outcomes in Chapter 11, working paper, University of Utah. LoPucki, L.M., and J.W. Doherty, 2004, The determinants of professional fees in large bankruptcy reorganization cases, Journal of Empirical Legal Studies 1, Shleifer, A., and R.W. Vishny, 1992, Liquidation values and debt capacity: A market equilibrium approach, Journal of Finance 47, Skeel, D.A., 2003, Creditor s ball: The new new corporate governance in Chapter 11, University of Pennsylvania Law Review 152, Skeel, D.A, 2004, The past, present, and future of debtor-in-possession financing, Cardozo Law Review 25, Tashjian, E., R.C. Lease, and J. McConnell, 1996, Prepacks: An empirical analysis of prepackaged bankruptcies, Journal of Financial Economics 40, Weiss, L.A., 1990, Bankruptcy resolution: Direct costs and violation of priority of claims, Journal of Financial Economics 27,

36 Table 1: Use of KERPs in Chapter 11 The table reports annual distribution of firms adopting key employee retention plans. Columns 3 to 5 provide annual distribution of three different types of KERPs plans that provide only retention bonuses, plans that provide both retention and incentive bonuses, and finally plans that provide only incentive bonuses. The initial sample includes all Chapter 11 filings by public U.S. firms with book assets above $100 million (in constant 1980 dollars) from 1996 to We exclude bankruptcy cases that were dismissed and those that were still pending as of December 31, We also exclude financial firms, utilities, and firms headquartered outside the U.S. Year is the year in which of filing of Chapter 11. KERPs Featuring Year Total Adopted Retentions Retention Incentives Filings KERP Only w/incentives Only (1) (2) (3) (4) (5) (3.4%) 4 (29%) 3 (21%) 1 (7%) 0 (0%) (3.1%) 5 (38%) 3 (23%) 0 (0%) 2 (15%) (5.8%) 6 (25%) 5 (21%) 1 (4%) 0 (0%) (8.6%) 15 (42%) 8 (22%) 7 (19%) 0 (0%) (17.3%) 22 (31%) 9 (13%) 13 (18%) 0 (0%) (19.7%) 30 (37%) 11 (13%) 18 (22%) 1 (1%) (16.1%) 25 (37%) 10 (15%) 15 (22%) 0 (0%) (10.8%) 23 (51%) 6 (13%) 10 (22%) 7 (16%) (6.5%) 15 (56%) 7 (26%) 7 (26%) 1 (4%) (4.6%) 10 (53%) 5 (26%) 5 (26%) 0 (0%) (2.6%) 6 (55%) 0 (0%) 1 (9%) 5 (45%) (1.7%) 3 (43%) 0 (0%) 0 (0%) 3 (43%) Total 417 (100.0%) 164 (39%) 67 (16%) 78 (19%) 19 (5%) 35

37 Table 2: Summary Statistics The table presents summary statistics of our sample firms. Panel A presents mean and median values of firm characteristics in the year before bankruptcy. Panel B provides summary statistics of bankruptcy-related variables. Panel C summarizes governance and CEO characteristics, while panel D tabulates bankruptcy outcomes and presents means and medians of time to resolution in months for each of the three outcomes. The initial sample includes all Chapter 11 filings by U.S. public firms with book assets above $100 million (in constant 1980 dollars) from 1996 to We exclude bankruptcy cases that were dismissed and those that were still pending as of December 31, We also exclude financial firms, utilities, and firms headquartered outside the U.S. The financial and ownership data are as of the year before the filing. The variables are defined in Appendix Table 1. Variable N M ean M edian Panel A: Firm Characteristics Assets (in millions of 2008 dollars) Leverage Industry-adjusted leverage EBITDA-to-assets Industry-adjusted EBITDA-to-assets Secured debt/assets Institutional ownership Panel B: Bankruptcy Characteristics Pre-packaged Delaware DIP financing Creditors committee Equity committee AP RDev Panel C: Governance and CEO Characteristics Board independence Board size CEO-chairman CEO-founder CEO age CEO tenure CEO incumbent CEO internal hire CEO external hire CEO turnaround specialist Panel D: Bankruptcy Outcomes Bankruptcy duration (in months) Outcome N (%) Mean Median Reorganization 249 (59.7%) Acquisition 46 (11.0%) Liquidation 122 (29.3%) Total 417 (100.0%)

38 Table 3: Details of KERPs The table reports mean and median values of employee coverage of retention and incentive plans, the bonuses paid under these plans, aggregate plan costs, and plan objectives for retention and incentive plans. The initial sample includes all Chapter 11 filings by U.S public firms with book assets above $100 million (in constant 1980 dollars) from 1996 to We exclude bankruptcy cases that were dismissed and those that were still pending as of December 31, We also exclude financial firms, utilities, and firms headquartered outside the U.S. The variables are defined in Appendix Table 1. Retention Plans Incentive Plans Plan Features N Mean Median N Mean Median # of key employees in the plan # of key employees/total employees # of tier groups Key employees: highest-tier group Key employees: lowest-tier group Bonus (% of salary): highest-tier group Bonus (% of salary): lowest-tier group Plan includes CEO Plan includes non-ceo executives Plan includes other employees Retention plan objectives: Retention plan: minimum stay Minimum months of stay required Retention plan: plan confirmation Incentive plan objectives: Objective: emergence Objective: EBITDA Objective: asset sale Objective: enterprise value Objective: speed Objective: recovery Plan Costs: Total costs (in 2008 $ mill) Total costs/assets (%) Maximum pool (in 2008 $ mill) Maximum pool/assets (%)

39 Table 4: Logit Models of KERP Adoption in Chapter 11 Firms The table presents the logit estimates from models that relate KERPs to measures of creditor power and employees outside options. The initial sample includes all Chapter 11 filings by U.S. public firms with book assets above $100 million (in constant 1980 dollars) from 1996 to We exclude bankruptcy cases that were dismissed and those that were still pending as of December 31, We also exclude financial firms, utilities, and firms headquartered outside the U.S. The variables are defined in Appendix Table 1. All regressions control for Fama-French 12-industry fixed effects. Numbers in parentheses are z-values., and denote significance at the 1%, 5%, and 10% levels, respectively. (1) (2) (3) (4) (5) (6) Ln(assets) (3.7) (3.5) (3.9) (3.7) (2.8) (2.2) Pre-packaged (-2.8) (-3.2) (-2.7) (-3.0) (-2.7) (-2.3) Delaware (0.9) (1.0) (1.3) (0.7) (1.3) (1.4) Creditors committee (3.5) (3.4) (3.4) (3.3) (3.5) (3.3) DIP financing (4.2) (4.4) (4.0) (3.9) (4.1) (3.5) Industry in distress (-1.6) (-1.6) (-1.5) (-1.5) (-1.3) T hickemplmarkets (3.2) (3.0) (2.7) (3.0) (2.3) IndCompGrowth (2.0) (1.9) (2.2) (1.9) (1.5) Board independence (0.1) (-0.1) CEO-chairman (-0.6) (0.5) Board size (2.1) (2.2) 38

40 Table 4 Continued (1) (2) (3) (4) (5) (6) CEO age (0.2) CEO tenure (0.1) CEO-founder (1.5) CEO internal hire (0.1) CEO external hire (-0.8) CEO turnaround specialist (1.1) Constant (-5.6) (-5.5) (-5.3) (-5.2) (-5.6) (-4.9) Pseudo R Observations

41 Table 5: Multinomial Logit Models of Retention-Only Plans and Incentive Bonus Plans This table reports results from multinomial logit regressions for the adoption of bonus plans. The reference category is the set of firms without KERPs. The alternative categories are firms that use bonus plans that only pay retention bonuses and those that pay incentive bonuses (either with retention bonuses or without). The initial sample includes all Chapter 11 filings by U.S. public firms with book assets above $100 million (in constant 1980 dollars) from 1996 to We exclude bankruptcy cases that were dismissed and those that were still pending as of December 31, We also exclude financial firms, utilities, and firms headquartered outside the U.S. The variables are defined in Appendix Table 1. All regressions control for Fama-French 12-industry fixed effects. Numbers in parentheses are z-values., and denote significance at the 1%, 5%, and 10% levels, respectively. Retention-Only Bonus Plans (1) (2) (3) (4) Ln(assets) (2.2) (2.6) (2.3) (1.9) Pre-packaged (-1.9) (-1.6) (-1.7) (-1.5) Delaware (1.1) (1.2) (0.6) (1.2) Creditors committee (17.8) (15.2) (17.4) (17.2) DIP financing (1.9) (1.7) (1.7) (1.7) Industry in distress (-0.7) (-0.7) (-0.6) (-0.6) T hickemplmarkets (3.4) (2.9) (2.9) (2.9) IndCompGrowth (0.6) (0.4) (0.6) (0.3) Board independence (0.8) CEO-chairman (0.2) Board size (1.0) Plans with Incentive Bonuses Ln(assets) (3.6) (4.0) (3.7) (2.8) Pre-packaged (-3.1) (-2.5) (-3.0) (-2.6) 40

42 Table 5 Continued (1) (2) (3) (4) Delaware (0.6) (0.8) (0.5) (0.9) Creditors committee (2.0) (2.0) (1.8) (2.2) DIP financing (4.6) (4.4) (4.2) (4.4) Industry in distress (-1.7) (-1.8) (-1.7) (-1.7) T hickemplmarkets (2.3) (2.3) (2.0) (2.3) IndCompGrowth (2.6) (2.7) (3.0) (2.7) Board independence (-0.7) CEO-chairman (-1.1) Board size (2.1) Constant (-5.3) (-4.9) (-5.0) (-5.5) Pseudo R Observations

43 Table 6: Tobit Estimates of KERP Features The table presents the tobit estimates from models that relate the KERP plan features to firm and bankruptcy characteristics. The initial sample includes all Chapter 11 filings by U.S public firms with book assets above $100 million (in constant 1980 dollars) from 1996 to We exclude bankruptcy cases that were dismissed and those that were still pending as of December 31, We also exclude financial firms, utilities, and firms headquartered outside the U.S. The variables are defined in Appendix Table 1. All regressions control for Fama-French 12-industry fixed effects. Numbers in parentheses are z-values., and denote significance at the 1%, 5%, and 10% levels, respectively. Key plan employees/ Total employees Bonus(% Salary) Plan Cost/ Assets (%) Max Pool/ Assets (%) Key plan employees/ Highest tier Total employees Bonus (% of Salary) Highest tier Plan Cost/ Assets (%) Max Pool/ Assets (%) Retention Bonuses Incentive Bonuses (1) (2) (3) (4) (5) (6) (7) (8) Ln(assets) (3.3) (3.9) (2.7) (2.3) (2.5) (1.8) (2.3) (2.8) Pre-packaged (-1.3) (-2.3) (-2.6) (-2.7) (-1.2) (-1.0) (-1.9) (-2.1) Delaware (1.6) (1.2) (0.8) (1.7) (1.3) (-0.3) (1.2) (1.8) Creditors committee (3.5) (3.1) (3.2) (3.4) (2.0) (1.2) (1.1) (1.2) DIP financing (3.1) (3.1) (2.9) (2.7) (3.3) (3.3) (3.6) (2.9) T hickemplmarkets (2.3) (2.2) (2.4) (2.4) (0.9) (0.8) (0.6) (0.4) IndCompGrowth (0.7) (1.0) (0.4) (1.0) (2.1) (1.7) (1.9) (1.8) Industry in distress (0.0) (-0.3) (-1.1) (-0.9) (-1.0) (0.0) (-1.2) (-1.2) Constant (-5.4) (-5.3) (-4.2) (-4.3) (-4.5) (-4.0) (-4.1) (-4.5) Pseudo R Observations

44 Table 7: CEO Participation in KERPs The table presents logit estimates from regressions that predict the participation of CEOs in KERPs as a function of CEO characteristics, governance variables, firm and bankruptcy characteristics. The initial sample includes all Chapter 11 filings by U.S.public firms with book assets above $100 million (in constant 1980 dollars) from 1996 to We exclude bankruptcy cases that were dismissed and those that were still pending as of December 31, We also exclude financial firms, utilities, and firms headquartered outside the U.S. The variables are defined in Appendix Table 1. All regressions control for Fama-French 12-industry fixed effects. Numbers in parentheses are z-values., and denote significance at the 1%, 5%, and 10% levels, respectively. CEO Participation in KERPs CEO Participation in Incentive Plans (1) (2) (3) (4) (5) (6) (7) (8) CEO age (-0.7) (-0.9) (-0.8) (-0.6) (-1.6) (-1.7) (-1.6) (-1.8) CEO tenure (0.9) (0.9) (1.1) (0.8) (0.2) (0.3) (0.5) (0.4) CEO-founder (0.1) (0.1) (0.4) (0.8) (0.7) (0.7) (1.0) (1.6) CEO incumbent (-0.5) (-0.1) CEO internal hire (0.7) (0.7) (0.8) (0.7) (0.6) (0.7) CEO external hire (-0.6) (-0.5) (-0.8) (-0.9) (-0.7) (-1.0) CEO turnaround specialist (2.1) (1.9) (1.2) (1.4) (0.9) (0.4) Board size (3.0) (2.0) (2.9) (1.6) Board independence (1.0) (0.9) (-0.4) (-0.7) CEO-chairman (1.3) (0.4) (0.4) (-0.7) Ln(assets) (1.5) (2.5) Prepackaged (-1.7) (-1.4) Delaware (1.3) (1.3) Creditors committee (3.0) (1.5) DIP financing (2.7) (3.1) 43

45 Table 7 Continued CEO Participation in KERPs CEO Participation in Incentive Plans (1) (2) (3) (4) (5) (6) (7) (8) T hickemplm arkets (0.8) (0.4) IndCompGrowth (0.7) (2.1) Industry in distress (-0.1) (-0.5) Constant (-1.0) (-1.2) (-3.2) (-4.7) (-2.3) (-2.1) (-2.4) (-4.2) Pseudo R Observations

46 Table 8: Effect of Retention and Incentive Plans on Bankruptcy Outcomes The table examines the effect of retention only plans on emergence from bankruptcy, duration of bankruptcy, and absolute priority rule deviation. Columns (1) and (3) present results from bivariate probit regressions of reorganizing in bankruptcy. Columns (2) and (5) present results from treatment regressions of the log of duration. Finally, Columns (4) and (6) present results from bivariate probit regressions of APR violations. The initial sample includes all Chapter 11 filings by U.S public firms with book assets above $100 million (in constant 1980 dollars) from 1996 to We exclude bankruptcy cases that were dismissed and those that were still pending as of December 31, We also exclude financial firms, utilities, and firms headquartered outside the U.S. The variables are defined in Appendix Table 1. All regressions control for Fama-French 12-industry fixed effects. Numbers in parentheses are z-values., and denote significance at the 1%, 5%, and 10% levels, respectively. Reorganization Ln(Duration) AP RDev Reorganization Ln(Duration) AP RDev (1) (2) (3) (4) (5) (6) KERP (1.3) (-0.4) (-0.5) Incentive (15.2) (-3.1) (-11.1) Creditors committee (-1.5) (4.9) (-0.8) (-1.8) (6.2) (-0.3) DIP financing (-0.0) (-0.1) (-0.6) (-1.1) (0.7) (1.4) Ln(assets) (0.9) (1.2) (1.3) (0.5) (2.0) (2.8) Industry-adjusted leverage (2.2) (-1.2) (0.3) (2.6) (-0.9) (1.1) Industry-adjusted ROA (-0.3) (0.3) (0.0) (-0.3) (0.6) (0.8) Pre-packaged (6.8) (-8.4) (4.8) (7.0) (-10.9) (2.7) Delaware (-2.4) (-0.8) (0.7) (-2.1) (-0.7) (0.8) Secured debt/assets (1.0) (-1.4) (-1.0) (1.3) (-1.6) (-0.7) Institutional ownership (0.0) (0.6) (0.9) (-1.0) (1.3) (2.5) 45

47 Table 8 Continued Emergence Duration AP RDev Emergence Duration AP RDev (1) (2) (3) (4) (5) (6) Equity committee (1.4) (1.9) (1.4) (1.6) (1.6) (0.7) Industry in distress (0.5) (0.8) (-0.3) (1.1) (0.3) (-1.4) Constant (-1.1) (5.6) (-2.6) (-0.8) (5.9) (-3.7) Wald χ Observations

48 Table 9: Plan Objectives and Reorganization in Bankruptcy The table presents estimates from logit regressions that examine the effect of specific plan objectives on the likelihood of a firm s emergence from bankruptcy. The initial sample includes all Chapter 11 filings by U.S. public firms with book assets above $100 million (in constant 1980 dollars) from 1996 to We exclude bankruptcy cases that were dismissed and those that were still pending as of December 31, We also exclude financial firms, utilities, and firms headquartered outside the U.S. The variables are defined in Appendix Table 1. All regressions control for Fama-French 12-industry fixed effects. Numbers in parentheses are z-values., and denote significance at the 1%, 5%, and 10% levels, respectively. (1) (2) (3) (4) (5) (6) Retention plan: minimum stay (1.2) (2.2) Retention plan: plan confirmation (-0.0) (-1.3) Objective: emergence (2.7) (2.6) Objective: asset sale (-3.7) (-4.2) Objective: EBITDA (2.0) (2.1) Creditors committee (-0.9) (-0.8) (-0.9) (-0.5) (-0.8) (-0.9) DIP financing (0.4) (0.6) (0.5) (1.2) (0.7) (-0.0) Ln(assets) (1.9) (2.2) (2.2) (2.3) (2.3) (1.1) Industry-adjusted leverage (3.7) (3.7) (3.1) (3.2) (3.2) (3.5) Industry-adjusted ROA (0.8) (0.8) (0.4) (0.5) (0.4) (0.8) Pre-packaged (5.3) (5.1) (5.7) (5.2) (5.6) (5.2) Delaware (-1.7) (-1.6) (-2.0) (-1.9) (-2.0) (-1.6) Secured debt/assets (1.9) (1.8) (1.3) (1.3) (1.3) (2.0) 47

49 Table 9 Continued (1) (2) (3) (4) (5) (6) Institutional ownership (0.8) (0.8) (0.2) (1.5) (0.6) (1.1) Equity committee (1.8) (1.8) (2.1) (1.5) (1.8) (1.5) Industry in distress (0.8) (0.7) (0.5) (0.4) (0.5) (1.3) Constant (-2.3) (-2.5) (-2.2) (-2.5) (-2.4) (-1.6) Pseudo R Observations

50 Appendix Table 1: Variable Definitions and Data Sources The table provides definition of key variables. Data sources for firm characteristics and post-emergence performance are BRD, BankruptcyData.com, Compustat, 10Ks, Execucomp, and Thomson Reuters Ownership Database (13Fs). Data sources for firm characteristics are BRD, BankruptcyData.com, Factiva, 8K filings, and bankruptcy plans. Details on KERPs are obtained from BankruptcyData.com, Factiva, PACER, Parcels Inc., and National Archives. Variable Firm Characteristics Definition Assets Book value of assets (in 2008 dollars) Leverage Total liabilities to assets ratio EBITDA-to-assets Ratio of EBITDA to book assets Secured debt/assets Ratio of secured debt to book assets Institutional ownership Institutional ownership (in %) Industry in distress 0-1 dummy varaible, =1 if the median stock return of same 2-digit SIC industry is -30% or less in the year before a firm files for bankruptcy. T hickemplmarkets 0-1 dummy variable, = 1 if there are 20 or more firms in the same-2-digit industry and headquartered within 100 km of the company in bankruptcy. IndCompGrowth Industry median growth in salary and bonus of non-ceo executives in the year before the Chapter 11 filing. Bankruptcy Characteristics Pre-packaged 0-1 dummy variable, = 1 if bankruptcy is prepackaged or prenegotiated Delaware 0-1 dummy variable, = 1 if bankruptcy filed in Delaware DIP financing 0-1 dummy variable, =1 if debtor obtained DIP financing Creditors committee 0-1 dummy variable, = 1 if creditor committee appointed Equity committee 0-1 dummy variable, = 1 if equity committee appointed Reorganization 0-1 dummy variable, = 1 if firm reorganized in Chapter 11 Liquidation 0-1 dummy variable, = 1 if firm is liquidated Acquisition 0-1 dummy variable, = 1 if firm is acquired Duration Months in bankruptcy from filing to plan confirmation AP RDev 0-1 dummy variable, =1 if equity holder receive payoffs before creditors are paid in full. Governance and CEO Characteristics Board independence Board size CEO-chairman CEO-founder CEO age CEO tenure CEO incumbent CEO internal hire CEO external hire CEO turnaround specialist 0-1 dummy variable, =1 if a majority of board members are independent Number of board members 0-1 dummy variable, =1 if CEO is also chairman of the board 0-1 dummy variable, =1 if CEO is also the firm s founder Age of CEO Tenure as CEO with the firm 0-1 dummy variable, =1 if CEO has been with the firm from before filing 0-1 dummy variable, =1 if the newly-hired CEO is hired internally 0-1 dummy variable, =1 if the newly-hired CEO is hired externally 0-1 dummy variable, =1 if the external hire is a turnaround specialist 49

51 Appendix Table 1 continued Variable Key Employee Retention Plans KERP Retention Incentive Key employees Key employees/total employees Tier groups Employees: highest tier group Employees: lowest tier group Retention bonus-highest tier Retention bonus-lowest tier CEO in retention plan Non-CEO execs in retention plan Other managers in plan Minimum months of stay Bonus on minimum stay Bonus on plan confirmation Objectives in Retention Plans Retention: min stay Retention: plan confirmation Objectives in Incentive Plans Objective: emergence Objective: EBITDA Objective: asset sale Objective: enterprise value Objective: speed Objective: debt recovery Definition 0-1 dummy variable, = 1 if retention/incentive plan approved 0-1 dummy variable, = 1 if firm offers retention bonuses 0-1 dummy variable, = 1 if firm offers incentive bonuses # key employees in plan # of key employees/total employees Number of tier groups # of employees in highest tier group # of employees in lowest tier group Bonus (as % of salary) in highest tier group Bonus (as % of salary) in lowest tier group CEO is included in the retention plan Senior execs (other than CEO) in the retention plan Other employees in the retention plan Minimum months of stay required to receive bonus Fraction of bonus paid on minimum stay Fraction of bonus paid on plan confirmation 0-1 dummy variable, = 1 if retention bonus tied to minimum stay 0-1 dummy variable, = 1 if retention bonus tied to plan confirmation. 0-1 dummy variable, = 1 if objective is tied to reorganization 0-1 dummy variable, = 1 if objective is tied to EBITDA 0-1 dummy variable, = 1 if objective is asset sale 0-1 dummy variable, = 1 if objective is tied to enterprise value 0-1 dummy variable, = 1 if objective is tied to speed of restructuring 0-1 dummy variable, = 1 if objective is debt recovery. 50

52 Appendix A. KERP Examples from Court Motions and Approvals Examples of key employee retention and incentive plans taken from court document (such as motions and orders approving key employment retention or incentive plans for firms in Chapter 11) RETENTION PLAN FOR STAYING WITH THE DEBTOR Excerpts from Order Granting Debtors Motion to Approve Key Employee Retention Plan for Kitty Hawk, Inc. dated August 23, 2000 by the US Bankruptcy Court for the Northern District of Texas. IT IS, THEREFORE, ORDERED AND DECREED that the Key Employee listed on Exhibit A who retain employment with Kitty Hawk, Inc. or a Successor to the earlier of the effective date of a Plan of Reorganization or January 1, 2001, shall be paid a retention bonus equal to six (6) months salary, payable in six monthly instalments beginning on the earlier of the effective date of a plan of reorganization or January 1, 2001, if these cases remain in Chapter 11. No bonus would be payable (and any unpaid bonus would be forfeited) if a Key Employee: (a) resigns, (b) is terminated for cause or (c) does not execute a covenant not to compete with the Debtors (or their successors under a plan of reorganization) through December 31, Excerpts from Motion for an Order Pursuant to 11 U.S.C. 105(a) and 363(b) Authorizing the Debtors to Implement a Key Employee Retention Plan for Horizon PCS, Inc. dated August 22, 2003 by the US Bankruptcy Court for the Northern District of Ohio. The Debtors propose to provide stay bonuses (the Stay Bonuses ) to the 45 Key Employees that the Debtors deem to be so critical to their operations that the loss of such employees services would cost the Debtors more than the cost of the Stay Bonus and other benefits provided under the Retention Plan. The Debtors selected the 45 Key Employees based on their skill sets and knowledge, which are essential to the operation of the Debtors businesses during these Chapter 11 restructurings, and other factors such as the likelihood of their leaving for other employment opportunities. The Stay bonus are designed to induce the 45 Key Employees to remain in the Debtors employ through the pendency of these chapter 11 cases, or for as long as the Debtors require their services. The Stay Bonus will be earned by each of qualifying Key Employee in the amounts and times set forth below, and will be paid as soon as practicable thereafter. A. 25% (the First Payment ) on the 45th day after the Petition Date; B. 25% (the Second Payment ) on earlier of: (1) confirmation of a plan of reorganization, (2) a Court order approving sale of substantially all assets becoming final, and (3) 105 days after the First Payment; C. 50% upon the earlier of: (1) consummation of a Qualifying Event and upon earlier of (a) involuntary termination of employment (in which case the employees will be entitled to the greater of the remaining Stay Bonus or his/her Severance Pay); and (b) 90 days after consummation of Qualifying Event; and (2) 190 days after the Second Payment. Excerpts from Motion of the Debtors Pursuant to Sections 363(b) and 105(a) of the Bankruptcy Code for Authorization to Establish a Key Employee Retention Plan filed by WorldCom Inc. dated October 18, 2002 with the US Bankruptcy Court for the Southern District of New York. 51

53 The Debtors have to date identified approximately 329 Key Employees who will participate in the Retention Plan. In developing the Retention Plan, the Debtors classified those Key Employees into four groups (each a Group ) based on each employee s role in the Company and expected contribution to the reorganization efforts of the Debtors: Group 1 includes 4 Key Employees (the Group 1 Employees ) who hold the most senior positions at WorldCom. None of these employees will participate in the Retention Plan. Group 2 includes 25 Key Employees (the Group 2 Employees ). The Stay Bonus for each Group 2 Employee is equal to 65 % of the individual s annual base compensation, subject to a cap of $125,000. The range of Stay Bonuses for Group 2 Employees is expected to be from $90,000 to $125,000. Group 3 includes 90 Key Employees (the Group 3 Employees ). The Stay Bonus for each Group 3 Employee is equal to 50% of the individual s annual base compensation, subject to a cap of $125,000. The range of Stay Bonuses for Group 3 Employees is expected to be from $47,000 to $125,000. Group 4 includes approximately 210 Key Employees (the Group 4 Employees ). The Stay Bonus for each Group 4 Employee is equal to 35% of the individual s annual base compensation, subject to a cap of $125,000. The range of Stay Bonuses for Group 4 Employees is expected to be from $20,000 to $90,000. The Retention Plan provides bonuses designed to encourage Key Employees to both remain employed by the Debtors throughout the reorganization process and to work productively to ensure that the Debtors complete their reorganization in a timely and efficient manner. The Retention Plan provides for a stay bonus (the Stay Bonus ) if the Key Employee remains employed by the Debtors on specific target dates. The Stay Bonus for any Key Employee is equal to a percentage of the individual s annual base compensation according to the classification of the Key Employee set forth below. The Debtors propose to pay the Stay Bonuses pursuant to the following schedule: 25% of the Stay Bonus paid on December 1, 2002, 25% of the Stay Bonus paid on March 31, 2003, and 50% of the Stay Bonus paid 60 days after confirmation of a plan of reorganization. In addition, the Retention Plan provides that each Key Employee who remains employed by the Debtors on the date that a plan of reorganization is confirmed (the Plan Confirmation Date ) will receive an additional bonus amount equal to 10% of the Key Employee s Stay Bonus (the Plan Progress Bonus ). The Plan Progress Bonus would be earned if the Plan Confirmation Date occurs by December Should the Plan Confirmation Date occur earlier, the Plan Progress would increase as set forth on the schedule below: 100% of the Plan Progress Bonus if the Plan Confirmation Date occurs in December 2003; 150% of the Plan Progress Bonus if the Plan Confirmation Date occurs in November 2003; 200% of the Plan Progress Bonus if the Plan Confirmation Date occurs in October 2003; and 250% of the Plan Progress Bonus if the Plan Confirmation Date occurs on or before September 30,

54 RETENTION BONUS TIED TO STAY AND INCENTIVE BONUS TIED TO EMER- GENCE Excerpts from Debtors Motion for an Order Pursuant to Section 363(a) and 105(a) of the Bankruptcy Code Authorizing Implementation of Retention Plan filed by Galey & Lord, Inc. on May 1, 2002 with the US Bankruptcy Court for the Southern District of New York. The Retention Program is designed to provide the Critical Employees with competitive financial incentives, among other things, (a) to remain in their current positions with the Debtors through the effective date (the Emergence ) of a plan or plans of reorganization in these cases, (b) to assume the additional administrative and operational burdens imposed on the Debtors by these cases, and (c) to use their best efforts to improve the Debtors financial performance and facilitate the Debtors successful reorganization. The Retention Program includes six separate components: (a) a performance incentive plan designed to provide performance incentives to key management employees; (b) a stay bonus plan designed to ensure the continued employment of certain key management through the completion of the Debtors restructuring; (c) an emergence bonus plan designed to provide an additional incentive to the Debtors CEO, who is particularly essential to the implementation of the Debtors restructuring plan, through the confirmation process; (d) a severance plan designed to ensure basic job protection for key management employees terminated other than for cause; (e) a discretionary transition payment plan designed to provide management with the ability to offer incentives to certain employees during a transition period at the end of which such employees would be terminated, in the event such circumstances arise; and (f) a discretionary retention pool designed to provide the CEO discretionary authority to offer incentives to employees (including new employees) not otherwise participating in the Stay Bonus Plan or the Emergence Bonus Plan. RETENTION BONUS TIED TO PLAN CONFIRMATION AND INCENTIVE BONUS TIED TO ASSET SALE, EMERGENCE, AND DEBT RECOVERY Excerpts from Debtors Motion for an Order under 11 U.S.C. Section 105 and 363 Authorizing Implementation of Key Employee Severance/Retention Program filed by SLI, Inc. on October 3, 2002 with the US Bankruptcy Court for the District of Delaware. The Severance/Retention Program is a three-tier program that provides certain key employees or their successors (the Key Employees ) with an opportunity to receive a retention/stay bonus (the Retention Payment ) and a severance payment (the Severance Payment ). Tier One Key Employee. The first tier ( Tier One ) covers a single employee, the Chief Executive Officer (the CEO ) who has been designated as a corporate employee. Under the program, the Tier One employee would receive a retention payment of $350,000 and would be entitled to a severance payment of $150,000. The Tier One employee s Retention Payment shall be earned, due and payable in the following manner and on the earliest of the following events: (i) payment in full on termination of the Tier One employee s employment by the company without cause ; (ii) payment in full on consummation of a plan of reorganization; or (iii) payment of 50% on consummation of a sale of substantially all of the Debtors assets pursuant to 11 U.S.C. Section 363 in the GLE business line or the ML business line and the remaining 50% on consummation of a sale of the remaining business line or consummation of a plan of reorganization. In addition to the Retention and Severance Payments, the Tier One employee would also be eligible to receive incentive compensation in an amount 53

55 not to exceed $1.2 million. This additional Incentive compensation is earned based upon the prepetition lenders aggregate percentage recovery. Receipt of the Incentive Compensation would thus be directly tied to the amount of proceeds generated by one or more sales of assets of the Debtors respective business lines or distributions under a reorganization plan. Tier Two Key Employee. The second tier of the Severance/Retention program ( Tier Two ) covers twenty (20) employees or positions within the Debtors Corporate, ML, GLE and GLA business lines. Retention and Severance Payments to Tier Two employees are based on position and are calculated as a percentage of a Tier Two employee s current base salary. With respect to the Retention Payments, certain members of the Debtors executive management, including the Chief Financial Officer and the Executive Vice Presidents, are eligible to receive payments ranging from 75% to 150% of base salary. Retention Payment shall be earned, due and payable in the following manner and on the earliest of the following events: (i) payment in full on termination of the Tier One employee s employment by the company without cause ; (ii) payment in full on consummation of a plan of reorganization; or (iii) payment of 50% on consummation of a sale of substantially all of the Debtors assets pursuant to 11 U.S.C. Section 363 in the GLE business line or the ML business line and the remaining 50% on consummation of a sale of the remaining business line or consummation of a plan of reorganization. Tier Three Key Employee. The third tier ( Tier Three ) of the severance/retention Program provides for a discretionary pool of $50,000 to be reserved for certain essential staff members, which total includes any and all payments to such persons on account of Retention and Severance Payments. RETENTION BONUS TIED TO MINIMUM STAY AND INCENTIVE BONUS TIED TO EMERGENCE, ASSET SALES, AND ENTERPRISE VALUE Excerpts from the Motion for Entry of Order Authorizing the Debtor to Implement and Honor a Key Employee Retention Program and Approve Severance and Separation Plans filed by Anchor Glass Container Corporation on October 25, 2005 with the US Bankruptcy Court for the Middle District of Florida. The Debtor seeks to enter into retention agreements (the Retention Agreements ) with 81 Key Employees (including the CEO) to retain the Key Employees and ultimately maximize the value of the Debtor s assets for the benefit of all parties in interest. Specifically, the Debtor seeks to minimize the turnover of Key Employees by providing incentives for these people to remain in the Debtor s employ and work toward a successful reorganization of the Debtor. For 80 of the 81 proposed participants in the Retention Program, the retention incentive consists of cash retention payments at a percentage of base salary ranging from 20% to 65% the participants base pay payable at various critical points in the Debtor s Chapter 11 case. The timing of these retention payments is contemplated as follows: Tier # of % of Court 2/15/06 Emergence 6 Months Total Employees Base Approval Date Post KERP Pay of KERP Emergence Payment Tier I 7 65% 5% 15% 40% 40% 100% Tier II 9 65% 5% 15% 40% 40% 100% Tier III 11 40% 5% 15% 40% 40% 100% Tier IV 53 20% 5% 15% 40% 40% 100% 54

56 For the remaining proposed Retention Program participant, CEO Mark Burgess, the retention incentive consists of the following scenarios: (a) in the event of a reorganization in which Mr. Burgess is retained as CEO of the reorganized Debtor, Mr. Burgess would be entitled to i) a retention payment of $500,000, which is equal to 83 percent of his base salary, (payable upon the Debtor s emergence from Chapter 11), plus ii) additional payments of $500,000 if the enterprise value of the Debtor equals or exceeds $300 million together with an amount equal to one percent of the amount by which the enterprise value of the Debtor exceeds $300 million (both of these additional payments would be payable 6 months after Debtor emerges from Chapter 11), or (b) in the event of a reorganization in which Mr. Burgess is offered to be retained as CEO of the reorganized Debtor with an employment agreement that is at least equivalent to the prevailing terms of employment in the open market for CEO s of similarly sized companies with usual and customary CEO duties, but Mr. Burgess declines to accept the offer, then Mr. Burgess would be entitled to i) a retention payment of $500,000, which is equal to 83 percent of his base salary, (payable upon the Debtor s emergence from Chapter 11), plus ii) additional payments of $500,000 if the enterprise value of the Debtor equals or exceeds $300 million, together with an amount equal to one percent of the amount by which the enterprise value of the Debtor exceeds $300 million and 12 months severance pay (these additional payments would be payable upon the earlier of the termination of Mr. Burgess employment with the Debtor or 6 months after the Debtor emerges from Chapter 11); or (c) in the event of a reorganization in which Mr. Burgess is not retained as CEO of the Debtor, or in a situation where Mr. Burgess is terminated without cause prior to emergence to Chapter 11, or in which the Debtor s offer of continued employment to Mr. Burgess is not at least equivalent to the prevailing terms of employment in the open market for CEO s of similarly sized companies with usual and customary CEO duties as discussed in (b) above, Mr. Burgess would be entitled to i) a retention payment of $600,000, which is equal to his base salary (payable upon the Debtor s emergence from Chapter 11), plus ii) additional payments of an amount equal to one percent of the amount by which the enterprise value of the Debtor exceeds $300 million and 18 months of severance pay (both of these additional payments would be payable upon the earlier of the termination of Mr. Burgess employment with the Debtor or 6 months after the Debtor emerges from Chapter 11, with the exception of the case where he is terminated without cause prior to emergence from Chapter 11, whereby the payment based on the enterprise value calculation would be paid within 30 days of the emergence date); or (d) in the event of a sale of substantially all of the assets of the Debtor, Mr. Burgess would be entitled to i) a retention payment of $500,000, which is equal to 83 percent of his base salary, plus ii) additional payments of $500,000, if the gross sales price of the assets of the Debtor equals or exceeds $300 million, together with an amount equal to one percent of the amount by which the gross sales price of the assets of the Debtor exceeds $300 million and 12 months severance pay (these additional payments would be payable upon the earlier of the termination of Mr. Burgess employment with the Debtor or 3 months after the completion of the sale of substantially all of the assets of the Debtor). RETENTION AND INCENTIVE BONUS TIED TO DEVELOPING RESTRUCTURING PROCESS (FILING A PLAN), OPERATION COMMITMENT, SPEED, AND EMER- GENCE 55

57 Excerpts from the Motion for an Order Authorizing Debtors to Implement a Key Employee Restructuring Milestone Incentive and Income Protection Program filed by Exide Technologies on April 15, 2002 with the US Bankruptcy Court for the District of Delaware. The Incentive Plan provides incentives to Key Employees to remain with the Debtors throughout the Reorganization and to implement the changes needed to successfully complete the Reorganization. Under the Incentive Plan, participants can earn an additional bonus equal to % of their annual base pay. Each program participant received 25% of their Incentive Plan bonus after completing the Debtors Five Year Business Plan. Each Participant will receive the second 25% of their Incentive Plan bonus if and only if they meet certain operation and restructuring commitments that have been assigned to each participant. The final 50% of their Incentive Plan bonus will be paid to eligible employees on the day the plan of reorganization is approved. However, the plan of reorganization must be approved on or before June 30, 2003 to qualify for the third phase of the payment. Thus, because a portion of a participant s payout is contingent upon continuing service through most- and hopefully all-of the Reorganization process, the participant will be motivated to stay with the Debtors and to assist in the Debtors efforts during these Chapter 11 Cases. INCENTIVE BONUS TIED TO FILING A PLAN, EMERGENCE, TARGET CASH FLOW AND WORKING CAPITAL, AND ENTERPRISE VALUE Excerpts from the Debtors Motion for an Order Authorizing the Implementation of the Calpine Incentive Program filed by Calpine Corporation on April 6, 2005 with the US Bankruptcy Court for the Southern District of New York. The Emergence Incentive Plan (EIP) provides cash awards - payable only at emergence - to selected senior employees in the positions most capable of influencing the success of Debtors ongoing business and reorganization efforts. The purpose of the EIP is to provide a compelling and market-competitive cash incentive designed to encourage key management personnel to maximize the value of the enterprise while working toward a successful reorganization of Debtors business. The plan is specifically geared toward rewarding those employees who will devote their energies, knowledge, and creativity to consummating a successful plan of reorganization. There are three principal benefits of the EIP. First, the plan is simple in concept and administration. The structure of the EIP mirrors that of the incentive opportunities jointly developed by Calpine and the Committee for Debtors chief executive officer and chief financial officer. Second, the structure of the EIP motivates eligible employees to increase Debtors enterprise value-directly benefiting all stakeholders-by tying EIP award level to value creation. Compensation for eligible employees increases proportionate to the value created for Debtors and their creditors. Thus, the financial interests of Calpine, creditors and core management are aligned. Third, the EIP is designed to provide a market-competitive longterm compensation opportunity for eligible employees. Accordingly, compensation levels for eligible employees are in line with long-term equity and cash-based opportunities at comparable institutions. The Debtors have identified approximately 20 senior employees, which include primarily executive vice presidents and a select group of senior vice presidents, who will be eligible to participate in the Emergence Incentive Plan. The Debtors seek also to implement a Management Incentive Plan (MIP) for approximately 600 of Debtors employees who occupy positions critical to the operation of Calpine s ongoing business as well as Debtors specific reorganization goals. At its core, the MIP will be similar to the traditional bonus programs (the Bonus Programs ) utilized by the Debtors pre-petition. The Management Incentive Plan will consist of awards as described below 56

58 to be paid for performance for the calendar year 2006 and beyond. The MIP is designed to achieve two goals. First, the plan creates value by motivating employees to work effectively and expeditiously to achieve critical short term operational and financial goals-both of which advance the interests of creditors and the estate in a timely emergence from restructuring. Thus, the MIP meets the goal of aligning the interests of Calpine, its creditors, and its employees so that success is shared by all. Second, the plan provides marketcompetitive compensation opportunities for participants that are consistent with Calpine s historical practices while tempered by the financial constraints under which Calpine operates. Market-competitive compensation helps achieve the goal of preserving a critical asset of the Debtors-their human capital-by promoting employee loyalty and morale and militating against attrition. The first performance period will run from January 1, 2006 to June 30, During this period, performance will be measured relative to four goals: (a) delivery of a Business Plan to the Board of Directors by June 1, 2006; (b) achievement of a target-adjusted cash flow that is calculated as an improvement to the DIP budget; (c) achievement of specific headcount reductions and cost-cutting goals; and (d) the achievement of a working capital target. The second performance period would run from July 1, 2006 to December 31, The performance measures for this period will be set forth in the Business Plan required to be delivered to the Board of Directors prior to the end of the first performance period. Payments under the MIP will only be made if performance objectives are achieved. 57