The COVID-19 pandemic dealt an unexpected blow that pushed a number of companies into bankruptcy. The impact of pandemic-related shutdowns was broad: Companies in a diverse range of industries – including retail, oil and gas, consumer goods, restaurants, and entertainment and recreation – filed for Chapter 11 bankruptcy protection in the first half of 2020. While the number of filings has not yet reached the level seen in the 2008 financial crisis, the number of bankruptcies is expected to rise through the remainder of the year.

The 2020 surge in bankruptcies has been accompanied by heightened scrutiny of executive pay in restructuring situations. Bankruptcy filings are often preceded by announcements of executive retention and other short-term performance-based awards. These awards can draw criticism as excessive and even inappropriate given the impact of bankruptcy on shareholders and the broader employee population. However, 2020 is unique. While situations vary by industry, most agree that this flurry of bankruptcy filings is not the result of poor management but rather the inevitable impact of unprecedented and unforeseeable broad shutdowns across the country to contain the pandemic. The companies entering bankruptcy need continuity, stability, and motivated leadership. Carefully designed and communicated retention and performance awards can play an important role in keeping leadership in place and focused on moving the company through the restructuring process.

The Evolution of Prepaid Awards

Corporate bankruptcies cause a significant amount of uncertainty for executives and employees, who can be tempted to leave for more stable work situations with predictable, secure compensation streams. Poor company performance means that annual incentives are unlikely to pay out, and equity holdings lose almost all value. In situations where shareholders need to retain executives through the bankruptcy period, cash retention awards to critical members of management can be effective by providing compensation stability. These programs are often called Key Executive Retention Programs (KERPs).

Executive retention awards in bankruptcy situations today have a unique design: they are paid before the bankruptcy filing and are subject to clawback provisions. Clawback provisions are triggered if the executive terminates employment during a specified time period or is terminated for cause. In addition, some clawbacks are tied to performance goals not being achieved. If triggered, the clawback provisions require executives to pay back the after-tax award value. The fact that the awards are prepaid differentiates them from most other cash incentives and makes them the subject of criticism and misunderstanding.

The unique design for executive retention awards emerged from changes to the U.S. bankruptcy code made through the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Prior to BAPCPA, a large portion of executive compensation in bankruptcy situations was delivered through retention awards. Executive retention awards were typically paid out in a lump sum or through several payments based on the executive’s continued employment. Executive retention awards also had special status in the bankruptcy proceedings that ensured payment ahead of many other company obligations. As a result of the special status and lack of performance features, executive retention awards were not viewed favorably.

BAPCPA imposed stringent restrictions on awards to “insiders” implemented during the bankruptcy process that are based solely on retention and that lack performance features (“Insiders” are defined as directors, officers, individuals in control of the corporation, and relatives of such individuals). BAPCPA’s restrictions effectively stopped the use of executive retention awards once companies file for bankruptcy. Despite BAPCPA, executive retention awards eventually re-emerged – as prepaid awards subject to clawbacks. By paying the awards before the bankruptcy filing, companies can generally avoid the BAPCPA restrictions and avoid having the award subject to Bankruptcy Court approval.

Prevalent Executive and Employee Pay Practices during Bankruptcy

CAP analyzed the 8-K filings of a number of companies that entered bankruptcy in 2020. Based on this analysis, companies today often use a mix of compensation programs to retain and motivate executives and employees leading up to, and during, the bankruptcy process:

• Pre-filing, prepaid executive retention awards
• Performance-based Key Employee Incentive Plans (KEIPs)
• Employee retention and incentive programs

Pre-Filing, Prepaid Executive Retention Awards

A number of companies that filed for bankruptcy during 2020 announced prepaid retention awards for executives anywhere from days to months before the legal filing. The 8-K filings indicate that the prepaid retention awards are designed by the board with advice from compensation consultants, as well as bankruptcy and other advisors. Typical design parameters for executive retention bonus awards include:

While less common, some companies, including Chesapeake Energy and Ascena Retail Group, include base-level performance criteria in the clawback provisions to add a performance element to the prepaid retention awards. This improves the overall optics of such awards and helps avoid additional scrutiny during bankruptcy.

Performance-Based Key Employee Incentive Plans (KEIPs)

After BAPCPA, KEIPs emerged to provide incentives to executives without running afoul of the bankruptcy code. KEIPs, which are approved during the bankruptcy process, are performance-based incentives that pay out in cash based on the achievement of financial and operational goals. The goals can be very short-term in nature, such as quarterly performance periods.

Typical design parameters for KEIPs include:

A current trend is to design and implement the KEIP prior to filing. This is especially true in pre-packaged bankruptcies where the financial reorganization of the company is prepared in advance in cooperation with its creditors. Having these programs in place with payouts contingent on performance improves continuity throughout the entire process, incentivizes the management team to perform, and meets the court’s requirement that any variable compensation to executives be performance based.

One recent example of a company announcing a KEIP before the bankruptcy filing is Diamond Offshore Drilling. The company announced a prepaid retention program for executives, as well as a KEIP, a non-executive incentive plan and an additional retention plan. All plans except for the prepaid executive retention program are subject to Bankruptcy Court approval, according to the 8-K. The KEIP, nonexecutive incentive plan and the additional retention plan replace past incentives – including requiring the forfeiture of past restricted stock unit awards and stock appreciation rights – and current incentives that would have been granted in 2020. The KEIP includes nine participants, including the senior executive team.

Employee Retention and Incentive Programs

Retention and incentive programs for employees are also used during the bankruptcy process. The use of employee programs depends on the company’s business needs and other factors, such as size and industry. Retention and incentive programs for non-executives typically replace the value of annual incentives and sometimes long-term incentives. Employee retention programs are cash-based and pay out at specific intervals, often quarterly given the uncertainties associated with companies in restructuring situations. The duration of employee retention programs often mirrors those for executives.

Severance programs, which provide compensation to individuals at termination, are also used in bankruptcy situations. When communicated broadly during bankruptcy, severance can be considered a retention program as it helps employees have some financial security and focus on their current jobs rather than finding new positions. Severance programs tend to be used more commonly for employees than executives because BAPCPA limits the value that can be delivered to “insiders.” However, a recent example of a severance program for executives came from Hertz Global Holdings, which announced amendments to its executive severance programs prior to its bankruptcy filing in May 2020. The severance programs, which were disclosed in the same 8-K filing as a prepaid key employee retention program, cover senior executives and vice presidents, and the payment multiple was reduced to 1X salary and bonus from 1.5X.

Conclusion

Executive compensation programs implemented in conjunction with a bankruptcy should be carefully designed and reviewed with outside advisors to ensure that the company is complying with bankruptcy code. Companies should carefully review the value of executive awards to ensure that they are reasonable while also in line with competitive practices and past incentive opportunities. Executive award amounts should be considered in the context of employee awards and the company’s overall financial situation to ensure fairness and avoid the appearance of excess. Lastly, companies should carefully communicate the rationale for executive awards and what the company is doing for employees in the 8-K current report or other announcement. Clear communication up front can help head off later public relations and optics headaches.

CAP reviews and publishes an annual update on pay levels for Chief Financial Officers (CFOs) and Chief Executive Officers (CEOs). This year’s update is based on a sample of 119 companies with median revenue of $13 billion. Additional information on criteria used to develop the sample of companies is included in the Appendix.

Highlights 2017 vs 2016

Study Results

Salaries

In the past, we have seen a steady growth in the number of CEOs and CFOs receiving salary increases in each year. However, for the 2016-2017 period the salary increase prevalence of 51% for CEOs and 70% for CFOs was very comparable to the increases for 2015-2016. The median 2017 salary increases were 3.1% for CFOs and 0.6% for CEOs.

2017 Salary Increases

Actual Pay Levels

Salary increases were higher for CFOs since only about one-half of CEOs received an increase. Yet, the median increases in actual bonus and long-term incentives were at similar levels for both CFOs and CEOs.

The median rate of increase in actual total direct compensation levels for CEOs and CFOs was 10.9% and 9.9% in 2017, respectively. We found that in 58% of the companies, the CEO received a higher percentage total compensation increase than the CFO.

While target bonuses remained relatively the same, actual bonuses had significant increases indicating a strong performance year among the sampled companies. Year-over-year revenue and operating income growth was 7% for both measures which was much higher than 2016 performance of 1% and 4% growth, respectively.

Median Pay Increase by Industry1

Actual Total Direct Compensation2

Median TDC increases by industry were generally aligned with the year-over-year revenue and operating income improvements.

Total compensation increases lagged the total sample for the Consumer Discretionary and Consumer Staples industries. While the companies in Consumer Staples improved total shareholder returns, revenue growth, and operating income growth in 2017, the overall industry performance still lagged the total sample. On the other hand, the companies in Consumer Discretionary generally saw a decrease in operating performance and an improved total shareholder return in 2017, but total compensation was generally flat.

The underperformance of the Consumer Staples companies is partially attributed to the pressure on sales volume as a result of taxes on soda, competition from store brands / smaller upstarts, battle for shelf space, and health conscious consumers.

For Consumer Discretionary companies, the trend is less clear as this industry is more diverse and covers a lot more sub-sectors (for example: media and entertainment, distributors, retail, hotels, automobiles, etc.). When we look at the companies in this industry individually, the compensation changes year-over-year were most often aligned with improved or deteriorated performance.

Target Pay Mix

The structure of the overall pay program (salary, bonus, LTI) has remained largely unchanged since 2011. CEOs continue to receive less in the form of salary and more in variable pay opportunities, especially LTI, than CFOs.

Target Bonuses

Target bonuses as a percentage of salary remained unchanged at median and only changed slightly at 25th and 75th percentiles. We do not foresee any major changes in target bonus percentages in the near future.

Long-Term Incentive (LTI) Vehicle Prevalence and Mix

Prevalence of performance plans continued to increase in 2017. The use of two different vehicles to deliver LTI remains the most prevalent approach and approximately 25% of companies studied use all 3 equity vehicles (stock options, time-based stock awards, and performance plan awards).

Performance plans account for around 60% of LTI awards on average among companies studied. The other portion of LTI is delivered through an almost equal mix of stock options and time-vested restricted stock awards.

Conclusion

2017 performance overall, was higher compared to last year. Median revenue growth was 7% (vs 1% in 2016) and operating income growth was 7% (vs 4% in 2016). Total shareholder return in 2017 was comparable to 2016; the full year return was 20% (vs 16% in 2016). Total pay increases were much higher than in 2017, which we believe were directionally aligned with the performance improvements. A strong year of financial performance led to high annual incentive payouts in 2017 and after multiple years of sustained TSR growth companies are increasing LTI opportunities among their top executives.

The pay mix has been relatively consistent since 2011, but where we are seeing the most change is within LTI delivery vehicles. Since 2011 performance-based LTI plans have increased about 13% for both CEOs and CFOs with a similar drop in the prevalence of stock options, and time vested stock being relatively the same. With the focus on aligning pay outcomes with company performance by Boards and investors, we are not surprised to see large increases in total compensation after multiple years of sustained strong performance across industries.

APPENDIX

Sample Screening Methodology

Based on the screening criteria below, we arrived at a sample of 119 public companies with median 2017 revenue of $13B.