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Above-Board: Officers of a Corporation Not Entitled to Key Employee Retention Plan Payments

A key goal of the Bankruptcy Code is to prevent corporate insiders from profiting from their employer’s misfortune. Section 503(c) of the Code makes clear: “there shall neither be allowed, nor paid... a transfer made to, or an obligation incurred for the benefit of, an insider of the debtor for the purpose of inducing such person to remain with the debtor's business” absent certain court-approved circumstances.

An “insider” under section 503 includes corporate officers. See also Code Section 101(31)(B). Courts generally use two different approaches (or a balancing test weighing the combination of the two) to determine if a person is a corporate officer.  In some courts, a person is considered a corporate officer because he/she was appointed to the position by the corporation’s board of directors.  See e.g., Office of the U.S. Trustee v. Fieldstone Mortgage Co., 2008 WL 4826291 (D. Md. Nov. 5, 2008)).  Elsewhere, a person is considered a corporate officer because the person’s day-to-day activities meet the elements of a more subjective test. See e.g.In re Borders Group, Inc., 453 B.R. 459 (S.D.N.Y. 2011).  A recent decision by the United States District Court for the Southern District of New York applied the objective test in the absence of a strong showing that the person does not “perform a significant role in management.”  In re LSC Communications Inc. et al.Harrington v. LSC Communications Inc. et al., No. 20-cv-5006, 2021 WL 2887708, at *6 (S.D.N.Y. July 9, 2021).

In April 2020, LSC filed for chapter 11 and LSC sought to create a Key Employee Retention Plan (“KERP”) to compensate 190 "crucial" employees with "in-depth knowledge" of its business operations. Id. at *1. The KERP would be funded with $8 million to be distributed to employees after dividing them into tiers. The 11 employees in the top two tiers would receive up to $1.8 million.

The U.S. Trustee objected to the KERP, arguing that LSC had not provided enough information to determine whether some of the proposed KERP recipients, including six board-appointed officers, were corporate "insiders" within the meaning of section 503 of the Code.  If they were, then the Trustee asserted they should not be eligible for the KERP.  In response, LSC argued that these employees were not insiders because, notwithstanding their official titles, they lacked decision-making authority.

The bankruptcy court rejected the U.S. Trustee’s objection and concurred with LSC that the six employees were "officers in title only" and not insiders  Id. at *2.  The U.S. Trustee appealed to the district court, arguing that Delaware law should apply to the analysis since LSC is a Delaware corporation.  Under Delaware law, the U.S. Trustee said, the six employees in question should be considered insiders.

On appeal, District Judge J. Paul Oetken confirmed that the Bankruptcy Code does not define the term "officer" and provides no insight as to the term's meaning aside from listing possible groups of employees who might be considered officers.  Judge Oetken noted that, when analyzing this issue, some courts look to state law while others do not. In this case, Judge Oetken applied Delaware law, which provides that any person appointed to a corporation's board of directors is an officer, but also observedthat the result would be the same even if Delaware law was not controlling, “[E]ven if the Court were to adopt a more expansive analysis, the fact that the six employees were appointed by the board and would be deemed officers under Delaware corporate law would weigh heavily in concluding that the employees are officers for Bankruptcy Code purposes.” Id. at *7 (S.D.N.Y. July 9, 2021).

Ultimately, Judge Oetken held that the functional approach of looking to the employees’ specific powers and duties, as utilized by the bankruptcy court in this case, should only be used in cases where the employees can make a strong showing that they have no significant management role because, “from a policy standpoint, giving more weight to an objective criterion — whether an employee was appointed by the board — provides better guidance to parties than a functional, non-exhaustive test.” Id. at *6.

Accordingly, since the six employees in question were board members of the debtor, Judge Oetken held that they were officers within the meaning of section 503 of the Bankruptcy Code.  As such, they were also “insiders” who weren’t entitled to participate in the KERP.