KERPs (Key Employee Retention Plans) and KEIPs (Key Employee Incentive Plans), otherwise referred to as “pay to stay” compensation plans, are commonly offered by employers to incent key employees to remain with the company during an insolvency restructuring proceeding when so-called “key employees” may be tempted to find more stable employment elsewhere. However, courts will carefully scrutinize these plans because there are multiple competing interests as well as the overall policy objective of maximizing recoveries from the restructuring which can be diluted through overly generous incentive plans. Employers who are contemplating restructuring under the Companies’ Creditors Arrangement Act (CCAA) should be aware of the framework for assessing KERPs or KEIPs recently established by the Ontario Superior Court of Justice.
To be defensible, the employer will need to demonstrate that its KERPs and KEIPs are objectively reasonable. In particular, the employer should be prepared to establish that the following criteria are met:
- there was significant arm’s length and objective oversight in the negotiation, design and implementation of the plans;
- the plans are justifiable on the basis of necessity; and
- the plans are reasonably related to the goals pursued and those goals are demonstrably beneficial to the restructuring process.
Framework for assessing KERPs and KEIPs
In Aralez Pharmaceuticals Inc (Re.), 2018 ONSC 6980 (Aralez), Justice Dunphy of the Ontario Superior Court of Justice described the challenges associated with analyzing KERP/KEIP approval motions. In his view, the court’s role is to assess the totality of circumstances to determine whether the process has provided a reasonable means for objective business judgment to be brought to bear and whether the end result is objectively reasonable. Integrating his view with the principles that emerged in earlier decisions, Justice Dunphy set out a three-pronged framework for the court to apply when deciding whether or not to approve KERPs or KEIPs:
1. Arm’s length safeguards: The court will consider the sources of input into the design, scope and implementation of the KERPs or KEIPs. The greater the level of input from arm’s length, third parties, who are independent of the plan’s beneficiaries, the better. In particular, the recommendation by the court-appointed monitor supervising the insolvency restructuring about the appropriateness of the plans will be given significant weight by the court.
2. Necessity: The moving party must show that the proposed KERP or KEIP is necessary under the circumstances. KERPs and KEIPs must be justified on a case-by-case basis, having regard to the following factors:
a) Employees working to protect their own long-term job security are already well-aligned with creditor interests and may generally be considered as being near one end of the necessity spectrum, while employees who have critical responsibility in the company but with little realistic chance of having an ongoing role with the company may necessitate the creation of KERPs or KEIPs.
b) Employees in a sector that is in demand pose a greater retention risk while employees with relatively easily replaced skills in a well-supplied market pose a lesser degree of necessity.
c) KERPs and KEIPs should not be overbroad by including employees who are not truly critical.
3. Reasonableness of design: The KERP/KEIP design must align the interests of the beneficiaries with those of the stakeholders. The targets and incentives created must be reasonably related to the goals pursued and those goals must be of demonstrable benefit to the objects of the restructuring process. Payments made before the desired results are achieved are generally less defensible. In Aralez, the Applicants, Aralez Pharmaceuticals Inc. and Aralez Pharmaceuticals Canada Inc., had moved for approval of the KERPs and KEIPs in the insolvency restructuring proceeding under the CCAA. The KERPs would provide three employees with retention bonuses of between 25-50% of salary, amounting to approximately $256,710. The KEIPs would impact nine members of the senior management team and could pay out just over $4 million. The motion was opposed by the unsecured creditors who argued that the KEIP was too generous.
In Aralez, the Applicants, Aralez Pharmaceuticals Inc. and Aralez Pharmaceuticals Canada Inc., had moved for approval of the KERPs and KEIPs in the insolvency restructuring proceeding under the CCAA. The KERPs would provide three employees with retention bonuses of between 25-50% of salary, amounting to approximately $256,710. The KEIPs would impact nine members of the senior management team and could pay out just over $4 million. The motion was opposed by the unsecured creditors who argued that the KEIP was too generous.
Applying the three-factor framework of arm’s length safeguards, necessity and reasonableness of design to the facts at hand, Justice Dunphy approved the KERP and the KEIP on the basis that the incentive amounts being awarded to the employees were appropriate in the circumstances.