In In re Airway Industries Inc., the U.S. Bankruptcy Court for the Western District of Pennsylvania denied the motion of an unsecured creditors' committee seeking the turnover of certain transaction bonuses provided by a secured creditor to four of a debtor's officers.

In the alternative, the committee had asked that the payment of these bonuses be disallowed under 11 U.S.C. Section 503(c). The court likewise overruled an objection by the U.S. Trustee to the payment of these bonuses. In their papers, the committee and U.S. Trustee advanced legal and equitable arguments that these payments were improper.

Facts and Background

Before the filing of its petition for relief under Chapter 11 of the Bankruptcy Code on Jan. 20, 2006, Airway Industries Inc. (the debtor) was in the business of selling specialty luggage and travel accessories to department stores and through certain other distribution channels, both in the United States and abroad. For some time before the petition date, Airway's business had been in decline, and management decided that a sale of the company was its only alternative. In order to stabilize business and preserve the value of Airway's assets, Cerberus Capital Management L.P., Cerberus Partners L.P., and Madeline L.L.C., three secured creditors of Airway (collectively, Cerberus), entered into written incentive bonus agreements with four of Airway's officers on Aug. 15, 2005.

The bonus agreements, entered into before the petition date and before the effective date of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), conditioned payment of the bonuses on Airway selling all or nearly all of its assets; Cerberus receiving cash distributions from the sale proceeds; and the officers remaining with Airway until the proposed sale was completed.

On Jan. 27, 2006, Airway filed a motion for an order approving an asset purchase agreement among itself, a potential purchaser, and Cerberus Partners L.P. (the sale motion). The U.S. Trustee appointed an official committee of unsecured creditors on Feb. 6. On Feb. 8, Airway filed a supplement to the sale motion, disclosing the existence of the bonus agreements. On Feb. 10, the U.S. Trustee objected to the sale motion, asking the court to prohibit the payment of the bonuses.

On Feb. 23, the creditors' committee filed a motion seeking the entry of an order directing that the bonuses be turned over to Airway's estate or, in the alternative, that the payment of the bonuses be prohibited under 11 U.S.C. Section 503(c). Following a hearing on the sale motion on Feb. 27, the court entered an order on Feb. 28, approving the sale, finding that Airway's marketing efforts were appropriate, reasonable, and designed to obtain the highest and/or best price in the sale of assets.

Court's Analysis

The committee first argued that the bonuses should be turned over to Airway's estate pursuant to 11 U.S.C. sections 541 and 542, but the court found that Cerberus had agreed to pay the bonuses from its own funds, as provided in the bonus agreements. The committee could not provide any relevant case law to support the turnover of non-estate property under Section 542, so the court denied the request on these grounds.

The committee alternatively argued that the bonuses should be disallowed or prohibited under 11 U.S.C. Section 503(c), a provision of BAPCPA, which went into effect on Oct. 17, 2005. Section 503(c) was enacted in order to limit the scope of Key Employee Retention Plans (KERPs) and other such programs that provide incentives to a debtor's management as a means of inducing them to remain in the debtor's employ. The court noted that Section 503(c) covered certain categories of administrative expenses, including "(1) 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 . . . " and "(2) a severance payment to an insider of the debtor." The committee argued for the application of Subsection (1), while the U.S. Trustee argued that both subsections (1) and (2) should apply.

The court noted that it had not received an administrative expense request from either the officers who would receive the bonuses or from Cerberus; rather, the notice of the bonus agreements was introduced in the supplement to the sale motion. As Cerberus, rather than Airway's estate, would make the bonus payments from its own funds and would not seek reimbursement from the estate, the payments could not be characterized as administrative expenses.

The court found that the purpose of Section 503(c) - to deal with the effect upon a debtor's estate of large administrative claims arising pursuant to KERPs - was not implicated in the instant case, as the bonuses in question did not create any expense to the Airway's estate or decrease any distribution to the creditor body. Further, regardless of any diminution of the estate allegedly attributable to the bonuses, unsecured creditors could not be paid from the sale because Cerberus was undersecured: as a result, all sale proceeds would be used to pay the secured portion of Cerberus' claim. Thus, the court denied the requests of the committee and U.S. Trustee on Section 503(c) grounds.

The committee further alleged that Cerberus structured the bonus agreements with the intention of circumventing Section 503(c), but the court found that the facts suggested otherwise. Cerberus' obligation under the bonus agreements was not predicated on Airway's filing for bankruptcy, but only on the sale of assets. The court found the evidence to suggest that the bonus agreements were not written in anticipation or contemplation of the new bankruptcy law, thus neutralizing the committee's claims that Cerberus intended to circumvent Section 503(c).

The U.S. Trustee argued that even if Section 503(c) did not apply, the directors and shareholders of Airway had created a conflict of interest by allowing the officers of Airway to be compensated by a secured creditor of Airway. The U.S. Trustee further argued that the directors, officers, and controlling shareholders had breached their fiduciary duty to act in the best interests of Airway and creditor body, which could constitute equitable grounds upon which to grant the motion for turnover.

Though the court recognized the potential for breaches of fiduciary duty, it found that the facts did not establish any such breach, and all evidence indicated that both Cerberus and the officers of Airway acted in good faith to maximize the value of Airway's business and estate. The bonus agreements were entered into in order to maximize the sale proceeds, which would serve the interests of creditors, as well as those of Airway and Cerberus. Given that Cerberus was undersecured, the bonuses could not have come from the estate, which is why Cerberus paid them itself. Thus, the court overruled the U.S. Trustee's objection and denied the committee's motion, finding no basis upon which to force the turnover of the bonuses, or to disallow payment.

Conclusion

The court noted the unique circumstances of this case, "likely never to occur again," whereby Airway pursued the sale and negotiated the bonus agreements before the petition date and prior to the effective date of BAPCPA. The court stated in dicta that similar arrangements should be closely scrutinized in the future so they are not used to circumvent Section 503(c) or to compromise the fiduciary duty of insiders.

However, given the unique timing of the negotiation of the bonus agreements and Airway's sale, as well as the fact that these agreements were entered into in good faith and for the benefit of Airway and the creditor body, the court refused to prohibit the payment, or order the turnover, of these bonuses.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

Matthew E. Hoffman practices in the area of business reorganization and financial restructuring. Hoffman is admitted to practice in Pennsylvania and New Jersey.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.