Grading U.S. Bankruptcy Watchdogs

It’s report-card season, and the federal government’s team of bankruptcy watchdogs isn’t immune from evaluation. In a self-generated report card, those watchdogs say they’ve earned straight A’s in everything but executive bonuses.

The U.S. Trustee Program, an arm of the U.S. Department of Justice, monitors bankruptcy cases around the country to make sure laws are being followed and to prevent fraud. One of the program’s big efforts has been to crack down on the bonuses that companies in Chapter 11 seek to pay to their executives while other obligations go unpaid—an effort in which trustees have a 66.7% success rate, according to a recently filed annual report.

As a result of a 2005 overhaul by Congress, today’s Bankruptcy Code generally prohibits so-called “pay-to-stay” bonuses for its executives, allowing such retention bonuses for employees who don’t count among the company’s top ranks. To justify bonuses for executives and other insiders, companies must tie the payments to tough-to-reach goals that, if achieved, would significantly benefit the company and its creditors.

According to the U.S. Trustee Program, however, the executive bonus plans that many companies are putting forth for court approval today aren’t true incentives. Instead, trustees argue that the bonus plans set easily achievable goals, making them disguised—and illegal—retention payments.

According to the report, U.S. Trustees earned better grades for their role objecting to professional fees (94.7% success rate), bringing motions to appoint an independent trustee or examiner (90.3%), asking that a Chapter 11 case be dismissed or converted to a cheaper Chapter 7 liquidation (97.9%) and Chapter 11 plan objections (95.3%).

Bonuses, however, have always been a tough area for the trustees to win. They’re often the only ones objecting in the first place, and while their impartial stance carries a lot of weight with the bankruptcy judges, so too does a debtor’s argument that the success of its restructuring is at stake.

The U.S. Trustee Program did point to one successful week in the 2012 fiscal year (October 2011 through September 2012). In August, two Manhattan bankruptcy judges sided with U.S. Trustee Tracy Hope Davis to deny $5.3 million in bonuses for Hawker Beechcraft Inc. executives and $7 million for Residential Capital LLC executives. Ms. Davis had argued that the bonuses were—no surprises here—illegal retention payments poorly disguised as incentives.

ResCap tried again this spring, and Ms. Davis objected a second time, but the company eventually won court approval to pay out $3.3 million in incentives to top executives.

Write to Jacqueline Palank at [email protected]. Follow her on Twitter at @PalankJ.