The Government Accountability Office (GAO) recently released a report examining over 7,000 companies that filed for bankruptcy in the 2020 fiscal year. They found that 42 debtor companies, including Hertz and Neiman Marcus, paid out over $165 million in incentive bonuses to their executives just before filing for Chapter 11 bankruptcy.

The height of the COIVD-19 pandemic in 2020 led to the highest number of companies declaring bankruptcy since 2010. Some of the largest of these companies that filed for bankruptcy turned to layoffs and furloughs of workers yet continued to pay incentive and retention bonuses to their top executives. Hertz CEO Paul Stone, for instance, was paid $700,000 before the company filed for Chapter 11.

The U.S. Bankruptcy Code Chapter 11 allows companies to restructure their debt to continue operations and retain their executives to navigate the company through the proceedings. It gives companies a fresh start but is the most complex and usually the most expensive form of bankruptcy proceedings. The debtor company must propose or accept a reorganization plan that is in the best interest of its creditors.

The code is highly regulatory of all payments made during bankruptcy proceedings as well as most of the payments made up to 90 days before filing for Chapter 11 bankruptcy. Section 503 (c) of the Bankruptcy Code specifically restricts retention bonuses during bankruptcy proceedings for executives unless they fulfill certain requirements. The executive must have another job offer at the same or greater compensation, and the company/debtor must receive court approval.

In 2005, Congress amended the Code by enacting the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 to mandate that companies must receive court approval before paying out incentive and retention bonuses to executives and non-executive employees to stay on during a bankruptcy proceeding. Of the 7,300 companies examined by GAO, less than one percent of the debtors requested court approval for incentive bonuses for their executive and non-executive employees.

However, pre-bankruptcy bonuses are not governed by the Bankruptcy Code and therefore are a heavily used workaround. But not all payments made before filing for Chapter 11 are safe from being recalled and redistributed by a bankruptcy trustee. Preferential transfers are payments made by a debtor company to one or more (but not all) creditors. While under Chapter 11 bankruptcy proceedings, the rules require debtor companies to treat all creditors equally and to not favor one over the other in repayments.

A company must disclose all payments made 90 days before filing bankruptcy if they total $6,825 or more to a single creditor. If a preferential payment is made within 90 days of a company filing for bankruptcy, a bankruptcy trustee has the right to halt the transfer and redistribute the funds to similar creditors.

Companies may get around preferential transfers if the creditor proves that the debtor company was solvent when the payment was made. However, a trustee can review all payments up to a year before filing for bankruptcy if the payment was made to an insider, which includes business partners.

The GAO’s financial markets director, Michael Clements, discussed in a GAO podcast that companies paid bonuses to executives “anywhere from five months to as little as two days before the company filed for bankruptcy,” showing the stark contrast of how payments internally and externally are governed. The ability for companies to make these payments has been described as a loophole in the bankruptcy code and one of the only parts of the proceedings that aren’t regulated.

Large companies argue that the incentive bonuses are paid to keep the best of the best onboard while the company navigates through some of the toughest times the company sees. Another argument is that the amount of time it takes to replace and fully train an executive after the company comes out of bankruptcy proceedings would be a cost that could be as detrimental as a bankruptcy.

The GAO report recommended to Congress to amend the Bankruptcy Code to make pre-bankruptcy bonuses subject to court approval and oversight, especially following the recently published report.

The report has spurred lawmakers on both sides of the aisle to introduce legislation that would curtail these payments and bonuses to top executives. Representative Cheri Bustos from Illinois introduced a bill that would prevent certain executives from receiving bonuses during bankruptcy proceedings and up to six months before a company files for bankruptcy.