Unfunded And Unsecured: Nonqualified Deferred Comp Lessons From Kodak's Chapter 11

One of the major risks for participants in nonqualified deferred compensation (NQDC) plans is what can happen to these plans in bankruptcy, as we explain in detail at myNQDC.com, our sister website on NQDC topics. The following analysis of this risk was written by a guest blogger: John Lawson, Vice President of Executive Compensation at Tompkins Financial Advisors and a member of the advisory board at myNQDC.com. Prior to joining his current firm in 1999, John was employed by Kodak as an Executive Compensation Consultant in Kodak Human Resources. For further reading on bankruptcy topics, see articles at myNQDC.com about the effects of bankruptcy on NQDC and about the related protections that participants should look for in NQDC plans.

For over 100 years, the Eastman Kodak Company dominated the market in photographic film. By 1982, the company's sales had topped $10 billion and its brand was a worldwide icon. The Kodak Executive Deferred Compensation Plan (EDCP) was started in 1982 to enable key employees to elect pre-tax deferrals of salary and annual incentives, thereby effectively raising their tax-advantaged savings to a meaningful percentage of total compensation when added to their secured, funded 401(k) deferrals.

Initially, Kodak's EDCP was so popular a savings vehicle for executives that balances topped $200 million in the mid-1990s. But layoffs, turnover, and growing concerns about Kodak's future curtailed participation. This decrease in the number of participants, combined with the accelerated distribution feature, dramatically reduced plan balances. Uncertainties stemming from the introduction of Internal Revenue Code Section 409A in 2004 reduced executives' interest, and 409A increased Kodak's apprehension over compliance to the extent that the company discontinued deferrals in 2007.

Kodak Bankruptcy: Impact On Unsecured, Unfunded Deferred Comp

Thirty years after the start of the Kodak EDCP, Kodak filed for bankruptcy in January 2012 (see our earlier blog entry on Kodak). Approved by creditors and the US Bankruptcy Court for southern New York, Kodak's Plan of Reorganization (Aug. 20, 2013) stipulates that EDCP participants, with total balances equaling $15 million, will receive 4%–5% of their earned but deferred salaries and incentive awards. Delivery will not be in cash but in common shares of the new Kodak to be issued upon the company's emergence from Chapter 11. Taxation upon grant to the creditors, including participants in the Kodak EDCP, will be as ordinary income based on the value at grant. No deductions will be permitted for amounts lost. Recovery of the $15 million in salary and bonuses owed to former Kodak managers is to be treated under the plan of reorganization in the same way as the other $2.8 billion in unsecured debt, including unfunded pensions, accounts payable, customer rebates, royalties, shippers/warehouses, and litigation. Only the former EDCP participants forfeit earned compensation.

"PARTICIPANT'S RIGHTS UNSECURED. The amounts payable under the Plan shall be unfunded, and the right of any Participant or his or her estate to receive any payment under the Plan shall be an unsecured claim against the general assets of the Company."
Excerpt from a Kodak EDCP document included in annual participant enrollment materials.

State Tax Seduction

Many participants "elected" distributions to occur over a period of up to 20 years after the year of separation: 10 annual installments beginning 10 years after separation was the longest allowed. The tax advantage was that the EDCP distributions were considered "retirement income" under the Federal Source Tax Exclusion as long as they were made over at least 10 years. So departing executives saw a way to avoid state taxation of amounts earned, for example, in New York state but received while they were retired in Florida. What they did not appreciate was the additional credit risk inherent in the extended payments.

What Can We Learn From The Kodak Experience?

Should we have known? Looking back, how did $15 million remain in the Kodak EDCP on the Chapter 11 filing date, Jan. 19, 2012? What warning signs were ignored by those who got stuck with amounts remaining in the plan? Probably no one event stands out more than others, but when three decades' worth of red flags are added up, the outcome seems almost unavoidable. The less obvious warning signs may have included the following.

A culture of entitlement at the top: Long-term incentive award metrics were reduced every few years after 1982 to ensure material awards in the face of deteriorating financial performance. The satisfaction of share ownership requirements for senior managers was facilitated by large grants of stock requiring no intrusion into executives' personal finances or assumption of additional risks. Starting in the early 1990s, many special deals were cut to attract and retain new "talent" whose employment was later severed, all typically within a three-year period.

The Kodak board of directors was included in Fortune's "Dirty Half Dozen," which recognized the six worst boards in America during the year 2000.

A plethora of special letter employment agreements started in 1993 for outside executives who were considered requisite to the company's success. Most left in a few years without adding sustainable value to shareowners but with large severance amounts and a nondisparagement provision which prevented anyone from knowing exactly what happened.

Cessation of cost–of-living adjustments to defined benefit plan pensioners occurred while payments of severance were made to executives from the defined benefit plan trust fund.

The tax-qualified defined benefit pension plan was amended in 1990 to permit lump sum distributions, allowing non-tax-qualified unfunded pension distributions as lump sums, thereby diffusing the creditworthiness concerns inherent in lifetime monthly payments from Kodak working capital. Lump sums were discontinued from the defined benefit tax-qualified plan in 1996 to the extent possible under the IRC anti-cutback rule, and from the unfunded pension plans to the same extent.

In 1991, Kodak sponsored the richest voluntary early retirement program from a tax-qualified defined benefit pension plan in US history. It was accepted by 8,700 employees (Kodak had estimated 3,700 ). The program involved 100% of pension to participants as young as age 49, one year of full pay, and a $900 per month Social Security bridge to age 62, all payable from the funded, PBGC-insured, tax-advantaged pension plan subject to IRS limits. If IRS limits were exceeded, benefits were paid from unfunded pension plans.

Annual incentive award metrics encouraged short-term value enhancement at the expense of long-term value.

In 1982, Kodak began the differentiation in total rewards between the top 5% of employees and the rest. Previously, the components of compensation were essentially the same for 100% of Kodak employees, both exempt and nonexempt. After 1982, the top 5% were differentiated by the additional components of stock options, restricted stock, long-term and short-term cash performance awards, ad hoc bonuses, deferred compensation, additional vacation, ERISA excess plans, and perquisites. In contrast, the compensation at many successful, "best to work for" companies has maintained its egalitarianism.

Broad-based benefits formally eliminated for all employees were preserved for some executives outside of the ERISA plans via individual letter agreements.

The authority to make hard decisions need to sustain and grow long-term value was not delegated by the board, and the board seemed to be merely being paid for "fogging the mirror" or "collecting pay for pulse," as executive comp critics are fond of saying. In the early 1990s, one key executive hired from Citibank in a well-publicized transition resigned soon afterward when he realized that the Kodak culture did not arm him with the authority to make requisite changes.

Curious strategic business decisions included the acquisition of Sterling Drug for $5 billion in the late 1980s and then its sale 5 years later for $5 billion; the divestiture of Eastman Chemical Company in 1993 as the recent Malcolm Baldridge Award winner for exemplary management and now a top performer in its industry; the sale in 2002 of the remote sensing systems unit to ITT, now known as Exelis; the sale in 2007 of the multi-billion-dollar health-care imaging unit to Onex, now known as highly successful Carestream Health; and a history of unsuccessfully expanding into a variety of businesses based on skills and technologies that Kodak possessed.

The More Obvious Red Flags

Important and perhaps more obvious red flags included the following:

1. The downgrading of publicly held debt to junk.
2. The trading of Kodak's credit default swaps at distressed levels suggested near-term inability to repay corporate debt.
3. In 2011, two members of Kohlberg Kravis Roberts resigned from the Kodak board; they had hoped for a turnaround by injecting funds several years earlier.
4. Constant business reorganizations for over 20 years.
5. Suppliers' termination of agreements to extend Kodak credit.
6. In 2004, Kodak was kicked out of the Dow.
7. In 2007, Kodak was kicked out of the Better Business Bureau.
8. The marketing of the patent portfolio in 2011.
9. Resignation of key technical experts who could have written their own ticket within Kodak.
10. In the mid-1990s, a key consumer marketing exec resigned to join FUJI in North Carolina.
11. Short-interest rose so high that computer-generated stock reports showed that institutions held 110% of Kodak common shares (shorted shares were reported twice in the numerator).
12. Thirty years of layoffs and cost reductions, but a growing reputation on Wall Street for missing quarterly earnings estimates.
13. In 2007, large portions of the largest industrial park in the US were imploded to save on property taxes.

Absence Of NQDC In Post-Bankruptcy Kodak May Hurt

As Kodak emerges from Chapter 11, the absence of a viable elective nonqualified unfunded deferred compensation plan, whereby key employees lend their salary and bonuses to Kodak in return for tax deferral and tax-deferred compounding of earnings, may well be an additional challenge in attracting and retaining key employees.

Comments

[Rich DeVita]

The question is did the company utilize a rabbi trust and if so, why didn't management terminate the plan and pay out the account balances. My guess is that he plan wasn't informally funded and therefore a plan termination would have been a significant negative cash event, something Kodak couldn't afford. Lesson? Avoid hubris and fund the liability no matter how bulletproof you may feel.