When the Top Hat Tips: Protecting Executive Compensation from the Creditors’ Hit List

Your company is heading towards Chapter 11, and suddenly a portion of executive compensation has become a creditor target. Senior executives (and key leaders) want to know when and how much they’ll get paid. Creditors scrutinize every payment to senior executives. 

The board must thread the needle between competing interests while preserving enterprise value. When Chapter 11¹ becomes a real possibility, non-qualified deferred compensation (NQDC) arrangements and “top-hat” plans can quickly transform from retention tools into contested liabilities. This article provides a practical framework for distressed companies navigating top-hat plans, covering:

• What top-hat plans are and why they are uniquely vulnerable in distressed companies.
• Key bankruptcy risks: preferences, fraudulent transfers, and avoidance actions.
• Pre-filing preparation strategies that work and pitfalls to avoid.
• Section 409A compliance essentials for distressed companies.
• Post-petition retention tools: Key Employee Incentive Plans (KEIPs) vs. Key Employee Retention Plans (KERPs).

What Is a Top-Hat Plan, and Why Does It Matter for Distressed Companies?

A top-hat plan is a NQDC arrangement maintained for “a select group of management or highly compensated employees.” Unlike qualified retirement plans (e.g., 401(k) plans, and defined benefit pension plans) which are broadly available and subject to full Employee Retirement Income Security Act of 1974 (ERISA) requirements, top-hat plans provide supplemental deferred compensation without regard to qualified plan limits. Common forms include supplemental executive retirement plans (SERPs), and individual deferred compensation agreements. By statute, top-hat plans are unfunded and unsecured promises to pay the executive participant’s agreed-upon amount.

Because of their limited participant group, top-hat plans are exempt from ERISA’s funding, vesting, participation, and fiduciary requirements. The distressed company faces no mandatory funding obligations straining limited cash. It retains discretion over vesting and forfeiture schedules rather than being locked into statutory minimums. And the board can make restructuring decisions without ERISA fiduciary liability. The tradeoff? Participants likely only hold general unsecured claims², putting them in the same pool as trade creditors and other unsecured claimants.

Rabbi trusts are irrevocable grantor trusts that earmark assets for NQDC obligations while keeping them subject to the employer’s general creditors. Using a rabbi trust preserves the “unfunded status” requirement and avoids current income recognition for participants, but provides no bankruptcy protection. Secular trusts place assets beyond creditor reach, providing genuine protection, but at a steep cost: destroying the top-hat exemption, triggering immediate income recognition, and inviting fraudulent transfer³ challenges when funded near insolvency.

Bankruptcy Exposure: Preferences and Fraudulent Transfers

Once a filing becomes probable, the Bankruptcy Code’s avoidance provisions take center stage. The preference⁴ rules allow the estate to claw back transfers made to satisfy pre-existing debts within 90 days before the petition date⁵ and one year for insiders (which likely includes the key executives of a debtor). The fraudulent transfer rules go after transactions made while the debtor was insolvent for less than reasonably equivalent value. Pre-petition payments to executives, eve-of-filing trust funding, and grants of security interests are all squarely in the crosshairs of the creditors’ committee⁶, the U.S. Trustee⁷, or both.

Executive employment agreements are typically treated as executory contracts⁸ that the debtor-in-possession⁹ can assume or reject.  If the executive employment agreement(s) is/are rejected, the NQDC claims will likely become general unsecured claims subject to significant haircuts under the plan of reorganization¹⁰. Pre-petition attempts to elevate those claims frequently face challenges and generate creditor opposition that complicates restructuring.

Pre-Filing Preparation: Document Hygiene, Section 409A Compliance, and Exposure Management

When a bankruptcy filing enters the 6- to 12-month planning horizon, top-hat and NQDC planning needs to become its own workstream.

The first priority is a comprehensive Internal Revenue Code Section 409A (Section 409A) compliance audit. Plan definitions and payment triggers should be audited for compliance. Issues fall into two categories: documentary failures and operational failures. Documentary failures arise when plan language does not conform to Section 409A requirements. Operational failures arise when the plan has been administered inconsistently with its terms or with Section 409A, for example, making a payment at the wrong time or permitting an impermissible deferral election. The IRS has established limited correction programs, but remediation options narrow quickly. Uncorrected failures result in income inclusion, a 20% additional tax, and a premium interest tax for affected participants.

Unresolved Section 409A issues complicate executive negotiations, impair the company’s ability to use the court-approved plan termination pathway (the most practical way to distribute NQDC benefits in bankruptcy without triggering the penalty tax), and create uncertainty in claims reconciliation. The audit should happen as early as possible, ideally before flexibility is further constrained by filing proximity.

Once compliance issues are identified, attention should turn to amendment and termination mechanics. Sponsors should confirm that plan documents permit prompt termination and court-approved liquidation under Section 409A regulations. Related arrangements — employment agreements, severance plans, equity awards, and change-in-control provisions — should be reconciled to eliminate overlapping or inconsistent entitlements.

Finally, companies should freeze prospective exposure. Companies frequently suspend new deferral elections and employer credits prospectively, capping unsecured claim growth without violating Section 409A’s anti-acceleration rules. Crediting rates should be adjusted to commercially reasonable levels, with contemporaneous documentation of the business rationale.

Common Pitfalls

Pre-petition attempts to improve executives’ positions through asset transfers or payment acceleration typically generate tax exposure for executives, avoidance exposure for the company, and no real improvement in recoveries. Eve-of-filing rabbi trust funding provides no incremental protection while inviting preference challenges. Secular trust funding near insolvency is a prime fraudulent transfer target. Ad hoc cash-outs violate Section 409A’s anti-acceleration rule (and may result in Section 409A’s 20% additional tax being applied to such amounts) and attract avoidance actions¹¹.

Payment Timing: The Section 409A Framework

Section 409A permits NQDC distributions only upon six enumerated payment events: (1) separation from service (with a six-month delay for specified employees of public companies), (2) disability, (3) death, (4) a specified time or fixed schedule, (5) a change in control event, and (6) an unforeseeable emergency. Limited exceptions to the anti-acceleration rule also exist, including plan terminations and liquidations under specified conditions.

The most practical path in bankruptcy is court-approved plan termination and liquidation under Section 409A rules, which expressly permit termination precipitated by corporate dissolution or approved by a bankruptcy court. Payments made this way do not trigger the 20% additional tax, and the process is transparent and court-supervised. Discretionary termination outside bankruptcy is also possible, but requires termination of all same-type arrangements, a three-year bar on similar plans, and a 12- to 24-month distribution delay — conditions that often make it useless when filing is imminent.

Post-Petition Retention: KEIPs and KERPs

The Bankruptcy Code significantly restricts retention payments to insiders. A KERP  vests solely on continued employment and faces stringent statutory requirements — including proof of a bona fide outside job offer and dollar-amount caps. Courts rarely approve insider KERPs. A KEIP ties compensation to measurable performance objectives and is evaluated under a more flexible business judgment standard.

KEIPs and KERPs can be subject to Section 409A if their payment terms extend beyond the “short-term deferral” window (generally, the 15th day of the third month after the taxable year in which the right vests). Arrangements paid within that window are exempt from Section 409A requirements. Those that are not, must comply with Section 409A’s full requirements, including permissible payment event rules and anti-acceleration restrictions — with the 20% penalty tax applying to noncompliance. KEIP design should always be clearly distinguished from legacy NQDC claims to avoid creditor objections.

Pre-Filing Checklist

• Compile a complete inventory of top-hat and NQDC plans, rabbi trusts, employment agreements, and equity arrangements.
• Conduct a Section 409A compliance review and address any documentary or operational deficiencies before they become obstacles.
• Verify that plan documents allow for prompt termination and court-approved liquidation under Section 409A.
• Suspend new deferral elections and employer credits going forward to cap unsecured claim growth.
• Resist pressure to fund rabbi trusts or accelerate payments on the eve of filing.
• Develop KEIP performance metrics, secure compensation committee sign-off, and gather market data to support the incentive structure.
• Coordinate messaging with lenders, the board, and other key stakeholders so that executive compensation decisions do not come as a surprise.

Conclusion

Top-hat plans can be managed effectively in financial distress if the company focuses on document readiness, disciplined exposure management, and processes that hold up under creditor and judicial scrutiny. The best approach is cross-functional: benefits counsel ensures Section 409A compliance and plan optionality; restructuring counsel sequences pre-petition actions to minimize avoidance exposure; and finance and HR leadership execute within a unified stakeholder narrative. If filing looks probable within three to six months, this workstream should be accelerated immediately.

1: Chapter 11 is a chapter of the United States Bankruptcy Code that provides a mechanism for a debtor to reorganize its business and financial affairs under the supervision of a bankruptcy court, typically allowing the debtor to continue operating while it develops a plan to repay creditors.

2: General unsecured claims are claims against a debtor in bankruptcy that are not secured by collateral or entitled to any statutory priority, meaning they are paid only after administrative expenses, secured claims, and priority claims are satisfied — often resulting in recovery of only a fraction of the amount owed.

3: Fraudulent transfer refers to a transfer of the debtor’s property made with actual intent to defraud creditors, or made while the debtor was insolvent and for less than reasonably equivalent value; such transfers may be avoided and the property recovered for the benefit of the estate.

4: Preference refers to a transfer of the debtor’s property to a creditor, made within a specified lookback period before a bankruptcy filing, on account of a pre-existing debt, that enables the creditor to receive more than it would have received in a Chapter 7 liquidation; such transfers may be “avoided” (i.e., recovered) by the bankruptcy estate.

5: Petition date is the date on which a bankruptcy case is formally commenced by the filing of a petition with the bankruptcy court; it establishes the dividing line between pre-petition and post-petition claims, obligations, and transfers.

6: Creditors’ committee is a committee, typically composed of the debtor’s largest unsecured creditors, appointed by the U.S. Trustee in a Chapter 11 case to represent the interests of all unsecured creditors and to participate in the administration of the case.

7: U.S. Trustee is a component of the U.S. Department of Justice responsible for overseeing the administration of bankruptcy cases, including appointing creditors’ committees, monitoring debtor-in-possession operations, and ensuring compliance with the Bankruptcy Code.

8: Executory contract is a contract under which material performance obligations remain on both sides at the time of the bankruptcy filing; the debtor-in-possession may assume (continue) or reject (breach) such contracts, subject to bankruptcy court approval.

9: Debtor-in-possession (DIP) refers to a debtor in a Chapter 11 case that remains in possession of its assets and continues to operate its business, exercising many of the powers of a bankruptcy trustee, subject to court oversight.

10: Plan of reorganization is the document filed in a Chapter 11 case that sets forth the proposed treatment of each class of claims and interests, specifying how creditors and equity holders will be paid or otherwise treated; it must be confirmed by the bankruptcy court to become effective.

11: Avoidance actions are lawsuits brought by the bankruptcy estate (typically by the debtor-in-possession or a trustee) to recover transfers of the debtor’s property that are voidable under the Bankruptcy Code, including preferences and fraudulent transfers.