CLIENT ALERT: Retaining Key Talent in Chapter 11: Lessons from Sleep Number

Last week, the U.S. Bankruptcy Court for the Southern District of New York issued an opinion in In re Sleep Number Corporation authorizing approximately $1.8 million in retention payments to 38 non-insider employees.^[1] The decision offers a timely illustration of how courts apply the statutory framework governing key employee retention and incentive plans.

Background on KERPs/KEIPs

Retaining key personnel in the early stages after filing for chapter 11 relief is a common challenge debtors face. Employees confront uncertainty including job loss, heavier workloads, potential cuts to pay and benefits, and diminished equity value. At the same time, a stable, experienced workforce is often essential to executing a turnaround, completing a sale, or maximizing recoveries.

To bridge this gap and keep essential employees engaged through the case, debtors frequently adopt one of two types of incentive arrangements:

• Key Employee Retention Plans (KERPs) keep targeted employees with the company through a defined date or milestone (e.g., closing an asset sale). Awards are typically a set dollar amount paid simply for continued employment.
• Key Employee Incentive Plans (KEIPs) drive performance by tying compensation to results. Awards fluctuate based on whether participants meet benchmarks such as achieving financial targets or securing a target sale price.

Statutory Authorization: Section 503(c)

Section 503(c) of the Bankruptcy Code establishes a two-track framework for compensating key employees during chapter 11. Sections 503(c)(1) and (c)(2) restrict retention and severance payments to insiders unless the court finds the transfer is essential because the individual has a bona fide outside offer at comparable compensation, the services are essential to survival, and the payment does not exceed statutory limits (ten times the mean transfer to nonmanagement employees or 25% of any similar prior-year transfer). Section 503(c)(3), by contrast, governs transfers to both insiders and non-insiders outside the ordinary course of business, requiring justification under a “facts and circumstances” business judgment standard.

The practical effect is that insiders face the stringent requirements of sections 503(c)(1) and (c)(2), while non-insiders need only satisfy the more permissive standard of section 503(c)(3).

Eligible Employees and Common Objections

Insider Status

One of the most common objections to a KERP is that a debtor is attempting to disguise insiders as non-insiders to secure more favorable treatment under section 503(c)(3). Section 101(31)(B) defines “insider” of a corporate debtor to include directors, officers, and persons in control. Importantly, a job title alone does not establish insider status. In Borders Group, 453 B.R. 459, 468–69 (Bankr. S.D.N.Y. 2011), the court held that “director” refers to one who sits on the board, and “officer” refers to a person appointed by the board to manage daily operations. Where an employee is not board-appointed, courts apply a functional test asking whether the individual exercises sufficient authority to “unqualifiably dictate corporate policy.” Id. at 469.

The Section 503(c)(3) Business Judgment Standard

Non-insiders are eligible for retention payments under section 503(c)(3)’s “facts and circumstances” test, which courts equate with the business judgment standard under section 363(b). In re Endo Int’l PLC, 2022 WL 16935997, at *9 (Bankr. S.D.N.Y. Nov. 14, 2022). The leading formulation is the multi-factor test from In re Dana Corp., 358 B.R. 567, 576–77 (Bankr. S.D.N.Y. 2006). As Sleep Number illustrates below, courts routinely apply the Dana Corp. factors to determine whether the debtor exercised sound business judgment.

Recent Ruling: In re Sleep Number Corporation

The Sleep Number Court overruled a U.S. Trustee objection and approved a non-insider retention plan.

Facts. Sleep Number, a retail mattress company with approximately 3,000 employees, filed chapter 11 to effectuate a going-concern sale. Senior leadership formulated a Non-Insider Retention Plan providing aggregate awards of $1.825 million to 38 employees (individual awards from $10,000 to $125,000), payable upon continued employment through December 31, 2026, or acceleration upon a change in control. None of the 38 participants sat on the Board, Executive Leadership Team, or Management Committee, and none were Board-appointed. The sale closed for $701.8 million.

U.S. Trustee’s Objection. The U.S. Trustee argued the employee participants were statutory insiders, nine had “vice president” titles and thirteen held “director” titles, and that even if not insiders, the plan was not justified under section 503(c)(3).

Holding. The court held none of the participants were insiders. None were board members, none were board-appointed, and their titles signified increased responsibility but not executive rank. Applying Borders Group, the court concluded insider status turns on board appointment or functional control—not title alone. The court also rejected the argument that employees become insiders merely by reporting to insiders.

Application of Dana Corp. Factors. Having determined section 503(c)(3) governed, the court applied the multi-factor test from Dana Corp., finding the plan satisfied each factor:

• Reasonable relationship to results sought: Payments were tied to a $701.8 million going-concern sale. One participant resigned the day of the hearing, demonstrating real retention risk.
• Reasonable cost: The $1.825 million total was modest relative to the debtor’s assets, liabilities, and earning potential. No economically affected party objected and the Official Committee of Unsecured Creditors’ statement in support of the plan was particularly persuasive to the court.
• Fair and reasonable scope: Participants were selected through a documented process evaluating criticality, performance, retention risk, and replaceability. The plan did not discriminate unfairly.
• Consistency with industry standards: The plan was formulated after consultation with external advisors.
• Due diligence and independent counsel: The Debtors’ advisors guided formulation of the plan, noting the payments were within market range and the sale would be a “resounding success” for creditors.

The court concluded that the Debtors exercised sound business judgment and that the retention payments were justified under section 503(c)(3). The U.S. Trustee’s objection was overruled.

Key Takeaways

Sleep Number reinforces practical lessons for debtors:

• Insider status turns on substance, not title. Whether an employee is an “insider” depends on board appointment and functional control over corporate policy—not on holding a “vice president” or “director” title.
• Document the business justification. Plans with articulated selection criteria, calibrated award levels, and a clear nexus to value-preserving objectives are far more likely to survive section 503(c)(3) scrutiny.
• Courts are hesitant to renege on promised retention incentives. Once employees have contributed to a successful sale process, courts are less likely to renege on incentive programs. This is especially true where the debtors’ employees play an integral role in consummating a successful going-concern sale.

Please contact the Olshan attorney with whom you regularly work or the attorney listed below if you would like to discuss further or have questions.

^[1] Case No. 26-11399 (KYP) [Dkt. No. 454] (Bankr. S.D.N.Y. July 28, 2026)

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