Protecting Executive Severance Claims

The Bankruptcy Code classifies all unsecured “claims” against a debtor and prioritizes them according to specific rules depending upon, among other things, when the claim arose (ie, either pre- or post-petition) and whether it should be entitled to some specially elevated status of payment in accordance with various policy considerations and special-interest concerns identified by Congress. Not all unsecured claims are treated equally. Bankruptcy Code section 507(a) establishes nine separate categories of claims that must be paid before the holder of any other unsecured claim can receive a distribution from the estate. Foremost among these unsecured priorities are the post-petition expenses of administering the bankruptcy estate (discussed below). Third priority status (11 U.S.C. ' 507(a)(3)) is conferred upon claims for “wages, salaries and commissions, including vacation, severance and sick leave pay earned by an individual,” but only to the extent that they were earned within 90 days of the bankruptcy filing and do not exceed a periodically adjusted amount (currently $4650).

To the extent that an employee's pre-petition claim exceeds the statutory dollar limitation, it will be treated as a general unsecured claim against the debtor's estate. However, if the claim is one for damages arising from the termination of an employment contract, it will be disallowed to the extent it exceeds the compensation payable under the contract for 1 year (11 U.S.C. ' 502(b)(7)).

Priority of Administrative Expenses

An employee's claim can enjoy higher priority if it qualifies as an “administrative expense.” Bankruptcy Code section 503(b)(1) provides that administrative expenses include “the actual, necessary costs and expenses of preserving the estate, including wages, salaries, or commissions for services rendered after the commencement of the case.” The enhanced priority was intended to encourage vendors and other creditors to do business with, or extend credit to, a bankruptcy trustee or Chapter 11 debtor (In re Commercial Financial Services, Inc., 246 F.3d 1291, 1293 (10th Cir. 2001)). It was also designed to provide an incentive for employees, officers, directors and consultants to continue working for the debtor so that it can continue operating and restructure its operations with the assistance of qualified personnel (Campo Electronics, Inc. v. Ross, 247 B.R. 646, 651 (E.D. La. 1998)). A claim will be conferred with administrative status only “if it arises out of a transaction between the creditor and the bankrupt's trustee or debtor in possession … and 'only to the extent that the consideration supporting the claimant's right to payment was both supplied to and beneficial to the debtor-in-possession in the operation of the business.'” (Trustees of Amalgamated Ins. Fund v. McFarlin's, 789 F.2d at 101 (quoting In re Mammoth Mart, Inc., 536 F.2d 950, 954 (1st Cir.1976)).) Courts interpret this standard very strictly and sparingly grant administrative status. See, e.g., In re Commercial Financial Services, Inc., 246 F.3d at 1293; In re Hemingway Transp., Inc., 954 F.2d 1, 5 (1st Cir. 1992).

Severance As an Administrative Expense

If the debtor hires personnel after filing for bankruptcy, either in the ordinary course of its business or pursuant to a court-approved employment agreement, an employee's claim for compensation (including severance) is clearly entitled to administrative priority. However, where the debtor engages someone pre-petition and the employee continues to work for the debtor during the case before being terminated, the priority of the employee's claims for compensation is more difficult to determine, particularly as far as severance is concerned.

This is so because severance claims do not fit neatly into the pre-petition/post-petition paradigm underpinning the administrative priority determination – unlike ordinary wages, severance pay can be “earned” at different times during the course of employment. A handful of courts, like the Second Circuit Court of Appeals in Straus-Duparquet, Inc. v. Local U. No. 3 Int. Bro. of Elec. Wkrs., 386 F.2d 649 (2d Cir. 1967), subscribe to the view that severance pay is compensation for the hardship that all employees, regardless of their length of service, suffer when they are terminated, and that it is therefore earned when an employee is dismissed. However, this is decidedly the minority view. See In re Phones for All, Inc., 288 F.3d 730 (5th Cir.2002); In re Commercial Financial Services, Inc., 246 F.3d at 1293; In re Public Ledger, Inc., 161 F.2d 762 (3rd Cir.1947); In re AcoustiSeal, Inc., 290 B.R. 354 (Bankr. W.D. Mo. 2003). Most courts will carefully examine the particular type of severance payment involved to determine whether the employee's claim should qualify for administrative priority.

There are two general types of severance pay. The first consists of a payment to the employee at termination based upon the duration of employment. As exemplified by the Ninth Circuit's ruling in Lines v. System Board (In re Health Maintenance Foundation), 680 F.2d 619 (9th Cir. 1982), most courts find that “length-of-service” severance does not qualify for administrative expense priority because the benefit was earned prior to the bankruptcy filing. Other courts have adopted a less draconian approach. Some prorate the severance claim into pre-petition and post-petition amounts corresponding to the duration of the employee's service during both periods, and rule that the latter qualifies for administrative priority, while the former may qualify at least in part as third priority pre-petition unsecured claim.

The second kind of severance is payment at termination in lieu of advance notice of termination. This type of severance is perceived as compensating a terminated employee for being deprived of advance notice of termination, and it is therefore “earned” on the termination date. Most courts accordingly hold that “termination in lieu of notice” severance qualifies for administrative priority. See, e.g., In re Roth Am., Inc., 975 F.2d 949, 957 (3d Cir.1992); In re Health Maintenance Found., 680 F.2d at 621; In re Mammoth Mart, Inc., 536 F.2d at 952.

Other severance packages do not fit into either category or may have characteristics of both. For example, companies struggling to restructure their operations and avoid bankruptcy commonly retain crisis managers and other workout professionals under employment agreements with severance provisions entitling the employee to “severance” if he or she is terminated at any time after executing the agreement. Courts confronted with hybrid severance arrangements have sometimes struggled to articulate a rational standard to apply to the employee's request that the claim be conferred with priority status. By default, many courts apply the standard governing other types of administrative claims – ie, the claim will be conferred with administrative expense status only if the expense was necessary and benefited the debtor's estate.

First Circuit's Ruling in FBI Distribution Corp.

The First Circuit Court of Appeals recently became the latest court of appeals to weigh in on the priority of employee severance claims in In re FBI Distribution Corp., 330 F.3d 36 (1st Cir. 20030. Prior to filing for Chapter 11 in 1999, FBI Distribution Corp. entered into separate employment and retention agreements with the president and chief merchandising officer of its Filene's Basement division. The agreements provided that in the event the officer was terminated without cause or following a qualifying “change in control,” she was entitled to receive 3 years' salary (approximately $1.2 million) and other fringe benefits. The officer continued to render services to the corporation after it filed for bankruptcy. FBI Distribution Corp. never assumed her employment and retention agreements.

The bankruptcy court held that the officer's severance claim under the employment agreement was only a general unsecured claim for damages (capped by section 502(b)(7)) because the consideration supporting the termination clauses-her agreement to forgo other employment-was supplied to the company when she signed the agreement pre-bankruptcy. It characterized her inducement allegations as “implausible.” Finally, the court ruled that her claims under the retention agreement were similarly not entitled to administrative priority because the contract was non-executory and any rights under it gave rise to a pre-petition claim. The officer appealed to the district court, which affirmed, albeit on different grounds, finding that she had failed to show that her post-petition services were “necessary to preserve the estate.”

She fared no better on appeal to the First Circuit. The Court of Appeals agreed with the bankruptcy court's determination that the consideration supporting the officer's claim for severance benefits was not “being an employee in good stead at the time of discharge,” but her agreement to forgo other employment opportunities, which she provided pre-petition to FBI Distribution the moment she executed the employment agreement. It rejected the officer's assertion that her claim for severance was entitled to administrative status because the debtor induced her to continuing performing or elected to receive benefits under the employment agreement after the petition date. Rather, the First Circuit observed, absent court-approved assumption of the agreement, it was unenforceable against FBI Distribution despite its election to continue her employment. The court accordingly ruled that while the officer was entitled to an administrative claim for the reasonable value of services rendered to FBI Distribution during the bankruptcy case, her claim for severance under the employment agreement was a general unsecured claim. In doing so, the First Circuit rejected the idea that FBI Distribution somehow assumed the agreement by implication, remarking that “the plain text of section 365 requires express approval by the court.” Finally, the Court of Appeals found no fault with the bankruptcy court's conclusion that the officer's claim for severance payable under the non-executory retention agreement was a general unsecured pre-petition claim.

Where Do We Go from Here?

FBI Distribution Corp. is consistent with the approach applied by the majority of courts in determining whether severance payable under a pre-bankruptcy employment contract is entitled to administrative priority. Unlike ordinary employees, corporate executives are generally entitled to severance irrespective of the duration of their employment. Where this is the case, most courts will find that the severance obligation is a pre-petition debt, irrespective of the fact that the payment obligation is triggered post-petition.

However, FBI Distribution Corp. provides a glimmer of hope for executives intent upon safeguarding their interests if a company is considering a bankruptcy filing. An employee can be assured that his or her severance payments will enjoy priority only if the debtor assumes the employment agreement or reaffirms the severance provisions in a new contract. Pre-bankruptcy management should insist upon assumption as a quid pro quo for remaining with the company during a bankruptcy case.

Conclusion

Getting the full benefit of a compensation package has always been a challenge for management presiding over the affairs of a financially troubled company. It promises to become even more difficult in the era of corporate accountability, as shareholder and investor tolerance of the real or perceived indiscretions of corporate management at the more than 15,000 publicly traded companies in the U.S. is at an all-time low.

Amid the furor surrounding headline-grabbing scandals at corporate giants, the conduct of corporate executives is being scrutinized more closely than ever. Ushered in by the enactment of the Sarbanes-Oxley Act of 2002 (the Act), the era of “corporate accountability” has left many officers and directors worried about their potential exposure if a company struggling to remain profitable goes south during their tenure at the helm, regardless of the cause of the meltdown.

Of particular concern is management's ability to get the full benefit of a bargained-for compensation package, including bonus and severance pay. If a failing company is forced to seek bankruptcy protection, an executive's claims for unpaid compensation may be relegated to the same status as the company's other pre-petition unsecured debts, with recovery amounting to only a fraction of the amount of the claim. This can be the case even if the executive continues to work for the Chapter 11 debtor-in-possession in accordance with the terms of a pre-bankruptcy employment agreement. Still, executives may be able to protect their interests with careful planning.

Priority Claims in Bankruptcy

The Bankruptcy Code classifies all unsecured “claims” against a debtor and prioritizes them according to specific rules depending upon, among other things, when the claim arose (ie, either pre- or post-petition) and whether it should be entitled to some specially elevated status of payment in accordance with various policy considerations and special-interest concerns identified by Congress. Not all unsecured claims are treated equally. Bankruptcy Code section 507(a) establishes nine separate categories of claims that must be paid before the holder of any other unsecured claim can receive a distribution from the estate. Foremost among these unsecured priorities are the post-petition expenses of administering the bankruptcy estate (discussed below). Third priority status (11 U.S.C. ' 507(a)(3)) is conferred upon claims for “wages, salaries and commissions, including vacation, severance and sick leave pay earned by an individual,” but only to the extent that they were earned within 90 days of the bankruptcy filing and do not exceed a periodically adjusted amount (currently $4650).

To the extent that an employee's pre-petition claim exceeds the statutory dollar limitation, it will be treated as a general unsecured claim against the debtor's estate. However, if the claim is one for damages arising from the termination of an employment contract, it will be disallowed to the extent it exceeds the compensation payable under the contract for 1 year (11 U.S.C. ' 502(b)(7)).

Priority of Administrative Expenses

An employee's claim can enjoy higher priority if it qualifies as an “administrative expense.” Bankruptcy Code section 503(b)(1) provides that administrative expenses include “the actual, necessary costs and expenses of preserving the estate, including wages, salaries, or commissions for services rendered after the commencement of the case.” The enhanced priority was intended to encourage vendors and other creditors to do business with, or extend credit to, a bankruptcy trustee or Chapter 11 debtor (In re Commercial Financial Services, Inc., 246 F.3d 1291, 1293 (10th Cir. 2001)). It was also designed to provide an incentive for employees, officers, directors and consultants to continue working for the debtor so that it can continue operating and restructure its operations with the assistance of qualified personnel ( Campo Electronics, Inc. v. Ross, 247 B.R. 646, 651 (E.D. La. 1998)). A claim will be conferred with administrative status only “if it arises out of a transaction between the creditor and the bankrupt's trustee or debtor in possession … and 'only to the extent that the consideration supporting the claimant's right to payment was both supplied to and beneficial to the debtor-in-possession in the operation of the business.'” (Trustees of Amalgamated Ins. Fund v. McFarlin's, 789 F.2d at 101 (quoting In re Mammoth Mart, Inc., 536 F.2d 950, 954 (1st Cir.1976)).) Courts interpret this standard very strictly and sparingly grant administrative status. See, e.g., In re Commercial Financial Services, Inc., 246 F.3d at 1293; In re Hemingway Transp., Inc., 954 F.2d 1, 5 (1st Cir. 1992).

Severance As an Administrative Expense

If the debtor hires personnel after filing for bankruptcy, either in the ordinary course of its business or pursuant to a court-approved employment agreement, an employee's claim for compensation (including severance) is clearly entitled to administrative priority. However, where the debtor engages someone pre-petition and the employee continues to work for the debtor during the case before being terminated, the priority of the employee's claims for compensation is more difficult to determine, particularly as far as severance is concerned.

This is so because severance claims do not fit neatly into the pre-petition/post-petition paradigm underpinning the administrative priority determination – unlike ordinary wages, severance pay can be “earned” at different times during the course of employment. A handful of courts, like the Second Circuit Court of Appeals in Straus-Duparquet, Inc. v. Local U. No. 3 Int. Bro. of Elec. Wkrs. , 386 F.2d 649 (2d Cir. 1967), subscribe to the view that severance pay is compensation for the hardship that all employees, regardless of their length of service, suffer when they are terminated, and that it is therefore earned when an employee is dismissed. However, this is decidedly the minority view. See In re Phones for All, Inc., 288 F.3d 730 (5th Cir.2002); In re Commercial Financial Services, Inc., 246 F.3d at 1293; In re Public Ledger, Inc., 161 F.2d 762 (3rd Cir.1947); In re AcoustiSeal, Inc., 290 B.R. 354 (Bankr. W.D. Mo. 2003). Most courts will carefully examine the particular type of severance payment involved to determine whether the employee's claim should qualify for administrative priority.

There are two general types of severance pay. The first consists of a payment to the employee at termination based upon the duration of employment. As exemplified by the Ninth Circuit's ruling in Lines v. System Board (In re Health Maintenance Foundation), 680 F.2d 619 (9th Cir. 1982), most courts find that “length-of-service” severance does not qualify for administrative expense priority because the benefit was earned prior to the bankruptcy filing. Other courts have adopted a less draconian approach. Some prorate the severance claim into pre-petition and post-petition amounts corresponding to the duration of the employee's service during both periods, and rule that the latter qualifies for administrative priority, while the former may qualify at least in part as third priority pre-petition unsecured claim.

The second kind of severance is payment at termination in lieu of advance notice of termination. This type of severance is perceived as compensating a terminated employee for being deprived of advance notice of termination, and it is therefore “earned” on the termination date. Most courts accordingly hold that “termination in lieu of notice” severance qualifies for administrative priority. See, e.g., In re Roth Am., Inc., 975 F.2d 949, 957 (3d Cir.1992); In re Health Maintenance Found., 680 F.2d at 621; In re Mammoth Mart, Inc., 536 F.2d at 952.

Other severance packages do not fit into either category or may have characteristics of both. For example, companies struggling to restructure their operations and avoid bankruptcy commonly retain crisis managers and other workout professionals under employment agreements with severance provisions entitling the employee to “severance” if he or she is terminated at any time after executing the agreement. Courts confronted with hybrid severance arrangements have sometimes struggled to articulate a rational standard to apply to the employee's request that the claim be conferred with priority status. By default, many courts apply the standard governing other types of administrative claims – ie, the claim will be conferred with administrative expense status only if the expense was necessary and benefited the debtor's estate.

First Circuit's Ruling in FBI Distribution Corp.

The First Circuit Court of Appeals recently became the latest court of appeals to weigh in on the priority of employee severance claims in In re FBI Distribution Corp., 330 F.3d 36 (1st Cir. 20030. Prior to filing for Chapter 11 in 1999, FBI Distribution Corp. entered into separate employment and retention agreements with the president and chief merchandising officer of its Filene's Basement division. The agreements provided that in the event the officer was terminated without cause or following a qualifying “change in control,” she was entitled to receive 3 years' salary (approximately $1.2 million) and other fringe benefits. The officer continued to render services to the corporation after it filed for bankruptcy. FBI Distribution Corp. never assumed her employment and retention agreements.

The bankruptcy court held that the officer's severance claim under the employment agreement was only a general unsecured claim for damages (capped by section 502(b)(7)) because the consideration supporting the termination clauses-her agreement to forgo other employment-was supplied to the company when she signed the agreement pre-bankruptcy. It characterized her inducement allegations as “implausible.” Finally, the court ruled that her claims under the retention agreement were similarly not entitled to administrative priority because the contract was non-executory and any rights under it gave rise to a pre-petition claim. The officer appealed to the district court, which affirmed, albeit on different grounds, finding that she had failed to show that her post-petition services were “necessary to preserve the estate.”

She fared no better on appeal to the First Circuit. The Court of Appeals agreed with the bankruptcy court's determination that the consideration supporting the officer's claim for severance benefits was not “being an employee in good stead at the time of discharge,” but her agreement to forgo other employment opportunities, which she provided pre-petition to FBI Distribution the moment she executed the employment agreement. It rejected the officer's assertion that her claim for severance was entitled to administrative status because the debtor induced her to continuing performing or elected to receive benefits under the employment agreement after the petition date. Rather, the First Circuit observed, absent court-approved assumption of the agreement, it was unenforceable against FBI Distribution despite its election to continue her employment. The court accordingly ruled that while the officer was entitled to an administrative claim for the reasonable value of services rendered to FBI Distribution during the bankruptcy case, her claim for severance under the employment agreement was a general unsecured claim. In doing so, the First Circuit rejected the idea that FBI Distribution somehow assumed the agreement by implication, remarking that “the plain text of section 365 requires express approval by the court.” Finally, the Court of Appeals found no fault with the bankruptcy court's conclusion that the officer's claim for severance payable under the non-executory retention agreement was a general unsecured pre-petition claim.

Where Do We Go from Here?

FBI Distribution Corp. is consistent with the approach applied by the majority of courts in determining whether severance payable under a pre-bankruptcy employment contract is entitled to administrative priority. Unlike ordinary employees, corporate executives are generally entitled to severance irrespective of the duration of their employment. Where this is the case, most courts will find that the severance obligation is a pre-petition debt, irrespective of the fact that the payment obligation is triggered post-petition.

However, FBI Distribution Corp. provides a glimmer of hope for executives intent upon safeguarding their interests if a company is considering a bankruptcy filing. An employee can be assured that his or her severance payments will enjoy priority only if the debtor assumes the employment agreement or reaffirms the severance provisions in a new contract. Pre-bankruptcy management should insist upon assumption as a quid pro quo for remaining with the company during a bankruptcy case.

Conclusion

Getting the full benefit of a compensation package has always been a challenge for management presiding over the affairs of a financially troubled company. It promises to become even more difficult in the era of corporate accountability, as shareholder and investor tolerance of the real or perceived indiscretions of corporate management at the more than 15,000 publicly traded companies in the U.S. is at an all-time low.