Payment of Pre-petition and Post-petition Employee Severance Benefits

Journal Issue

Apr 2003

Column Name

Journal HTML Content

Editor's Note:

Part I of this article appeared in the March 2003 issue, Vol. XXII, No. 2.

</blockquote>

A widely quoted case is <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…
re Mammoth Mart Inc., 536 F.2d 950 (1st Cir.
1976)</a>. In that case, the court considered several hypotheticals.
First, the court reasoned that where a debtor assumed a pre-petition contract
containing a severance provision, upon assumption the pre-petition contract
would become a post-petition contract and the severance claims would become an
administrative expense. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…; at 953</a>. The court also stated in
dicta that if a debtor had to induce his
employees to stay on the job by promising them that, if discharged, they would
receive severance pay, then the consideration supporting the severance claims
would be the post-petition performance, and hence would be entitled to
administrative priority. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…
F. 2d at 955 n.4</a>. These statements suggest that a chapter 11 debtor
could assume the pre-petition contract and obtain administrative expense
priority, if necessary, to retain employees.

Using the logic of In re Mammoth, the court in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Commercial Financial Services Inc., 233
B.R. 885 (Bankr. N.D. Okla. 1999)</a>, rejected the claims of
former employees for administrative expenses in finding that the lump-sum
severance provisions of the pre-petition agreement was an incentive to accept
employment, not an incentive to continue service with the debtor post-petition.
To the extent that the employees performed post-petition services, they were
paid the value of their services. Similarly, in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Phones for All Inc., 249 B.R. 426 (N.D. Tex.
2000)</a>, the court denied administrative expense priority for
lump-sum severance benefits for three main reasons. First, §503(b)(1),
which authorizes payment of administrative expenses, does not provide for
payment of severance benefits. Second, even if §503(b)(1) did permit
payment of severance benefits, as some courts have held, the payments must
arise from a post-petition transaction with the debtor. In this case, the
agreement was pre-petition and there was no evidence that the employee would
have stopped working for the debtor but for the severance benefit. Finally,
although the employee's post-petition services enhanced the
debtor's ability to operate, he received his base pay as compensation.
Payment of a severance benefit did not further benefit or add to the benefit
derived from the employee's post-petition services. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. at 429-431</a>.

If an employee is hired specifically to assist with restructuring or a potential bankruptcy, severance benefits may be deemed a priority expense, even if the employment agreement was entered into pre-petition.
</center></big>
<hr>
</blockquote></blockquote>

The court in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re M Group Inc., 286 B.R. 896 (Bankr. Del.
2001)</a>, followed the Uly-Pak ruling in holding that an executive's pre-petition lump-sum severance
provision did not arise from a post-petition transaction with the debtor. In
determining administrative priority, courts look to when the acts giving rise
to a liability took place. In that case, the executive was eligible for
severance pay when his employment contract was signed; thus, it did not arise
post-petition, and the claimant was not entitled to an administrative priority
for his severance claims. It is interesting to note that in that case, the
court had authorized the debtor to offer a retention incentive plan, but the
claimant declined to accept it.

3. Bankruptcy Courts Will Scrutinize Efforts to Convert a Pre-petition Severance
Agreement into a Post-petition Administrative Claim. A debtor may want to try to get around the majority rule by converting
the terms of a pre-petition severance agreement into one that is eligible for
post-petition administrative priority. Courts will closely scrutinize such
arrangements, and will most likely nullify the attempt.

In <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Levinson Steel Co., supra, 117 B.R. 194</a>,
the debtor attempted to convert its pre-petition severance pay policy that was
based on the length of service into a post-petition policy that entitled
employees who might be terminated to full payment of their severance pay as an
administrative claim. The court denied administrative expense priority for
severance pay attributable to pre-petition services. The court held that a
willingness to work for the debtor post-petition was not alone sufficient
consideration conferred upon the debtor to support payment of severance
benefits as an administrative expense. The debtor did not show that any
employees would have left the debtor's employ unless the post-petition
severance policy was confirmed. Thus, all the consideration necessary for the
severance pay claims had accrued before the bankruptcy occurred. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
B.R. at 196</a>.

In <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Cincinnati Cordage and Paper Co., 271 B.R.
264 (Bankr. S.D. Ohio 2001)</a>, the debtor obtained court approval
for a post-petition retention agreement that provided for lump-sum payments to
key executives in the event of termination. The pre-petition agreement provided
for three times annual base salary in the event of termination, while the
post-petition agreement provided six months salary "in addition to all
other pre-petition severance or termination benefits." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; at 266</a>. The debtor did not request
administrative priority for the severance pay, and the creditors'
committee reserved its right to object to the payment of benefits. After the
employees were terminated post-petition, the court denied administrative claims
for all severance benefits. The court held that the post-petition benefits
arose from a pre-petition agreement, and that the benefits could have been paid
the day after the pre-petition agreement was signed. In short, the court found
that the post-petition agreement was essentially an attempt to convert the
pre-petition contract into an administrative claim. At the very least, the
debtor should have requested that the severance pay be an administrative
expense when it filed its motion for approval of the post-petition severance
agreement. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; at 267-68</a>.

In future cases, a chapter 11 debtor will have difficulty in obtaining
administrative expense treatment for severance claims under a post-petition
severance agreement, particularly for employees who were with the debtor for a
long period prior to the bankruptcy. If a debtor intends to file a motion for a
post-petition severance agreement, the debtor should show that administrative
treatment of the claims is essential to the preservation of the estate, and
that vital employees have left or would leave the debtor's employ unless
a severance plan providing for administrative priority of claims is authorized
by the court.

<h3>Employee Hired Pre-petition
for Turnaround or Restructuring May Be Entitled to Administrative Expense
Priority for Termination Benefits</h3>

If
an employee is hired specifically to assist with restructuring or a potential
bankruptcy, severance benefits may be deemed a priority expense, even if the
employment agreement was entered into pre-petition. In <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Steel, supra 117 B.R. 194</a>, the
debtor hired a chief financial officer shortly before its bankruptcy filing.
The court found that the termination benefits were a necessary incentive to
obtain the employee's services on behalf of the debtor and approved the
employee's claim for administrative expense. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
B.R. at 196-97</a>. This case can be distinguished from Former Employees of
Builders Square in that the employees in Builders
Square were already working for the company
at the time that the special enhanced benefits were offered. Indeed, length of
service was a component of the enhanced benefits.

Of course, a severance benefit that is contracted as part an employment agreement
for an employee hired post-petition is entitled to administrative priority. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=C…
re Doctors Hospital Inc., 1995 U.S. App. LEXIS
1576 (1st Cir. 1995</a>).

<h3>Debtor Should Obtain Court Approval to Implement Post-petition Retention and Severance Agreement</h3>

A post-petition severance plan will not be deemed to be in the ordinary course of
business. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=C…
re Buyer's Club Markets Inc., LEXIS 40129
(10th Cir. 1994</a>) (where post-petition agreement provides for
severance pay in the event of conversion of chapter 11 to chapter 7, request
for an administrative expense for severance pay was denied because the
severance pay policy was not in the ordinary course of business); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Media Central Inc., 115 B.R. 119 (E.D. Tenn.
1990)</a> (post-petition severance pay policies were not in the
ordinary course of business). Thus, before implementing a post-petition
retention or severance agreement, the debtor should first obtain court authorization
and include a request that the severance payments be treated as an
administrative expense.

Journal Authors

Daniel A. Austin

Journal Date

Tuesday, April 1, 2003 - 12:00

Bankruptcy Rule

2003