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

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Mar 2003

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This article examines whether severance benefits promised to
employees pre-petition may be paid after the employer has filed a chapter 11
bankruptcy petition. The answer depends on whether the severance benefits were
payable based on length of service or in a single lump-sum payment, and whether
the debtor is in a majority- or minority-rule jurisdiction.

For most debtors,
pre-petition lump-sum severance benefits are not payable as an administrative
expense. Severance benefits based on length of service must be allocated
between pre- and post-petition service. This article does not deal with benefits
provided under a collective bargaining agreement, which are governed under
§1113 of the Bankruptcy Code and may be modified only with court approval.
<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Golden Distributors Ltd. and Capital Cigar and Tobacco Co. Inc., et al., 134 B.R.
760 (S.D.N.Y. 1991)</a>.

<h3>Typical Scenario</h3>

A
typical chapter 11 debtor may offer severance benefits based on the number of
years of service to the company, or as a lump-sum payment regardless of length
of time employed by the debtor.<a href="#2" name="2a">2</a> For example, the company may provide for one
week of severance pay for each full year of employment for hourly employees.
The company may also offer a lump-sum payment of up to a year of base salary as
a termination benefit for salaried employees. In addition, medical benefits may
be offered as part of the severance package.

<h3>Severance Benefits Based on Length of Service</h3>

1. Minority
Rule: Severance Is Payable Based on the Date that the Claim Arises. The Second Circuit has held that where severance payments arise
post-petition, the full amount of the payments are entitled to administrative
priority, regardless of when the services giving rise to the payments were
performed. Thus, where severance benefits are based on length of service, an
employee terminated post-petition may receive the entire amount of his severance
benefits as an administrative expense, even if most of his service was prior to
the bankruptcy. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…
Inc. v. Local Union No. 3, International Brotherhood of Electrical Workers, 386 F. 2d 649 (2d Cir. 1967)</a>. The ruling has been criticized by some cases within the Second
Circuit (see cases cited 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, 889 (Bankr. N.D. Cal. 1999))</a>.
Although this is still the rule in the <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Circuit (In re Spectrum Information Technologies Inc., 193 B.R. 400, 407 (Bankr. E.D.N.Y. 1996)</a>), no other circuits follow it.

2.
Majority Rule: Must Allocate Between Pre-petition and Post-petition Service. The majority rule is that only the portion of the severance pay
claim that can be apportioned to post-petition service may be afforded priority
treatment as an administrative expense. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Levinson Steel Co., 117 B.R. 194, 195-96
(Bankr. W.D. Pa. 1990)</a>. The majority
rule is based on the seminal case of <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Public Ledger Inc., 161 F.2d 762 (3d Cir.
1947)</a>. In that case, the court held that
only vacation pay and severance pay that was earned under the management of
bankruptcy trustees could be given priority as an administrative expense. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; at 773</a>. Most
courts outside the Second Circuit have followed this rule.

Where
severance pay is based on length of service, the consideration for the pay is
the services performed for the employer over the entire period of an
employee's employment. If no part of the claim for severance is based on
post-petition employment, then none of the severance claim is entitled to
administrative expense priority. <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, 955 (1st
Cir. 1976)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Public Ledger Inc., 161 F.2d 762 (3d Cir.
1947)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6…
of Health Maintenance Foundation, 680 F.2d 619,
621 (9th Cir. 1982)</a>.

More
recently, the Third Circuit in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Employees of Builders Square v. Hechinger Investment Co. of Delaware (In re
Hechinger Investment Co. of Delaware), 298 F.
3d 219 (3d Cir. 2002)</a>, dealt with
"stay-on" benefits promised prior to its bankruptcy filing. The
company decided to close certain stores and wanted to ensure that experienced
staff would be available to help liquidate inventory at the
going-out-of-business sale held at each store. The stay-on benefits consisted
of special enhanced accumulation of vacation, sick days and personal time.
Full-time employees who had completed nine months of service by the date of
termination were also entitled to additional severance pay. In order to receive
the enhanced benefits, the employee had to remain with the company until the
employee's store was closed or the employee was released by the company.
Shortly thereafter, the company filed for bankruptcy, and many employees
continued to work for the company while the stores were conducting the
going-out-of-business sales.

In
seeking to obtain payment of the entire amount of stay-on benefits as
administrative priority, the employees argued that the benefits were not earned
until after the last day of business of the individual store or the
employee's release date, which for each plaintiff was after the
bankruptcy filing date. The court rejected this argument, finding that the
consideration furnished by the employees for the stay-on benefits was the work
they did each day from the time they agreed to the stay-on benefits until the
time their store was closed or they were released. Thus, allocation of
pre-petition and post-petition services was necessary. The court found that
§503(b)(1)(A) gives administrative priority based on the time the service
was rendered, not the time scheduled for payment. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
F.3d at 225</a>. It was irrelevant that the
employees' pre-petition services continued to benefit the estate. Section
503(b)(1)(A) only gives priority to services "rendered after the commencement
of the case." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
F.3d at 226</a>.

3.
How to Allocate Between Pre-petition and Post-petition Severance. The court in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Yarn Liquidation Inc., 217 B.R. 544 (Bankr.
E.D. Tenn. 1998)</a>, devised a formula for
determining the amount of severance benefits earned after the filing date. The
amount of benefits is calculated by determining the rate at which severance pay
is earned, then multiplying that rate by the number of days worked
post-petition, divided by 365. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. at 547</a>. Thus, if severance is earned at the
rate of one week per year of service, the calculation is as follows:

Days worked post-petition 
Weekly salary x -------------------------------- 
365

The
court in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Russell Cave Co. Inc., 248 B.R. 301 (E.D.
Ky. 2000)</a>, reached a similar result. In
that case, creditors objected to payment of the full amount of severance claims
as an administrative expense. The court found that severance pay claims were
entitled to administrative priority only to the extent that they were earned
after the bankruptcy petition was filed. Severance pay based on length of
service was an administrative expense only to the extent it was earned by
service during the bankruptcy case. The court adopted the same formula used in Yarn
Liquidation for calculating the amount of
post-petition severance benefits.

<h3>Lump-sum Severance Benefits May Be Disallowed as an Administrative Claim</h3>

1. Minority
Rule: The Entire Severance Claim Is an Administrative Expense. In the case of <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
re Miami General Hospital Inc., 89 B.R. 980,
986 (Bankr. S.D. Fla., 1988)</a>, a hospital
executive was hired under a pre-petition severance agreement that provided for
a lump-sum payment upon termination other than "for cause." The
debtor sold the hospital facility, and all employees were terminated as a part
of the sale. The court held that because the employee was terminated incident
to the administration of the estate, the severance pay was an expense of the
administration of the estate and entitled to priority. As an alternative theory,
the court also found that the debtor assumed that the claimant's
agreement was implied by accepting the post-petition services. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…; at 988</a>.

The
decision in In re Miami General Hospital was
based on two earlier cases, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
of Tucson Yellow Cab Co. Inc., 789 F. 2d 701
(9th Cir. 1986)</a>, and <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4…
re Northwest Engineering Co., 43 B.R. 603
(Bankr. E.D. Wis. 1984)</a>. In Northwest
Engineering, the debtor's employees were
terminated post-petition, but before their severance pay agreement was rejected
as an executory contract by the debtor. The court held that their claims for
severance were entitled to administrative priority because the motion to reject
did not vitiate the employee's right to severance pay that had accrued
before the motion to reject was filed. Tucson Yellow Cab actually went further in holding that even though the executory
contract with employees was rejected 11 days before the employees were
terminated, the fair value of the services rendered to the estate was the
contract value, and thus the employees were entitled on a quantum meruit basis to payment of severance pay as a cost of administration.

As
with severance pay based on length of service, the Second Circuit in Straus-Duparquest allows the entire amount of lump-sum severance benefits as an
administrative expense for post-petition terminated employees, reasoning that
severance pay is compensation for the hardship that all employees suffer when
they are terminated and is therefore earned upon dismissal. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Spectrum Information Technologies Inc., 193
B.R. 400, 405 (E.D.N.Y. 1996)</a>. This is a
minority rule.

2.
Majority Rule: For Lump Sum Severance as an Administrative Expense, Employer
Must Assume the Severance Agreement or Induce the Employee to Continue
Employment with Promise of Severance Pay. The court
in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Uly-Pak, 128 B.R. 763 (Bankr. S.D. Ill.
1991)</a>, expressly rejected the holding of
In re Miami General Hospital. In Uly-Pak, an employee had a pre-petition agreement that provided for lump-sum
severance pay upon termination for any reason. The employee continued to work
for the debtor post-petition, although his contract was neither assumed or
rejected. After the debtor's assets were sold and the employee was
terminated, the employee sought payment of severance benefits as an
administrative expense. In rejecting the claim, the court found that the
severance claim did not arise from a transaction with the debtor, nor did it
benefit the estate. The claimant asserted that he was induced to work for the
debtor by the expectation of receiving severance pay and that it would
therefore be inequitable to deny the claim. However, the court held that the
provisions of §503(b) left no room for equitable considerations, and
furthermore, the claimant could have requested that the court order the debtor
to assume or reject the agreement. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
B.R. at 768</a>. Thus, the court appears to suggest
that had the debtor assumed the employment contract, then severance benefits
could have been paid as an administrative expense.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Daniel
Austin is a lawyer at McGuire Woods LLP in Pittsburgh. He may be reached at
daustin@mcguirewoods.com. <a href="#1a">Return to article</a>

<a name="2">2</a> Most severance policies require the termination to be involuntary and not "for cause." <a href="#2a">Return to article</a>

Journal Authors

Daniel A. Austin

Journal Date

Saturday, March 1, 2003 - 12:00

Bankruptcy Rule

2003