Bankruptcy CourtsTreatment Of Severance Agreements Providing For Continued Payments To Former Employees

• Author: Michael J. Lichtenstein
• Pages: 05

Page 28

WHEN COMPANIES FACE FINANCIAL DIFFICULTIES, management often negotiates severance agreements with employees that require certain payments for an extended period. In exchange, the former employees may agree to sign a non-compete, non-disclosure and non-solicitation agreement or to provide other consideration. For example, rather than pay a 6-figure salary to a senior executive who might be redundant, a company that is downsizing might terminate the employment contract but agree to pay some amount of severance over an extended period of time. If the company's fortunes fail further, resulting in the filing of a Chapter 11 bankruptcy petition, management may desire to escape liability for making continued payments under such severance agreements or under existing contracts with former employees. Unfortunately, under such circumstances, the Bankruptcy Code is not designed to favor the former employee. Many courts have severely curtailed former employees' rights to receive payment in full on account of such severance agreements.

In a Chapter 11 proceeding, a pre-petition severance agreement can be deemed to be executory¹ or non-executory. The consequence of which definition applies is the claim priority to which the former employee may be entitled. In plain English, this may mean a former employee receives either 100 cent dollars or "bankruptcy dollars" (typically less than 100 cents)² on account of payments due under the severance agreement.

Obviously, a debtor company will usually seek a way to minimize payments to former employees, whereas, former employees would rather be paid in full. Infrequently, a reorganizing company may wish to continue such payments to engender continued good will from its current employees. Not surprisingly, the scales are tipped in favor of the debtor on this issue,³ and a former employee faces an uphill battle to convince a bankruptcy court that she is entitled to payment in full on account of her severance agreement with the employer for whom she no longer works. Unfortunately, this may be true whether a contract is deemed to be executory and therefore capable of rejection or not. Section 365 of the Bankruptcy Code⁴provides that a trustee⁵ may assume or reject any executory contract.

Most courts defer to the debtor's business judgment in determining whether or not to allow rejection of an executory contract.⁶ The rejection of an executory contract enables the non-rejecting party to file an unsecured claim which is deemed to arise as of the date the bankruptcy petition was filed. However, until the court enters an order rejecting the contract, the non-debtor party to the contract may be entitled to an administrative claim based upon the actual and necessary benefit provided to the estate.⁷

Thus, a party to a rejected executory contract, who can demonstrate

actual and necessary benefit to the estate, will have a bifurcated claim consisting of an administrative portion for

post-petition services through the rejection date (likely to be paid in full) and an unsecured portion for the rejection damages(unlikely to be paid in full).

There is no clear authority on how to treat severance agreements in a Chapter 11 proceeding. Like many bankruptcy issues, the outcome depends on the jurisdiction in which decisions have been made. This is the result of a lack of national binding precedent for bankruptcy courts located across the country. For example, a New York bankruptcy judge has rendered a decision on severance contracts that is directly at oddsPage 29with one written by a Missouri bankruptcy judge. However, despite the differing analysis, the end result has been that courts have been reluctant to achieve a result that allows post-petition payments to former employees on account of severance agreements. Some courts have been hesitant to classify...