Chapter IV Executory Contract Problems

• Jurisdiction: United States

IV. Executory Contract Problems

Into the Brambles: Section 507(a)(4) and Executoriness¹

Written by:
Pamela M. Egan
Pachulski Stang Ziehl & Jones LLP
San Francisco

Some courts have borrowed concepts of executoriness to grant certain severance claims § 507(a)(4) priority. But when courts must resort to a judicial doctrine notorious for being a "bramble-filled thicket,"² it is time for statutory intervention.

The Problem of the Employee Who Is Terminated

The Fourth Circuit recently held that under § 507(a)(4), "severance pay is 'earned' on the day that an employee shows up to work and is terminated by the company without cause."³ If that day occurs within 180 days of the petition date, the employee's entire severance claim (up to the § 507(a)(4)) cap is entitled to priority. The Fourth Circuit rejected the trustee's argument that severance is earned day-to-day, and that the amount entitled to priority should be calculated by dividing the number of days within the priority period that the employee worked by the total number of days that the employee worked for the debtor. Section 507(a)(4) only applies to claims that are "earned" within 180 days before the petition date. If a claim is "earned" after the petition date, then § 507(a)(4) does not apply, and § 503(b)(1) determines the claim's priority.⁴

Courts have adopted different approaches to determine whether severance claims arising after a post-petition termination are entitled to administrative priority. One line of cases looks to the terms of the severance or employment agreement. If the severance is in lieu of notice, then it receives administrative priority under the rationale that the severance pay is in lieu of post-petition wages. If the severance is based on length of service, any portion of the severance attributable to the post-petition work is entitled to administrative priority.⁵ Under this approach, courts will prorate between the post- and pre-petition period, and also between the pre-priority period and the priority period.⁶

However, many other courts take a different approach and apply the standard two-pronged administrative-priority test, which requires (1) a post-petition agreement and (2) a benefit to the debtor in possession.⁷ According to these decisions, if the severance claim does not meet both requirements, then no part of the claim is entitled to administrative priority. Under this line of cases, administrative priority for severance is "all or nothing." Those who stay on after the petition date cannot receive § 503(b)(1) administrative priority on any part of their claims and are relegated to general unsecured status.

In reaction to this all-or-nothing approach—which in effect punishes employees who remain with a distressed company through the bankruptcy by giving them a lower priority than is given to employees who are terminated shortly before bankruptcy—some bankruptcy courts have created a judicial rule that grants § 507(a)(4) priority to these severance claims.

Trying to Solve the Problem Through an Executory/Rejection Analysis

The first reported decision that leverages a post-petition severance claim into pre-petition priority status via rejection is the chapter 11 case of Dornier Aviation (North America) Inc.⁸ In Dornier Aviation, the court held, consistent with many other courts, that a claim for severance arising from a pre-petition severance agreement was not entitled to § 503(b) administrative priority, even though the employee was terminated and the severance was payable post-petition.

However, after denying the employee an administrative claim, the court held that the severance claim would be entitled to § 507(a)(4) priority because there was "little doubt" that the severance contract was executory and the debtor's rejection of the severance agreement constituted a breach of the severance contract as of the petition date pursuant to § 365(g).⁹ Therefore, "his right to severance pay is properly treated as having occurred" within the priority period set forth in § 507(a)(4).¹⁰

Using rejection to leverage a claim into priority next appeared in LandAmerica, which the Fourth Circuit affirmed in Matson.¹¹ After holding that a severance claim was entitled to § 507(a)(4) priority because it was earned within six months prior to the filing, the court added that if the severance had been payable post-petition and had arisen pursuant to a rejected executory contract, it would have been entitled to § 507(a)(4) priority under Dornier Aviation.

In Circuit City,¹² the same judge who decided LandAmerica reiterated his agreement with the Dornier Aviation approach during claim objection hearings. He stated that he considered pre-petition retention and incentive bonus programs to be executory, and he suggested that therefore claims arising under these programs would also be entitled to § 507(a)(4) priority under the executory-rejection analysis employed in Dornier Aviation.¹³ While these cases attempt to solve a genuine problem, they misunderstand the executoriness doctrine and violate the basic premise that priority should not be inferred by courts, but should be expressly stated by Congress.

The Controversy of Rejection

Michael T. Andrew (McKenna, Long & Aldridge LLP; San Diego) has argued in his oft-cited article¹⁴ that rejection of an executory contract is nothing more than a deemed breach by the debtor of obligations going forward. As he states:

[The assume-or-reject and deemed-breach rules] recognize that a party to a pending contract is fundamentally no different from other claimants, and thus should not receive different treatment merely as a consequence of the contract's "executoriness."... Rather, the design of executoriness doctrine is to eliminate "executoriness" as a factor in determining the nondebtor party's rights when a contract is not assumed.¹⁵

In practice, courts disagree regarding the effect of rejection. For example, in the bankruptcy case of HQ Global Holdings, the court held that the non-debtor party's "right to use the trademark stops on rejection."¹⁶ In contrast, in the case of Exide Technologies, Judge Thomas L. Ambro stated in a concurring opinion: "Courts may use § 365 to free a bankrupt trademark licensor from burdensome duties that hinder its reorganization. They should not—as occurred in this case—use it to let a licensor take back trademark rights it bargained away."¹⁷ The court in Drexel Burnham also explained that "'we can understand that the term 'rejection,' a product of the exclusionary doctrine, does not embody the contract-vaporizing properties so commonly ascribed to it.' Rejection merely frees the estate from the obligation to perform; it does not make the contract disappear."¹⁸ This backdrop highlights the confusion among courts regarding the effect of rejection.

Rejection Should Not Elevate a Severance Claim into § 507(a)(4) Priority

In Dornier Aviation and LandAmerica,¹⁹ the courts used rejection to grant priority to claims of employees who deserve priority but do not fit within the confines of either § 503(b) (administrative priority) or § 507(a)(4) (fourth-level wage priority). In light of its history, the deemed-breach rule is intended to put the nondebtor party to an executory contract on a par with parties to nonexecu-tory contracts. It is not intended to create priority rights. The Dornier Aviation line of cases directly contradicts this intent by putting executoriness front and center into the claims-priority analysis.

It also substitutes one arbitrary measure for another. Under § 507(a)(4), only employees who are terminated within the time period set forth in the statute are entitled to priority. By its terms, those terminated after the petition date are not entitled to § 507(a)(4) priority. Dornier Aviation tried to avoid this arbitrariness by holding that employees terminated post-petition will be entitled to priority (up to the statutory cap) if the severance claim arises from a rejected executory agreement. The problem is that executoriness is in the "eyes of the beholder."²⁰ Courts disagree on what is or is not executory²¹ to such an extent that the case law has been called "chaotic,"²² even "psychedelic."²³ Priority claims should not depend on such an unreliable doctrine.

Further, many authorities state that priority should not be imposed by judicial gloss or inferred by courts, but should appear clearly from stat-ute.²⁴ Finally, even if priority should be inferred by the courts, the inference drawn by Dornier Aviation is weak. Under § 365(g), rejection constitutes a breach by the debtor as of the petition date. However, the date that the debtor breaches is not necessarily the same as the date that the employee earns the severance pay as required by § 507(a)(4) because severance (or an incentive or retention bonus) could be due after the termination or other vesting date. The Dornier Aviation rule mistakenly assumes that the breach date and the earned date are necessarily the same.

Conclusion

Under the case law in many courts, employees who stay with a company after the petition date are relegated to general unsecured status, while employees who are terminated shortly before the petition date are rewarded with § 507(a)(4) priority, which is unfair. Employees who take the risk and stick with a debtor in possession should receive the same priority as those who are terminated shortly before the petition date.

However, the solution does not rest with a rejection/deemed-breach analysis. The law regarding rejection and executoriness is one of the most confused and inconsistent areas of bankruptcy law, and the priority of employee claims should not be dragged into this bramble-filled thicket. Instead, Congress should amend § 507(a)(4) so that employees who stay with a distressed company past the petition date are rewarded to the same extent as employees who stay with the company during the six months before the petition date.

In re Interstate Bakeries: Self-Defining Executoriness²⁵

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