A widely quoted case is In re Mammoth Mart Inc., 536 F.2d 950 (1st Cir. 1976). 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. Id. at 953. 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. 538 F. 2d at 955 n.4. 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 In re Commercial Financial Services Inc., 233 B.R. 885 (Bankr. N.D. Okla. 1999), 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 In re Phones for All Inc., 249 B.R. 426 (N.D. Tex. 2000), 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. 249 B.R. at 429-431.

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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.

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The court in In re M Group Inc., 286 B.R. 896 (Bankr. Del. 2001), 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 In re Levinson Steel Co., supra, 117 B.R. 194, 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. 117 B.R. at 196.

In In re Cincinnati Cordage and Paper Co., 271 B.R. 264 (Bankr. S.D. Ohio 2001), 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." Id. at 266. 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. Id. at 267-68.

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.

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

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 Levinson Steel, supra 117 B.R. 194, 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. 117 B.R. at 196-97. 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. In re Doctors Hospital Inc., 1995 U.S. App. LEXIS 1576 (1st Cir. 1995).

Debtor Should Obtain Court Approval to Implement Post-petition Retention and Severance Agreement

A post-petition severance plan will not be deemed to be in the ordinary course of business. In re Buyer's Club Markets Inc., LEXIS 40129 (10th Cir. 1994) (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); In re Media Central Inc., 115 B.R. 119 (E.D. Tenn. 1990) (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.