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

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

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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. In re Golden Distributors Ltd. and Capital Cigar and Tobacco Co. Inc., et al., 134 B.R. 760 (S.D.N.Y. 1991).

Typical Scenario

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.2 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.

Severance Benefits Based on Length of Service

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. Straus-Duparquest Inc. v. Local Union No. 3, International Brotherhood of Electrical Workers, 386 F. 2d 649 (2d Cir. 1967). The ruling has been criticized by some cases within the Second Circuit (see cases cited in In re Commercial Financial Services Inc., 233 B.R. 885, 889 (Bankr. N.D. Cal. 1999)). Although this is still the rule in the Second Circuit (In re Spectrum Information Technologies Inc., 193 B.R. 400, 407 (Bankr. E.D.N.Y. 1996)), 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. In re Levinson Steel Co., 117 B.R. 194, 195-96 (Bankr. W.D. Pa. 1990). The majority rule is based on the seminal case of In re Public Ledger Inc., 161 F.2d 762 (3d Cir. 1947). 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. Id. at 773. 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. In re Mammoth Mart Inc., 536 F. 2d 950, 955 (1st Cir. 1976); In re Public Ledger Inc., 161 F.2d 762 (3d Cir. 1947); Matter of Health Maintenance Foundation, 680 F.2d 619, 621 (9th Cir. 1982).

More recently, the Third Circuit in Former Employees of Builders Square v. Hechinger Investment Co. of Delaware (In re Hechinger Investment Co. of Delaware), 298 F. 3d 219 (3d Cir. 2002), 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. 298 F.3d at 225. 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." 298 F.3d at 226.

3. How to Allocate Between Pre-petition and Post-petition Severance. The court in In re Yarn Liquidation Inc., 217 B.R. 544 (Bankr. E.D. Tenn. 1998), 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. 217 B.R. at 547. 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 In re Russell Cave Co. Inc., 248 B.R. 301 (E.D. Ky. 2000), 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.

Lump-sum Severance Benefits May Be Disallowed as an Administrative Claim

1. Minority Rule: The Entire Severance Claim Is an Administrative Expense. In the case of In re Miami General Hospital Inc., 89 B.R. 980, 986 (Bankr. S.D. Fla., 1988), 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. Id. at 988.

The decision in In re Miami General Hospital was based on two earlier cases, Matter of Tucson Yellow Cab Co. Inc., 789 F. 2d 701 (9th Cir. 1986), and In re Northwest Engineering Co., 43 B.R. 603 (Bankr. E.D. Wis. 1984). 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. In re Spectrum Information Technologies Inc., 193 B.R. 400, 405 (E.D.N.Y. 1996). 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 In re Uly-Pak, 128 B.R. 763 (Bankr. S.D. Ill. 1991), 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. 128 B.R. at 768. 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.


Footnotes

1 Daniel Austin is a lawyer at McGuire Woods LLP in Pittsburgh. He may be reached at [email protected]. Return to article

2 Most severance policies require the termination to be involuntary and not "for cause." Return to article

Journal Date: 
Saturday, March 1, 2003