Severance Compensation is Earned on Termination for Section 507(a)(4) Priority

By: Eric Small

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

In a case of first impression, the Fourth Circuit, in Matson v. Alarcon, held that employees terminated pre-petition “earned” their entire severance compensation upon termination.[1] The debtor, LandAmerica, offered employees severance based on each employee’s length of employment with the company.[2] Because the debtor terminated the employees within 180 days of the petition date,[3] the Fourth Circuit determined that the employees were entitled to priority treatment pursuant to section 507(a)(4) of the Bankruptcy Code up to the then statutory maximum amount: $10,950.[4] In so holding, the Fourth Circuit rejected the trustee’s view that employees should receive only a pro-rated portion of the compensation based on the amount “earned” during the 180 days prior to the bankruptcy petition.[5]

Section 507(a)(4) grants a fourth priority to “unsecured claims . . . earned within 180 days before the date of the filing of the petition . . . for wages, salaries, or commissions, including vacation, severance, and sick leave pay earned by an individual.”[6] The Fourth Circuit considered the meaning of the term “earned” as used in section 507(a)(4) and took the view that “earned” means “to come to be duly worthy of or entitled [to]” rather than “receive as equitable return for work done or services rendered.”[7] Because severance payments are compensation for losses resulting from termination,[8] the employees “earned” all of the compensation at the time of termination and, thus, the entire severance amount fell within the 180-day period.[9] The Fourth Circuit distinguished cases involving post-petition termination and the administrative expense priority under section 503(b)(1)(A). Most sister circuits have found that severance compensation based on length of employment is entitled to priority as an administrative expense only to the extent that the compensation was based on services provided after the bankruptcy filing.[10] However, the Fourth Circuit noted that section 503(b)(1)(A) deals with post-petition services while section 507(a)(4), which is at issue in this case, refers to severance compensation “earned within” 180 days before the bankruptcy filing.[11] The Fourth Circuit found that unlike the term “services rendered,” which must refer to a specific time period during which an employee gave services to the company, the use of “earned” allows for the broader interpretation advanced in this case.[12]      

The Fourth Circuit’s decision in Matson v. Alarcon suggests that a company considering a bankruptcy filing should pay close attention to the timing of terminating employees who may be entitled to severance compensation. This decision may encourage companies to postpone bankruptcy filings beyond the 180-day statutory period in order to avoid the priority treatment for severance pay.[13] The decision may also lead companies contemplating bankruptcy to expedite the termination of employees. However, one countervailing factor is potential liability under the WARN Act, which requires employers to give 60-days notice before a mass layoff.[14] This notice requirement might present an obstacle to an employer trying to hasten its termination of a large number of employees if the employer wants to avoid liability for back pay and for a civil penalty under the WARN Act.[15]