Going Broke? Not Until You Pay Me

William R. Baldiga, James L. Hauser, and Jed M. Nosal

Corporate Counsel

12-01-2012

Financially distressed companies face a host of challenging legal issues when a potential reorganization or dissolution is on the horizon, especially in the balancing of fiduciary duties to constituents such as creditors, shareholders, customers, and employees. Among these are a variety of federal and state laws governing employee compensation that can offer snares for the unwary. Particularly when a company is teetering on the brink of insolvency, in-house counsel are faced with protecting the corporation from liability as well as with shielding corporate officers from personal responsibility for unpaid severance claims.

A company's failure to pay earned wages, regardless of circumstances, will likely trigger civil or criminal liability under state wage and hour laws. Wage laws vary from state to state, but typically include provisions requiring the immediate payment of wages when an employee is terminated for any reason. Many states have enacted wage and hour laws that provide for severe penalties in successful actions to recover unpaid wages. Most of these laws state that the company's "responsible officer" may also be personally subject to civil liability and even criminal prosecution for the company's nonpayment of wages.

Recent court decisions such as Juergens v. MicroGroup (2011) have expanded the scope of "wages" to include severance payments and earned or accrued bonuses. In situations such as the one addressed in Juergens, where cash is tight or the company's prospects are shifting or uncertain, a company may be forced to swiftly implement a reduction in force.

This can happen even when cash resources do not permit full payment of earned bonuses or severance payments. In these situations, company counsel must be ready to address the question often posed by corporate officers or boards as they consider reductions in force: If we terminate people now, but put off (or even become unable to make) severance payments or bonuses, can we face personal liability for those amounts? Yes, in many instances, you can.

For example, employees may have the right to personally pursue recovery of wages allegedly owed. It is also not uncommon for class action lawyers to bring claims on behalf of a group of aggrieved former employees. Raising the stakes further, some state statutes that authorize civil complaints for recovery of unpaid wages include additional damages provisions.

While enforcement responsibilities for wage and hour laws vary by state, they generally fall to a state's department of labor or attorney general's office. Personal exposure can be severe under certain state laws. In Massachusetts, in addition to the amounts owed, a company and its responsible officers are subject to civil penalties that can reach up to $25,000 per violation, criminal prosecution, and fines, and also private suits seeking treble damages and attorney fees.

The enforcement of these laws against responsible officers is generally not affected by the employer's financial distress or even bankruptcy. Enforcement officials may offer a short breathing spell to help a distressed company find the cash, but generally are unsympathetic. Even a company's bankruptcy filing does not stay enforcement actions against officers.

In fact, it is precisely in insolvency situations that company counsel's guidance is most needed. Executive management and the board may find themselves caught between two competing concerns. On the one hand, they may have compelling fiduciary responsibilities to rapidly cut staffing levels to reflect the company's declining prospects. On the other hand, the company may not have ready access to cash to pay all of the accrued bonuses, severance, and other obligations to discharged employees, putting responsible officers at direct personal risk. Officers, accordingly, may be reluctant to implement reductions in force even when substantial cutbacks are consistent with the best interests of the company and its creditors.

When bankruptcy seems truly imminent, the competing considerations outlined above are further exacerbated. In all but the Second Circuit, severance claims are not entitled to statutory priority in a bankruptcy case, putting the company at significant risk that a bankruptcy filing would render the company unable to pay more than a few pennies on the dollar for accrued severance claims.

Even within the Second Circuit, case law is widely inconsistent, and the payment of severance claims is often significantly delayed if approved at all. Further, even if severance or other employee accruals are paid in the weeks leading up to a bankruptcy filing, these payments may be subject to later attack as "preferential" and thus clawed back for the bankruptcy estate, leaving the employees once again looking to responsible officers for any amounts that may be disgorged.

These competing mandates require careful legal planning to appropriately balance the best interests of the company and its creditors generally, and in particular to head off potentially severe legal risk to those officers responsible for reductions in force. While there is theoretical risk that severance and other employee payments may be subject to clawback attack in a later bankruptcy case, bankruptcy judges are very reluctant to order the return of payments previously made to rank-and-file employees, making the practical risk of disgorgement remote.

Large severance or projected bonus payments to exiting officers would be subject to more careful scrutiny. It appears, however, that there are no decided cases that impose personal liability upon responsible persons for the payment of such court-ordered clawed-back amounts. In our experience, state enforcement agencies would be less likely to pursue such clawed-back amounts even if those amounts were severance or other wages that would have created officer liability if not paid in the first place. Where state law allows, enforcement agencies are likely to authorize the employee to pursue such amounts through a private right of action.

In light of the above, in most instances you should pay all accrued severance and bonus amounts at the time of the reduction in force. You should do this even if it means taking those funds from your vendor check-run or other obligations that do not give rise to such severe risk of officer liability.

Also, in these situations state enforcement agencies are usually very receptive, in all but the most egregious cases, to a constructive dialogue with the company. It will almost always be more protective, in the long run, for you to start this dialogue with the enforcement agency before employee complaints are lodged. Ultimately, enforcement actions may still be brought against your responsible officers. But you may be able to delay the commencement of these proceedings until all sources of other funding are exhausted, if the enforcement agency believes that good faith efforts are under way and are reasonably likely to bear fruit.

Few workplace issues raise emotions, and the danger of liability, as starkly as compensation and terminations do. But by following the steps outlined above, you can successfully navigate the shoals of your obligations to your executives and other employees when your company faces corporate restructuring or bankruptcy.

William R. Baldiga is the managing director of the litigation and restructuring department of Brown Rudnick, which includes the firm's worldwide bankruptcy practice. James L. Hauser is a Brown Rudnick partner who focuses his practice on executive compensation and ERISA–related matters. Jed M. Nosal is counsel in Brown Rudnick's government law and strategies group, as well as in the firm's energy, utilities, and environmental group.