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When a company files for protection under Chapter 11 of the Bankruptcy Code, its management and other employees normally stay in place. Post-petition salaries are generally paid in the ordinary course of business. Absent a court order, compensation claims for work performed pre-petition would not be paid until a reorganization plan is confirmed. [FOOTNOTE 1]Therefore, to preserve employee relations, one of the first motions (or set of motions) a new Chapter 11 debtor usually presents to the bankruptcy court is a motion seeking an order permitting the debtor to pay current salary and benefits without holding back compensation for pre-petition work. It is in this context that the debtor’s management may first become aware of the distinctions and restrictions applicable to compensation and benefits in the Chapter 11 context. There are, however, numerous ways in which a debtor’s relationships with its employees, particularly employees with individually negotiated contracts, are affected by its status as a Chapter 11 debtor. [FOOTNOTE 2]Employees may find that golden parachutes, [FOOTNOTE 3]severance packages and other such devices do not afford them as much protection against termination by an employer in Chapter 11 as they thought. Moreover, retention or other bonus programs must be re-evaluated in the context of a Chapter 11 case. This article summarizes the key issues that affect golden parachutes, severance packages and bonus programs in Chapter 11 and outlines the standards for court approval of post-petition severance and retention programs. PRE-PETITION/POST-PETITION DISTINCTION The distinction between pre-petition and post-petition creditors is one of the most critical distinctions made in the bankruptcy context. Creditors are entitled to receive distributions on their claims in the order of their claims’ respective priorities. Because post-petition (or “administrative”) creditors are generally accorded higher priority of payment than pre-petition creditors, whether a claim is considered pre- or post-petition may determine when it is paid and whether it is paid in full. Moreover, the aggregate amount of administrative claims against the debtor will affect its ability to confirm a reorganization plan, because one of the requirements for plan confirmation is that allowed administrative claims be paid in cash on the effective date unless the claimant agrees to different treatment. Further, the amount and classification of pre-petition claims will affect voting on the debtor’s reorganization plan. A claim’s characterization as pre- or post-petition rests not on when payment of the claim is due, but rather on when the transactions or occurrences giving rise to the claim took place. In the employment context, this rule generally means that the status of the employee’s claim will turn on whether the employee’s services giving rise to the claim were rendered before the petition date. Thus, for example, if the debtor is scheduled to pay its employees for the period of Jan. 1 through Jan. 15 on Jan. 15, and the debtor files its petition Jan. 10, then its employees would have pre-petition claims for wages and benefits earned from Jan. 1 through Jan. 9 and administrative claims for wages earned after Jan. 9. For most employees, the amount of the claim for earned but unpaid salary that gets caught up in a mid-pay period filing is likely to be small, especially given the regularity of courts entering first-day wage orders; nevertheless, the executive who has earned deferred compensation (whether denominated “salary” or “bonus”) over a significant pre-petition period may have a sizable pre-petition wage claim. Like wages and salary, severance claims of employees hired pre-petition and terminated post-petition may also be divided into pre- and post-petition portions. Most circuits hold that where the calculation of severance is based on the length of the employee’s service, the employee earned the severance over the entire course of his employment, and the severance claim in such cases should therefore be bifurcated into pre- and post-petition portions. [FOOTNOTE 4]Nevertheless, in pre-Code cases, the 2nd U.S. Circuit Court of Appeals treated the severance claim of employees terminated post-petition as entirely post-petition claims. [FOOTNOTE 5]The 2nd Circuit has not squarely revisited this issue under the current Bankruptcy Code, although it has stated that severance is principally compensation for the hardship of discharge and therefore earned at the time of discharge. [FOOTNOTE 6] An interesting nuance to the general rule regarding the priority of claims arising out of post-petition employment terminations arises in the context of contractual severance. Several courts have held that where the severance entitlement in a pre-petition employment agreement is not tied to the length of the executive’s tenure when terminated, it was entirely “earned” when the contract was entered, even though at the time it constituted only a contingent claim. [FOOTNOTE 7]Administrative priority requires that a post-petition benefit be conferred on the debtor-in-possession’s estate. [FOOTNOTE 8]To the extent that the consideration for a golden parachute is the employee’s agreement to become an employer’s employee, that consideration is given when the employee first starts the job; hence, the priority of a golden parachute claim often turns on when the employment agreement was entered. MAXIMIZING THE ESTATE A debtor-in-possession has a duty to maximize the value of the estate for the benefit of its creditors (and shareholders, if creditors are to be paid in full). To the extent that maximizing value means preserving the debtor’s value as a going concern (either so that it can reorganize on a stand-alone basis or to facilitate a reorganization encompassing a merger or acquisition transaction), the debtor must evaluate which employees it wishes to retain (or attract, if there are vacancies to be filled) and how it can do so, given the restrictions of the Chapter 11 environment. To the extent that the debtor must terminate certain employees, it will find that Chapter 11 provides some opportunities for substantial cost savings respecting certain liabilities arising from termination. SEC. 365: ASSUMPTION AND REJECTION OF EXECUTORY CONTRACTS Section. 365 gives the debtor-in-possession the right to assume or reject executory contracts and unexpired leases that were entered pre-petition. If the debtor assumes a contract, its performance becomes an obligation of the debtor-in-possession, and any claims under the contract would have administrative priority. If the debtor rejects a contract, rejection constitutes a breach of that contract as of the petition date: In other words, under Bankruptcy Code � 365(g), a claim for any damages as a result of rejection is treated as a pre-petition claim. A pre-petition employment agreement with an employee who is still employed by the debtor on the petition date is an executory contract. If the debtor rejects the contract and terminates the employee, then the employee’s claims, under or relating to, the employment contract would be treated as pre-petition claims except to the extent that such claims are for services rendered post-petition. Thus, for example, if an executive had a three-year contract that still had 2-1/2 years left to its term on the petition date, and the debtor rejected the contract 18 months after it filed its petition, the executive would have been (or would be entitled to be) paid on an administrative expense basis for his post-petition services through the rejection/termination date and would have a pre-petition claim for any rejection damages with respect to the remainder of his contract. To the extent that the executive worked for the debtor post-petition, some courts hold that even though the pre-petition contract may be (or have been) rejected, in most cases it is the best evidence of the value of the executive’s post-petition services. [FOOTNOTE 9] SEC. 502(B)(7): LIMITATIONS ON CLAIMS FOR TERMINATION OF AN EMPLOYEE CONTRACT Section 502(b)(7) limits the claim of “an employee for damages resulting from the termination of an employment contract” to one year’s compensation plus any amounts due for work performed prior to termination. [FOOTNOTE 10]Thus, � 502(b)(7) allows for two components of an employee’s claim under a terminated employment agreement: (1) the loss of future earnings under the contract, which is subject to the one-year limitation; and (2) unpaid compensation earned prior to termination, which is not subject to the one-year limitation. Generally, breach-of-contract, severance and golden parachute claims fall into the first category, and deferred compensation and vested retirement benefits fall into the second. [FOOTNOTE 11] SEC. 363: USE OF ESTATE PROPERTY Section 363 governs the use, sale or lease of property of the debtor’s estate. Sec. 363(b) provides that use of estate property outside the ordinary course of business requires court approval. Whether a debtor/ employer’s post-petition promises to an employee regarding severance, golden parachutes or bonuses were made in the ordinary course of the debtor’s business is the critical issue in cases where the employee is seeking payment of such claims, and the debtor did not obtain court authorization to make such payments prior to the triggering event. Most courts that have addressed the issue have held that the post-petition payment of substantial severance or bonuses to senior management employees (i.e., severance or bonuses in excess of those available under widely applicable company policies [FOOTNOTE 12]) is not in the ordinary course of business and therefore requires court approval. [FOOTNOTE 13]This is not to say that such agreements should not be approved, but rather that notice to creditors and a demonstration to the court that the agreement reflects a sound exercise of the debtor’s reasonable business judgment are required before the parachute agreement can give rise to an administrative claim against the estate. Even if this view is not a matter of “black letter” law, an executive who relies on a debtor’s unapproved promise to pay a bonus, golden parachute or severance does so at his peril, particularly if the amount in question is in excess of one year or the executive’s base salary. COURT APPROVAL OF SEVERANCE AND RETENTION PACKAGES As is apparent from the discussion above, there are numerous reasons for a debtor’s employees to feel less than sanguine about their rights when the debtor files its petition. Given the risks to their employees, most Chapter 11 debtors planning to reorganize will evaluate their need to retain employees and take action to reassure their work force and induce their management teams to remain with the debtor. With respect to its most senior executives who have individually negotiated contracts, the debtor may seek to assume those contracts — possibly in modified form — pursuant to � 365. Because of the need to retain a broader base of its personnel, the debtor is likely, however, to seek approval of a post-petition retention and severance policy that would apply to a broader constituency. A motion to approve a severance and retention program is typically made under � 363(b) as a use of property of the estate out of the ordinary course of business. For the motion to be granted, the debtor must show that its proposal is justified by a sound business purpose. [FOOTNOTE 14]In the severance and retention context, such a showing can be made by demonstrating that there is a significant risk that the debtor will lose valued employees without such a program, and that the program is reasonably designed to achieve desired results without unduly burdening the estate. It is not necessary to prove that the debtor has a reasonable probability of successful reorganization. [FOOTNOTE 15] Retention and severance programs should be tailored to the reorganization process, rather than simply mimicking any incentive programs the debtor may have had pre-petition. [FOOTNOTE 16]Generally, the timing of bonuses and severance payments are tied to key milestones in the Chapter 11 process. Common milestones for payments include presentation of a business plan, filing of a reorganization plan, and confirmation or consummation of a reorganization plan. Frequently, bonuses will be greater under the incentive portion of the plan if milestones are met by early dates. Performance criteria under severance and retention plans are typically modified versions of prevailing industry plans. Thus, in addition to seeing incentives tied to EBITDA or sales revenues, many bonus programs provide for increased benefits if returns to creditors are above a certain level. If the debtor succeeds in proving to the court that the proposed plan is a reasonable exercise of its business judgment, the court should approve the plan. [FOOTNOTE 17]By proposing a severance and retention plan that is properly designed to attract and retain valued employees, achieve a timely reorganization and maximize the value of the reorganized debtor (even if the debtor is “reorganized” by means of a sale of the debtor or its assets), the debtor will be acting in a manner consistent with its duties to creditors. By providing post-petition services in accordance with the plan, employees will be conferring post-petition value on the estate, and, therefore, their claims under the plan are entitled to administrative claim status under � 503(b). By obtaining court approval of its severance and retention program, the debtor therefore minimizes the risks to the covered employees that their claims for severance and bonuses will be at the front rather than the back of the line for payment. Shari Siegel is with the bankruptcy department at New York’s Simpson Thacher & Bartlett. Ms. Siegel has litigated issues respecting severance, executive contracts, retention and benefit plans, and golden parachutes in several Chapter 11 cases, including Pan Am, Spectrum Information Technologies, Crystal Brands and Pegasus Gold Corp. FOOTNOTES: FN1In the typical “first-day wage and benefit order,” the debtor seeks court authorization to honor any outstanding pre-petition paychecks and/or issue its next scheduled paychecks even though some of the employee services being paid for in the particular payroll period addressed were rendered pre-petition. Concomitantly, the debtor typically requests permission to make its regular payments in connection with its existing employee benefit plans without withholding any payments relating to pre-petition services. Even the entitlement to paid vacation or sick days earned as a result of pre-petition services may be considered a pre-petition claim. The argument in support of this first-day order is not only that the requested relief is necessary to retain the debtor’s employees at a time when the debtor is making increased demands on their time, but also that the Bankruptcy Code affords the majority of such employee claims some priority anyway. See 11 U.S.C. �� 507(a) (3) and (4) (giving third priority for wage claims of up to $4,300 per employee and fourth priority to contributions to employee benefit plans to the extent of $4,300 times the number of covered employees for each such plan). Although many bankruptcy courts will allow the debtor to make all wage and benefit payments without restrictions other than that such payments should only be comprised of regular (as opposed to bonus) pay and benefits, some courts will restrict such payments to the respective $4,300 per employee caps on wage and benefit claims. FN2Many of the priority and claims limitation issues discussed in this article also arise in the Chapter 7 context. FN3A “golden parachute” provides for payment of a specified benefit to an employee upon his or her termination or constructive termination after a change in control of the employer. Schreiber v. Burlington N. Inc.,472 U.S. 1, 3 n.2 (1985); In re Forum Group Inc., 82 F.3d 159, 162 (7th Cir. 1996). As such, it is distinct from “severance,” which is generally payable in the event of any involuntary termination of employment other than for cause. FN4See Dullanty v. Selectors Inc. ( In re Selectors Inc.), 85 B.R. 843, 844-45 (9th Cir. BAP 1988). FN5See, e.g., Straus-Duparquet Inc. v. Local Union No. 3, Int’l Bd. of Elec.Workers( In re Straus-Duparquet), 386 F.2d 649 (2d Cir. 1967). FN6See Bradwell v. GAF Corp., 954 F.2d 798, 801 (2d Cir. 1992). FN7See, e.g., Dullanty, 85 B.R. 843 (the consideration the employee gave for the parachute clause was giving up his law practice and coming to work for the debtor pre-petition); In re Commercial Fin. Servs. Inc., 233 B.R. 885 (Bankr. N.D. Okla. 1999) (same). FN8 Calphine Corp. v. O’Brien Envtl. Energy Inc. ( In re O’Brien Envtl. Energy Inc.), 181 F.3d 527, 532-33 (3d Cir. 1999); Commercial Fin., 233 B.R. at 889-90. FN9See In re Ralph Lauren Womenswear Inc., 197 B.R. 771, 776 (Bankr. S.D.N.Y. 1996). But see In re Midland Capital Corp., 82 B.R. 233 (Bankr. S.D.N.Y. 1988). FN10Sec. 502(b)(7) disallows a claim for termination of an employment contract to the extent that such claim is in excess of: (A) the compensation provided by such contract, without acceleration, for one year following the earlier of . . . (i) the date of the filing of the petition; or (ii) the date on which the employer directed the employee to terminate, or such employee terminated, performance under such contract; plus (B) any unpaid compensation due under such contract, without acceleration, on the earlier of such dates. 11 U.S.C. � 502(b)(7). FN11See Irvine-Pac. Commercial Ins. Brokers Inc. v. Adams( In re Irvine-Pac. Commercial Ins. Brokers Inc.), 228 B.R. 245 (9th Cir. BAP 1998) (claim for deferred compensation and attorney fees not limited by � 502(b)(7)); In re Handy Andy Home Improvement Ctrs. Inc., 1997 WL 401583, at *7 (Bankr. N.D. Ill. July 9, 1997) (severance claim capped by � 502(b)(7), but claim for portion of bonus earned prior to termination not subject to the � 502(b)(7) one-year limit); Cohen v. Drexel Burnham Lambert Group Inc.( In re Drexel Burnham Lambert Inc.), 138 B.R. 687, 713 (Bankr. S.D.N.Y. 1992) (golden parachute claim limited by � 502(b)(7)); In re CPT Corp., 1991 WL 255679 (Bankr. D. Minn. Nov. 26, 1991) (� 502(b)(7) caps executive severance claim even though claim had been reduced to a state court judgment prior to the petition date). FN12Bankruptcy courts tend to distinguish between widely applicable company policies that apply a formula for calculation of severance or benefits to categories of employees generally and individually negotiated contract terms that apply only to a particular senior executive. See, e.g., In re Hooker Invs. Inc., 145 B.R. 138, 150 (Bankr. S.D.N.Y. 1992); Midland Capital., 82 B.R. 233. FN13See, e.g., Bagus v. Clark( In re Buyer’s Club Markets Inc.), 5 F.3d 455 (10th Cir. 1993); Chaney v. Official Comm. of Unsecured Creditors of Crystal Apparel Inc.( In re Crystal Apparel Inc.), 220 B.R. 816 (Bankr. S.D.N.Y. 1998); In re Media Central Inc., 115 B.R. 119 (Bankr. E.D. Tenn. 1990); In re Century Brass Prods. Inc., 107 B.R. 8 (Bankr. D. Conn. 1989). The author represented the Unsecured Creditors’ Committee in the Crystal Apparelcase. FN14 In re Montgomery Ward Holding Corp., 242 B.R. 147, 153 (D. Del. 1999). FN15Id. FN16See, e.g., Montgomery Ward, 242 B.R. 147; “Favorite Brands Gets Nod for Worker Retention Plan,” Fed. Filings (May 6, 1999); “Venture Severance/Retention Program OK’d, Report Says,” Daily Bankr. Rev. at 3 (Feb. 26, 1998). FN17 Montgomery Ward, 242 B.R. 147.

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