This article appeared in The Bankruptcy Strategist, featuring the strategies and techniques devised by the country's top bankruptcy lawyers and reports on innovative procedural techniques, legislative developments and recent judicial rulings — plus what they mean for you and your clients.

The filing of a bankruptcy case by a company creates substantial uncertainty for its employees. This uncertainty can translate into employee departures, lack of focus on the business, and diminution in the value of the company. Recognizing these potential consequences, companies in Chapter 11 bankruptcy often try to reduce employee uncertainty by seeking authority from the bankruptcy court to: 1) honor unpaid compensation and benefit obligations to employees; 2) continue severance and benefit plans post-bankruptcy; and/or 3) continue existing bonus programs or establish retention or new incentive programs for employees.

The Bankruptcy Code, however, imposes a variety of limitations on the ability of a debtor-employer to provide certain types of compensation and benefits to "insiders," a term that is broadly defined in the Bankruptcy Code. Moreover, as a general matter, compensation and benefits paid to insiders by a debtor company are closely scrutinized, and incentive programs for insiders often become a focal point for disputes between a company, its creditors, and the United States Trustee. This article, which focuses primarily on Delaware law, provides a high-level summary of several common issues that often arise in bankruptcy related to insider compensation and benefits.

Who Is an Insider?

Under section 101(31) of the Bankruptcy Code, an "insider" of a corporation includes, but is not limited to: a) a "director of the debtor;" b) an "officer of the debtor;" c) a "person in control of the debtor;" d) a "partnership in which the debtor is a general partner;" e) a "general partner of the debtor;" f) a "relative of a general partner, director, officer, or person in control of the debtor;" or g) any "affiliate, or insider of an affiliate as if such affiliate were the debtor." 11 U.S.C. §101(31)(B) & (E). Thus, courts will consider titles, relationships, and general ability to "control" a debtor (as discussed below) in determining whether an individual constitutes an insider. Importantly, individuals who are named officers or directors of a debtor — including named officers or directors of defunct or shell subsidiaries of a debtor — should be wary that, based on such titles, courts may consider them presumptively insiders of the debtor under section 101(31). See, In re Foothills Texas, Inc., 408 B.R. 573, 579 (Bankr. D. Del. 2009) ("Just as there may be non-statutory insiders that fall within the definition of an insider but are outside of the enumerated categories, there may be persons that fall within the enumerated categories but do not meet the definition of the category …. In order to overcome the presumption that a person holding an officer's title is not what he or she appears to be requires submission of evidence sufficient to establish that the officer is, in fact, not participating in the management of the debtor.").

In addition, because this definition is non-exclusive, bankruptcy courts have fashioned additional tests to determine whether an individual who does not fall within one of the categories in section 101(31) is a "non‑statutory insider." For example, in examining whether an individual is a non-statutory insider, the Third Circuit has noted that "the question is whether there is a close relationship [between the debtor and the purported insider] and … anything other than closeness to suggest that any transactions were not conducted at arm's length." Schubert v. Lucent Techs. Inc. (In re Winstar Commc'ns, Inc.), 554 F.3d 382, 396–97 (3d Cir. 2009) (quoting Anstine v. Carl Zeiss Meditec AG (In re U.S. Med.), 531 F.3d 1272, 1277 (10th Cir. 2008)) (ellipsis in original). As a result, employees who do not consider themselves to be senior executives or persons in control of a company can nevertheless be captured by the insider definition.

Limitations on Compensation and Benefits

Statutory Caps on Prepetition Compensation and Benefits

As a threshold matter, the Bankruptcy Code grants priority claim status for a limited amount of unpaid prepetition compensation owed to any employee. By contrast, any compensation due that arises postpetition qualifies for second priority status as an administrative expense, and there is no cap on such amounts. See, 11 U.S.C. §§503(b)(1)(A)(i) and 507(a)(2). Specifically, section 507(a)(4) of the Bankruptcy Code grants fourth priority status to a claim filed by an individual or corporation for up to $13,650 in compensation earned within 180 days before the petition date or the date on which the debtor-employer stopped operating, whichever occurs first. See, 11 U.S.C. § 507(a)(4). Any additional unpaid prepetition compensation qualifies only as a general unsecured claim against the estate, and thus, such claimants may recover only a small dividend thereon. Accordingly, regardless of the amount of prepetition unpaid wages an employee is owed, an employee is unlikely to recover much more than $13,650 in respect of his or her prepetition wage claim during the bankruptcy case. Rather than requiring an employee to wait until the end of a bankruptcy case to obtain a recovery on his or her unsecured wage claim, companies often seek bankruptcy court approval at the beginning of the case to pay unpaid compensation up to the $13,650 statutory cap for priority claims. Nevertheless, given the statutory cap, highly compensated employees or employees with an extended pay cycle at such companies — resulting in relatively larger amounts of compensation per pay period — may not be paid all outstanding prepetition compensation.

Retention Payments

In general, retention payments to insiders are not allowed after a debtor-employer files for bankruptcy, and to the extent they are allowed, such amounts are strictly limited by section 503(c)(1) of the Bankruptcy Code. In general, a proposed retention payment to an insider may only constitute an administrative claim of the debtor's estate, if all of the following conditions exist: a) the payment is necessary to retain the insider, due to the existence of an actual and legitimate offer of employment to the insider at the same or a greater rate of compensation; b) the insider's offered services are vital to the debtor's business operations; and c) either (i) the proposed retention payment to the insider is not more than 10 times the average amount of retention payments offered to non‑insiders during the year in which the insider is to be paid, or (ii) if no such non-insider retention payments are so offered, such retention payment is not more than 25% of the amount of any prior retention payment offered to the insider in the prior year. See, 11 U.S.C. §503(c)(1).

Although courts strictly apply this test to determine whether proposed insider payments qualify for administrative expense status, debtors have sought to avoid the restrictions of section 503(c)(1) by structuring bonuses and payments to insiders as "incentive" plans — i.e., plans tethered to specified business performance metrics — that may also include retentive characteristics. See, In re Global Home Prods., LLC, 369 B.R. 778, 783 (Bankr. D. Del. 2007) (referring to the "bright light [sic] and restrictions" on retention plans imposed by section 503(c) of the Bankruptcy Code); id. at 784 (noting that the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) "imposed a set of challenging standards debtors must meet to have 'stay' bonuses approved" and that "[BAPCPA] requires the Court to apply specific standards if a bankruptcy court is asked to authorize payments to insiders for the purpose of inducing insiders to remain in a debtor's employ") (internal citations, quotation marks and footnotes omitted); id. at 785 ("The statute makes it abundantly clear that in a post-[BAPCPA] bankruptcy case, [key employee retention plans] … subject to review under section 503(c) — those whose purpose is to retain employees — are severely restricted.") ("The entire analysis changes if a bonus plan is not primarily motivated to retain personnel or is not in the nature of severance."); id. at 786 (finding that bonus plans were "primarily incentivizing and only coincidentally retentive because Debtors employed virtually identical plans prepetition when retention was not the motive"); see also, In re Nellson Nutraceutical, Inc., 369 B.R. 787, 802 (Bankr. D. Del. 2007) (finding that "although the modification of the … bonus program has some retentive effect, it is for the primary purpose of motivating employees and, thus, the limitations of section 503(c)(1) are not applicable"). To the extent a proposed bonus plan constitutes an incentive plan, courts analyze such plan under the more easily satisfied "business judgment" standard. See, Global Home Prods., 369 B.R. at 783. As discussed further below, courts may also scrutinize an incentive plan under section 503(c)(3) of the Bankruptcy Code, which utilizes a "business judgment" standard similar to the standard applied to a proposed use, sale, or lease of estate property outside the ordinary course of the debtor's business pursuant to section 363(b) of the Bankruptcy Code. As also discussed further below, however, the business judgment standards applied under sections 363 and 503(c)(3) are slightly different and the standard under section 503(c)(3) is often applied in a more exacting fashion.

Severance Payments

As a threshold matter, claims for severance by employees terminated prior to a bankruptcy filing are general unsecured claims, although a portion of such claims might be entitled to priority under section 507(a)(4). The ability of the debtor-employer to pay severance to employees terminated after the bankruptcy filing may also be limited depending on whether such severance was based on length of service and the jurisdiction in which the bankruptcy case is pending. Compare, Matson v. Alarcon, 651 F.3d 404, 409 (4th Cir. 2011) (finding that "an employee 'earns' the full amount of 'severance pay' on the date the employee becomes entitled to receive such compensation" under section 507(a)(4)(A) of the Bankruptcy Code); Straus-Duparquet, Inc. v. Local Union No. 3 Int'l Bhd. of Elec. Workers, AFL, CIO, 386 F.2d 649, 651 (2d Cir. 1967) ("Severance pay is not earned from day to day and does not 'accrue' so that a proportionate part is payable under any circumstances. After the period of eligibility is served, the full severance pay is due whenever termination of employment occurs."), with In re Roth Am., Inc., 975 F.2d 949, 957 (3d Cir. 1992) ("This court, along with the vast majority that have considered the type of severance pay claim at issue here, has held that these claims … only have administrative priority to the extent that they are based on services provided to the bankruptcy estate post‑petition."); Lines v. Sys. Bd. Of Adjustment No. 94 Bhd. of Ry., Airline & Steamship Clerk (In re Health Main. Found.), 680 F.2d 619, 621 (9th Cir. 1982) (same); Cramer v. Mammoth Mart, Inc. (In re Mammoth Mart, Inc.), 536 F.2d 950, 953 (1st Cir. 1976) (same). With respect to insiders, the ability of a debtor-employer to honor severance payments to insiders terminated during the bankruptcy case is further restricted. In particular, section 503(c)(2) of the Bankruptcy Code prohibits severance payments to an insider of the debtor unless: 1) the payment is part of a program that is generally applicable to all employees of the debtor; and 2) such payment is not more than 10 times the average non-management severance payment that was made during the prior year.

There have been few cases analyzing the provisions of section 503(c)(2) — and none in the District of Delaware — but other courts have ruled that non-compete agreements that include severance provisions may be governed by section 503(c)(2) and that severance obligations that would be payable by a reorganized debtor pursuant to a plan of reorganization are also subject to the restrictions included in section 503(c)(2). See, In re Dana Corp., 351 B.R. 96, 102–03 (Bankr. S.D.N.Y. 2006) (reasoning that proposed payments included as part of non-compete agreements were actually payments for dismissal and, thus, constituted severance payments subject to section 503(c)(2)). See also, In re TCI 2 Holdings, LLC, 428 B.R. 117, 172–73 (Bankr D.N.J. 2010) (language in a competing Chapter 11 plan requiring the reorganized debtors to offer one-year salary severance packages to certain officers and directors, without prior court approval and contrary to the restrictions imposed by section 503(c)(2), caused the plan to violate section 1129(a)(4), which requires court approval of the reasonableness of fee and expense payments proposed in a Chapter 11 plan).

Bonuses and Other Compensation

Section 503(c)(3) of the Bankruptcy Code places a more general restriction on other forms of compensation and bonuses that cannot neatly be characterized as either retention or severance payments. Section 503(c)(3) imposes a "catch-all" limitation on proposed transfers and incurred obligations that are both outside of the ordinary course of the debtor's business and "not justified by the facts and circumstances" of the case. See, 11 U.S.C. § 503(c)(3). Although seemingly broad, any transfers that are either: a) within the ordinary course of the debtor's business; or b) justified by the particular facts of the case are allowable under section 503(c)(3).

In analyzing a proposed bonus plan under section 503(c)(3), the first question courts will generally consider is whether a proposed compensation plan falls within the ordinary course of the debtor's business. See, Nellson Nutraceutical, Inc., 369 B.R. at 797 (examining whether a proposed payment was within the ordinary course of a debtor's business by considering the two-part test adopted in the Third Circuit, which involves analysis of the transaction from the "horizontal" perspective — i.e., whether such payment structure is common in the particular industry — as well as the "vertical" perspective — i.e., whether such payment structure exposes a hypothetical creditor to unanticipated economic risk compared to when it determined to extend the debtor credit). If so, the inquiry ends there. If not, the courts then consider whether such transfer is "justified by the facts and circumstances" of the case. Generally, courts consider this question to be one within the debtor's business judgment, but, as noted above, the standard is slightly more exacting than a traditional "business judgment" standard, as the courts consider several delineated factors to determine if a bonus plan qualifies under section 503(a)(3). See, Global Home Prods., 369 B.R. at 786 (considering the following factors in determining whether an incentivizing plan was proper under section 363 of the Bankruptcy Code: a) "[i]s there a reasonable relationship between the plan proposed and the results to be obtained"; b) "[i]s the cost of the plan reasonable in the context of the debtor's assets, liabilities and earning potential"; c) [i]s the scope of the plan fair and reasonable" and "does it apply to all employees [or] does it discriminate unfairly"; d) "[i]s the plan or proposal consistent with industry standards"; e) [w]hat were the due diligence efforts of the debtor in investigating the need for a plan"; and f) [d]id the debtor receive independent counsel in performing due diligence and in creating and authorizing the inventive compensation?") (quoting In re Dana Corp., No. 06‑10354 (BRL), 2006 WL 3479406, at 6 (Bankr. S.D.N.Y. Nov. 30, 2006)). Importantly, other courts have applied an even more exacting standard than the factors specifically examined in this article, demanding instead that the debtor establish that the bonus plan will "serve the interests of the creditors and the debtor's estate." See, In re Pilgrim's Pride Corp., 401 B.R. 229, 237 (Bankr. N.D. Tex. 2009) (employing a more exacting standard than business judgment and reasoning that, "even if a good business reason can be articulated for a transaction, the court must still determine that the proposed transfer or obligation is justified by the case before it" so "the court must make its own determination that the transaction will serve the interests of creditors and the debtor's estate").

Employment Contract Damages

Additionally, section 502(b)(7) provides a cap on the amount of a claim that may be allowed resulting from the termination of any employment contract, whether involving an insider or not. See, 11 U.S.C. §502(b)(7). Specifically, section 502(b)(7) limits the amount of such claims to the total of: 1) any outstanding prepetition amounts due under the terminated employment contract; and 2) one year's total future compensation due under such contract (without acceleration) from the earlier of: a) the petition date, or b) the date on which the contract was terminated. See, id. Thus, to the extent an employee's relationship with the debtor is established by an employment contract and such contract is terminated — whether the employee is an insider or not — this provision operates to limit the potential exposure of the debtor thereunder.

SERP and Rabbi Trusts

Finally, obligations owing under a Supplemental Executive Retirement Plan (SERP) are generally treated as unsecured claims during the course of a bankruptcy case, and therefore, participating executives likely will receive treatment on a par with other unsecured claimants. A SERP may take many forms, with some being funded in a segregated account — e.g., a "rabbi trust" — or not funded, but evidenced by, a contractual relationship — e.g., a "top hat plan." Regardless of the structure, however, the Bankruptcy Code provides little protection for claims based on such obligations. Additionally, early termination of and payment from a SERP will result in potentially harsh tax consequences for the participating executive and may result in preferential transfer or fraudulent conveyance liability, depending on the timing of the payment and the structure of the SERP. See, e.g., TSIC, Inc. v. Thalheimer (In re TSIC, Inc.), 428 B.R. 103 (Bankr. D. Del. 2010) (avoiding, as a constructive fraudulent incurrence of an obligation, certain obligations to pay a former executive SERP benefits under a settlement agreement and authorizing the recovery of payments made pursuant thereto).

Conclusion

The filing of bankruptcy can have substantial negative impacts on claims for compensation and benefits for all employees. This is particularly true with respect to those employees who may fall within the "insider" definition, as the Bankruptcy Code imposes additional limitations on their compensation and benefits. Companies can mitigate certain of these impacts by understanding the issues that bankruptcy raises with respect to employee compensation and benefits and planning accordingly.

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Carl Black is a Partner with Jones Day in the Cleveland, OH office. He has played a leading role in Jones Day's representations of debtors and potential debtors, creditors' committees, contract counterparties, equity sponsors, and other significant creditors in many of the nation's largest in-court and out-of-court corporate restructurings. Jonathan Noble Edel is an Associate in the firm's Cleveland office and focuses his practice on corporate restructuring, bankruptcy, and other matters pertinent to the reorganization of distressed businesses.