Payments under a severance program established after the commencement of a bankruptcy case typically qualify as administrative expenses and receive priority treatment under the Bankruptcy Code. But what about the trained staff of an insolvent company who agree to help liquidate the company by running going-out-of-business sales in the months leading up to the company’s bankruptcy in exchange for “stay-on benefits?”
In In re Hechinger Investment Co. of Delaware, 298 F.3d 219 (3d Cir. 2002), the Third U.S. Circuit Court of Appeals found that the employees were not entitled to administrative priority treatment for any amounts they earned prior to the filing of the bankruptcy petition.
The issue arose when Hechinger Investment Co. and related entities decided to close and liquidate 34 of its stores. In an effort to retain experienced staff to run the liquidation sales, Hechinger offered certain stay-on benefits to employees.
First, for participating employees, Hechinger would increase the percentage of “BHQ Time” (a combination of vacation, sick, holiday and personal days) for which an employee would be paid upon termination. Second, these employees would receive severance pay in amounts based on length of service. To be eligible to receive any of the stay-on benefits, however, an employee could not leave the company until either the store closed or the employee’s position was terminated.
Hechinger filed its Chapter 11 bankruptcy petition on June 11, 1999. Shortly thereafter, the former employees filed a motion with the bankruptcy court requesting immediate payment of the amounts earned under the stay-on benefits plan as administrative expenses under 11 U.S.C. 503(b)(1)(A) and �105. The bankruptcy court granted the employees only partial relief by awarding administrative expense status to their post-petition work.
The employees appealed, arguing that the entire stay-on benefit claims should have been given administrative priority. They contended that they had earned the stay-on benefits after the filing of the bankruptcy petition and that their work had directly and substantially benefited the estate. They further argued that an affirmance of the bankruptcy court’s decision would unjustly enrich Hechinger and its creditors, and that �105 of the Bankruptcy Code authorized the immediate payment of the stay-on benefits.
The employees urged that they had earned all of their stay-on benefits after Hechinger filed for bankruptcy protection, reasoning that they were not seeking payment of ordinary severance benefits (which typically are not entitled to administrative priority if the benefits are related to work performed before a bankruptcy petition is filed). Instead, since no employee participating in the stay-on benefit plan could expect payment until the Hechinger store in which he or she worked was closed, or until Hechinger terminated the employee, the stay-on benefits “were not earned ratably over time but were earned upon the [e]mployees’ release.”
Moreover, the consideration given by the employees for the stay-on benefits was to remain in good standing with their employer until their positions were terminated. The employees argued that they could not have furnished such consideration until after the filing of the petition, which was when a benefit was bestowed upon the estate. Unfortunately, the court found that the employees’ reliance on the scheduled payment date of the stay-on benefits was misplaced.
EXISTENCE OF ESTATE�
The court began its analysis by examining the language of �503(b)(1)(A) of the Bankruptcy Code, which provides that “the actual, necessary costs and expenses of preserving the estate including wages, salaries, or commissions for services rendered after the commencement of the case” may be allowed as administrative expenses.
The court noted that �503 refers to necessary services rendered to preserve an estate. Since an estate does not come into existence until a bankruptcy petition is filed, any services rendered to a company before the filing cannot preserve the estate. Thus, the court found it irrelevant that the employees’ pre-petition services might have continued to benefit the post-petition debtor.
Instead, the court explained that �503(b)(1)(A) looks to when services are rendered, rather than when they are scheduled for payment. In order for all of the stay-on benefits to qualify for administrative expense treatment, the services had to be rendered “after the commencement” of Hechinger’s bankruptcy: “Under the stay-on benefits program, the consideration furnished by the employees was the work that they did every day from the time when they agreed to the stay-on benefits program until the closing of their stores or their release by the company.”
Because some services were rendered pre-petition and some were rendered post-petition, the court found it necessary to apportion the two periods.
PRESERVATION IS KEY
The court determined that the employees failed to show that the work they performed prior to the commencement of the case represented an “actual, necessary cost � and expense � of preserving the estate.” It noted, instead, that the pre-petition liquidation sale might actually have decreased the value of the estate because Hechinger sold off its inventory at drastically reduced prices.
Hence, the court concluded that the employees’ pre-petition services were not entitled to administrative expense priority.
The appellees, on the other hand, argued that circuit court precedent supported the bankruptcy and district court decisions, which classified only that portion of the employees’ benefit payments incurred post-petition as an administrative expense. The primary support for such a classification of benefits can be found in In re Roth American Inc., 975 F.2d 949 (3d Cir. 1992).
In Roth American, the court noted the difference between two different types of employee benefits plans: “pay at termination based on length of employment” and “pay at termination in lieu of notice.” While pay based on length of employment is typically not classified as an administrative expense, pay at termination in lieu of notice qualifies as such an expense.
Traditionally, pay at termination in lieu of notice is allowed as an administrative expense priority because the payments are made in consideration of quick departure from employment after the petition date � consideration given after the petition. Severance pay at termination based on length of employment is given in consideration of work performed both pre- and post-petition and, thus, not all such pay is entitled to treatment as an administrative expense.
The rationale employed by the court in Roth American led the Third Circuit to determine that the stay-on benefits plan was more comparable to “length of service” pay than to severance pay in lieu of notice. As a result, the court classified only that portion of the employees’ benefits attributable to their post-petition work as an administrative expense.
NO UNJUST ENRICHMENT
The court was even less impressed with the employees’ argument that Hechinger and its creditors would be unjustly enriched if the bankruptcy court’s decision were allowed to stand.
Noting that the employees had cited no real authority for that position, the court concluded that the employees’ reliance on �105 of the Bankruptcy Code was misplaced. Given that other specific provisions of the Bankruptcy Code control the issue of administrative expense priority, the court determined that any reference to �105 was inappropriate.
Consequently, the court affirmed the judgment of the district court, which only allowed payment as an administrative expense to that portion of the employees’ benefit payments related to the post-petition work performed by the employees. The pre-petition benefit payments were merely allowed as a general unsecured claim.
Although the Third Circuit’s decision seems to reflect the majority view, it leaves open the question of how a company experiencing financial difficulties can convince experienced employees not to abandon a sinking ship.
Following the reasoning of this case, future employers of an ailing company should structure their stay-on benefit plans in such a way that payment is made in exchange for a quick departure from the company in lieu of notice and not in exchange for the work performed. This distinction may provide the employees with the security of having their payments treated as administrative expenses in the event that the company subsequently files for bankruptcy protection.
The author is a partner at Duane Morris of Philadelphia and is a member of the American Bankruptcy Institute.
