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Section Review

Executive Severance in the Face of Bankruptcy

John R. Mayer is an associate with Perkins, Smith & Cohen in Boston, focusing his practice on commercial and technology litigation and creditors’ rights in bankruptcy.

Patricia Washienko is an associate with Perkins, Smith & Cohen in Boston, practicing in the Executive Advocacy and Labor, Employment & Employee Benefits groups.

Laura Jones, chief financial officer of the financially ailing Acme Corporation, separated from Acme six weeks ago. On her way out, Jones and the company negotiated a separation agreement. In the six weeks since she left Acme, Jones has received significant payments under the terms of the agreement. Yesterday, however, Jones learned that Acme had filed for bankruptcy. Should she be concerned that her separation package is at risk? Absolutely.

This article will examine certain bankruptcy-related risks to the viability of separation agreements. It begins with a brief overview of settlement negotiations and common terms of settlement agreements, and then provides an overview of the bankruptcy law that may place these settlements at risk. Finally, it concludes with suggestions for minimizing the risk that a bankruptcy filing will allow the company to avoid its payment obligations.


I. Overview of severance

Most separation agreements offer benefits to both the employer and the departing employee. For the employer, some of the most common benefits include releases of claims against the company; covenants preventing competition; solicitation of clients; solicitation of employees; disparagement of the company; and disclosure of the terms of the agreement. For the departing employee, the most common benefits include severance pay; medical and dental benefits; life and disability insurance coverage; pension enhancement; acceleration of vesting schedules for stock and/or stock options; bonuses; and transition assistance (like legal fees or outplacement). Even given such potentially generous terms, severance packages for senior management and upper-level employees are quite common, both because the departing officer and the company have strong incentives to avoid adverse publicity stemming from a contentious separation and because officers and executives frequently have employment contracts that specifically provide for severance packages in the event of their terminations. Thus, executives frequently depart jobs under comparatively good circumstances and terms.

Despite the good intentions of the departing executive and the company, however, when a severance agreement has been negotiated in the face of impending bankruptcy, the agreement is at risk. This is true even where a separation package is required by the terms of an employment contract.


II. Brief overview of bankruptcy law

Corporate bankruptcies come in two flavors. In a Chapter 7 case, the company's assets are sold for the benefit of creditors. In a Chapter 11 case, the company tries to reorganize its finances. However, even where a company elects Chapter 11, unhappy creditors can sometimes force a liquidation.

The Bankruptcy Code contains some protections for employees whose employers declare bankruptcy. However, the special protections for employees' wages and benefits will be cold comfort for most senior executives. Unpaid wages are protected to a maximum of $4,300. Likewise, unpaid pension benefits are protected to the same $4,300 maximum.

Even more disquieting is the fact that the code also contains tools that can interfere with negotiated severance packages. Under certain circumstances, payments already made pursuant to a severance agreement can be recovered by the company - in their entirety - as a preferential transfer. Similarly, a continuing contract for severance payments over time can be rejected by the bankrupt company. The implications of these provisions should make executives pause when negotiating severance packages.

For companies facing hard times, a bankruptcy filing gives them (or more likely, their creditors) the opportunity to recover severance payments made to executives by claiming such payments were preferential transfers prohibited by the Bankruptcy Code. Preferential transfers are transfers of a debtor's property to a creditor for payment of a prior debt, and which result in the creditor receiving more than it would have received in a Chapter 7 Bankruptcy if the property had not been transferred. Application of this prohibition can force the departed executive to pay back the severance monies received from the company. To recover such monies (or "avoid the transfer"), the company (or bankruptcy trustee) needs only to establish that the payment was made within a specified period (one year for corporate insiders), for an "antecedent debt," and that the company was "insolvent" when it made the payment. As companies in bankruptcy are almost always insolvent (the statute presumes that companies in bankruptcy are in fact insolvent), establishing payment was for an "antecedent debt" is frequently the only obstacle to forcing repayment.

While "antecedent debt" is a complicated legal concept, for purposes of this article it can be understood to mean, roughly, payment for goods and services previously received by the company. Think of it this way: while the code allows an ailing company to pay its suppliers for the goods and services it will need to allow it to keep doing business, the code disfavors payments made to creditors for goods and services provided previously. However, some payments made in the face of impending bankruptcy are nonetheless permissible under the code, such as contemporaneous transfers made for new value given the debtor company. But beware, this solution is not foolproof: under the code, "new value" does not include an obligation substituted for an existing obligation (i.e., a new severance package substituted for an obligation set out in an underlying employment contract). Congress feared such payments too frequently would be made to preferred insiders and would deprive other equally legitimate creditors of their share of recoverable monies.

The concern for a former executive receiving severance payments - especially if the payments are made pursuant to the terms of an employment contract - is that the severance payments may be construed as payments for an antecedent debt. After all, the executive is not providing goods and services necessary to allow the company to stay afloat. On the contrary, and virtually by definition, the former executive provided services in the past.


III. How to minimize the risk

You can advise you client how to minimize the risk that his or her employer will avoid fulfilling its severance payment obligations in the wake of a bankruptcy filing. You may want consider the following possible strategies:

•  Structure employment compensation differently at the outset by, for instance, negotiating for a larger salary rather than a larger severance package.

•  Plan far ahead -advise clients to leave a company well in advance of a bankruptcy.

•  Negotiate a severance agreement with the aforementioned exception to the preferential transfer statute in mind, e.g., a single lump sum payment made contemporaneously for a release of certain, specific claims against the company.

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