Inside: Your executive employment agreement in bankruptcy

The Bankruptcy Code has certain limitations on executive compensation, and here's what you can do about it

Congratulations! You are in the prime of your career. You are a senior executive at a well-respected company. You have successfully negotiated and executed an employment agreement that rewards you for your impressive skills, years of experience, and high demand in the marketplace. Although your company is not performing particularly well right now, you believe things will improve and that, in any event, you have protection through severance provisions triggered upon any termination of your employment or change of control of the company. Life is good, and you sleep well at night.

But, suppose your company doesn’t turn around and is forced to file for bankruptcy. Will you have the protections you think you have? Should you really be sleeping that well at night?

Naturally, the answers to these questions depend upon many factors, but the analysis starts by recognizing that senior executive benefits are highly scrutinized in bankruptcy, including under certain Bankruptcy Code provisions that were enacted to prevent what Congress viewed as excessive payments to Chapter 11 corporate insiders in the early 2000s. Thus, in the event of bankruptcy, you might recover only a small fraction of the total benefits owed to you.

Executives are often surprised to learn of these limitations, which can arise in a number of different ways, including in the form of onerous pre-conditions to, or a strict cap on, certain types of executive compensation. These limitations also can involve a bar on administrative priority, meaning the executive’s compensation claims are sent to the end of the payment line (sharing pari passu with other general unsecured claims, just ahead of equity). For example:

All severance claims are limited to a single year of benefits. Section 502(b)(7) of the Bankruptcy Code limits total severance claims to a single year of compensation, measured from the date of the bankruptcy filing or the date of termination, whichever comes earlier. Thus, for example, an executive who is otherwise entitled to 18 months of severance benefits would lose at least six months of benefits the moment the company filed for bankruptcy. And if terminated before the filing, any severance benefits already received by the executive as of the filing would count against the one-year cap, potentially wiping out the remaining severance claim entirely.

No insider severance if no rank-and-file severance. Section 503(c)(2) of the Bankruptcy Code prohibits administrative priority for severance claims of “insiders” (e.g., senior executives, like you) if the company does not provide a severance program for rank-and-file employees. Thus, for example, if a collective bargaining agreement does not include severance benefits for the company’s unionized workforce, executives will not get administrative priority for their own severance claims. Instead, those claims would be treated like any other general unsecured claim, which might ultimately receive only pennies on the dollar.

Limits to administrative priority for executive severance. Even if rank-and-file employees are entitled to severance (thus, permitting administrative priority for executive severance claims), Section 503(c)(2) of the Bankruptcy Code limits such claims to 10 times the amount of the mean severance pay received by non-management employees during the same calendar year. Thus, if hourly employees received only minimal severance benefits during the calendar year (say, for example, an average of four weeks or less of benefits), senior executives likely would be entitled to administrative priority for only a small portion of their total severance claims.

No executive retention payments. In theory, Section 503(c)(1) of the Bankruptcy Code permits administrative priority for retention incentive payments owed to insiders (i.e. payments designed to induce the insider to remain with the company for a specified period of time). In practice, however, pure retention payments have been largely eliminated because the statute imposes near-impossible prerequisites and severe limits on payments even if the prerequisites are somehow met. Thus, prepetition retention agreements with executives often get replaced by post-petition incentive programs that are primarily designed to reward executives for achieving specified performance goals — not for simply remaining with the company.

Unfortunately for the executive, these limitations apply even when the bankrupt company assumes the prepetition employment agreement. Moreover, if the executive is fired before the company heads into bankruptcy, the employment agreement may no longer even be capable of assumption and, in any event, would be subject to immediate rejection.

Even worse, any pre-bankruptcy severance payments received by the executive could be subject to avoidance and disgorgement as a “preference” under Section 547 of the Bankruptcy Code.

So, how can executives protect themselves? Here are several options:

Avoid “severance” claims. Because many of these limitations apply only to “severance” claims, executives might consider bargaining for other, non-“severance” benefits. Such benefits might include post-termination payments to the executive in exchange for a release of certain claims or to compensate the executive for continuing obligations related to confidentiality, non-competition, non-solicitation, and/or non-disparagement — all of which should be described as “material terms” of the agreement.

Preserve “executory” status. Contracts that are not “executory” cannot give rise to administrative priority claims. Therefore, a terminated executive’s only hope for administrative priority is through an “executory” contract, which generally requires continuing material obligations on both sides of the agreement (which would include continuing obligations related to confidentiality, non-competition, non-solicitation, etc.). To the extent these obligations are at all important to the company, the executive may be able to negotiate assumption of the agreement (even if on modified terms). But, even if the debtor ultimately rejects the employment agreement, the executive can at least argue for administrative priority for potentially significant claims that arise before rejection.

Sidestep avoidance issues. A terminated executive who receives irregular severance payments preceding a bankruptcy filing may be particularly vulnerable to creditor efforts to disgorge those payments as “preferences” under Section 547 of the Bankruptcy Code. The executive can eliminate this issue altogether by receiving a single, lump sum payment as part of a contemporaneous exchange of equal value (which is an express statutory defense to preference actions). That contemporaneous exchange could involve, for example, a release of certain claims or some other similar consideration that would effectively immunize the executive from future disgorgement efforts.

Be prepared to work strictly for performance. If the company has not already terminated the executive as of the filing and wants him to work during the bankruptcy, compensation will be based on market rates and the executive’s anticipated contributions to the estate — all regardless of what any existing employment contract calls for. The court will place great weight on creditor opinions regarding any changes to the executive’s compensation package. And any proposed bonuses must be based on specific, measurable milestones approved by the bankruptcy court. Because the executive will not get paid for merely punching the clock, he should be prepared to roll up his sleeves and show his contribution to creditor recoveries.

Strategize now. Finally, investing a little time now to plan for potential future disaster could pay huge dividends. A bankruptcy expert in these matters can help you negotiate (or re-negotiate) appropriate terms and a proper compensation structure to ensure that you actually receive your bargained-for compensation in bankruptcy.

Contributing Author

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Nicholas M. Miller

Nicholas M. Miller is a partner and bankruptcy attorney at Neal, Gerber & Eisenberg LLP (Chicago). He  has substantial experience in general insolvency matters and...

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