Employment Contract, Bankruptcy, and Severance: A complicated situation

A reader poses an interesting question that involves bankruptcy and employment law.  He writes as follows:

The company I work for is a start-up headquartered in California and incorporated in Delaware.  The company is on the verge of running out of money within the next 2-3 months.  It still has close to $2 million in the bank and a burn rate of $1 million per month.  It has been venture funded and some high profile people are on the board.  Existing investors will likely not put new money into the company unless an outside investor joins in the next round.

My employment letter states that I will be given a six month severance if I am removed for no cause.  Where cause is defined as me doing something illegal, or absent or substantially not doing my duties, etc.  Given that we are headed towards running out of money, is the company legally required to reserve money aside to be able to pay my severance before any other debtors are paid?

As with many issues involving the law, the answer is not so simple.  I’m sure you’d like to hear that your employer needs to set aside a severance piggy bank that he handed to you on your last day of work.  But, that’s unlikely to happen if a cash flow crunch results in a bankruptcy filing.

Here’s why.

Just because your employer is running out of money does not necessarily mean they will go belly up.  Even when a company files a petition for bankruptcy, it can do so in one of two ways: under Chapter 11 of the bankruptcy code, or under Chapter 7.  Chapter 11 allows for reorganization.  Chapter 7, on the other hand is liquidation.  Turn off the lights (if the electric company hasn’t already done so).  Shut the doors.  Bye, bye.

Under Chapter 11 reorganization your employer continues to operate, so your severance provision might not get triggered.  Your job might continue without interruption. Or you might get terminated as part of the reorganization.  Then what?

What happens to your severance in terms of priority of payment will depend on the time line of events.  The defining moment is when the filing of the petition in bankruptcy occurs.  Everything gets defined in relation to that date.  Everything else happens either pre-petition, or post-petition.

The other important thing to know is that employment agreements fall into a category called “executory contracts.”  The legal definition of an executor contract according to Black’s Law Dictionary is a “contract under which the obligation of both the bankrupt and the other part to the contract are so far unperformed that failure of either to complete performance would constitute a material breach excusing performance of either.” 

An office lease for example requires continued rent payment and continued availability of the leased premises.  There is continued performance required by both parties.  A lack of performance by either party is the kind of material breach that would justify nonperformance by the other party.  So, a failure to pay rent can mean the premises no longer need to be made available.  A loan, on the other hand, is not an executor contract because the lender has already completed their part of the bargain.  They’ve lent the money.  An employment contract is akin to the office lease example than the loan example.  The employee continues to perform work.  The employer continues to pay.

Within this framework of definitions, your employment contract is a pre-petition executor contract.  In Chapter 11 reorganization the trustee in bankruptcy has the discretion to either assume or reject executory contracts.  They get to exercise their business judgment.  The rejection of a pre-petition executor contract typically gives rise to a pre-petition unsecured claim.

Where does that leave you?

The hierarchy of creditors consists of secured creditors and unsecured creditors.  Secured creditors, for example mortgage lien holders, are the first to receive payment from the bankrupt estate.  However, within the unsecured group there is a further categorization resulting in some unsecured claims being paid ahead of others.  Those that go to the head of that line are called preferred claims and the bankruptcy code sets forth a clear pecking order of priorities. 

At the top of the unsecured list of preferred claims are the post-petition administrative expenses of the bankrupt estate.  Next are certain claims arising during an involuntary bankruptcy, and then comes your pre-petition severance claim.

The payment priority of a severance claim can be higher, if for example, as part of the reorganization the contract is affirmed and then severance is triggered post-petition.  In that example post-petition severance might get included in post-petition administrative expenses, placing the claim at the very top of the unsecured creditor list.

Please keep in mind that this area of the law is very complex.  I don’t want to over simplify it.  There are more factors to consider than we have room to discuss and more facts that need to be evaluated than you have provided, or have yet occurred.

In terms of cash flow, the sad reality with any bankruptcy proceeding is that the distribution of payment of any claims does not occur until after the case is over.  The trustee in bankruptcy’s first task is to return as many assets to the bankrupt estate as possible so that there is a larger pool of money available for distribution.  Then they figure out who gets what and in what order, and of course how much.

Ultimately, there is no guarantee that you’ll be paid everything you think you’re owed if the severance provision is triggered.  I suggest you discuss your situation in more detail with a bankruptcy specialist in your area.