Among other strategic considerations a financially troubled company must grapple with as it prepares for a potential bankruptcy filing is how best to effectively implement necessary workforce reductions as part of its overall reorganization efforts. A workforce reduction could potentially give rise to severance and other employee obligations, and, under certain circumstances, could also give rise to significant WARN Act claims. Understanding and appropriately planning for these kinds of claims is important, especially because employee-related claims earned within the 180-day period preceding the bankruptcy filing are generally entitled to priority under section 507(a)(4) of the Bankruptcy Code up to $12,850 (subject to periodic adjustment) per individual employee. As with all priority claims, these kinds of employee claims must be paid in full before any general unsecured claims can be paid in order for a plan of reorganization or liquidation to be capable of confirmation under section 1129 of the Bankruptcy Code.

In In re ADI Liquidation, Inc. (f/k/a AWI Delaware, Inc.), et al., Docket No. 3772, Case No. 14-12092, United States Bankruptcy Court for the District of Delaware, Bankruptcy Judge Kevin Carey addressed the issue of priority for severance claims resulting from a termination without cause during the 180-day priority period for employee claims. Judge Carey ruled that when severance pay is owed as a result of a termination without cause, the employee’s right to receive severance payments was earned not earlier than upon the employee’s termination.

The employee in Adi Liquidation was a manager who had been terminated one month prior to the company commencing a chapter 11 case. The Debtors had a severance policy in place under which employees would earn one week of severance pay as they completed a year of service on the anniversary date of their employment. Under this policy, the employee had earned fifteen weeks of severance pay on account of his service. The Debtors had paid nine weeks of severance pay prior to the petition date, and agreed that another approximately $8,600 remain unpaid. The manager filed a timely claim for the unpaid severance pay asserting, among other things, priority status under section 507(a)(4) of the Bankruptcy Code. The Debtors objected to the claim arguing that, because the manager earned only one week of severance pay as he completed a year of service and only one year of service was completed during the priority period, only one week of severance pay was entitled to priority under the statute. The Debtors had already paid nine weeks of severance pay prepetition. As such, the Debtors argued that they had already paid in full more than what was entitled to priority and that the remainder of the severance pay was only a general unsecured claim. The Court disagreed.

Judge Carey noted that many bankruptcy courts have viewed severance pay as being similar to vacation pay, which is earned over the course of an employee’s employment and that, since severance pay is a component of compensation, only that portion of severance pay attributable to the preference period is entitled to priority status. However, Judge Carey noted that he had previously considered the underlying issue here in a prior opinion he issued in 2006 and had held that, for purposes of determining priority status for employee severance claims, the specific event or circumstance triggering the employee’s right to receive the severance payment is what matters. In particular, Judge Carey focused on the distinction between when an employee becomes eligible for severance pay and when an employee actually earns the right to receive the severance pay itself. An employee may become eligible to receive severance payments over a period of years. However, that employee only becomes entitled to receive the severance payments upon being terminated without cause. Where such termination occurs during the 180-day priority window, Judge Carey would grant priority status to the entire severance pay obligation triggered by the termination (up to the statutory cap) rather than granting priority status to only that limited portion of severance payments corresponding to the period of time the employee worked during the 180-day priority period.

Although subject to a relatively low cap under section 507(a)(4) of the Bankruptcy Code, the potential exposure could be significant depending upon the number of employees at issue and the availability of unencumbered assets to pay priority claims in any given case. If, for example, a debtor sells all of its assets in through a section 363 sale in exchange for a credit bid, with no cash proceeds being generated, the debtor may find itself unable to confirm a liquidating plan unless it has sufficient unencumbered assets available from other sources to satisfy priority claims. A financially distressed company and its advisors must be mindful that if a plan is to be confirmed, all priority claims must be paid in full – plain and simple. It is a matter of priority.