Readers, welcome to the latest installment of our ongoing coverage of the Final Report and Recommendations of the ABI Commission to Study the Reform of Chapter 11.  This post’s topic:  trade creditor and employee priorities (discussed in sections IV.D. and V.E. of the Report).  Although the Bankruptcy Code has a general policy of treating like creditors alike (e.g., unsecured creditors generally recover pari passu), this policy is subject to various exceptions – including several that favor a debtor’s employees and certain trade claimants.  The Commission took a close look at these types of priorities and made several key recommendations, described below. 

Employee Priorities

Sections 507(a)(4) and 507(a)(5)

The Commission focused on several different ways that a debtor’s employees can receive priority claims.  First were sections 507(a)(4) and 507(a)(5) of the Bankruptcy Code (which, respectively, provide priority claim status to certain employee wages and benefits earned during a 180-day period prior to a debtor’s petition, up to a certain calculated threshold).  As background, section 507(a)(4) provides that an employee’s claim for wages and other types of compensation, up to $12,475, will be accorded priority status.  Courts split over whether contributions to employee plans were “wages” for purposes of section 507(a)(4), and therefore priority claims that would count against the dollar-amount limit, and in response Congress enacted section 507(a)(5).  Section 507(a)(5) provides that employee plan contributions are also entitled to priority status, again up to a limit but, in this case, one derived from a more complicated calculation (i.e., the number of employees covered by such plan multiplied by $12,475 less the aggregate amount paid to such employees under section 507(a)(4) and also less the aggregate amount paid by the estate to another benefit plan on behalf of the employees).  While section 507(a)(5) resolved the prior split in the law, the Commission noted that it also created a great deal of confusion for debtors, courts, and employees (among other reasons, because of the complexity of its calculation).  In addition, the Commission noted concerns that, because the cap on section 507(a)(5) claims is reduced by the amount of priority wage claims paid under section 507(a)(4), it could leave employees with too small of a recovery and thus lead to hardship.  To address these issues and simplify the law, the Commission proposed scratching the calculation and instead using a joint cap on wage and benefit plan contribution claims fixed at $25,000 per employee (applied first towards wage and then benefit claims).

The Commission also noted that a lot of paper and ink has been wasted on routinely-granted first day motions seeking permission to pay employee wages and benefits in the ordinary course of business.  The Commission thus recommended streamlining first day practice by revising sections 507(a)(4) and (5) to permit a debtor to pay priority employee wage and benefit claims up to the new limit without court approval (provided that notice of the amounts paid is filed).

Warn Act Claims

The second type of employee claim reviewed was that arising from a violation of the Worker Adjustment and Retraining Notification (or WARN) Act.  In certain circumstances and subject to various defenses, the WARN Act requires employers to provide employees with 60 days’ notice prior to closing a plant or conducting a mass layoff and, if notice is not timely given, creates liability for affected employees’ back pay and benefits for each day that notice had not been timely given (up to the maximum 60 days).

Whether WARN Act claims garner administrative claim status has generally depended on when the triggering event (e.g., the mass layoff) has occurred – if the event occurs after the petition, the WARN Act claims are administrative claims; if it occurs before, they are not.  However, at least one court has held that the relevant date is the date that notice should have been provided (meaning that if an employee was laid off after the petition date, but the required notice was due before the petition date, the WARN Act claim would not be entitled to administrative priority).  Courts have also come down differently on the measure of WARN Act administrative claims, with some granting administrative status to the entire claim and others to only the portion of the claim arising from postpetition days without notice.

In response to the varying decisions, the Commission recommended bright line clarifications of the law on this topic.  The relevant event for determining when WARN Act damages arise should be the loss of employment, and not 60 days earlier when the WARN Act notice should have been given.  Although the WARN Act creates employer liability for each day (up to 60) leading up to a loss of employment where the employer fails to provide proper notice, administrative priority would only be given to claims based on postpetition days where notice is not given.  Claims based on prepetition days where notice has been given would be treated as prepetition claims.

Thus, for example, suppose that a debtor laid off employees 25 days after the petition date, and had given them 15 days’ notice (i.e., notice was provided 10 days after the petition date).  The employer could be liable for WARN Act damages for the 45 days out of the 60 leading up to the layoff for which notice had not been provided.  Of those 45 days, 10 were postpetition and their share of the damages would be accorded administrative priority status.  The remaining days without notice occurred prior to the petition date and would give rise to general unsecured claims.

Severance Benefits

The third type of employee claim addressed were claims for severance benefits, which in some circumstances have been given administrative expense priority pursuant to section 503(b)(1)(A)(i) of the Bankruptcy Code.  One issue the Commission identified was that section 503(b)(1)(A)(i) does not actually mention “severance benefits,” and instead grants a more general administrative priority to the “actual, necessary costs and expenses of preserving the estate.”  In addition, the Commission noted lack of uniformity in the approaches that courts follow when determining the priority status of severance claims.  In some jurisdictions, priority status depends on the type of severance plan at issue; in the Second Circuit, the timing of termination determines the issue (if an employee is terminated after the petition date, he or she is entitled to an administrative claim for severance benefits, if he or she is terminated before – no dice).

Again, the Commission recommended clarifying and streamlining the mix of approaches.  First, the Commission recommended adding “severance benefits” to the text of section 503(b)(1)(A)(i).  Second, and more substantively, the Commission recommended bifurcating severance benefits that are calculated based on length of service between portions that are based on pre- and postpetition service (with only the latter portion receiving administrative claim status).  In doing so the Commission rejected Second Circuit jurisprudence, which views severance payments as benefits that “accrue” when an employee is actually terminated as compensation for job loss – not incrementally day by day as wage- or pension-like compensation.  This was apparently a contentious topic, prompting one commissioner to prepare a dissenting essay included as an appendix to the Report.

Trade Creditor Priorities – Sections 503(b)(9) and 546(c) and the Doctrine of Necessity

The Commission also focused on three different ways that a debtor’s prepetition vendors and trade creditors have been given priority.  The first was section 503(b)(9), which provides administrative claim status for the value of any good received by the debtor in the ordinary course of business during the 20 days prior to the commencement of a case and which has been justified as a way to encourage creditors to continue doing business with a company on the eve of bankruptcy.  The second was section 546(c), which permits creditors to exercise state law rights to reclaim goods delivered during the 45 days prior to commencement (but only if the debtor was insolvent at the time of delivery and certain notice procedures are adhered to).  The third was the age-old “doctrine of necessity,” a common law doctrine that traces back to railroad equity receivership cases and today rears its head when debtors use it in conjunction with section 105(a) to justify paying prepetition claims of “critical vendors” (i.e., vendors who are in some way necessary for the debtor’s ongoing business) to secure their continued business.

Testimony on these priorities was mixed.  Some witnesses suggested the additional administrative claims they fostered (which must be paid in full upon the effective date of a plan) made it harder for a chapter 11 debtor to achieve a reorganization.  Others emphasized the importance of critical vendor payments and other trade creditor priorities, which are used to protect a debtor’s supply of those goods and services that are necessary to support its business, appease creditors who threaten to discontinue supply if they are not paid, and ensure the survival of key vendors dependent on the debtor’s business (and in these ways protect the debtor’s own ongoing business).  These witnesses thus believed that trade creditor priorities foster the reorganization and ongoing viability of debtors’ businesses.

Although the Commission recognized the rationale behind the various vendor priorities, the Report indicated that “each additional administrative or priority claim category undercuts the Bankruptcy Code’s policy of fair and pro rata distributions among similarly situated creditors,” which should be the rule with limited exceptions.  Unsurprisingly, given this policy statement, the Commission recommended a limited scaling back the priority treatment given to a debtor’s vendors.

Specifically, the Commission recommended section 503(b)(9) as the sole remedy for vendors who are eligible for early or priority payment on their prepetition claims.  In the Commission’s view, this relief provided such vendors with sufficient protection and enough of an incentive to continue doing business with the debtor prior to the petition date.  Priority for reclamation rights under section 546(c) would be eliminated.  The Commission also recommended that the doctrine of necessity should not be available for vendor’s claims arising from goods received by a debtor prior to the commencement of its case, as such claims fall within the reach of section 503(b)(9).  Notably, the Commission did recommend the continued application of the doctrine of necessity in scenarios where 503(b)(9) did not apply (namely, for services rendered) and only if more stringent standards were satisfied.  A specific standard was not suggested, but the Commission recommended, for example, that a court should require evidence to establish why a debtor could not obtain a particular service from another source.

Concluding Thought

Overall, the Commission’s recommendations for employee and trade creditor priorities share a general theme of clarifying and streamlining areas of the law that have led to confusion or splits in opinion.  However, on the issue of priority for pre-petition claims, there was a marked contrast:  trade claimants’ priorities were diminished, while priority treatment of employees’ wage and benefit plan contributions were expanded.  Why the difference?  One thing to consider is that the Commission took a sympathetic view of employees, noting that they were the driving force of a business and that, unlike many creditors, they generally depend on their employer for their subsistence and are not well positioned to assess the credit risks of an employer or negotiate for contractual protections.  On the other hand, the Report indicated that “the Commissioners generally understood the potential hardship imposed on certain vendors” by limiting trade creditor priorities, but recognized the view that vendors were not “substantively distinguishable” from other creditors and should therefore be similarly situated.  The different rationales indicate that behind the scenes, the Commission engaged in a careful balancing of policies and entitlements when it decided how to rejigger the priorities.  Importantly, the legislative branch will be responsible for the same balancing act before any of the recommendations become law.  While certain technical changes are unlikely to be controversial, for example doing away with the need for routine first-days for the payment of employee wages, areas involving special-interest priorities have more exposure to the risk that different political or policy views will result in a different set of rules.