In Henderson v. Powermate Holding Corp. (In re Powermate Holding Corp.)1, the United States Bankruptcy Court for the District of Delaware became the second bankruptcy court to address the status of WARN Act claims after the 2005 amendments to section 503 of the Bankruptcy Code. The Bankruptcy Court in Powermate declined to grant administrative expense priority to the WARN Act claims of the debtors’ former employees, reasoning that these claims vested at the time the employees were terminated, prior to commencement of the bankruptcy proceeding, and, therefore, the claims did not merit administrative priority.

Background

Powermate Holding Corp. and certain of its affiliates (collectively, the “Debtors”) filed voluntary petitions for chapter 11 relief on March 17, 2008. Earlier that month, Powermate had closed one of its plants. On March 17, before filing its petitions, and without prior notice to its employees, Powermate discharged the remainder of its workers. On April 3, 2008, the discharged employees filed an adversary complaint in the Powermate bankruptcy, alleging that their termination had violated the Worker Adjustment and Retraining Notification Act (“WARN Act”).2

Under the WARN Act, employees are entitled to at least 60 days’ notice of a potential termination. When an employer fails to give this notice, the terminated employees may be entitled to back pay and benefits for up to the full 60-day notice period. The WARN Act provides exceptions to the notice requirement where, for example, the terminations are due to shutdowns that were not reasonably foreseeable, natural disasters, or where notice would interfere with the employer’s attempts to obtain capital investments that would have prevented the terminations.

The former Powermate employees claimed that, because they were terminated as “part of a mass layoff and/or plant closing,” they were entitled to 60 days of wages, ERISA, and other benefits, and that these claims should be granted administrative status priority under the Bankruptcy Code. Administrative expense claims are governed by section 503 of the Bankruptcy Code, and are given second priority under section 507(a)(2), requiring them to be paid ahead of most other claims against a debtor’s bankruptcy estate.

The Debtors, in their answer and motion to dismiss, responded that, even if the Bankruptcy Court concluded that the employees’ terminations had violated the WARN Act, the employees’ claims were entitled to, at most, fourth or fifth priority status under sections 507(a)(4) and (5), and not second priority under section 507(a)(2). The Debtors also disputed WARN Act liability, arguing that they were excepted from the obligation to give notice because of unforeseen business circumstances and because they were actively seeking capital in the 60-day period prior to the terminations.

Ripeness

As a threshold matter, the Bankruptcy Court determined that priority of the employee WARN Act claims was ripe for adjudication, even though the Court had yet to find the Debtors liable for WARN Act violations. The Court concluded that it was appropriate to consider priority before liability because the issue was purely legal, requiring only interpretation of the Bankruptcy Code, and because the facts were not in dispute. Additionally, the Court pointed out that the Debtors admitted several allegations implicating WARN Act liability, and that failure to give any notice whatsoever often rendered the “faltering business” or “unforeseen circumstances” defenses to WARN Act liability unavailable. Finally, the Bankruptcy Court noted that the Debtors’ ability to develop a plan of reorganization and negotiate with creditors could be frustrated if the status of the WARN Act claims was left undetermined.

Analysis

In 2005, Congress revised the Bankruptcy Code and added a new provision to section 503(b) which provides administrative priority to certain post-petition employee wage and benefit claims, specifically those

wages and benefits awarded pursuant to a judicial proceeding . . . as back pay attributable to any period of time occurring after the commencement of the case under this title, as a result of the violation of Federal or State law by the debtor, without regard to the time of the occurrence of unlawful conduct on which such award is based or to whether any services were rendered. . . .3

11 U.S.C. § 503(b)(1)(A)(i). Employee claims for wages earned before commencement of an employer’s bankruptcy case are governed by sections 507(a)(4)-(5) of the Bankruptcy Code, which grant fourth priority to such claims, cap individual recovery at $10,950, and require that the claim be “earned” within the 180 days before the debtor-employer filed its bankruptcy petition. Any amount exceeding the $10,950 cap is a general unsecured claim.

For the Bankruptcy Court, the key issue to be determined was when WARN Act damages are effectively “earned.” The court stated that if the WARN Act damages vest or accrue prepetition, then the “back pay” referred to in section 503(b) is attributed to the time before commencement of the bankruptcy case. On the other hand, if the WARN Act damages vest or accrue post-petition, then the “back pay” is attributable to the period after the case. Only in the latter situation would a claim based on the WARN Act damages be entitled to administrative priority.

To assess when WARN Act damage claims vest, and, therefore, their priority, the Bankruptcy Court compared them to claims for severance pay, based on the Court’s conclusion that “‘the purpose of WARN is to provide a statutory form of severance pay.’”4 In the Third Circuit, bankruptcy courts recognize two forms of severance pay: payment at termination in lieu of notice, and payment at termination based on length of employment. Claims for severance pay are granted administrative priority only to the extent that they are based on post-petition services. Payment at termination in lieu of notice “vests at the time of termination because it is based solely on lack of notice” and “the entirety of such a claim becomes an administrative expense claim in a post-petition discharge.”5 If the termination is pre-petition, the severance claim does not qualify for priority status.

The Bankruptcy Court determined that WARN Act damages are “specifically like termination in lieu of notice” and, therefore, the right to such damages vests entirely upon termination. Because the Powermate employees were terminated pre-petition, their WARN Act claims vested or accrued before the commencement of the debtors’ cases. Refuting both parties’ arguments, the Bankruptcy Court found it irrelevant whether the back pay was due for the time prior to termination or following it. WARN Act claims, the Court pointed out, “cannot be divided by the petition date, they are either entirely completely administrative expense (if the claims vest post-petition) or wage priority claims (if the claims vest pre-petition).”6 The “going forward or relating back analyses”7 would be pertinent only if the applicable statute or decision provided that wage claims vest on a daily basis, which the WARN Act does not do.

The Bankruptcy Court also noted that the introduction of section 503(b)(1)(A)(ii) to the Bankruptcy Code does not represent a “sea change” for WARN Act damage claims. Prior to the 2005 amendments to the Bankruptcy Code, courts consistently held that claims for WARN Act damages resulting from pre-petition terminations received only fourth or fifth level priority status because administrative priority was reserved for services “rendered” post-petition. The Bankruptcy Court theorized that if Congress had intended to award administrative expense priority to such claims – a change that could dramatically increase the value of wage claims and would “effectively cripple”8 many debtors’ ability to reorganize – there would be at least some legislative history to that effect. Instead, the record is entirely silent. The absence of legislative history supports the Court’s conclusion that wage claims should receive administrative expense priority only where services are actually “rendered” postpetition and have actively benefited the bankruptcy estate.

Conclusion

Powermate is one of only two bankruptcy court decisions to date that analyze the status of WARN Act claims after the 2005 amendments to the Bankruptcy Code and the introduction of section 503(b)(1)(A)(ii). The other case to address the issue, In re First Magnus Financial Corp.,9 reached the same conclusion by applying a slightly different analysis to the text of the new provision.

Although the holding of Powermate makes clear that a company is better off terminating employees pre-petition, the issue remains as to whether the alarm bells of distress signaled by these terminations foreclose the possibility of the company altogether averting a bankruptcy filing. In light of the Powermate decision, the desire to avoid bankruptcy should be balanced against the substantial advantage that can be gained when a company is relieved of significant administrative claims for WARN Act damages. This will be a slippery slope for debtors seeking economic survival in increasingly challenging financial circumstances.