The United States Bankruptcy Court for the Southern District of New York has held that a severance payment made to an executive who worked for both Enron Corp. (“Enron”) and various affiliates of Enron prior to Enron’s filing for bankruptcy was a preferential transfer that could be avoided by the Official Committee of Unsecured Creditors (the “Committee”).1 In reaching this conclusion, the Bankruptcy Court rejected the argument that the severance payment was an “ordinary course” transaction that was protected from avoidance. The Bankruptcy Court also dismissed various claims by the executive against Enron and its affiliates regarding breach of contract and fraud. The Court left open the possibility, however, that the executive could assert her claims against an affiliate of Enron, by whom she had previously been employed.

The Bankruptcy Court’s ruling has implications for companies with numerous subsidiaries which seek to make severance payments to executives on the eve of bankruptcy, as well as for the executives who stand to receive those payments.

Enron Facts

In 1991, Amanda K. Martin (“Martin”) began to work for an affiliate of Enron called Enron Gas Services Co., and, subsequently, for the affiliate’s successor entity, Enron Capital and Trade Resources Corp. (“ECT”). On June 1, 1998, Martin entered into an executive employment agreement (as amended, the “Employment Agreement”) with ECT which provided that the “[e]mployer may assign [the Employment] Agreement and [Martin’s] employment to [Enron] or any affiliates of [Enron]. . . .”2

In 1998, Martin joined Azurix Corp. (“Azurix”), a company formed as an affiliate of Enron, as Executive Director and President of the Americas. ECT, Azurix and Martin then executed two amendments to the Employment Agreement, one of which assigned the Employment Agreement to Azurix, which assumed it. Under the Employment Agreement, in the event Martin was involuntarily terminated, she would be entitled to her monthly salary for the remaining term of the Employment Agreement to be paid on a semi-monthly basis and any bonuses on an annual basis.

In 2000, Azurix North America Corp. (“ANA”) and Azurix Industrial Corporation (“AIC”), two of Azurix’s subsidiaries, were sold to American Water Services, Inc. (“AWS”).3 Martin was an officer of both ANA and AIC prior to the closing of the sale (at which time she resigned both positions), but did not receive any compensation directly from either one.

Following the sale of its subsidiaries, Azurix began to wind down its operations. As part of the cost-saving efforts during its wind-down, certain of Azurix’s employees, including Martin, were moved onto Enron’s payroll system and began drawing salaries from Enron. In connection with this move, Enron issued a W-2 to Martin. Azurix was to reimburse Enron for payroll expenses for these employees and it did so in some cases; however, Enron maintained that its business records did not reflect that payments to Martin had ever been reimbursed by Azurix.

In August 2001, Martin began negotiating an employment termination agreement with Enron’s CEO (who had not held any position at Azurix for several months prior to the commencement of the negotiations, and had not been an officer or director of either ANA or AIC). On October 22, 2001, Enron’s Vice President of Executive Compensation (the “VP”) executed the agreement (the “Separation Agreement”). The introductory paragraph of the Separation Agreement states that the agreement is between “Enron Corp. and its affiliates” – which grouping is defined as “Company” – and Martin. The Separation Agreement was signed by only Martin and the VP. 4

Pursuant to the Separation Agreement, Martin was to receive $2,817,000 (the “Separation Payment”) within 30 days of execution of the Separation Agreement.5 In addition, in consideration for signing the Separation Agreement, a payment of $500,000 dollars was due to Martin within six months of Martin’s execution of the agreement (which would have been on or about April 22, 2002).6 The Separation Agreement was intended to resolve any obligations owed to Martin under the Employment Agreement and contained a release by Martin of all future claims against Enron, its subsidiaries and affiliates. The Separation Agreement provided that Martin’s termination of employment would be effective January 31, 2002.

Seventeen days before Enron filed for bankruptcy protection, Enron made the Separation Payment to Martin.

Enron Procedural History and Arguments

On December 1, 2003, the Committee, acting on behalf of the Enron bankruptcy estate, filed a complaint to avoid the Separation Payment on the ground that the payment was a preference or fraudulent conveyance.7 Martin responded raising several defenses, and asserted counterclaims against Enron, and third-party claims against Azurix and AWS (as successor to ANA), for breach of contract and fraud.8

The Committee alleged that the Separation Payment to Martin was a preference under section 547(b) of the Bankruptcy Code. That section provides generally that a transfer can be avoided if it is a transfer of an interest of the debtor in property (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before the transfer was made; (3) made while the debtor was insolvent; (4) made on or within 90 days before the date of the filing of the petition; and (5) that enables the creditor to receive more than the creditor would have received if (A) the case were a case under chapter 7; (B) the transfer had not been made; and (C) the creditor received payment of the debt in accordance with the Bankruptcy Code.

Even if a transfer is a preference under section 547(b), however, there are certain defenses that can be raised. One of those defenses is that the transfer was made in the ordinary course of business. Specifically, the transfer may not be avoided as a preference if the transfer was (A) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee; (B) made in the ordinary course of business or financial affairs of the debtor and the transferee; and (C) made according to ordinary business terms.9 The first two elements of this defense are subjective inquiries, looking at the parties’ own prior dealings that gave rise to the debt and whether the payment is ordinary in relation to other business dealings between those parties. The third element is an objective inquiry, considering whether the payment is ordinary from the perspective of the industry.

Martin asserted that the Separation Payment was not a transfer “of an interest of the debtor in property.” Martin conceded that the Separation Payment came from Enron, but argued that Enron did not have a beneficial interest in the funds transferred because Azurix reimbursed Enron for the transferred funds. Martin contended that she was an Azurix employee and her payments were issued by Enron only because she was transferred to a “work order” number for Enron for the purpose of obtaining certain benefits. Specifically, Martin asserted that Enron and Azurix were parties to a cost-sharing agreement whereby Enron would service the payroll of employees performing services for Azurix, and Azurix would reimburse Enron for these payments, and that because the Separation Payment made to her was reimbursed by Azurix, Enron’s estate was not depleted. Thus, Martin never became an employee of Enron after the sale of the Azurix subsidiaries.

In response, Enron contended that Martin became an Enron employee in approximately June 2001 when she began drawing her salary from Enron. Enron asserted that Azurix did not reimburse Enron for the Separation Payment made to Martin, and provided testimonial and documentary evidence to support its argument that the Separation Payment was not reimbursed. The Managing Director and Chief Administrative Officer of Enron testified (i) he reviewed Enron’s accounting records and these showed that the transfer was made by Enron; (ii) he reviewed Enron’s general ledger account from its computer accounting system and its payroll report and neither reflected any reimbursement from Azurix to Enron for payroll expenses related to payments made to Martin; and (iii) he had a Separation Payment report created by Enron’s accounting department which reflected that while Enron made the Separation Payment, it was not reimbursed by Azurix.

Martin also argued that, even if the Separation Payment was a preference, it was insulated from avoidance because it was made in the ordinary course of business.10 Martin raised several arguments in this regard, including that the Separation Payment was consistent with other transactions between Enron and its affiliates, consistent with payments to and agreements with other Enron executives, and consistent with other severance agreements entered into by other executives in the industry. Martin contended that her arguments raised fact issues not properly decided on summary judgment.

 In contrast, Enron argued that the ordinary course defense was not available to Martin because the Separation Payment was not the kind of transaction section 547(c)(2) of the Bankruptcy Code was created to protect. Enron claimed that section 547(c)(2) was not intended to cover one-time payments in settlement of contract claims or to severance payments to outgoing officers. Nevertheless, even if section 547(c)(2) was available to Martin as a defense, Enron argued that it was not applicable to this case. First, it was unusual that Enron incurred the obligation to Martin at all, given that she became an Enron employee in 2001, with no formal duties at Enron, while still providing services to Azurix. Martin continued to work at the company for over two months after receipt of the Separation Payment. Further, Enron alleged that Martin received a much higher amount than that to which she was entitled. Moreover, her agreement was negotiated with Enron’s CEO, even though it was Azurix that was ostensibly obligated to her (and thus, the Separation Payment conferred no benefit on Enron, as it had no obligation to Martin). Enron also contended that allowing evidence of payment to other executives as evidence of an ordinary course transaction would subvert the purpose of preference law.

After completing fact discovery, the Committee moved for summary judgment in its favor on (i) Enron’s claim that its transfer of the Separation Payment was an avoidable preference, (ii) Martin’s counterclaims against Enron, and (iii) Martin’s third-party complaint against Azurix. AWS also moved for summary judgment in its favor concerning Martin’s third-party complaint against it. Martin moved for summary judgment in her favor against Azurix on her claims that the Employment Agreement was breached, and a declaratory judgment that, if there were a determination that she must return the $2.8 million Separation Payment to Enron as a preference, Azurix was liable for that amount, or, alternatively, if the Court were to find that Azurix was not a party to the Separation Agreement, Martin would be entitled to summary judgment against Azurix pursuant to the terms of the Employment Agreement.

Enron Court’s Analysis Preferential Transfer

Whether the Separation Payment was a preference turned on whether the payment was a transfer of an interest of Enron in property. In considering this issue, the Bankruptcy Court focused on the testimonial and documentary evidence that established that Enron was not reimbursed by Azurix for making the Separation Payment to Martin. The Bankruptcy Court accepted into evidence Enron’s accounting records that showed that the transfer was made by Enron; Enron’s general ledger account and payroll report that did not show any reimbursement from Azurix to Enron for payroll expenses related to payments made to Martin; and the Separation Payment report showing that while Enron made the Separation Payment, it was not reimbursed by Azurix. Because Enron was not reimbursed for the Separation Payment, the Bankruptcy Court found that the Committee had satisfied its burden of proving that the Separation Payment to Martin was a transfer of Enron’s property.

The Bankruptcy Court then considered Martin’s argument that even if the Separation Payment was a preference, it could not be avoided because the payment was made in the ordinary course of business. The Bankruptcy Court’s analysis began with the principle that section 547(c)(2) of the Bankruptcy Code was intended to protect recurring, customary trade transactions. Certain courts have refused to apply this defense to a single transaction between a creditor and debtor, while other courts have found that a first-time or one-time transaction may qualify as an ordinary course of business exception to a preference recovery.

The Bankruptcy Court noted that a severance package is generally a one-time event with a particular employee. The Bankruptcy Court reasoned there was obviously no prior course of dealing between Enron and Martin concerning the Separation Payment, and a requirement for a prior course of dealing between the parties would preclude application of the defense. It further reasoned that, for the defense to apply to a “first-time” transfer, the transfer should be of a type that could have been a recurring, customary trade transaction had the parties continued their business relationship. The agreement at issue, the Separation Agreement, was not a simple debt repayment arrangement, but, instead, was a complex integrated agreement. The Court concluded that a payment made as part of a global settlement resolving myriad issues could not be incurred or made in the debtor’s ordinary course of business.

The Bankruptcy Court then considered how Martin’s contention that she was not an Enron employee but rather was employed by Azurix would apply to her potential ordinary course defense. The Court concluded that if this argument was accepted, the transfer was part of an overall transaction that was even more extraordinary: it would not be in the ordinary course of business for Enron to represent itself as Martin’s employer to the IRS if Azurix was in fact her employer. Further, the Court reasoned, even if it were shown that Enron ordinarily transacted its business in this manner, it would not be ordinary business practice within the industry for an employer to make salary and severance payments and represent itself as the recipient’s employer if it were not.

Thus, the Bankruptcy Court found that the Separation Payment was not in the ordinary course of business of Enron. Accordingly, the Separation Payment did not qualify as an ordinary course payment, Martin could not avail herself of the ordinary course defense, and the Separation Payment could be avoided pursuant to section 547(b) of the Bankruptcy Code.

Other Claims

Martin asserted various counterclaims against Enron, including breach of the Separation Agreement because Enron never made the $500,000 payment due under the agreement, and fraudulent misrepresentation because Enron represented to Martin that she would be entitled to the payments under the Separation Agreement. The Bankruptcy Court ultimately concluded that the Committee was entitled to summary judgment in its favor on Martin’s claims alleging fraudulent misrepresentation and breach of contract against Enron, because it was the application of the Bankruptcy Code, and not Enron’s actions, that caused Enron to miss its payment obligation and to seek to recover the Separation Payment as a preference. 11 The Bankruptcy Court suggested that, once Martin returned the preferential Separation Payment, she could assert a section 502(h) claim for the Separation Payment; but she had waived her opportunity to assert the $500,000 claim against the Enron bankruptcy estate by not filing a proof of claim for the amount by the bar date established in Enron’s cases.

Martin also asserted third-party claims against Azurix and AWS for breach of the Separation Agreement and fraudulent misrepresentation. With respect to her third-party claims against AWS, as successor to ANA, for breach of contract, the Bankruptcy Court concluded that AWS, as successor entity to ANA, was not obligated under the Separation Agreement. The Bankruptcy Court also concluded that there was no basis for the fraud allegation against Azurix. Nevertheless, there were factual issues in dispute as to whether Martin was an employee of Enron or Azurix and whether there was apparent authority for Enron to negotiate the Separation Agreement on behalf of Azurix. Therefore, the Bankruptcy Court denied the requests for summary judgment concerning Martin’s breach of contract claim against Azurix. The Bankruptcy Court also provided the parties with additional time to brief the issue of whether, if the Court were to determine that Azurix were liable for the Separation Payment, summary judgment on the breach of contract claim concerning the $2.8 million payment was appropriate.

Reconsideration

On November 20, 2007, the Bankruptcy Court issued an opinion denying motions for reconsideration filed by both Martin and the Committee.

Conclusion

The Bankruptcy Court’s ruling raises issues relating to severance payments and other separation benefits made to executives by distressed companies where the executive has worked at or holds titles at multiple affiliates. The Bankruptcy Court’s ruling requires a factintensive inquiry to determine which of the entities may have liability for the severance payments. The ruling also casts doubt on whether a severance payment could ever constitute a payment in the “ordinary course” so as to withstand attack as a preferential transfer.

The Bankruptcy Court, however, did not rule definitively on all claims asserted by Martin, leaving open the possibility that an affiliate of Enron may be liable for the payments under the Separation Agreement. Subsequent history in this case should reveal whether Martin receives only a pre-petition claim against the estate of Enron, or whether she is able to pursue her claims against Azurix on the ground that that entity was her true employer.