In a decision filed on July 6, 2011, the Fourth Circuit held that former employees of a debtor "earned" their severance compensation "on the date they became participants in the debtor’s severance plan immediately after their termination from employment" rather than over the course of their employment, as argued by the trustee. Matson v. Alarcon, 2011 WL 2624437 at *1, 2011 U.S. App. LEXIS 13729 (4th Cir. July 6, 2011). This memorandum outlines the case and the practical implications for clients facing potential severance compensation claims.
Section 507(a)(4) of the Bankruptcy Code establishes priority for "allowed unsecured claims, but only to the extent of $10,950 [presently $11,725] for each individual . . . earned within 180 days before the date of the filing of the petition . . . for (A) wages, salaries, or commissions, including vacation, severance, and sick leave pay earned by an individual." 11 U.S.C. § 507(a)(4). The issue raised here is how and when an individual earns severance pay for purposes of § 507(a)(4).
LandAmerica Financial Group, Inc. (LandAmerica) filed its bankruptcy petition on November 26, 2008. LandAmerica established a severance benefit plan in April 2004 that entitled employees to receive compensation equal to their weekly salary for a certain number of weeks, based on the employee’s length of service to LandAmerica. For example, an employee who worked for more than one year but less than two years received two weeks’ pay, while an employee who worked for eight years received six weeks’ pay.
LandAmerica terminated Diego Alarcon and 124 other claimants (together, the "claimants") in the 180 days before filing for bankruptcy. The claimants filed proofs of claim and asserted that their severance claims were entitled to priority treatment up to the statutory maximum provided in 11 U.S.C. § 507(a)(4). The LandAmerica Trustee objected to the priority treatment of the severance claims, arguing that severance was "earned" over the entire course of employment and that only the amount of severance "earned" during the pre-petition period was entitled to priority treatment. For example, according to the trustee, an employee who worked a total of 437 weeks (more than eight years, entitled to $8,500 of severance), 22 of which were during the pre-petition period, was entitled to receive priority treatment only for the severance that represented the 22 pre-petition weeks out of the 437 total weeks (5.03%) or $429.31.
The bankruptcy court noted that the trustee’s calculation results in terminated employees who worked many years at the company will receive a much smaller percentage of their severance package as a priority payment than will employees who worked for only a short period of time. The bankruptcy court called this result "absurd" and held that severance pay is earned on the date of termination. In re LandAmerica Fin. Group, Inc., 2010 WL 2803808 at *3, *7 (Bankr.E.D.Va. July 14, 2010). The severance claims remained entitled to priority treatment for each claimant up to the statutory cap.
The Fourth Circuit affirmed the bankruptcy court upon de novo review of disputed statutory terms. First, the Fourth Circuit concluded that the ordinary meaning intended by its use in § 507(a)(4) of "to earn" means "to come to be duly worthy of or entitled," Webster’s Third New International Dictionary 714 (2002), and that "triggering events permitting employees to receive wages, salaries, and commissions generally lie within the employees’ control upon performance of their work, subject to the terms of the employment agreement." Slip. Op. at 8-9. The Fourth Circuit next defined "severance pay" as "’an allowance usually based on length of service that is payable to an employee’ upon termination without cause" for the purpose of alleviating the consequent need for economic readjustment and recompensating the employee for losses attributable to the dismissal. Slip. Op. at 9 (quoting Webster’s Third New International Dictionary 2081 (2002). In contrast to wages, the triggering events allowing employees to receive severance pay lie within the employer’s control, i.e. the decision to provide severance compensation and the decision to terminate the employee. Therefore, the court concluded, "an employee ‘earns’ the full amount of ‘severance pay’ on the date the employee becomes entitled to receive such compensation, subject to satisfaction of the contingencies provided in the applicable severance compensation plan." Slip. Op. at 10. Thus, the purpose of severance compensation and the plain terms of the statute dictated that the claimants earned severance compensation when they became participants in the severance benefit plan upon termination and their signing a severance agreement and release.
The trustee’s argument was largely based on cases addressing administrative expense claims for severance compensation under 11 U.S.C. § 503(b)(1)(A) and holding that "severance pay based on length of employment is earned over the entire term of the employee’s tenure." In re Fleming Packaging Corp., 2004 Bankr.LEXIS 1384, at *8, 2004 WL 2106579 (Bankr. C.D. Ill. Aug. 31, 2004); see In re Roth American, Inc., 975 F.2d 949, 957 (3d Cir. 1992); In re Yarn Liquidation, Inc., 217 B.R. 544, 546 (Bankr. E.D. Tenn. 1997). In these cases, in order to calculate the amount of severance pay entitled to administrative expense treatment, courts use a formula much like the one proposed by the trustee here. The Second Circuit, on the other hand, treats all severance pay, even severance pay claimed as an administrative expense, as earned on the date of termination. See Matter of Staus-Duparquet, Inc., 386 F.2d 649, 651 (2d Cir. 1967). But the Fourth Circuit, like the bankruptcy court below, noted that § 503(b)(1)(A) and § 507(a)(4) are "materially different." Slip. Op. at 11. Section 503(b)(1)(A) requires a calculation of the value of "services rendered" in a period of time after a debtor files its bankruptcy petition and does not use the word "earned" or specifically include "severance pay" as a form of compensation.
The Fourth Circuit affirmed the bankruptcy court’s holding that severance claims are entitled to priority treatment up to the maximum amount provided by § 507(a)(4). Although this holding makes conceptual sense given the inequitable results from the trustee’s formula, it is the first circuit-level opinion on the issue and serves to clarify the law. The decision does highlight the influence LandAmerica’s board of directors had over the severance benefit plan, noting that the board retained the unilateral right to modify, alter, or amend the plan, or to eliminate the plan entirely. The Fourth Circuit bolstered its conclusion by noting that "if the board had eliminated the plan before an employee was terminated, then, under the trustee’s position, that employee would have earned severance compensation for a period of time but would never receive that compensation." Slip. Op. at 11. In light of the Fourth Circuit’s decision, companies should keep in mind whether elimination of a severance benefit plan may serve to greatly reduce potential priority claims.
Finally, Matson does not claim to alter the analysis of administrative expense claims for severance resulting from post petition employee termination. In most jurisdictions (except the Second Circuit), such claims constitute an administrative expense only to the extent they are limited to "services rendered" post petition and thus to the extent the severance relates to employment during the post-petition period. However, the Fourth Circuit’s reasoned analysis in Matson would seem to apply equally to the period of time one works post-petition, and would avoid the absurd result noted by the Court that occurs from using a pro-rata analysis.