You might think that a company in bankruptcy wouldn’t be able to give its CEO a multi-million-dollar severance payment. 

But just because a company is in bankruptcy doesn’t necessarily mean it doesn’t have any money – it just means it doesn’t have enough to pay all of its debts, or to function as a continuing concern.  The company may, in fact, have the means to make a rather generous severance payment – like the $20 million American Airlines is proposing to pay its CEO, Tom Horton, as the airline comes out of Chapter 11 and into a merger with US Airways. 

This proposed payment, though, has aroused more objection than a lost bag or a missed connection.  Indeed, we’ve written about this dispute before at Suits-by-Suits, but like a three-mile-long runway it just keeps going on and on in bankruptcy court.  In advance of a hearing on the payment scheduled for tomorrow, it’s time to take a look at where this case has been and what it can teach executives and companies about the turbulence that can happen when bankruptcy law meets severance agreements.  In short, executives should know that unlike their seat cushions, their severance agreements may or may not keep them afloat in the event their employer has a crash landing. 

Before we tell you about the primary objection to Horton’s severance payment, we need to give you some background so you may have – ahem – the 40,000 foot view of the situation.

American sought Chapter 11 bankruptcy protection in November of 2011. Chapter 11 of the Bankruptcy Code allows companies to reorganize their debts, negotiate with their creditors, and ultimately (usually) exit bankruptcy and return to normal business. Several airlines have used Chapter 11 in the past two decades.

Horton’s severance payment was one of American’s obligations. When the company entered bankruptcy, it disclosed that Horton would earn $6.4 million if he left the company. Curiously enough, somewhere during the bankruptcy, that severance payment increased to $20 million. The bankruptcy judge hearing American’s case rejected that severance payment in April. Unwilling to be deterred, American resubmitted the $20 million payment, this time in a disclosure statement it submitted to the court. The disclosure statement needs to be approved before American can move forward to finish its reorganization plan. The U.S. Trustee for this case – a federal official appointed by the Justice Department to monitor big bankruptcy cases and represent the government’s interest – has objected to the severance payment. Tomorrow, the bankruptcy court will hold a hearing on that objection.

The U.S. Trustee’s objection is based on Section 503(c) of the Bankruptcy Code. This section – added after public outcry over large severance payments to Enron executives – provides that a bankrupt company can’t pay severance to executives unless it has a similar severance program for non-management employees, and the payment it wants to make is no more than 10 times the amount paid to those non-management employees. The bankruptcy judge rejected American’s $20 million payment to Horton on that basis – the discrepancy between the payment and the amount available to non-management employees – in April, so it’s not clear how American will get around that decision tomorrow.

American’s argument seems to be that the $20 million won’t actually be paid by debtor American, but by merged American-US Airways, and so therefore Section 503(c) doesn’t apply. Maybe tomorrow, we’ll see if that argument flies. As soon as we hear how it goes, we’ll let you know what happens