Contributed by David G. Litvack

We have previously blogged about the creative ways terminated executives of a debtor attempt to retain, postpetition, the severance packages they negotiated prepetition.  An executive whose employment is terminated postpetition sometimes argues that he or she is entitled to severance payments as an administrative expense of the debtor’s estate.  Even this argument, however, has been discredited by some bankruptcy courts, as courts are hesitant to sanction a debtor’s postpetition payments on a prepetition contract.  When the termination has taken place prepetition, the ability to receive postpetition severance payments is even more tenuous, but that doesn’t mean the severed employee will give up without a fight.

In Shults & Tamm v. Brown (In re Hawaiian Telcom Communications, Inc.), a former executive of the debtors was sued in connection with his postpetition receipt of certain severance payments arising under an employment agreement terminated prepetition.  In response, the executive argued that the litigation trustee, who was pursuing the claims, should be precluded from recovering the postpetition severance payments because the payments were made in the ordinary course of the debtors’ business pursuant to section 363(c)(1) of the Bankruptcy Code.  The executive also argued that the severance payments were valid because they were made pursuant to an executory employment contract that was allegedly assumed under the debtors’ plan of reorganization.  The United States Bankruptcy Court for the District of Hawaii rejected both arguments.
Approximately four months before filing for protection under chapter 11 of the Bankruptcy Code, the debtors terminated the executive’s employment.  Pursuant to his employment agreement, the executive was entitled to six months of severance payments from the debtors, and the executive was required to safeguard certain confidential information of the debtors and to not compete with the debtors’ business.  Following the debtors’ bankruptcy filing, the debtors made three severance payments to the executive, each in the amount of approximately $9,000.  Shortly thereafter, the debtors notified the executive that the postpetition payments were made in error, and the debtors reserved their rights to avoid such transfers.  Two years later, the debtors’ litigation trustee brought an adversary proceeding to recover the payments pursuant to sections 547, 548, and 549 of the Bankruptcy Code and filed a motion for summary judgment to avoid the transfers under section 549 of the Bankruptcy Code as an unauthorized postpetition transaction.
Section 549(a) of the Bankruptcy Code provides that a debtor (or trustee) “may avoid a transfer of property of the estate . . . that occurs after the commencement of the case; and . . . is not authorized under this title or by the court.”
Postpetition Severance Payments Are Not “Ordinary Course”
Attempting to retain the postpetition severance payments, the executive argued that they were made in the “ordinary course” of the debtor’s business, and, therefore, fell outside the purview of section 549.  The bankruptcy court acknowledged that section 363 of the Bankruptcy Code is designed to “afford a debtor in possession flexibility to continue its daily operations without unnecessary court supervision while simultaneously protecting creditors by giving them an opportunity to be heard when the transaction is not ordinary.”  Nonetheless, the bankruptcy court went on to state that such flexibility may not result in permitting payments that “frustrate the theory and philosophy” underlying the Bankruptcy Code.  A type of payment that runs contrary to the goals of the Bankruptcy Code, the bankruptcy court ruled, is the postpetition payment of prepetition unsecured debts.  Accordingly, the bankruptcy court held that a debtor cannot pay prepetition debts (in this case, severance payments) under the auspices of section 363(c).  In doing so, the bankruptcy court rejected the executive’s novel argument that postpetition severance payments on account of a severance agreement executed prepetition can be made in the ordinary course of business pursuant to section 363 of the Bankruptcy Code.
A Contract That Is Not Executory Cannot Be Assumed
The bankruptcy court also rejected the former executive’s argument that his employment agreement was assumed by the debtors.  Under the debtors’ plan of reorganization, subject to certain exceptions not relevant here, all executory contracts were assumed.  The debtors argued that the employment agreement was not executory because the executive’s remaining obligations under the agreement were not sufficiently material under the so-called “Countryman” test to render the employment agreement an executory contract.  The “Countryman” test, which is used by the majority of circuits, determines whether a contract is executory by examining if, when a bankruptcy petition is filed, “the obligations of both parties are so unperformed that the failure of either party to complete performance would constitute a material breach and thus excuse the performance of the other.”  It was undisputed that the debtors’ obligation to pay severance was a material obligation.  Thus, the relevant inquiry turned on whether the executive’s remaining obligations under the contract were material.
The debtors argued that the executive’s remaining obligations, namely to not compete/solicit and safeguard any confidential information, were de minimis and not sufficient to render the agreement executory.  After surveying the applicable case law, the bankruptcy court ruled that the non-competition and non-solicitation obligations were not sufficiently material under the “Countryman” test to render the employment agreement executory and, thus, assumable under section 365 of the Bankruptcy Code. The bankruptcy court also noted that the safeguarding of confidential information is a standard requirement that is found in many confidentiality agreements and is insufficient to render a contract executory under section 365 of the Bankruptcy Code.  Ultimately, the court granted the litigation trustee’s motion for summary judgment.
The bankruptcy court’s decision reflects the hesitation of many bankruptcy courts to elevate what is nothing more than a prepetition claim into the functional equivalent of an administrative expense.  Although the bankruptcy court’s decision is straightforward, it raises some interesting questions: can a debtor “deem” a contract to be executory, for whatever reason, and thus elevate a prepetition debt into a postpetition obligation?  In other words, if the debtors had elected to keep making the severance payments, could they have simply argued that they were “assuming” the employment agreement in their business judgment?  Similarly, could the debtors have taken the position that the payments were made in ordinary course?  The answer appears to be, absent objection, yes, as the decision to assume or reject an executory contract is in a debtors’ business judgment, notwithstanding the “Countryman” test, and a debtor does not typically announce its view that ordinary course transactions are, in fact, ordinary course. However, the bankruptcy system, though not foolproof, is designed to prevent these types of things from happening.  Unsecured creditors’ committees, the Office of the United States Trustee, and the bankruptcy courts act as “watchdogs” in chapter 11 cases to prevent a debtor from knowingly (or unknowingly) frustrating the principles of the Bankruptcy Code.  Nonetheless, a creditor who is concerned about a debtor’s potential abuses will be best served by carefully scrutinizing any documents listing executory contracts to be assumed by the debtor (many times an exhibit to a plan supplement) and monitoring the debtor’s general transactions.