In the Fourth Circuit, Terminated Employees Are Entitled to Priority Claim for Severance. Why? Because They Earned It (When They Were Fired)

Contributed by Dana Hall
In In re LandAmerica Fin. Group, Inc., the Fourth Circuit Court of Appeals recently held that, for purposes of determining the amount of severance compensation entitled to priority treatment pursuant to section 507(a)(4)(A) of the Bankruptcy Code, severance compensation is “earned” in its entirety upon an employee’s termination.  Although the question of treatment of severance compensation as an administrative expense pursuant to section 503(b)(1)(A)(i) of the Bankruptcy Code has been extensively litigated with differing jurisdictional outcomes, the question of treatment of severance compensation as a prepetition priority claim has not been previously considered.
In LandAmerica, the debtors, during the 180 days preceding the petition date, terminated the employment of over 100 employees who later filed claims asserting priority treatment for severance compensation up to the statutory maximum (at that time, $10,950), pursuant to section 507(a)(4).  Section 507(a)(4) of the Bankruptcy Code grants fourth priority treatment to allowed unsecured claims for, among other things, severance “earned” within the 180-day period preceding the petition date.  LandAmerica’s severance plan entitled terminated employees to receive compensation equal to their weekly pay for a certain number of weeks.  The number of weeks of compensation to which a particular employee was entitled was not based on a pro rata calculation of the number of days or months that an employee had been employed, but rather was based upon a tiered structure.  Accordingly, employees were entitled to one week of severance pay if they had worked for one to three years, two weeks of pay if they had been employed for three to five years, and so on.  The terminated employees asserted that the entire sum of their severance compensation was entitled to priority treatment because severance compensation was “earned” upon termination, and the employees had been terminated during the 180 days preceding the petition date.  The liquidating trustee objected to the employees’ claims and asserted that the severance compensation had been “earned” throughout the course of each employee’s employment and that the amount entitled to priority treatment should be determined by pro-rating the severance compensation – dividing the total severance compensation amount by the total number of days of employment and then multiplying the quotient by the number of days worked during the 180-day period preceding the petition date.
The Fourth Circuit Court of Appeals affirmed the holding of the United States Bankruptcy Court for the Eastern District of Virginia and held that the claimants “earned” their severance compensation on the date of their termination.  The LandAmerica court found that, unlike wages and salaries, which are earned in exchange for services rendered, severance compensation is designed to compensate an employee for the loss resulting from termination.  Furthermore, the plain meaning of “earn” – to become entitled to – suggests that severance compensation could not have been earned prior to the time the employee was terminated and simultaneously signed the severance agreement and release, thereby becoming entitled to the severance compensation.  Additionally, as noted by the bankruptcy court in LandAmerica, pro-rating of severance compensation would have the likely unintended consequence of harming most those who had been employed the longest.  The lower court also noted in its decision that were the statute to be interpreted as the trustee urged, the statute would require the absurd result that severance compensation could have been earned prior to the date that the severance plan itself was put in place.
Significantly, the LandAmerica court distinguished its holding from the oft-litigated issue of the appropriate treatment of severance compensation pursuant to section 503(b).  Section 503(b) provides for treatment of wages, salaries, and commissions for services rendered postpetition as an administrative expense.  Section 503(b), unlike section 507(a)(4), does not make specific reference to “severance” and, unlike section 507(a)(4)’s reference to amounts “earned” during the 180-day priority period, section 503(b) references the value of “services rendered” postpetition.
No consensus exists among the circuits with regard to the treatment of severance compensation as an administrative expense.  For example, the Second Circuit treats all severance pay as an administrative expense if an employee is terminated postpetition, while the Third Circuit treats severance as an administrative expense only to the extent that the compensation is based on postpetition services.  The LandAmerica bankruptcy court specifically noted that courts in the Fourth Circuit will only permit administrative expense treatment for severance obligations incurred pursuant to severance contracts that are assumed by the debtor or negotiated and approved postpetition.  For prepetition severance plans that are rejected postpetition, the breach, pursuant to section 365(f) of the Bankruptcy Code, constitutes a prepetition breach within the 180-day priority period and the claimant is, therefore, only entitled to priority status pursuant to section 507(a)(4).  That said, in the Fourth Circuit at least, this may not be so bad.
Although the 507(a)(4) issue in LandAmerica is not as often litigated as its 503(b) counterpart, there is little doubt that this decision will provide a certain amount of firepower for terminated employees going forward.