Chapter 11 for the Labor and Employment Law Practitioner

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By Dianne LaRocca and Daniel Egan, DLA Piper

Not surprisingly in light of the global recession, there continues to be a large number of corporate entities filing for bankruptcy protection under Chapter 11 of the Bankruptcy Code. All of these entities employ employees and, following the decision to file under Chapter 11, questions concerning the status of existing labor and employment agreements and viability of employee claims arise. This article attempts to address these often complicated inquiries in a straightforward manner, highlighting the most useful information for the labor and employment law practitioner. Specifically, this article provides an overview concerning:

  • How an entity can make changes to its employees' terms and conditions of employment to permit successful reorganization;
  • How (if at all) the Worker Adjustment and Retraining Notification (“WARN”) Act is applicable to bankruptcy situations;
  • What claims may be pursued against the entity during the Chapter 11 proceeding; and
  • What priority is given to claims for unpaid wage and employee benefit contributions.
How can an entity make changes to employees' terms and conditions of employment to permit successful reorganization ?

After filing a petition with the bankruptcy court, a corporate entity may decide that a reduction of labor costs is necessary to permit a successful reorganization, particularly where these labor costs are above market. Where those employees are at-will, the process is pretty straightforward – the entity has the right to change existing terms and conditions and/or implement a reduction in force in the ordinary course of its business provided it does so in a nondiscriminatory manner; in compliance with any federal, state, or local notice requirements;1 and pursuant to any policies, procedures or past practices it may have. Where those employees are the beneficiaries of an employment or collective bargaining agreement, however, the process is not as straightforward.

Employees with Employment Agreements

An entity that continues to operate in Chapter 11 as a debtor in possession or, if one is appointed, a Chapter 11 trustee may assume or reject executory contracts subject to bankruptcy court approval and provided certain requirements are satisfied. The right to reject an executory contract is considered vital to the basic purpose of a Chapter 11 reorganization, since rejection may release the debtor's estate from an obligation that could impede successful reorganization or may allow the debtor to escape the burden of the contract. However, because the Bankruptcy Code does not define what constitutes an executory contract, there has been much litigation surrounding the issue of what constitutes one.

Generally, whether a contract is executory turns on whether the contract requires further performance from each party at the time the bankruptcy petition is filed. Thus, employment agreements that have not been terminated generally are considered to be executory and may be assumed or rejected by the debtor since each party has unperformed obligations. In comparison, employment agreements that have been terminated prepetition, even if they contain continuing restrictive covenant obligations, are not considered to be executory and may not be assumed or rejected.

Even when a contract is executory, however, an issue employers that are reorganizing face is that executory contracts, including employment agreements, cannot be assumed or rejected in part. It is an all or nothing proposition. Therefore, employers that wish to reduce labor costs through revision of employment agreements should consider rejecting and entering into new employment agreements with their employees.

Of course, any assumption or rejection of an executory contract is subject to the bankruptcy court's approval. In making its determination, the court will consider whether assumption or rejection represents the debtor's sound business judgment and whether the interests of other creditors of the estate will be prejudiced. In addition, any debtor seeking to assume an employment agreement will need to satisfy certain Bankruptcy Code requirements for assumption, including curing defaults under the agreement and providing adequate assurance of future performance under such agreement. Court approval generally is withheld only if the debtor's judgment is clearly erroneous, too speculative, or contrary to the intent of the Bankruptcy Code.

A debtor's rejection of an employment agreement will leave the employee with an unsecured claim against the debtor's bankruptcy estate, subject to a cap as set forth in Section 502(b)(7) of the Bankruptcy Code. Section 502(b)(7) provides for a damages claim against the estate for an employee resulting from the termination of an employment agreement, except to the extent such claim exceeds:

(A) the compensation provided by such contract, without acceleration, for one year following the earlier of—

(i) the date of the filing of the petition; or

(ii) the date on which the employer directed the employee to terminate, or such employee terminated, performance under such contract; plus

(B) any unpaid compensation due under such contract, without acceleration, or the earlier of such dates… . .”

11 U.S.C. §507(b)(7). This unsecured claim in favor of the employee will receive pro rata distribution with other unsecured claims against the debtor's bankruptcy estate.

Employees Covered by Collective Bargaining Agreements

Like employment agreements, collective bargaining agreements are considered executory contracts. Thus, a Chapter 11 debtor in possession or a Chapter 11 trustee may assume or reject collective bargaining agreements that govern the terms and conditions of employment of the debtor's employees.

To assume a collective bargaining agreement, the debtor must follow the same procedure for assuming other executory contracts. How claims arising under agreements that have not been rejected are treated depends upon jurisdiction. Some courts, including the Sixth Circuit Court of Appeals, have required payment during the Chapter 11 case of all wages and benefit fund contributions due under an unrejected collective bargaining agreement (including those that accrued pre and post-petition) as administrative expenses. These courts strictly apply the language of Section 1113(f) of the Bankruptcy Code2 and hold that, absent a court-ordered modification or rejection of a collective bargaining agreement, the terms of that agreement should be enforced in the bankruptcy proceeding. In contrast, other courts, such as the Third Circuit Court of Appeals, have refused to afford claims arising under an unrejected collective bargaining agreement administrative expense status, and instead apply the standard priority scheme under Section 507 of the Bankruptcy Code to pre- and post-petition claims.3

The process of rejecting a collective bargaining agreement, however, is more cumbersome than it is for other executory contracts. To reject a collective bargaining agreement, the trustee must comply with certain stringent requirements of Section 1113 of the Bankruptcy Code. Pursuant to Section 1113, a court will approve the application for rejection of a collective bargaining agreement only if it finds that: (1) the trustee previously has made a proposal to the union for modifications and the proposal complies with certain requirements; (2) the union has refused to accept this proposal without good cause; and (3) the balance of the equities clearly favors rejection of the collective bargaining agreement. 11 U.S.C. §1113(c).4

The Bankruptcy Code does not specify procedures for the implementation of employment terms following the rejection of a collective bargaining agreement. Some courts, however, have authorized the employer to implement the terms and conditions of employment contained in a prior proposal made to the union. Absent such court authorization, under the National Labor Relations Act, the union remains the exclusive representative of the employees and thus the employer has an obligation to bargain in good faith with the union. In addition, although Section 1113 does not expressly address the availability of claims following the rejection of a collective bargaining agreement, several courts have found that rejection damages are available.

How is WARN applicable to bankruptcy situations?

The WARN Act requires employers to provide written notice at least sixty (60) calendar days in advance of covered plant closings and mass layoffs.5 The WARN Act remains applicable to an employer that declares bankruptcy in some circumstances. For instance, if an employer declares bankruptcy and then orders a plant closing or mass layoff, it may be liable under the WARN Act where it knew about the closing or mass layoff before filing a petition in bankruptcy and should have given notice but seeks to use bankruptcy to avoid giving notice. A violation of the WARN Act provisions may give rise to priority claims in favor of the affected employees, which would reduce recoveries of unsecured creditors of the employer's bankruptcy estate.6

However, liability under the WARN Act does not apply where an exception to the notice requirement exists. The exceptions that often arise in bankruptcy cases are the faltering company and unforeseeable business circumstances exceptions.7 The faltering company exception exists when, before a plant closing, a company is actively seeking capital or business and reasonably in good faith believes that advance notice would preclude its ability to obtain such capital or business, and this new capital or business would allow the employer to avoid or postpone a shutdown for a reasonable period. The unforeseeable business circumstances exception exists when the closing or mass layoff is caused by business circumstances that were not reasonably foreseeable at the time that 60-day notice would have been required (i.e., a business circumstance that is caused by some sudden, dramatic, and unexpected action or conditions outside the employer's control, like the unexpected cancellation of a major order). In these situations, notice must be provided as soon as is practicable and the employer must provide a statement of the reason for reducing the notice requirement in addition to fulfilling the Act's other notice requirements.

What claims may be pursued against the entity during the Chapter 11 proceeding?

A petition filed under Chapter 11 of the Bankruptcy Code operates as a temporary stay of a broad range of acts to recover claims against the debtor, thus preserving the status quo of the bankruptcy estate as of the date the petition is filed. This automatic stay covers claims that may be raised by employees in court or arbitral forums for acts arising prior to the commencement of the bankruptcy case. The stay continues until the debtor's bankruptcy case is closed or dismissed, until a discharge is granted or denied, or until the court disposes of the case or grants relief from the stay. In Chapter 11 cases, confirmation of the plan of reorganization generally operates as a discharge of these pre-petition claims, and holders of such claims will receive the treatment and distribution, if any, that is provided under the plan of reorganization.

As discussed below, the automatic stay does not apply to pre-petition claims raised by employees through governmental units (or by the governmental units themselves) and protected concerted activity under the National Labor Relations Act. In addition, it may not apply to grievances raised by a labor organization pursuant to a collective bargaining agreement. These claims may be pursued and may be inherited by the reorganized entity if not resolved during the pendency of the Chapter 11 case.

The stay also does not apply to post-petition employee claims. Claims that arise during the course of the Chapter 11 case may be pursued against the debtor without violation of the automatic stay. In addition, claims arising after the conclusion of the Chapter 11 case may be brought against the reorganized entity.

Government Actions

The Bankruptcy Code expressly exempts from the stay's operation actions “by a governmental unit to enforce such governmental unit's policy or regulatory power.” 11 U.S.C. § 362(b)(4). These governmental units include the Secretary of Labor, Equal Employment Opportunity Commission, and the National Labor Relations Board. Thus, claims arising under the Fair Labor Standards Act, the Occupational Safety and Health Act, violations of officers' fiduciary responsibility under the Employee Retirement Income Security Act, the National Labor Relations Act, Title VII of the Civil Rights Act, the Age Discrimination in Employment Act, the Americans with Disabilities Act, and other statutes enforced by these units of government generally move forward, provided that the governmental unit is acting to enforce its police or regulatory power. However, because the enforcement of a money judgment is not exempt under the exception to the stay, these governmental units may not enforce an order for the payment of back wages, penalties, or other monetary liabilities on account of a debtor's violation of labor and employment laws. Instead, these claims will be addressed and treated in a debtor's Chapter 11 plan.

Arbitration Proceedings

The automatic stay applies to labor and employment arbitration proceedings. However, relief from the automatic stay may be granted to allow the merits of a labor dispute, which arises under the terms of a collective bargaining agreement, to be resolved through arbitration where the arbitration proceeding bears no relationship to the debtor or the orderly administration of the estate. The rationale for providing relief is the prevention of debtors from unilaterally avoiding their obligations under collective bargaining agreements without satisfying the requirements of Section 1113 of the Bankruptcy Code. In short, the automatic stay will be applied to the extent it is not in irreconcilable conflict with Section 1113 of the Bankruptcy Code as determined on a case-by-case basis.

Protected Concerted Activity

The automatic stay does not supersede the anti-injunction provisions of the Norris-LaGuardia Act, which provides that particular activities involving or growing out of a labor dispute are not subject to a restraining order or injunction. Thus, the bankruptcy court may not issue an injunction against activities such as work stoppages or peaceful picketing at the debtor's place of business in connection with a labor dispute.

What priority is given to claims for unpaid wage and employee benefit contributions?

Although they are considered unsecured claims under the Bankruptcy Code, claims for unpaid wage and employee benefit contributions (up to a cap, as discussed below) generally are treated as priority claims during Chapter 11 proceedings, meaning that they must be paid in full as a condition to confirmation of a plan of reorganization, subject to waiver by the holder of the claim. Section 507 of the Bankruptcy Code establishes the relative priority of competing unsecured claims and Section 1129 of the Bankruptcy Code specifies the required treatment under a plan for each type of priority claim.

Claims for post-petition wages and benefits are administrative expense claims, which are afforded secondary priority (subject only to certain domestic support obligations). This includes post-petition wages, salary, commissions, vacation, severance, and sick leave pay earned. These claims must be paid in full in cash on the plan's effective date.

Claims for pre-petition wages are fourth priority claims. However, this priority is limited to wages, salaries, commissions, including vacation, severance, and sick pay, up to $11,725 per employee, which have been earned within 180 days of the earlier of the date of the filing of the bankruptcy petition or the date of the cessation of the debtor's business.

Claims for pre-petition contributions to an employee benefit plan are fifth priority claims. However, this priority is limited to contributions up to $11,725 per employee multiplied by the number of employees covered by the plan less the aggregate amount paid to such employees as fourth priority claims. In addition, this priority is limited to contributions arising from services rendered within 180 days of the earlier of the date of the filing of the bankruptcy petition or the date of the cessation of the debtor's business.

Where the holders of claims for pre-petition wages and benefits have accepted the plan, the claims must be paid in full (up to the allowed amount) in deferred cash payments of a value, as of the plan's effective date, equal to the allowed amount of such claim. Where the holders of claims have not accepted the plan, the claims must be paid in full (up to the allowed amount) in cash on the plan's effective date.

Dianne LaRocca is an associate in the Labor and Employment Law Practice at DLA Piper and Daniel Egan is an associate in the Restructuring Practice. Both lawyers are based in New York.

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