Contributed by Rich Mullen
Unless you’re a skydiving enthusiast, just the metaphor of a “golden parachute” should cause a bit of trepidation. After all, the failure of a parachute to work when it’s needed causes certain doom. And when a golden parachute may be needed most—when a high-flying executive is facing termination by its troubled employer—the protection such parachute offers may not be available as a result of section 502(b)(7) of the Bankruptcy Code. Section 502(b)(7) generally limits a terminated employee’s claim for damages under an employment contract to no more than one year’s future compensation plus past due compensation, and was designed to snip the cords of golden parachutes that key executives are often able to negotiate. Recently, several executives found themselves free falling; in In re VeraSun Energy Corp., the Bankruptcy Court for the District of Delaware applied section 502(b)(7) to cap the claims of four former executives of the debtor, holding that certain “change in control agreements” containing golden parachutes were part of the executives’ employment contracts with the debtor, and the claim of each executive under such agreements were capped because they arose from the termination of his employment contract.
Before bankruptcy, the debtor, a leading ethanol producer, sought to increase production by acquiring a competitor. In light of the potential merger, the board of directors adopted a number of “change in control agreements” under which certain key executives (who were employed under at-will employment contracts) would commit to see the merger through in exchange for an enhanced compensation package should they later be terminated.
The change in control agreements contemplated that the possibility of a change in control could create uncertainty and questions that might distract or lead to the departure of members of the management team. To prevent such occurrences, the change in control agreements provided severance benefits to executives who were terminated without cause within two years of the merger, including a cash payment double or even triple the base salary and target annual bonus, continued medical benefits, payment for unused vacation, and a guaranty of any unvested equity awards and contributions under the debtor’s 401(k) plan.
The merger created one of the largest producers of corn-based ethanol in the world, but the company was not strong enough to survive the 2008 economic crisis. In bankruptcy, the debtor sold substantially all of its assets and fired a host of employees, including four executives who were party to the change in control agreements. These four executives filed proofs of claim in excess of $7.3 million.
The debtor objected to the executives’ claims, arguing that the change in control agreements were employment contracts and that the executives’ claims were thus capped by section 502(b)(7) of the Bankruptcy Code. The executives countered that the change in control agreements were “stand alone ‘stay in place’ agreements” that were designed to retain key employees and that their claims were for “amounts already earned” because the executives fulfilled their obligations under the change in control agreements by staying with the debtor throughout the merger process.
Applying state law, Judge Shannon concluded that the change in control agreements merely modified the at-will employment contracts and were thus “employment contracts” within the meaning of section 502(b)(7). First, while acknowledging that the Bankruptcy Code does not define the term, the Bankruptcy Court determined that an “employment contract” is a writing that establishes the terms and conditions of an employment relationship and can be modified by later agreements. The change in control agreements, Judge Shannon reasoned, were modifications to the employment contracts because, among other reasons, the change in control agreements (i) set forth new terms and conditions that affected the employment relationship between the debtor and the executives, (ii) relied upon the employment contracts for context and definitions of important terms such as “salary,” “bonus,” “benefits,” and “assigned duties,” and (iii) explicitly stated that any conflicts between the change in control agreements and the employment contracts should be read as if the employment contracts had been formally amended.
The Bankruptcy Court rejected the executives’ argument that, because their claims were for “amounts already earned” by seeing the merger through, the 502(b)(7) cap did not apply. In doing so, the Court stated that the change in control agreements contained provisions typical for severance agreements and even explicitly stated that the executives would get “Severance Benefits.” Moreover, the Court stated that the key compensation provision of the change in control agreements read that the severance pay would be “in lieu of any further salary for periods subsequent to the Date of Termination,” which the Court found to be a clear indication that the compensation was prospective and not for services already rendered.
While holding that the executives’ claim was capped by section 502(b)(7), the Court did not decide the allowed claim amounts, instead directing the parties to confer and reach agreement. Despite the huge “economic impact” the holding would have on the executives, the Court could find no “good reason to depart from the long line of cases” supporting its decision. Executives of distressed companies should be wary—your golden parachute may not provide you a safe landing when leaving a company in bankruptcy.
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