Managing Human Resources for a Company in Bankruptcy

Overview

Bankruptcy is defined as the condition of being unable to pay debts, meaning that liabilities are greater than assets. Federal law provides for the development of a plan that allows an individual or business with insufficient assets to resolve outstanding debt through the division of available assets among creditors.

Bankruptcy proceedings range from the total liquidation of assets to a reorganization that attempts to rehabilitate the debtor by establishing a schedule for the gradual repayment of what the individual or organization owes. All proceedings are administered by a federal bankruptcy court that supervises them per Title 11 of the United States Code.

The process of filing for a business bankruptcy, as well as the ability to successfully emerge from the bankruptcy, is a complex and difficult time for all parties. Employment-related issues in bankruptcy fall generally into two broad areas: staffing issues and compensation and benefits issues.

Compassion, frequent communication and expeditious decision-making will help reduce the stress an organization's employees are likely to experience. Showing genuine respect for people and treating them with honesty, dignity and fairness—even as the management team makes difficult decisions about pay, benefits and job reductions—are key behaviors that will drive the success (or failure) of an organization post-bankruptcy.

This toolkit is not exhaustive. It includes a very general overview of the process and only the issues that will be directly relevant to most human resource practitioners. It discusses the following broad topics:

• Governing law.
• Types of bankruptcy proceedings.
• Pre-filing issues.
• Post-filing issues.
• Staffing issues.
• Compensation and benefits issues.

Governing Law

Bankruptcy law is federal statutory law contained in Title 11 of the United States Code. Congress passed the Bankruptcy Code under its constitutional grant of authority to "establish… uniform laws on the subject of bankruptcy throughout the United States."

States may not regulate bankruptcy, though they may pass laws that govern other aspects of the debtor-creditor relationship. Several sections of Title 11 incorporate the debtor-creditor law of the individual states.

Bankruptcy proceedings are supervised by and litigated in the United States Bankruptcy Courts. These courts are a part of the District Courts of the United States federal court system. Congress established the United States Trustee Program to handle many of the supervisory and administrative duties of bankruptcy proceedings. Proceedings in bankruptcy courts are governed by rules promulgated by the Supreme Court under the authority of Congress.

A debtor can enter into a bankruptcy proceeding voluntarily, or creditors may initiate it. Typically, a trustee is appointed to supervise the division of the debtor's assets. After a bankruptcy proceeding is filed, creditors are generally prohibited from seeking to collect their debts outside the bankruptcy proceeding. The debtor is not allowed to transfer property that has been declared part of the estate subject to proceedings. Furthermore, certain pre-proceeding transfers of property, secured interests and liens may be delayed or invalidated.

Passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 brought major reforms in bankruptcy law. The law was designed to curb what many saw as abuses of bankruptcy rules that allowed organizations to build debt and then walk away from those obligations. The law also expanded the responsibilities of the United States Trustees Program to include greater oversight of small business reorganization cases.

Notably in the unionized workplace context, bankruptcy does not give an organization the ability to simply assume or reject contracts. Section 1113 of the Bankruptcy Code provides special protections for these types of contracts. A debtor can modify or reject these legislatively protected agreements only with the consent of the union. If no agreement is reached, court approval is required.

Types of Bankruptcy Proceedings

Organizations have two basic types of bankruptcy proceedings: liquidation and reorganization.

Liquidation

A filing under Chapter 7 is called "liquidation" and is the most common type of bankruptcy proceeding. Liquidation involves the appointment of a trustee who collects the nonexempt property of the debtor, sells it and distributes the proceeds to the creditors. This type of bankruptcy filing makes sense if a business concludes that it has no viable future or that its debts are simply too overwhelming for any plan of reorganization to overcome. In a nutshell, a Chapter 7 filing is an orderly way to completely liquidate and close an organization.

Reorganization

Bankruptcy proceedings under Chapter 11 occur when an organization desires to pay off as many of its debts as possible while continuing to operate under court supervision. This type of proceeding involves the rehabilitation of the debtor to allow it to use future earnings to pay off creditors. It is comparable to an orderly repayment plan with payments usually staggered over three to five years.

Issues That Arise Before a Petition Is Filed

Before filing a bankruptcy petition, organizations are well advised to secure the services of third-party professionals (e.g., lawyers, accountants, bankruptcy specialists, turnaround experts, benefits consultants and related advisers) who can objectively and unemotionally counsel them about the process and help management make the inevitable tough decisions. Fees for this type of expertise are high, making costs a huge issue when cash is in short supply.

HR leaders in particular should learn as much as possible about the bankruptcy process and the rules governing it.

The whole HR team must be well informed about the process to establish a clear working timetable for key actions before the organization actually files the bankruptcy petition (knowing it will likely change many times throughout the proceedings).

HR professionals should lead the organization in identifying and thoroughly analyzing issues—both legal and operational—related to the following subjects:

• Workforce reduction.
• Employee retention.
• Performance management.
• Changes to compensation and incentive programs.
• Policy revisions.
• Benefits plan changes.
• Collective bargaining agreements.
• Ongoing employment litigation.

In addition, HR should examine unfunded liabilities such as vacation accruals, deferred compensation and bonuses to determine whether these obligations should be paid out in advance of the filing. Otherwise, affected employees would be deemed unsecured creditors and would "go to the back of the line."

Organizations must also identify all contracts, such as noncompete and nondisclosure agreements and executive and key manager employment contracts, that may be impacted by a bankruptcy filing. Properly reorganizing human capital and related expenses will cut down on litigation, help attract financing and contribute to the organization's successful emergence from bankruptcy if that is the goal.

Issues That Arise After a Petition Is Filed

When the organization has explored all alternatives and the decision to seek bankruptcy protection is final, lawyers for the organization submit a petition to the bankruptcy court asking for approval of a First Day Order. This document asks the court to authorize management to remain in charge of the company as the "debtor-in-possession." The petition also asks the court to empower the organization to honor commitments necessary to continue operating (e.g., salaries, benefits, severance pay).

With the court's agreement, all other debts are suspended pending approval of a workout plan. The creditors and the court must approve this plan of reorganization before the organization's emergence from bankruptcy.

Creditors are divided into categories—secured creditors have preference on company assets, followed by unsecured creditors that are assigned a place in line in terms of the priority of their claims. Secured creditors have a lien on the organization's property as security for a debt, whereas unsecured creditors are owed money but have no liens on organization assets.

See High Court to Hear Truck Drivers' Challenge to Employer's Bankruptcy Dismissal.

The trustee appoints a creditor committee that has the right to sign off on all funding requests not deemed to be in the ordinary course of business. Bonus plans, salary increases and retention plans are initially taken to management and the organization's board of directors, and then to the creditors. If they object, the bankruptcy judge makes the final decision.

Once the bankruptcy petition is filed, either the liquidator or the managers of the organization take charge of closing or continuing the business, depending on whether it is a Chapter 7 or Chapter 11 bankruptcy. Liquidating companies generally establish a wind-down team, and reorganizing companies set up a transition team—a group of generalists with the skills to work in an ever-changing situation.

For example, in a large retailer's liquidation bankruptcy, the team consisted of four generalists: a liquidator liaison and three field HR professionals, including employees who had expertise in pensions, health and welfare, and compensation issues. Each had allotted time to complete tasks—from eight to 26 weeks and longer—and each had specific milestones to meet.

See After a business closes, what do we do with company and employee records? 

Staffing Issues

Either before or after the filing for bankruptcy protection, employers will likely need to decide how many people they will need to operate in the post-bankruptcy environment.

Communications

Employers are well advised to announce and implement decisions about management structure, key roles, layoffs, overall organizational structure and other aspects of the bankruptcy filing that will impact staff as soon as possible—ideally within just a few days of filing a bankruptcy petition, if not before. If changes are going to occur, announcing them as early as possible is preferable. A lack of communication can lead employees to believe that leaders are being secretive and to generate rumor mills.

See:

Managing Organizational Communication
Managing Organizational Change

Development of a strategic communication plan is critical. This blueprint for communication should include regular written updates to employees, postings on the organization's intranet and, most importantly, regular briefings from senior management (preferably face-to-face or via video if the company has multiple sites). In addition to using a variety of forms of communication to reach employees, the plan should guide the frequency of those messages.

Even if the organization has little information to report, communicating frequently will help reduce the misinformation likely to develop within a company in financial distress. Organizations should also keep customers, suppliers, investors and retirees regularly updated about decisions, changes, the company's financial status and breaking news.

Workforce Reduction

Reduction-in-force or voluntary-separation programs are designed to downsize the workforce and are quite common for financially troubled firms, as are other serious cost-cutting measures (e.g., benefits plan cuts for current employees or retirees, reductions in compensation and bonuses, elimination of services).

See:
Managing Downsizing by Means of Layoff
How to Conduct a Layoff or Reduction in Force
Layoffs Require Communication, Compassion and Compliance
Global Reductions in Force: A Practical Checklist
 

In the event of a layoff, consideration should be given to federal and state notice requirements. Under the federal Worker Adjustment and Retraining Notification Act (WARN Act), employees must be given 60 days' notice of a mass layoff or plant closing, or employers must pay affected employees 60 days' wages and full benefits.

See Plant Closings and Layoffs and WARN Notice Letter.

Several states have their own versions of the WARN Act that may differ from the federal act. Employers considering a layoff can contact the State Rapid Response Team to find out more information on notice requirements in their state.

Retention

Amid layoffs and reductions in force, it may seem counterproductive to focus on employee retention; however, much of the pre- and post-bankruptcy planning and action should focus on developing a comprehensive strategy to retain employees deemed critical to the organization's future. The longer the period of uncertainty and speculation lasts, the more attractive alternative employment may become to talented and key employees. Competitor recruiters usually target the most talented managers immediately, and the loss of key employees can seriously erode a company's potential to survive a bankruptcy successfully.

Under Section 503(c)(1) of the bankruptcy code, retention bonuses, or key employee retention plans (KERPs), paid to insiders are permissible only if they meet all three of the following conditions:

• The bonus is essential to the retention of the insider because the insider has a bona fide job offer from another business at the same or greater rate of compensation.
• The services provided by the insider are essential to the survival of the business.
• The amount of the bonus is not greater than 10 times the mean retention bonus paid to nonmanagement employees during the year in which the bonus is paid to the insider, or if no retention bonuses are paid to nonmanagement employees during the year, the amount of the bonus is not greater than 25 percent of the amount of any retention bonus paid to the insider in the preceding calendar year.

See Chapter 1 of the bankruptcy code for a definition of "insider."

Role Changes

Employers should announce decisions related to title, job location, position, reporting relationships, authority, scope of decision-making, office space and compensation as early as possible according to the strategic communication plan. Unless employers address these issues quickly, progress on the organization's main turnaround objectives will be slow at best due to employee anxiety and distraction. See Managing Employees in a Downsized Environment.

Compensation and Benefits Issues

A great deal of flexibility becomes available to an organization immediately after filing for bankruptcy protection. Within certain legal parameters, a company can now take action to significantly revise its health plans, pension plans, policies and employment contracts. Some primary benefits-related issues that HR professionals must consider when their employer is facing the possibility of bankruptcy include the following.

Pre-Petition Payments to Insiders

A bankruptcy trustee has the ability to recover excessive compensation or benefits paid by the employer to insiders before it files for bankruptcy. Under current law, payments made in certain circumstances during the two-year period before the employer's bankruptcy filing are recoverable, including payments made to insiders pursuant to employment agreements.

See What happens to unpaid wages owed employees when a company files for bankruptcy?

Post-Petition Employment Agreements

A debtor's payment of expenses outside the ordinary course of business and not justified by the facts and circumstances is not permissible in bankruptcy. This activity specifically includes transfers of property to, and payments of obligations incurred for the benefit of, officers, managers and consultants hired after the employer's bankruptcy filing. Therefore, a wide variety of compensation payments and benefits distributions for officers, managers and consultants could be vulnerable to disallowance unless they are in the ordinary course of business and justified by the facts and circumstances.

Retirement Plans

Retirement benefits are generally protected under federal law in the event an organization declares bankruptcy. The Employee Retirement Income Security Act of 1974 (ERISA) requires pension and 401(k) accounts to be adequately funded and kept separate from the employer's business assets. Thus, retirement funds should not be at risk when an organization goes bankrupt.

The Rapid ERISA Response Team project enables the federal government (through the Employee Benefits Security Administration, or EBSA) to step in to protect the rights and benefits of plan participants when a company files for bankruptcy protection.

EBSA takes immediate action to ascertain whether plan contributions have not been paid to the plans' trusts; to advise all affected parties of the bankruptcy filing; to provide assistance in filing proofs of claim to protect the plans, the participants and the beneficiaries; and, if necessary, to seek the appointment of an independent fiduciary to distribute plan assets to participants and beneficiaries.

EBSA also attempts to identify the assets of the responsible fiduciaries and evaluate whether a lawsuit should be filed against those fiduciaries to ensure that the plans are made whole and the benefits secured.

Defined Benefit Plans

The Pension Benefit Guaranty Corporation (PBGC), a federal agency created under ERISA, guarantees an employee's pension payments up to a maximum amount determined by a formulas prescribed by federal law. The effect of bankruptcy on a company's defined benefits plan is generally governed by the company's summary plan description (SPD) for each plan.

See Maximum Monthly Guarantee Tables.

Defined Contribution Plans

The PBGC does not insure assets in defined contribution plans. Whereas defined contribution plan assets generally stay intact when an organization fails, an employee can still incur losses. If too much of an employee's investments are in company stock, their value will decrease along with the company's share value.

See IRS Retirement Topics—Bankruptcy of Employer.

Health Care Plans

An organization in bankruptcy may decide to reduce or eliminate health care benefits. Employers considering employee cost-sharing increases will need to ensure compliance with affordability under the Patient Protection and Affordable Care Act (PPACA), and terminating a plan altogether may result in an employer being subject to penalties for failing to offer coverage.

These penalties must be considered in determining the cost savings of reducing or eliminating health care benefits. In addition, the PPACA requires a 60-day advance notice to participants of any material modifications to health benefits.

See Communicating with Employees About Health Care Benefits Under the Affordable Care Act.

If the debtor is an administrator of an employee benefits plan at the time the bankruptcy petition is filed, the debtor is required to continue administering the plan during the proceeding (unless the bankruptcy trustee assumes those duties). However, whether employee coverage will continue depends in part on whether the organization liquidates under Chapter 7 or continues operating under Chapter 11 reorganization.

See DOL Fact Sheet: Your Employer's Bankruptcy: How Will It Affect Your Employee Benefits? [pdf]

If an organization files for Chapter 7 bankruptcy, health coverage is terminated, along with jobs. Under Chapter 11 restructuring, however, health coverage could stay unchanged as the company reorganizes, or it could be terminated with probable consequences under the PPACA. If an employer decides to eliminate its health care plans (or reduce coverage), there is no legal requirement to restore it. If a plan is terminated, the requirement for the organization to provide COBRA coverage is canceled, too.

See When an employer files bankruptcy, does it have an obligation to continue its group health plan or offer COBRA?

Retirees have a few more protections against certain health benefits cutbacks. A bankruptcy court may reinstate, retroactively, any retiree welfare benefits that are modified or terminated within the 180-day period preceding the employer's bankruptcy filing, provided the employer was insolvent at the time of such modification or termination.

Severance Pay

Employers that file for bankruptcy are prohibited from paying severance benefits to insiders (e.g., directors, executive officers or persons in control of the organization), unless the payments meet specific criteria.

Severance payments to insiders are permissible only if they are part of a program generally available to all full-time employees and if the amount of the payment is not greater than 10 times the amount of the mean severance paid to nonmanagement employees during the year in which the payment is made to the insider.

See Designing and Administering Severance Pay Plans.

Additional Resources

Federal Bankruptcy Code

Regulations Relating to the Bankruptcy Reform Acts of 1978 and 1994, 28 C.F.R. Section 58

Bankruptcy Forms

Department of Justice U.S. Trustee Program

IRS: Closing a Business Checklist