How Bankruptcy Affects Personnel Contracts

When a firm declares bankruptcy, this decision has an impact on all the contracts signed by the firm. The law forces the firm to complete its performance in case of some contracts. On the other hand, the firm has the option to opt-out of some contracts. One such category of contracts is called employment contracts. There is a lot of ambiguity regarding what happens to employment contracts when bankruptcy is filed. In this article, we will understand how bankruptcy laws view personnel contracts and how enforceable these contracts are in the event of actual bankruptcy.

Is it Necessary for the Employment to Cease?

It is not necessary for all companies filing bankruptcy to terminate all their employees. In the United States, there are two types of bankruptcies. One is governed by Chapter 7, whereas the other is governed by Chapter 11. Chapter 7 bankruptcy refers to a liquidation bankruptcy filing. This means that the firm in question does not have the wherewithal to continue the business even for a few days. Filing Chapter 7 bankruptcy generally means curtains for the business and for all employees. This is the situation in which employment contracts get automatically terminated since the business ceases to be a going concern.

On the other hand, there is Chapter 11 bankruptcy as well. Under Chapter 11 bankruptcy, the company does not cease its operations. In such cases, the company can continue with its regular operations. It is, therefore, possible for a company to file bankruptcy and not terminate even one employment contract. However, this is not what happens, usually. Under normal circumstances, companies that file for Chapter 11 bankruptcy are looking to rationalize costs. One of the ways they do this is by asking employees to take a pay cut and by terminating their contract.

Can a Bankrupt Company Unilaterally Terminate the Employment Contract?

When companies sign employment contracts, they normally include provisions that allow them to terminate this contract after giving certain days’ notice to the other party. For example, an employment contract can be terminated by either party after giving one month’s notice to the other.

If a company suddenly decides to terminate a contract, then they will owe one month’s salary as compensation to the other party. The payment made to employee-facing involuntary attrition is called severance pay. Now, the severance pay may be as little as one month’s pay, or it could run into millions of dollars in case the services of senior personnel are terminated.

What is the Meaning of Executor Contracts?

Under bankruptcy proceedings, employment contracts are called executor contracts. The legal definition of these contracts is very simple. Executor contracts are those contracts in which non-performance by one party becomes a material breach of the contract. This material breach is considered to be good enough reason for the other party not to perform.

In simple terms, an employment contract is about future performance. One party has to pay the salary in the future whereas the other has to work in the future. Therefore, if one party does not pay a salary, then they are in breach of the contract, and the other party does not need to work in the future either.

In the case of executory contracts, both parties have to perform in the future. This can be better understood by comparing it with a bank loan wherein one party has already given the loan i.e., performed their task in the past. Hence, the other party needs to be forced to perform in the future.

In simple words, companies can terminate employment contracts by paying severance. In case, they do not have the money to pay severance, then the personnel to which severance is owed need to be added to the list of unsecured creditors.

The seniority of Debts Related to Severance Payments

The fact of the matter is that severance payments are quite junior in relation to other debts. The firm first needs to pay taxes and government obligations. Then, they need to pay the various tranches of bondholders which hold secured debt. Then, they need to move on to unsecured lenders. In most cases, there is no money left by the time a firm reaches unsecured lenders. Severance claims are very low in the hierarchy of unsecured creditors as well. The firm first needs to pay the fees of personnel which was employed post the bankruptcy filing. Then the firm needs to pay some claims which often arise as a result of the bankruptcy filing. Only after the above two are paid does the firm have the permission to pay down severance claims.

Hence, unsecured lenders are paid on a pro-rata basis or may even remain completely unpaid in the event of a bankruptcy. Also, unsecured debtors are not liable to receive any interest payments. This means that the real value of the money owed to them may be considerably reduced by the time the company finally makes the principal payments over a long period of time.

The sad reality is that personnel contracts are not very enforceable when it comes to bankruptcy proceedings. In most cases, employees will end up losing their money, if they are owed any, in the form of severance payments.