United States: New Bankruptcy Act – Employee Benefits and Executive Compensation Provisions

On April 20, 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Act), which is generally effective for bankruptcy filings commenced after October 17, 2005. The Act clarifies how certain Bankruptcy Code rules apply to employee benefits and enhances the protection of plan benefits in bankruptcy and contains new restrictions on executive compensation that may be paid by an employer in (or prior to) bankruptcy. Below is a summary of the Act’s principal provisions affecting employee benefits and executive compensation.

Individual debtors’ retirement plan benefits have been protected from creditors to varying degrees under the United States Supreme Court’s decision in Patterson v. Shumate and subsequent court decisions. The Act resolves many of the open issues identified by the subsequent cases, essentially by extending the principle of Patterson v. Shumate to arrangements that are not subject to the Employee Retirement Income Security Act (ERISA). The Act now allows a debtor to exclude from the debtor’s bankruptcy estate any benefits under a fund or account that is exempt from taxation under Internal Revenue Code Sections: 401(a) (tax-qualified plans); 403 (tax-sheltered annuities); 408 (individual retirement accounts and annuities (IRAs)); 408A (Roth IRAs); 414 (governmental and church plans); 457 (not-for-profit and state and local government plans); and 501(a) (plans funded solely with employee contributions). If the plan involved does not have a favorable IRS determination letter, the debtor must demonstrate that the plan is in substantial compliance with the applicable Internal Revenue Code requirements.

The Act limits the exclusion for IRA benefits to $1 million. The limit applies to Roth IRAs but not to Simplified Employee Pension Plan (SEPs) and SIMPLE IRAs. The $1 million limit on the IRA exclusion is determined without regard to amounts rolled over from certain employer tax-favored retirement plans. The Act gives a bankruptcy court the power to increase the limit if "the interests of justice so require," and the limit will be adjusted in the future for inflation. (Note that on April 4, 2005, the United States Supreme Court ruled, in Rousey v. Jacoway, that debtors can exempt IRAs from their bankruptcy estates as payments "on account of . . . age" but only to the extent that such IRAs are "reasonably necessary" to support the IRA holder or his or her dependents.)

The Act provides that any amount an employer withholds from an employee’s wages or receives from the employee for payment of contributions to most employee benefit plans (including all ERISA plans) is excluded from the employee’s bankruptcy estate. This provision protects from creditors a debtor’s plan contributions (such as 401(k) deferrals) that were withheld from the debtor’s pay but were not deposited in the plan’s trust before the bankruptcy filing.

If an employer files for bankruptcy, the Act increases the dollar limit on priority claims for unpaid plan contributions from $4,925 to $10,000 per participant (subject to reduction for certain other priority claims related to employee compensation). These claims have priority over most other unsecured claims against the employer in bankruptcy. This change is effective April 20, 2005.

Under current bankruptcy law, the continued deduction of repayment amounts from an employee’s paycheck is prohibited. The Act now allows a plan sponsor to continue to withhold plan loan repayments from a bankrupt employee’s wages. The Act also specifically provides that plan loans are not dischargeable in the individual participant’s bankruptcy.

The Act provides for the appointment of a committee of retired employees for negotiation purposes if a bankrupt employer seeks to modify or refuses to pay retiree benefits (including health coverage) and if a motion is made to the bankruptcy court. Modifications made to retiree benefits (including health coverage) within 180 days before the employer files a bankruptcy petition must be restored if the employer was insolvent at the time the coverage was changed, unless the court finds that "the balance of the equities clearly favors such modification." This provision is effective for bankruptcy cases that began after April 19, 2005.

An individual debtor may deduct any reasonably necessary health insurance, disability insurance and health savings account expenses for the debtor, the spouse of the debtor or the dependents of the debtor when determining his or her statement of monthly income. However, there is no exemption in the Act specifically protecting HSA balances from the reach of bankruptcy creditors.

The Act provides that if a debtor is a plan administrator of an employee benefit plan at the time of commencement of the bankruptcy, the debtor must continue to perform its duties as the plan administrator during bankruptcy, unless the bankruptcy trustee assumes these obligations. This requirement for plan administrators is designed to limit the number of "orphan" plans resulting from employer bankruptcies.

Under the Act, an employer in bankruptcy cannot transfer to an executive or other "insider" a retention bonus package to induce that executive to stay (often referred to in the bankruptcy context as a "Key Employee Retention Program" or "KERP") unless all the following conditions are met:

The bankruptcy court finds the transfer is essential to retention of the person because the individual has a bona fide job offer from another business at the same or greater rate of compensation.

The services provided by the person are essential to the survival of the business.

The amount of the transfer made is not greater than 10 times the mean transfer given to non-management employees during the calendar year in which the transfer is made.

If no such similar transfers were made, then the amount of the transfer or obligation must not be greater than 25 percent of the cost of any similar transfer or obligation for this executive for any purpose during the previous calendar year. The Act also forbids other transfers or obligations that are outside the ordinary course of business and are not justified by the facts and circumstances of the case, including transfers for the benefit of officers, managers or consultants hired after the date of the filing of the bankruptcy petition.

Severance payments are permissible to insiders of the employer in bankruptcy only if the payment is part of a program that is generally applicable to all full-time employees, and the amount of the payment is not greater than 10 times the amount of the mean severance pay given to non-management employees during the calendar year in which the payment is made.

Generally, a bankruptcy trustee may nullify any transfer (including any transfer to or for the benefit of an insider under an employment contract) of property of the debtor made within two years (previously one year) before the date of the bankruptcy petition if the transfer was made with intent to defraud or for less than a reasonably equivalent value. The Act specifically includes transfers to an insider under an employment contract not made in the ordinary course of business, making it easier to recover unusual amounts paid to insiders under their employment contracts within the two-year period prior to the bankruptcy. However, under the Act a transferee may be able to defeat a preference claim by showing that the transfer was made in the ordinary course of business. (There also is an exception for transfers with an aggregate value of $5,000 or less.)

These stringent requirements may make it difficult for troubled companies to retain key employees or attract qualified individuals to assist with a successful reorganization.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.