In a recent decision in the VeraSun bankruptcy cases, the U.S. Bankruptcy Court for the District of Delaware held that “change in control” agreements between former executives and the debtors are “employment contracts” under section 502(b)(7) of the Bankruptcy Code. Accordingly, the Court determined that the former executives’ claims asserted under the agreements were appropriately capped by the claims-allowance scheme set forth in section 502. In re VeraSun Energy Corp., et al., 2012 Bankr. LEXIS 1262 (Bankr. D. Del. Mar. 26, 2012).
Change in Control Agreements
Due to the uncertainty caused by corporate mergers, and the increased likelihood that executives of merging firms may seek employment elsewhere, “change in control” agreements or “CIC Agreements” were conceived to ensure that key executives continue their employment until a merger is either completed or abandoned. CIC Agreements typically provide that if a particular executive is terminated without cause within a specified time period after the closing of a merger, certain benefits will become due. In VeraSun, the CIC Agreements at issue involved compensation packages featuring, upon termination, a cash payment equal to a multiple of the executive’s base salary and bonus, continued medical benefits, payment for unused vacation, vesting of any unvested equity, and a guarantee that once the merger occurred, the debtor could not change the executive’s position, duties, compensation, benefits, or work location.
The VeraSun Decision
VeraSun filed for bankruptcy protection in October 2008. Shortly thereafter, VeraSun terminated various CIC Agreements, and the executives that were parties to these agreements subsequently asserted claims for amounts owing thereunder. The debtors objected to the claim amounts, arguing that the CIC Agreements were “employment contracts”, and because Bankruptcy Code section 502(b)(7) caps claims for “damages resulting from the termination of an employment contract” at one year’s salary and fringe benefits (plus any earned but unpaid compensation), the executives’ claims should be capped accordingly.
In determining whether the 502(b)(7) cap applied, the Court first considered whether the CIC Agreements modified the executives’ employment contracts and thus constitute “employment contracts” under section 502(b)(7), or are stand-alone agreements outside the ambit of 502(b)(7). Because the employment contracts and the CIC Agreements both relate to employment compensation, the CIC Agreements modified the executives’ employment relationship, and the CIC Agreements could not be interpreted without reference to the employment contracts, the Court held that each CIC Agreement formed a single contract with its associated employment contract. Accordingly, the Court determined that the CIC Agreements are “employment contracts”, as that term is used in section 502(b)(7).
The Court then considered whether the executives’ claims under the CIC Agreements were “for damages resulting from the termination of an employment contract”, thus justifying the application of the 502(b)(7) cap. The Court focused on the fact that the CIC Agreements explicitly define the compensation to be awarded as “severance benefits”, which are routinely capped under section 502(b)(7), and contain language nearly identical to severance agreements that have been subject to the cap in numerous prior bankruptcy cases. Further, the Court noted that Congress enacted 502(b)(7) to counter self-serving actions by a debtor’s executives, such as the approval of generous severance packages.
The court explained that section 502(b)(7) of the Bankruptcy Code is necessary to offset the “distinct advantage” executives enjoy “over other unsecured creditors, including other employees, who cannot easily adjust their claims to the company’s assets”. Accordingly, based on the plain language of the CIC Agreements and the important policy considerations underlying section 502(b)(7), the Court determined that the 502(b)(7) cap applied to the CIC Agreements.
In VeraSun, the Court applies a common sense approach to the executives’ CIC Agreements that comports with prior case law and the plain language of the Bankruptcy Code. Although the Court is mindful of a debtor’s need to retain key employees during uncertain periods, such as during a merger or a bankruptcy, Congress has made clear that executive claims are to be reviewed carefully and that executive claims arising under employment contracts, regardless of their form, should generally be subject to the 502(b)(7) cap.