The recent bankruptcy case of Hostess has centered on Hostess’s attempts to reject collective bargaining agreements with its unions.  Hostess has emphasized that realigning labor costs is essential to its ability to successfully reorganize.  Section 1113 of the Bankruptcy Code sets forth detailed requirements that a debtor must meet to modify or reject CBAs.  Bankruptcy courts’ ultimate decision to authorize rejection of a CBA frequently turns on a detailed examination of the evidence presented in support of the rejection motion.

This post discusses the recent ruling of Judge Robert Drain of the United States Bankruptcy Court for the Southern District of New York denying Hostess’s motion to reject several CBAs with local affiliates of the International Brotherhood of Teamsters.  Although the court did not issue a written opinion of its decision, we have reviewed and analyzed the lengthy hearing transcript.  See Transcript of Hearing, In re Hostess Brands, Inc., No. 12-22052 (RDD) (Bankr. S.D.N.Y. May 14, 2012).  Judge Drain analyzed extensively the parties’ proposed modifications to the CBAs.  Although he found that most of the key modifications related to withdrawing from multiemployer pension plans were necessary and thus permitted under applicable law, he did not authorize the rejection because the Teamsters had cause to reject Hostess’s final proposal.  Judge Drain’s holding turned on a relatively minor point of fact pertaining to a one percent difference in proposed EBITDA margin – an issue only addressed briefly in the pleadings and the ruling.

Section 1113

Congress added section 1113 to the  Bankruptcy Code in 1984 as a response to the Supreme Court’s ruling in NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984), which held that a debtor could (i) reject a CBA subject to the bankruptcy court’s approval and (ii) unilaterally modify the CBA pending the bankruptcy court’s approval of the rejection motion.  Congress was concerned with debtors’ ability to reject a CBA without any of the employee protections provided under the National Labor Relations Act.  Accordingly, Congress enacted section 1113 which sets forth a detailed process that debtors must undertake to obtain bankruptcy court approval of rejection of a CBA and prohibits unilateral modification of the CBA prior to obtaining bankruptcy court approval.

Specifically, in order for a debtor to obtain bankruptcy court approval to modify/reject a CBA, (i) the debtor must make a proposal to the union, (ii) that contains only those modifications that are “necessary to permit the reorganization of the debtor,” and (iii)the union must refuse to accept the proposed modifications without “good cause.”

Courts are split on the meaning of the term “necessary to permit the reorganization of the debtor.”  Courts in the Third Circuit require the debtor to demonstrate that the proposed modification is essential to prevent liquidation in the short term.  See Wheeling-Pittsburgh Steel Corp. v. United Steel Workers of America, 791 F.2d 1074 (3d Cir. 1986).  Courts in the Second Circuit – including the bankruptcy courts presiding over the Hostess and American Airlines cases in the Southern District of New York – use a more flexible approach and analyze the effects that an unmodified CBA would have on the debtors ability to attain financial health.  See Truck Drivers Local 807 v. Carey Transportation, Inc., 816 F.2d 82 (2d Cir. 1987).

Hostess

On January 25, 2012, Hostess filed a motion seeking to (i) reject certain CBAs with local affiliates of the International Brotherhood of Teamsters[1] and (ii) modify certain retiree benefits plans.  In its motion and subsequent reply brief, Hostess argued that it had emerged from a previous bankruptcy in early 2009 with excessive debt and had not obtained substantial relief from its labor costs in the previous bankruptcy.  Specifically, Hostess asserted that almost 80% of its active employees were unionized, and under the CBAs, its employees were provided with above-market health care and pension benefits.  Hostess also stated that its participation in certain multiemployer pension plans (MEPPs) was particularly onerous, estimating that its 2011 contribution obligation was over $90 million, and if it was to withdraw from the MEPPs, it would incur withdrawal liability of approximately $2 billion.  Hostess noted that some of the MEPPs were severely underfunded and that it was possible for the MEPPs to be terminated without its consent in a “mass termination.”  Under applicable law, if the MEPPs experienced a “mass termination,” withdrawal liability would be triggered for all participating employers (including Hostess).

As a result of these looming liabilities, Hostess argued that it would be unable to successfully attract an investor willing to inject new capital in the company unless it could reject certain CBAs, withdraw from the affiliated MEPPs and discharge the MEPP withdrawal liability upon emerging from bankruptcy.  Hostess also claimed that its proposal treated all parties fairly and equitably, pointing to various other components of its planned turnaround strategy, such as closing certain bakeries and unprofitable outlet stores, and outsourcing production of certain product lines.  Accordingly, Hostess proposed a strategy that (i) rejected the CBAs, (ii) withdrew from the MEPPs, and (iii) implemented other economic concessions which would allow it to achieve an EBITDA margin of 11%.  Hostess contended that at this level of EBITDA margin, it would be slightly below the EBITDA margin levels of its principal competitors which would ultimately enhance its ability to attract capital investments.

The Teamsters objected to the motion, arguing that Hostess had not fulfilled the statutory elements of section 1113.  In particular, the Teamsters asserted that:

• Withdrawing from the MEPPs was not necessary because their counterproposal to Hostess contained significant concessions in other areas that would allow Hostess to successfully reorganize;
• They had good cause to reject Hostess’s proposals because – contrary to Hostess’s claims – credible investors had expressed interest in providing fresh capital without demanding a full withdrawal from the MEPPs;
• Hostess’s insistence on using the 1113 process to achieve a stated EBITDA margin was inappropriate because investors would focus on the expected return on their investment – not Hostess’s ability to achieve a particular margin;
• It was premature to enter into a final agreement because Hostess could not guarantee the constitution of its post-emergence capital structure without a committed exit facility; and
• Over 90% of their members had voted in favor of striking if the court granted Hostess’s motion.

On April 18 and 19, 2012 the court held an evidentiary hearing to determine if Hostess could reject the CBAs.  Hostess and the Teamsters provided the court with their most recent proposals and, presented testimony from the individuals responsible for negotiations and expert witnesses regarding the MEPPs and other financial matters.  Hostess’s final proposal prior to the hearing provided that the CBAs would be amended to allow it to withdraw from the MEPPs that were in poor financial condition and instead attempt to re-enter into other stronger MEPPs.  Additionally, the final proposal provided a package of financial concessions that would result in an EBITDA margin of approximately 10%.  The Teamsters final proposal prior to the hearing provided that Hostess would exit and re-enter the distressed MEPPs.  In turn, the distressed MEPPs agreed to allow Hostess’s bankruptcy discharge to constitute full satisfaction of the withdrawal liability triggered by Hostess’s initial exit from the MEPP and if a mass withdrawal occurred after Hostess re-entered the MEPP, Hostess’s withdrawal liability would be calculated based on the unfunded liabilities as of the re-entry.  The Teamsters contended that this arrangement satisfied Hostess’s fears of being saddled with excessive withdrawal liability.  Additionally, the Teamsters’ final proposal provided a package of financial concessions that would result in an EBITDA margin of approximately 9%.

On May 14, 2012, the court denied Hostess’s motion to reject the CBAs.  As an initial matter, the court determined that Hostess had generally met its burden and had shown that withdrawing from the MEPPs was necessary to its reorganization and that the Teamsters did not have good cause to reject this aspect of Hostess’s proposal.  However, the court was troubled by the fact that Hostess did not intend to include new hires upon re-entry into the stronger MEPPs.  The court found that prohibiting new employees from joining the MEPPs would place those plans in substantial risk.  The court analyzed extensively the merits of Hostess’s proposed withdrawal from the MEPPs and appeared to endorse the broad contours of Hostess’s proposal.  Despite the general tone of approval, the court honed in on one narrow issue – the amount of EBITDA margin that Hostess claimed was necessary to attract new investors.  The court concluded that Hostess had not met its burden of proving that an EBITDA margin of 10% was necessary to its reorganization and that the one percent differential between Hostess’s proposed EBITDA margin and the Teamster’s proposed EBITDA margin was essential.  As a result of Hostess’s failure to prove this narrow point, the Teamsters had good cause to reject the proposal.

In light of these flaws, the court stated that if Hostess (i) adopted the economic concessions proposed by the Teamsters and assumed the CBAs pursuant to these concessions, (ii) provided a mechanism under which Hostess would agree that the final capital structure would be consistent with the capital structure that Hostess had presented to the Teamsters, and (iii) included new hires upon Hostess’s re-entry into the stronger MEPPs, such a proposal would satisfy the criteria of section 1113.

Finally, the court acknowledged that the Teamsters’ members had voted to strike if Hostess ultimately attempted to impose a CBA along the lines proposed by the court.  However, the court dispensed with this contingency, observing that if the Teamsters did strike, it would ultimately result in a liquidation which would effectively cause Hostess to withdraw from the MEPP in any event.

Conclusion

The Hostess court’s analysis serves as an excellent example of the detailed attention bankruptcy courts pay to the parties’ proposals and counter-proposals when negotiating CBA modifications.  Additionally, the Hostess decision is a helpful reminder to debtors and practitioners alike, of the fact-intensive nature of section 1113 and the need to put on a thorough evidentiary showing even under the Second Circuit’s broader interpretation of “necessary to permit the reorganization of the debtor.”  Debtors seeking to reject a CBA must be prepared to justify the necessity of its proposed terms as opposed to simply identifying the deficiencies of the competing terms proposed by the union.  Although the parties’ pleadings focused heavily on the effects of withdrawing from the distressed MEPPs and whether Hostess would be able to attract investors if it was forced to remain in the distressed MEPPs, the court ultimately denied Hostess’s motion because it did not effectively explain why the additional one percent of EBITDA margin was necessary for its reorganization.  It is noteworthy that the Teamsters had threatened to strike if Hostess withdrew from the MEPPs.  The court’s decision prevents Hostess from immediately withdrawing from the MEPPs and sends the parties back to the negotiating table.  However, the decision also informs the parties of the court’s willingness to authorize Hostess’s withdrawal at a later date if the court’s conditions are met.

Section 1113 issues will also figure prominently in the American Airline bankruptcy case.  Last month, Judge Sean Lane of the United States Bankruptcy Court for the Southern District of New York held a hearing on American Airlines’ motion to authorize rejection of certain CBAs with its pilots, flight attendants and transportation workers.  Judge Lane has indicated that he intends to rule on the motion by June 22, 2012.  The Restructuring Review will provide analysis regarding Judge Lane’s decision when it is issued.