New Bankruptcy Legislation Impacts Employee Benefits and Executive Compensation

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A new law, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("Act"), enhances protection of retirement plan benefits in bankruptcy and provides new restrictions on the ability of employers to retain key employees while in bankruptcy. The Act generally will become effective for bankruptcy cases filed on or after October 17, 2005. This Alert highlights changes made by the Act that impact employee benefits and executive compensation.


Protected Retirement Benefits

To varying degrees, prior court decisions have protected the retirement benefits of individual employees from their creditors. The Act unifies the protection of certain retirement benefits by exempting from an employee's bankruptcy estate any benefits under:

  • qualified retirement plans (including 401(k) plans),
  • 403(b) plans,
  • 457 plans of tax-exempt organizations and state and local governments,
  • certain other retirement arrangements, including IRA benefits up to $1 million, and
  • amounts rolled over from plans of other employers.

This exemption is available, however, only if the employee can demonstrate to the bankruptcy court:

  • that the plan is covered by a current IRS determination letter,
  • if the plan is not covered by a current IRS determination letter, that the plan is in substantial compliance with the applicable Internal Revenue Code ("Code") requirements, or
  • if the plan is neither covered by a current IRS determination letter nor in substantial compliance with the applicable Code requirements, that the employee is not materially responsible for the plan's non-compliance.

Therefore, employers may be asked to provide a copy of their plan's most recent IRS determination letter (or other evidence of substantial compliance with Code requirements) to the employee or the bankruptcy court.

Protected Employee Contributions

The Act excludes from an employee's bankruptcy estate contributions made by the employee to an employee benefit plan. The exclusion covers employee contributions to tax-qualified retirement plans (such as 401(k) plans), 403(b) tax-deferred annuity plans, 457 plans, and health insurance plans regulated by state law. The exclusion applies regardless of whether the contributions are withheld from the employee's paycheck or paid directly by the employee.

The scope of this exclusion is not entirely clear. For example, it is uncertain whether the exclusion applies to employee contributions made to self-insured health plans, 403(b) custodial accounts and nonqualified deferred compensation plans for executives and highly compensated employees.

Retirement Plan Loans

Under the Act, repayments of an employee's loan from his or her retirement plan account (e.g., 401(k) plan loans) may be deducted from the employee's pay after the employee's bankruptcy filing. Additionally, the Act prevents an employee's loan from being discharged or modified in bankruptcy.


Plan Administration Duties

If the debtor is a plan administrator of an employee benefit plan at the time the bankruptcy petition is filed, the Act requires the debtor to continue administering the plan during the bankruptcy proceeding, unless a bankruptcy trustee assumes responsibility for ongoing administration of the plan.

Retiree Health Benefit Protections

The Act provides additional protections for retirees against certain health benefit 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 and Retention Bonuses

The Act prohibits an employer who files bankruptcy from paying severance benefits or retention bonuses to insiders (e.g., directors, executive officers, or persons in control of the company), unless the payments meet certain criteria.

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

Retention bonuses paid to insiders are permissible only if: (1) 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; (2) the services provided by the insider are essential to the survival of the business; and (3) the amount of the bonus is not greater than 10 times the mean retention bonus paid to non-management employees during the year in which the bonus is paid to the insider, or if no retention bonuses are paid to non-management employees during the year, the amount of the bonus is not greater than 25% of the amount of any retention bonus paid to the insider in the preceding calendar year.

These restrictions on severance payments and retention bonuses are expected to severely curtail or eliminate the use of Key Employee Retention Plans (KERPs), which are currently permissible under the Bankruptcy Code, to motivate and retain insiders while an employer is in bankruptcy.

Post-petition Employment Agreements

The Act disallows payment of expenses of the debtor that are outside the ordinary course of business and not justified by the facts and circumstances. This provision 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. The broad language of this provision suggests that a wide variety of compensation payments and benefit 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.

Pre-petition Payments to Insiders

The Act expands a bankruptcy trustee's ability to recover excessive compensation or benefits paid to insiders before the employer's bankruptcy filing. Under current law, payments made in certain circumstances during the one-year period before the employer's bankruptcy filing are recoverable. The Act extends the recovery period from one year to two years, and the Act specifically includes payments made during this two-year period to insiders pursuant to employment agreements.

Claims for Unpaid Contributions

Under the Bankruptcy Code, certain claims for unpaid contributions to an employee benefit plan have priority status allowing those claims to be paid ahead of certain other claims. Prior to the Act, priority claims for plan contributions generally were limited to $4,925 per employee covered under the plan. The Act increases the limit on priority claims to $10,000 per covered employee. This change became effective April 20, 2005.

Key Contributors

Bethany A. Bacci
Jeffrey M. Krueger
David B. Levant
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