Making it a Priority: What Happens to Employee Claims When a Business Declares Bankruptcy?

Making it a Priority: What Happens to Employee Claims When a Business Declares Bankruptcy?

Legal Sidebari

Making it a Priority: What Happens to
Employee Claims When a Business Declares
Bankruptcy?
April 16, 2019
Workers are not immune from their employer’s financial difficulties. Troubled companies commonly
downsize their workforce, cut wages, and curtail employee benefits. Businesses on the brink of collapse
may also lack the funds necessary to pay compensation and benefits that employees have already earned.
Companies in particularly dire financial straits may ultimately declare bankruptcy to restructure their
obligations or liquidate the business. Individuals employed by such companies face a significant risk of
loss of employment or reduced wages or benefits.
In part because of the risks that an employer’s bankruptcy creates for its employees, the federal
Bankruptcy Code contains multiple provisions intended to protect a debtor’s workers. For instance,
Congress has created statutory protections for collective bargaining agreements and retiree benefits that
apply in certain business bankruptcy cases. Of particular relevance here, the Bankruptcy Code also grants
certain employee claims “priority” status, thereby entitling covered employees to more favorable
treatment than some—but not all—of the other interested parties in the bankruptcy case.
Commentators have debated whether current law “provide[s] too little protection for employees.” Some
advocates have encouraged Congress to add additional worker protections to the Bankruptcy Code.
Several Members of recent Congresses have introduced legislation proposing to amend the Bankruptcy
Code’s priority hierarchy to afford workers more favorable treatment in the bankruptcy process. Others,
however, argue that increasing protections for such employees would make it harder for debtors to satisfy
the necessary prerequisites for reorganizing their businesses through bankruptcy. Opponents contend that
amending the Bankruptcy Code to further favor workers could have the unintended consequence of
forcing more companies to shutter their businesses completely—an outcome diametrically opposed to the
goal of increasing job security and financial stability.
To provide context to this policy debate, this Sidebar discusses the legal issues implicated by proposals to
modify the Bankruptcy Code’s priority scheme with respect to employee claims. After providing a
general overview of existing federal law governing bankrupt businesses, the Sidebar then explains how
current bankruptcy law treats various categories of creditors. In particular, the Sidebar focuses on (1) the
ways in which the Bankruptcy Code affords different levels of priority treatment to certain types of claims
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held by employees; and (2) the legal and economic effect of priority status. The Sidebar concludes by
identifying legal issues for Congress to consider as it mulls proposals to reconfigure the existing priority
structure.
Background on Business Bankruptcies
Federal law creates various types of bankruptcy proceedings, two of which are particularly relevant for
business debtors:
 Liquidation proceedings under Chapter 7 of the Bankruptcy Code; and
 Reorganization proceedings under Chapter 11.
A Chapter 7 proceeding liquidates the business’s assets so that it may cease operations. To effectuate a
Chapter 7 liquidation, an officer known as the Chapter 7 trustee collects the debtor’s assets, sells them,
and distributes the proceeds to creditors in accordance with a statutorily defined hierarchy described in
greater detail below.
Chapter 11, by contrast, is primarily (but not exclusively) a means for restructuring a business’s debts so
it may continue to operate as a going concern. Chapter 11 bankruptcies ideally result in a reorganization
“plan” that adjusts the rights and obligations among the debtor and its creditors. Before a plan may
become legally binding, a bankruptcy court must first review and confirm it. The court may not confirm a
proposed plan that does not comply with multiple statutory prerequisites, the most relevant of which are
discussed below.
Types and Hierarchy of Claims
A bankrupt business’s debts fall within several general categories. Some creditors hold claims that are
secured by specific property (known as collateral) that the debtor has pledged against the debt in the event
the debtor defaults. For example, a bank might hold a security interest in a fleet of trailers that the debtor
utilizes to operate its business, which the bank could potentially repossess if the debtor fails to satisfy its
payment obligations. Because such secured creditors possess legal rights that are enforceable against
particular assets of the debtor, they are generally in a better position than unsecured creditors, who do not
enjoy rights against any specific property.
Some unsecured creditors, however, enjoy a more privileged position than other unsecured creditors. For
policy reasons, Congress has singled out several categories of unsecured claims and expenses for priority
treatment. The Bankruptcy Code establishes the following hierarchy of claims and expenses that are
entitled to different levels of priority status.
Hierarchy of Priority Unsecured Creditors
Level of Priority
Description of Claim
First
Domestic Support Obligations
In Between First and Second
“Super-Priority” Claims
Second
Administrative Expenses
Third
Claims Arising in Involuntary Bankruptcy Cases
Fourth
Unpaid Employee Compensation
Fifth
Employee Benefits
Sixth to Tenth
Additional Priority Levels

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Level of Priority
Description of Claim
Non-Priority
General Unsecured Creditors
Source: 11 U.S.C. §§ 364(c), 503(b), 507.
Several priority levels may be particularly significant for employees:
Second-Level Priority: Administrative Expenses. Section 507(a)(2) of the Bankruptcy Code grants
second-level priority to certain types of “administrative expenses,” which may include claims held by
employees. With limited exceptions, administrative expenses are costs that a debtor incurs during a
bankruptcy case to “either preserve the [debtor’s assets] in a reorganization or facilitate the winding-down
in a liquidation.” Congress granted administrative expenses a higher priority than most other claims to
“encourag[e] lenders and others to continue or commence doing business with the debtor” during
bankruptcy proceedings. As relevant here, wages, salaries, and commissions for services an employee
renders after the commencement of the bankruptcy case may qualify as administrative expenses insofar as
they constitute “actual, necessary costs and expenses of preserving the” debtor’s assets. Certain back pay
awards may also be entitled to administrative expense priority.
Fourth-Level Priority: Unpaid Employee Compensation. Section 507(a)(4)’s fourth-level priority tier
established is particularly significant for workers, as it confers priority status to certain claims for unpaid
wages, salaries, commissions, severance pay, and other forms of employee compensation. To qualify for
priority treatment under Section 507(a)(4), the worker must have earned the compensation “within 180
days before the date” on which the debtor filed for bankruptcy “or the date of the cessation of the debtor’s
business, whichever occur[red] first.” Thus, in contrast to Section 507(a)(2), which grants second-level
priority to administrative expenses incurred after the bankruptcy case begins, Section 507(a)(4) grants
fourth-level priority to certain types of compensation workers earned before the case began. Priority status
under Section 507(a)(4) is subject to certain monetary caps that fluctuate every 3 years to reflect changes
in the Consumer Price Index. Thus, as of the date of this Sidebar, to the extent an individual worker’s
claim for compensation exceeds $13,650, the excess amount is not entitled to priority status.
Fifth-Level Priority: Employee Benefits. Section 507(a)(5)’s fifth-level priority tier—which grants
priority status to certain “claims for contributions to an employee benefit plan . . . arising from services
rendered within 180 days before” the employer filed for bankruptcy “or the date of the cessation of the
debtor’s business, whichever occurs first”—is likewise significant for employees. Like Section 507(a)(4),
priority status under Section 507(a)(5) is subject to monetary caps that periodically adjust to reflect
changes in the Consumer Price Index.
General Unsecured Claims Not Entitled to Priority. Underneath priority creditors are “general
unsecured” claims—that is, claims that are not entitled to priority treatment under the Bankruptcy Code.
Generally speaking, to the extent an employee holds a claim against his employer that does not fall within
one of the categories discussed above—such as a workers’ compensation claim arising from a workplace
injury that occurred prior to the bankruptcy—that claim sits at the bottom of the creditor hierarchy.
The Benefit of Priority Status
Although the level of priority that a creditor enjoys generally remains the same irrespective of which
Chapter of the Bankruptcy Code the debtor invokes, the benefit of priority status varies depending on
whether the debtor has declared bankruptcy under Chapter 7 or Chapter 11.
Chapter 7. In Chapter 7 cases, with limited exceptions, secured creditors are generally entitled to be paid
in full out of the proceeds of their collateral before other creditors—including priority and general
unsecured claims—may receive anything. The Chapter 7 trustee then distributes the remaining assets (if
any) to the remaining creditors in the order specified in Section 726 of the Bankruptcy Code. Priority

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creditors are the first in line to receive payment under Section 726, and the Chapter 7 trustee pays those
creditors in the order specified in the table above. Lower priority creditors may not receive anything until
higher priority creditors have been paid in full. If, due to a shortfall of assets, “a priority tier cannot be
paid in full, distribution is made pro rata among creditors within such tier,” while creditors in lower
priority tiers and general unsecured creditors remain unpaid.
Chapter 11. In Chapter 11 cases, by contrast, the primary benefit of priority status is the entitlement to
cash payments. As relevant here, administrative expense creditors, employee compensation creditors, and
employee benefit creditors are all entitled to receive cash equal to the amount of their claims (subject to
the statutory caps discussed above). Unless these priority creditors agree to be treated otherwise, the court
lacks the authority to confirm a Chapter 11 plan that does not propose to pay their claims in full.
Legal Considerations for Congress
As mentioned above, some commentators and several Members of Congress have advocated modifying
the priority hierarchy to benefit employee creditors, such as by creating new tiers of priority claims for
certain types of employee creditors. If Congress opts to create a new priority tier, it could consider:
 Which types of claims will be eligible for priority treatment;
 Where to place the new tier in the existing creditor hierarchy;
 Whether priority claims in the new tier will be subject to monetary caps like those that
presently exist in Section 507(a)(4)-(5);
 If so, what those caps will be, and whether they will adjust automatically for inflation;
 Whether—and under what terms—claimants in the new tier will be entitled to cash
payments in Chapter 11 cases as a prerequisite to plan confirmation; and
 Whether to impose a temporal limitation on claims entitled to priority treatment akin to
Section 507(a)(4)-(5)’s command that priority status only extends to claims accruing
“within 180 days before the date of the filing of the [bankruptcy case] or the date of the
cessation of the debtor’s business.”
With regard to the existing priority classes, Congress could also consider:
 Moving claims for wages and benefits earned prior to the bankruptcy case to a different
priority level;
 Altering or eliminating the monetary caps in Section 507(a)(4)-(5); and/or
 Eliminating or modifying Section 507(a)(4)-(5)’s temporal limitation.
Each of these considerations involves tradeoffs. Giving employees a more preferable position in the
creditor hierarchy, for example, could potentially “diminish[] the recovery of other types of creditors,
such as taxing authorities, trade vendors, customers or tort victims.” Prohibiting bankruptcy courts from
confirming Chapter 11 plans that do not afford employees preferred treatment might also make it harder
for some business debtors to successfully reorganize themselves as a going concern, which might in turn
encourage more companies to liquidate through Chapter 7. Accordingly, adjusting the legal standards
governing the hierarchy of creditor claims may implicate a range of policy questions as well.

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Author Information

Kevin M. Lewis

Legislative Attorney

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