Easing pension and healthcare burdens in Chapter 11

Read our article in the Cayman Financial Review Magazine, eversion 

Recent headlines have once again drawn attention to pitched battles over companies’ attempts to ease staggering pension and health care burdens through Chapter 11 reorganisation.

The parent company of American Airlines is considering dumping $10 billion in underfunded pension liabilities (after United did the same for its $10 billion shortfall in 2005), Eastman Kodak finally tipped into a formal bankruptcy case in part to deal with a $1.5 billion shortfall in its US and UK pension plans, and Hostess Brands has entered bankruptcy for the second time within three years primarily to restructure its long-term employee benefits.   

Hedge funds and other financiers can take comfort in understanding how, despite some complex and seemingly beneficiary-friendly statutes, US bankruptcy law generally facilitates efforts to escape from “legacy” pension and healthcare burdens.

“Defined-benefit” pension plans and health care insurance plans present two potentially massive problems (“defined-contribution” retirement plans, such as 401(k) accounts, pose fewer problems, especially since the uncertainty of future payouts is borne by employees rather than employers).

First, employers cover obligations to present and especially future pension beneficiaries by making periodic deposits into special-purpose trusts. Large companies like Eastman Kodak and American Airlines might fail to make sufficient periodic funding deposits (intentionally or unintentionally), resulting in a growing debt for “underfunded” pension plans. For large companies, this underfunding debt can climb into the billions of dollars.

Second, for both pension plans and health insurance premiums, rising life expectancies and a host of other factors often result in larger than expected obligations to pension and healthcare beneficiaries and consequently larger required ongoing funding obligations. Premiums for employee health insurance in particular have grown astronomically in recent years.

Smaller companies like Hostess can find themselves overwhelmed by higher and higher bills for pension contributions and health care premiums, and for companies with large numbers of covered retired employees skyrocketing health care premiums can represent an especially staggering financial burden.

US bankruptcy law is generally quite liberal in allowing companies to alleviate pressure from ballooning pension and health care costs. Federal pension law theoretically charges the Pension Benefit Guaranty Corporation (PBGC) with controlling “distress terminations” of pension plans.

Practically, however, the bankruptcy courts control the standard for pension terminations in Chapter 11 cases: The debtor must simply establish that, unless the plan is terminated, the debtor will be unable to effectuate a viable plan for remaining in business.

However strenuously the PBGC might argue for the existence of some option for continuing in business without a pension termination, US bankruptcy judges generally tend to favour the debtor’s evaluation of the prospects for a successful reorganisation. The unsustainable burdens that many pension plans impose on business are impossible for US bankruptcy judges to ignore. In all likelihood, most debtors in most large Chapter 11 cases will thus manage to meet the “but for termination, we can’t make it” standard.

If a company is allowed to terminate its existing pension plan, any underfunding debt to pension beneficiaries is likely to be swept away as a general unsecured claim. The shortfall to beneficiaries is protected by the PBGC’s insurance program, though only up to a rather limited maximum benefit (about $4,500 per month).

While the PBGC might in turn assert a claim in the debtor’s Chapter 11 case, the bankruptcy courts have all but uniformly rebuffed attempts by the PBGC to claim higher priority for its pension subrogation claims. Even if the PBGC’s claim is secured by a pre-bankruptcy statutory lien, the lien is likely to be destroyed in bankruptcy or to rank well behind other creditors with liens or encumbrances on all of the company’s assets.

Avoiding health care premium obligations can be either much easier or more complicated, depending upon who the beneficiaries are. For non-retiree employees, US law places no substantial constraint on an employer’s decision to reduce healthcare coverage.

Reducing or terminating health care coverage for retired employees, however, is subject to a more complex process in Chapter 11. Section 1114 of the Bankruptcy Code ensures that the interests of retired employee health care beneficiaries will be represented by a specially appointed committee. The debtor is required to negotiate with this committee if it proposes “necessary modifications in the retiree benefits that are necessary to permit the reorganisation of the debtor.”

The emphatic repetition of the word “necessary” is intentional, and this statute essentially reproduces the “but for” test for termination of pension plans, discussed above. The debtor can reduce or terminate retiree health care benefits only if the committee “refused to accept such proposal without good cause” and the court finds the modifications “necessary to permit the reorganisation of the debtor.”

As with pension plan terminations, most US bankruptcy judges in most cases will ultimately side with the debtor in evaluating the “necessity” of a retiree health care plan modification, again especially in light of the enormous financial burdens that retiree health coverage has come to impose on employers in recent years.

One major wrinkle for modification of both pension and health care burdens is that either or both might arise as part of a collective bargaining arrangement (CBA) with organised labour. While union membership has fallen precipitously in the last half-century in the US, many unions continue to represent industries that often find themselves in Chapter 11.

Union negotiators often represent retired as well as current employees, so efforts to renegotiate past, present or future retirement and health benefits might well implicate a CBA.

While Chapter 11 debtors can simply “reject” the burdens of most ongoing contracts pursuant to the liberal rules on “executory contracts”, a special rule protects the beneficiaries of CBAs in much the same way as section 1114 protects retiree health benefits. Section 1113 of the Bankruptcy Code requires Chapter 11 debtors to negotiate with union representatives about “necessary modifications [to a CBA] that are necessary to permit the reorganisation of the debtor”.

Like retiree healthcare benefits, a CBA can be forcibly modified only if the union representative “refused to accept such proposal without good cause” and the court finds that the “balance of the equities clearly favours rejection of such agreement.” Given the enormity and centrality of labour costs for debtors like Eastman Kodak, American Airlines, Hostess and a long list of other union employers, US bankruptcy courts have been generally quite deferential to debtors’ appraisals of “necessary” modifications to CBAs.

Of course, one can’t run a labour-intensive business without labour, so one last major consideration is the threat of a strike. The main union for Hostess employees has already announced its intention to strike if management proposes modifications to employee benefits, and many other Chapter 11 debtors have faced strikes following coerced CBA modifications.

Though the automatic stay prevents creditor enforcement action, it does not prevent labour strikes. In industries with particularly acute labour disputes, the threat of union non-cooperation complicates any decision to engage the more heavy-handed strategies discussed above.

For example, in the General Motors bankruptcy, current and former employees alike avoided the termination of their pension and health benefits thanks to the powerful bargaining position of the relevant unions and the threat of a strike (not to mention unprecedented intervention by a labour-friendly presidential administration). Even in GM’s exceptional case, however, the pension plan was frozen and converted to an employer-friendly “defined-contribution” plan going forward.

The ultimate resolution of pension and healthcare burdens in many cases is likely to pit the powerful force of the Bankruptcy Code against the stiff resistance of a labour strike. In the end, a middle ground of some sort usually emerges. As illustrated by the successful reorganisation of Continental Airlines in the mid-1980s despite a bitter labour dispute, however, the extraordinary powers that Chapter 11 grants to debtors generally shift the balance in the company’s favour.

 

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Jason Kilborn

Professor Jason Kilborn teaches business and commercial law at John Marshall Law School in Chicago.  His primary focus is on the comparative analysis of insolvency systems for individuals, though his interest extends to international bankruptcy as well. He recently co-authored a book on international co-operation in cross-border insolvency cases, published by Oxford University Press.

Jason Kilborn
Professor of Law
John Marshall Law School, Chicago
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