Ruling in Lehman Bankruptcy Shows Risks of Deferred Compensation

The Lehman Brothers bankruptcy has been grinding along for several years, but it occasionally produces a judicial ruling that has importance outside the specific case. A recent ruling by the bankruptcy judge supervising the case provides an important reminder for employees that lucrative deferred compensation plans come with significant risks – including non-payment if the employer seeks a Chapter 7 or Chapter 11 bankruptcy.

In 1985, Lehman Brothers’ corporate ancestor created a deferred compensation plan for its executives. Each plan participant was required to sign an agreement that provided in part that claims for payment under the plan “shall be subordinate in right of payment and subject to the prior payment or provision for payment in full of all claims” of all other creditors. In effect, this term placed claims for payment of deferred compensation last in line in a bankruptcy. The term placed deferred compensation payments on the same level as unsecured creditors, a notoriously unfavorable position.

The plan participants brought a motion in bankruptcy court seeking rejection of the subordination provision. The court rejected all of the employees’ arguments. The court essentially ruled that, in accepting the subordination term, participants in the deferred compensation plan knowingly agreed to move to the end of the line for payment in return for favorable tax treatment. While noting that the arrangement seemed a bit unfair, the court ruled that the employees willingly accepted higher risk of payment in exchange for the ability to defer payment of income taxes.

Many corporations use deferred compensation plans to reward high earning employees. The ruling in the Lehman Bothers bankruptcy might provide a significant warning that such plans carry significant risk in addition to immediate tax benefits.