United States: Not-for-Profit Bankruptcies: Eleemosynary Corporations on the Brink

Last Updated: November 24 2004
Article by Mark G. Douglas

In the wake of controversial bankruptcy cases recently filed by the Roman Catholic Archdiocese of Portland, Oregon, National Benevolent Association, Allegheny Health, Education, and Research Foundation and most recently, the Roman Catholic Archdiocese of Tucson, Arizona, scrutiny has been increasingly brought to bear on the benefits and burdens that federal bankruptcy laws offer to eleemosynary corporations. Non-profits seek bankruptcy protection for a variety of reasons. The Portland archdiocese filed for chapter 11 to head off (at least temporarily) 60 pending clergy sexual abuse cases seeking hundreds of millions of dollars in damages. The Tucson archdiocese's bankruptcy filing on September 20, 2004 was similarly precipitated by a rash of potential sexual abuse litigation exposure. National Benevolent Association, a 117-year-old charitable organization that manages more than 70 facilities financed by the U.S. Department of Housing and Urban Development and owns and operates 18 other facilities, including residential homes for seniors, at-risk children and the disabled, filed for bankruptcy in February of this year in an effort to stem ballooning losses in the aftermath of issuing more than $200 million in bonds. AHERF, the largest non-profit healthcare chain in Pennsylvania and owner/operator of 14 hospitals in Pennsylvania and New Jersey before it rolled up approximately $1.4 billion in debt, filed for chapter 11 in 1998 to liquidate its assets amid allegations (later proven) that management raided more than 350 charitable endowments to prop up the non-profit’s ailing system.

Regardless of the motive, the filings raise important questions regarding the utility of a bankruptcy filing as an effective means of dealing with the woes of non-profits. Non-profit trustees or other decision makers weighing the full complement of possible solutions for a non-profit's financial difficulties can make an informed decision only if they understand the issues unique to non-profits that may arise in a bankruptcy case. These can range from something as basic as the company's eligibility to file for bankruptcy, to more complex matters concerning what assets are properly included as part of the debtor's bankruptcy estate and whether the debtor's business may be sold in bankruptcy notwithstanding non-bankruptcy regulations making such transactions the exclusive province of a regulatory agency.

Bankruptcy Relief and Staying in Control

One of the threshold issues that must be considered is whether a non-profit can file for bankruptcy in the first place. The answer to this question hinges largely on the way that the entity is organized and the nature of its operations. Some states may not permit their non-profit corporations to seek bankruptcy protection. Instead, these states have enacted detailed receivership procedures to be carried out under the supervision of state courts. Related issues include whether a non-profit's bankruptcy case, once filed, is subject to dismissal or conversion to a case under another chapter of the Bankruptcy Code and whether existing management can retain control of the company after it files for relief.

Section 109 of the Bankruptcy Code dictates the eligibility requirements for a bankruptcy filing under any chapter of the Bankruptcy Code. Initially, it provides that "only a person that resides in or has a domicile, a place of business, or property in the United States, or a municipality, may be a debtor under [title 11.]" The statute expressly makes certain entities ineligible for certain kinds of bankruptcy relief, including railroads (which can only file for chapter 11), domestic insurance companies, banks, and savings and loan associations, all of which are subject to different legislative schemes enacted to effect their reorganization or dissolution. The Bankruptcy Code defines "person" to include any individual, partnership or corporation. Not-for-profit corporations qualifying for that status under applicable state law are eligible to file under both chapter 7 and chapter 11 of the Bankruptcy Code. Even unincorporated non-profit enterprises may qualify. However, if a not-for-profit enterprise is not organized as either a corporation or a "business trust" within the meaning of Bankruptcy Code section 101(9), it will not be eligible for relief under the Bankruptcy Code.

Bankruptcy Code section 303 provides that an involuntary case may be commenced under chapter 7 or chapter 11 "only against a person, except a farmer, family farmer, or a corporation that is not a moneyed, business, or commercial corporation" if the requisite number of unsecured creditors files an involuntary petition against the entity. The statute expressly excludes corporations that do not qualify as "moneyed, business or commercial." Its legislative history indicates that "schools, churches, charitable organizations and foundations" are protected from involuntary bankruptcy. Some courts have struggled to devise a workable standard for determining whether an entity ― regardless of its denomination as not-for-profit ― actually is a "moneyed, business, or commercial corporation," such that it can be an involuntary debtor. Some look to the powers and characteristics imposed on the entity by the law of the state where it was organized (particularly tax laws), while others examine the company's charter or its business activities.

The Bankruptcy Code provides for the conversion of a chapter 11 case to a chapter 7 liquidation upon demonstration of "cause," including continuing loss or diminution of the estate and the absence of a reasonable likelihood of rehabilitation, the inability to effectuate a plan of reorganization or unreasonable delay by the debtor that is prejudicial to creditors. This remedy allows creditors and other parties-in-interest to force a debtor languishing in chapter 11 with no real prospect of rehabilitation into an orderly liquidation where any available assets can be sold in relatively short order and the proceeds distributed to creditors in respect of their claims. However, section 1112(c) of the Bankruptcy Code prohibits the conversion of a chapter 11 to a chapter 7 liquidation if the debtor is a "non-moneyed, non-business or non-commercial corporation." Although the statute does not define these phrases, they have acquired a specific meaning by judicial interpretation to encompass only those corporations organized as not-for-profit. As with courts assessing eligibility for involuntary filings, in determining whether a debtor corporation is included in the exception set forth in section 1112(c), courts have looked to, among other things, applicable state law, the debtor's articles of incorporation and the actual character and activities of the corporation.

Even though a non-profit cannot be the subject of an involuntary liquidation under chapter 7, it may nevertheless be possible to effect an involuntary liquidation of a non-profit by confirming a liquidating chapter 11 plan over the debtor’s objection. A chapter 11 debtor has the exclusive right to propose a plan of reorganization for 120 days ensuing its bankruptcy filing, unless that period is augmented or shortened by the court. Once the debtor’s "exclusivity" expires (due to lapse of time or the appointment of a trustee), any party-in-interest (e.g., creditor or shareholder) may propose its own plan of reorganization for the debtor. Among the things that a chapter 11 plan can accomplish is liquidation of the debtor. Thus, if a creditor or other party-in-interest proposed a liquidating plan and the requisite number of creditors and shareholders vote to approve it, any debtor ― including a non-profit or other “non-moneyed, business or commercial corporation” ― can be liquidated involuntarily according to the express terms of the Bankruptcy Code. Applying the statute strictly, some courts have allowed confirmation of liquidating plans over the objection of other kinds of debtors that are also protected from involuntary bankruptcy and liquidation under Bankruptcy Code section 303(a), such as farmers. Others have taken the opposite tack, reasoning that the policy underlying the involuntary bankruptcy and conversion preclusion for such debtors should apply equally to preclude the confirmation of a liquidating plan proposed by someone other than the debtor. The same reasoning should apply in the case of a non-profit debtor.

Although a non-profit's chapter 11 case cannot be converted non-consensually, the case can be dismissed upon a showing of one of more of the grounds enumerated in Bankruptcy Code section 1112(b)(1), including continuing loss or diminution of the estate and the absence of a reasonable likelihood of rehabilitation, the inability to effectuate a plan of reorganization or unreasonable delay by the debtor that is prejudicial to creditors.

If a non-profit files a petition under chapter 7 of the Bankruptcy Code, a trustee will be either elected or appointed to effect an orderly liquidation of its assets. If the filing is under chapter 11, existing management will retain its power to manage the debtor's ordinary course affairs and the debtor will be deemed a "debtor-in-possession." However, the management of a chapter 11 debtor-in-possession can be displaced and a chapter 11 trustee appointed to run the business upon a showing of "cause," including fraud, dishonesty, incompetence, or gross mismanagement, or if the appointment is in the best interests of creditors and shareholders.

What Qualifies as Property of the Non-Profit's Bankruptcy Estate?

Among the issues most frequently litigated in bankruptcy cases filed by not-for-profit corporations is whether assets, money or other property in the debtor's possession at the time it files for bankruptcy is included in the debtor's bankruptcy estate, such that it is available in whole or in part for distribution to creditors. This is so because assets held by non-profits are frequently acquired by means of government grants or bequests from private individuals or foundations that are subject to use limitations.

Section 541 of the Bankruptcy Code broadly defines property of a debtor’s bankruptcy estate to include "all legal or equitable interests of the debtor as of the commencement of the case." The scope of section 541 is broad. According to the Supreme Court, it should be interpreted to "include all kinds of property, including tangible or intangible property, causes of action . . . and . . . other forms of property." In enacting section 541, Congress understood that, in large measure, applicable non-bankruptcy law would define the debtor's property interests and thereby determine the contents of the debtor's estate. Thus, the extent of a non-profit’s interest in property at the time of its bankruptcy filing will be determined by applicable state law which creates and defines property interests.

Pre-bankruptcy restrictions on property held by a non-profit debtor, such as those associated with donor-restricted funds, can significantly limit the broad grasp of Bankruptcy Code section 541. It has long been established that a debtor's post-petition property interests are subject to certain pre-existing restrictions. By the same token, certain property may be excluded altogether from the estate because it either is held in trust by the debtor for the benefit of third parties or is subject to restrictions precluding its alienation to anyone other than the non-profit.

Non-profits are often required to use certain assets for one or more specific purposes determined by the individual or entity conveying the property to the non-profit. A contributor or grantor, for example, may restrict the use of property given to the non-profit through its bequest, deed or by contract. If a non-profit debtor wants to use restricted funds in a manner inconsistent with their intended purpose, it may need bankruptcy court authority to do so, as a proposed use of property outside the ordinary course of the non-profit debtor’s business pursuant to Bankruptcy Code section 363(b). It may also be required to provide adequate protection of any interest in the property asserted by others pursuant to Bankruptcy Code section 361. Complicating matters further are laws in most states requiring notification of a state agency of any unauthorized use of restricted funds by a non-profit.

Once a non-profit company files for bankruptcy, the automatic stay prohibits any creditor action against either the debtor or property of its estate to collect on a claim that arose prior to the bankruptcy filing. However, if property or assets in the non-profit debtor’s possession at the time it files for bankruptcy are excluded from its bankruptcy estate because, for example, they were the subject of a restricted grant or are held in trust, the stay will not prohibit creditor collection activities involving the property. Property or other assets belonging to non-profits may be in the possession of other entities, such as banks, other creditors, customers or state regulatory agencies that are authorized to administer the non-profit’s assets or take over its business. If the non-profit files for bankruptcy, it may be difficult to recover the assets so that they can be administered as part of the debtor’s bankruptcy estate. Difficulty or delay in forcing the turnover of the assets may be of particular concern to creditors whose claims are secured by the assets in question.

A related issue that has received a great deal of coverage in connection with the recent Catholic archdiocese chapter 11 filings is the conflict between federal bankruptcy law and canon law in determining what qualifies as estate property. Within the Catholic Church, dioceses, or geographic districts established by the church, control local parishes, or congregations. Each diocese is constituted as a separate corporation and governed by a bishop (or an archbishop, if the area is extensive enough to be designated an archdiocese). The bishop holds title to all parish properties in the name of the church. However, under canon law, bishops hold the properties in trust for parishioners. Church officials have taken the position that only the bishop's direct holdings, as opposed to properties held in trust for parishes, should be included in an archdiocese's bankruptcy estate. The 9th Circuit will likely be called upon to resolve this conflict between church and bankruptcy law in connection with the Portland archdiocese's chapter 11 case.

Special Problems Regarding Recoupment and Setoff

Non-profit institutions, such as hospitals and other healthcare providers, frequently receive Medicare or similar payments from government agencies as reimbursement for services provided. These payments are sometimes made before the agency has determined whether the non-profit is fully entitled to reimbursement. The institution is legally obligated to return any overpayments. If it files for bankruptcy before remitting overpayments, the automatic stay may or may not, depending on the nature of the institution’s obligations to the payor, prevent actions by the agency to recover the funds, either directly or by way of recouping the obligation from future amounts due to the institution.

Whether and under what circumstances the federal government can collect Medicare overpayments made to a healthcare provider when that health care provider files for either chapter 7 or 11 is an unsettled question in the courts. In many cases, the answer to that question will hinge upon the precise terms of the obligation and whether or not the debtor assumes or rejects the operative agreement. It may also depend on whether the government has a right of setoff or a right of recoupment under applicable non-bankruptcy law.

The payor’s ability to recover overpayments may also depend on the bankruptcy court’s characterization of the provider agreement. If the agreement is deemed to be a series of separate contracts, the payor’s recovery action will be deemed an impermissible setoff. This is the minority view. The majority of courts find that a provider agreement is a single integrated transaction, such that the payor’s recoupment of overpayments does not violate the automatic stay.

Selling a Non-Profit's Assets in Bankruptcy

The Bankruptcy Code expressly sanctions the sale of a debtor’s assets or it entire business free and clear of claims, liens and other interests either as part of a confirmed chapter 11 plan of reorganization or as a stand-alone "non-ordinary" course sale transaction under Bankruptcy Code section 363(b). In determining whether or not to approve a proposed sale transaction, the bankruptcy court must decide whether the transaction represents an exercise of the debtor’s sound business judgment. Non-profits have frequently been sold in bankruptcy. However, the jurisdiction of the bankruptcy court in determining whether the sale of a non-profit should be approved may conflict with applicable non-bankruptcy laws. For example, "conversion" laws have been enacted by many states regulating the sale of non-profit hospitals to for-profit enterprises. Also, in many other states, common law allows the state attorney general to exercise such oversight even in the absence of express statutory authorization. Various states have adopted the view that conversion statutes should apply to regulate a sale even if the non-profit healthcare provider is a debtor in bankruptcy. Litigation has resulted in at least two bankruptcy cases over whether the Bankruptcy Code as a federal statute pre-empts arguably inconsistent state laws that purport to give state regulatory authorities the power to fetter the discretion of a bankruptcy judge to approve the sale of a non-profit healthcare provider in bankruptcy. The issue is a controversial one and will likely continue to spawn debate as more and more non-profit healthcare providers file for bankruptcy protection.

Conclusion

The foregoing is illustrative of the basic kinds of bankruptcy issues that a non-profit may face as it encounters financial difficulties and considers seeking bankruptcy protection as a means of sorting out its financial woes. Although this discussion highlights some of the most significant issues involved, it is by no means comprehensive. Other potentially important areas of interest to a non-profit weighing the utility of a bankruptcy filing might include the ability to assume, reject or modify various contracts and other agreements in effect on the bankruptcy filing date (e.g., collective bargaining agreements, employment contracts involving tenure and retiree benefit arrangements). Also of concern to a non-profit's management are the extent of their fiduciary responsibilities as the company approaches insolvency.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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