United States: Eighth Circuit Holds That Non-Profit, Non-Bankrupt Entities Are Insulated From Substantive Consolidation

The Bottom Line:

The Eighth Circuit affirmed the District Court of Minnesota and the Bankruptcy Court in holding that section 303(a) of the Bankruptcy Code prohibits the substantive consolidation of non-debtor non-profit schools, churches and charitable organizations with debtors.  The Court looked to the plain language and legislative history of section 303, and determined that Congress intended to protect non-debtor non-profit and not-for-profit entities from being subject to involuntary bankruptcy petitions, which would be the effect of allowing the Committee's motion for substantive consolidation.  The Court declined to consider whether non-debtor non-profits that act as 'alter egos' of a debtor under state law would be subject to the same protections.

What Happened:

In Official Committee of Unsecured Creditors v. Archdiocese of Saint Paul & Minneapolis (In re The Archdiocese of Saint Paul & Minneapolis), No. 17-1079, 2018 WL 1954482 (8th Cir. Apr. 26, 2018), the Official Committee of Unsecured Creditors (the "Committee") filed a motion against the Archdiocese of Saint Paul and Minneapolis (the "Debtors"), seeking to substantively consolidate the estates of the Debtors and more than 200 affiliated non-profit non-debtors.  The Committee asserted that this relief was permissible under the Court's equitable powers granted by section 105(a) of the Bankruptcy Code. 

The Debtors consist of a "geographically defined entity of the Roman Catholic Church . . . covering the Saint Paul and Minneapolis metropolitan area."  2018 WL 1954482, at *1.  Following the passage of the Minnesota Child Victim's Act in 2013, a number of individuals with previously time-barred claims filed civil suits asserting clergy sexual abuse against the Archdiocese, precipitating the Archdiocese's bankruptcy filing in 2015.  The Committee, representing more than 400 potential victims of clergy sexual abuse, sought the substantive consolidation of the Debtors' estates with those of non-Debtor, non-profit entities such as parish corporations, schools, and various related organizations.  Id

The Committee argued that the standard for substantive consolidation was met, as the majority of the Debtors' assets were held by these non-Debtors entities, which were entirely under the Debtors' control, and citing specifically "the role the Archdiocese plays in terms of (1) the incorporation of the Targeted Entities under state law; (2) the oversight of financial and property-related decision-making; (3) the management of priest employment and diocese-wide employment policies; (4) the management of excess parish funds (the Inter-Parish Loan Fund) and parish insurance premiums (the General Insurance Fund); and (5) the operational changes to affiliated non-parish entities."  Id. at *2.

The Bankruptcy Court converted the motion for substantive consolidation into an adversary proceeding, and then granted motions to dismiss filed by the Debtors and the related non-Debtors, finding that section 303(a) of the Bankruptcy Code prohibited the requested relief and that the Committee had failed to show sufficient factual evidence favoring substantive consolidation.  In re The Archdiocese of Saint Paul & Minneapolis, 553 B.R. 693 (Bankr. D. Minn. 2016).  The District Court affirmed the Bankruptcy Court's ruling.  Official Comm. of Unsecured Creditors v. Archdiocese of Saint Paul & Minneapolis, 562 B.R. 755 (D. Minn. 2016).

The Eighth Circuit, applying de novo review, noted that while substantive consolidation is permissible under section 105(a) of the Bankruptcy Code, only the Ninth Circuit has allowed substantive consolidation of the estates of debtors with non-debtors.  2018 WL 1954482, at * 5, citing In re Bonham, 229 F.3d 750, 769-71 (9th Cir. 2000).  No circuit court had previously addressed the issue of substantive consolidation of a debtor and a non-profit, non-debtor. 

The Court then turned to section 303(a) of the Bankruptcy Code, which prohibits the filing of involuntary petitions against "the equivalent of [a] 'non-profit' or 'not-for-profit' corporation," and was intended to protect "[e]leemosynary institutions, such as churches, schools, and charitable organizations" from involuntary bankruptcies.  2018 WL 1954482, at *5 (internal citations omitted).  Finding that the equitable powers of section 105(a) were limited by the explicit constraints of section 303(a) of the Bankruptcy Code on forcing a non-profit into bankruptcy, the Court found that the non-Debtor entities were non-profit organizations under state law.  "Section 303(a) prevents the use of § 105(a) to force truly independent non-profit entities into involuntary bankruptcy."  Id. at*6.  The Court also found that the Committee had failed to make sufficient allegations to overcome the "express prohibition of § 303(a) against an involuntary bankruptcy of non-debtor non-profits."  Id.

While the Court ruled on a plain reading of the statute, it declined to opine on whether a non-profit, non-debtor that is an alter ego of a debtor under state law would be subject to the same protections against substantive consolidation, as the Committee had failed to raise that argument.

Why the Case is Interesting:

The Eighth Circuit is only the second circuit to consider whether the estates of non-debtors and debtors can be substantively consolidated.  While the Court did not allow substantive consolidation in this instance, the Court implied that substantive consolidation between debtors and non-debtors is not beyond the Court's powers over for-profit entities where the same restrictions on commencing an involuntarily bankruptcy against the non-debtor are inapplicable.  In addition, the Court alluded to the potential for substantive consolidation of non-profits if the alter ego test were satisfied since, in such a context, the debtor and non-debtor would effectively be treated as the same entity.  In the end, the decision underscores that affiliated non-profit entities are protected from the risk of substantive consolidation when creditors of the debtor try to reach beyond the assets of the debtor itself to satisfy their claims (e.g., substantial tort claims).  Although the case was in the context of a religious institution, it applies equally to schools or hospitals and other medical providers, especially in states (like New York) where hospital systems are non-profit entities.

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