United States: Bankruptcy Court Lacks Power To Substantively Consolidate Nondebtor, Nonprofit Entities With Archdiocese Debtor

In the wake of scandal-driven bankruptcies filed by nearly 20 U.S. Roman Catholic dioceses and religious orders, scrutiny has been increasingly brought to bear on the benefits and burdens that federal bankruptcy laws offer to eleemosynary (nonprofit) corporations. Nonprofits seek bankruptcy protection for a variety of reasons. In the case of the dioceses and religious orders, chapter 11 has been a vehicle to head off (at least temporarily) thousands of pending and potential clergy sexual-abuse cases seeking hundreds of millions of dollars in damages. Other nonprofit filings have been designed to restructure balance sheets bloated with debt, to facilitate sales of nonprofits' assets, to effect orderly liquidations, to give nonprofits a needed breathing spell in a climate of regulatory change and uncertainty, or to more effectively manage claims of fiduciary infractions or fraud.

One issue that commonly arises in nonprofit bankruptcies—the scope of the debtor's bankruptcy estate—was recently addressed by the U.S. Court of Appeals for the Eighth Circuit in Official Committee of Unsecured Creditors v. Archdiocese of St. Paul and Minneapolis (In re Archdiocese of St. Paul and Minneapolis), 888 F.3d 944 (8th Cir. 2018). The court affirmed lower court rulings that the assets of parishes and other entities associated with an archdiocese were not, by means of "substantive consolidation," available to fund bankruptcy settlements with clergy abuse victims. According to the Eighth Circuit, a bankruptcy court's authority to issue "necessary or appropriate" orders does not permit it to order substantive consolidation of the assets and liabilities of a debtor archdiocese with the assets and liabilities of nondebtor entities that also operated as nonprofits because the remedy would contravene the prohibition of involuntary bankruptcy filings against nonprofits.

Eligibility of Nonprofits for Bankruptcy Relief

One of the threshold issues that must be considered is whether a nonprofit can file for bankruptcy in the first place. A related issue is whether a nonprofit's bankruptcy case, once filed, is subject to conversion to a case under another chapter of the Bankruptcy Code.

Section 109 of the Bankruptcy Code sets forth the eligibility requirements for a bankruptcy filing, including requirements for filings under certain chapters. Section 109(a) provides that "only a person that resides or has a domicile, a place of business, or property in the United States, or a municipality, may be a debtor under [the Bankruptcy Code.]" The Bankruptcy Code defines "person" to include (in addition to certain governmental units) any individual, partnership, or corporation.

Other subsections of section 109 expressly make some entities ineligible for certain kinds of bankruptcy relief, including railroads (which can file only for chapter 11); municipalities (which can file only for chapter 9); and domestic insurance companies, banks, and savings and loan associations, all of which are subject to different legislative schemes enacted for their reorganization or dissolution.

Corporations qualifying for nonprofit status under applicable state law are eligible to file under both chapter 7 and chapter 11 of the Bankruptcy Code. See Collier on Bankruptcy ¶ 109.02 (16th ed. 2018) ("A nonprofit corporation, like a for-profit corporation, is eligible to file for relief under the Bankruptcy Code despite the fact that its assets may be subject to the beneficial ownership of governmental agencies."). Even unincorporated nonprofit enterprises may qualify. However, where a nonprofit enterprise is not organized as a corporation, a business trust, a joint stock company, or an association with the power or privilege of a private corporation, it will not be eligible for relief under the Bankruptcy Code. See 11 U.S.C. §§ 101(9) and 109.

Prohibition of Involuntary Nonprofit Bankruptcies

Section 303 of the Bankruptcy Code provides that an involuntary bankruptcy 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 eligible creditors files an involuntary petition against the entity. Although the Bankruptcy Code does not define "moneyed, business, or commercial corporation," the legislative history of section 303 indicates that "churches, schools, charitable organizations and foundations" are exempt from involuntary bankruptcy. H.R. Rep. No. 95-595, 321 (1977); S. Rep. No. 95-989, 33 (1978). Courts, which generally decide whether this exemption applies by examining the charter of the entity, as well as its activities and its characteristics and powers under state law, have interpreted the provision to exclude nonprofits from involuntary bankruptcy filings. See Archdiocese of St. Paul, 888 F.3d at 952 ("We agree with the bankruptcy court's interpretation that 'not a moneyed' is equivalent to the modern-day terms 'not-for-profit' or 'non-profit.' ").

Conversion of Nonprofit Chapter 11 Case to Chapter 7 Liquidation Prohibited

The Bankruptcy Code provides for the conversion of a chapter 11 case to a chapter 7 liquidation upon demonstration of "cause," including continuing loss to or diminution of the estate, the absence of a reasonable likelihood of rehabilitation, and the inability to effectuate substantial consummation of a confirmed chapter 11 plan. However, section 1112(c) of the Bankruptcy Code prohibits the involuntary conversion of a case from chapter 11 to chapter 7 if the debtor is not a "moneyed, business, or commercial corporation." Courts have interpreted these terms to refer to nonprofit entities. See, e.g., In re Cult Awareness Network, Inc., 151 F.3d 605, 609 (7th Cir. 1998); In re Forum Health, 444 B.R. 848, 860 n.13 (Bankr. N.D. Ohio 2011).

What Qualifies as Property of a Nonprofit's Bankruptcy Estate?

Among the issues most frequently litigated in bankruptcy cases filed by nonprofit corporations is whether assets, money, or other property in the debtor's possession (or nominally under its control) at the time it files for bankruptcy should be included in the debtor's bankruptcy estate, such that they are available in whole or in part for distribution to creditors. This is so because assets held by nonprofits are frequently acquired by means of government grants or bequests from private individuals or foundations that are subject to use limitations.

Section 541(a)(1) of the Bankruptcy Code broadly defines property of a debtor's bankruptcy estate to include "all legal or equitable interests of the debtor in property as of the commencement of the case." Although the scope of section 541 is broad, applicable non-bankruptcy law defines the debtor's property interests and thereby determines the extent of the bankruptcy estate. See Butner v. U.S., 440 U.S. 48, 55 (1979).

Pre-bankruptcy restrictions on property held by a nonprofit debtor, such as those associated with donor-restricted funds, can significantly limit the broad grasp of section 541. See In re Joliet-Will County Community Action Agency, 847 F.2d 430 (7th Cir. 1988) (federal and state agency grants to nonprofits that imposed restrictions on use were made to the organization as a trustee, such that the debtor lacked beneficial title to the funds, and hence they were not property of the estate); In re Roman Catholic Archbishop of Portland in Oregon, 345 B.R. 686, 705 (Bankr. D. Or. 2006) (a charitable trust of which the debtor was not the sole beneficiary was not the property of the bankruptcy estate, as the debtor held legal but not entire equitable title to the fund, but the debtor's interest in the trust as the beneficiary was part of its estate); Parkview Hospital v. St. Vincent Medical Center, 211 B.R. 619 (Bankr. N.D. Ohio 1997) (because the debtor hospital's contributors manifested an intent that the hospital's development fund would be used for specific charitable purposes, an express charitable trust was created that excluded the funds from the bankruptcy estate). Accordingly, section 541(d) of the Bankruptcy Code provides that:

[p]roperty in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest ... becomes property of the estate ... only to the extent of the debtor's legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.

A related issue that has received a great deal of coverage in connection with the Catholic archdiocese chapter 11 filings is the conflict between federal bankruptcy law and canon law in determining what qualifies as estate property. See generally Religious Organizations and the Law § 13:22 (2018); Justin Baumgartner, Remedying Scandal: Pooling the Assets of Catholic Entities to Pay Off Tort Creditors Through Substantive Consolidation in a Bankruptcy Proceeding, 18 Rutgers J. L. & Religion 388 (2017). Within the Catholic Church, dioceses, i.e., geographic districts established by the church, control local parishes, i.e., congregations. Each diocese is 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, such properties are held in trust for parishioners. Church officials commonly argue 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. See In re Catholic Diocese of Wilmington, Inc., 432 B.R. 135 (Bankr. D. Del. 2010) (funds that a debtor-diocese received from different parishes for investment in a pooled investment fund were held in the resulting trust, but because the funds were held in the debtor's general account and the parishes could not trace them, they were estate property; funds deposited in a separate account pursuant to an express trust agreement were not estate property); Comm. of Tort Litigants v. Catholic Diocese of Spokane, 364 B.R. 81 (E.D. Wash. 2006) (issues of fact existed as to whether the debtor-diocese was the unencumbered owner of parish properties or whether the parishes were the beneficial owners of the real properties upon which their churches and schools were located, precluding summary judgment for either the diocese or for the committee of tort litigants and the claimant on the issue of whether the properties belonged to the chapter 11 estate); In re Roman Catholic Archbishop of Portland in Oregon, 335 B.R. 842, 861 (Bankr. D. Or. 2005) ("[I]f defendants can show that, under state law, the disputed properties are held by the Archdiocese in trust for the parishes and schools, § 541 would recognize that trust relationship, subject to the avoidance provisions of § 544(a)(3).").

In light of these issues, claimants and their representatives have sought to avail themselves of the assets of entities affiliated with a nonprofit to satisfy claims by means of alter ego-type theories or "substantive consolidation."

Substantive Consolidation

Substantive consolidation is an equitable remedy pursuant to which a bankruptcy court may order that the assets and liabilities of separate entities be treated as if they belonged to a single, combined entity.

The Bankruptcy Code does not expressly authorize substantive consolidation, but it recognizes that a chapter 11 plan may provide for the "consolidation of the debtor with one or more persons" as a means of implementation. See 11 U.S.C. § 1123(a)(5)(C). In addition, Fed. R. Bankr. P. 1015(b) provides that a bankruptcy court may direct that cases involving affiliated debtors be jointly administered, but the rule is silent regarding substantive consolidation.

A majority of courts have concluded that bankruptcy courts have the power to substantively consolidate debtor entities under section 105(a) of the Bankruptcy Code, which provides that a court "may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions" of the Bankruptcy Code. However, because forcing the creditors of one entity to share equally with the creditors of a less solvent entity is not appropriate in many circumstances, courts generally hold that substantive consolidation is an extraordinary remedy that should be used sparingly. See Buridi v. KMC Real Estate Investors, LLC (In re KMC Real Estate Investors, LLC), 531 B.R. 758 (S.D. Ind. 2015).

Different standards have been employed by courts to determine the propriety of substantive consolidation. For example, in Eastgroup Properties v. Southern Motel Assoc., Ltd., 935 F.2d 245 (11th Cir. 1991), the Eleventh Circuit adopted a modified version of the standard articulated by the District of Columbia Circuit in Drabkin v. Midland Ross Corp. (In re Auto-Train Corp., Inc.), 810 F.2d 270, 276 (D.C. Cir. 1987). According to this standard: (i) the proponent of consolidation must demonstrate that there is substantial identity between the entities to be consolidated and that consolidation is necessary to avoid some harm or to realize some benefit; and (ii) a creditor may object on the grounds that it relied on the entities' separate credit and will be prejudiced by consolidation, in which case the court can order consolidation only if it determines that the benefits of consolidation "heavily" outweigh the harm.

The Second Circuit established a somewhat different two-part disjunctive standard for gauging the propriety of substantive consolidation in Union Savings Bank v. Augie/Restivo Baking Co., Ltd. (In re Augie/Restivo Baking Co., Ltd.), 860 F.2d 515, 518 (2d Cir. 1988). There, the court concluded that the factual elements considered by the courts are "merely variants on two critical factors: (i) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, ... or (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors."

Factors that may be relevant in satisfying these requirements include the following:

  1. Fraud or other complete domination of the corporation that harms a third party;
  2. The absence of corporate formalities;
  3. Inadequate capitalization of the corporation;
  4. Whether funds are put in and taken out of the corporation for personal rather than corporate purposes;
  5. Overlap in ownership and management of affiliated corporations;
  6. Whether affiliated corporations have dealt with one another at arm's length;
  7. The payment or guarantee of debts of the dominated corporation by other affiliated corporations;
  8. The commingling of affiliated corporations' funds; and
  9. The inability to separate affiliated corporations' assets and liabilities.

Id. at 518–19. The Augie/Restivo test was adopted by the Ninth Circuit in Bonham v. Compton (In re Bonham), 229 F.3d 750 (9th Cir. 2000). Many other circuit and lower courts have adopted tests similar to the Augie/Restivo and Eastgroup standards. In In re Owens Corning, 419 F.3d 195, 210 (3d Cir. 2005), however, the Third Circuit opted for an "open-ended, equitable inquiry" rather than a factor-based analysis, as employed by many courts, in reversing lower court rulings approving "deemed" consolidation of 18 debtors and three nondebtor subsidiaries under a plan.

Substantive Consolidation of Debtors and Nondebtors

Although most courts have held that the substantive consolidation of debtor entities is permitted, they disagree as to whether the substantive consolidation of debtors and nondebtors should be allowed. Some courts have concluded that such substantive consolidation is appropriate on the basis of: (i) section 105's broad grant of authority; (ii) a bankruptcy court's ability to assert personal and subject matter jurisdiction over nondebtors; and/or (iii) a bankruptcy court's mandate to ensure the equitable treatment of all creditors. See, e.g., Bonham, 229 F.3d at 769–71; Lassman v. Cameron Constr. LLC (In re Cameron Constr. & Roofing Co.), 565 B.R. 1, 10 (Bankr. D. Mass. 2016); In re S&G Fin. Servs., 451 B.R. 573, 579–82 (Bankr. S.D. Fla. 2011); Simon v. ASIMCO Techs., Inc. (In re Am. Camshaft Specialties, Inc.), 410 B.R. 765, 786 (Bankr. E.D. Mich. 2009); Walls v. Centurion Asset Mgmt., Inc. (In re Bolze), 2009 BL 157145, *4 (Bankr. E.D. Tenn. July 23, 2009); Dominion Fin. Corp. v. Morfesis (In re Morfesis), 270 B.R. 28, 31 (Bankr. D.N.J. 2001); see also Clark's Crystal Springs Ranch, LLC v. Gugino (In re Clark), 692 Fed. Appx. 946, 2017 BL 240043 (9th Cir. July 12, 2017) (because the Bankruptcy Code does not expressly forbid the substantive consolidation of debtors and nondebtors, the U.S. Supreme Court's decision in Law v. Siegel, 134 S. Ct. 1188 (2014), does not bar bankruptcy courts from ordering the remedy).

Other courts have held that the substantive consolidation of debtors and nondebtors is inappropriate because, among other things, it circumvents the procedures concerning involuntary bankruptcies set forth in section 303 of the Bankruptcy Code. See, e.g., Audette v. Kasemir (In re Concepts America, Inc.), 2018 WL 2085615, *6 (N.D. Ill. May 3, 2018); In re Pearlman, 462 B.R. 849, 854 (Bankr. M.D. Fla. 2012); Helena Chem. Co. v. Circle Land & Cattle Corp. (In re Circle Land & Cattle Corp.), 213 B.R. 870, 877 (Bankr. D. Kan. 1997); In re Hamilton, 186 B.R. 991, 993 (Bankr. D. Colo. 1995).

In Archdiocese of St. Paul, the Eighth Circuit considered whether an archdiocese debtor could be substantively consolidated with more than 200 nonprofit, nondebtor parishes and other related entities.

Archdiocese of St. Paul

The nonprofit Archdiocese of St. Paul and Minneapolis (the "debtor") includes 187 parishes as well as several schools, cemeteries, and related organizations. After the State of Minnesota enacted legislation in 2013 extending the statute of limitations for clergy sexual-abuse lawsuits, hundreds of claimants filed claims against the debtor. To address the claims, the debtor filed a chapter 11 case in 2015 in the District of Minnesota.

In 2016, the unsecured creditors' committee sought an order from the bankruptcy court substantively consolidating the debtor with the more than 200 related nonprofit entities, none of which had filed for bankruptcy. Whereas the debtor had only $45 million in unencumbered assets, the related nondebtors' assets were reportedly worth as much as $1 billion. In its complaint, the committee alleged that the debtor "had direct control and supervision in all material aspects" of the nondebtor entities and that their assets should be treated as assets of the debtors.

The bankruptcy court ruled that it lacked the authority to substantively consolidate the debtor with its nonprofit, nondebtor affiliates because it violated section 303(a)'s exemption of nonprofits from involuntary bankruptcy. The court also held that, even if it had the authority to grant the remedy, the committee failed to allege facts sufficient to support substantive consolidation of the entities. The district court affirmed the bankruptcy court's dismissal of the committee's complaint, and the committee appealed to the Eighth Circuit.

The Eighth Circuit's Ruling

A three-judge panel of the Eighth Circuit affirmed.

Citing Bonham, the panel noted that, to date, only the Ninth Circuit has directly addressed the substantive consolidation of debtors with nondebtors at the court of appeals level and that "[n]o appellate court has recognized the substantive consolidation of a debtor and a non-profit debtor, let alone a debtor and over 200 non-profit non-debtors."

Next, the Eighth Circuit panel cited Law v. Siegel, 134 S. Ct. 1188 (2014), for the proposition that, in exercising its broad equitable powers under section 105, "a bankruptcy court may not contravene specific statutory provisions" of the Bankruptcy Code. Concluding that the plain and ordinary meaning of "corporation that is not a moneyed, business, or commercial corporation" is the equivalent of "non-profit," the panel ruled that a bankruptcy court does not have the power to order substantive consolidation of a nonprofit entity because it would directly contravene section 303(a) of the Bankruptcy Code. According to the court:

Section 303(a) prevents the use of § 105(a) to force truly independent non-profit entities into involuntary bankruptcy.

We leave for another day the issue of whether a non-profit non-debtor that is the alter ego, under state law, of the debtor, or has been formed as part of a fraudulent scheme, such as a Ponzi scheme, can be consolidated.

The Eighth Circuit panel held that, even taken as true, the facts alleged by the committee in its complaint—"isolated incidents of lack of corporate formality and commingling of assets"—fell far short of the requirement for alter ego status under Minnesota law. Moreover, the court explained, the debtor's effective control over the related nondebtor entities is a function of Minnesota statutory law governing the operation of religious organizations, and the committee's arguments "would apply to virtually any non-profit organization" incorporated in Minnesota, thereby effectively "nullify[ing] the protections of § 303(a)."

Outlook

The Eighth Circuit panel in Archdiocese of St. Paul was mindful of the plight of clergy abuse victims affected by its ruling, writing that "[w]e understand the Committee's sincere attempts at recovery for a class of creditors who have suffered clergy abuse." Even so, the court concluded that a bankruptcy court's equitable (i.e., nonstatutory) powers—here, the power to order substantive consolidation—cannot be deployed in a way that contradicts an express provision of the Bankruptcy Code. In the absence of any substantiated allegations that the nondebtor entities were alter egos of the debtor or that the separateness of the entities should be disregarded for other reasons, the Eighth Circuit was constrained to affirm lower court rulings denying the committee's attempt to enlarge the asset pool available for abuse-victim recoveries.

The decision is emblematic of the reluctance of some courts to order substantive consolidation of nondebtors with debtors because the remedy end-runs the general procedures governing involuntary bankruptcy cases in section 303 and, in this case, the specific prohibition of involuntary filings against nonprofit entities. It also indicates that, as in other contexts, the evidentiary showing needed to support alter ego-type claims in cases involving dioceses and other related entities organized under applicable state and canon law is more demanding than "isolated incidents of lack of corporate formality or commingling of assets."

In May 2018, the debtor reached a $210 million settlement with abuse victims—the largest ever by a Catholic diocese in bankruptcy. In June, the debtor and the committee filed a new joint chapter 11 plan providing that $40 million of the settlement amount not covered by insurance will be paid by means of budget cuts, asset sales, donations, and voluntary contributions from parishes.

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Mark G. Douglas
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