Unique Issues Faced by Non-Profits in Bankruptcy

Nelson Mullins Riley & Scarborough LLP

Nelson Mullins Riley & Scarborough LLP

Non-profits are just like for-profit companies in that they can be faced with significant financial challenges for which bankruptcy provides an opportunity for restructuring or liquidation for the benefit of their creditors and other stakeholders. Many times, particularly in the areas of healthcare and religious institutions, non-profit bankruptcies raise complex and novel insolvency issues. This blog post discusses four of the unique aspects of non-profit bankruptcies.

1. Non-profits are not subject to involuntary bankruptcy.

The United States Bankruptcy Code allows some parties to be put into bankruptcy by their creditors if certain conditions are met. This is referred to as an “involuntary” bankruptcy. Under Section 303(a) of the Bankruptcy Code, an involuntary bankruptcy case may not be brought against a corporation that is not a moneyed business or commercial corporation. Consequently, though non-profits may be indirectly forced into bankruptcy by an aggressive creditor or regulator through economic pressure, they cannot be placed into bankruptcy involuntarily by another party.

2. There is likely no “absolute priority” rule in non-profit Chapter 11 cases.

One of the requirements of the provisions governing plans of reorganization in Bankruptcy Code Section 1129(b) is that the plan must be “fair and equitable.” Section 1129(b)(2)(B) goes on to provide a statutorily defined requirement of the fair and equitable rule as it is applied to unsecured creditors, referred to as the “absolute priority rule,” which essentially requires senior classes (such as general unsecured debt) to be paid in full before the equity interest holders retain or receive any property under the plan if the senior classes do not approve the plan. Though there are various ways to satisfy the absolute priority rule while allowing current equity interests holders to retain their interests, the absolute priority rule is intended to maximize the payment to creditors from the disposition of the debtor’s property. In the case of a non-profit entity, however, courts generally hold that the absolute priority rule is not applicable because such entities do not have shareholders or equity interests. This gives non-profits additional flexibility in crafting plans of reorganization.

3. Non-Profit sales must comply with applicable non-bankruptcy law

As part of the 2005 amendments to Section 363(d)(1) of the Bankruptcy Code was added to state, “in the case of a debtor that is a corporation or trust that is not a moneyed business, commercial corporation, or trust, [a debtor or trustee may use or sell property under Section 363] only in accordance with non-bankruptcy law applicable to the transfer of property by a debtor that is such a corporation or trust. In addition, Section 541(f) of the Bankruptcy Code was added, which requires that property which is held by a 501(c)(3) debtor may be transferred to an entity that is not such a corporation only “if the transfer is in compliance with applicable non-bankruptcy law.” Finally, Section 1129(a)(16) was added to provide that a non-profit debtor may only transfer assets under a plan if non-bankruptcy law governing such transfers is observed. As a result of these provisions, any sale or transfer of assets by a non-profit pursuant to a bankruptcy case must still comply with applicable state law regarding such transactions by non-profit entities. Thus, for example, if a state attorney general must review and approve a sale of substantially all of a non-profit’s assets under state law like many healthcare businesses, the non-profit debtor must comply with those requirements in bankruptcy.

4. Non-profits may continue to consider their charitable mission while in bankruptcy

It is recognized that an insolvent company in or outside of bankruptcy should consider the interests of its creditors in its decision making. In the non-profit context, however, there may be tension between this duty to creditors and the debtor’s duty to further its charitable mission. Consider a situation faced by a non-profit hospital: it has a charitable mission of providing and preserving healthcare for the people in its service area, while the interests of creditors may be served by cutting services or selling assets to for-profit organizations. At least two courts have recognized that a non-profit’s duty to its charitable mission may be considered along with a debtor’s duties to its creditors. See In re United Healthcare Sys., Inc., 1997 BL 8656 (D.N.J. Mar. 27, 1997); In re HHH Choices Health Plan LLC, 554 B.R. 687 (Bankr. S.D.N.Y. 2016). Therefore, there is some support for the argument that the successful bid in the sale of a non-profit’s business should not be based only on the highest price and the bidder who is most likely to be able to fund the transaction — but may also include consideration of the buyer who is best able to preserve the charitable mission of the non-profit debtor.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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