The Other Estate : A Primer On Bankruptcy for Non-Profits Lawrence G. McMichael Catherine G. Pappas Dilworth Paxson, LLP Philadelphia, PA
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1 The Other Estate : A Primer On Bankruptcy for Non-Profits Lawrence G. McMichael Catherine G. Pappas Dilworth Paxson, LLP Philadelphia, PA A. Eligibility (1) The Bankruptcy Code sets forth certain eligibility requirements. [O]nly 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 [the Bankruptcy Code]. 11 U.S.C A person is defined to include any individual, partnership, or corporation. 11 U.S.C. 101(41). A corporation is defined to include a business trust. 11 U.S.C. 101(9)(A)(v). (2) Non-profit corporations and business trusts qualifying as such under applicable state law are generally eligible to file under Chapter 7 and Chapter 11 of the Bankruptcy Code. (3) Some states prohibit non-profit corporations from filing for bankruptcy protections and instead provide for non-bankruptcy, receivership-type protections. Depending on how such state laws are written, the federal Bankruptcy Code may preempt them. B. Chapter 11 (reorganization) v. Chapter 7 (liquidation) (1) Chapter 11: A proceeding commenced by a debtor under federal law (the Bankruptcy Code, 11 U.S.C. 101 et seq.) in the United States Bankruptcy Court to reorganize the debtor s affairs and adjust its debts while generally continuing normal operations of the business. (2) Chapter 7: A proceeding in which a trustee is appointed to control, collect, and liquidate a debtor s non-exempt assets to satisfy creditors. (3) No involuntary petitions against non-profits: The Bankruptcy Code provides that involuntary cases may be commenced by creditors only against a person, except a farmer, family farmer, or a corporation that is not a moneyed, business, or commercial 1
2 corporation. 11 U.S.C Thus, an involuntary petition cannot be filed against a non-profit or charitable corporation. (4) No forced liquidation in non-profit context. Some Chapter 11 cases result in conversion to Chapter 7. The Bankruptcy Code prohibits the conversion of a chapter 11 to a chapter 7 liquidation if the debtor is not a moneyed, business, or commercial corporation. 11 U.S.C C. Basic Bankruptcy Process (1) Petition: A debtor can commence a bankruptcy voluntarily, at the time of its choosing, by filing a standard petition and paying the associated fee (presently, $1,717). (2) List of Creditors, Schedules, and Statement of Financial Affairs: Shortly after filing the petition, a debtor must file a list of its creditors, various schedules identifying all assets and liabilities, and a statement of financial affairs, which details and discloses sources of income, transfers of property, and other relevant financial information. (3) Judge: Upon the filing of a petition, the bankruptcy case is assigned to a judge sitting in the U.S. Bankruptcy Court, an arm of the federal district court. (4) United States Trustee: The office of the United States Trustee oversees the administration of the bankruptcy case, appoints a committee of the debtor s creditors, reviews the debtor s financial and monthly operating reports, and otherwise ensures that the debtor complies with the requirements of the Bankruptcy Code. (5) Forum: Upon the filing of a petition, the Bankruptcy Court becomes the forum and the focal point for resolution of the debtor s problems. (6) Effect of a Filing: The filing of a voluntary bankruptcy petition automatically constitutes an order for relief. A debtor is relieved of making any payments on pre-petition debt and, in fact, is prohibited from paying pre-petition debt without court authorization. In Chapter 11, a debtor may continue to operate its business in the ordinary course without court approval. All other 2
3 decisions, not arising in the ordinary course of the debtor s business, require court approval. In Chapter 7, a Chapter 7 trustee is appointed to oversee the debtor s liquidation. In the non-profit context, the state Attorney General or equivalent non-profit supervisory authority will monitor the debtor s activities in the bankruptcy case and participate in the bankruptcy proceedings as necessary. D. The Bankruptcy Estate (1) Upon the commencement of a bankruptcy case, the Bankruptcy Code operates to create an estate that can be used to conduct the debtor s operations and to satisfy the claims of creditors. (2) The estate is comprised of, among other things, of all legal or equitable interests of the debtor in property. 11 U.S.C. 541(1). (3) The estate does not include any power that the debtor may exercise solely for the benefit of an entity other than the debtor, or [p]roperty in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest. 11 U.S.C. 541(1),. (4) The legal or equitable interest of a debtor in a particular asset is generally determined by state law. See Butner v. United States, 440 U.S. 48, 54 (1979) (superseded by statute on other grounds) (determination of property rights in assets of bankruptcy estate are governed by state law). (5) Thus, in situations involving charitable trusts, restricted endowments, and other donor-restricted funds, the extent to which such funds are protected under applicable state law will generally also be the extent of protection from the claims of creditors in bankruptcy. (6) The property interest of the bankruptcy estate is only as broad as the applicable, enforceable restrictions on the use of the property permit. Compare In re Roman Catholic Archbishop of Portland in Oregon (Tort Claimants Comm. v. Roman Catholic Archbishop of Portland in Oregon), 345 B.R. 686, 707 (Bankr. D. Ore. 2006) (debtor s beneficial interest in income from charitable trust is property of the estate, subject to non-bankruptcy conditions on use) with In re Bishop College (Salisbury v. Ameritrust Texas, N.A.), 151 B.R. 394, 401 (Bankr. N.D. Tex. 1993) (neither income nor 3
4 principal of charitable trust constituted property of bankruptcy estate where charitable purpose could no longer be carried out when debtor college ceased operation). (7) Unlike income, the principal amounts of donor-restricted funds or charitable trusts generally do not constitute property of the bankruptcy estate. See In re Roman Catholic Archbishop of Portland, 345 B.R. at 705; In re Bishop College, 151 B.R. at 401; In re Parkview Hosp. (Hunter v. St. Vincent Medical Center), 211 B.R. 619, 641 (Bankr. N.D. Ohio 1997); City of Farrell v. Sharon Steel Corp., 41 F.3d 92, 95 (3d Cir. 1994) ( funds held in trust are not property of the estate ). Because such charitable trusts or restricted endowments are not property of the bankruptcy estate, they will not be available to creditors in a bankruptcy proceeding. Rather, they may only continue to be used for their specified purposes in accordance with applicable state law. (8) Importantly, there are exceptions to the general protections that apply to donor-restricted funds in bankruptcy. The occurrence of such exceptions may render the fund at issue vulnerable to the claims of a debtor s creditors, as when: a debtor donee unilaterally establishes an endowment fund and has the right to revoke that endowment; a debtor donee establishes an endowment fund on the eve of bankruptcy as a shield from creditors; an endowment fund has historically been used for general obligations of the debtor donee s operations (and could then be used to satisfy creditors whose claims may arise from general obligations of the debtor); or a debtor donee has invaded the principal in order to fund general operations. E. The Automatic Stay (1) Operation and Effect Upon filing of bankruptcy petition, the automatic stay takes effect, enjoining commencement or continuation of litigation against the debtor (but not by the debtor), perfection or enforcement of security interests, termination of contracts or leases, and practically any other creditor remedies/collection activities. See 11 U.S.C
5 Automatic stay precludes secured creditors from foreclosing on collateral without court permission. Effect of stay is to give the debtor the breathing spell from creditors that bankruptcy promises. Also protects creditors by halting actions that would deplete the estate and frustrate reorganization or orderly liquidation efforts. (2) Scope Automatic stay is extremely broad, but not limitless. Certain actions are not subject to the automatic stay, such as criminal actions against a debtor and the enforcement of police and regulatory powers by governmental units. Additionally, if property or assets are excluded from the bankruptcy estate, the automatic stay will not operate to protect them from claims of creditors. (3) Stay is limited to debtors. Courts can extend protections of stay/enjoin acts against non-debtors in certain circumstances. If pursuit of action against non-debtor would effectively be an action against the debtor, the court may issue injunction/expand the stay. (4) Stay may be lifted by the Bankruptcy Court for cause. (5) Stay is not permanent. As to property, stay generally continues until the asset is no longer part of the estate. As to other actions, stay continues as provided in a confirmed plan or until the earliest of: 1) closure or dismissal of the bankruptcy case or 2) denial or grant of a discharge to the debtor. (6) Penalties for violation of the automatic stay can be significant. 5
6 F. Claimants and Classes of Creditors (1) Secured creditors Typically banks/pre-petition lenders, equipment lessors, and others with security interests. Secured creditors are granted allowed claims against the debtor up to the value of their collateral. Under the Bankruptcy Code, secured creditors are entitled to payment in full of their allowed claims or the return of the collateral. The portion of the claim of a secured creditor that exceeds the value of the collateral becomes an unsecured deficiency claim. See F.(2)(1) below. (2) Unsecured creditors Priority unsecured claims 1) The Bankruptcy Code provides for administrative priority of certain claims such that they are paid ahead of all other unsecured creditors. See 11 U.S.C ) Priority claims include: A) Bankruptcy administration fees. B) Claims of taxing authorities. C) Wages, commissions, benefits. D) Customer deposits (up to $2,775). E) Claims for post-petition goods or services provided to a debtor (if not paid in the ordinary course, as should be). General unsecured claims 1) Typically trade creditors, contract counterparties, landlords, deficiency claims. 2) In Chapter 7, paid pro-rata from unencumbered funds in estate. 6
7 3) In Chapter 11, paid in accordance with Chapter 11 plan. Insider claims 1) Generally, insiders are directors, officers, or persons in control of a debtor, as well as affiliates of the debtor and insiders of affiliates. 2) Affiliates include entities that control 20% or more of the debtor or entities where the debtor has 20% or more control. 3) Insiders holding claims against a debtor are treated the same as non-insider claims but their votes do not count in determining an impaired class for confirmation of a Chapter 11 plan. See G(2) below. 4) Transactions with insiders are subjected to heightened scrutiny. Equity interests G. Objective of a Chapter 11 Filing 1) Non-profit and charitable corporations do not have shareholders and issues involving equity are not addressed here. 2) Equity cannot be preserved or receive any value unless all claims are paid in full. See Absolute Priority Rule below. (1) The Plan: Where reorganization is the goal, the debtor (and only the debtor during the first part of the bankruptcy case) will propose a Chapter 11 Plan. The Plan essentially divides creditors into classes and prescribes what treatment or payment each class of creditors will receive on account of their claims. The plan also determines which contracts are assumed by the reorganized debtor and continue in place and which contracts are rejected. The plan is the blueprint for the debtor s reorganization. (2) Requirements for Confirmation of a Plan: The Bankruptcy Code contains numerous requirements that a debtor must meet in order for its plan to be confirmed. See 11 U.S.C The confirmation requirements that are usually at issue are the following: 7
8 (e) At least one class of impaired creditors must vote to accept the plan. Each class of impaired creditors that does not accept the plan must receive value on account of their claims at least equal to the value that they would get in a liquidation. Generally, administrative and priority claims must be paid in full. The plan must be feasible (not likely to be followed by liquidation or need of further reorganization). No junior class of claims or interests may receive a payment under the plan until all senior classes are paid in full. 1) Absolute Priority Rule : The Bankruptcy Code prohibits distribution of property to interest holders unless all other creditors have been paid in full. Senior classes of creditors must be paid in full before junior classes of creditors can receive anything. 2) In non-profit context, courts have grappled with whether retention of control of a non-profit entity by its pre-bankruptcy membership violates the Absolute Priority Rule. 3) Generally, because non-profit members have no right to dividends or corporate assets, retention of control by existing members notwithstanding a debtor s inability to pay all other creditors in full is not a violation of the Absolute Priority Rule. However, if membership confers any economic benefit on members, courts may scrutinize the issue carefully. (3) Effect of a Plan: Creditors who oppose a plan are forced to accept its terms if the plan is confirmed (a result usually known as a cram down ). The confirmation of a plan discharges any liability of the debtor not paid under the plan. So if the value of the debtor s assets is sufficient only to pay 1 cent on a dollar of debt, the other $.99 of debt is forgiven as a matter of law. The debtor can keep its assets as long as another means for paying out the value to creditors is provided by the plan (e.g., a note secured by the retained assets). 8
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