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Applying the absolute priority rule to nonprofit enterprises in bankruptcy.

Article Excerpt
With the explosion of the nonprofit sector in recent years, (1) courts have struggled to adapt bankruptcy law-normally applied in the context of individuals and businesses (2)--to the context of nonprofit insolvency. (3) One area of confusion has been the absolute priority rule in section 1129 (4) of the U.S. Bankruptcy Code. (5) The rule provides a way for courts to confirm a debtor's reorganization Plan over the objection of an impaired class of creditors, (6) thereby preserving the going-concern value of a firm in the face of creditor demands for liquidation.

Section 1129 states that in order for a Plan to be confirmed by cram down, (7) "the holder of any claim or interest that is junior to the claims of [the impaired] class [must] not receive or retain under the plan on account of such junior claim or interest any property." (8) In other words, not one cent may be received by a junior class of claimants until the class of creditors ahead of it has been repaid in full. (9) This provision furthers several related policy goals, including the maintenance of a hierarchy of claims to priority between the various classes of debt and equity interests, (10) the protection of each class of interests against collusion by the other classes, (11) and the safeguarding of public investors from insider dealing. (12)

Courts have puzzled over the bankruptcy implications of a certain subtle distinction between for-profit and nonprofit organizations. Namely, the typical residual claimant in a business is an equity holder, whereas a junior interest in a nonprofit usually is not regarded as "equity." (13) This contrast raises the question of how to apply the absolute priority rule to Plans in which the pre-petition interest holders of a nonprofit (usually its directors or members) retain control of, and thus an interest in, the reorganized, post-petition debtor. (14) An equity holder of a similarly situated business debtor would not be permitted to retain such an interest. (15)

A doctrinal split has emerged, revealing two conflicting judicial approaches. Courts of the Fourth, Seventh, and Ninth Circuits have concluded that old interest holders of a nonprofit are permitted to control it throughout its reorganization process, reasoning that the operational limitations inherent to nonprofits render the absolute priority rule effectively irrelevant. (16) On the other hand, courts of the First, Fifth, and Eleventh Circuits have not inferred any inevitability about nonprofit compliance with absolute priority, applying the rule on fact-specific grounds to reject reorganization Plans that allowed old interests to be preserved. (17)

This Comment proposes a framework that courts can utilize for systematically adjudicating absolute priority claims in nonprofit bankruptcies. Specifically, nonprofits may be classified along a continuum depending upon the particular type of interest they assign to directors and members: those that have an "entrepreneurial" structure mark one end of the continuum, and those that have a "mutual" structure mark the other end. (18) Part I of this Comment describes entrepreneurial nonprofits and explains why their directors and members should be able to conform with the absolute priority rule and yet maintain an interest in the nonprofit through a Plan confirmed by cram down. The second half of Part I elucidates the features of mutual nonprofits, whose directors and members enjoy equity-like interests that courts should not allow them to retain through cram down. Part II then provides guidance for courts faced with structurally ambiguous cases, highlighting additional contextual and policy factors that can be used to decide whether a bankrupt nonprofit's reorganization Plan should be prohibited. In summary, this Comment suggests a way for courts to assess whether a particular nonprofit is able to abuse the Chapter 11 process in the way that section 1129 was designed to prevent.

I. THE ENTREPRENEURIAL-MUTUAL CONTINUUM

Nonprofit entities can be categorized as having primarily an "entrepreneurial" or primarily a "mutual" structure. (19) By analogizing a nonprofit to one of the ideal types anchoring this continuum, courts can more readily identify violations of the absolute priority rule and thus better harmonize the charitable goals of nonprofits with the public policy goals of the bankruptcy system.

A. Entrepreneurial Nonprofits

The classic entrepreneurial nonprofit--such as a public hospital, museum, or national charity (20)--is controlled by a board of directors (or similar management group) whose members do not comprise the nonprofit's own patrons. (21) In other words, an entrepreneurial organization is characterized by the self-perpetuating nature and independence of its board; its directors do not substantially benefit from the charitable or social mission of the nonprofit that they operate.

An entrepreneurial structure, in light of statutory textual and contextual considerations, can be construed as a signal to courts that there is no conflict between the insolvent nonprofit's Plan and the requirements of absolute priority. (22) First, board members and trustees of entrepreneurial nonprofits control the organization but receive no "property" under section 1129 by virtue of that control. (23) The interest of any nonprofit director, whether entrepreneurial or mutual, is sharply limited by the nondistribution constraint (24) imposed upon all nonprofits; in an entrepreneurial structure, however, the successful fulfillment of the organization's mission provides no special benefit to its directors--that is, no more than it might provide to any other outside party in the greater community. This is quite unlike the effect of a controlling interest...

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