Navigating a Nonprofit Corporation through Bankruptcy

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Storms

Introduction

The nonprofit sector is an enormous contributor to the American economy, providing 5.5 percent of the nation’s GDP and employing 13.7 million people. Just like for-profit corporations, nonprofits can be susceptible to financial problems and insolvency, and may ultimately seek protection under the Bankruptcy Code (although, unlike for-profit corporations, nonprofits cannot be forced into bankruptcy involuntarily). While there is ample guidance for nonprofit directors regarding their fiduciary duties generally, very little has been written about the duties of directors of insolvent nonprofit corporations.

Overview

It is well settled that the duties of officers and directors emanate from state law.[1] Directors are stewards charged with balancing risk and furthering the purpose of the enterprise. The purpose of a for-profit corporation is to enhance the value of the enterprise for the benefit of residual interest-holders, ordinarily the owners of the enterprise. The purpose of a nonprofit corporation is to further the stated mission of the enterprise, rather than to generate wealth for stakeholders.

Some nonprofits have members (nonprofit membership organizations) and some do not (non-member not-for-profit organizations). While in some respects the members of a nonprofit membership organization are like shareholders of a for-profit corporation, in that they elect a board of directors, membership interests in a nonprofit, unlike shares in a for-profit corporation, represent a controlling rather than an economic stake in the enterprise. They cannot be transferred for value like shares of for-profit corporations, and often do not even entitle members to a share of the residual value of the enterprise upon dissolution.[2]

The members of a nonprofit membership organization periodically elect a board of directors, which is ultimately responsible for the operation of the enterprise and the fulfillment of its mission. The boards of non-member not-for-profit corporations are self-selecting and self-perpetuating. The mission of a nonprofit membership organization may either be to advance a charitable or public purpose—as in the case of a nonprofit hospital system, a nonprofit theater, National Public Radio (NPR) or Public Broadcasting Services (PBS)—or to benefit the members of the nonprofit—as in the case of a rural electrical cooperative, a local food cooperative, a university club, a country club, or a professional sports association, such as the National Football League (NFL), Major League Baseball (MLB), and the Professional Golfers’ Association (PGA). The mission of a non-member not-for-profit will be to advance a particular charitable or public purpose.

When a for-profit corporation becomes insolvent, the directors continue to be obligated to preserve (and, if possible, enhance) the value of the enterprise, although the beneficiaries of this obligation shift from the owners to the creditors of the company. Similarly, when a nonprofit corporation becomes insolvent, the directors remain obligated to fulfill their fiduciary obligations as delineated under state law (i.e., to advance the stated mission of the enterprise). While in either case, state law, rather than federal bankruptcy law, will continue to govern a director’s fiduciary duties in a bankruptcy proceeding, a bankruptcy filing will require a board to navigate an entirely new statutory framework while discharging its fiduciary obligations.[3]

In some respects, a bankruptcy filing will shift the landscape to provide greater power to creditors. For example, in a bankruptcy case a debtor will be required to provide a greater level of transparency regarding its financial condition and operations than is ordinarily required. Soon after the filing of a chapter 11 case, a representative of the Office of the United States Trustee (a branch of the Department of Justice) will solicit indications of interest from unsecured creditors in forming an official committee. If a sufficient level of interest is shown, a committee will be formed, which may retain legal and financial professionals at the debtor’s expense and will act as the creditors’ watchdog in the chapter 11 process. During bankruptcy, a debtor will be required to seek court approval, after providing creditors with notice and the opportunity to object, before taking any action that is not in the debtor’s ordinary course of business. Bankruptcy will also provide creditors with remedies for addressing director malfeasance that are not ordinarily available, such as replacing the debtor-in-possession with a trustee or examiner, subordinating a director’s claim under section 510(c), converting the case to chapter 7 (if the debtor is not a farmer or a nonprofit), and objecting to plan confirmation on the basis of improper enrichment of directors.[4]

In other respects, a bankruptcy filing shifts the landscape to provide directors with greater power to deal with recalcitrant creditors. For example, bankruptcy can be used to force a restructuring over a group of holdouts,[5] and a debtor may even strip a creditor of its right to vote on a proposed plan as a consequence of the creditor’s conduct during the chapter 11 case by “designating” or disqualifying that creditor’s vote.[6]

Fiduciary Duties of For-Profit Corporate Boards

The goal of the board of a for-profit corporation is to maximize the value of the enterprise (without subjecting the enterprise to unreasonable risk).[7] Under state law, directors of a corporation generally owe a fiduciary duty to the corporation, including, among other things, to maximize its value. [8]

As set forth in Torch Liquidating Trust ex rel. Bridge Associates L.L.C. v. Stockstill, 561 F.3d 377 (5th Cir. 2009), when a corporation is solvent, the shareholders are the beneficiaries of the corporation’s growth and increased value and have standing to bring actions against directors on the company’s behalf asserting a claim for breach of the directors’ duties to the corporation.[9] When the corporation is insolvent, however, the creditors take the place of the shareholders as the holders of the residual interest in the enterprise, and thus acquire standing to bring derivative actions on behalf of the company.[10] The derivative suit is a powerful weapon for enforcing directors’ fiduciary duties under state law and challenging corporate mismanagement.

It is important to understand that a direct fiduciary duty to creditors does not spring into being upon the insolvency of the enterprise. Rather, creditors simply replace shareholders as the class entitled to commence a derivative action to assert a breach of a director’s state law fiduciary obligations when the enterprise becomes insolvent.[11] While bankruptcy cases often speak of a duty to creditors, that duty is better articulated, as in the Torch Liquidating case, as a continuation of the pre-petition duty of a board of directors to the enterprise, which derivatively redounds to the benefit of creditors when the enterprise becomes insolvent.

Fiduciary Duties of Nonprofit Corporate Boards

Directors of nonprofit corporations have fiduciary duties that to a large extent parallel the duties of for-profit directors.[12] However, unlike the duties of a board of a for-profit corporation, the duties of a board of a nonprofit are not to maximize the value of the enterprise. The obligations of a board of a nonprofit corporation are to the corporation and its stated purpose and mission.[13] While nonprofit corporations do not have shareholders, there are still constituencies who have standing to bring derivative suits, including members (in the case of a nonprofit membership corporation) and directors of the nonprofit.[14] One commentator has even suggested the possibility of beneficiary derivative actions.[15] At the same time, however, federal law and the nonprofit laws of some states provide qualified immunity for uncompensated officers and directors of certain nonprofit organizations.[16]

As with the duties of a board of a for-profit corporation, the duties of a board of a nonprofit do not change when the enterprise becomes insolvent. The board of an insolvent nonprofit need not act like the board of a for-profit corporation and seek to maximize the value of the enterprise in contravention of the entity’s corporate mission. A board of an insolvent nonprofit must remain true to its mission as set forth in its organizational documents. In fact, in forgoing the corporate mission to pursue a path of value maximization, a nonprofit board could expose itself to liability for violating the nonprofit’s organizational documents.[17]

Creditors of an insolvent nonprofit corporation have different rights than creditors of an insolvent for-profit corporation and should not expect nonprofit boards to act like for-profit boards in bankruptcy. For example, unlike creditors of a for-profit corporation, creditors of a nonprofit cannot put the nonprofit into bankruptcy by filing an involuntary bankruptcy petition against it[18] and may not compel a nonprofit debtor to convert its case from chapter 11 to chapter 7 liquidation.[19] Further, while creditors of for-profits in bankruptcy can expect to receive the residual value of an insolvent for-profit corporation unless the debtor is sold or a plan is approved providing for a recapitalization, courts have generally held that creditors of nonprofits are not entitled to the residual value of the enterprise in bankruptcy.[20] This means that unlike in a bankruptcy of a for-profit corporation, managers and directors of a reorganized nonprofit may often retain control of the nonprofit over the objection of an impaired class of creditors.

Creditors that contract with a nonprofit corporation know that they are dealing with an entity that has a mission other than the maximization of the value of the enterprise, and engage with the company with full knowledge that the corporation will be operated on that basis. While such creditors may reasonably expect that a nonprofit board will not intentionally waste corporate assets under any circumstances, there is no basis to expect that a nonprofit board will abrogate its stated mission in order to maximize enterprise value once the company becomes insolvent. While many bankruptcy cases discuss the fiduciary duty of an estate representative to maximize the value of the enterprise for the benefit of creditors, upon closer inspection these cases generally involve for-profit entities whose boards are obligated to maximize value under state law.[21] There is no provision of the Bankruptcy Code that specifically obligates a trustee or debtor-in-possession to maximize the value of the enterprise for the benefit of creditors.[22]

It is instructive that in the context of asset sales (where one might reasonably argue that even a nonprofit debtor should be obligated to maximize value), the Bankruptcy Code places clear restrictions on a nonprofit debtor, which frequently prevent the debtor from maximizing value: (i) a transfer of assets of a nonprofit debtor must comply with whatever applicable non-bankruptcy law governs transfers of property by that nonprofit (i.e., state law, including laws relevant to nonprofits);[23] (ii) a nonprofit debtor may transfer assets to a for-profit corporation only under the same conditions that would apply if the debtor had not filed a bankruptcy case;[24] and (iii) all transfers of a nonprofit debtor’s property under a proposed plan must be made in accordance with applicable non-bankruptcy law that governs transfers of property by a nonprofit entity.[25] The legislative history of these three subsections evidences Congress’s intent to keep in place state law restrictions on nonprofits and “restrict the authority of a trustee to use, sell, or lease property by a nonprofit corporation or a trust.”[26]

Conclusion

State law frames and controls the duties and responsibilities of corporate directors, and often provides qualified immunities for directors of nonprofit corporations. No provision of the Bankruptcy Code preempts any state law concerning the duties and responsibilities of corporate directors, nor are we aware of any state law that modifies a director’s duty when a corporation becomes insolvent. Bankruptcy merely imposes a new overlay of tools to be used and obstacles to be navigated by a board while complying with its fiduciary duties and shepherding an enterprise through the restructuring process.


Evan C. Hollander (Evan.Hollander@aporter.com) is a partner in the Bankruptcy and Corporate Restructuring Group of Arnold & Porter LLP, resident in the New York office. His practice focuses on advising debtors and creditors in restructuring matters, both in and out of court. He counsels parties interested in acquiring assets of troubled companies, and structuring commercial transactions to reduce or eliminate risk. Dana Yankowitz Elliott (Dana.Elliott@aporter.com) is an associate in the same group, resident in the Washington, D.C. office. She has experience in all aspects of bankruptcy, as well as out-of-court restructurings and receivership cases.


NOTES

  1. See Baggett v. First Nat’l Bank, 117 F.3d 1342, 1352 (11th Cir. 1997) (“causes of action for breaches of fiduciary duties are traditionally creatures of state law, and . . . it would be inappropriate to infer a cause of action for such based solely on federal law”); Gearhart Indus., Inc. v. Smith Int’l, Inc., 741 F.2d 707, 719 (5th Cir. 1984) (fiduciary duties of officers and directors “are creatures of state common law”); Data Probe Acquisition Corp. v. Datatab, Inc., 722 F.2d 1, 4 (2d Cir. 1983) (“The gravamen of the claim advanced here is a breach of management’s fiduciary duty to shareholders, a matter traditionally committed to state law, which, if entertained, would unquestionably embark us on a course leading to a federal common law of fiduciary obligations.”).
  2. Many nonprofits (both membership and non-membership organizations) convey the term “member” on their donors. However, a nonprofit membership organization is made up of the members that control the organization and elect the board (for example, National Public Radio (NPR) is an organization made up of local NPR member stations), and donors are not true “members” of such organization.
  3. Davis v. Yageo Corp., 481 F.3d 661, 679 (9th Cir. 2007).
  4.  In re Schepps Food Stores, Inc., 160 B.R. 792, 799 (Bankr. S.D. Tex. 1993).
  5. A debtor can force holdout creditors to accept proposed modification of their contractual rights under a plan if, subject to certain other conditions, a majority of similarly situated creditors holding at least two-thirds in amount of claims classified together with the hold-out claims approve the modification, see 11 U.S.C. §§ 1126(c) and 1129(a)(8), or if no junior claims or interests receive or retain any property under the plan, see id. § 1129(b).
  6. See id. § 1126(e).
  7. See Prod. Res. Grp., L.L.C. v. NCT Grp., Inc., 863 A.2d 772 (Del. Ch. 2004) (noting that directors must “comply with their fiduciary duties to the firm by selecting and pursuing with fidelity and prudence a plausible strategy to maximize the firm’s value”); Regina F. Burch, Worldview Diversity in the Boardroom: A Law & Social Equity Rationale, 42 Loy. U. Chi. L.J. 585 (2011) (“In the very few cases where directors were found to have breached the duty of care, the courts engaged in a risk versus reward analysis and determined that the directors had taken unreasonable risks.”).
  8. See Revlon Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1986).
  9. Torch Liquidating Trust ex rel. Bridge Associates L.L.C. v. Stockstill, 561 F.3d 377, 385-86 (5th Cir. 2009).
  10. Ibid.
  11. Ibid. See also Kerr–McGee Chem. Worldwide LLC v. Anadarko Petroleum Corp. (In re Tronox Inc.), 429 B.R. 73, 105 (Bankr. S.D.N.Y. 2010) (“the directors of an insolvent corporation have duties to creditors that may be enforceable in a derivative action on behalf of the corporation.”).
  12. Thomas Lee Hazen & Lisa Love Hazen, Punctilios & Nonprofit Corporate Governance – A Comprehensive Look at Nonprofit Directors’ Fiduciary Duties, 14 U. Pa. J. Bus. L. 347, 355 (2012).
  13. In re United Healthcare System, Inc., 1997 WL 176574, at *5 (D. N.J. Mar. 26, 1997) (“The officers and directors of a nonprofit organization are charged with the fiduciary obligation to act in furtherance of the organization’s charitable mission.”); Summers v. Cherokee Children & Family Servs., 112 S.W.3d 486, 504 (Tenn. Ct. App. 2002) (“nonprofit directors must be ‘principally concerned about the effective performance of the nonprofit’s mission”’); John Tyler, Negating the Legal Problem of Having “Two Masters”: A Framework for L3C Fiduciary Duties & Accountability, 35 Vt. L. Rev. 117 (2010) (“The clarity and certainty of purpose for exempt organizations focuses not on shareholder value but on faithfulness to the charitable exempt purposes as defined by law and declared by the organization, which helps distinguish these entities from for-profit operations.”).
  14. See, e.g., N.C. Gen. Stat. § 55A-7-40 (discussing derivative suits by members and directors); Revised Model Nonprofit Corp. Act ch. 13 (2009) (discussing derivative suits and providing that a derivative suit may be brought by the lesser of five percent or fifty persons with voting rights or any member or director of a designated body).
  15. See Harvey J. Goldschmid, The Fiduciary Duties of Nonprofit Directors & Officers: Paradoxes, Problems, and Proposed Reforms, 23 J. Corp. L. 631, 652 (1998).
  16. See, e.g., 42 U.S.C. § 14503(a) (providing that if certain conditions are met and subject to certain exceptions: “[N]o volunteer of a nonprofit organization or governmental entity shall be liable for harm caused by an act or omission of the volunteer on behalf of the organization or entity if—(1) the volunteer was acting within the scope of the volunteer’s responsibilities in the nonprofit organization . . . at the time of the act or omission [and] the harm was not caused by willful or criminal misconduct, gross negligence, reckless misconduct, or a conscious, flagrant indifference to the rights or safety of the individual harmed by the volunteer . . .”); N.Y. Not-for-Profit Corp. Law § 720-a (“[N]o person serving without compensation as a director, officer or trustee of a corporation, association, organization or trust described in section 501 (c) (3) of the United States internal revenue code shall be liable to any person other than such corporation, association, organization or trust based solely on his or her conduct in the execution of such office unless the conduct of such director, officer or trustee with respect to the person asserting liability constituted gross negligence or was intended to cause the resulting harm to the person asserting such liability.”); Cal. Corp. Code § 5239(a) (providing that if certain conditions are met, “There shall be no personal liability to a third party for monetary damages on the part of a volunteer director or volunteer executive officer of a nonprofit corporation subject to this part, caused by the director’s or officer’s negligent act or omission in the performance of that person’s duties as a director or officer . . .”).
  17. See Hegy v. Cmty. Counseling Ctr. of Fox Valley, 158 F. Supp. 2d 892, 897 (N.D. Ill. 2001) (allegations that defendant-officers acted contrary to nonprofit’s bylaws “would be sufficient to demonstrate that they acted outside the scope of their corporate authority”); State ex rel. Butterworth v. Anclote Manor Hosp., Inc., 566 So.2d 296, 298-99 (Fla. App. 2 Dist. 1990) (directors of nonprofit breached fiduciary duties and acted in ways that were inconsistent with the corporation’s articles of incorporation).
  18. See 11 U.S.C. § 303. The provision prohibits creditors from filing an involuntary petition against a “corporation that is not a moneyed, business or commercial corporation,” which courts have generally construed to mean nonprofits.
  19. See id. § 1112(c). The bankruptcy court cannot convert a case “if the debtor is . . . a corporation that is not a moneyed, business, or commercial corporation unless the debtor requests such conversion.” Like creditors of for-profit corporations, however, creditors of nonprofits may seek the appointment of a chapter 11 trustee to displace management, see id. § 1104(a), and if a trustee is appointed, the debtor’s exclusive right to file a plan (which ordinarily is in force for the first 120 days of the case) automatically expires and the trustee (and any other party-in-interest in the case) may then file a chapter 11 plan providing for the liquidation of the debtor, see id. § 1121(c)(1).
  20. See, e.g., In re Wabash Valley Power Ass’n, 72 F.3d 1305, 1314 (7th Cir. 1996), cert. denied, 519 U.S. 965 (1996) (members of nonprofit debtor did not hold “interests” and therefore plan did not violate absolute priority rule (which provides that a junior class may not receive or retain any property under a plan unless all senior classes either consent or are paid in full), where the members retained control and received some economic benefit from the reorganized debtor); In re Henry Mayo Newhall Mem’l Hosp., 282 B.R. 444, 453 (B.A.P. 9th Cir. 2002) (noting that creditors of nonprofit debtors, which have no equity owners, are at a disadvantage because “they are not able to assert the Bankruptcy Code’s absolute priority rule to block unacceptable plans”). However, some courts have applied the absolute priority rule in the context of nonprofit membership organizations where the courts concluded that the membership interests embodied significant indicia of equity ownership. See S. Pac. Transp. Co. v. Voluntary Purchasing Groups, Inc., 252 B.R. 373, 386-89 (E.D. Tex. 2000) (technical characteristics of patronage stock qualified it as equity that nonprofit agricultural cooperative debtor’s members could not retain through the reorganization); In re Maine Elec. Coop., Inc., 125 B.R. 329, 335-59 (Bankr. D. Me. 1991) (electric cooperative members’ interest in patronage accounts were ownership interests, so the absolute priority rule applied).
  21. See, e.g., In re Reliant Energy Channelview LP, 594 F.3d 200 (3d Cir. 2010) (in the context of a for-profit chapter 11 debtor’s asset sale: “debtors-in-possession have a fiduciary duty to maximize the value of the estate”); In re Union Square Assocs., LLC, 392 B.R. 474 (Bankr. D. Utah 2008) (in the context of a for-profit chapter 11 debtor’s sale of condominium units: “A debtor in Chapter 11 carries certain duties and responsibilities which include the duty to maximize the estate for benefit of creditors. A debtor in possession, like a bankruptcy trustee, is a fiduciary whose fiduciary obligations run to the estate.”).
  22. Sections 1106 and 1107 of the Bankruptcy Code set forth the duties of a chapter 11 trustee and debtor-in-possession. See 11 U.S.C. §§ 1106, 1107. Neither speaks of a duty to maximize the value of the enterprise for the benefit of creditors. Similarly, the Handbook published by Office of the U.S. Trustee provides that a chapter 11 trustee “steps into the shoes of the debtor’s management and becomes a fiduciary with an obligation of fairness to all parties in the case.” Chapter 11 Handbook, May 2004, at 6. The guidelines provide that a chapter 11 trustee must protect and preserve assets, but that obligation is different from an obligation to maximize creditor recoveries. See id. at 19.
  23. See 11 U.S.C. § 363(d).
  24. See id. § 541(f).
  25. See id. § 1129(a)(16).
  26. H.R. Rep. No. 109-31, pt. 1, at 145 (2005).