U.S. Circuit Court Protects Assets of Nonprofit Corporations From Creditors of an Affiliated Entity

By Eric Johnson

May 4, 2018 – In a decision with major implications for nonprofit organizations, the U.S. Eighth Circuit Court of Appeals recently protected over 200 nonprofit corporations affiliated with the bankrupt Archdiocese of Saint Paul and Minneapolis. (See In re The Archdiocese of Saint Paul and Minneapolis, Case No. 17-1079 (8th Cir. Apr. 26, 2018).) The Court rejected efforts to include the real property and financial assets of these affiliates in the assets available to creditors of the Archdiocese in bankruptcy (the “bankruptcy estate”).

The ruling provides both sweet and bitter news for nonprofit corporations. On the sweet side, the decision, if followed by courts around the country, could reduce the risk that a nonprofit corporation will be dragged into bankruptcy due to the misfortunes or misdeeds of an affiliated entity. Some bitter aftertaste results, however, from the Court’s warning that nonprofits’ failure to respect principles of entity separateness under state law could still result in an involuntary merger of entities in bankruptcy.

An all-too-familiar unpleasant scenario led to this decision. The Archdiocese filed for Chapter 11 bankruptcy in the wake of a flood of sex abuse claims. In response, the committee representing all unsecured creditors (primarily comprising abuse claimants) sought to expand the Archdiocese’s bankruptcy estate—i.e., the “pot” of assets available to creditors for recovery on their claims—to include all of the assets owned by over 200 nonprofit corporations affiliated with the Archdiocese. These entities, which were all separate nonprofit corporations, included parish churches, schools, cemeteries, and the Catholic Community Foundation. The vehicle through which the creditors sought to tie the nonbankrupt affiliates to the bankrupt Archdiocese was the equitable doctrine of “substantive consolidation.” Through that doctrine, a bankruptcy court effectively has the discretion to merge or consolidate two entities in bankruptcy, combining all of their assets and liabilities into a larger bankruptcy estate.

The affiliates resisted creditors’ efforts to put them into bankruptcy, claiming that the creditors were using the substantive consolidation doctrine improperly to ignore statutory requirements for filing an involuntary bankruptcy case against an entity. But the creditors’ claims were not without significant appeal, as the numerous sympathetic victims of abuse cited examples of how the affiliates appeared to allow—and in many cases require—control of the affiliates’ assets and activities by the Archbishop for the Archdiocese’s benefit.

Ultimately, the Eighth Circuit Court held that the equitable substantive consolidation doctrine cannot be used to put a nonprofit corporation into bankruptcy involuntarily. Bankruptcy Code § 303(a) says that an involuntary bankruptcy case cannot be commenced against “a corporation that is not a moneyed, business, or commercial corporation.” The Court read “not a moneyed” corporation as synonymous with a “nonprofit” corporation. From there, it was an easy step for the Court to rule that a nonprofit corporation cannot be thrown into bankruptcy involuntarily, and thus cannot be thrown into bankruptcy involuntarily through substantive consolidation with a bankrupt affiliate.

However, the Court expressly did not decide whether a nonprofit corporation “that is the alter ego, under state law, of the debtor . . . can be consolidated.” The law of “alter ego,” also known as “piercing the corporate veil,” is a state-law doctrine that will allow a court to disregard the separateness of corporate entities and allow one entity’s creditors to recover against an owner’s or affiliate’s assets because the entities did not respect separateness or otherwise abused the privilege of being a separate corporation. The key factors in an alter ego analysis generally involve blurring the lines between entities based on things like commingling assets, failure to follow corporate formalities, and holding out one entity as being responsible for another’s debts. Also noteworthy is that all of the Archdiocese’s affiliates were separately incorporated—numerous courts have held that affiliates that do not even establish themselves as separate entities under state law will not be recognized as separate from a debtor under bankruptcy law.

Nonprofit corporations cannot view the Eighth Circuit’s ruling as a “get out of jail free” card with respect to bankruptcy. Another court might conclude that a nonprofit entity’s business, financial, or real estate activities justify a departure from the conclusion that all nonprofits are “not a moneyed, business, or commercial corporation.” Similarly, a result-oriented judge could hold that bare allegations or isolated examples of commingling assets and a debtor’s control of a nonprofit corporation’s affairs could get creditors over the goal line in alleging an alter ego relationship. As always, nonprofits must remain ever-vigilant in conducting their business and fulfilling their charitable missions.

Sherman & Howard has a team of lawyers with wide-ranging expertise and experience in helping sophisticated nonprofit corporations in corporate governance, debtor-creditor risk management, tax, and financial planning matters. Our lawyers are skilled in helping clients navigate the complex issues in today’s dynamic legal and business environment. We would welcome the opportunity to work with nonprofit and charitable organizations in helping them achieve their goals while minimizing legal risks. For further information on the matters discussed in this Alert or other legal issues pertaining to nonprofit organizations or bankruptcy matters, please contact Eric Johnson, Peter Cal, Stuart Lark, John Wylie, or Mike Dubetz.