Wednesday, April 30, 2014

Navigating a Nonprofit Corporation through Bankruptcy

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.
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]
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.

No comments: