Sacred Assets: Church Creditors Cannot Force Nonbankrupt Affiliate Assets Into Bankruptcy

01/9/2017

Bankruptcy has always been a strong tool for restructuring charitable, non-profit entities.¹  Now, there is even more reason to consider chapter 11 for such entities struggling under a heavy load of debt or an onslaught of claims – the United States District Court for the District of Minnesota recently held that substantive consolidation cannot be used to bring in the assets of related entities into the bankruptcy estate of the entity or entities that filed bankruptcy.

The Archdiocese of Saint Paul and Minneapolis (“Debtor”) filed bankruptcy on January 16, 2015.  A year and a half later, the Official Committee of Unsecured Creditors (“Creditors’ Committee”) asked the bankruptcy court to consolidate the Debtor with 187 separately-incorporated and non-consenting, charitable organizations, including parishes and their related schools and cemeteries within the Debtor’s region (“Targeted Entities”).  Official Committee of Unsecured Creditors v. Archdiocese of Saint Paul and Minneapolis, 2016 WL 7115977 *1 (D. Minn. Dec. 6, 2016).  For what purpose?  To include the assets of the Targeted Entities in the Debtor’s bankruptcy estate to satisfy bankruptcy claims against it, including abuse claims.

The bankruptcy court denied the motion on two grounds: (1) a creditor cannot force a non-profit (charitable) entity into bankruptcy via the involuntary Bankruptcy Code provisions, and substantive consolidation would effectively do the same; and (2) even if substantive consolidation were permitted, the Creditors’ Committee failed to allege sufficient facts to support substantive consolidation.  Id. at *1-*2.

The District Court affirmed.  The Bankruptcy Code does not specifically authorize a bankruptcy court to substantively consolidate non-debtors with debtor entities.  Instead, bankruptcy courts must rely on their “equitable powers” under § 105 of the Bankruptcy Code.  Section 105 says a bankruptcy court may “issue any order process, or judgment that is necessary or appropriate to carry out the provisions of the Bankruptcy Code.”  11 U.S.C. § 105(a).  However, a bankruptcy court cannot “override explicit mandates of other sections of the Bankruptcy Code.”  Id. at *2 (quoting Law v. Siegel, 134 S.Ct. 1188, 1194 (2014)). 

Substantive consolidation “treats separate legal entities as if they were merged into a single survivor left with all the cumulative assets and liabilities.”  Id. at *2 (quoting In re Owens Corning, 419 F.3d 195, 205 (3d Cir. 2005)).  In other words, substantive consolidation can wreak havoc on the non-debtor entity or entities.  It must only be applied sparingly per three non-exclusive factors (1) the necessity of consolidation due to the interrelationship of the debtors; (2) the benefits of consolidation versus the harm to creditors; and (3) the prejudice resulting from not consolidating the debtors.  Id. at *3 (quoting In re Giller, 962 F.2d 796, 799 (8th Cir. 1992)).  In Giller, for example, which did substantively consolidate debtor and non-debtor entities, all six corporations were owned by the same individual; all corporations had filed bankruptcy; and abuses as to the corporate form existed as to all six entities (e.g., there were multiple, unreconciled intercompany loans, fraudulent transfers and employees of one entity working for another entity without compensation).

The District Court agreed with the Bankruptcy Court that substantive consolidation has the same effect that an involuntary bankruptcy would have on an entity.  Because Section 303 of the Bankruptcy Code governing involuntary bankruptcies would not apply to the Targeted Entities, the Creditors’ Committee could not use Section 105 of the Bankruptcy Code (which cannot be used to circumvent “explicit mandates of other sections of the Bankruptcy Code”) to substantively consolidate the assets of the Target Entities with the assets of the Debtor.  In essence, “[b]oth remedies force the Targeted Entities into bankruptcy against their will.”  Id. at *3.  All of the cases cited by the Creditors’ Committee were unavailing because none of them dealt with non-profit, charitable organizations.  Id.

The District Court further agreed that the Creditors’ Committee did not allege sufficient facts to establish substantive consolidation against the non-debtor entities, even if substantive consolidation were permissible.  Substantively consolidation looks primarily at “whether entities are so intertwined that they are ‘functionally one’.” Id. at *4 (citing Giller and In re Petters Co., Inc., 506 B.R. 784, 803 (Bankr. D. Minn. 2013)).  The Creditors’ Committee did not allege that the Targeted Entities were run out of the same headquarters; or that the Debtor financed all of the entities with no provision for repayment; or that the Debtor’s employees provided uncompensated services for the Target Entities.  Id.  While these are not the only factors a court can consider, none of the allegations “plausibly inferred” that the Debtor and the Targeted Entities were “functionally one”.  Id.

Further, the pleaded facts did not establish the three “non-exclusive” factors set forth in Giller.  The allegations did not establish that the creditors relied on any interrelationship and treated the entities as a single entity.  Nor did they establish that the benefits of consolidation outweigh the harm to the creditors – e.g. some creditors stood to benefit from consolidation and no creditors would be harmed.  And they did not establish that prejudice would result if consolidation is not ordered.

In summary, substantive consolidation does not appear to be possible in cases involving charitable, non-profit entities.  This enhances bankruptcy as a tool to use in restructuring such entities without burdening the assets of related entities that do not wish to file bankruptcy or pay for the debts of the entity in bankruptcy.  And even if it were possible, any attempt to substantively consolidate charitable, non-profit entities faces the same difficult hurdles that any substantive consolidation motion faces.

Scott K. Brown is a partner at Lewis Roca Rothgerber Christie LLP in its religious institutions practice group.  He is admitted in Arizona, Colorado and New Mexico.