Do Nonprofits Need to Comply with the Absolute Priority Rule?

February 25, 2021

By Steven R. Kinsella and Emily M. McAdam

As financial distress grows due to the pandemic, charitable organizations are faced with two immovable forces–increased demand from hard hit communities and decreased funding due to both the economic hardships facing many donors and the cancellation of most live fundraising events. The increased demand and decreased resources of many nonprofit and charitable organizations have caused such organizations to consider filing for chapter 11 protection. Other nonprofit organizations are contemplating bankruptcy for totally different reasons, with many Catholic dioceses and the Boy Scouts of America filing for chapter 11 protection to provide a mechanism for compensating survivors of sexual abuse.

If a nonprofit organization files for bankruptcy protection, one of the key questions is how can the organization reorganize and how much does the reorganization need to pay creditors? A key component of this analysis is the organization’s ability to cramdown its plan over the objection of an unsecured creditor class under 11 U.S.C. § 1129(b)(2). The absolute priority rule ensures that, for any equity holder to retain his or her ownership interest in the debtor, either unsecured creditors must be repaid in full or the equity holder must make a substantial contribution to the reorganization. With nonprofit organizations, there generally is no equity holder, so does the nonprofit organization need to satisfy the absolute priority rule?

The first court to substantively address whether the absolute priority rule applies to nonprofit bankruptcies was in In re Eastern Maine Electric Cooperative, Inc., 125 B.R. 329, 331 (Bankr. D. Me. 1991). In this case, the non-profit was a cooperative and, because the members who held patronage stock retained an ownership interest, the court determined that the absolute priority rule would apply. The court in S. Pac. Transp. Co. v. Voluntary Purchasing Groups, Inc., also dealing with issues surrounding patronage stock, reached a similar conclusion. 252 B.R. 373, 386–89 (E.D. Tex. 2000).

The Seventh Circuit, however, dealing with a similar electric cooperative, reached the opposite conclusion, identifying three components of an equity interest – (1) control, (2) profit share, and (3) ownership of corporate assets – before concluding that the holders of patronage stock were not equity holders and the absolute priority rule could not apply. In re Wabash Valley Power Assoc. Inc., 72 F.3d 1305 (7th Cir. 1995). More recently, courts analyzing the applicability of the absolute priority rule to non-profits have similarly concluded that the rule does not apply:

  • In re Save Our Springs (S.O.S.) Alliance, Inc., 388 B.R. 202 (Bankr. W.D. Tex. 2008), aff’d, 632 F.3d 168 (5th Cir. 2011): Here, in rejecting a creditor’s argument that the reorganization plan of the debtor, a citizen action group nonprofit charitable organization, violated the absolute priority rule, the court stated simply that, “[the] Plan does not provide for equity holders to receive or retain an interest, because the Debtor, as a nonprofit organization, has no equity holders.”
  • In re Indian Nat. Finals Rodeo Inc., 453 B.R. 387 (Bankr. D. Mont. 2011): Here, citing Wabash, the court held that the absolute priority rule was inapplicable because the debtor was a nonprofit organization with no shareholders, and with board members who received no salary and members who received no dividends. at 401.
  • In re Henry Mayo Newhall Mem’l Hosp., 282 B.R. 444 (B.A.P. 9th Cir. 2002): Here, while not explicitly analyzing the applicability of the absolute priority rule, the BAP noted that “the Hospital’s nonprofit status puts creditors in an unusually disadvantaged negotiating position because they are not able to assert the Bankruptcy Code’s absolute priority rule to block unacceptable plans that give value to junior interests before paying creditors in full.”

Most courts analyzing the absolute priority rule in the context of nonprofit bankruptcy reorganization plans have held the rule inapplicable to or categorically satisfied by such plans. In so holding, courts will generally look to a fact-specific analysis of whether the entity’s remaining owners/interest-holders are deemed to retain an equity interest in the form of control plus profit share and/or ownership over corporate assets. Thus, the filing of a chapter 11 case for nonprofit organizations may provide an opportunity for such organizations to truly reorganize under the Bankruptcy Code.

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