Non-Bankrupt Nonprofit Entities Are Not Subject to Substantive Consolidation

May 1, 2018

Because substantive consolidation is the equivalent of involuntary bankruptcy, Section 303(a) precludes a bankruptcy court from ordering substantive consolidation with non-bankrupt nonprofit schools, churches and charitable organizations, the Eighth Circuit ruled on April 26, affirming two lower courts.

The appeal arose in the chapter 11 reorganization of the Archdiocese of St. Paul and Minneapolis, where the church is dealing with claims of clergy sexual abuse.

To expand the pool of assets available for abuse claimants, the official creditors’ committee filed a motion seeking substantive consolidation of the archdiocese with about 200 non-bankrupt schools, parishes, and other nonprofit organizations controlled by the church. The committee said that the non-bankrupt church entities owned the majority of the assets in the archdiocese.

As described in the decision for the appeals court authored by Circuit Judge Michael J. Melloy, the committee’s complaint alleged in detail how the archdiocese exercised direct and virtually total control of even minute activities by the parishes and schools, including the forced consolidation of parishes over opposition from the parishes themselves, the parishioners, and the parish priests.

Bankruptcy Judge Robert J. Kressel of Minneapolis granted the archdiocese’s motion to dismiss without reaching the First Amendment or the Religious Freedom Restoration Act. He dismissed because substantive consolidation would be the equivalent of an involuntary petition against the nonprofit schools and parishes. The district court affirmed, as did Judge Melloy.

Judge Melloy explained that substantive consolidation “is an equitable remedy grounded in the broad powers” of Section 105(a), which gives the bankruptcy court authority to issue “any order” that is “necessary or appropriate to carry out the provisions of” the Bankruptcy Code. He described substantive consolidation as combining “the consolidated entities’ assets and liabilities to satisfy creditors from a combined pool of assets.”

Although the circuits allow substantive consolidation among debtors, Judge Melloy said that only the Ninth Circuit has permitted consolidation with non-bankrupt entities. However, no circuit has authorized consolidation with a nonprofit non-bankrupt entity.

Analyzing the propriety of the rulings below, Judge Melloy began with Law v. Siegel, 134 S. Ct. 1188, 1194 (2014), where the Supreme Court taught that the equitable powers in Section 105(a) cannot “override explicit mandates of other sections of the Bankruptcy Code.”

Judge Melloy then turned to Section 303(a), which effectively prohibits the filing of an involuntary petition against “a corporation that is not a moneyed, business, or commercial corporation.” Surveying state law governing the incorporation of religious entities, he said that the parishes, schools, and other non-bankrupt entities in the archdiocese were nonprofit corporations falling within the ambit of Section 303(a).

Judge Melloy agreed with Judge Kressel’s conclusion that substantive consolidation “would necessarily pull non-profit entities into bankruptcy involuntarily in contravention of Section 303(a).” Again agreeing with Judge Kressel, Judge Melloy held there was no legal authority to order substantive consolidation because doing so “would override an explicit statutory protection in the Bankruptcy Code.”

Judge Melloy went on to say that “Section 303(a) prevents the use of Section 105(a) to force truly independent non-profit entities into involuntary bankruptcy.”

By using the words “truly independent,” Judge Melloy left the door open to allegations that consolidation may be proper if the nonprofit entity is an alter egounder state law or was part of a fraudulent scheme, such as a Ponzi scheme.

However, Judge Melloy was careful to say that “isolated incidents of lack of corporate formality or commingling,” as alleged in the committee’s complaint, “fall far short of the requirement of alter ego status under Minnesota law.” Moreover, Judge Melloy said that the committee’s theory “would effectively nullify” Minnesota law, which gives the archbishop “effective control” over the affiliated entities.

In sum, Judge Melloy said that “global consolidation of all entities in the archdiocese is not authorized by the Bankruptcy Code.”

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