n recent years, courts have struggled to apply the absolute priority rule to non-profit entities, whose organization reflects some, but not all, of the attributes of a for-profit corporation. The absolute priority rule provides that, when an unsecured creditor is not paid the full amount of its claim against the debtor under the terms of the debtor’s reorganization plan, no equity holder junior to that unsecured creditor may receive or retain any property on account of its equity interest. The rule, which is codified in the Bankruptcy Code at §1129(b)(2)(B), enables unsecured creditors to challenge a plan of reorganization when the plan allows holders of equity in the debtor to retain their equity interest, but fails to pay all unsecured creditors in full.

Application of the absolute priority rule to non-profit debtors presents unique issues that are particularly relevant to health care entities, which so often are organized as non-profit organizations. Individuals involved in non-profit entities do not necessarily possess the type of equity interest to which the absolute priority rule historically has been applied, and recent cases considering these issues demonstrate that the rule provides an awkward fit in the non-profit context.

The rise in the number of entities with non-profit status is a relatively recent phenomenon, and, not surprisingly, the case law is relatively undeveloped. Cases have arisen in the context of non-profit health care facilities and utility cooperatives.

Health Care Cases

In In re Whittaker Memorial Hospital Ass’n, 149 B.R. 812 (Bankr. E.D. Va. 1993), the bankruptcy court held that the retention of control of a hospital (the debtor) did not violate the absolute priority rule. The Secretary of Housing and Urban Development (HUD), a creditor of the debtor, objected to the hospital’s reorganization plan on the basis that the plan violated the absolute priority rule. HUD urged that, by failing to pay HUD in full while allowing a junior class of interest holders to retain their control of the hospital, the plan allowed parties to retain property on account of their junior interest in violation of the rule. Whittaker, 149 B.R. at 815. The bankruptcy court rejected the argument and discounted the importance of the "control" retained by the junior class, noting that such control "did not give them anything, certainly not a favored position over HUD." Id. at 816. In its succinct treatment of the issue, the court observed that the debtor was a Virginia non-stock corporation, and therefore different than a private enterprise, and implied that retention of control over such a non-profit entity did not implicate the absolute priority rule. Id.

The debtor in In re Independence Village Inc., 52 B.R. 715 (Bankr. E.D. Mich. 1985), was a non-profit organization that operated a "life-care" facility for the elderly. Independence Village, 52 B.R. at 717. Construction of the facility was financed through a city entity (the "EDC"), which obtained the funds in exchange for bonds secured by a mortgage on the premises and leased the facility to the debtor. Id. A bank, acting as trustee for the bondholders, raised several objections to the reorganization plan. Id.

The bank contended that the debtor had no hope of effectively reorganizing without violating the absolute priority rule because the debtor was hopelessly insolvent in that its property was worth approximately $4 million and its secured debt totaled $15 million. Id. In rejecting this contention, the court observed that, because the debtor was a non-profit corporation, it had "no shareholders, hence...no interests inferior to the unsecured creditors," and accordingly that "there should be little difficulty with the absolute priority rule. ..." Id. at 726. Like the Whittaker court, the Independence Village court considered the unique attributes of the reorganizing non-profit entity and concluded that the absolute priority rule was not implicated under the circumstances.

Utility Cases

In the Matter of Wabash Valley Power Association, 72 F.3d 1305 (7th Cir. 1995), dealt with the reorganization of a rural electric cooperative, Wabash Valley Power Association Inc. (WVP). The Rural Electrification Administration (REA), a federal regulatory agency and the debtor’s significant creditor, raised two challenges to the plan on the basis of the absolute priority rule. First, the REA alleged that the plan violated the absolute priority rule by allowing members to retain their rights in "patronage capital accounts."¹ Id. at 1315. Second, the REA urged that continued control of the debtor by its members after reorganization also violated the absolute priority rule. Id. The Seventh Circuit rejected both arguments. Id. at 1320.

The REA contended that, by allowing members to retain their rights to eventual repayment of patronage capital, the plan allowed WVP members to retain property in violation of the absolute priority rule. WVP’s plan treated the members’ interests in patronage capital as "claims" that were of equal seniority to the REA’s unsecured claims. Conversely, the REA urged that members’ rights in patronage capital constituted an equity interest, junior to unsecured debt. Id. at 1316. The Seventh Circuit held that the plan properly classified these interests as claims rather than as equity and, accordingly, that the plan did not run afoul of the absolute priority rule. Id. at 1317. To reach its conclusion, the Seventh Circuit relied on the state law governing non-profit electric cooperatives, which precluded members from owning any asset of the cooperative. Id. at 1317. The court reasoned that, in light of that prohibition, these accounts were actually no-interest loans to the cooperative by its members and not equity interests.

The REA also urged that the plan allowed members to control the reorganized WVP in violation of the absolute priority rule. Id. at 1318. The Seventh Circuit rejected this argument and held that the "control" over a non-profit entity is distinguishable from "control" over a for-profit corporation. In particular, the court focused on the fact that, unlike the controllers of a for-profit enterprise, the controllers of a non-profit entity have no right to use their control to afford themselves potential future profits. Id. The court explained that control alone, divorced from any right to share in corporate profits or assets, does not constitute an equity interest and seemed to conclude that the absolute priority rule has no application to such a situation. Id. at 1320.

The Wabash court referred to the reasoning in Whittaker, noting that the Whittaker facts presented an even more compelling reason to find that control over a non-profit entity was not sufficient to trigger the absolute priority rule. The court explained that in Whittaker, not only did the parties who would "control" the hospital lack the ability to use that control to generate profits for themselves, but neither were they recipients of the services provided by the hospital. Id. at 1319. By contrast, in the utility cooperative context, controlling members reap an economic benefit in the form of lower utility rates. Notwithstanding this fact, the Wabash court described this benefit as "an inescapable product of the cooperative form" and "not exploitation of insider status of the sort the absolute priority rule was designed to prevent." Id.

In re Eastern Maine Electric Cooperative Inc., 125 B.R. 329 (Bankr. D. Maine), also addressed the reorganization of a rural electric cooperative, Eastern Maine Electric Cooperative (EMEC). Id. at 339. Unlike the Seventh Circuit in Wabash, the Eastern Maine court decided that members’ rights to recover patronage capital were more accurately described as equity interests rather than as claims for repayment of debt. The court concluded that, as ownership interests, members’ interests in patronage capital were junior to unsecured debt of the objecting creditor. Id.

Although it reached a different conclusion than the Wabash court reached, the Eastern Maine court relied upon many of the same types of factors. For example, it looked to the state law governing non-profit cooperatives, particularly state cases holding that members had no immediately enforceable right to the repayment of amounts in their patronage capital accounts and that members were not allowed to offset any amount owed to the cooperative by the amount owed to the member in patronage capital. Id. at 335-37. The Eastern Maine court was also swayed by the terms of the cooperative’s by-laws, which it interpreted to create no liability to repay the patronage capital until such a time as the board of directors voted to retire those accounts. Id. In addition, the court noted that the cooperative itself had referred to patronage capital as representing "ownership" in the cooperative and had not recorded patronage capital as a liability unless directors voted to retire some portion of those accounts. Id. at 339.

Recurring Considerations in Applying the Rule

Although the inconsistent conclusions of the two courts addressing this issue in the utility context create some uncertainty in this area, the fact that courts in both the utility and health care contexts looked to similar sources for guidance suggests that at least some of these criteria are likely to drive subsequent consideration of this issue. Defining the interests of parties controlling non-profit entities, in order to determine the appropriate application of the absolute priority rule, requires courts to compare interests that exist in the non-profit format with the types of interests to which the rule historically has been applied. The diverse holdings of the few cases dealing with this issue suggest that this comparison is complex. All the courts that have dealt with the issue, however, have considered some or all of the following factors in reaching a conclusion about the application of the absolute priority rule to these entities: (i) state law governing the particular non-profit entity; (ii) by-laws and behavior of the non-profit entity with regard to its equity holders; (iii) and the ability of the equity holder to assert control in a manner that affords it a meaningful economic benefit.

Footnotes

¹"Patronage capital" is unique to a cooperative scheme. Because of the difficulty in predicting precisely the cost of providing power, utilities sometimes collect revenues in excess of the actual costs for generation and transmission of power. State law generally allows the utility to retain portions of this excess revenue to defray unpredictable costs without having to first raise extra capital. The amounts retained for this purpose are accounted for using a bookkeeping system of "patronage capital accounts" into which each member's share of these funds is allocated on the basis of that member's power usage. [Return to Text]