State Sanctioned and Regulated Community Mental Health Center Is Entitled to Chapter 11 Relief

By: D. Nicholas Panzarella

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Recently, in In re Seven Counties Services, Inc.,[1] a bankruptcy court held that a Kentucky non-profit corporation designated as a community mental health center (“CMHC”) was not a “governmental unit” and therefore, was eligible to be a debtor in a chapter 11 bankruptcy case.[2]  In Seven Counties, the CMHC debtor filed for bankruptcy under chapter 11 of the Bankruptcy Code after the Kentucky General Assembly raised the contribution rate for participants in a state pension system, which the debtor participated in pursuant to a state statute.[3]  After filing, the CMHC debtor sought to reject its executory contract with the pension system.[4]  In response, the state pension commenced an adversary proceeding seeking (1) a determination that the CMHC debtor was a “governmental unit,” and not a “person,” and thus was statutorily barred from seeking relief under chapter 11 of the Bankruptcy Code and (2) the issuance of a preliminary injunction compelling the CMHC debtor to continue contributing to the pension.[5]  The Seven Counties court held that the CMHC debtor was entitled to chapter 11 relief and permitted the CHMC debtor to reject its executory contract with the pension system.[6]

Section 109(a) of the Bankruptcy Code provides that only a “person” may be a debtor under chapter 11.[7]  Section 101(41) provides that the term “person” includes “individual, partnership, and corporation,” but explicitly excludes a “governmental unit.”[8]  The term “governmental unit” includes a “department, agency, or instrumentality of . . . a State.”[9]  The legislative history of section 101 indicates that Congress intended to define “governmental unit” in the “broadest sense.”[10]  The legislative history, however, further provides that a “department,” “agency,” or “instrumentality” “does not include any entity that owes its existence to state action, such as the granting of a charter or license but that has no other connection with a State . . . .  The relationship must be an active one in which the [entity] is actually carrying out some governmental function.”[11]  When determining whether the CMHC debtor was a governmental unit, the Seven Counties court concluded that the evidence produced at trial did not support a finding that the CMHC debtor was a “department,” “agency,” or “instrumentality” of Kentucky, and therefore, the CMHC debtor was not a “governmental unit.”[12]

First, the Seven Counties court concluded that the CMHC debtor was not a “department,” based on the plain meaning of the term.[13]  The pension system argued that the CMHC debtor was a “department” since a state statute[14] defined “department” to include any entity participating in a state pension system.[15]  The court found this argument unpersuasive, however, because federal law, not state law, determines the meaning of terms used in the Bankruptcy Code.[16]  Since the Bankruptcy Code does not define the term “department,” the court applied the Black’s Law Dictionary definition of “department” (i.e., a “principal branch or division of government”)[17] because the court determined that doing so “comport[ed] with federal statutory interpretation of the term in case law.”[18]  Ultimately, the court reasoned that the CMHC debtor was not a “department” because a private individual incorporated the CMHC debtor, and the CMHC debtor was not administered by individuals that are accountable to public officials or the electorate.[19]

Next, the Seven Counties court also held that the CMHC debtor was not an “agency.”[20]  The pension system argued that the CMHC debtor was an “agency” because under state law, the CMHC debtor was a “board,” and the term “board” is included in the Black’s Law Dictionary’s definition of “agency.”[21]  The court, however, rejected the pension system’s argument.  In determining that the CMHC debtor was not an “agency,” the court relied on a Kentucky Supreme Court case[22] that held that community mental health centers were not agencies.[23]  There, the Kentucky Supreme Court reasoned that CMHCs were “not claimed to be state agencies for any purpose other than retirement system participation,” and that their employees were “not under the merit system, state salary schedules, or any other state personnel regulations.”[24]  Accordingly, the Seven Counties court found that the CMHC debtor was not an agency after applying the same reasoning.[25]

Finally, the court held that the CMHC debtor was not an “instrumentality” of Kentucky.[26]  The state pension argued that the CMHC debtor was an “instrumentality” of the state because the state exercised substantial oversight over the debtor’s budget and operations.[27]  Because the plain meaning of the term provided little assistance, the Seven Counties court identified three factors for determining whether an entity is an “instrumentality” of the State: (1) “whether the entity as any of the powers typically associated with sovereignty, such as eminent domain, the taxing power, or sovereign immunity”; (2) “whether the entity has a public purpose, and if so, the level of control exerted by the state on the entity’s activities in furthering the purpose”; and (3) “the effect of the State’s own designation and treatment of the entity.”[28]  In applying the factors, the Seven Counties court concluded that the debtor was not an “instrumentality” because the court found that (a) the CMHC debtor did not exercise any powers typically associated with sovereignty, and (b) Kentucky exerted very little control over the CMHC’s operations.[29]  In particular, the CMHC debtor was a private organization, and Kentucky did not appoint or approve its board of directors, officers, executives, or employees.[30]  Indeed, the only power that Kentucky exercised over the CMHC debtor was the power to remove the CMHC debtor’s recognition as a mental health services provider.[31]  Thus, the court concluded that the CMHC debtor was not a “governmental unit” because it was not a “department,” “agency,” or “instrumentality.”[32]  Therefore, the CMHC debtor was entitled to seek chapter 11 relief, and as part of that relief, the CMHC debtor was entitled to reject its executory contract with the pension system.[33]

The Seven Counties decision demonstrates that while Congress intended to define the term “governmental unit” in the “broadest sense,” the definition is not broad enough to encompass an independent, private non-profit entity that works closely with a state or the federal government,” even if the entity participates in a government pension system.  Accordingly, an independent, private non-profit entity will likely be eligible for chapter 11 relief.  That eligibility for chapter 11 is important because a governmental unit is only eligible for chapter 9 relief if the governmental unit can meet the strict statutory requirements for being a chapter 9 debtor.[34]  For example, chapter 9 relief may not be available to a governmental unit in a state that does not authorize chapter 9 filings.[35]  Thus, an independent, private non-profit entity will likely be entitled to bankruptcy relief under chapter 11 even if the entity would not be entitled to file for bankruptcy had the entity been found to be a governmental unit.