Creditors Face Limits on Involuntary Bankruptcy Petitions against Nonprofit Health Care Entities

Under most circumstances, the Bankruptcy Code authorizes the filing of an involuntary bankruptcy case against an entity by three or more creditors holding unsecured claims. The right to file an involuntary case is limited, however, and may not be available to creditors of nonprofit health care entities.

Section 303(a) of the Bankruptcy Code states that an involuntary bankruptcy proceeding may be commenced only under chapter 7 or chapter 11 and “only against a person, except a farmer, family farmer or a corporation that is not a moneyed, business, or commercial corporation.” The legislative history indicates that the intent was to protect “schools, churches, charitable organizations and foundations” from involuntary bankruptcy (See H.R. Rep. No. 95-595, 95th Cong., 1st Sess. 321 (1977); S. Rep. No. 95-595, 95th Cong., 2d Sess. 33 (1978)).

Yet the Bankruptcy Code does not define a “moneyed, business or commercial corporation,” which leaves it up to the courts to develop standards for determining whether a potential debtor qualifies for protection under Section 303(a). While some courts have adopted a “state classification rule,” looking only to a potential debtor’s formation documents, the modern trend is to adopt an “activity rule,” looking to both the potential debtor’s formation documents as well as to evidence regarding the nature of its activities. It is imperative that nonprofit healthcare entities and creditors in contested involuntary bankruptcy cases understand these rules and which is likely to apply.

State Classification Rule

Under the state classification rule, whether an entity may be an involuntary debtor in bankruptcy depends only on the powers and characteristics imposed upon it by the law of the state of its incorporation. In other words, for purposes of Section 303(a), a corporation has the same status as stated in its articles or certificate of incorporation. In adopting this rule, the Second Circuit declared, “Now it is the powers conferred upon the company, not its activities, which are decisive.” In re Union Guarantee & Mortg. Co., 75 F.2d 984, 985 (2d Cir. N.Y. 1935). See also In re Dairy Marketing Ass'n, 8 F.2d 626, 628 (D. Ind. 1925) (“The character of a corporation or association must be determined from its articles of incorporation and the statute authorizing its formation.”). Thus, under the state classification rule, healthcare entities organized as nonprofit corporations generally may not be made involuntary debtors in bankruptcy.

Activities Rule

Under the activities rule, a corporation must show that it both “(i) is considered an eleemosynary organization under state law, and (ii) actually conducts itself as an eleemosynary organization.” In re The Centre for Management and Technology, Inc., 2007 Bankr. LEXIS 3734 (Bankr. D. Md. Oct. 26, 2007). Courts that adopt the activities rule look at both the entities’ organization as well as its operations to determine whether it is eligible for involuntary bankruptcy relief.

In In re Capitol Hill Healthcare Group, 242 B.R. 199 (Bankr. D.D.C. 1999), a nursing home moved to dismiss an involuntary bankruptcy petition filed against it by a creditor, arguing that the petition could not be filed against it under Section 303(a). The court held that state law organization as a nonprofit corporation is “probative” but “not decisive.” Id. at 202. While many of the nursing home’s characteristics indicated that it was a nonprofit (e.g., organization under District of Columbia law as a nonprofit corporation, a mission to provide health care to the community, lack of distributions), the creditor alleged that the nursing home should be considered the alter ego of a for-profit entity to which the nursing home made payments for providing services such as maintaining a cafeteria, security, and housekeeping. Moreover, the creditor pointed to the fact that the nursing home and for-profit entity were operated as related entities under 42 C.F.R. 413.17 for Medicare cost reimbursement purposes and underwent a joint audit resulting in a single audit report. However, the court dismissed the case as it “fail[ed] to see how any of these facts are relevant to whether the debtor is operated for pecuniary gain.” Id. at 202.

In contrast, in Schuster v. Ohio Farmers’ Coop. Milk Ass’n, 61 F.2d 337 (6th Cir. 1932), the Sixth Circuit held that involuntary bankruptcy proceedings were properly commenced against a cooperative because, although the cooperative was “legislatively deemed a nonprofit,” the cooperative was a “moneyed, business, or commercial corporation” based on its activities. The Sixth Circuit stated that “where the chief purpose of the corporation is to carry on trade or commerce…there is but little room for doubt that the corporation is a ‘business or commercial’ one within the intendment of the Bankruptcy Act.” Id. at 338. While the entity may have been organized solely for the benefit of the cooperative members, this did not negate the fact that the cooperative was intended to specifically provide a “financial benefit” to its members. Id. The Sixth Circuit also rejected the premise that a potential benefit to non-members of the cooperative disproved the court’s contention that the cooperative’s primary purpose was to promote the pecuniary gain of its members. Id.

Distinction between Nonprofit and Tax-Exempt for Purposes of Section 303(a)

The activities rule is similar to the standard set by Internal Revenue Code 501(c)(3) for charities, which requires that charities be both “organized and operated” exclusively for tax exempt purposes. However, it is important not to conflate “tax-exempt” and “nonprofit” when considering whether a potential debtor qualifies for exemption under Section 303(a). In 2010, the Bankruptcy Court in the Eastern District of California dismissed an involuntary bankruptcy proceeding against an alleged debtor that was formed as a California nonprofit public benefit corporation. The court declared:

“While the tax exempt status of a corporation may indicate that the corporation is also a nonprofit entity, the absence of a tax exempt status by no means indicates that the corporation is not a nonprofit entity…Moreover, the creditors do not challenge the nonprofit nature and character of [the potential debtor]. They challenge only [the potential debtor’s] nonprofit tax exempt status…The opposition makes no effort to distinguish between ‘tax exempt’ and ‘nonprofit’ entities. Instead, the opposition conflates the two.”

In re Davis Area Cooperative Housing Association, United States Bankruptcy Court, Eastern District of California, Case No. 10-30314-A-11 (June 14, 2010). (See also In re Capitol Hill at 202, noting that being a charity is not a prerequisite to not being a moneyed, business, or commercial corporation under Section 303(a).)

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