Navigating Nonprofit Bankruptcy

by | Jun 18, 2024

Nonprofit organizations play a critical role in our communities, with many delivering essential services and tackling social issues. However, even the most well-intentioned organization can face financial difficulties. In such situations, bankruptcy may be a viable option, but it’s crucial to understand how it differs for nonprofits compared to for-profit businesses. Here are some of the more unique aspects of nonprofit bankruptcy to keep in mind:

Navigating Nonprofit Bankruptcy

Involuntary Immunity

Unlike for-profit corporations, nonprofits cannot be involuntarily forced into bankruptcy by another party. Section 303(a) of the Bankruptcy Code specifically lays out an exemption for charitable organizations by providing that creditors may not bring a case against “a corporation that is not a moneyed, business, or commercial corporation.” Yet the Bankruptcy Code does not define what a “moneyed, business or commercial corporation” is. That leaves it up to the courts to create standards for determining whether a potential debtor qualifies for protection under Section 303(a). And while some courts have adopted a “state classification rule” by only referencing a potential debtor’s formation documents, a more contemporary trend is to adopt an “activity rule,” which references both the potential debtor’s formation documents and evidence regarding the nature of its activities. If you need more clarification, it’s wise to work with a lawyer or accountant specializing in nonprofits, as they will better understand the rules and which ones would apply to your organization.

Nonprofits and Asset Sales

Throughout the bankruptcy process, nonprofit organizations must consider their fiduciary duties to their stakeholders. These include donors, employees, and the communities they serve. All asset sales and other financial transactions must be transparent and accountable. Therefore, when a nonprofit organization in bankruptcy seeks to sell its assets, it must obtain approval from the bankruptcy court. Section 363(d)(1) of the Bankruptcy Code specifies that nonprofit sales during bankruptcy must follow applicable state laws for such transactions. However, Section 541(f) restricts how nonprofit assets can be sold. Proceeds must be used for a charitable purpose similar to the original use of the asset. Section 1129(a)(16) of the Bankruptcy Code restricts profiting from asset sales while ensuring that any reorganization plan protects the organization’s charitable mission. State oversight remains in place in all cases, even during a nonprofit’s bankruptcy. This prevents organizations from using bankruptcy as a potential loophole for bypassing state regulations regarding asset sales.

Absolute Priority 

In a nonprofit bankruptcy, absolute priority determines the order in which various stakeholders, such as creditors, employees, and other interested parties, are entitled to receive distributions from the nonprofit’s assets. The principle of absolute priority is typically applied during the confirmation of a Chapter 11 bankruptcy plan, where the court evaluates the proposed plan to ensure it complies with the Bankruptcy Code’s requirements. Here’s how absolute priority applies in the context of nonprofit bankruptcies:

  • Secured Creditors: Secured creditors typically have the highest priority in bankruptcy proceedings. They hold liens or security interests in specific nonprofit organization assets, which serve as collateral for their loans or debts. When those assets are sold or distributed, secured creditors are entitled to receive payment first, up to the value of their collateral.
  • Unsecured Creditors: Unsecured creditors who do not have collateral securing their claims are next in line for distribution. They include vendors, service providers, and other creditors who have extended credit to the nonprofit without securing specific assets. Unsecured creditors are typically paid from the nonprofit’s remaining assets after secured creditors have been satisfied.
  • Equity Interest Holders: Equity interest holders, such as shareholders in a for-profit corporation or members in a nonprofit organization, are last in line under the absolute priority rule. They are entitled to receive distributions only after all secured and unsecured creditors have been paid in full. If there are insufficient assets to satisfy all creditors, equity interest holders may receive nothing.
Balancing Mission and Debts

Keep in mind that nonprofits don’t solely answer to creditors. Even in bankruptcy, the organization may have obligations to fulfill its charitable or mission-related purposes, which could impact the treatment of specific claims or distributions. The bankruptcy court will consider this dual responsibility when evaluating a reorganization plan. The goal is to ensure the organization emerges financially stable while continuing its mission-driven work.

Is Your Nonprofit on the Cusp of Bankruptcy? Here’s What to Do… 

If your nonprofit is facing financial hardship, don’t wait until it’s too late. Seek professional guidance from a lawyer or accountant who specializes in nonprofit bankruptcy. These experts can help you explore various options, including restructuring, negotiating with creditors, and, if need be, navigating the bankruptcy process. Remember, bankruptcy can be a tool for saving your organization and ensuring its continued service to the community. Take the first step towards peace of mind and book a complimentary consultation with Qbix. Our team of nonprofit accountants will provide wise advice and specific action steps to improve your organization’s financial health — and maybe even help you avoid bankruptcy. Don’t delay: Schedule your free call now.

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