The Applicability of the Absolute-Priority Rule to Nonprofit Debtors

The absolute-priority rule was a judicial invention intended to prevent equityholders and secured creditors from colluding to the detriment of unsecured creditors.[1] The Bankruptcy Reform Act of 1978 codified the absolute-priority rule at 11 U.S.C. § 1129(b)(2)(B)(ii), which requires for dissenting unsecured creditors to be paid in full before equityholders may retain property under a reorganization plan.

The absolute-priority rule is “generally applied to for-profit corporations facing bankruptcy, where an equityowner seeks to retain property, often represented by stock.”[2] The applicability of the absolute-priority rule to a nonprofit debtor presents an uncommon question. The only two circuit courts of Appeal to decide the issue have found the absolute-priority rule does not apply to nonprofit debtors.

Seventh Circuit: Absolute-Priority Rule Does Not Apply to a Nonprofit Electric Utility     The Seventh Circuit analyzed the absolute-priority rule in the context of an electric utility cooperative.[3] The Seventh Circuit ruled that members (equityholders) of a nonprofit debtor did not hold “interests” in the debtor and therefore the debtor’s reorganization plan did not violate the absolute-priority rule. The dissenting unsecured creditor in Wabash objected on the grounds that the member cooperatives retained control of the reorganized debtor and received some economic benefit from the reorganized debtor. The Seventh Circuit found the “member cooperatives…do not improperly retain property ‘on account of’ either their patronage capital accounts (which are mere refunds of overpayments) or their control over [the Debtor].”[4] Identifying three indicia of ownership (control, profit share and ownership of corporate assets), the Wabash court determined that retention of managerial control was insufficient to trigger the absolute-priority rule in the context of an electric utility.

In concluding that the member cooperatives did not retain an interest in the reorganized debtor, the Seventh Circuit relied on Indiana state law as it pertains to nonprofits in general as well as regulation on Indiana utility companies. Generally, Indiana law prohibits nonprofit companies from paying dividends to its members and provides that, upon dissolution, any equity in assets escheats to the state.[5] As to utility regulations, the Seventh Circuit found it important that Indiana law prohibited the debtor from charging customers more than the cost of electricity provided.[6]

Thus, the Seventh Circuit’s decision is limited to some extent as the debtor was an electric utility. However, the decision still may generally apply to any nonprofit chapter 11 debtor. Provisions similar to the Indiana statutes noted in Wabash may exist in the law of one’s jurisdiction. For example, under Florida law, nonprofit corporations are prohibited from making distributions to its members, subject to limited exceptions.[7]

Ninth Circuit Expands on the Wabash Decision     Ninth Circuit relied on Wabash in ruling that an international labor union was not an owner of its local branches for purposes of the absolute-priority rule.[8] In the Teamsters case and unlike the circumstances in Wabash, the debtor held a contingent future interest in the assets of any dissolved local union. The Ninth Circuit found this insufficient to establish ownership without any other indicia of ownership. The Ninth Circuit noted the rationale behind the absolute-priority rule as it pertains to for-profit chapter 11 debtors. The concern of an equityholder is purely an economic one, focused on the profitability of the corporation.

Other courts have applied slightly different rationale in reaching the same conclusion as the Seventh and Ninth Circuits.Rather than focusing on the interest retained by equityholders, the court in In re Save Our Springs Alliance Inc.[9] found that a nonprofit corporation simply has no equityholders. The debtor in that case existed to promote water conservation in west Texas. The court did not find it necessary to examine the indicia of ownership or other factors, but cited the circuit court decisions that the proposition that the equityholders did not retain an interest in the reorganized debtor.

Conclusion     The applicability of these decisions to other types of nonprofit organization will largely hinge on the stated purpose of a given debtor and the existence of monetary incentives for the equity holders provided in a proposed plan of reorganization. As explained by the Ninth Circuit, the absolute-priority rule exists to prevent abuse by debtors with solely pecuniary motivation, which is the motivation of most business ventures. The same rationale behind the absolute-priority rule fails where the debtor exists to serve a community function, such as in the context of a labor union, electric cooperative, historical society, environmental protection group or religious organization.

1. See In re Wabash Valley Power Ass’n, 72 F.3d 1305, 1314 (7th Cir. 1996).

2. Sec. Farms v. Gen. Teamsters (In re Gen. Teamsters), 265 F.3d 869, 873 (9th Cir. 2001).

3. See In re Wabash Valley Power Ass’n, 72 F.3d 1305.

4. See In re Wabash, 72 F.3d at 1320.

5. Id. at 1309.

6. Id. at 1313-1314.

7. See Florida Statutes § 617.1301.

8. Sec. Farms v. Gen. Teamsters (In re General Teamsters), 265 F.3d 869, 874 (9th Cir. 2001).

9. 3388 B.R. 202, 245 (Bankr. W.D. Tex. 2008), aff’d, 2009 WL 8637183 (W.D. Tex. Sept. 29, 2009), aff’d, 632 F.3d 168 (5th Cir. 2011).

This posting was originally published as an article in the American Bankruptcy Institute (ABI) Young and New Members Journal, Volume 10, Number 3 / September 2012, which can be accessed at:

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