Like their for-profit counterparts, nonprofit corporations face a variety of challenges throughout their corporate life cycles, some of which may lead an organization to pursue reorganization under chapter 11 of the Bankruptcy Code.[1] One of the issues that arises during a nonprofit’s reorganization is whether its board of directors must continue to act pursuant to their fiduciary duties of care, loyalty and obedience under state law or must maximize the value of the bankruptcy estate for its creditors.[2] This article will argue that a board of directors’ fiduciary duties of care, loyalty and obedience endure after the nonprofit files for chapter 11 protection. Accordingly, the board must continue to further the organization’s mission during reorganization.
Nonprofit Governance and the Duties of the Board of Directors
Nonprofits are governed generally by state law.[3] These statutes provide that a nonprofit shall have a board of directors that governs the organization.[4] The board “exist[s] to establish [the organization’s] strategic direction.”[5] The board is also responsible for the development of the organization’s fundraising and fiscal policies.[6] The board’s members are fiduciaries of the organization and must fulfill their responsibilities in accordance with certain legal duties, including the duties of care, loyalty and obedience.[7]
Duty of Care
Directors of a nonprofit must abide by the duty of care when making decisions on behalf of the organization.[8] “The duty of care requires each director to discharge all responsibilities in good faith and with the degree of care, diligence, and skill that ordinarily a prudent person would exercise under similar circumstances, and in a manner reasonably believed to be in the corporation’s best interest.”[9] The duty of care also requires that directors be “attentive to their responsibilities as board members” and “be reasonably informed with respect to board decisions”[10] Courts utilize the “business judgment rule” to determine whether a director breached his or her duty of care, finding a breach of the duty “in the presence of fraud, known illegality, or self-dealing.”[11]
Duty of Loyalty
“The duty of loyalty ... reminds board members to keep the interests of the corporation paramount and avoid benefitting unfairly from their relationship with the corporation.”[12] A director must execute his or her duties with the best interests of the organization in mind.[13] A director breaches the duty of loyalty when (1) the director “has interests on both sides of a transaction and could experience personal monetary gain,” (2) “the director appropriates a corporate opportunity ... usurping potential financial reward for the corporation,” or (3) “the director provides an economic benefit for a third party....”[14]
Duty of Obedience
The duty of obedience ensures that directors of nonprofits “act in accordance with the charitable purpose of their organization” and faithfully fulfill the organization’s mission.[15] The duty guides — and constrains — a director’s actions.[16] It requires that directors use their power and authority to further the mission of the organization while avoiding activities and transactions that do not align with the organization’s goals.[17]
Reorganization Under Chapter 11 of the Bankruptcy Code and the Duties of a DIP
The Bankruptcy Code allows certain “persons”[18] to reorganize their liabilities.[19] By filing a petition for chapter 11 protection, the debtor-in-possession (DIP) may “formulate a repayment plan” for their debts.[20] Generally, if creditors of the DIP accept the plan, the DIP may continue to operate its business while making lower payments on its obligations.[21] The DIP is also authorized to continue the operations of the business.[22] Unlike liquidation under chapter 7 of the Bankruptcy Code, “[t]he purpose of reorganization is to save a sick business, not to bury it and divide up its belongings.”[23]
Section 1107 of the Bankruptcy Code states that the DIP “shall have all the rights ... and powers, and shall perform all the functions and duties ... of a trustee serving in a case,”[24] including (1) taking care of property of the estate; (2) examining creditors’ proofs of claim; and (3) filing a schedule of assets, liabilities, income, and expenditures.[25] The DIP is authorized to continue the operation of its business and use its property in the ordinary course.[26] In exercising its powers, “a debtor in possession owes the same fiduciary duties to creditors and the estate as a trustee.”[27] Further, a DIP has a fiduciary duty to maximize the value of the state for its creditors’ benefit.[28] “This duty to maximize the estate often trumps other duties the debtor may owe to individual creditors or third parties.”[29]
State law governs a DIP’s duties in chapter 11.[30] A DIP owes “‘a duty to exercise that measure of care and diligence that an ordinary prudent person would exercise’” and “must make informed decisions and ‘use reasonable diligence in gathering information and considering material information.’”[31] A DIP must also refrain from self-dealing, avoid conflicts of interest and the appearance of impropriety and treat all parties fairly.[32] Ultimately, while reorganizing, a DIP is a fiduciary of the bankruptcy estate, and owes specific duties to the estate and its creditors.[33]
The Fiduciary Duties of the Board of Directors of a Nonprofit Corporation Continue During Its Reorganization
State Law Defines the Duties Owed by a DIP
“It is well settled that the duties of officers and directors emanate from state law.”[34] The duties established under state law continue even after a corporation has filed a petition for chapter 11 protection.[35] This concept holds true irrespective of whether the organization in bankruptcy is a for-profit or nonprofit corporation.[36]
Based on the foregoing, when a nonprofit files for chapter 11 bankruptcy protection, state law fiduciary duties of care, loyalty and obedience continue.[37] As such, the board must act in the best interests of the organization.[38] Further, it cannot use its position of power to benefit creditors or any other third party.[39] The board of directors must also continue to further the DIP’s mission, regardless of whether its actions maximize the value of the estate.[40] In fact, “a nonprofit board could expose itself to liability for violating the nonprofit’s organizational documents” if it contradicts the mission of the organization.[41] Because state law governs the duties of a DIP, the board of directors of a nonprofit corporation must act in the best interests of the organization during reorganization.[42]
The Bankruptcy Code Provides Special Protections to Nonprofit Corporations
Nonprofit corporations are given special status throughout the Bankruptcy Code.[43] For example, a nonprofit corporation cannot be forced into bankruptcy by its creditors.[44] Additionally, a court cannot compel a nonprofit corporation to convert its case from chapter 11 to chapter 7.[45] Most significantly, the Bankruptcy Code protects certain charitable contributions to the nonprofit corporation from its creditors.[46] While the Bankruptcy Code contains no explicit language, based on the foregoing, the DIP’s fiduciary duties should favor the best interests of the organization and further the organization’s mission. The organization, the public and the organization’s creditors are best served by imposing state law duties on a DIP and its board of directors. The nonprofit corporation continues to operate pursuant to its mission, regaining its financial stability in the process. The public and the organization’s other stakeholders continue to receive the benefits of the organization’s charitable work. Finally, the creditors of the organization likely receive more than they would in a chapter 7 liquidation.[47] Ultimately, the continuation of the fiduciary duties of the board of directors of a nonprofit corporation is compatible with the Bankruptcy Code.[48]
Conclusion
The duties of the board of a nonprofit corporation directly conflict with the duties of a DIP reorganizing under chapter 11 of the Bankruptcy Code. On one hand, the board of directors must act in the best interest of the organization, thereby furthering its mission. On the other hand, a DIP has a duty to its creditors to maximize the value of the bankruptcy estate. Because state law governs a DIP’s fiduciary duties, the board of directors’ duties of care, loyalty and obedience endure post-petition. This principle complements the Bankruptcy Code’s favorable treatment of nonprofit corporations. Therefore, when a nonprofit corporation enters chapter 11 bankruptcy, the board of directors must continue to further the organization’s stated mission, as well as act and make decisions in the best interests of the organization.
[1] See Elizabeth Schmidt, Nonprofit Law: The Life Cycle of a Charitable Organization 672-74 (2d ed. 2017) (listing examples of nonprofits in bankruptcy).
[2] Compare Dana Yankowitz Elliott & Evan C. Hollander, “Navigating a Nonprofit Corporation through Bankruptcy,” Nonprofit Q. (Apr. 29, 2014), available at https://nonprofitquarterly.org/2014/04/29/nonprofit-corporation-navigat… (“[T]he duties of a board of a nonprofit corporation do not change when the enterprise becomes insolvent.”), with Nancy A. Peterman & Sherri Morissette, “Directors Duties in the Zone of Insolvency the Quandary of the Nonprofit Corp.,” 23-Mar. Am. Bankr. Inst. J. 12, 50 (Mar. 2004) (“As a result, upon entering the zone of insolvency, a board of directors has a fiduciary duty to consider all constituencies of the nonprofit corporation, including the creditors....”).
[3] See Schmidt, supra n. 1, at 68 (stating that state laws provide “broad parameters” for the governance of nonprofit organizations).
[4] See, e.g., Cal. Corp. Code § 5210 (West 2017); N.Y. Not-for-Profit Corp. Law § 701(a) (McKinney 2017); Model Nonprofit Corp. Act § 8.01(a) (Am. Bar. Ass’n 2008).
[5] Vernette Walker, Corporate Governance, in Nonprofit Management 101: A Complete and Practical Guide for Leaders and Professionals 502-03 (Darien Rodriguez Heyman ed., 2011).
[6] See Joan M. Hummel, Starting and Running a Nonprofit Organization 10-12 (2d ed. 1996).
[7] See Manhattan Eye, Ear & Throat Hosp. v. Spitzer, 715 N.Y.S.2d 575, 593 (N.Y. Sup. Ct. 1999); Hummel, supra n. 6 at 9-10.
[8] See Denise Ping Lee, Note, “The Business Judgment Rule: Should It Protect Nonprofit Directors?,” 103 Colum. L. Rev. 925, 938 (2003); Michael W. Peregrine & James R. Schwartz, “Revisiting the Duty of Care of the Nonprofit Director,” 36 J. Health L. 183, 188 (2003).
[9] Nina J. Crimm, “A Case Study of a Private Foundation’s Governance and Self-Interested Fiduciaries Calls for Further Regulation,” 50 Emory L.J. 1093, 1142 (2001) (citing New York’s Not-for-Profit Corporation Law).
[10] Dana Brakman Resier, “Decision-makers without Duties: Defining the Duties of Parent Corporations Acting as Sole Corporate Members in Nonprofit Health Care Systems,” 53 Rutgers L. Rev. 979, 999 (2001).
[11] Peregrine & Schwartz, supra n. 8 at 189.
[12] Schmidt, supra n. 1 at 96.
[13] See Christyne J. Vachon, “Blurring. Not Fading. Looking at the Duties of Care and Loyalty as Nonprofits Move into Commercialism,” 12 Transactions: Tenn. J. Bus. L. 37, 48 (2011).
[14]Nicole Huberfeld, “Tackling the ‘Evils’ of Interlocking Directorates in Healthcare Nonprofits,” 85 Neb. L. Rev. 681, 702 (2007).
[15] Jeremy Benjamin, Note, “Reinvigorating Nonprofit Directors’ Duty of Obedience,” 30 Cardozo L. Rev. 1677, 1679-80 (2009).
[16] See Francie Ostrower & Melissa M. Stone, Governance: Research Trends, Gaps, and Future Prospects, in The Nonprofit Sector: A Research Handbook 613 (Walter W. Powell & Richard Steinberg eds., 2d ed. 2006).
[17] See Alan R. Palmiter, “Duty of Obedience: The Forgotten Duty,” 55 N.Y.L. Sch. L. Rev. 457, 466-69 (2010) (“The obedience duty there tracks and reinforces the non-profit’s mission — ‘to act with fidelity, within the bounds of the law generally, to the organization’s mission.’”).
[18] 11 U.S.C. § 101(41) (2012) (“The term ‘person’ includes individual, partnership, and corporation....”).
[19] 11 U.S.C. § 109(d) (2012); see Elizabeth Warren, Chapter 11: Reorganizing American Businesses 4 (“‘Reorganization’ refers to a change in the debt obligations of the business.”).
[20] Liliya Gritsenko, Note, “Everybody Wins! Elimination of the Absolute Priority Rule for Individuals under BAPCPA: A Middle Ground,” 35 Cardozo L. Rev. 1255, 1259 (2014).
[21] See W. Homer Drake Jr. & Christopher S. Strickland, Chapter 11 Reorganizations § 2:12 (2d ed. 2013).
[22] Mfrs. and Traders Tr. Co. v. Morningstar Marketplace Ltd. (In re Morningstar Marketplace Ltd.), 544 B.R. 297, 303 (Bankr. M.D. Pa. 2016).
[23] Susquehanna Chem. Corp. v. Producers Bank & Tr. Co., Bradford, Pa., 174 F.2d 783, 787 (3d Cir. 1949).
[24] 11 U.S.C. § 1107(a) (2012); see also In re Count Liberty, LLC, 370 B.R. 259, 275 (Bankr. C.D. Cal. 2007) (“By virtue of § 1107(a), a chapter 11 debtor in possession stands in the shoes of a trustee and is a fiduciary for the estate and its creditors.”).
[25] See Warren, supra n. 19 at 54-55.
[26] See Drake Jr. & Strickland, supra n. 21 at § 7:4; see also 11 U.S.C. § 1108 (“[T]he trustee may operate the debtor’s business.”).
[27] In re China Fishery Grp. Ltd. (Cayman), Case No. 16-11895 (JLG), 2016 WL 6875903, at *15 (Bankr. S.D.N.Y. Oct. 28, 2016) (citing Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 355 (1985)). The officers and employees of the DIP owe similar fiduciary duties. Id.
[28] See, e.g., Pacificorp Ky. Energy Corp. v. Big Rivers Elec. Corp. (In re Big Rivers Elec. Corp.), 233 B.R. 739, 751-52 (Bankr. W.D. Ky. 1998) (citing several cases).
[29] Id. (citing In re Wintex Inc., 158 B.R. 540, 543 (D. Mass. 1992)).
[30] See John Wm. (“Jack”) Butler, Jr., et al., “Preserving State Corporate Governance Law in Chapter 11: Maximizing Value Through Traditional Fiduciaries,” 18 Am. Bankr. Inst. L. Rev. 337, 337 (2010) (“In designing chapter 11 of the United States Bankruptcy Code ... Congress made a considered judgment ... to leave both the operation of the company’s business and control of the chapter 11 case, in most instances, in the hands of state law fiduciaries operating as debtors-in-possession.”).
[31] In re Bowman, 181 B.R. 836, 843 (Bankr. D. Md. 1995) (citing cases).
[32] See, e.g., Lange v. Scropp (In re Brook Valley VII, Joint Venture), 496 F.3d 892, 900-01 (8th Cir. 2007).
[33] See discussion, supra Sections I.A, I.B, I.C.
[34] Elliott & Hollander, supra n. 2.
[35] See Butler Jr., et al., supra n. 30 at 342 (“Each of the powers and duties that the Bankruptcy Code bestows upon debtors-in-possession must be viewed through the lens of applicable state law notions of fiduciary duty.”); David A. Skeel, Jr., “Rethinking the Line Between Corporate Law and Corporate Bankruptcy,” 72 Tex. L. Rev. 471, 491 (1994) (“The second phenomenon can be traced to federal bankruptcy’s courts’ tendency to incorporate rather than override relevant state law wherever possible, an inclination that has been approved both by the Supreme Court and by most commentators.... [B]ankruptcy courts are particularly deferential to state law in the corporate governance context....”).
[36] Elliot & Hollander, supra n. 2.
[37] See id. (“[T]he duties of a board of a nonprofit corporation do not change when the enterprise becomes insolvent.”).
[38] Contra Peterman & Morissette, supra n. 2.
[39] See Vachon, supra n. 13.
[40] Elliot & Hollander, supra n. 2. In fact, there is no provision in the Bankruptcy Code that requires the DIP to maximize the value of estate for creditors. Id.
[41] See id.
[42] See supra text accompanying n. 34-41.
[43] See infra text accompanying n. 44-46.
[44] Elliot & Hollander, supra n. 2; see also 11 U.S.C. § 303(a) (2012) (“An involuntary case may be commenced only under chapter 7 or 11 of this title, and only against a person, except ... a corporation that is not a moneyed, business, or commercial corporation....”).
[45] Elliot & Hollander, supra n. 2; see also § 1112(c) (2012) (“The court may not convert a case under this chapter to a case under chapter 7 of this title if the debtor is ... a corporation that is not a moneyed, business, or commercial corporation, unless the debtor requests such conversion.”).
[46] See Reid K. Weisbord, “Charitable Insolvency and Corporate Governance in Bankruptcy Reorganization,” 10 Berkeley Bus. L.J. 305, 311–314 (2013) (“Bankruptcy law ... tends to amplify the public interest in charitable assets by insulating charitable endowments from distributions to unpaid creditors.”).
[47] Id. at 314-315.
[48] See supra text accompanying n. 43-47.