A nonprofit provider of community health services is not a governmental unit and is therefore eligible for chapter 11 reorganization, even though 95% of its budget is covered by state funding, according to two judges on the Sixth Circuit.
Noting that the Supreme Court has classified the Red Cross and Amtrak as governmental instrumentalities, the dissenter “easily” concluded on the same facts that the organization is an instrumentality of the state and is therefore ineligible for chapter 11.
The debtor is not out of the woods, however, because the appeals court has asked the Kentucky Supreme Court to determine in substance whether participation in the state pension program is based on an executory contract subject to rejection.
The Debtor’s History and Structure
A nonprofit organization, the debtor is the primary provider of mental health services for the state in seven Kentucky counties. Formed in 1996, the debtor provides local services that previously were performed by the state Department of Mental Health. Many of the original employees had worked for the state. To ensure they would not lose their state pensions, the governor issued an executive order allowing the debtor to join the state pension system. Legacy employees and new hires are all covered by the state pension system.
Required contributions to the state pension system grew dramatically in recent years. The debtor said it could not provide mental health services while continuing to contribute to the state pension system. The debtor filed a chapter 11 petition to reject its relationship with the pension system because there was no statutory mechanism to withdraw.
Seeking dismissal of the chapter 11 case, the pension system contended that the debtor is a governmental unit and therefore ineligible for chapter 11. Alternatively, the pension system sought a declaration that the relationship with the pension system is a statutory obligation that cannot be rejected like an executory contract.
The bankruptcy court and the district court sided with the debtor on both issues. The pension system appealed to the Sixth Circuit.
The Statute
Under Section 109(d), only a “person” may be a chapter 11 debtor. A “person” is defined in Section 101(41) to exclude most governmental units. Pertinent to the case at hand, Section 101(27) defines “governmental unit” to be an “instrumentality” of a state.
In her majority opinion on August 24, Circuit Judge Jane B. Stranch said that no circuit court has developed a test to divine whether an entity is a state instrumentality. She liberally cited In re Las Vegas Monorail Co., 429 B.R. 770 (Bankr. D. Nev. 2010), which has been the leading authority to decide whether an entity that seemingly performs governmental functions is a bankruptcy-ineligible governmental unit.
To conclude that the Monorail was not a governmental unit, Bankruptcy Judge Bruce A. Markell confronted a certificate that the debtor had executed to obtain tax-exempt financing. To give bond investors assurance that the Monorail could not file bankruptcy, the certificate stated that the company was an instrumentality of the state.
Judge Markell overcame the certificate by alluding to Nevada law saying that any monorail in the state is a “person” and not a municipality. He also noted that the monorail had no power of eminent domain, no taxing power, and no sovereign immunity. Of most importance, Judge Markell said that the “low level of state control” showed that the monorail was not a municipality. He said that state control was in the nature of regulation or oversight, like casinos or taxicabs. He noted that creditors had no ability to look to the state for payment.
Markell is now the Professor of Bankruptcy Law and Practice at the Northwestern Univ. Pritzker School of Law.
The Majority’s Analysis
Although governmental control is not determinative in itself, Judge Stranch said it “plays a critical role in identifying state instrumentalities.” Her disagreement with the dissent, she said, stems from the “‘degree of control” that is required.
Judge Stranch said that governmental control over day-to-day activities is not necessary. To analyze the degree of control, she evaluated five factors.
First, the state did not create the debtor. It was incorporated by private individuals. Second, the state does not appoint the debtor’s officers. Third, the debtor does not function pursuant to an enabling statute, although it is subject to state regulation and “recognition.”
Fourth, the debtor receives 95% of its funding from three public sources. However, Judge Stranch said the debtor does not receive direct appropriations. Its funding sources are “generally available to state and non-state entities alike.” Fifth, the state “cannot destroy” the debtor’s corporate existence.
Synthesizing the factors, Judge Stranch said the debtor is “a unique entity with some features that might seem to belong to a state agency and others that would be entirely inconsistent with a governmental designation.” All the factors, she said, “suggest” that the debtor “is not a government entity.”
Judge Stranch said that governmental control is not the only consideration. Possessing “commonly recognized governmental attributes, for example, would give pause.”
The debtor, she said, does not have governmental attributes, such as the power of eminent domain or the ability to levy taxes. Although the debtor “may have attempted to claim the defense of sovereign immunity in litigation, that claim has never been adjudged in its favor.”
Considering all factors, Judge Stranch concluded that the organization is eligible for chapter 11 relief because the state did “not create [the debtor], does not in the normal course of events choose its leadership, does not govern its operations through an enabling statute, does not fund it through a mechanism that is normally reserved for public entities, and cannot unilaterally destroy it.”
The Dissent
Circuit Judge David M. McKeague issued a vigorous dissent in an opinion as long as the majority’s.
Paraphrasing a dictionary, he said that the debtor is an “instrumentality” if “it ‘serves as an intermediary or agent through which one or more [traditional government] functions of a controlling [state or municipality] are carried out.’”
Because “instrumentality” has the same definition for state and federal entities, Judge McKeague said that the Supreme Court in a constitutional context had found the Red Cross and Amtrak to be governmental instrumentalities. He suggested that the court should not “reject the Supreme Court’s mandated, ordinary-meaning approach to a mere statutory definition.”
The Certified Question
To the satisfaction of two of the three appeals court judges, the debtor established its eligibility for chapter 11 relief. The retirement system, though, had also appealed from the finding in bankruptcy court that its relationship with the debtor was contractual, allowing rejection as an executory contract under Section 365.
The retirement system argued on appeal that the relationship was purely statutory and thus beyond the rejection power.
On a certified question, the two-judge majority asked the Kentucky Supreme Court to decide whether the debtor’s participation in the retirement system is “based on a contractual or statutory obligation.”
The appeals court majority said that the answer from Kentucky’s high court may not necessarily decide all the issues regarding rejection. If the Kentucky court decides that the relationship is statutory, the majority said “the relatively minor issue of whether that obligation must be faithfully maintained during the pendency of proceedings under 28 U.S.C. § 959(b) would remain.”