Seven Counties Services: Is a Nonprofit Mental Health Provider Eligible to File Under Chapter 11?

Nonprofits and governments rely on each other to provide social services.[1] Governments rely on nonprofits to provide services that they cannot provide; nonprofits rely on governments to fund those services.[2] This relationship leads some to question whether a nonprofit is an instrumentality of a state and, as a result, the nonprofit’s eligibility to be a debtor under chapter 11 of the Bankruptcy Code.

In Seven Counties Services, the Sixth Circuit addressed this issue in the context of a nonprofit mental health provider in Kentucky.[3] Despite the public purpose of the nonprofit, the court found that it was not an instrumentality of the state.[4]

Debtor’s Preference for Chapter 11 over Chapter 9

A gatekeeping issue for any potential debtor is eligibility to file bankruptcy. Section 109 of the Bankruptcy Code sets forth who may be a debtor.[5] Under the Code, a “person” may file under chapter 11 if that person is eligible to file under chapter 7.[6] A “person” is defined as an individual, a partnership or a corporation.[7] With few exceptions, a person may not be a “governmental unit.”[8] Thus, a governmental unit generally is not eligible to file under chapter 11. An example of a governmental unit is an instrumentality of a state or commonwealth.[9] But beyond these statutory definitions, caselaw offers limited guidance on what the terms mean.[10] In a widely cited opinion,[11] Hon. Bruce A. Markell synthesized three factors to consider: (1) the power of the entity, (2) the purpose of the entity and (3) the treatment by the state of the entity.[12]

If an entity is a governmental unit ineligible to file under chapter 11, it may instead file under chapter 9.[13] Some examples of recent filings under chapter 9 include those of Jefferson County, Ala.,[14] and Detroit.[15] A case under chapter 9 is much like one under chapter 11.[16] For example, a debtor under chapter 9 may reject executory contracts and borrow money as an administrative expense.[17] However, there are also significant differences — namely, that the court in a chapter 9 case may not interfere with the property or revenues of the debtor.[18]

Importantly, the filing of a chapter 9 case requires approvals of the state or controlling government body, and approvals may be withheld for a variety of reasons.[19] As a result, chapter 9 is not always a viable option. Therefore, designation of an entity as a governmental unit could hamstring the entity’s reorganization efforts.

Background of Seven Counties Services

In Kentucky, the state government provided mental health services until the 1960s.[20] Then, community mental health centers (CMHC) formed to deliver services that had previously been provided by the state.[21] After one CMHC filed for bankruptcy in 1978, Seven Counties Services, Inc. (Seven Counties) was incorporated and began delivering mental health services in that bankrupt CMHC’s area.[22] As a nonprofit mental health services provider in Louisville, Ky., Seven Counties helped people “with mental illnesses, emotional or behavioral disorders, developmental or intellectual disabilities, and alcohol or drug addictions.”[23] In 2013, Seven Counties filed a chapter 11 petition.[24]

Seven Counties filed for bankruptcy because it needed to withdraw from its participation in the Kentucky Employees Retirement System (KERS).[25] In 1979, Seven Counties joined KERS after the governor issued an executive order that designated Seven Counties as an eligible participant.[26] But “the General Assembly had failed for years to budget sufficient funds to make the actuarially required contribution that would ensure the financial health of KERS.”[27] And to fix the problem, the General Assembly asked employers, such as Seven Counties, to make up the difference.[28] The contribution rate increased too much for Seven Counties to continue both paying KERS and offering health services.[29] To fix its problem, Seven Counties sought to “reject its obligation to contribute to KERS as an executory contract.”[30]

After Seven Counties filed for chapter 11, KERS filed a complaint.[31] KERS argued that Seven Counties was ineligible for protection under chapter 11 of the Bankruptcy Code.[32] In the same proceeding, Seven Counties filed its motion to reject an executory contract.[33] Seven Counties won on all counts in the bankruptcy court, and the district court affirmed.[34] KERS appealed the district court’s decision to the Sixth Circuit.[35]

Analysis

In determining KERS’s eligibility to file under chapter 11, the Sixth Circuit had to address whether Seven Counties qualified as a “governmental unit.”[36] KERS argued that Seven Counties was an “instrumentality of a State” and therefore should qualify as a governmental unit.[37] The Sixth Circuit relied on a variety of sources to define the elements of an instrumentality.[38] Legislative history and case precedent established that a state government must exercise some degree of control over an instrumentality.[39]

The Sixth Circuit applied a factor test to determine whether an entity was subject to governmental control.[40] The factors included, but were not limited to, (1) whether the government created the entity, (2) whether the government appointed the entity’s leadership, (3) whether an enabling statute guided or otherwise circumscribed the entity’s actions, (4) whether and how the entity received government funding, and (5) whether the government could destroy the entity.[41] When applying the abovementioned factors, the Sixth Circuit concluded that (1) Kentucky had not created Seven Counties because private individuals incorporated Seven Counties as a non-profit, (2) Kentucky had no input in appointing Seven Counties’ leadership except for in emergency situations, (3) Seven Counties did not function pursuant to an enabling statute, (4) Seven Counties did not receive direct appropriations but instead received 95 percent of its funding from three public sources, and (5) although Kentucky could impair Seven Counties’ ability to function, Kentucky could not destroy Seven Counties entirely.[42] The Sixth Circuit determined that although Seven Counties was an unusual entity, an analysis of the factors led to the conclusion that Seven Counties was not under the requisite governmental control to be considered an instrumentality of the state.[43]

The Sixth Circuit noted that governmental control was not the only factor that could be considered in determining whether an entity qualified as an instrumentality of the state.[44] If Seven Counties had “possessed commonly recognized governmental attributes” or had been classified as a governmental entity by the state’s classifications, the Sixth Circuit would have strongly considered those factors.[45] However, KERS did not persuasively establish any of these additional considerations in this case.[46] The Sixth Circuit held that because Seven Counties was not an instrumentality of Kentucky, it was eligible to file under chapter 11.[47]

Dissent

The dissent’s main qualm with the majority opinion in this case was the majority’s analysis of what degree of governmental control is required for an incorporated entity to be classified as a governmental unit under the Bankruptcy Code. The dissent first noted that Congress intended to define the term “in the broadest sense” according to the legislative history.[48] State sovereignty required Congress to ensure that the States retain control over their political subdivisions, instrumentalities and agencies.[49] Indeed, the Supreme Court struck down a previous version of the law that permitted state instrumentalities to file for bankruptcy without state consent.[50]

In critiquing the majority for failing to develop a clear test to determine whether an entity is a state instrumentality, the dissent distilled three elements from its definition of an instrumentality — an entity that “serves as an intermediary or agent through which one or more traditional government functions of a controlling state or municipality are carried out.”[51] First, the state or its municipality creates or designates an intermediary or agent.[52] Second, that intermediary or agent must carry out one or more traditional government functions.[53] Finally, “the state or its municipality retains a degree of sovereign control over the intermediary’s or agent’s existence or designation and its exercise of one or more traditional government functions.”[54]

Although the dissent agrees that Kentucky did not “create” Seven Counties in its original corporate form, it placed emphasis on the fact that Kentucky specifically designated Seven Counties as the sole mental health provider in its area.[55] As a result, Seven Counties provided the traditional government function of caring for the people’s general welfare by fulfilling the State’s responsibility to the less fortunate.[56]

Refusing to acquiesce to the majority’s heightened “day-to-day” control requirement, the dissent concluded that the Commonwealth retained the required degree of sovereign control.[57] First, Seven Counties was statutorily required to submit to special community-based boards, which must include local government stakeholders.[58] Additionally, if Seven Counties failed to fulfill its government functions, the state health agency “has authority to appoint a caretaker to operate and administer the programs and to make personnel changes necessary to ensure Seven Counties’ continued operations in compliance with its plan and budget and [other] requirements.”[59] Even though Kentucky could not destroy Seven Counties as a corporate entity, it certainly had the power to destroy its status as the sole direct provider of community-based mental health care in the seven-county area, the very status that gave rise to its name.[60]

Conclusion

In sum, the Sixth Circuit found that Seven Counties was eligible to file under chapter 11.[61] Because the court found that Seven Counties was a person instead of an ineligible municipality, the court concluded that Seven Counties could file under chapter 11 instead of chapter 9. Relying on several factors, the court found that Kentucky failed to exercise sufficient control over Seven Counties for it to be an instrumentality of Kentucky. This allowed Seven Counties to enter bankruptcy to reorganize and shed its obligations to the state retirement syste