Charities in Financial Distress: The Impact of Bankruptcy on Donor-Restricted Funds

Charities in Financial Distress: The Impact of Bankruptcy on Donor-Restricted Funds

Article posted in Compliance on 11 November 2015| 3 comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 11 November 2015
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Summary

What happens to your gift when the charity goes bust? That's the question that Richard Fox examines based on several recent cases.

By: Richard L. Fox, Esquire

Background on Charities and Financial Pressures

With the substantial growth of the charitable sector and nonprofit organizations operating more like businesses, it is now more common than ever for charities – in the face of decreasing revenues, increasing expenses, mounting financial pressures and weakness in the economy – to file for bankruptcy protection.   In recent years, there have been a number of high profile bankruptcy cases involving charitable organizations, including the New York City Opera, the National Heritage Foundation, the Philadelphia Orchestra, Architecture for Humanity, Banner Health System, and San Diego’s Orchestra Nova, as well as a host of other nonprofit organizations.

Unburdened by having to provide an economic return to shareholders or other owners, charitable organizations receive significant public support in the form of charitable contributions and grants, subsidized in part through the charitable tax deduction offered through the Internal Revenue Code of 1986, as amended, as well as an exemption from income taxation, in general, except for any unrelated business taxable income the charitable organization may receive.  A substantial portion of the public support provided to charitable organizations is restricted by donors for specified charitable purposes or uses, including donations, often in the millions of dollars, in the form of permanent endowment funds or charitable trusts, thereby making such funds unavailable to the recipient organization for its general charitable purposes.  Donations earmarked for specified charitable purposes should be distinguished from donations made for general charitable purposes, where the charity may use the gift as it determines in carrying out its charitable mission.

When a charity enters bankruptcy, an issue arises as to whether its assets, which are otherwise committed to serving the public interest and the community, should be available for payment to unpaid creditors who will generally seek to have their claims satisfied from any assets in which the charity has an interest, often including substantial endowment funds.  In essence, the bankruptcy of a charity represents the clash of two policy regimes: the aim of state law to protect donor intent with respect to assets contributed to charity for the public good versus the bankruptcy law goal of maximizing assets available for distribution to satisfy the claims of creditors.  Although bankruptcy law itself does not exclude charitable assets from the claims of creditors, it protects the public interest in such assets from the claims of creditors by respecting property rights that are created under the applicable state law, thereby protecting the public interest in charitable assets.  Therefore, when a charity declares bankruptcy, courts will try to identify those charitable assets that are restricted in such a manner that they survive bankruptcy.  Those assets so identified will be excluded from the bankruptcy estate and, accordingly, will be insulated from the claims of creditors.  This issue is not only relevant when a charity emerges from bankruptcy in a Chapter 11 reorganization and continues its operations, but also when a charity is forced to cease operations and close down its doors in a Chapter 7 liquidation.

Eligibility of a Nonprofit Corporation to File for Bankruptcy Protection

Charities organized as nonprofit corporations are generally eligible to file for bankruptcy protection under Chapter 7 and Chapter 11 of the Bankruptcy Code.  A proceeding commenced under Chapter 11 seeks to reorganize the debtor’s affairs and adjust its debts while generally continuing normal operations of the business. Therefore, Chapter 11 can often be used effectively to preserve a charity facing financial difficulties as a going concern and allow for the continuation of the charitable purposes of the charity.  At the heart of a Chapter 11 case is the plan of reorganization, which sets forth how the debtor proposes to repay its creditors.  Debtors may use a number of strategies in developing a plan, such as trying to reduce payments to some creditors and spread them out over a longer period of time.  In a proceeding filed under Chapter 7, a trustee is appointed to control, collect and liquidate a debtor’s assets to satisfy creditors.  A Chapter 7 bankruptcy case does not involve the filing of a plan of repayment as it does in a Chapter 11 reorganization.

The Bankruptcy Code also contains provisions that protect charities from involuntary bankruptcy petitions against the charity.  The Bankruptcy Code states that involuntary cases may be commenced by creditors “only against a person, except a farmer, family farmer, or a corporation that is not a moneyed, business, or commercial corporation.”  11 U.S.C. § 303(a).  Hence, an involuntary petition cannot be filed against a nonprofit or charitable corporation.  It should also be noted that the Bankruptcy Code prohibits the conversion of a Chapter 11 to a Chapter 7 liquidation if the debtor is a nonprofit or charitable organization.  11 U.S.C. § 1112(c).

The Bankruptcy Estate

Under the Bankruptcy Code, the commencement of a bankruptcy proceeding results in the determination of the “bankruptcy estate,” which is set aside and used to pay the claims of creditors (as well as the costs of the proceeding).  The bankruptcy estate includes “all legal or equitable interests of the debtor in property as of the commencement of the case.”  11 U.S.C. § 541(a)(1).  In addition, the Bankruptcy Code specifically provides that the bankruptcy estate does not include any “[p]roperty in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest.  The bankruptcy estate does not include any property in which the debtor does not hold an equitable interest.” 11 U.S.C. § 541(d).  The nature and extent of a debtor’s interest in property is determined by reference to applicable state law which creates and defines property interests, such that the legal or equitable interest of a debtor in a particular asset is generally determined by state law.  See Butner v. United States, 440 U.S. 48, 54 (1979).  Therefore, although the Bankruptcy Code is a federal law, the determination of a debtor's bankruptcy estate involves the application of the controlling state law.

Exclusion of Donor-Restricted Assets from Bankruptcy Estate of Charity

Donations are not considered restricted where they can be used at any time, in any manner, and for any of the charitable purposes of the charity, including a charitable purpose it did not have at the time of the gift.  Therefore, an outright gift to a charity, expressly or impliedly to be used for its general purposes, becomes the property of the charity which it can use as it determines in its sole and absolute discretion in carrying out its charitable mission.  Donors to charity, however, may desire to earmark the contribution for a specified use or purpose of the charity, such as to support medical research, perhaps on a particular disease, to establish a scholarship fund in a certain field of study, to endow a chair for a professor, or for the construction of a new building to be named after the donor.  Even a contribution to a medical research organization might be specifically earmarked such as specifying that it must be used to conduct a certain type of research such as using stem cells to repair heart damage.

Whether donor-restricted assets held by a charity in bankruptcy will be subject to the claims of creditors depends upon the terms and conditions placed on the use of the assets by the donor and the applicable state law that determines a charity’s underlying property interest in the assets.  The exclusion of restricted assets from a charity’s bankruptcy estate, often referred to as the “charitable trust doctrine,” can be a potent weapon to insulate such assets from the claims of creditors.  This doctrine, therefore, offers important asset protection to those charities holding substantial endowments restricted for specific purposes or uses, in many cases consisting of hundreds of millions of dollars.

Are Assets Held by Charity Sufficiently Restricted to be Excluded from Bankruptcy Estate?

Donors usually may impose restrictions on the use of their contributions, which may be as broad or narrow as the donor imposes subject, of course, to the charity’s acceptance of such restrictions and potential limitations under the law.

The restrictions may also limit the charity’s ability to expend the principal by limiting expenditures by the charity to the annual income generated by the charity or to an annual spending rule based upon a specified percentage of the value of the principal.  The restrictions may be memorialized in different types of documents, such as an inter vivos gift agreement, the terms under a will, an endowment fund agreement, or the provisions of a charitable trust.  Restrictions may also arise even in the absence of a written document, such as where gifts are solicited from donors based on the charity making representations regarding the specific use or purpose to which contributions will be put and the donors contribute in reliance of such representations.  

Even in the absence of a formal document creating a separate and distinct charitable trust whose trustees have legal ownership of the trust property, an implied or constructive charitable trust will generally arise under state law where property is contributed to a charitable organization and it is directed by the terms of the gift to devote the property to one or more specified purposes for which it is organized. In the constructive or implied trust situation, the charity itself is considered to be the trustee, essentially holding legal but not equitable title to the property.

If a charitable trust exists for state law purposes, the Bankruptcy Code contains two important provisions that are specifically applicable to such a trust.  Under Bankruptcy Code Section 541(d), “[p]roperty in which the debtor holds, as of the commencement of the case, only legal title” is not included in the debtor’s bankruptcy estate “to the extent of any equitable interest in such property that the debtor does not hold.”  Under this provision, even where a charity owns legal title to property that is considered to constitute a trust, the trust funds will not be part of the charity’s estate if the purpose of the trust is to benefit a particular charitable purpose, not the charity itself, and the charity has no present right to utilize the corpus of the trust.  Bankruptcy Code Section 541(c)(2), provides that a “restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.”  Under this provision, a trust enforceable under state law as a spendthrift trust is excluded from the assets of a bankruptcy estate.       

Assets Not Subject to Donor Restrictions as to Specified Charitable Uses 

Major charitable benefactors often use a charitable endowment structure to provide long-term support for a charity, which provides the charity with a present right to the income or a specified spending rule percentage payout from the endowment, but no right to use principal.  Such endowments may arise as a result of an express charitable trust document, under which a donor creates a separate trust independent of the charitable beneficiary, which specifies the permissible distributions to the charity by the trustee, or by a donor creating or contributing to an endowment fund that is owned and maintained by the charity that generally limits spending to the income of the fund.  Even where an endowment or other gift to a charity is not in the form of an express trust created pursuant to a formal trust document, it will generally be considered to constitute an implied or resulting trust under state law if the surrounding facts and circumstances evidence an intention of the donor to create a trust.  Therefore, a charitable trust can arise even where a gift does not constitute a charitable trust in a technical or formal sense including, in certain cases, in the absence of any gift instrument or other writing.

Various Alternatives for Exclusion of Charitable Trust from Bankruptcy Estate of Charity

There are various alternative situations under which assets held by a charitable trust, including an endowment fund treated as a charitable trust under state law, may be excluded from the bankruptcy estate of a charity.  These include situations where: the charity is not considered to hold the beneficial interest in the trust; there is a valid spendthrift provision; and the charity has ceased operations and applicable state law considers the use of charitable trust funds to repay debts incurred while the charity was operational as not furthering a charitable purpose.

Exclusion of Corpus of Charitable Trusts from Bankruptcy Estate of Charity Because Charity Lacks Beneficial Interest in Trust

When a charity holds only the bare legal title to charitable trust funds but not the beneficial interest, the trust funds will be excluded from the charity’s bankruptcy estate and, therefore, will not be subject to the claims of it’s creditors. See, e.g., In re Parkview Hospital, 211 B.R. 619 (Bankr. N.D. Ohio 1997).

In In re Roman Catholic Archbishop of Portland in Oregon, 345 B.R. 686, 693 (Bankr. D. Ore. 2006), the debtor charity held title to the assets of a fund that was considered to be a charitable trust.  Only the income of the trust could be expended each year and the charity was only one of multiple beneficiaries of the trust, with any distributions to the charity to be used for its “operating expenses.”  Therefore, although the charity held the legal title to the trust funds, it did not hold the entire equitable title to the fund.  Accordingly, citing Bankruptcy Code Section 541(d), the court held that the trust fund was not property of the bankruptcy estate.

Exclusion of Corpus of Charitable Trusts from Bankruptcy Estate of Charity Because of Existence of Spendthrift Protection

Section 541(c)(2) of the Bankruptcy Code provides that a “restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.”  As such, “a trust enforceable under state law as a spendthrift trust is excepted and excluded from the assets of a bankruptcy estate.” In re Roman Catholic Archbishop of Portland in Oregon, supra. The application of a spendthrift provision to exclude assets from the bankruptcy estate is consistent with the nature and extent of a debtor’s interest in property being determined under bankruptcy law by reference to state law. 

Exclusion from Bankruptcy Estate Where Charity Has Ceased Operations and Applicable State Law Considers Payments to Creditors as Not Furthering a Charitable Purpose

Where a charity has ceased operations and, therefore, is no longer carrying out any charitable purpose, an issue arises in regard to whether the charity is ineligible to continue to receive funds from a charitable trust if the funds will only be used to repay debts that were incurred when the charity was operational.  This issue is resolved based upon whether applicable state law considers the repayment of those debts to further the charitable purposes of the organization.  State law on this issue is not uniform. Cf. Boston Regional Medical Center, 410 F.3d 100 (1st Cir. 2005), with Winstead Memorial Hospital, 249 B.R. 588 (Bankr. D. Conn. 2000).

Treatment of Income on Restricted Endowment Fund or Charitable Trust as Part of Bankruptcy Estate 

While the corpus of a charitable trust may be excluded from the bankruptcy estate of a charity, income from the trust, once distributed to the charity, may be part of the bankruptcy estate.  The charity takes such income, however, subject to whatever restrictions on the use of that income that are enforceable under nonbankruptcy law.  Therefore, if income is distributed to the debtor charity subject to conditions on the use of the income in accordance with the charitable trust, and those conditions are enforceable under nonbankruptcy law, the bankruptcy estate takes the income subject to the conditions on use. 

If the income distributed to the charity is not subject to any restriction and may be used for its general uses, the income can be used for any purpose, including the payment of debts.  This is the case even in the case of a spendthrift trust, which affects only the beneficiary's right to obtain trust benefits in the future, so that trust payments already received by the beneficiary may be transferred to creditors or seized for the collection of creditors' claims.

Special Bankruptcy Law Protections Afforded Charities

Section 363(d)(1) of the Bankruptcy Code limits the right of trustees of certain nonprofit entities to use, sell and convey the assets of the non-profit.  Section 363(d)(1) was added in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, as was a companion provision, Section 541(f).  The purpose was to restrict the use, sale or lease of a non-profit entity's property except in accordance with applicable nonbankruptcy law, so that a nonprofit entity cannot escape supervision by its state’s Attorney General, who is given standing to appear and be heard on this issue.  Section 541(f) of the Bankruptcy Code provides that “property that is held by a debtor that is a corporation described in section 501(c)(3) of the Internal Revenue Code of 1986 and exempt from tax under section 501(a) of such Code may be transferred to an entity that is not such a corporation, but only under the same conditions as would apply if the debtor had not filed a case under this title.”

Donor Advised Funds as Part of Bankruptcy Estate of Sponsoring Organization

As a result of losing a substantial lawsuit and in the face of a $6.2 million judgment against it, the National Heritage Foundation (“NHF”), a Virginia-based charity sponsoring thousands of donor advised funds (“DAFs”) totaling millions of dollars, was forced to file for Chapter 11 bankruptcy protection in January 2009.  In re National Heritage Foundation, Inc., 510 B.R. 526 (E.D. Va. 2014).

The plan of reorganization stated that the NHF bankruptcy estate under Bankruptcy Code Section 541 includes "all assets received from Donors (including without limitation all [DAFs])," thereby, in the view of the NHF, subjecting DAFs to the claims of its creditors.  Thus, under its plan of reorganization, the DAFs maintained by the NHF, which were otherwise dedicated to making distributions to charities recommended by its donors, would, by virtue of being included in its bankruptcy estate under Bankruptcy Code Section 541, be used by the NHF to satisfy claims of creditors, pay expenses and create reserves for future operations, a clearly distressful outcome for donors having DAFs with the NHF.  Ultimately, the plan of reorganization was confirmed by the bankruptcy court, wiping out nearly 9,000 DAFs totaling approximately $25 million.

Notwithstanding the use of DAFs to pay creditors in the NHF case discussed above, there would still appear to be an argument that DAFs should be excluded from the bankruptcy estate of a sponsoring organization.  In the context of a DAF, a donor clearly gives up ownership and control of the contributed funds.  The same is true, however, for a donor-restricted contribution to an endowment or charitable trust, but the relinquishment of ownership and control by a donor does not, in and of itself, mean that the funds will be included in the bankruptcy estate of the sponsoring organization and used to satisfy its creditors.

Protecting Charitable Assets from Claims of Creditors

When a donor is contemplating making a large donation for the benefit of a charity to be held over a long period of time, consideration should be given to the impact of the charity’s bankruptcy on the use of those funds and steps that might be taken to ensure their continued use for charitable purposes, rather than the loss of the funds to the claims of creditors.  Maximum protection can be achieved by the donor creating an express trust with an independent trustee, which limits distributions for specified charitable purposes of the charity. Including a spendthrift provision in the trust will provide even further asset protection.  If funds are to be given directly to the charity, there should be a written gift agreement containing appropriate restrictions and conditions on the use of the funds.  If the funds are sufficiently restricted for specified charitable purposes, the charitable purposes of the funds should be protected and the funds should be kept outside the bankruptcy estate of charity, notwithstanding that the legal title to the funds are held by the charity.  A charitable trust or gift agreement should also contain provisions that anticipate the possibility of the donee facing charity financial distress, closing down, declaring bankruptcy or other events that could impair the effectiveness of the charitable funds provided by the donor.  Donors have enjoyed success in protecting charitable assets by using covenant-like restrictions in a grant agreement and including provisions that make the donation expressly revocable upon the deterioration of a charity’s financial conditions, the charity becoming insolvent or filing for bankruptcy, the loss of its tax-exempt status, or other triggering events.

Conclusion

It is now more common than ever for charities, in the face financial distress, to file for bankruptcy protection, thereby potentially exposing to the claims of creditors contributions made by donors that were intended to be used charitable purposes.  When donors give substantial funds to a charity, particularly funds to be held over a long period of time or in perpetuity, consideration should be given to the possibility of the charity eventually ceasing operations, changing its purpose, becoming insolvent or declaring bankruptcy.  To ensure that the funds will continue to be used according to the charitable intention of the donors, rather than lost to the claims of creditors, appropriate conditions and restrictions should be imposed on any donation that will not be immediately expended by the charitable recipient of the contribution.

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Comments

Re: Charities in Financial Distress: The Impact of ...

Great to hear this was helpful to you, and hopefully it was to other readers as well! This is more and more becoming a topical issue.

Richard Fox

Re: Charities in Financial Distress: The Impact of ...

Very helpful. Helped me convince a charity of the importance of so designating restricted contributions.

Re: Charities in Financial Distress: The Impact of ...

Glad this article was of help to you, and hopefully to others as well. This is becoming more and more a topic issue.

Richard Fox

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