In years past, not-for-profit organizations that found themselves in financial trouble typically would have closed their doors and quietly dissolved. More recently, with increased institutional lending and funding to not-for-profits, organizations must operate more like for-profit businesses when winding up their operations. In times of distress, not-for-profit entities, often layered with debt and other obligations, are more likely to seek bankruptcy in order to wind up and/or transition their operations. Although not-for-profit organizations may look in many respects like for-profit business structures (e.g., generating revenues through for-profit affiliates and engaging in hedging transactions), key distinctions exist that lenders should be aware of when extending credit to a not-for-profit borrower.

Generally, for-profit entities have the goal of maximizing profits for the benefit of their shareholders. Not-for-profit entities have no shareholders—instead they operate with a goal of fulfilling their stated mission. Such a fundamental difference in purpose provides a vastly different landscape for lenders, and certain expectations that lenders bring with them from the for-profit context need to be closely examined when engaging in not-for-profit lending. This may lead to the consideration of additional covenants and protections, which otherwise might not be necessary when lending to for-profit borrowers. While certainly not a comprehensive review, we highlight some of the key differences below.

Bankruptcy Eligibility

Lenders should consider whether their not-for-profit borrower is eligible for bankruptcy protection. With limited exceptions, many for-profit borrowers are eligible for bankruptcy protection (whether voluntary or involuntary), whereas a not-for-profit entity may not be. As lenders are aware, the Bankruptcy Code provides an often efficient mechanism for restructuring or winding down a business, for example, allowing for the provision of debtor-in-possession financing to provide capital for an orderly process and ensuring that priorities among different creditor groups are honored. Bankruptcy also allows for oversight by the court and, where warranted, transition of management to a third-party trustee or the appointment of an examiner. When bankruptcy is not available, a borrower may be able to wind down its business unfettered by the meaningful restrictions and general monitoring of its activities that would otherwise come in a Chapter 7 liquidation or Chapter 11 reorganization.

Section 109 of the Bankruptcy Code provides certain criteria that must be met for a "person" to file bankruptcy under any Chapter of the Bankruptcy Code.1 The Bankruptcy Code defines "person" to include an "individual, partnership or corporation."2 Not-for-profit entities must qualify under applicable state law to meet such Bankruptcy Code definitions (typically a review of the "corporation" definition in §101(9)(A-B) of the Bankruptcy Code is most applicable), in order to be eligible to file under either Chapter 7 or Chapter 11 of the Bankruptcy Code. It is important for a lender to know whether their not-for-profit borrower is organized within the confines of these definitions in determining if bankruptcy protection is available or if alternative recovery strategies, such as state receivership regimes, need to be considered. For example, a "non-business trust" cannot file for bankruptcy protection. The difference between a business trust and a non-business trust, although a nuanced distinction that courts have even had difficulty grappling with, is worthy of a lender's advanced consideration.

Even if a not-for-profit entity is eligible to commence a voluntary case, generally speaking, charitable and non-profit organizations are immune from being forced into bankruptcy by creditors.3 Bankruptcy Code §303 provides that an involuntary case may be commenced "only against […] a corporation that is not a moneyed, business, or commercial corporation." The statute expressly excludes organizations that do not qualify as "moneyed, business or commercial." Although involuntary proceedings are rare in practice, the ability of a lender to force a borrower into bankruptcy may be necessary in instances of mismanagement or fraud. Holding the "bankruptcy card" may allow lenders and other creditors a greater opportunity to negotiate in a typical for-profit restructuring and further provide some incentive for borrowers to proceed with due haste. Where the threat of an involuntary petition does not exist in the case of a not-for-profit borrower, there may be a risk that costs and expenses mount as borrowers try to reverse their fortunes without oversight of a restructuring process.

Similarly, although a not-for-profit entity may have commenced a voluntary Chapter 11 bankruptcy, creditors may be prohibited from petitioning for conversion from a Chapter 11 reorganization to a Chapter 7 liquidation. The ability to request that the court convert a case provides creditors a vehicle to force a debtor, not successfully rehabilitating, into liquidation. In all cases, the Bankruptcy Code provides for the conversion of a Chapter 11 case to a Chapter 7 liquidation upon demonstration by any party-in-interest of "cause."4 However, the ability of a lender to request conversion under §1112(b) is restricted by §1112(c) of the Bankruptcy Code prohibiting the involuntary conversion of a Chapter 11 to a Chapter 7 liquidation if the debtor is a "non-moneyed, non-business or non-commercial corporation." This is similar to the immunity from involuntary proceedings.

It is important that lenders understand the treatment of their borrower under the Bankruptcy Code, which may require consultation of applicable state law. Bankruptcy eligibility cannot be taken for granted in the not-for-profit space.

Collateral Considerations

Lenders, whether to for-profits or not-for-profits, are concerned with the universe of their borrower's assets and funds that are available to repay their obligations. In addition to the host of issues raised by the nature of the lender's claim (e.g., unsecured versus secured), where those claims reside in the corporate structure (e.g., senior versus structurally subordinated), not-for-profit borrowers have additional risks that certain of their assets are restricted and not available as collateral or to cover lenders claims regardless of a lender's priority.

Lenders may not be able to access restricted or designated funds, endowments, and other trust assets of not-for-profit borrowers. To a lender's surprise, it might find that assets held by not-for-profits are not private corporate property, but rather constructive or implied charitable trusts for the benefit of the stated non-profit mission. It follows that a heightened review needs to be undertaken by lenders, not just of priming and positioning, but also of the universe of available unencumbered and unrestricted assets for distribution. Loan facilities should allow a lender to undertake a thorough periodic review of its borrower's accounting of assets (keeping a careful eye on any commingling of restricted and unrestricted funds) and require regular reporting of restricted and unrestricted assets.

The Bankruptcy Code respects property and contractual rights created outside of bankruptcy and does not alter the pre-petition nature of a debtor's interests in property that is restricted under non-bankruptcy law, including government grants, private donations, endowment funds, assets held in trust by the debtor for the benefit of third parties and assets subject to restrictions precluding its alienation to anyone other than the non-profit. For example, donations made for a limited purpose are excluded from creditor collection and may not be permitted to be used for the repayment of loan obligations. The restricted funds must be used for their stated purpose, or a sufficiently similar purpose found to satisfy the restriction. Accordingly, absent a release by the donor, these funds will not be available for the repayment of creditor claims, whether in connection with a restructuring or in a liquidation. Certain restricted funds and endowments may even need to be returned to the donor if such parameters of the donation cannot longer be met.

A lender should know the types of assets held by its borrower, taking into account on a granular level the different types of assets vis-à-vis their restrictions (e.g., endowment funds that are generally restricted versus income from an endowment fund that are generally unrestricted unless endowment fund is held by a third party). Moreover, it is common in not-for-profit charities that funds and assets are held by a third-party trustee or a for-profit financial institution. This adds a layer of difficulty in administering any not-for-profit debtor's bankruptcy estate.

There are, however, certain partially restricted funds outside of a formal endowment structure that may be used to satisfy creditor claims (e.g., quasi-endowment funds, reserves, and accrued interest). In addition, if a bankrupt not-for-profit borrower wants to use restricted funds for another purpose, including the repayment of debts, it may be able to do so by requesting approval from the bankruptcy court to use property outside the ordinary course of business.5 Note that the statute requires the debtor to make such request (another party in interest may not make such request). Approval of such request, although possible, may also require "adequate protection" to be provided to others with interest in the property pursuant to Bankruptcy Code §361.6

A lender may want to consider requesting additional information relating to restrictions on the assets of a not-for-profit borrower, including any terms and conditions for which assets are subject to and all related copies of reports required to be submitted in connection with grants or other assets received. Many grants require rigorous reporting requirements in connection with the earmarking of their donations as well as having specific terms and conditions associated with the grant. A casual review of the borrower's accounting records may not be sufficient to understand the restrictions.

Potential for Clawbacks

Certain not-for-profits, particularly in the health care, child care and education spaces, receive payments from government agencies as reimbursement for services provided (e.g., Medicare and Medicaid with respect to heath care providers). The payment structure of the reimbursement/payback arrangement (sometimes course of dealings differ from contractual provisions) is important as to whether a borrower may be exposed to requirements to repay funds received on account of alleged overpayments by the agency.

Often payments are made in the ordinary course prior to a thorough accounting by the government agency. It should be expected that when a provider is in financial distress, agencies will more carefully audit historical reimbursements. To the extent overpayments are alleged, the agencies will often be able to setoff legitimate payables under applicable non-bankruptcy law, thereby further stressing the finances of the borrower and its ability to service debt and otherwise continue operations. Of course, they will also have a claim for such overpayments. Lenders may want to consider enhanced reporting requirements, required detailed accounting of billings to, and payments from, governmental agencies. To the extent the economics of the transaction permit, a lender may also want to perform its own audit of the books and records of the borrower with the assistance of an experienced professional. If feasible, lenders should further consider the ongoing funding of segregated accounts intended to cover the amount of any reimbursement exposure.

It follows that lenders must be aware of the ability of an agency to recoup and/or setoff against amounts it has overpaid and the scope of such exposure. Lenders must also appreciate that in any restructuring scenario, the applicable agencies will have a pivotal role in determining the outcome of discussions.

Fiduciary Duty

Generally, the goal of a board of directors of a for-profit corporation is to maximize the value of the organization—ultimately for the benefit of its shareholders. The board of directors is typically made up of individuals appointed by the equity holders, often aligning personal interest with the fiduciary duty to maximize profits. Of course, in times of distress, fiduciary duties require the board to consider the interests of the entity's creditors, among others. In contrast, the duty of a not-for-profit board is to pursue the stated mission and purpose of the entity as set forth in its organizational documents. Not-for-profit board members are not proprietary owners (or appointed by them) and do not derive profits on account of successful organizations.

A primary creditor protection of the Bankruptcy Code is the "absolute priority rule," which requires that creditors be paid before any value can flow to holders of equity interests.7 The absolute priority rule protects creditors by preventing owners from abusing bankruptcy to reduce debt while at the same time maintaining or recovering their equity position. In not-for-profit reorganizations where there are no equity owners, the absolute priority rule does not offer the same protection to creditors as against the proponents of a restructuring plan. The structure of the not-for-profit, by its terms, extinguishes this fail safe as between equity holders and other creditors. The absolute priority rule is important as the decision makers and plan proponents are the controlling board of directors. If creditors believe that board members should be removed and/or replaced, creditors do not have the protections of plan dissent to object. In addition, there is no equity structure also vetting the incumbent officers and directors. Lenders should be aware that due diligence typically conducted by equity owners who have economic incentives to diligence incumbent officers and directors before retaining them initially or in consideration of retaining them in a reorganized entity will not exist. The very absence of ownership of a not-for-profit increases the risk that dysfunctional leadership or mismanagement will not be fettered out in bankruptcy.

More often in not-for-profit entities than for-profit companies, the not-for-profit board is typically more involved in the substantive operations of the company. The absolute priority rule in the for-profit context governs control of the entity premised on the economics of equity value. In the not-for-profit space, without the same equity economics, the leverage of the creditors to control corporate governance is not constrained because incumbent officers and directors need not obtain creditor consent outside of the plan if they seek to remain in office after the debtor emerges from bankruptcy.

Additional Sensitivities

Although not a legal or contractual limitation, lenders to not-for-profit entities must recognize that their ability to exercise valid contractual rights and remedies may be restricted by practical concerns and sensitivities. These may include the humanitarian concerns for those recipients of the not-for-profit's assistance that may be displaced following the foreclosure of a group home, for example, but may also include broader concerns driven by the lender's public relations policies.


Lenders should consider the issues described above in lending to not-for-profit entities. It is important that lenders understand the treatment of their not-for-profit borrower under the Bankruptcy Code, which may require consultation of applicable state law. Bankruptcy eligibility as well as continued recognition of restricted assets and clawbacks of agency overage payments are just some of the potential issues for consideration in the not-for-profit space.


1. See 11 U.S.C. §109(a).

2. See 11 U.S.C. §101(41).

3. Although the Bankruptcy Code §303 seemingly excludes all not-for-profits, instead of applying a bright-line classification, some courts have looked at the powers and characteristics imposed on the entity by applicable state law (including tax laws), while other courts examine the company's charter or its business activities.

4. "Cause" includes continuing loss or diminution of the estate and the absence of a reasonable likelihood of rehabilitation, the inability to effectuate a plan of reorganization or unreasonable delay by the debtor that is prejudicial to creditors. See 11 U.S.C. §1112(b)(4).

5. 11 U.S.C. 363(b)(1).

6. 11 U.S.C. 361: "[…] such adequate protection may be provided by—

(1) requiring the trustee to make a cash payment or periodic cash payments to such entity, to the extent that the stay under section 362 of this title, use, sale, or lease under section 363 of this title, or any grant of a lien under section 364 of this title results in a decrease in the value of such entity's interest in such property;

(2) providing to such entity an additional or replacement lien to the extent that such stay, use, sale, lease, or grant results in a decrease in the value of such entity's interest in such property; or

(3) granting such other relief, other than entitling such entity to compensation allowable under section 503(b)(1) of this title as an administrative expense, as will result in the realization by such entity of the indubitable equivalent of such entity's interest in such property."

7. See 11 U.S.C. 1129(b).

Reprinted with permission from the June 22, 2015 edition of The New York Law Journal © 2015 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.