When a Nonprofit Corporation Is Insolvent...
| Publication year | 2016 |
| Citation | Vol. 2016 No. 2 |
| Author | Reno F.R. Fernandez and Lisa A. Runquist |
Reno F.R. Fernandez and Lisa A. Runquist
Reno F.R. Fernandez III is a partner with Macdonald Fernandez LLP, focusing on commercial bankruptcy and litigation throughout California, and a member of the Insolvency Law Committee of the Business Law Section of the State Bar of California. Mr. Fernandez has been privileged to reorganize several nonprofits.
Lisa A. Runquist represents nonprofits, teaches at Trinity Law School and Shiloh University, is author/editor of Guide to Representing Religious Organizations and The ABC's of Nonprofits, has won both the ABA BLS-NP Organizations Committee Outstanding Lawyer Award and the Vanguard Award for lifetime achievement, and is an Editorial Advisor for ChurchLawAndTax.com
Just as the formation and administration of a nonprofit corporation requires special considerations and planning, the disposition of an insolvent nonprofit is governed by special statutes and rules. Boards of directors need specific guidance when a nonprofit enters insolvency. This article discusses the choices a California nonprofit public benefit corporation faces when it can no longer meet its financial obligations.
Initial Considerations
There are two tests for evaluating the solvency of a corporate entity for most purposes. One test is the "balance sheet test," in which a corporation is deemed insolvent when its debts exceed the value of its assets. The other test is the "cash-flow test," in which a corporation is deemed insolvent if it cannot pay its debts as they become due.
When the organization fails to meet either of the standard tests for solvency, the board of directors must act. Unless the organization's cash flow is sufficient to reorganize its own operations, the board has three basic options: First, wind up and dissolve. Second, merge with another organization. Third, file for bankruptcy, which is discussed in brief, below.1
This article assumes that the reader understands the basic steps to wind up and dissolve, or merge, a nonprofit public benefit corporation under California law, except as it pertains to an insolvent nonprofit.2 This article does not cover mutual benefit corporations, private foundations, freestanding charitable trusts, political action committees, or religious corporations, although there are many similarities. This article also does not cover involuntary dissolutions3 or special requirements for the dissolution of health facilities.4
There are several factors to consider in deciding whether to wind up and dissolve or attempt a merger. In a merger, the surviving entity succeeds to both the assets and the liabilities of the disappearing entity.5 This means that the creditors of the insolvent disappearing entity have the ability to pursue the assets of the surviving entity. This is a risk for the surviving corporation.
Nevertheless, the benefits of a merger may outweigh the risks. A significant benefit is that the surviving entity is entitled to receive bequests pledged to the disappearing entity.6 This allows a cash-poor nonprofit to preserve the contingent, future value of bequests. By contrast, a nonprofit that receives a distribution from a dissolved entity does not receive bequests that would otherwise go to the dissolved entity.
Another factor to consider is whether the two entities serve the same population, in which case a merger may allow the surviving entity to continue to serve individuals previously served by the disappearing entity. Also, a merger may allow the surviving entity to extend its operations into new areas at less expense than setting up entirely new programs. Some of the existing directors may serve on the board of the surviving entity, adding continuity and experience; in fact, the disappearing entity may negotiate a requirement to appoint a certain number of its directors to the surviving entity's board.
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The board should carefully consider which entity should be the surviving entity, including considering whether one has a more favorable tax exempt status, as well as the employee benefits being offered (significant differences in salaries or benefits need to be addressed before the merger is completed). A public benefit corporation can merge with any type of business entity, including a for-profit entity.7
Many nonprofits will be reluctant to take on the liabilities and risks of an insolvent nonprofit. However, the board of directors should consider the benefits and feasibility of a merger. If a merger is not possible, dissolution may be in order. Even if a merger is possible, a dissolution may be preferable where there is insufficient cash to see the nonprofit through the merger process, where finality is required, or where the population is already adequately served by other nonprofits.
In contrast to a typical business corporation, the Attorney General of the State of California plays a role in the dissolution or merger of a nonprofit. Because of their very nature, the Attorney General considers public benefit corporations to hold assets in a charitable trust, over which the Attorney General has broad powers of supervision.8 This means that the Attorney General must receive notice before any disposition of assets and may play a role in the ultimate disposition of said assets.
Before the merger or dissolution of a public benefit corporation can be completed, the corporation must file with the Attorney General, certain information about the corporation and each organization that will receive assets pursuant to a plan of distribution. With a merger, as discussed more below, only a notice filing is required; however, before a certificate of dissolution can be filed with the Secretary of State, a written waiver of objections must be obtained from the Attorney General, and attached to the certificate. Alternatively, the distribution may be made pursuant to a court decree.9 The corporation itself has no vested right to designate the recipients, although the choice of the corporation will normally be honored.10
Plans for the ultimate distribution of assets should be made as soon as possible, once the determination is made to dissolve. Even if the corporation has determined that its liabilities exceeds its assets, it is advisable to name an entity to receive any assets that might remain.
The Attorney General must be given twenty days' notice of the proposed sale or disposition of all or substantially all of the assets of a public benefit corporation.11 The Attorney General's prime concern is the purpose and use of the assets after distribution. Assets subject to restrictions under the articles of incorporation, the bylaws, or a trust must be distributed for a use that is consistent with the restrictions.12 Moreover, assets of a nonprofit corporation that are exempt from taxation under Internal Revenue Code section 501(c)(3) are dedicated to the purposes for which the exemption was given and may only be used for these purposes. This includes payment of debts incurred in the process of operating for exempt purposes.
If none of the assets are held in charitable trust and there are no other unusual issues, the Attorney General is unlikely to object to the payment of legitimate liabilities, even if it means that there are no assets left to distribute to another nonprofit entity. However, assets that were given for a specific charitable purpose and are held in trust for that purpose may not be available for distribution to creditors. The Attorney General may make this determination even if the board did not raise the issue. Depending on the amounts of liabilities, creditors may object to this determination.
If the Attorney General objects to the proposed distribution, there is an opportunity to obtain court approval of a distribution outside of the articles under the doctrine of cy pres. Cy pres is a French phrase translated "as near as," and in American law it means: "[t]he equitable doctrine under which a court reforms a written instrument with a gift to charity as closely to the donor's intention as possible, so that the gift does not fail."13
With a merger, the Attorney General must be provided with notice of the proposed merger, including a copy of the merger agreement, at least twenty days prior to consummation of the merger.14 If the merger is with another public benefit or...
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