Handling the Non-Profit Workout/Bankruptcy

There appeared to be no justification for the DIP loan because the Debtors had $90 million of cash and investments (C&I). Given the amount of the Debtors' C&I, the proposed DIP loan, and the associated substantial fees, charges and expenses, appeared to be unnecessary and imprudent. The funding of the Debtors' bankruptcy battle and ongoing operating losses with secured borrowing was particularly dangerous for the bondholders because the priority repayment of the DIP loan would thereby reduce the assets available to pay unsecured creditors, and could potentially be used as an excuse by the Debtors to justify paying less than the full amount owed to unsecured creditors. The Debtors, on the other hand, argued that the C&I was restricted by the terms of gifts, bequests, annuities and endowments, and that the charity actually had almost no cash to run its day-to-day operations. The Debtors, however, failed to produce any documentation of such restrictions and relied, instead, on the unsubstantiated characterization of such funds on their financial statements and on arguments that even those funds characterized as unrestricted were subject to a generalized charitable trust.

The Debtors also sought to significantly change the business model at the senior care facilities with respect to so-called “entrance fees,” which are fees paid by new residents and refunded to departing residents in certain amounts and at certain times in accordance with the business model adopted by the particular senior care facility. UMB's professionals expressed great concern that the Debtors' requested changes to its entrance fee model, while perhaps enhancing short-term cash flow, would have substantial, negative long-term ramifications for cash flow. It was likely that the only viable exit strategy in the bankruptcy case would include a sale of the facilities. Any sophisticated buyer in this specialized industry would easily recognize that the modified entrance fee model compromised future cash flow, which would result in a reduction of any purchase price or, perhaps, a complete refusal to bid. UMB and the bondholders opposed the Debtors' proposed change as constituting a breach of their fiduciary duties to maximize the return to creditors.

Creditors' Committee

The DIP motion and the entrance fee motion were both continued until a Creditors' Committee was appointed. The Committee, which was chaired by UMB, was represented by Haynes and Boone, as counsel, and Houlihan Lokey, as financial consultant. Following a collaborative effort between the professionals of UMB and the Committee in a trial that lasted almost 2 weeks, the Bankruptcy Court denied the Debtors' request for the DIP loan, and the Debtors entered into a consensual order which, among other things, compelled the NBA to put in place an entrance fee model at the senior care facilities that would be acceptable to a future buyer. The Bankruptcy Court rejected the Debtors' key argument that the court must give special deference to the “mission” of a charity in bankruptcy, even when that mission conflicted with the requirements of the Bankruptcy Code. During the trial, the Bankruptcy Court informed the Debtors that the NBA had a new mission: “to pay its creditors.”

The strategic benefit of defeating the Debtors' motions was enormous. It permitted the Committee, UMB and the bondholders to execute their strategy of controlling the case and being able to block any unacceptable plan of reorganization with little or no fear of cramdown. It put the Debtors in a position of having to use their existing cash to fund losses, thereby imposing a real sense of urgency upon the Debtors to exit bankruptcy. It made it evident that the Bankruptcy Court was not inclined to accept the Debtors' premise that there were unwritten provisions of the Bankruptcy Code establishing different criteria for the resolution of cases involving charitable corporations. And it set the desired tone for the case by suggesting that all of the Debtors' assets, including the C&I (absent some affirmative substantiation by the Debtors of the amount that was legally restricted), could be available to satisfy the claims of creditors. At the conclusion of the trial, the Debtors were faced with the possibility that all of its assets might be dissipated by operations or the need to pay creditors, and that the charity might not survive the bankruptcy process.

Benefits to the Creditors

The NBA's creditors were also able to garner the support of two important constituencies: the residents of the senior care facilities, and the attorneys general who oversaw the NBA and its charitable activities in the various states. The residents were crucial players in the bankruptcy case because they were, in effect, the Debtors' “customers.” Prior to bankruptcy, it had become apparent that a substantial number of residents were extremely dissatisfied with the NBA's management. Without a stable customer base, it is highly unlikely that a debtor's assets — in this case, the senior care facilities — can be sold for the highest price. The creditors seized the opportunity to persuade the residents to support the bondholders' proposed exit strategy in which the facilities would be sold to an operator who would better serve their needs. This alliance of the creditors with the principal users of the Debtor-owned facilities proved extremely powerful and counterbalanced any perception by the Court and other constituencies in the case that the Debtors' were victims of unyielding creditors making unreasonable demands on a well-operated charity.

The attorneys general in the 12 states where the NBA had operations, each of whom might have objected to any sale of charitable assets, were another crucially important constituency. The creditors successfully demonstrated to the attorneys general that a sale of the senior care facilities not only would facilitate the repayment of creditors, but also would serve the interests of the residents and of the reorganized NBA. In many not-for-profit bankruptcy cases, the creditors not only end up battling the debtor, but are also opposed by the attorneys general who are frequently aligned with the debtor. By showing that a sale of the senior care facilities to a more experienced and financially viable operator would better serve the residents as well as resolving the bankruptcy and leaving the NBA intact to continue to conduct its charitable mission, the creditors were able to ally with the attorneys general on virtually all of the primary issues during the bankruptcy proceeding.

Result of the Strategy

The strategy begun by UMB and the bondholders, and then pursued in a collaborative manner with the Committee professionals, ultimately resulted in unanimous support by the creditors, the residents and the attorneys general for a sale of the senior care facilities. Faced with this unified front, and the fact that the Bankruptcy Court was unwilling to agree that a penumbra of special rights applied to charities in bankruptcy, the Debtors acquiesced in an auction of the senior care facilities and to the use of the sale proceeds, along with a significant amount of their C&I, to fund a plan of reorganization that was jointly proposed by the Committee and the Debtors. The auction of the facilities, which was run exclusively by Houlihan Lokey as investment banker and Mintz Levin as legal counsel, resulted in 43 bids. Ultimately, the facilities were sold to Fortress Investments for $210 million. As part of the sale process, Fortress Investments agreed to invest at least $10 million of new capital improvements at the facilities for the benefit of the residents, in exchange for a release of all resident claims against the NBA.

Given that the debt in the case totaled approximately $250 million, including post-petition interest and professional fees payable to the unsecured creditors, a gap of $40 million remained after the sale of the senior living facilities in order to repay the creditors in full. (The creditors were prepared to accept post-petition interest at a stipulated rate in order to avoid the need to litigate whether the appropriate post-petition rate was the contract rate or the judgment rate.) The creditors, utilizing support generated from the attorneys general for the proposition that at least the portion of C&I needed to resolve the case was available for such purpose, negotiated a consensual plan with the Debtors whereby, among other things, the C&I and the proceeds of additional miscellaneous asset sales were used to bridge the gap. The Plan, providing for repayment in full of all creditor claims, together with post-petition interest and costs of collection, was confirmed a mere 13 months after the case was commenced, and became effective when the senior care facilities were sold approximately one month after confirmation.

From the NBA's side of the ledger, the charity continues to pursue its mission of helping children, youth and families in need. In effect, the NBA has returned to its roots and its original mission as it existed prior to the time of its ill-fated decision to enter the senior care facility business. For their part, the residents have a new operator that is experienced in managing senior care facilities and has committed to making millions of dollars of capital improvements. Lastly, the attorneys general have preserved the charity, and not one of the individuals that it served was disadvantaged.

Conclusion

Some observers of the NBA saga have questioned whether it was necessary or prudent for the NBA to file bankruptcy. The principal creditors were receptive to a solution involving external management of the facilities, a resource employed by many nonprofit organizations in furtherance of their charitable objectives. The sale value of the NBA's senior living facilities, together with its cash-on-hand, was sufficient to pay all creditors in full outside of bankruptcy. As a result of the bankruptcy case, the NBA has paid many millions of dollars of fees and expenses, and was consumed with legal matters – instead of devoting its entire energy to its charitable mission – for more than a year. Not one of the pre-petition proposals put forth during the pre-petition workout negotiations required a sale of assets to the extent that occurred in bankruptcy.

From a creditor's standpoint, there are many lessons to be learned from the NBA case, such as not being afraid of bankruptcy if the Debtors' assets are sufficiently valuable to ensure a better outcome than the Debtors' pre-bankruptcy proposals, the importance of building the proper alliances to control a bankruptcy case and achieve the optimal outcome, and the need to assemble a team of professionals that not only individually possess the necessary talents and skills but that also have the aptitude and desire to work together in a cooperative and complimentary manner under calm, patient and sound leadership (such as that provided by UMB). For the NBA's creditors, application of these principles produced a happy result.

Paul J. Ricotta is a member of the Bankruptcy, Restructuring and Commercial Law section, and Leonard Weiser-Varon is a member of the Public Finance section at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. Together with Ann-Ellen Hornidge, a member of the Public Finance Section, they served as counsel to UMB Bank, N.A. prior to and during National Benevolent Association. Phone: 617-542-6000. E-mails: [email protected]; [email protected]; [email protected].

Last month, we discussed how to handle the non-profit workout/bankruptcy with an analysis of one of the largest not-for-profit bankruptcy cases even filed — In re: the National Benevolent Association of the Christian Church (Disciples of Christ) et al., (Bankr. W.D. Texas), Case No. 04-50948 (RBK). As we explained, the National Benevolent Association of the Christian Church (Disciples of Christ) (NBA) was founded in 1887 as a Missouri-based nonprofit corporation. Its mission was to provide services to disadvantaged families and others. Prior to bankruptcy, the NBA was the parent company of approximately 25 affiliated nonprofit entities that owned and operated 11 senior care facilities, four children's care centers, and three special care facilities in 12 states, among other things. We presented a great deal of analytical background on the nonprofit corporation and its path toward bankruptcy. This month, we discuss the bankruptcy case itself.

The Bankruptcy Case

Along with the usual first-day motions, the NBA sought to enter into a secured, super-priority DIP loan and to change significantly its business model at its senior care facilities. Because no Creditors' Committee had yet been appointed, and because UMB and the bondholders had specific and unique familiarity with the Debtors' business, finances, and existing business model, UMB and the bondholders vigorously undertook to oppose the Debtors' requests.

There appeared to be no justification for the DIP loan because the Debtors had $90 million of cash and investments (C&I). Given the amount of the Debtors' C&I, the proposed DIP loan, and the associated substantial fees, charges and expenses, appeared to be unnecessary and imprudent. The funding of the Debtors' bankruptcy battle and ongoing operating losses with secured borrowing was particularly dangerous for the bondholders because the priority repayment of the DIP loan would thereby reduce the assets available to pay unsecured creditors, and could potentially be used as an excuse by the Debtors to justify paying less than the full amount owed to unsecured creditors. The Debtors, on the other hand, argued that the C&I was restricted by the terms of gifts, bequests, annuities and endowments, and that the charity actually had almost no cash to run its day-to-day operations. The Debtors, however, failed to produce any documentation of such restrictions and relied, instead, on the unsubstantiated characterization of such funds on their financial statements and on arguments that even those funds characterized as unrestricted were subject to a generalized charitable trust.

The Debtors also sought to significantly change the business model at the senior care facilities with respect to so-called “entrance fees,” which are fees paid by new residents and refunded to departing residents in certain amounts and at certain times in accordance with the business model adopted by the particular senior care facility. UMB's professionals expressed great concern that the Debtors' requested changes to its entrance fee model, while perhaps enhancing short-term cash flow, would have substantial, negative long-term ramifications for cash flow. It was likely that the only viable exit strategy in the bankruptcy case would include a sale of the facilities. Any sophisticated buyer in this specialized industry would easily recognize that the modified entrance fee model compromised future cash flow, which would result in a reduction of any purchase price or, perhaps, a complete refusal to bid. UMB and the bondholders opposed the Debtors' proposed change as constituting a breach of their fiduciary duties to maximize the return to creditors.

Creditors' Committee

The DIP motion and the entrance fee motion were both continued until a Creditors' Committee was appointed. The Committee, which was chaired by UMB, was represented by Haynes and Boone, as counsel, and Houlihan Lokey, as financial consultant. Following a collaborative effort between the professionals of UMB and the Committee in a trial that lasted almost 2 weeks, the Bankruptcy Court denied the Debtors' request for the DIP loan, and the Debtors entered into a consensual order which, among other things, compelled the NBA to put in place an entrance fee model at the senior care facilities that would be acceptable to a future buyer. The Bankruptcy Court rejected the Debtors' key argument that the court must give special deference to the “mission” of a charity in bankruptcy, even when that mission conflicted with the requirements of the Bankruptcy Code. During the trial, the Bankruptcy Court informed the Debtors that the NBA had a new mission: “to pay its creditors.”

The strategic benefit of defeating the Debtors' motions was enormous. It permitted the Committee, UMB and the bondholders to execute their strategy of controlling the case and being able to block any unacceptable plan of reorganization with little or no fear of cramdown. It put the Debtors in a position of having to use their existing cash to fund losses, thereby imposing a real sense of urgency upon the Debtors to exit bankruptcy. It made it evident that the Bankruptcy Court was not inclined to accept the Debtors' premise that there were unwritten provisions of the Bankruptcy Code establishing different criteria for the resolution of cases involving charitable corporations. And it set the desired tone for the case by suggesting that all of the Debtors' assets, including the C&I (absent some affirmative substantiation by the Debtors of the amount that was legally restricted), could be available to satisfy the claims of creditors. At the conclusion of the trial, the Debtors were faced with the possibility that all of its assets might be dissipated by operations or the need to pay creditors, and that the charity might not survive the bankruptcy process.

Benefits to the Creditors

The NBA's creditors were also able to garner the support of two important constituencies: the residents of the senior care facilities, and the attorneys general who oversaw the NBA and its charitable activities in the various states. The residents were crucial players in the bankruptcy case because they were, in effect, the Debtors' “customers.” Prior to bankruptcy, it had become apparent that a substantial number of residents were extremely dissatisfied with the NBA's management. Without a stable customer base, it is highly unlikely that a debtor's assets — in this case, the senior care facilities — can be sold for the highest price. The creditors seized the opportunity to persuade the residents to support the bondholders' proposed exit strategy in which the facilities would be sold to an operator who would better serve their needs. This alliance of the creditors with the principal users of the Debtor-owned facilities proved extremely powerful and counterbalanced any perception by the Court and other constituencies in the case that the Debtors' were victims of unyielding creditors making unreasonable demands on a well-operated charity.

The attorneys general in the 12 states where the NBA had operations, each of whom might have objected to any sale of charitable assets, were another crucially important constituency. The creditors successfully demonstrated to the attorneys general that a sale of the senior care facilities not only would facilitate the repayment of creditors, but also would serve the interests of the residents and of the reorganized NBA. In many not-for-profit bankruptcy cases, the creditors not only end up battling the debtor, but are also opposed by the attorneys general who are frequently aligned with the debtor. By showing that a sale of the senior care facilities to a more experienced and financially viable operator would better serve the residents as well as resolving the bankruptcy and leaving the NBA intact to continue to conduct its charitable mission, the creditors were able to ally with the attorneys general on virtually all of the primary issues during the bankruptcy proceeding.

Result of the Strategy

The strategy begun by UMB and the bondholders, and then pursued in a collaborative manner with the Committee professionals, ultimately resulted in unanimous support by the creditors, the residents and the attorneys general for a sale of the senior care facilities. Faced with this unified front, and the fact that the Bankruptcy Court was unwilling to agree that a penumbra of special rights applied to charities in bankruptcy, the Debtors acquiesced in an auction of the senior care facilities and to the use of the sale proceeds, along with a significant amount of their C&I, to fund a plan of reorganization that was jointly proposed by the Committee and the Debtors. The auction of the facilities, which was run exclusively by Houlihan Lokey as investment banker and Mintz Levin as legal counsel, resulted in 43 bids. Ultimately, the facilities were sold to Fortress Investments for $210 million. As part of the sale process, Fortress Investments agreed to invest at least $10 million of new capital improvements at the facilities for the benefit of the residents, in exchange for a release of all resident claims against the NBA.

Given that the debt in the case totaled approximately $250 million, including post-petition interest and professional fees payable to the unsecured creditors, a gap of $40 million remained after the sale of the senior living facilities in order to repay the creditors in full. (The creditors were prepared to accept post-petition interest at a stipulated rate in order to avoid the need to litigate whether the appropriate post-petition rate was the contract rate or the judgment rate.) The creditors, utilizing support generated from the attorneys general for the proposition that at least the portion of C&I needed to resolve the case was available for such purpose, negotiated a consensual plan with the Debtors whereby, among other things, the C&I and the proceeds of additional miscellaneous asset sales were used to bridge the gap. The Plan, providing for repayment in full of all creditor claims, together with post-petition interest and costs of collection, was confirmed a mere 13 months after the case was commenced, and became effective when the senior care facilities were sold approximately one month after confirmation.

From the NBA's side of the ledger, the charity continues to pursue its mission of helping children, youth and families in need. In effect, the NBA has returned to its roots and its original mission as it existed prior to the time of its ill-fated decision to enter the senior care facility business. For their part, the residents have a new operator that is experienced in managing senior care facilities and has committed to making millions of dollars of capital improvements. Lastly, the attorneys general have preserved the charity, and not one of the individuals that it served was disadvantaged.

Conclusion

Some observers of the NBA saga have questioned whether it was necessary or prudent for the NBA to file bankruptcy. The principal creditors were receptive to a solution involving external management of the facilities, a resource employed by many nonprofit organizations in furtherance of their charitable objectives. The sale value of the NBA's senior living facilities, together with its cash-on-hand, was sufficient to pay all creditors in full outside of bankruptcy. As a result of the bankruptcy case, the NBA has paid many millions of dollars of fees and expenses, and was consumed with legal matters – instead of devoting its entire energy to its charitable mission – for more than a year. Not one of the pre-petition proposals put forth during the pre-petition workout negotiations required a sale of assets to the extent that occurred in bankruptcy.

From a creditor's standpoint, there are many lessons to be learned from the NBA case, such as not being afraid of bankruptcy if the Debtors' assets are sufficiently valuable to ensure a better outcome than the Debtors' pre-bankruptcy proposals, the importance of building the proper alliances to control a bankruptcy case and achieve the optimal outcome, and the need to assemble a team of professionals that not only individually possess the necessary talents and skills but that also have the aptitude and desire to work together in a cooperative and complimentary manner under calm, patient and sound leadership (such as that provided by UMB). For the NBA's creditors, application of these principles produced a happy result.

Paul J. Ricotta is a member of the Bankruptcy, Restructuring and Commercial Law section, and Leonard Weiser-Varon is a member of the Public Finance section at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. Together with Ann-Ellen Hornidge, a member of the Public Finance Section, they served as counsel to UMB Bank, N.A. prior to and during National Benevolent Association. Phone: 617-542-6000. E-mails: [email protected]; [email protected]; [email protected].