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Planning Is Key to Treatment of Charities’ Endowment Funds in Bankruptcy

Articles & Publications

November 2017
Eric J. Monzo & Brenna A. Dolphin
Turnaround Management Association

The charitable nonprofit form creates unique issues of corporate governance. Officers and directors owe fiduciary duties to their charitable institutions, and insolvency or reorganization complicates issues, particularly with regard to the handling of endowment funds.

Donors can specify how gifts are to be spent, making those funds restricted and inviolable from general use. Having restricted endowment funds on hand but lacking availability to them may further complicate the equation. The board’s perception of its predicament may be clouded because its balance sheet may appear to be flush with cash, yet some funds remain out of reach, unavailable for general use.

Because nonprofits lack traditional owners, their endowments are for beneficiaries. There are serious consequences for tapping into restricted funds for an improper purpose, including looking to the directors and officers for breaching their fiduciary duties. If a nonprofit invades a restricted endowment fund, extricates funds, and applies them to its own general operating uses, then the withdrawn funds may be treated as general assets of the nonprofit, and in the bankruptcy context, they may become comingled with property of the estate, contrary to the documents governing the gifts. See generally Reid K. Weisbord, “Charitable Insolvency and Corporate Governance in Bankruptcy Reorganization,” 10 Berkley Bus. Law J. 307 (2013).

To avoid becoming entrenched in costly and time-consuming litigation, nonprofits and their boards should engage in careful prebankruptcy planning to determine the appropriate course of action for handling earmarked endowment funds. In doing so, they must remain aware of the delicate balance between the interests of bankruptcy constituents and the public policy that serves as the basis for tenets of nonprofit law.

Generally, charity law seeks to preserve assets for a donor’s chosen public purpose, but as a matter of bankruptcy policy, a primary objective is to maximize estate assets for disbursement to creditors. Bankruptcy Code Section 541 instructs that property of the estate includes all property, wherever located and by whomever held, and all legal or equitable interest, including tangible or intangible, and causes of action of the debtor as of the commencement of the bankruptcy case. The term “property of the estate” has an expansive reach, and state law determines the property rights of the estate.

One of the most frequently litigated issues in nonprofit bankruptcy cases, as a result, is whether at the time of the petition filing assets, money, or miscellaneous property in the nonprofit debtor’s possession is property of the estate and therefore available in whole or in part for disbursement to estate creditors. See Evelyn Brody, The Charity in Bankruptcy and Ghosts of Donors Past, Present, and Future, 29 Seton Hall Legis. J. 471, 505 (2005).

If a donor gifts cash to a nonprofit for use in its general fund, then upon the filing of the petition for bankruptcy relief, the donor’s cash gift becomes property of the estate. As a result, unrestricted gift funds become available to the nonprofit debtor’s creditors. See, e.g., In re Winsted Memorial Hospital, 249 B.R. 588 (Bankr. D. Conn 2000); In re Boston Reg’l Medical Ctr. v. Reynolds, 2004 U.S. Dist. LEXIS 15398, at *8-*9 (D. Mass. Aug. 9, 2004).

On the other hand, courts generally shield those assets donated to a nonprofit for a specific charitable purpose from disbursement to the nonprofit debtor’s creditors. Prebankruptcy restrictions on gifts made to nonprofit debtors significantly limit the reach of Section 541, and assets within a charitable trust vessel do not become property of the estate.

A debtor’s post-petition property interests, therefore, remain subject to certain pre-existing restrictions, and donor-restricted funds may be excluded from the bankruptcy estate altogether. Endowment funds kept separate from general operating funds and overseen and controlled by an independent board or a trustee generally do not become lumped into property of a nonprofit’s bankruptcy estate. See, e.g., In re Parkview, 211 B.R. 619, 636-37 (Bankr. N.D. Ohio 1997) (holding that when a fund is solicited or contributed as “restricted” with only the income available for use by the debtor, the fund is not included in the estate). 

Respecting Donors’ Intentions

Turnaround professionals should review financial records and examine whether funds have been allocated correctly and kept separate where appropriate. Upon discovering that restricted and general funds have been comingled, the nonprofit should correct its financial records and accounts to reflect the reality that restricted funds exist separate from general funds as part of the prefiling planning to avoid issues during the pendency of the case.

It may, however, be unclear whether the funds are unrestricted and hence property of the bankruptcy estate. One such murky area occurs when donors opt either to create trusts in favor of a nonprofit entity or to allow a nonprofit to hold specific property in trust. Generally, nonbankruptcy law favors charitable trusts, which are created to benefit the public interest and receive more liberal and favorable treatment than private trusts. Certain jurisdictions hold charitable trusts in such high regard that even where the particular charitable purpose for which the trust was created becomes impossible, illegal, or impracticable to accomplish, the charitable trust itself does not fail if the donor shows a general intention that the property be used for a charitable purpose. See Denckla v. Independence Foundation, 193 A.2d 538 (Del.Ch. 1963)(considering a challenge to a transfer of assets from a charitable corporation to another foundation).

Outside of bankruptcy, the cy pres doctrine operates in such cases to salvage a donor’s gifts and to preserve donations for the donor’s intended use. Under this equitable doctrine, a court must first determine that the donor’s intention is currently impracticable, inexpedient, or impossible to accomplish, and then the court may approximate the donor’s intent.

An example would be a donor who gifts property such as a stamp collection to a museum and restricts the use of the income from the property to fund specific research. If the museum later shuts down all research operations but otherwise remains a viable business, the cy pres doctrine may require the museum to divert the income earned from the gifted property to a different institution that conducts research that the donor intended its gift to benefit. The identity of the museum did not prompt the gift; the donor intended that the gift benefit specific research, and a court would likely look to honor that intent.

The terms of the controlling documents also help dictate what happens to donated property upon a bankruptcy filing. When a nonprofit seeks bankruptcy protection, an inevitable inquiry arises: what happens to a gift once the nonprofit recipient ceases to exist or becomes incapable of performing the terms of the gift? Courts will review each bequest to determine whether it comprises a restricted asset or property of the bankruptcy estate that must be repurposed, then allocated toward repayment of the estate’s creditors, if permitted. See, e.g., Hobbs v. Bd. of Educ. of N. Baptist Convention, 126 Neb. 416, 628-69, 630 (Neb. 1934) (holding that endowment funds were not accessible to general creditors, but gifts without limitations were); St. Joseph’s Hosp. v Bennett, 281 N.Y. 115, 118-19, 120 (N.Y. 1939)(courts ascertain the intent of donors and follow the intent as closely as the circumstances permit); In re Ruth Easton Fund, 680 N.W.2d 541, 544, 548 (Minn. Ct. App. 2004) (an order providing for the redirection of funds must be supported by specific findings and evidence). 

Just as the donor’s intent remains paramount when the drafter puts pen to paper to achieve the donor’s goals and to protect against unforeseen events, a turnaround advisor must examine a distressed nonprofit client’s general and endowment funds to evaluate possible outcomes after the petition is filed.

Just as the donor’s intent remains paramount when the drafter puts pen to paper to achieve the donor’s goals and to protect against unforeseen events, a turnaround advisor must examine a distressed nonprofit client’s general and endowment funds to evaluate possible outcomes after the petition is filed. Conditional gift instruments, like the earlier example of the stamp collection, may continue to be in play. If properly documented, the donor’s stamp collection may be conveyed to a trust that provides for the transfer of the collection to a different museum dedicated to preserving information about the era from which the stamp collection stems.

If the museum ceases to operate, the institution will never own the stamp collection, and then the property may be repurposed. Gift instruments may provide instructions that not only establish the donor’s primary goal but also govern how funds are to be allocated if the charitable entity ceases to exist or becomes incapable of fulfilling the charitable purpose of the gift. 

If a nonprofit that holds funds in charitable trusts liquidates, such as through the filing of a Chapter 7 bankruptcy, decisions regarding how to repurpose those funds held within charitable trusts must be made. The organization’s endowment funds need to go somewhere, and equity prevents the creditors of liquidated nonprofits from invading the principal of those charitable trusts.

In a liquidation, the failure of a nonprofit to continue operations does not by itself leave gifted funds nestled within charitable trusts vulnerable to the nonprofit’s creditors. See Brody, supra at 472 (“These trusts and restricted gifts, if they can no longer be performed as originally specified, are modified for another use by the same charity or are transferred to another charity, subject to the same or modified purpose.”). The filing of a bankruptcy petition does not operate to expand the debtor’s right with regard to property. If a nonprofit possesses property subject to restrictions prepetition, then its bankruptcy estate holds the same property subject to those same restrictions. 

If a restricted gift contains a gift over provision, then the gift must be transferred to the subsequent recipient specified. Going back to the earlier example, a donor gifts the stamp collection to a museum to use in a special exhibit, the income from which is to benefit an art college. The donor then provides that if the museum ceases to operate, the stamp collection transfers to the art college in trust for its use in fundraising efforts that generate income for the art college. Here, when the museum liquidates and ceases to operate, neither the stamp collection nor the income generated from the exhibition of the collection would become property of the museum’s estate. The stamp collection would transfer to the art college, and the collection and income generated from its exhibition would be immune from the museum’s creditors.

Such express trusts require either explicit language or circumstances that show with reasonable certainty that a donor intended to create a trust. It is not uncommon for a nonprofit, either intentionally or out of a lack of understanding of how endowment funds operate, to improperly borrow against or use restricted funds for other purposes.

Careful planning is the key to avoiding issues over these funds after a bankruptcy filing. Careful review of trust documents, which may go back many years, to determine whether funds are restricted is important to assessing the insolvency options available to a nonprofit and, in turn, may protect the directors and officers from potential claims relating to their fiduciary duties regarding the proper use of escrow funds.  

This article on the importance of careful planning of bankruptcies for non-profits was originally published by the Turnaround Management Association (TMA) in November 2017.  View the article on TMA's website.

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