When is an entity an `instrumentality’ of the state for Chapter 11 eligibility?

It is often said that you cannot always judge a book by its cover. This is particularly true when determining whether an entity that is related to a municipality is an “instrumentality” of the state for purposes of determining eligibility for Chapter 11 relief. Simply put, if an entity is an “instrumentality” of the state, it falls under the definition of “municipality,” and is thus a “governmental unit” that is not a “person” eligible for Chapter 11 relief. Governmental units may file bankruptcy only under Chapter 9 of the Bankruptcy Code, and in many states such filings are not permitted, or are restricted, by state law.

John B. Hutton III

By definition, an “instrumentality of a State” is a “municipality” under Section 101(40); a municipality in turn is a “governmental unit” under Section 101(27) of the Bankruptcy Code. The issue that is often disputed is what constitutes an “instrumentality” of a state. When an entity that has some attributes of a governmental unit files bankruptcy under Chapter 11, creditors often litigate whether that entity is eligible for Chapter 11, particularly if the bankruptcy is filed in a state that restricts or does not offer access to Chapter 9.

Courts have determined that each of the following entities was not an “instrumentality” of a state, and therefore was eligible for Chapter 11 bankruptcy relief:

  • a non-profit public facilities corporation that owns and operates a hotel and convention center (deemed to be an “instrumentality” of the state for federal tax purposes). In re Lombard Public Facilities Corporation, 579 B.R. 493 (Bankr. N.D. Ill. 2017);
  • an entity that owns and operates the monorail system in Las Vegas (designated in tax documents as “an instrumentality of the State of Nevada . . . controlled by the Governor”). In re Las Vegas Monorail Co., 429 B.R. 770 (Bankr. D. Nev. 2010);
  • and a non-profit provider of community health services. Kentucky Employees Retirement System v. Seven Counties Services, Inc., 901 F.3d 718 (6th Cir. 2018).

On the other hand, courts have determined that the each of the following entities was an instrumentality of a state, and thus ineligible for Chapter 11 relief:

  • a public retirement fund formed and funded by the government. In re Northern Mariana Islands Retirement Fund, No. 12-00003, 2012 WL 8654317, at *3 (D. N. MR. I. June 13, 2012);
  • a hospital authority founded under Georgia law that authorized its creation and operation. United States Trustee v. Hospital Authority of Charlton County (In re Hospital Authority of Charlton County), No. 50305, 2012 WL 2905796 (S.D. Ga. July 3, 2012);
  • and a public benefit corporation operating a pari-mutual betting system. In re N.Y.C. Off-Track Betting Corp., 427 B.R. 256 (Bankr. S.D.N.Y. 2010).

As indicated by these examples, the determination of whether an entity is an “instrumentality” of a state is not always readily apparent and requires a detailed analysis of the facts of each situation. In addition, courts have found that an entity is not an instrumentality of a state even where the entity is deemed an instrumentality of the state for purpose of the federal tax code.

  • Without a definition in the Bankruptcy Code for the term “instrumentality,” courts have struggled to develop a test to make that determination. While each case is based upon its unique facts, certain factors have been given considerable weight:
  • Does the entity have the typical governmental powers – the ability to assess taxes, the power of eminent domain, and sovereign immunity?
  • Was the entity created by special legislative enactment (as opposed to being just a non-profit corporation)?
  • Does the government control the day-to-day operations of the entity, beyond just regulation or board appointments?
  • Does the state government have financial responsibility for losses or liabilities of the entity?
  • Does the state consistently and clearly designate and treat the entity as an instrumentality of the state in its legislation?

Although there are a number of other factors to consider, a negative answer to some or all of the above questions make it more likely that the entity will not be treated as an “instrumentality” of the state, and thus be eligible for Chapter 11 relief.

The Sixth Circuit recently rendered the first-ever Circuit Court decision on the “instrumentality” issue, which illustrates the application of the factors. In Kentucky Employees Retirement System v. Seven Counties Services, Inc., 901 F.3d 718 (6th Cir. 2018), a 2-1 majority of the Sixth Circuit panel decided that Seven Counties Services, Inc. (“Seven Counties”), a nonprofit provider of mental health services, was not an “instrumentality” of the State of Kentucky, and thus was eligible for Chapter 11 relief, affirming the decisions made by the bankruptcy court and the district court. Seven Counties had filed Chapter 11 in order to terminate its relationship with the Kentucky public pension plan (the “KERS”), as employer contribution rates skyrocketed up to 24% in 2013, and Seven Counties could no longer sustain operations at that contribution level. KERS sought dismissal of the Chapter 11 filing, asserting that Seven Counties was an “instrumentality” of the State of Kentucky, and thus ineligible for Chapter 11 relief.

The Sixth Circuit placed primary emphasis on governmental control and noted that the disagreement with the dissent was on the extent of control required. While stating that day-to-day control would be sufficient to deem an entity a governmental instrumentality, the Court held that such a “granular level of control is not necessary.” Id. at 727. Instead, the Sixth Circuit applied the following control factors: (1) whether the government created the entity, (2) whether the government appoints the entity’s leadership, (3) whether an enabling statute guides or otherwise circumscribes the entity’s actions, (4) whether and how the entity receives government funding, and (5) whether the government can destroy the entity. Id. While noting that Seven Counties is “an unusual entity” with some features that belong to a state agency and others that do not, the Sixth Circuit determined that there were not sufficient indicia of government control to conclude that Seven Counties was an instrumentality of the State. Id. at 729. Applying the control factors, the Sixth Circuit concluded: “The Commonwealth of Kentucky did not create Seven Counties, does not in the normal course of events choose its leadership, does not govern its operations through an enabling statute, does not fund it through a mechanism that is normally reserved for public entities, and cannot unilaterally destroy it.” Id.

In situations in which Chapter 9 access was not available, the trend in the courts seems to be in favor of granting access to Chapter 11, by finding that entities are not “instrumentalities” of the state. This is particularly important in states that do not permit access to Chapter 9, as the determination that an entity in such states is an “instrumentality” of the state would preclude access to bankruptcy (unless the state subsequently grants its municipal entities access to Chapter 9). As a result, those involved with financing such entities need to go beyond labels, and fully understand the facts that impact eligibility:

Bondholders and Investors. Parties who invest on the assumption that the borrowing entity will not have recourse to bankruptcy, or that recourse will be limited based upon state restrictions or conditions on filing for Chapter 9 relief, need to carefully scrutinize the facts. Statements in the offering documents that an entity is an “instrumentality” of the state are not controlling, and the courts will consider all relevant facts, as highlighted above. An entity that is able to file under Chapter 11 does not need to meet the eligibility requirements that apply to a Chapter 9, such as insolvency and good faith negotiations with creditors.

Issuers and Underwriters: Parties preparing the offering memoranda should ensure that they describe the remedies and bankruptcy options correctly. If an entity is not an instrumentality of the state, a description of Chapter 9 requirements and any applicable state authorizations required in such circumstances could cause confusion in the event of a subsequent Chapter 11 filing, and provide some unintended bondholder leverage. Bondholders and other creditors can raise the eligibility issue in the context of a Chapter 11 filing as leverage to obtain better terms; as a result, it is important for issuers to be clear about Chapter 11 eligibility in all offering documents, and be prepared to contest the eligibility issue if Chapter 11 becomes necessary to implement a deal.

Rating Agencies: In evaluating the potential for default risk and payment risk, rating agencies will want to scrutinize carefully the entity’s eligibility for Chapter 9 or 11, as an entity having recourse to either Chapter of the Bankruptcy Code creates leverage for the borrower, which is more likely to default and seek the protection of the automatic stay in bankruptcy.

State Governments: State governments that are involved with quasi-governmental entities will want to scrutinize the structure, particularly if the state has financial obligations with regard to the entity (a factor that also makes it more likely that the entity will be considered an instrumentality of the state). If the entity has access to bankruptcy under either Chapter, the filing would stay creditors from taking action against the entity, but not against the state with respect to any independent financial obligation the state may have.

Nancy Peterman and Mark Bloom of Greenberg Traurig LLP contributed to this commentary. Nancy Peterman and Kevin Finger represented ACA Financial Guaranty Corporation, as bond insurer, in the Lombard Public Facilities Corporation case, successfully supporting the Debtor’s eligibility for Chapter 11 relief.

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