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Business Law Today

Counseling the Nonprofit Debtor in Financial Distress
Some Practical Pointers
By Shelly Crocker
Nonprofit corporations come in a variety of shapes and sizes; the diversity of corporate form, scope of the mission, size of the effort, and structure of the organization have as many possible variations as seen in the corporate world generally. In this time of great economic distress, nonprofit organizations are suffering decreased funding, whether from donations, grants, or other sources. Moreover, many nonprofits seek to provide those social services that are needed in increasing measure, and find themselves straining to make ends meet. While a for-profit company may possess skills that enable it to adapt to increasing economic pressures, many nonprofits are ill-equipped to deal with economic distress, particularly if they are already making do on an inadequate budget.

This article will address some issues that might arise when commencing a relationship with a small nonprofit facing insolvency. Larger nonprofit institutions such as universities or hospitals will generally have sophisticated boards and access to appropriate legal services, but smaller nonprofits often exist at the margins and may not have regular contact with a lawyer. Thus, they might find themselves in financial trouble with little information about their legal rights and responsibilities. At this juncture, a nonprofit may reach out for pro bono legal assistance, or use its board's network of contacts to find a business lawyer. Similarly, a general business lawyer who serves on a nonprofit board might encounter requests for advice about how to deal with an organization's financial distress.

Initial Contact
Many times, the first contact with a small nonprofit seeking legal advice will come at a time of great distress. Usually, a prospective client will first make contact over the phone, and the lawyer will follow up with a more extensive interview in person. Advice is often sought as a last resort and in the direst circumstances, particularly when a low-budget organization has lacked access to legal services and has previously avoided incurring the costs of obtaining legal advice until circumstances left no alternatives. A potential client may be facing immediate eviction, or may have received a default notice from a secured creditor. There might be a court proceeding under way with potentially adverse consequences. Often, a potential client in distress will come to the lawyer with an assumption that bankruptcy is the only possible outcome. Even in an emergency, however, prior to filing a bankruptcy petition, counsel should ensure that filing a petition in the bankruptcy court is both appropriate and necessary, and that the client understands the potentially negative consequences of a filing and the range of other alternatives available.

During the initial phone call, the practitioner will need to determine the urgency of the client's circumstances to understand whether immediate attention is needed, and probe for conflicts of interest. Sometimes, the potential client will have problems that require referral to another professional, such as a tax professional or a forensic accountant. If pro bono assistance is requested, the attorney should utilize whatever screening is appropriate to decide if the caller is a potential candidate for such services.

Initially, it may be helpful to understand whether the potential client is seeking advice on its own impulse, or instead was referred by another attorney, an accountant, or some other professional. A client who is cold-calling counsel for bankruptcy assistance may have only the vaguest idea about what is involved in filing a petition, whereas a client who was referred by a trusted advisor is likely further along in the decision-making process, and may prove to be a better candidate for bankruptcy protection.

Additionally, counsel should ask what role the caller has in the organization. While the relationship between a board and its paid staff is similar to that of a for-profit organization's director/management relation, the interpersonal and political dynamics will reflect the particular nonprofit's history and culture. A forthright discussion focusing on the caller's authority and support within the organization, or rather identifying who the decision makers are, is essential to avoid creating an untenable conflict between the attorney and the potential corporate client. Other potential conflicts also must be investigated immediately, in accordance with counsel's usual practice, even if the representation will be pro bono. When dealing with a nonprofit organization, it may be easy to overlook certain categories of potentially adverse interests, such as grantors, other funding sources, and volunteers. Asking for the names and relationships of the various stakeholders in an organization is an important topic for the opening conversation.

During the initial phone call, counsel might seek general information on the background and mission of the nonprofit organization, determine the identity of its board members and inquire about size of membership or other constituencies served. General business questions also should be addressed, such as number of employees and size of payroll, annual budget, number of locations, and geographic reach of the organization. The nature of the issues prompting the client to seek out legal help should be discussed, including whether there are pending litigation or eviction proceedings, and what adverse actions creditors are pursuing.

In setting an in-person appointment, think about who should attend, whether board or staff, and what financial data you will need to see. If accounting functions are performed by a volunteer or outside accountant, it may be necessary to include that person at the first meeting. Consider as well the terms of your engagement, whether pro bono, reduced fee, or ordinary course of business, and communicate your inclinations to the prospective client before any inappropriate expectations are formed. Nonprofit organizations, especially smaller entities, tend to operate on very tight budgets and may not have experience with the cost of legal services.

Intake Appointment
As for any initial appointment, the first meeting with a prospective nonprofit corporation facing insolvency should result in counsel beginning to understand the client's problems and reasons for considering bankruptcy or other legal action, learning about the client's financial situation, and acclimating the client to the benefits and drawbacks of filing a bankruptcy case. Counsel should approach the meeting with an open mind and willingness to listen. Nonprofit corporations come in a wide variety of configurations, and many of them are staffed by people with little experience dealing with sophisticated legal or financial matters. Debtor's counsel in any corporate bankruptcy, including that of a nonprofit organization, is required to have a broad understanding of virtually every aspect of a debtor's business. A solution to the prospective client's financial difficulties could entail reorganizing the debtor so it can continue in business, arranging a sale of the debtor's assets, or liquidation in some circumstances.

Background. At the outset, counsel must establish a trusting relationship with the client, despite all the adverse conditions of such a meeting. Open, frank discussion of all the pros and cons of bankruptcy and other alternatives will usually promote trust, even when the client is given news it does not want to hear. Open the interview with general, open-ended questions. Usually, it is best to ask the client why they have come to see the attorney, or what brought them in to a bankruptcy or business lawyer. Sometimes, it makes sense to start with the general background of the nonprofit—when it was founded, what it does, what its mission is. Usually, there is some particular problem that resulted in the current crisis, and understanding the genesis of the client's troubled state is often illuminating. During this phase of the interview, counsel may wish to inquire about background issues not discussed in the initial phone interview, such as how many employees there are, what are the most significant relationships with members, agency beneficiaries, and the nature of any obligations to vendors or grantors. It is also important to understand the sources and uses of revenue over the last few years.

Ascertaining Assets and Liabilities. Once the client has had an opportunity to explain the background, counsel should guide a discussion of the organization's assets and liabilities. It usually helps to ask for a valuation in each general category, tailoring the inquiry to the nature of the institution. For example, some nonprofit organizations will have interests in real estate, and others, such as thrift shops or the like, may have inventory. The client should estimate rough values, but exact figures are probably not necessary at this point. Sometimes, a current balance sheet can be consulted during the interview. An understanding of the organization's primary fund-raising techniques will aid counsel in this inquiry, and counsel should inquire as to the organization's expectations for future support as well. Depending on the state law of the relevant jurisdiction, pledges may or may not be binding, and inquiry into the extent and nature of any such pledges is prudent.

Special attention may be required, depending on the organization, to the handling of private information of the nonprofit's members or donors. While the corporation might possess valuable intangible assets, such as marketing or branding collateral, mailing lists, literature, and even endorsements or affiliations, it may not have sophisticated procedures in place to protect these assets. Counsel should inquire carefully into the nature of any intellectual property or other general intangibles.

Next, counsel should inquire about debts, again guiding the client through a discussion of any secured debt, tax debt, unpaid employee obligations (including pensions, severance, and other related obligations), vendor debt, and related categories. In addition, contingent liabilities, such as pending litigation or anticipated contract rejections, also should be discussed.

For a nonprofit organization, potential obligations also may include promises to pay for projects or provide other funding in support of its mission. For instance, a charitable organization that funds cancer research may have committed the proceeds of its annual fun run to a scientific foundation, and may have made representations to its donors, volunteers, and participants that funds were allocated for that specific purpose. Grants may have already been approved. State law might establish the priority of such obligations, which could vary widely among jurisdictions. In any event, the lawyer should inquire whether promises have been made.

Specific Concerns. During the intake interview, the lawyer must listen carefully for political undercurrents. Understanding the dynamics between the organization's board, its volunteers, its funders, and any paid staff may lead to a better comprehension of the underlying problems facing the nonprofit corporation, and may provide valuable insight into the potential solutions available. Invariably, the potential client will have sought additional funding before seeking legal assistance, but may have overlooked a resource you can access or the value of its intangible assets. The lawyer also should consider and understand the potential implications of obtaining grant funds or other revenues in light of the client's precarious situation, as well as the law of the local jurisdiction governing solicitation of funds. Certainly, misrepresentations must be avoided by the insolvent nonprofit corporation seeking new funds, and it may be that the organization has an added obligation to reflect on the potential harm that could result to its underlying cause if funds are sought primarily to retire debt rather than advance the common mission of the nonprofit and its benefactors.

The concerns of a nonprofit client differ in important ways from those of a for-profit corporation. The nonprofit organization may be generally motivated by concern for its mission, and may not be troubled by ending its corporate existence if its goals can be furthered otherwise in some creative way. For example, a strategic alliance or even merger with another organization in a similar space could provide a solution. On the other hand, nonprofits' desires to protect employees, including officers, and to avoid negative publicity or unproductive litigation equal those of for-profit companies. Of course, individual ambitions or unfulfilled dreams for the future can color decisions for any client facing insolvency. Counsel should be sensitive to this landscape.

Offering an Initial Opinion. Finally, counsel must be prepared to provide at least an initial opinion as to the appropriate direction of the case. If the client does not have a sophisticated understanding of the legal system, they may need some rudimentary explanations of basic concepts of corporate law, limitations on liability, insolvency, and other pertinent issues. Smaller nonprofits often do not have legal advice readily accessible, and usually they have not previously encountered problems of the sort that are likely to have them considering bankruptcy. In some cases, an explanation of the limitations on the potential for personal liability can be very reassuring. Indeed, it is common that such a conversation can guide the organization through the steps necessary to shut down outside of a bankruptcy with little need for additional legal intervention.

Providing Alternatives
A variety of alternatives should be considered, depending on the client's particular financial condition. In some cases, an attorney need do no more than offer wise counsel. It is often possible to wind down the corporation's affairs without any court proceeding. Sometimes, nonprofit clients simply need to sell certain assets and use the proceeds to pay existing debt, and then close the doors. Counsel might need only to offer simple information about contacting taxing authorities, creditors, and landlords, or may offer to help draft correspondence to creditors or other constituents to explain the situation. State law pertaining to corporate dissolution including any specific provisions for nonprofit corporations must be consulted. In some states, the attorney general should be notified of the demise of a nonprofit organization, particularly where contributions have been solicited.

In those cases where a bankruptcy would be useful, the attorney should provide legal counsel substantially similar to that for a for-profit corporation. A discussion of the issues common to corporate bankruptcies is outside the scope of this article, but many resources exist for the attorney inexperienced in bankruptcy practice. One consideration that will differ in this context: counsel should explore with the nonprofit client the mission and purpose of the organization, and how that mission might bear on the choices to be made. As suggested above, an organization that lacks the revenue to properly support its stated goal might seek to merge with a stronger organization. Membership or other mailing lists may have value that should be maintained to support the ultimate aims, and should be put to good use even after the organization's demise. Consideration should perhaps be given as well to the impact that negative publicity will have on the goals of the nonprofit, and counsel should endeavor to limit such impact.

In this challenging economic environment, many small nonprofit organizations will be unable to survive. Many lawyers serve on nonprofit boards or are connected through family, friends, or civic or religious communities to nonprofit organizations. Attorneys can expect that, increasingly, we will be called upon to provide advice and support to nonprofit corporations in financial distress. The task requires all the skill a business lawyer would commonly bring to the table and, in addition, an appreciation for the role and functions filled by the nonprofit corporation in our communities.

Crocker is a managing partner of Crocker Kuno PLLC, in Seattle. She practices in the areas of reorganization, insolvency, and bankruptcy issues. Her e-mail is scrocker@crockerkuno.com.

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