Archdiocese's Potential Fraudulent Transfer Not Protected by RF...

The Archdiocese of Milwaukee’s Chapter 11 case remains the longest running Chapter 11 case filed by an Archdiocese or other Catholic entity. It filed in January 2011, and because of religious-based objections to the application of the Code's fraudulent and preferential transfer provisions, Bankruptcy Judge Susan Kelley has declined to rule on any reorganization plan until the objections are settled.

The main hang-up is an April 2007 pre-petition transfer of $55 million from the Archdiocese’s general accounts to a trust earmarked for maintaining cemeteries--generally known as the "Cemetery Trust Fund." Post-filing, the Archbishop, acting in his role as the trustee of the Cemetery Trust Fund, sought a declaratory judgment from the bankruptcy court that the $55 million would never be part of the Archdiocese's bankruptcy because the First Amendment and/or the Religious Freedom Restoration Act (RFRA) barred the application of the Code's avoidance provisions. The action was defended by the Unsecured Creditors' Committee -- because the DIP was just a tad conflicted given that it acts through its sole corporate member, the Archbishop.

The question made its way up to the 7th Circuit, which issued a long awaited opinion today. The rulings are: (1) RFRA is not applicable because it only applies to suits in which the government is a party, and the Creditors' Committee is not the government; and (2) the Archbishop's free exercise rights are not violated by application of the Code's generally neutral principles that are narrowly tailored to support a compelling government interest in protecting creditors. In short, the Archdiocese decided to file under Chapter 11 and now it cannot seek a religious exemption for purported fraud.

I'll add: if the Archdiocese did not want to file for bankruptcy and face the Code's avoidance provisions, no creditor or other party ever could force it into bankruptcy because nonprofits are not subject to the Code's involuntary provisions. The 7th Circuit essentially held that the Bankruptcy Code is a scheme that applies equally to all businesses, including nonprofits. If a religious organization engages in pre-bankruptcy planning that involves moving assets into separate legal entities that will not file for bankruptcy, per the Code, there is a chance that these "safe" separate legal entities will have to give the assets back to the entity that filed under Chapter 11. Religious organizations' ability to engage in pre-petition planning is subject to the same limiting rules as applicable to every other business. The Code (rightly) is no more beneficial to religious organizations than the Code is to any other business.  

What's the import of the case? As to the Archdiocese of Milwaukee, Judge Kelley now likely will be tasked with determining whether the $55 million was an avoidable transfer. But the decision undoubtedly is being scrutinized by other Catholic entities in Chapter 11 or thinking about filing under Chapter 11. Of note, the Archdiocese of Saint Paul and Minneapolis filed under Chapter 11 relatively recently. Questions about its pre-petition transfers already have surfaced. The 7th Circuit's decision specifically distinguishes some applicable 8th Circuit precedent. The "religious exemption from the Code's avoidance provisions" question could come out differently in the Archdiocese of Saint Paul and Minneapolis case, which seems to tee up a battle in that case and potentially across circuits.

Finally, in order to reach its ultimate holding, the 7th Circuit definitively ruled that RFRA only applies to suits in which the government is a party. This places the 7th Circuit with two other circuits and against a lone circuit, potentially setting up a writ of certiorari.