Jackson Hospital Substantive Consolidation Bid Raises Questions About Interplay Between Chapter 11, Chapter 9

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Legal Analyst: Lucas Hammonds

The request this week by the Jackson Hospital & Clinic debtors to substantively consolidate their bankruptcy estates with nondebtor Medical Clinic Board of the City of Montgomery, Ala., or MCB, presents unique questions about the interplay between chapter 11 and chapter 9 of the Bankruptcy Code. Specifically, the motion raises the issue of whether a state instrumentality can be consolidated into a corporate bankruptcy estate.

The debtors, who are in chapter 11, are Alabama nonprofit corporations. In contrast, the debtors’ motion describes MCB as “a public agency and instrumentality of the State of Alabama” created to promote the public health of the state’s residents. As a result, MCB would ordinarily be eligible for relief under chapter 9 of the Bankruptcy Code and ineligible for relief under chapter 11.

Below we discuss the unique issue raised by the motion: a chapter 11 debtor seeking substantive consolidation with an entity that would otherwise only be eligible for chapter 9 relief. The motion also raises the separate but related issue of substantive consolidation with a nondebtor. That latter issue was addressed by Judge Craig Whitley in 2022 in the DMBP cases, and the Jackson Hospital debtors contend that such consolidation is permissible in the Eleventh Circuit. The Jackson Hospital cases are pending in front of Judge Christopher Hawkins in the U.S. Bankruptcy Court for the Middle District of Alabama.

The Bankruptcy Code requires an entity to be a “municipality” in order to be a debtor under chapter 9, a term that means a “political subdivision or public agency or instrumentality of a State.” Conversely, the Bankruptcy Code excludes municipalities from chapter 11 by limiting eligibility to railroads, certain persons eligible for relief under chapter 7 and certain corporations organized under the Federal Reserve Act. The Bankruptcy Code’s definition of “person” also expressly excludes “governmental units,” which include municipalities.

The debtors are nevertheless seeking to consolidate MCB into their chapter 11 estates because MCB owns the majority of the real estate used by Jackson Hospital and leases that property to the hospital under an arrangement in which the hospital’s rent payments mirror debt service owed to the debtors’ and MCB’s common secured creditors, including bondholders and ServisFirst Bank. As described by the debtors, MCB “leases all of the hospital’s material assets” to the debtors, and the lease agreements are “a dollar-for-dollar pass-through arrangement, meaning that the lease payments are actually made, dollar-for-dollar, by the Debtors directly to the Medical Board’s creditors that are selling or financing the assets (and are also the Debtors’ creditors).”

The debtors cited this circumstance as an impediment during a protracted sale process that concluded with a proposal by DIP lender Jackson Investment Group, or JIG, an entity unrelated to the debtors notwithstanding its similar name, to back the debtors’ exit from chapter 11 with a $75 million exit facility.

JIG’s proposal originally included a requirement that MCB transfer its assets to the debtors before the effective date of any chapter 11 plan. However, JIG subsequently eliminated the requirement in connection with the bankruptcy court’s approval of a DIP credit agreement memorializing JIG’s support for the debtors’ prospective chapter 11 exit. The debtors subsequently filed their substantive consolidation motion, aimed at the same result.

Although the debtors say consolidation will benefit their creditors because “a larger portion of each of the creditors’ claims will be paid than if consolidation did not occur – both because their claims would be paid from the larger pool of assets resulting from consolidation and because substantive consolidation eliminates claims that either debtor has against the other,” it is not clear the move will be possible in light of the Bankruptcy Code’s eligibility restrictions. The motion asserts a plausible claim to “substantial identity” between the debtors and MCB and reasons that debtors and nondebtors with differing corporate forms – for example, a corporate debtor and a nondebtor limited liability company, or an individual debtor and a nondebtor limited liability company and a trust – can be substantively consolidated. However, the motion does not highlight any case in which a debtor subject to one chapter of the Bankruptcy Code was substantively consolidated with a nondebtor that is subject to a different chapter of the Bankruptcy Code. A decision by the Bankruptcy Court that directly addresses the issue could therefore make new law.

If the proposed substantive consolidation is not successful, a chapter 9 filing by MCB may still be an option for bringing MCB’s assets into the debtors’ estates. Earlier this year, Alabama enacted a law that authorizes medical clinic boards to seek relief under the Bankruptcy Code, and the debtors have previously suggested that a chapter 9 filing by MCB could achieve the desired result. That path would involve its own challenges, including potential opposition from secured lenders and a race to effectuate a transaction before the hospital runs out of cash if JIG is unwilling to back a chapter 11 exit without MCB’s assets.

A hearing on the debtors’ consolidation motion is set for Dec. 2 at 3 p.m. ET.