Substantive Consolidation Under the Bankruptcy Code - ABA YLD 101 Practice Series

By Jason L. Boland and Mark A. Worden

Overview
Under the doctrine of substantive consolidation, a bankruptcy court may, under certain circumstances, consolidate the assets and liabilities of different entities by merging the assets and liabilities of the entities and treating them as a consolidated entity for purposes of the bankruptcy proceedings. Thus, the intercompany claims of the debtor companies are eliminated and the assets of all debtors are treated as common assets and claims of outside creditors against any of the debtors are treated as against the common fund. See Eastgroup Prop. v. Southern Motel Assocs., Ltd., 935 F.2d 245, 248 (11th Cir. 1991); In re Augie/Restivo Baking Co., 860 F.2d 515, 518 (2d Cir. 1988). A court need not, however, consolidate all claim for all estates. See In re Parkway Calabasas, Ltd., 89 B.R. 832, 837 (Bankr. C.D. Cal. 1988) (noting that to protect creditors, a court may qualify the consolidation or only consolidate certain claims - unsecured rather than secured), aff'd, 949 F.2d 1058 (9th Cir. 1991); see also In re Continental Vending Mach. Corp., 517 F.2d 997, 1000-02 (2d Cir. 1975).

Despite the various cases which have ordered substantive consolidation, there is no specific provision of the Bankruptcy Code that explicitly deals with or authorizes substantive consolidation. But see 11 U.S.C. § 105(a) (2007) (stating that "[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title [the Bankruptcy Code]"). Rather, the power arguably arises from the general equity powers exercised by bankruptcy courts. Thus, because the power to order substantive consolidation is derived from equity, a court's inquiry requires an examination, inter alia, of the structures of the entities proposed to be consolidated, their intercompany relationships, and their relationships with their respective creditors and other third parties, as well as any other factors the court finds relevant. Courts will also consider the impact on the creditors of each entity if consolidation were to be ordered, and whether such parties would be unfairly prejudiced or benefited by substantive consolidation. See In re WorldCom Inc., 2003 Bankr. LEXIS 1401, *104 (Bankr. S.D. N.Y. Oct. 31, 2003). The unfair prejudice or benefit to creditors generally results from the fact that each debtor has a different ratio of assets to liabilities, and, therefore, creditors of each respective debtor would generally receive different recoveries. However, by consolidating the debtors, creditors that would have received a 20% payout may be consolidated with creditors that would have received a 10% payout, resulting in an overall payout to both groups of creditors of a blended amount, possibly 15%. Thus, certain groups of creditors may be prejudiced by consolidation while others may benefit.

The D.C. Circuit's and the Eleventh Circuit's Approach to Substantive Consolidation
The most widely cited cases relating to substantive consolidation have come out of the D.C. Circuit, as expanded upon by the Eleventh Circuit, and from the Second Circuit. The D.C. Circuit, in Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.),810 F.2d 270, 276 (D.C. Cir. 1987), enunciated a three-part test:

  • The proponent must show a substantial identity between the entities to be consolidated, and
  • The proponent must show that consolidation is necessary to avoid some harm or to realize some benefit, and
  • If the proponent has met the first two elements and a creditor objects, then the creditor has the burden (and opportunity) of demonstrating that it relied on the separate credit of one of the entities and that it will be prejudiced by the consolidation. If the objecting creditor meets this burden, then the court may order consolidation only if it determines that the demonstrated benefits of consolidation "heavily" outweigh the harm.

The Eleventh Circuit, in Eastgroup Prop. v. Southern Motel Assocs., Ltd., 935 F.2d 245, 248 (11th Cir. 1991), adopted and elaborated on the D.C. Circuit test, and suggested that the substantive consolidation proponent should address the following specific factors:

  • The presence or absence of consolidated financial statements;
  • The unity of interest and ownership between various corporate entities;
  • The existence of parent and intercorporate guarantees on loans;
  • The degree of difficulty in segregating and ascertaining individual assets and liabilities;
  • The existence of transfer of assets without formal observance of corporate formalities;
  • The commingling of assets and business functions;
  • The profitability of consolidation at a single physical location;
  • The parent owning the majority of the subsidiary's stock;
  • The entities having common officers or directors;
  • The subsidiary being grossly under-capitalized;
  • The subsidiary transacting business solely with the parent; and
  • Both entities disregarding the legal requirements of the subsidiary as a separate organization.

Id.; see also In re Vecco Constr. Indus., Inc., 4 B.R. 407, 410 (Bankr. E.D. Va. 1980) (listing the first seven factors). The Eleventh Circuit, like many courts, stressed that no one factor was determinative and that these factors were only examples of information a court would consider in determining whether there was a substantial identity between the entities and whether consolidation was necessary to avoid harm or realize a benefit.

The Second Circuit's Approach to Substantive Consolidation
Similar to the D.C. and Eleventh Circuits, the Second Circuit, in In re Augie/Restivo Baking Co., 860 F.2d 515, 518 (2d Cir. 1988), also devised its own test in determining whether or not substantive consolidation was warranted. In particular, the Second Circuit summarized its test as whether:

  • The creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, or
  • The affairs of debtors are so entangled that consolidation will benefit all creditors because untangling is either impossible or so costly as to consume the assets.

See also In re Bonham, 229 F.3d 750, 767 (9th Cir. 2000) (adopting the Augie/Restivo test).

The Third Circuit's Approach to Substantive Consolidation
Prior to its 2005 ruling in In re Owens Corning, 419 F.3d 195 (3d Cir. 2005), the Third Circuit had not articulated its standards for substantive consolidation. Though not necessarily revolutionary, the Owens Corning opinion does approach the question of substantively consolidating bankruptcy estates in a more conservative manner than courts outside the Third Circuit and insisted that any deliberation over this issue requires a fact-intensive, case-by-case analysis (that may or may not include the consideration of the traditional factors applied by other courts in previously published opinions).

In analyzing the various tests set forth by the other circuits, the Third Circuit expressed concern that Auto-Train allowed "a threshold not sufficiently egregious and too imprecise for easy measure." Id.at 210. The court stated that the Augie/Restivo test was a more sound analytical structure with which to examine the facts of a case. Despite its general approval of the Augie/Restivo test, the Third Circuit developed its own variation and summarized its test as whether:

  • Absent consent concerning the entities for whom substantive consolidation is sought, the proponent of substantive consolidation must show
  • Pre-petition the debtors disregarded separateness so significantly that their creditors relied on the breakdown of entity borders and treated them as one legal entity, or
  • Post-petition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors.

Id.at 211-12. The Third Circuit emphasized that it adopted an intentionally open-ended, equitable inquiry to determine when to substantively consolidate two entities, but refrained from adopting specific factors because it did not want practitioners to simply recite those principles as factors on a checklist. Id. at 210-12 (setting forth basic "principles" to guide future court determination rather than a specific list of "Third Circuit Factors"). Finally, Owens Corning entails a restrictive departure from the Augie/Restivo test by requiring not only that the creditors treated the debtors as one legal entity but also that the debtors disregarded their own separateness such that their was a breakdown of entity borders.

Conclusion
Substantive consolidation can be a very effective tool for simplifying complex interrelationships among debtors and their respective creditors. However, because substantive consolidation combines all of the consolidated debtors' assets and liabilities, there is a significant risk that certain creditors will be unjustifiably prejudiced to the benefit of other creditors. Accordingly, as described above, several Circuit Courts have developed various tests which are intended to balance the benefits of substantive consolidation against its detriment to creditors, and practitioners should be aware of the significant variances that exist among the circuits.

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