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Tearing Down Invisible Walls Substantive Consolidation in Chapter 11

by Amy Tucker Ryan, Esq. and David Freed, law clerk
Martin, Leigh, Laws & Fritzlen, P.C.
USFN Member (KS)

In September 2008 Lehman Brothers Holdings Inc. collapsed and filed for chapter 11 relief, listing $613 billion in liabilities, the largest bankruptcy in history. As expected with a filing of such magnitude, there are unique debtor/creditor issues, legal uncertainties, and complicated disputes among creditors. At one point, one of the most important issues under consideration between two of Lehman’s largest creditor groups was whether Lehman should substantively consolidate as part of its chapter 11 reorganization plan; that is, should the separate bankruptcy estates involved in the Lehman bankruptcy be consolidated into one estate for the purposes of bankruptcy. One group led by Paulson & Co., a New York-based hedge fund, asserted that substantive consolidation would be the most efficient way to handle Lehman’s monumental and confusing array of debt. On the other hand, a group led by Goldman Sachs objected to consolidation.¹

Ch. 11: A Quick Primer
Substantive consolidation most often appears as part of corporate reorganizations, and the Lehman case provides the opportunity to review chapter 11 of the bankruptcy code. Chapter 11, simply, yet aptly, titled “Reorganization” allows a debtor business to restructure its finances and debts while it continues operations.²

Just as in chapters 7 and 13, once the debtor business files its petition, the automatic stay is imposed and the bankruptcy estate is created. Unlike chapters 7 and 13, however, a trustee in bankruptcy (TIB) is usually not appointed. Instead, the business continues to operate under the control of the debtor in possession (DIP), which is usually the pre-bankruptcy management. The DIP has many of the same rights and duties as a TIB, most importantly avoidance powers, which can play an important role in the subsequent reorganization negotiations with creditors. [11 U.S.C. § 1107(a)].

Under certain circumstances, a trustee may be appointed; however, this is not preferred by courts, debtors, or creditors, since the DIP is usually in the best position to continue the operations of the business. [U.S.C. § 1104(a).] Alternatively, an examiner may be appointed to investigate the integrity and abilities of the debtor if the debtor’s unsecured debts exceed $5 million or such appointment is in the interest of creditors. [U.S.C. § 1104(b)]. In Lehman’s case, an examiner has been appointed, and an examiner’s report has been filed.³  Additionally, a creditors’ committee, consisting of a small group of creditors, usually with the largest claims, is appointed to help with the formulation of the reorganization plan and other bankruptcy proceedings. [U.S.C. § 1102].

The DIP is allowed to operate in the ordinary course of business without any court approval, although its ability to use assets subject to security agreements is limited. Secured creditors are safeguarded by the assurance of adequate protection. [U.S.C. § 363(e)]. If that protection turns out to be inadequate, those creditors can obtain an administrative expense priority for the inadequacy. [11 U.S.C. § 507(b)]. The debtor business is also able to obtain post-petition financing subject to certain limitations. [11 U.S.C. § 364].

The debtor, or any party in interest, files a reorganization plan, which provides for the payment of debts and creates classes of similar claims where each claim within a class is treated equally. [11 U.S.C § 1123(a)]. The debtor has a period of exclusivity after filing its petition where only the debtor may file a reorganization plan. Assuming the debtor files a plan, there is also a period of exclusivity during which no other entity may file a plan. This gives the debtor time in which to secure acceptance from creditors. After this period expires, any interested party may file a plan.

The plan is voted on by creditors and shareholders of the debtor. Assuming the plan has been accepted by specified majorities described in the bankruptcy code, it must be confirmed by the bankruptcy judge, who will determine that the plan conforms with the requirements of § 1129 of the code. Section 1129 details several requirements, but there are a few that are most noteworthy. The code imposes a “best interest of creditors test,” which requires that creditors who voted against the plan will receive at least as much under the plan as they would have received under a chapter 7 liquidation. [11 U.S.C. § 1129(a)(7)]. Holders of certain priority claims, such as administrative expense claims, must be paid on the effective date of the plan. [11 U.S.C. § 1129 (a)(9)]. The court must determine that the plan is feasible and that the debtor can meet its plan commitments. [11 U.S.C. § 1129(a)(11)]. The plan must be accepted by at least one impaired class of claims⁴, which are claims whose holders’ legal, equitable, or contractual rights will be altered by the plan.⁵ If all impaired classes do not accept, then the plan must not discriminate unfairly and must be fair and equitable.⁶ Once a plan is confirmed, the debtor is discharged of all pre-petition debts except as provided for in the plan.⁷

How Substantive Consolidation Works
When a corporation and its subsidiaries file for bankruptcy, they file as separate legal entities, each having its own petition. Despite the relationships between the parent corporation and its subsidiaries, the separate bankruptcy filings create separate bankruptcy estates. For the purposes of the subsequent bankruptcy proceedings, the separateness of the legal entities is preserved.⁸

Substantive consolidation is a procedure in bankruptcy where, by disregarding corporate separateness, the assets and liabilities of separate, affiliated estates are merged into one single estate. Creditors of once separate entities become joint creditors of a new consolidated estate; and, as a result, their claims against separate debtors become claims against one single estate. The joint creditors have an equal share in the assets of the consolidated estate. Inter-entity claims of the debtor companies are eliminated.⁹ For chapter 11 purposes, claims are classified based on the consolidated estate and creditors are combined for voting purposes on the reorganization plan.¹⁰ There are some practical implications for the consolidated debtor. There may be associated transaction costs with the consolidation; such as, having to re-title property or obtain new business qualifications.¹¹  Additionally, the consolidated debtor may lose significant tax benefits that it previously had due to entity separateness.¹² Substantive consolidation comes into play when a group of related entities’ financial affairs are entangled or their separate identities have been ignored.

The procedure should not be confused with the corporate law doctrine of piercing the veil, which allows a court to set aside a corporation’s legal personality if corporate formalities were ignored.¹³ While both doctrines seek to address abuses of corporate form, and courts look at similar factors in making their rulings, the result for creditors can be very different. This difference can be shown with a simple example using a parent corporation that owns two subsidiaries. All three entities enter bankruptcy. Creditor A is owed money by less solvent Subsidiary A, while Creditor B is owed money by more solvent Subsidiary B. If Creditor A pierces the corporate veil, it will take whatever Subsidiary A has, and then draw from the parent corporation’s assets, which include Subsidiary B. However, Creditor B has priority in collecting from Subsidiary B, and might take everything from Subsidiary B, leaving nothing for Creditor A. If the assets of Subsidiaries A and B are consolidated, then Creditor A and Creditor B will share from the same pot, eliminating Creditor B’s priority and increasing Creditor A’s share.¹⁴

Substantive consolidation often dramatically affects the rights and interests of creditors; none more so than unsecured creditors because secured creditors still retain the full value of their security interests.¹⁵ As demonstrated above, as a result of having to share the assets of the consolidated debtor estate, creditors of more solvent entities lose out, while creditors of less solvent entities gain. Creditors whose loans to a parent corporation were guaranteed by the corporation’s subsidiaries lose their guarantee as a result of eliminated inter-entity guarantees. Due to the potentially drastic effects of substantive consolidation, courts across the country tend to agree that it is a measure to be used sparingly.¹⁶

There are no restrictions on the types of entities that may be consolidated. What is important is the relationship between the entities. Debtor entities may even be consolidated with non-debtor entities, although this is rare, and tends to be subject to very high scrutiny.¹⁷  In such a case there will often be other available remedies; for example, recovery of a fraudulently conveyed asset from the non-debtor.¹⁸ While any entity may be subject to substantive consolidation, the most frequent use is for related debtor corporations.¹⁹

Substantive consolidation can be sought by creditors, trustees, debtors, or a party in interest. Whether the bankruptcy case was filed via a voluntary or an involuntary petition is irrelevant. Reorganizing debtor corporations can request substantive consolidation as part of their reorganization plan. If the court is to grant substantive consolidation, there must be a clear showing that it is warranted.²⁰

Born Out Of Equity
Substantive consolidation is not clearly authorized by the bankruptcy code.²¹ However, bankruptcy courts are considered courts of equity, which allows them to employ common law in appropriate circumstances.²² Courts often cite § 105 of the bankruptcy code, which provides: “The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title,” as conferring upon them the power to order substantive consolidation.²³ Sometimes in chapter 11 cases, courts have also cited § 1123(a)(5)(C), which provides that a reorganization plan “shall … provide adequate means for the plan’s implementation, such as … merger or consolidation of the debtor with one or more persons.”²⁴ Due to the tenuous statutory basis, and because each bankruptcy filing has its own unique aspects, courts need to examine the circumstances of each case individually to determine if consolidation is warranted.²⁵

In 1941 in Sampsell v. Imperial Paper & Color Corporation, the U.S. Supreme Court approved the concept of consolidating debtor estates; however, that case did not offer any test to determine when consolidation should occur (313 U.S. 215). Over the years, courts have examined a plethora of factors to be considered in determining when substantive consolidation should be allowed, including the following:

 1.  The presence or absence of consolidated financial statements.
 2.  The unity of interests and ownership between various corporate entities.
 3.  The existence of parent and intercorporate guarantees on loans.
 4.  The degree of difficulty in segregating and ascertaining individual assets and  liabilities.
 5.  The existence of transfers of assets without formal observance of corporate  formalities.
 6.  The commingling of assets and business functions.
 7.  The profitability of consolidation at a single physical location.²⁶

For the past three decades, the circuit courts have been split on the issue of when to order substantive consolidation.²⁷ Currently, three tests exist to determine when to substantively consolidate; two from the late 1980s, coming out of the D.C. Circuit and the Second Circuit, and one 2005 case from the Third Circuit. [See In re Auto-Train Corporation, Inc., 810 F.2d 270, 276 (D.C. Cir. 1987); In re Augie/Restivo Baking Company, 860 F.2d 515, 518 (2d Cir. 1988); In re Owens Corning, 419 F.3d 195, 211 (3d Cir. 2005)].

The D.C. Circuit, in In re Auto-Train Corporation, set forth a three-part test. First, the proponent of substantive consolidation must show that there is a substantial identity between the entities to be consolidated and that consolidation is necessary to avoid some harm or realize some benefit. Following that showing, a creditor may object to consolidation on the ground that it relied on the separateness of one of the entities in extending credit. If that showing is made, the court will only order consolidation if it is determined that the benefits of consolidation outweigh the harm. Courts using this test will often look to the above-listed factors in making the substantial identity inquiry.²⁸ The Eighth and Eleventh Circuits were early adopters of the D.C. Circuit test.²⁹

The Second Circuit, one year after Auto-Train in In re Augie/Restivo Baking Co., established a disjunctive two-factor test that examines: (1) whether creditors dealt with an entity as a single unit and did not rely on its separateness in extending credit; or (2) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors. The Second Circuit’s test is stricter than the D.C. Circuit’s test. Under Augie/Restivo, showing substantial identity is not enough; a proponent of consolidation must also prove creditors did not rely on corporate separateness. This second reliance showing must always be proven by proponents seeking consolidation under the first factor, whereas under Auto-Train this showing only has to be proven if there are objections to the consolidation proposal. The Lehman Brothers case was filed in the Southern District of New York, so the group wanting substantive consolidation in the case is subject to this test.

Most recently, in 2005, the Third Circuit in In re Owens Corning established its own two-factor test. A proponent must prove: (1) the entities to be consolidated ignored corporate separateness so significantly that their creditors relied on that breakdown of entity borders and treated those entities as one single entity; or (2) if, post-petition, the debtor entities’ assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors. The court noted that a prima facie case exists under the first factor where the debtors’ corporate disregard created contractual expectations by creditors that they were dealing with the debtors as one indistinguishable entity. The proponent must also show that it relied on that unity. Creditors opposing the consolidation can defeat the first factor by showing they indeed relied on corporate separateness. The Third Circuit’s second factor is similar to that of the Second Circuit but has the added language that the task of untangling the debts must be “prohibitive and hurt all creditors,” making it harder to satisfy.

Owens Corning was particularly stringent in its standard for substantive consolidation. In addition to its test, the court set out principles to help guide future courts determining whether to order consolidation. Those principles are: courts should try to respect entity separateness; substantive consolidation is a remedy against harm caused by debtors; administrative convenience is not enough to warrant consolidation; substantive consolidation is imprecise and should be used rarely; and substantive consolidation may not be used offensively to disadvantage certain creditors. Some commentators believe that the Owens Corning decision will influence future courts to be stricter in their analysis.³⁰

Substantive consolidation is used rarely, and not all circuits have adopted a test for determining when it should be used. However, a number of courts look to the D.C. and second circuits’ tests in making their decisions.³¹ Other jurisdictions, such as the Tenth Circuit, have not confronted the issue post Auto-Train.³²

Related Doctrines
A “deemed” consolidation occurs when the court treats the debtor entities as consolidated only for plan purposes, including valuation and satisfaction of creditor claims, making distributions, and voting on the plan. The assets of the debtor entities are not actually merged, as in a full substantive consolidation.³³ By not merging assets and liabilities of the different debtor entities, debtors can avoid some of the associated costs, such as re-titling property as well as tax complications. Among the largest corporate bankruptcies, most consolidations are really deemed consolidations, even if the language is not used.³⁴ The Third Circuit however, in Owens Corning was particularly hard on deemed consolidations, noting that if the debtor’s operation was a sham in the first place, it doesn’t make sense for the corporate structure to remain undisturbed after reorganization. It remains to be seen what effect the Owens Corning court’s view of deemed consolidations will have on future chapter 11 plans.

The question of when an order of substantive consolidation takes effect for certain consolidated debtors arises when related debtors file bankruptcy petitions on different dates. This issue is often raised for preference liability purposes.³⁵ Some courts hold that consolidation can be retroactive, treating all entities as if they filed on the earliest filing date.³⁶ Others hold that a balancing test should be used to determine if a retroactive consolidation order would do more harm than good. [In re Auto-Train Corp., 810 F.2d at 276]. Additionally, some courts hold that no test is necessary, and it is simply a matter of the court exercising its equitable discretion. [In re Bonham, 229 F.3d 750 (9th Cir. 2000)].

Conclusion
Substantive consolidation is a powerful remedy that can dramatically alter the rights and interests of both debtors and creditors. The law is still developing in this area, and many courts have had little opportunity to address the issue. While courts tend to agree that it should be used sparingly, substantive consolidation is likely to appear more frequently as corporate structures become increasingly complex. Debtors, creditors, and their respective counsel, especially at the corporate level, should be aware of the potential consequences of substantive consolidation when drafting loan documents.

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¹  Matt Wirtz and Mike Spector, Fight For Lehman Heats Up, Wall Street Journal, Apr. 26, 2011.
² 11 U.S.C. Ch. 11 (2006). Chapter 11 is also available to individuals, although this is less common than its use by businesses. Often individuals who filed for chapter 11 would have otherwise filed for chapter 13 had their debts not exceeded the chapter 13 debt limit.
³  For the examiner’s report, s http://lehmanreport.jenner.com.
⁴  11 U.S.C. § 1129(a)(10
⁵  11 U.S.C. § 1124
⁶  11 U.S.C. § 1129(b)(1)
⁷  11 U.S.C. § 1141(d)(1). This is a notable difference from a chapter 13 discharge, which does not occur until completion of the plan. See 11 U.S.C. § 1328(a).
⁸  William C. Blasses, Redefining into Reality: Substantive Consolidation of Parent Corporations and Subsidiaries, 24 Emory Bankr. Dev. J. 469, 472 (2008).
⁹  J. Stephen Gilbert, Substantive Consolidation in Bankruptcy: A Primer, 43 VAND. L. REV. 207, 209 (1990).
¹⁰  Id. At 209-10.
¹¹  William H. Widen, Corporate Form and Substantive Consolidation, 75 Geo. Wash. L. Rev. 237, 255 (2007) (discussing costs that might be avoided by using a deemed consolidation as opposed to an actual consolidation).
¹²  In re Standard Brands Paint Co., 154 B.R. 563, 565 (Bankr. C.D. Cal. 1993); this case is considered to be the first deemed consolidation.
¹³  See generally Stoebner v. Lingenfelter, 115 F.3d 576 (8th Cir. 1997), discussing piercing the veil doctrine.
¹⁴  See Andrew Brasher, Substantive Consolidation: A Critical Examination, http://www.law.harvard.edu/programs/corp_gov/papers/Brudney2006_Brasher.pdf. (This example is a condensed version of a more detailed example given in Brasher’s paper).
¹⁵  See Blasses, supra note 8, at 473.
¹⁶  In re Owens Corning, 419 F.3d 195, 208-09 (3d Cir. 2005)
¹⁷  Gilbert, supra note 9, at 214, citing 5 COLLIER ON BANKRUPTCY ¶ 1100.06[1], at 1100-46 (L. King 15th ed. 1979).
¹⁸  Gilbert, supra note 9, at 214.
¹⁹  Gilbert, supra note 9, at 215.
²⁰  Gilbert, supra note 9, at 214.
²¹  Gilbert, supra note 9, at 210.
²²  Blasses, supra note 8, at 480.
²³  Blasses, supra note 8, at 483. See 11 U.S.C. § 105(a).
²⁴  Blasses, supra note 8, at 483. See 11 U.S.C. § 1123(a)(5)(C).
²⁵  Gilbert, supra note 9, at 215.
²⁶  Dennis J. Connolly, John C. Witnauer, and Jonathan T. Edwards, Current Approaches to Substantive Consolidation: Owens Corning Revisited, 2009 Ann. Surv. of Bankr. Law part I § 2. These factors are often known as the Vecco factors. See In re Vecco Constr. Indus., 4 Bankr. 407, 410 (Bankr. E.D. Va. 1980). The factors are merely guidelines, and the presence or absence of one will not guarantee or deny consolidation.
²⁷  Blasses, supra note 8, at 485.
²⁸  Connolly, Witnauer, & Edwards, supra note 26.
²⁹  See In re Giller, 962 F.2d 796 (8th Cir. 1992). (The Eighth Circuit’s ruling does not directly mention Auto-Train but uses the same standard), and Eastgroup v. Southern Motel Ass’n, Ltd., 935 F.2d 245 (11th Cir. 1991).
³⁰  Connolly, Witnauer, & Edwards, supra note 26.
³¹  Brasher supra note 14.
³²  See In Re Gulfco Investment Corp., 593 F.2d 921 (10th Cir. 1979). (The court, denying consolidation in this case, relied on factors similar to the Vecco factors.) See Connolly, Witnauer, & Edwards, supra note 26.
³³  William H. Widen, Report to the American Bankruptcy Institute: Prevalence of Substantive Consolidation in Large Public Company Bankruptcies from 2000 to 2005, 16 Am. Bankr. Inst. L. Rev. 1, 11 (2008).
³⁴  Widen, supra note 11.
³⁵  See generally In re Baker & Getty Financial Services, Inc., 974 F.2d 712 (6th Cir. 1992).
³⁶  Id. at 721.