Substantive Consolidation, its Application, and the Authority
By Byron Moldo, Ervin Cohen & Jessup LLP
The administration of a receivership or bankruptcy case in the US may include one or more entities. While there may only be one company that is the subject of the case at the inception, a body of law has developed which permits courts, in appropriate circumstances, to include other entities in the case administration for the benefit of creditors. The balance of this article summarises the concept of substantive consolidation, its application, and the authority.
Substantive consolidation of distinct legal entities placed in a receivership results in the combination of their assets and liabilities, and their treatment as though they are a single entity. In addition to pooling the assets and liabilities of several entities, consolidation also satisfies liabilities from the resulting common fund, while eliminating inter-entity claims and combining the creditors of the entities within the receivership estate.
Because it allows general unsecured creditors of various entities to share pro rata in a common pool of assets, substantive consolidation simplifies the processes of liquidation or reorganisation, and is therefore fair and reasonable when presented to judges and creditors. Surprisingly, there is no statutory basis for the doctrine of consolidation, and courts often disagree as to the appropriate contours of its practical application.
Substantive consolidation is a construct of federal common law. A federal court’s power to order substantive consolidation arises from its general equitable powers. As courts of equity, federal courts have the inherent power to assume possession and control of the property of an entity through the imposition of a receivership, for the purpose of preserving and administering assets for the ultimate benefit of the entity’s creditors, investors, and anyone entitled to share in the distribution of the estate’s assets. See Securities & Exchange Commission vs Capital Consultants, LLC, 397 F.3d 733, 739-741 (9th Cir. 2005); In re San Vicente Med. Partners Ltd., 962 F.2d 1402, 1406 (9th Cir. 1992).
When is Substantive and Administrative Consolidation of Receivership Entities Appropriate?
As an equitable doctrine, “[t]he purpose of substantive consolidation is to insure the equitable treatment of all creditors.” Eastgroup Properties vs S. Motel Ass’n, Ltd. (In re Eastgroup Properties), 935 F.2d 245, 248 (11th Cir. 1991). Such equitable treatment through consolidation usually redistributes wealth among investors and creditors because the various entities placed in a receivership have different debt to asset ratios. “Consolidation restructures (and thus revalues) rights of creditors, and for certain creditors this may result in significantly less recovery.” In re Owens Corning, 419 F.3d 195, 205 (3d Cir. 2005).
Since it has the potential of impairing creditors’ substantive rights and interests, some courts have warned that substantive consolidation should be used sparingly and with caution. In re Bonham, 229 F.3d 750, 771 (9th Cir. 2000); Owens Corning, 419 F.3d at 208–09. The Second Circuit has emphasised that the court’s power to consolidate should be “used sparingly because of the possibility of unfair treatment of creditors who have dealt solely with the companies having a surplus as opposed to those who have dealt with the related entities with deficiencies.” In re Continental Vending Machine Corp., 517 F.2d 997, 1001 (2d Cir. 1975).
The Ninth Circuit Court of Appeals in Bonham, 229 F.3d at 765, highlighted two “similar but not identical” circuit level tests that have been developed in assessing whether substantive consolidation is proper: (i) the DC Circuit test set forth in In re Auto-Train Corp., Inc., 810 F.2d 270, 276 (DC Cir. 1987); and (ii) the Second Circuit test set forth in In re Augie/Restivo Baking Co., Ltd., 860 F.2d 515, 518 (2d Cir. 1988).
After comparing both tests, the Ninth Circuit in Bonham adopted the Second Circuit’s approach in Augie/Restivo as “more grounded in substantive consolidation and economic theory” and “also more easily applied”. Bonham, 229 F.3d at 766.
In 2005, the Third Circuit, in In re Owens Corning, 419 F.3d 195 (3d Cir. 2005), joined the courts of appeal to have articulated tests for substantive consolidation by essentially adopting a slight variation of the Second Circuit’s approach in Augie/Restivo. The Owens court dismissed the DC Circuit’s test in Auto-Train as creating too low of a threshold for substantive consolidation, which should only be allowed under “compelling circumstances”. Owens Corning, 419 F.3d at 210–11. Specifically, the Owens court “disagree[d] that if a creditor makes a showing of reliance on separateness, the court may order consolidation if it determines that the demonstrated benefits of consolidation heavily outweigh the harm. If an objecting creditor relied on the separateness of the entities, consolidation cannot be justified vis-à-vis the claims of that creditor.” Id. at 210. Instead, the courtroom in Owens Corning stated the following: “The upshot is this. In our Court what must be proven (absent consent) concerning the entities for whom substantive consolidation is sought is that (i) prepetition they disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (ii) postpetition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors.”
Substantive consolidation can be an effective tool to maximise the recovery for creditors in both receivership and bankruptcy cases. If the facts are appropriate, courts have discretion to issue orders that expand the scope of the case based on the existing equities. Substantive consolidation can be an effective tool and mechanism to increase the assets that are available for distribution to creditors, treats all creditors fairly, and reduces administrative expenses.
Published: GGI Insider, No. 103, September 2019 l Photo: Kit Leong - stock.adobe.com