Opinion ID: 3015323
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Heading: History of Substantive Consolidation

Text: The concept of substantively consolidating separate estates begins with a commonsense deduction. Corporate disregard 10 as a fault may lead to corporate disregard as a remedy. 10 A term used by Mary Elisabeth Kors in her comprehensive and well-organized article entitled Altered Egos: Deciphering Substantive Consolidation, 59 U. Pitt. L. Rev. 381, 383 (1998) (hereinafter “Kors”). 23 Prior to substantive consolidation, other remedies for corporate disregard were (and remain) in place. For example, where a subsidiary is so dominated by its corporate parent as to be the parent’s “alter ego,” the “corporate veil” of the subsidiary can be ignored (or “pierced”) under state law. Kors, supra, at 386-90 (citing as far back as I. Maurice Wormser, Piercing the Veil of Corporate Entity, 12 Colum. L. Rev. 496 (1912)). Or a court might mandate that the assets transferred to a corporate subsidiary be turned over to its parent’s trustee in bankruptcy for wrongs such as fraudulent transfers, Kors, supra, at 391, in effect bringing back to the bankruptcy estate assets wrongfully conveyed to an affiliate. If a corporate parent is both a creditor of a subsidiary and so dominates the affairs of that entity as to prejudice unfairly its other creditors, a court may place payment priority to the parent below that of the other creditors, a remedy known as equitable subordination, which is now codified in § 510(c) of the Bankruptcy Code. See generally id. at 394-95. Adding to these remedies, the Supreme Court, little more than six decades ago, approved (at least indirectly and perhaps inadvertently) what became known as substantive consolidation.11 Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215 (1941). In Sampsell an individual in bankruptcy had transferred assets prepetition to a corporation he controlled. 11 The actual term was not used until 1967. In re Commercial Envelope Mfg. Co., 3 Bankr. Ct. Dec. 647, 648 (Bankr. S.D.N.Y. 1977) (Babitt, J.). 24 (Apparently these became the corporation’s sole assets.) When the bankruptcy referee ordered that the transferred assets be turned over by the corporation to the individual debtor’s trustee, a creditor of the non-debtor corporation sought distribution priority with respect to that entity’s assets. In deciding that the creditor should not be accorded priority (thus affirming the bankruptcy referee), the Supreme Court turned a typical turnover/fraudulent transfer case into the forebear of today’s substantive consolidation by terming the bankruptcy referee’s order (marshaling the corporation’s assets for the benefit of the debtor’s estate) as “consolidating the estates.” Id. at 219. Each of these remedies has subtle differences. “Piercing the corporate veil” makes shareholders liable for corporate wrongs. Equitable subordination places bad-acting creditors behind other creditors when distributions are made. Turnover and fraudulent transfer bring back to the transferor debtor assets improperly transferred to another (often an affiliate). Substantive consolidation goes in a direction different (and in most cases further) than any of these remedies; it is not limited to shareholders, it affects distribution to innocent creditors, and it mandates more than the return of specific assets to the predecessor owner. It brings all the assets of a group of entities into a single survivor. Indeed, it merges liabilities as well. “The result,” to repeat, “is that claims of creditors against separate debtors morph to claims against the consolidated survivor.” In re Genesis Health Ventures, 402 F.3d at 423. The bad news for certain creditors is that, instead of looking to assets of the 25 subsidiary with whom they dealt, they now must share those assets with all creditors of all consolidated entities, raising the specter for some of a significant distribution diminution. Though the concept of consolidating estates had Supreme Court approval, Courts of Appeal (with one exception) were slow to follow suit. Stone v. Eacho (In re Tip Top Tailors, Inc.), 127 F.2d 284 (4th Cir. 1942), cert. denied, 317 U.S. 635 (1942), was the first to pick up on Sampsell’s new remedy.12 Little occurred thereafter for more than two decades, until the Second Circuit issued several decisions—Soviero v. National Bank of Long Island, 328 F.2d 446 (2d Cir. 1964); Chemical Bank New York Trust Co. v. Kheel (In re Seatrade Corp.), 369 F.2d 845 (2d Cir. 1966); Flora Mir Candy Corp. v. R.S. Dickson & Co. (In re Flora Mir Candy Corp.), 432 F.2d 1060 (2d Cir. 1970); and Talcott v. Wharton (In re Continental Vending Machine 12 Another case oft-mentioned, and preceding both Sampsell and Stone, is Fish v. East, 114 F.2d 177 (10th Cir. 1940). Determining that a corporate subsidiary was simply the parent’s “instrumentality,” id. at 191, the Tenth Circuit affirmed the turnover of the subsidiary’s assets to the parent. Though asserting that a “corporate entity may be disregarded where not to do so will defeat public convenience, justify wrong or protect fraud,” id., “consolidation” was not mentioned. Indeed, as creditors of the subsidiary in Fish were given first priority as to its assets, id., a complete consolidation did not occur. Accord Kors, supra, at 391 (“true consolidation” occurs only when creditors of consolidated entities share pari passu). 26 Corp.), 517 F.2d 997 (2d Cir. 1975)—that brought substantive consolidation as a remedy back into play and premise its modern-day understanding. Other Circuit Courts fell in line in acknowledging substantive consolidation as a possible remedy. See, e.g., FDIC v. Hogan (In re Gulfco Inv. Corp.), 593 F.2d 921, 927-28 (10th Cir. 1979); Pension Benefit Guar. Corp. v. Ouimet, 711 F.2d 1085, 1092-93 (1st Cir. 1983); Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270, 276 (D.C. Cir. 1987); Eastgroup, 935 F.2d at 252; In re Giller, 962 F.2d at 799; First Nat’l Bank of Barnesville v. Rafoth (In re Baker & Getty Fin. Servs., Inc.), 974 F.2d 712, 720 (6th Cir. 1992); Reider v. FDIC (In re Reider), 31 F.3d 1102, 1106-07 (11th Cir. 1994); and In re Bonham, 229 F.3d at 771. The reasons of these courts for allowing substantive consolidation as a possible remedy span the spectrum and often overlap. For example, Stone and Soviero followed the well-trod path of alter ego analysis in state “pierce-the-corporate-veil” cases. Stone, 127 F.2d at 287-89; Soviero, 328 F.2d at 447-48. Accord In re Giller, 962 F.2d at 798; In re Gulfco Inv., 593 F.2d at 928-29. Kheel dealt with, inter alia, the net-negative practical effects of attempting to thread back the tangled affairs of entities, separate in name only, with “interrelationships . . . hopelessly obscured.” 369 F.2d at 847. See also, e.g., In re Augie/Restivo, 860 F.2d at 518-19. In re Continental Vending Machine balanced the “inequities” involved when substantive 27 rights are affected against the “practical considerations” spawned by “accounting difficulties (and expense) which may occur where the interrelationships of the corporate group are highly complex, or perhaps untraceable.” 517 F.2d at 1001. See also, e.g., In re Auto-Train, 810 F.2d at 276; Eastgroup, 935 F.2d at 249; In re Giller, 962 F.2d at 799; In re Reider, 31 F.3d at 1108. See generally Kors, supra, at 402-06. Ultimately most courts slipstreamed behind two rationales—those of the Second Circuit in Augie/Restivo and the D.C. Circuit in Auto-Train. The former found that the competing “considerations are merely variants on two critical factors: (i) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, . . . or (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors . . . .” In re Augie/Restivo, 860 F.2d at 518 (internal quotation marks and citations omitted). Auto-Train touched many of the same analytical bases as the prior Second Circuit cases, but in the end chose as its overarching test the “substantial identity” of the entities and made allowance for consolidation in spite of creditor reliance on separateness when “the demonstrated benefits of consolidation ‘heavily’ outweigh the harm.” In re Auto-Train, 810 F.2d at 276 (citation omitted). Whatever the rationale, courts have permitted substantive 28 consolidation as an equitable remedy in certain circumstances.13 No court has held that substantive consolidation is not authorized,14 though there appears nearly 13 Indeed, they have not restricted the remedy to debtors, allowing the consolidation of debtors with non-debtors, see, e.g., In re Bonham, 229 F.3d at 765 (explaining that “[c]ourts have permitted the consolidation of non-debtor and debtor entities in furtherance of the equitable goals of substantive consolidation”) (citing In re Auto-Train, 810 F.2d at 275-77; In re Tureaud, 59 B.R. 973, 974, 978 (N.D. Okla. 1986); In re Munford, 115 B.R. 390, 395-96 (Bankr. N.D. Ga. 1990)); Soviero, 328 F.2d 446, and in some cases consolidation retroactively (known also as nunc pro tunc consolidation), see, e.g., In re Baker & Getty Financial Services, 974 F.2d at 720-21; Kroh Brothers Development Co. v. Kroh Brothers Management Co. (In re Kroh Brothers Development Co.), 117 B.R. 499, 502 (W.D. Mo. 1989); In re Tureaud, 59 B.R. at 977-78; see also Auto-Train, 810 F.2d at 277 (acknowledging that nunc pro tunc consolidations can occur, though not in that case). In addition, though we do not permit the consolidation sought in this case, no reason exists to limit it under the right circumstances to any particular form of entity. (Indeed, this case involves corporations and limited liability companies.) Accord 2 Collier on Bankruptcy ¶ 105.09[1][c] (15th rev. ed. 2005). 14 See In re Bonham, 229 F.3d at 765 (explaining that “the equitable power [of substantive consolidation] undoubtedly survived enactment of the Bankruptcy Code” and noting that “[n]o case has held to the contrary”); but see In re Fas Mart 29 Convenience Stores, Inc., 320 B.R. 587, 594 n.3 (Bankr. E.D. Va. 2004) (noting “there is persuasive academic argument that there is no authority in bankruptcy law for substantive consolidation”) (citing Daniel B. Bogart, Resisting the Expansion of Bankruptcy Court Power Under Section 105 of the Bankruptcy Code: The All Writs Act and an Admonition from Chief Justice Marshall, 35 Ariz. St. L.J. 793, 810 (2003); J. Maxwell Tucker, Grupo Mexicano and the Death of Substantive Consolidation, 8 Am. Bankr. Inst. L. Rev. 427 (2000) (hereinafter “Tucker”)). Since the Supreme Court’s decision in Grupo Mexicano Desarrollo, S.A. v. Alliance Bond Fund, Inc., 527 U.S. 308 (1999) (federal district courts lack the equitable power to enjoin prejudgment transfers of assets, as such an equitable remedy did not exist at the time federal courts were created under the Judiciary Act of 1789), some argue that substantive consolidation, judge-made law not expressly codified in the Bankruptcy Code adopted in the late 1970s, does not qualify as an available equitable remedy. See, e.g., Tucker, supra at 44245. This argument has two facets. The first is that bankruptcy courts are limited to exercising only the equitable remedies extant at the time of the adoption of the Judiciary Act of 1789. As substantive consolidation is a relatively recent remedy nowhere contemplated in 1789, Grupo Mexicano by analogy bars substantive consolidation just as it does prejudgment preliminary injunctions forbidding asset transfers. Id. The second (and corollary) facet of the argument is that, as substantive consolidation is not specifically authorized in the Bankruptcy Code, authority to confer it can exist, if at all, only 30 in § 105(a) of the Bankruptcy Code (bankruptcy courts “may issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title”). Even if § 105(a) “constitutes a direct, fresh grant of supplemental power to the bankruptcy courts, independent of the power granted to the federal courts under title 28 [of the United States Code],” id. at 447, it can only implement powers already expressed in the provisions of the Bankruptcy Code. Id. at 447-48. See In re Combustion Eng’g, Inc., 391 F.3d 190, 236 (3d Cir. 2004) (“The general grant of equitable power contained in § 105(a). . . must be exercised within the parameters of the Code itself.”); In re Kmart Corp., 359 F.3d 866, 871 (7th Cir. 2004) (“The power conferred by § 105 is one to implement rather than to override.”). But for joint spouse estates in Bankruptcy Code § 302(a), consolidation is permitted only in the context of a confirmed plan of reorganization and the requirements that entails. Tucker, supra, at 449 (citing to, inter alia, Bankruptcy Code § 1123(a)(5)(C)). The first facet of the argument is, at the outset, premature. Consolidating estates (indeed, consolidating debtor and non-debtor entities) traces to the Supreme Court’s Sampsell decision in 1941. 313 U.S. at 219. What the Court has given as an equitable remedy remains until it alone removes it or Congress declares it removed as an option. See In re Stone & Webster, 286 B.R. at 540 (quoting Official Comm. of Asbestos Claimants v. G-I Holdings, Inc. (In re G-I Holdings, Inc.), Adv. No. 01-3065 (RG) (Bankr. D.N.J. March 12, 2001) (Hearing Tr. at 71-2)). In addition, at the core of Grupo Mexicano was the extent 31 of general, unarticulated equity authority in the federal courts (which, the Court held, can only be justified by reference to 1789 equity authority). It was not a bankruptcy case. The extensive history of bankruptcy law and judicial precedent renders the issue of equity authority in the bankruptcy context different to such a degree as to make it different in kind. Notably, in the only two instances in which the word “bankruptcy” appears in Justice Scalia’s majority opinion in Grupo Mexicano, he uses the existence of court authority in the bankruptcy context as a reason to support the conclusion that the district court did not have the authority under generalized equity powers to implement the remedy it imposed. First, he pointed out that “[t]he law of fraudulent conveyances and bankruptcy was developed to prevent [the] conduct [at issue]; an equitable power to restrict a debtor's use of his unencumbered property before judgment was not.” Grupo Mexicano, 527 U.S. at 322 (emphasis added). Second, he stressed that finding the authority to justify the District Court’s remedy in generalized equity power would “add[], through judicial fiat, a new and powerful weapon to the creditor’s arsenal[;] the new rule could radically alter the balance between debtor’s and creditor’s rights which has been developed over centuries through many laws– including those relating to bankruptcy, fraudulent conveyances, and preferences.” Id. at 331 (emphasis added). In short, the Court’s opinion in Grupo Mexicano acknowledged that bankruptcy courts do have the authority to deal with the problems presented by that case. One way to conceptualize this idea is to recognize that, had the company in Grupo Mexicano been in bankruptcy, the bankruptcy court 32 unanimous consensus that it is a remedy to be used “sparingly.” In re Augie/Restivo, 860 F.2d at 518; see also In re Bonham, 229 F.3d at 767 (explaining that “almost every other court has noted [that substantive consolidation] should be used would have had the authority to implement the remedy the district court lacked authority to order under general equity power outside the bankruptcy context. As for the argument’s second facet, it begins with a concession. Bankruptcy Code § 1123(a)(5)(C)’s very words allow for “consolidation of the debtor with one or more persons” pursuant to a plan “[n]otwithstanding any otherwise applicable non-bankruptcy law.” Accord Tucker, supra, at 448-49. See also In re Stone & Webster, 286 B.R. at 540-43. Whether § 105(a) allows consolidation outside a plan is an issue we need not address—though that arguably is what the Plan Proponents propose by moving for a “deemed” consolidation—because, as we note below, consolidation, no matter how it is packaged, cannot pass muster in this case. In this context, we also need not address the argument, made in the Amicus Curiae Brief of the Commercial Finance Association, that substantive consolidation fails the “best interests test” of Bankruptcy Code § 1129(a)(7) (a requirement for plan confirmation that each creditor that does not vote to accept the plan must receive or retain property under the plan at least equal to its recovery in a Bankruptcy Code Chapter 7 liquidation). See generally In re Stone & Webster, 286 B.R. at 544-46. 33 ‘sparingly’”) (citing In re Flora Mir, 432 F.2d at 1062-63).15