Opinion ID: 562372
Heading Depth: 2
Heading Rank: 1

Heading: The Legal Framework for Substantive Consolidation

Text: 9 While not specifically authorized by the bankruptcy code, bankruptcy courts have the power to order substantive consolidation by virtue of their general equitable powers. See, e.g., Union Savings Bank v. Augie/Restivo Baking Co. (In re Augie/Restivo Baking Co.), 860 F.2d 515, 518 & n. 1 (2d Cir.1988); Drabkin v. Midland-Ross Corp. (In re Auto-train Corp.), 810 F.2d 270, 276 (D.C.Cir.1987). 9 The purpose of substantive consolidation is to insure the equitable treatment of all creditors. In re Murray Indus., 119 B.R. 820, 830 (Bankr.M.D.Fla.1990). It involves the pooling of the assets and liabilities of two or more related entities; the liabilities of the entities involved are then satisfied from the common pool of assets created by consolidation. See In re Augie/Restivo Baking Co., 860 F.2d at 518; Holywell Corp. v. Bank of New York, 59 B.R. 340, 347 (S.D.Fla.1986). In a Chapter 11 consolidation case, the creditors of the consolidated entities are combined for the purpose of voting on reorganization plans. In re Augie/Restivo Baking Co., 860 F.2d at 518. In addition, substantive consolidation eliminates the inter-corporate liabilities of the consolidated entities. Id; see also Holywell Corp., 59 B.R. at 347. 10 Because the entities to be consolidated are likely to have different debt-to-asset ratios, consolidation almost invariably redistributes wealth among the creditors of the various entities. In re Auto-train, 810 F.2d at 276. Thus, courts have stated that substantive consolidation should be used sparingly. See In re Continental Vending Machine Corp., 517 F.2d at 1001 (quoting Chemical Bank New York Trust Co. v. Kheel, 369 F.2d 845, 847 (2d Cir.1966)). There is, however, a modern or liberal trend 10 toward allowing substantive consolidation, whichhas its genesis in the increased judicial recognition of the widespread use of interrelated corporate structures by subsidiary corporations operating under a parent entity's corporate umbrella for tax and business purposes. 11 In re Murray Indus., 119 B.R. at 828-29. 12 We have never addressed the issue of the standard which bankruptcy courts in this circuit should employ in making a determination of whether substantive consolidation is warranted. It is agreed that the basic criterion by which to evaluate a proposed substantive consolidation is whether the economic prejudice of continued debtor separateness outweighs the economic prejudice of consolidation. See In re Snider Bros., Inc., 18 B.R. 230, 234 (Bankr.D.Mass.1982). In other words, a court must conduct a searching inquiry to ensure that consolidation yields benefits offsetting the harm it inflicts on objecting parties. In re Auto-train, 810 F.2d at 276. 13 The D.C. Circuit has elaborated a standard, which we adopt today, by which to determine whether to grant a motion for substantive consolidation. Under this standard, the proponent of substantive consolidation must show that (1) there is substantial identity between the entities to be consolidated; and (2) consolidation is necessary to avoid some harm or to realize some benefit. Id; see also In re Murray Indus., 119 B.R. at 829; Matter of Lewellyn, 26 B.R. 246, 251 (Bankr.S.D.Iowa 1982); In re Snider Bros., 18 B.R. at 238. When this showing is made, a presumption arises that creditors have not relied solely on the credit of one of the entities involved. Matter of Lewellyn, 26 B.R. at 251-52. Once the proponent has made this prima facie case for consolidation, the burden shifts to an objecting creditor to show that (1) it has relied on the separate credit of one of the entities to be consolidated; and (2) it will be prejudiced by substantive consolidation. See In re Auto-train, 810 F.2d at 276 (a creditor may object on the grounds that it relied on the separate credit of one of the entities and that it will be prejudiced by the consolidation); see also Matter of Lewellyn, 26 B.R. at 252 (once the proponent of consolidation makes out a prima facie case the burden shifts to the objector to show there was sole reliance on the credit of one entity); In re Snider Bros., 18 B.R. at 238 (that objecting creditor has looked solely to the credit of its debtor and is certain to suffer more than minimal harm as a result of consolidation constitutes defense to substantive consolidation). 11 Finally, if an objecting creditor has made this showing, the court may order consolidation only if it determines that the demonstrated benefits of consolidation 'heavily' outweigh the harm. In re Auto-train, 810 F.2d at 276. 14 In making his prima facie case for consolidation, the proponent of consolidation may want to frame his argument using the seven factors outlined in In re Vecco Construction Industries, Inc. 12 : 15 (1) The presence or absence of consolidated financial statements. 16 (2) The unity of interests and ownership between various corporate entities. 17 (3) The existence of parent and intercorporate guarantees on loans. 18 (4) The degree of difficulty in segregating and ascertaining individual assets and liabilities. 19 (5) The existence of transfers of assets without formal observance of corporate formalities. 20 (6) The commingling of assets and business functions. 21 (7) The profitability of consolidation at a single physical location. 22 See In re Murray Indus., 119 B.R. at 830; Holywell Corp., 59 B.R. at 347. 13 Additional factors that could be presented in some cases include (1) the parent owning the majority of the subsidiary's stock; (2) the entities having common officers or directors; (3) the subsidiary being grossly undercapitalized; (4) the subsidiary transacting business solely with the parent; and (5) both entities disregarding the legal requirements of the subsidiary as a separate organization. Pension Benefit Guar. Corp. v. Ouimet Corp., 711 F.2d 1085, 1093 (1st Cir.1983). We stress, however, that we mention the specific factors set out in Vecco, Ouimet, and elsewhere only as examples of information that may be useful to courts charged with deciding whether there is a substantial identity between the entities to be consolidated and whether consolidation is necessary to avoid some harm or to realize some benefit. 14 No single factor is likely to be determinative in the court's inquiry.