Opinion ID: 3015323
Heading Depth: 2
Heading Rank: 3

Heading: Application of Substantive Consolidation to

Text: Our Case With the principles we perceive underlie use of substantive consolidation, the outcome of this appeal is apparent at the outset. Substantive consolidation fails to fit the facts of 21 “[T]ort and statutory claimants, who, as involuntary creditors, by definition did not rely on anything in becoming creditors,” Kors, supra, at 418, are excluded, leaving only those creditors who contract with an entity for whom consolidation is sought. 22 As noted already, supra n.16, we do not decide here whether such a showing by an opposing creditor defeats totally the quest for consolidation or merely consolidation as to that creditor. 40 our case and, in any event, a “deemed” consolidation cuts against the grain of all the principles. To begin, the Banks did the “deal world” equivalent of “Lending 101.” They loaned $2 billion to OCD and enhanced the credit of that unsecured loan indirectly by subsidiary guarantees covering less than half the initial debt. What the Banks got in lending lingo was “structural seniority”—a direct claim against the guarantors (and thus against their assets levied on once a judgment is obtained) that other creditors of OCD did not have. This kind of lending occurs every business day. To undo this bargain is a demanding task. 1. N O P RE PE T IT IO N D IS RE G ARD OF C ORPORATE S EPARATENESS Despite the Plan Proponents’ pleas to the contrary, there is no evidence of the prepetition disregard of the OCD entities’ separateness. To the contrary, OCD (no less than CSFB) negotiated the 1997 lending transaction premised on the separateness of all OCD affiliates. Even today no allegation exists of bad faith by anyone concerning the loan.23 In this context, OCD and the other Plan Proponents cannot now ignore, 23 The bondholders do claim certain Banks misled them in purchasing OCD debt subsequent to the 1997 loan. But we know of no claim of wrong by the Banks in connection with the 1997 transaction. 41 or have us ignore, the very ground rules OCD put in place. Playing by these rules means that obtaining the guarantees of separate entities, made separate by OCD’s choice of how to structure the affairs of its affiliate group of companies, entitles a lender, in bankruptcy or out, to look to any (or all) guarantor(s) for payment when the time comes. As such, the District Court’s conclusions of “substantial identity” of OCD and its subsidiaries, and the Banks’ reliance thereon, are incorrect. For example, testimony presented by both the Banks and the Debtors makes plain the parties’ intention to treat the entities separately. CSFB presented testimony from attorneys and bankers involved in negotiating the Credit Agreement that reflected their assessment of the value of the guarantees as partially derived from the separateness of the entities. As OCD concedes, these representatives “testified that the guarant[e]es were . . . intended to provide ‘structural seniority’ to the banks,” and were thus fundamentally premised on an assumption of separateness. Debtors Ans. Br. at 26. In the face of this testimony, Plan Proponents nonetheless argue that the Banks intended to ignore the separateness of the entities. In support of this contention, they assert, inter alia, that because the Banks did not receive independent financial statements for each of the entities during the negotiating process, they must have intended to deal with them as a unified whole. Because the Banks were unaware of the separate financial makeup of the subsidiaries, the argument goes, they 42 could not have relied on their separateness.24 This argument is overly simplistic. Assuming the Banks did not obtain separate financial statements for each subsidiary, they nonetheless obtained detailed information about each subsidiary guarantor from OCD, including information about 24 Debtors make a similar argument on the basis of the Banks’ failure to exercise their right to monitor the entities independently. For much the same reasoning that follows in the text, we reject that argument as well. We reject outright Debtors’ claim that the Banks’ alleged reliance on corporate separateness fails because they did not obtain a third-party legal opinion from counsel that substantive consolidation was unlikely to occur were OCD or the guarantors subject to bankruptcy. By custom and practice this type of counsel opinion is requested and given for newly formed entities whose “special purpose” is to obtain structured financing (i.e., where “a defined group of assets . . . [are] structurally isolated, and thus serve as the basis of a financing . . . .” Committee on Bankruptcy and Corporate Reorganization of The Association of the Bar of the City of New York, Structured Financing Techniques, 50 Bus. Law. 527, 529 (1995)). It is customarily not given (nor even requested) for entities in existence for any significant period of time or set up for other than a structured financing transaction. See Tribar Opinion Committee, Opinions in the Bankruptcy Context: Rating Agency, Structured Financing, and Chapter 11 Transactions, 46 Bus. Law, 717, 726 & n.42 (1991). 43 that subsidiary’s assets and debt. Moreover, the Banks knew a great deal about these subsidiaries. For example, they knew that each subsidiary guarantor had assets with a book value of at least $30 million as per the terms of the Credit Agreement, that the aggregate value of the guarantor subsidiaries was over $900 million and that those subsidiaries had little or no debt. Additionally, the Banks knew that Fibreboard’s subsidiaries (including the entities that became part of ESI) had no asbestos liability, would be debt-free post-acquisition and had assets of approximately $700 million. Even assuming the Plan Proponents could prove prepetition disregard of Debtors’ corporate forms, we cannot conceive of a justification for imposing the rule that a creditor must obtain financial statements from a debtor in order to rely reasonably on the separateness of that debtor. Creditors are free to employ whatever metrics they believe appropriate in deciding whether to extend credit free of court oversight. We agree with the Banks that “the reliance inquiry is not an inquiry into lenders’ internal credit metrics. Rather, it is about the fact that the credit decision was made in reliance on the existence of separate entities . . . .” CSFB Opening Br. at 31 (emphasis in original).25 Here there is no serious dispute as to that fact. 25 Further, a creditor’s lack of diligence is relevant only insofar as it bears on the credibility of its assertion of reliance on separateness. 44 2. N O H OPELESS C OMMINGLING E XISTS P OSTPETITION There also is no meaningful evidence postpetition of hopeless commingling of Debtors’ assets and liabilities. Indeed, there is no question which entity owns which principal assets and has which material liabilities. Likely for this reason little time is spent by the parties on this alternative test for substantive consolidation. It is similarly likely that the District Court followed suit. The Court nonetheless erred in concluding that the commingling of assets will justify consolidation when “the affairs of the two companies are so entangled that consolidation will be beneficial.” In re Owens Corning, 316 B.R. at 171 (emphasis added). As we have explained, commingling justifies consolidation only when separately accounting for the assets and liabilities of the distinct entities will reduce the recovery of every creditor—that is, when every creditor will benefit from the consolidation. Moreover, the benefit to creditors should be from cost savings that make assets available rather than from the shifting of assets to benefit one group of creditors at the expense of another. Mere benefit to some creditors, or administrative benefit to the Court, falls far short. The District Court’s test not only fails to adhere to the theoretical justification for “hopeless commingling” consolidation—that no creditor’s rights will be impaired—but also suffers from the infirmity that it will almost always be met. That is, substantive consolidation will nearly 45 always produce some benefit to some in the form of simplification and/or avoidance of costs. Among other things, following such a path misapprehends the degree of harm required to order substantive consolidation. But no matter the legal test, a case for hopeless commingling cannot be made. Arguing nonetheless to the contrary, Debtors assert that “it would be practically impossible and prohibitively expensive in time and resources” to account for the voluntary bankruptcies of the separate entities OCD has created and maintained. Debtors Ans. Br. at 63. In support of this contention, Debtors rely almost exclusively on the District Court’s findings that it would be exceedingly difficult to untangle the financial affairs of the various entities . . . [and] there are . . . many reasons for challenging the accuracy of the results achieved [in accounting efforts thus far]. For example, transfers of cash between subsidiaries and parent did not include any payment of interest; and calculations of royalties are subject to question. In re Owens Corning, 316 B.R. at 171. Assuming arguendo that these findings are correct, they are simply not enough to 46 establish that substantive consolidation is warranted. Neither the impossibility of perfection in untangling the affairs of the entities nor the likelihood of some inaccuracies in efforts to do so is sufficient to justify consolidation. We find R 2 Investments, LDC v. World Access, Inc. (In re World Access, Inc.), 301 B.R. 217 (Bankr. N.D. Ill. 2003), instructive on this point. In World Access the Court noted that the controlling entity “had no uniform guidelines for the recording of intercompany interest charges” and that the debtors failed to “allocate overhead charges amongst themselves.” Id. at 234. The Court held, however, that those accounting shortcomings were “merely imperfections in a sophisticated system of accounting records that were conscientiously maintained.” Id. at 279. It ultimately concluded that “all the relevant accounting data . . . still exist[ed],” that only a “reasonable review to make any necessary adjustments [was] required,” and, thus, that substantive consolidation was not warranted. Id. The record in our case compels the same conclusion. At its core, Debtors’ argument amounts to the contention that because intercompany interest and royalty payments were not perfectly accounted for, untangling the finances of those entities is a hopeless endeavor. Yet imperfection in intercompany accounting is assuredly not atypical in large, complex company structures. See, e.g., Lynn M. LoPucki, The Myth of the Residual Owner, 16 n.50 (2004), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=401160. 47 For obvious reasons, we are loathe to entertain the argument that complex corporate families should have an expanded substantive consolidation option in bankruptcy. And we find no reason to doubt that “perfection is not the standard in the substantive consolidation context.” In re World Access, 301 B.R. at 279. We are confident that a court could properly order and oversee an accounting process that would sufficiently account for the interest and royalty payments owed among the OCD group of companies for purposes of evaluating intercompany claims—dealing with inaccuracies and difficulties as they arise and not in hypothetical abstractions. On the basis of the record before us, the Plan Proponents cannot fulfill their burden of demonstrating that Debtors’ affairs are even tangled, let alone that the cost of untangling them is so high relative to their assets that the Banks, among other creditors, will benefit from a consolidation.26 3. O THER C ONSIDERATIONS D OOM C ONSOLIDATION AS W ELL Other considerations drawn from the principles we set out also counsel strongly against consolidation. First of all, 26 For example, we simply cannot imagine that it would cost Debtors even 1% of the Banks’ asserted $1.6 billion claim to account for the allegedly incalculable intercompany interest and royalty payments. 48 holding out the possibility of later giving priority to the Banks on their claims does not cure an improvident grant of substantive consolidation. Among other things, the prerequisites for this last-resort remedy must still be met no matter the priority of the Banks’ claims. Secondly, substantive consolidation should be used defensively to remedy identifiable harms, not offensively to achieve advantage over one group in the plan negotiation process (for example, by deeming assets redistributed to negate plan voting rights), nor a “free pass” to spare Debtors or any other group from proving challenges, like fraudulent transfer claims, that are liberally brandished to scare yet are hard to show. If the Banks are so vulnerable to the fraudulent transfer challenges Debtors have teed up (but have not swung at for so long), then the game should be played to the finish in that arena.27 But perhaps the flaw most fatal to the Plan Proponents’ proposal is that the consolidation sought was “deemed” (i.e., a 27 The same sentiment applies to the argument of the bondholders that, subsequent to the 1997 loan to OCD, the Banks defrauded them in connection with a prospectus distributed with respect to a sale of OCD bonds underwritten by some of the Banks. If the bondholders have a valid claim, they need to prove it in the District Court and not use their allegations as means to gerrymander consolidation of estates. 49 pretend consolidation for all but the Banks). If Debtors’ corporate and financial structure was such a sham before the filing of the motion to consolidate, then how is it that post the Plan’s effective date this structure stays largely undisturbed, with the Debtors reaping all the liability-limiting, tax and regulatory benefits achieved by forming subsidiaries in the first place? In effect, the Plan Proponents seek to remake substantive consolidation not as a remedy, but rather a stratagem to “deem” separate resources reallocated to OCD to strip the Banks of rights under the Bankruptcy Code, favor other creditors, and yet trump possible Plan objections by the Banks. Such “deemed” schemes we deem not Hoyle.