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

Heading: Our View of Substantive Consolidation

Text: Substantive consolidation exists as an equitable remedy. But when should it be available and by what test should its use be measured? As already noted, we have commented on substantive consolidation only generally in Nesbit, 347 F.3d at 86-88, and In re Genesis Health Ventures, 402 F.3d at 423-24. The latter nonetheless left little doubt that, if presented with a choice of analytical avenues, we favor essentially that of Augie/Restivo. Id. at 423. The Auto-Train approach (requiring “substantial identity” of entities to be consolidated, plus that consolidation is “necessary to avoid some harm or realize some benefit,” 810 F.2d at 276) adopts, we presume, one of the Augie/Restivo touchstones for substantive consolidation while adding the low bar of avoiding some harm or discerning some benefit by consolidation. To us this fails to capture completely the few times substantive consolidation may be considered and then, when it does hit one chord, it allows a threshold not 15 Thus we disagree with the assertion of a “liberal trend” toward increased use of substantive consolidation—e.g., Eastgroup, 935 F.2d at 248 (describing “a ‘modern’ or ‘liberal’ trend toward allowing substantive consolidation”) (citing In re Murray Indus., Inc., 119 B.R. 820, 828 (Bankr. M.D. Fla. 1990)); In re Vecco Construction Industries, Inc., 4 B.R. 407, 409 (Bankr. E.D. Va. 1980). 34 sufficiently egregious and too imprecise for easy measure. For example, we disagree that “[i]f 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.” Id. at 276 (citation omitted); see also Eastgroup, 935 F.2d at 249. If an objecting creditor relied on the separateness of the entities, consolidation cannot be justified vis-à-vis the claims of that creditor.16 In assessing whether to order substantive consolidation, courts consider many factors (some of which are noted in Nesbit, 347 F.3d at 86-88 nn. 7 & 9). They vary (with degrees of overlap) from court to court. Rather than endorsing any prefixed factors, in Nesbit we “adopt[ed] an intentionally openended, equitable inquiry. . . to determine when substantively to 16 This opens the question whether a court can order partial consolidation (such a consolidation order “could provide that . . . [a creditor relying on separateness] would receive a distribution equal to what [it] would have received absent consolidation and that the remainder of the assets and liabilities be consolidated.”) Kors, supra, at 450-51. Because this theoretical issue is not before us—and in any event (i) facts bringing it to the fore are unlikely, id. at 451 (“If circumstances lead one party to rely on the single status of the one debtor, it is unlikely that other creditors are relying on the joint status of the two entities, especially as reliance must be reasonable.”), and (ii) may present practical concerns depending on the facts of a particular case—we do not decide it in this case. 35 consolidate two entities.” Id. at 87. While we mentioned that “in the bankruptcy context the inquiry focuses primarily on financial entanglement,” id., this comment primarily related to the hopeless commingling test of substantive consolidation. But when creditors deal with entities as an indivisible, single party, “the line between operational and financial [factors] may be blurred.” Id. at 88. We reiterate that belief here. Too often the factors in a check list fail to separate the unimportant from the important, or even to set out a standard to make the attempt. Accord Br. of Law Professors 17 as Amici Curiae at 11-12. This often results in rote following of a form containing factors where courts tally up and spit out a score without an eye on the principles that give the rationale for substantive consolidation (and why, as a result, it should so seldom be in play). Id. (“[D]iffering tests with . . . agreed . . . factors run the risk that courts will miss the forest for the trees. Running down factors as a check list can lead a court to lose sight of why we have substantive consolidation in the first instance . . . and often [to] fail [to] identify a metric by which [it] can . . . [assess] the relative importance among the factors. The . . . [result is] resort to ad hoc balancing without a steady eye on the . . . [principles] 17 They are Robert K. Rasmussen of Vanderbilt Law School, Barry Adler of the NYU School of Law, Susan Block-Leib of Fordham University School of Law, G. Marcus Cole of Stanford Law School, Marcel Kahan of the NYU School of Law, Ronald J. Mann of the University of Texas Law School, and David A. Skeel, Jr. of the University of Pennsylvania School of Law. 36 to be advanced . . . .”). What, then, are those principles? We perceive them to be as follows. (1) Limiting the cross-creep of liability by respecting entity separateness is a “fundamental ground rule[].” Kors, supra, at 410. As a result, the general expectation of state law and of the Bankruptcy Code, and thus of commercial markets, is that courts respect entity separateness absent compelling circumstances calling equity (and even then only possibly substantive consolidation) into play. (2) The harms substantive consolidation addresses are nearly always those caused by debtors (and entities they control) who disregard separateness.18 Harms caused by creditors typically are remedied by provisions found in the Bankruptcy Code (e.g., fraudulent transfers, §§ 548 and 544(b)(1), and equitable subordination, § 510(c)). (3) Mere benefit to the administration of the case (for example, allowing a court to simplify a case by avoiding 18 Though creditors conceivably can cause debtors to conflate separate organizational forms, the specter of lender liability (which came to the fore in only the last two decades) makes this theoretical possibility all the more remote. 37 other issues or to make postpetition accounting more convenient) is hardly a harm calling substantive consolidation into play. (4) Indeed, because substantive consolidation is extreme (it may affect profoundly creditors’ rights and recoveries) and imprecise, this “rough justice” remedy should be rare and, in any event, one of last resort after considering and rejecting other remedies (for example, the possibility of more precise remedies conferred by the Bankruptcy Code). (5) While substantive consolidation may be used defensively to remedy the identifiable harms caused by entangled affairs, it may not be used offensively (for example, having a primary purpose to disadvantage tactically a group of creditors in the plan process or to alter creditor rights). 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,19 or (ii) postpetition their assets and liabilities are so 19 This rationale is meant to protect in bankruptcy the prepetition expectations of those creditors. Accord Kors, supra, 38 scrambled that separating them is prohibitive and hurts all creditors.20 Proponents of substantive consolidation have the burden of showing one or the other rationale for consolidation. The second rationale needs no explanation. The first, however, is more nuanced. A prima facie case for it typically exists when, based on the parties’ prepetition dealings, a proponent proves corporate disregard creating contractual expectations of at 419. The usual scenario is that creditors have been misled by debtors’ actions (regardless whether those actions were intentional or inadvertent) and thus perceived incorrectly (and relied on this perception) that multiple entities were one. 20 This rationale is at bottom one of practicality when the entities’ assets and liabilities have been “hopelessly commingled.” In re Gulfco Inv., 593 F.2d at 929; In re Vecco, 4 B.R. at 410. Without substantive consolidation all creditors will be worse off (as Humpty Dumpty cannot be reassembled or, even if so, the effort will threaten to reprise Jarndyce v. Jarndyce, the fictional suit in Dickens’ Bleak House where only the professionals profited). With substantive consolidation the lot of all creditors will be improved, as consolidation “advance[s] one of the primary goals of bankruptcy–enhancing the value of the assets available to creditors . . .–often in a very material respect.” Kors, supra, at 417 (citation omitted). 39 creditors 21 that they were dealing with debtors as one indistinguishable entity. Kors, supra, at 417-18; Christopher W. Frost, Organizational Form, Misappropriation Risk and the Substantive Consolidation of Corporate Groups, 44 Hastings L.J. 449, 457 (1993). Proponents who are creditors must also show that, in their prepetition course of dealing, they actually and reasonably relied on debtors’ supposed unity. Kors, supra, at 418-19. Creditor opponents of consolidation can nonetheless defeat a prima facie showing under the first rationale if they can prove they are adversely affected and actually relied on debtors’ separate existence.22