Court Opinion

ID: 150344
Source: CourtListenerOpinion
Date Created: 2010-07-09 16:56:42+00
Date Added: 2024-06-11T12:37:45.304770
License: Public Domain

NOT PRECEDENTIAL
                     UNITED STATES COURT OF APPEALS
                          FOR THE THIRD CIRCUIT

                                    No. 09-1261

                 IN RE: GARDEN RIDGE CORPORATION, et al.,

                                                            Debtor,

                               DANIEL FERGUSON,

                                                            Appellant.

                   On Appeal from the United States District Court
                             for the District of Delaware
                              (D. C. No. 1-06-cv-00213)
                    District Judge: Honorable Gregory M. Sleet

                            Argued on November 9, 2009

                Before: AMBRO, GARTH and ROTH, Circuit Judges

                            (Opinion filed: July 9, 2010)

William D. Sullivan, Esquire (Argued)
Sullivan, Hazeltine, Allinson, LLC
4 East 8 th Street, Suite 400
Wilmington, DE 19801

                         Counsel for Appellant Daniel Ferguson

Pauline K. Morgan, Esquire
Joseph M. Barry, Esquire (Argued)
Sean T. Greecher, Esquire
The Brandywine Building
1000 West Street, 17 th Floor
Wilmington, DE 19801
Ian S. Fredericks, Esquire
Skadden, Arps, Slate, Meagher & Flom
One Rodney Square
P. O. Box 636
Wilmington, DE 19899

David B. Stratton, Esquire
Pepper Hamilton
1313 Market Street, Suite 5100
P. O. Box 1709
Wilmington, DE 19899-1709

                           Counsel for Appellee Garden Ridge Corporation

Christian M. Thompson, Esquire
Connolly, Bove, Lodge & Hutz
1007 North Orange Street
P. O. Box 2207
Wilmington, DE 19899

                           Counsel for Appellee Concord Mall, LTD Partnership

James C. Carignan, Esquire
David M. Fournier, Esquire
Pepper Hamilton
1313 Market Street, Suite 5100
P. O. Box 1709
Wilmington, DE 19899-1709

                           Counsel for Appellee Official Committee of Unsecured Creditors

David M. Klauder, Esquire
United States Department of Justice
Office of the Trustee
844 King Street, Suite 2207
Lockbox 35
Wilmington, DE 19801
                            Counsel for Appellee United States Trustee

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                                      OPINION

ROTH, Circuit Judge:

       Daniel Ferguson, a creditor of the Garden Ridge debtors, appeals the District

Court’s denial of his setoff claim under sections 362(d) and 553(a) of the United States

Bankruptcy Code. We will affirm.

I. Background

       Because we write primarily for the parties, we only briefly recite the facts. In

2001, Garden Ridge Management, Inc., hired Ferguson as an executive employee.

Ferguson’s employment contract included severance pay of $250,000 and reimbursement

of $60,000 in relocation expenses. Upon commencing employment, Ferguson borrowed

$250,000 from Garden Ridge, L.P., under the terms of a written promissory note. In

2003, Garden Ridge Management, Inc., terminated Ferguson’s employment. Ferguson

filed a state law contract claim for damages of $310,000 (severance pay of $250,000 and

relocation expenses of $60,000). Garden Ridge, L.P., later filed an action against

Ferguson in federal court for collection on the $250,000 promissory note.

       In 2004, Garden Ridge Management, Inc., and six related corporate entities filed

for bankruptcy protection under Chapter 11. On March 29, 2005, the debtors filed a

proposed reorganization plan including a request for substantive consolidation.

Substantive consolidation “treats separate legal entities as if they were merged into a

                                             3
single survivor left with all the cumulative assets and liabilities.” In re Owens Corning,

419 F.3d 195, 205 (3d Cir. 2005). The proposed plan allowed the debtors to reserve all

legal and equitable defenses, but deemed the assets and liabilities of all Garden Ridge

debtors merged with the assets and liabilities of Garden Ridge, L.P. (A-473.) On April

28, 2005, the Bankruptcy Court confirmed the proposed substantive consolidation in the

plan because the debtors, in effect, functioned as a single entity.1 (A-591 to -592.)

       Ferguson, whose state law action was automatically stayed by the bankruptcy filing

under 11 U.S.C. § 362, asserted a claim against the bankruptcy estate for $310,000.

Claiming the existence of mutual debts – i.e., Ferguson’s debt of $250,000 and Garden

Ridge’s debt of $310,000 – Ferguson brought a setoff claim under state law, which would

place him in the position of an unsecured creditor for $60,000 ($310,000 less $250,000).

(Bankr. D.I. 1518, Apr. 13, 2005); see 11 U.S.C. § 553(a). Garden Ridge objected to

Ferguson’s setoff claim for lack of mutuality because the transactions involved two

separate Garden Ridge entities. Ferguson’s breach of contract claim related solely to his

employment by Garden Ridge Management, Inc., an entity that employed all of Garden

Ridge’s staff. Ferguson’s promissory note was held by Garden Ridge, L.P., an entity that

operated Garden Ridge’s stores and paid Garden Ridge Management, Inc., a fee for use of

its employees.

       1
         On the date of confirmation, Ferguson’s claim for damages against Garden
Ridge Management, Inc., and his loan with Garden Ridge, L.P., were at issue between the
parties.

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       Ferguson argues that, even if Garden Ridge Management, Inc., and Garden Ridge,

L.P., were separate entities when he transacted with them, the Bankruptcy Court’s

confirmation of substantive consolidation effectively merged the entities, thereby creating

mutuality for setoff purposes.

II. Discussion

       The District Court had jurisdiction pursuant to 28 U.S.C. § 158(a)(1) over the

appeal from the Bankruptcy Court, which had jurisdiction pursuant to 28 U.S.C. § 157(b).

We have jurisdiction over this appeal pursuant to 28 U.S.C. §§ 1291 and 158(d). The

District Court’s determinations are subject to plenary review. In re Prof’l Ins. Mgmt., 285
F.3d 268, 282-83 (3d Cir. 2002). The Bankruptcy Court’s factual determinations are

reviewed for clear error and its legal determinations are reviewed de novo. Id.

       Setoff rights arise under the common law of equity and “allow[] entities that owe

each other money to apply their mutual debts against each other, thereby avoiding the

absurdity of making A pay B when B owes A.” Citizens Bank v. Strumpf, 516 U.S. 16, 19

(1995) (internal quotation marks omitted). To perfect a setoff claim, the party asserting

setoff rights must prove the debts between the creditor and debtor are mutual. See In re

APF Co., 264 B.R. 344, 354 (Bankr. D. Del. 2001); see also In re Czyzk, 297 B.R. 406,

409 (Bankr. D.N.J. 2003).

       The question presented is whether substantive consolidation created mutuality for

setoff purposes even though, absent substantive consolidation, the element of mutuality

                                             5
would not have otherwise been satisfied. The debts of Ferguson and Garden Ridge, Inc.,

would only be mutual if Garden Ridge, Inc., and Garden Ridge, L.P., had disregarded

their entity separateness, a question the Bankruptcy Court did not decide when it

confirmed the reorganization plan because the then-prevailing standard for substantive

consolidation did not require such a finding. This Court’s subsequent decision in Owens

Corning, which held that substantive consolidation is appropriate when debtors disregard

their entity separateness, 419 F.3d at 211, does not operate as an ex post facto finding that

the Garden Ridge entities disregarded the entity separation. Whether the Garden Ridge

entities lost their mutuality defense because they disregarded entity separateness when

dealing with Ferguson is a factual question not resolved at the time of substantive

consolidation and raised for the first time in this adversarial proceeding.

       The element of mutuality is not satisfied for two related reasons. First, as the

Bankruptcy Court found, the record does not support Ferguson’s claim that, when he dealt

with Garden Ridge Management, Inc., and Garden Ridge, L.P., he believed they were

alter egos because they had acted in disregard of their corporate separateness. Second,

the Bankruptcy Court’s factual determination that Ferguson was employed by Garden

Ridge Management, Inc., and not Garden Ridge, L.P., has support in the record and is not

clearly erroneous. Ferguson was an executive of Garden Ridge and understood its

business operations. His debt to Garden Ridge, L.P., cannot be setoff against his claim

against Garden Ridge Management, Inc., because those debts are not mutual.

                                              6
      Although substantively consolidated with the other Garden Ridge entities, Garden

Ridge, L.P., preserved its defense to Ferguson’s setoff claim on grounds of lack of

mutuality. In the reorganization proceeding, the Bankruptcy Court approved a

substantive consolidation provision allowing the Garden Ridge debtors to retain all “legal

or equitable defense[s] that the Debtors had immediately prior to the Petition Date.” (A-

483 (Reorganization Plan, Art. VIII(F), p. 36).) The controversy between Ferguson and

the Garden Ridge entities was live at the time of the Chapter 11 proceeding, so the

Garden Ridge entities must have consented to the substantive consolidation provision

confirmed by the Bankruptcy Court with the mutuality defense in mind. Had Owens

Corning been precedent when the Garden Ridge entities were substantively consolidated

on April 28, 2005, the Bankruptcy Court might have considered other factors in

determining the appropriateness of that relief. But because Owens Corning was not

decided until August 15, 2005, the Bankruptcy Court’s prior confirmation of substantive

consolidation should not defeat the mutuality defense preserved here.

III. Conclusion

      For the reasons stated above, we will affirm the judgments of the Bankruptcy

Court and District Court.

AMBRO, Circuit Judge, dissenting

      This case turns on the meaning of substantive consolidation, a topic we addressed

                                            7
in In re Owens Corning, 419 F.3d 195 (3d Cir. 2005). Unlike Owens Corning, here we

are not confronted with a dispute over whether such a strong equitable remedy for a

reorganization is appropriate, as neither side wants to undo the deemed consolidation

contained in the debtors’ Plan of Reorganization. See id. at 211 (recognizing that deemed

consolidation is consensual).2 The only question is whether Ferguson is entitled to

benefit from that consolidation in the form of a setoff. Because I believe the substantive

consolidation here necessarily destroyed a mutuality defense to setoff, I would reverse the

judgment of the District Court (which affirmed the Bankruptcy Court’s decision) and

allow Ferguson to claim a setoff.

       Substantive consolidation . . . “treats separate legal entities as if they were
       merged into a single survivor left with all the cumulative assets and liabilities
       (save for inter-entity liabilities, which are erased). The result is that claims of
       creditors against separate debtors morph to claims against the consolidated
       survivor.” Consolidation restructures (and thus revalues) rights of creditors
       and for certain creditors this may result in significantly less recovery.

       ....

       Substantive consolidation . . . affects distribution to innocent creditors . . . .
       The bad news for certain creditors is that, instead of looking to assets of the
       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.

       2
            My colleagues conflate a deemed consolidation with consolidation to remedy a pre-
petition disregard of entity separateness. The former must have the consent of interested parties.
While the latter conceivably may be consensual, it typically is achieved by a Court finding over
objection (in which the Bankruptcy Court would consider the principles set out in Owens
Corning). Thus, any reference in the majority’s opinion to “disregard[ing] entity separateness
. . . [as] a factual question” is not relevant here.

                                                8
Id. at 205–06 (quoting Genesis Health Ventures, Inc. v. Stapleton (In re Genesis Health

Ventures, Inc.), 402 F.3d 416, 423 (3d Cir. 2005)). In short, substantive consolidation is a

blunt instrument that has a profound effect on creditors’ rights.

       As a result of the substantive consolidation of the Garden Ridge debtors, all assets

and all liabilities of all debtors were deemed the assets and liabilities of Garden Ridge,

L.P., “for all purposes related to the Plan,” and “each and every Claim filed or to be filed

shall be deemed filed against the Consolidated Debtors, and shall be deemed one claim

against and obligation of the Consolidated Debtors.” J.A. 473 (Reorganization Plan, Art.

VI). The effect of this consolidation is extraordinary; while some of the individual

Garden Ridge debtors could claim the “I do not owe you” defense to creditors of other

individual Garden Ridge debtors prior to consolidation, that defense was no longer

available after consolidation.

       For example, assume companies X, Y, and Z are independent legal entities. X

borrows only from Bank A, Y borrows only from Bank B, and Z borrows only from Bank

C. Bank A can only collect from company X, for companies Y and Z do not owe Bank A

any money. Indeed, if Bank A tried to collect from companies Y and Z, each would

simply respond “I do not owe you” and refuse to pay.

       However, assume that companies X, Y, and Z file for bankruptcy and are

substantively consolidated into debtor XYZ. The assets of companies X, Y, and Z thus

are pooled into XYZ. So are the liabilities. Hence, Banks A, B, and C all have claims

                                              9
against XYZ. Whereas before consolidation Bank A did not have any claim against the

assets of companies Y or Z, it now does. Furthermore, while it used to have the sole

claim against the assets of company X, it now shares those assets with Banks B and C.

This is how “[c]onsolidation restructures (and thus revalues) rights of creditors and for

certain creditors this may result in significantly less recovery.” Owens Corning, 419 F.3d

at 205.

          The situation is no different in this case. Ferguson had a claim against one of the

Garden Ridge debtors (which, if proven, is a liability of that debtor). He also owed

money to a different one of the Garden Ridge debtors (so it is an asset of that other

debtor). For ease of administering the debtors’ reorganization, a deemed consolidation

ignores walls of separation in the claims process. This is the essence of the consensual

tack taken. Fortunately for Ferguson (and unfortunately for some of Garden Ridge’s

other creditors), this means that he now has a claim against the consolidated debtor,

Garden Ridge, L.P., as well as a debt to that same consolidated debtor. By virtue of the

deemed consolidation, the debts are now deemed mutual.

          As the majority recognizes, setoff rights “allow[] entities that owe each other

money to apply their mutual debts against each other, thereby avoiding the absurdity of

making A pay B when B owes A.” Citizens Bank of Md. v. Strumpf, 516 U.S. 16, 18

(1995) (internal quotation marks omitted). As a consequence of the deemed

consolidation, Ferguson owes Garden Ridge, L.P., and Garden Ridge, L.P., owes

                                               10
Ferguson. Accordingly, Ferguson is entitled to a setoff.

          My colleagues believe, however, that this result is side-stepped when the Plan

buries a single sentence in another section that the debtors retain all “legal or equitable

defense[s] . . . [they] had immediately prior to the Petition Date” that are “not specifically

waived or relinquished by th[e] Plan,” and the Plan does neither specifically. See J.A.

483 (Reorganization Plan, Art. VIII.F). My response is that substantive consolidation by

definition destroys the mutuality defense—it turns assets and liabilities of individual

entities into assets and liabilities of a single consolidated entity. The “I do not owe you”

defense is necessarily destroyed, and there is no mutuality barrier to setoff. Garden Ridge

may find this outcome distasteful, but it is a side effect of the strong medicine of

substantive consolidation. Its effect “restructures . . . the rights of creditors,” Owens

Corning, 419 F.3d at 205, occasionally aiding one like Ferguson. That is the nature of the

beast.3

          What does this case mean in practice? The majority opinion allows the debtors to

play “heads I win, tails you lose” with Ferguson. The debtors apparently are consolidated

only when Ferguson owes them money, but not when they owe him money. Instead of

potentially offsetting $250,000 of mutual debt (“real dollars,” i.e., 100 cents on the dollar)

and leaving Ferguson with an unsecured $60,000 claim (“bankruptcy dollars,” i.e., if the

          3
         The majority here concludes the “Garden Ridge entities must have consented to the
substantive consolidation provision.” As they proposed it, no doubt they consented. If the
majority meant that Ferguson consented, it is true that he did not object to the proposal of a
deemed consolidation, likely because he perceived it as removing an obstacle to his setoff claim.

                                               11
claim is allowed, only a portion of each dollar is paid) against the consolidated debtors,

under my colleagues’ reading Ferguson owes $250,000 (“real dollars”) to the

consolidated debtors and has an unsecured $310,000 claim (“bankruptcy dollars”) against

them.

        Going forward, creditors are forewarned that debtor Jekyll seeking a deemed

consolidation for claims purposes may become debtor Hyde when it comes to the

consequences of that consolidation. For these reasons, I respectfully dissent.

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