The ABC's of Substantive Consolidation, Part I

Bankruptcy & Restructuring Advisor

PUBLISHED ON: January 4, 2004

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The phenomenon of mega-bankruptcy cases of huge corporations with multiple businesses and scores, if not hundreds, of constituent legal entities as subsidiaries is a recent development. While not all large, multi-national corporations have subsidiary issuers or guarantors of funded debt, a great many of them do, and most all of them have separate trade creditors for many separate legal entities. Thus, it has been widely reported that substantive consolidation is a hotly contested issue in the Enron, Worldcom, K-Mart, and Owens Corning megabankruptcy cases, among others.

Part one of this two-part series discusses generally the availability of substantive consolidation for related debtor and non-debtor entities, as well as their creditors. Part two will focus on the legal standards, burdens and key factors courts apply in determining whether substantive consolidation is proper in a given bankruptcy case.

What Is It?

Substantive consolidation is an equitable remedy which permits a bankruptcy court to ignore corporate distinctions, combine the assets and liabilities of separate and distinct — but related — legal entities into a single pool and treat them as though they belong to a single entity. The consolidated assets create a single fund from which all claims against the consolidated debtors are satisfied; the merged companies’ inter-company claims are extinguished; and the creditors of the consolidated entities are combined for purposes of voting on plans of reorganization.

“The primary purpose of substantive consolidation is to ensure the equitable treatment of all creditors.’” Bonham v. Compton (In re Bonham), 229 F.3d 750, 764 (9th Cir. 2000) (citations omitted). This does not mean, however, that substantive consolidation is improper if it would cause any harm to a creditor. Indeed, the law of substantive consolidation recognizes that there will always be some measure of harm because “consolidation almost invariably redistributes wealth among the creditors of the various entities.” Auto-Train Corp. v. Midland-Ross Corp. (In re AutoTrain), 810 F.2d 270, 276 (D.C. Cir. 1987). This almost necessarily results because “[t]he creditor of a debtor whose asset-to-liability ratio is higher than that of its affiliated debtor will receive a proportionately smaller satisfaction of its claim because the asset-to-liability ratio of the merged estates will be lower.” J. Stephen Gilbert, Note: Substantive Consolidation In Bankruptcy: APrimer, 43 VAND. L. REV. 207 (Jan. 1990).

Do Bankruptcy Courts Have The Power To Grant It?

Substantive consolidation was explicitly recognized by the Supreme Court as early as 1941. See Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215 (1941). Historically and today, the bankruptcy court’s power to order substantive consolidation is derived from its equity powers as expressed in Section 105 of the Bankruptcy Code. Although not codified by the Bankruptcy Reform Act of 1978, courts continue to recognize its validity and have ordered substantive consolidation subsequent to the enactment of the Bankruptcy Code.

Nevertheless, opponents of substantive consolidation still argue that orders of substantive consolidation are beyond the equity powers of the bankruptcy court. For this they rely on the Supreme Court’s decision in Grupo Mexicano de Desarrollo, S.A. v. Alliance Bond Fund, Inc., 527 U.S. 308 (1999). There, the Supreme Court held that a district court lacked the inherent equitable power to enjoin a debtor from transferring its unencumbered assets before the complaining creditor obtained a judgment. See id. at 333. The Supreme Court found that in the absence of a specific statute expanding the district court’s jurisdiction, it had no equitable powers beyond those exercised by the High Court of Chancery in England at the time of the adoption of the Constitution and the Judiciary Act in 1789. Thus, opponents of substantive consolidation argue that bankruptcy courts lack the equitable power to issue orders of substantive consolidation because there is no statutory or historical basis for such an order.

This argument was explicitly rejected, however, in In re Stone & Webster, Inc., 286 B.R. 532 (Bankr. D. Del. 2002). The Stone & Webster Court distinguished Grupo Mexicano, noting that it had “nothing to do with substantive consolidation” and also cited language from Justice Scalia’s majority opinion suggesting that bankruptcy law provides a court with authority to grant remedies not administered by courts of equity in 1789. But the court did not rely on these and other articulated reasons in rejecting the Grupo Mexicano argument. Instead, it concluded that a bankruptcy court’s power to issue orders of substantive consolidation is derived from Bankruptcy Code Section 1123(a)(5)(c), which provides, in relevant part: “[n]otwithstanding any otherwise applicable non-bankruptcy law, a plan shall. . .(5) provide adequate means for the plan’s implementation such as. . .(c) merger or consolidation of the debtor with one or more persons. . . .” 11 U.S.C.A. § 1123(a)(5)(c) (emphasis added). Because the court determined that it had a statutory basis for issuing orders of substantive consolidation, it was irrelevant whether courts of equity in 1789 administered remedies equivalent to substantive consolidation. See also In re G-I Holdings, Inc., 2001 WL1598178, at *7 (Bankr. D.N.J. Apr. 6, 2001) (denying preliminary injunction motion to order substantive consolidation, but rejecting the Grupo Mexicano argument); In re Bonham, 229 F.3d 750 (9th Cir. 2000) (ordering substantive consolidation subsequent to Grupo Mexicano); In re Perimian Producers Drilling, Inc., 263 B.R. 510, 515-16 (W.D. Tex. 2000) (rejecting argument that bankruptcy court did not have jurisdiction to order substantive consolidation).

Conclusion

Although creditors on the losing side of a substantive consolidation of the assets and liabilities of related debtors can be expected to continue challenging the power of a bankruptcy court to employ such a remedy, the great weight of authority on that issue supports the proponents of substantive consolidation.