Part one of this two-part series discussed the equitable remedy of substantive consolidation and its avail- ability in bankruptcy. As explained in part one, orders of substantive consolidation combine the assets and liabilities of separate and distinct, but related, legal entities into a single pool 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. It was concluded that, although creditors on the losing side of substantive consolidation are likely to continue to oppose the courts’ power to grant such a remedy, the great weight of authority currently supports the proponents of substantive consolidation. With the understanding that orders of substantive consolidation potentially are available to debtors and creditors alike, we now focus on the legal standards, burdens and key factors courts apply in determining whether an order of substantive consolidation is proper in a given bankruptcy case.
The Standards, Burdens and Factors Courts Apply
Two similar tests have emerged to determine whether to substantively consolidate two or more related entities.
The first is a three-part burden-shifting test announced in Auto-Train Corp. v. Midland-Ross Corp. (In re Auto-Train), 810 F.2d 270 (D.C. Cir. 1987). The Auto-Train test requires that the proponent of substantive consolidation show that (i) there is substantial identity between the entities to be consolidated; and (ii) consolidation is necessary to avoid some harm or to realize some benefit. Once this prima facie case is made, a presumption arises that creditors have not relied solely on the credit of one of the entities involved. The burden then shifts to an objecting creditor to show that (i) it has relied on the separate creditworthiness of one of the entities to be consolidated; and (ii) it will be prejudiced by substantive consolidation. Finally, if an objecting creditor sustains its burden, the court may order consolidation only if it determines that the demonstrated benefits of consolidation heavily outweigh the harm. See Eastgroup Prop. v. Southern Motel Ass’n, 935 F.2d 245, 249 (11th Cir. 1991).
Courts have articulated several non-determinative factors to be considered in determining whether a proponent of substantive consolidation has established a prima facie case. These factors include: (i) the presence or absence of consolidated financial statements; (ii) the unity of interests and ownership between various corporate entities; (iii) the existence of parent and inter-company loan guarantees; (iv) the degree of difficulty in separating and ascertaining individual assets and liabilities; (v) the existence of transfers of assets without formal observance of corporate formalities; (vi) the commingling of assets and business functions; and (vii) the profitability of consolidation at a single physical location. See Bonham v. Compton (In re Bonham) , 229 F.3d 750, 766 n.11 (9th Cir. 2000).
The second test, adopted by the Second Circuit in Augie/Restivo Baking Co. v. Augie/Restivo Baking Co. (In re Augie/Restivo) , 860 F.2d 515 (2d Cir. 1988), requires consideration of two independent factors: (i) whether the creditors of consolidated entities treated the entities as a single economic unit and did not rely on their separate creditworthiness in extending credit; or (ii) whether the business affairs of the consolidated entities were so hopelessly entangled that substantive consolidation would benefit all creditors. See, e.g., In re Augie/Restivo , 860 F.2d at 518. Substantive consolidation is proper under this test where either factor is present.
The first factor is based on the concept that, in structuring its loans, a lender typically does not anticipate having access to the assets of some other entity in the event that its borrower becomes insolvent. Nor does a lender expect to compete for its borrower’s assets with a creditor of a less reliable debtor. See id . at 518-19. Consolidation under the second factor involves the commingling of two entities’ assets and business functions. It should be used, however, “only after it has been determined that all creditors will benefit because untangling is either impossible or so costly as to consume the assets.” Id . at 519.
In keeping with its equitable nature, many courts warn that substantive consolidation should be used “sparingly” because of its potential for unfair treatment of creditors that dealt solely with a particular debtor without knowledge of that debtor’s interrelationship with others. Flora Mir Candy Corp. v. R.S. Dickson & Co. (In re Flora Mir Candy Corp.) , 432 F.2d 1060, 1062-63 (2d Cir. 1970). Nevertheless, even those courts which heed this warning do not pause to issue orders of substantive consolidation where the circumstances of a particular bankruptcy case warrant such a finding in accordance with the above-mentioned factors.
For instance, in Sampsell v. Imperial Paper & Color Corp. , 313 U.S. 215, 218-19 (1941), the United States Supreme Court approved the substantive consolidation of two estates where a debtor had abused corporate formalities and was alleged to have conveyed the debtor shareholder’s assets to the related corporation in fraud of creditors. Applying the Second Circuit’s test annunciated in Augie/Restivo , the Ninth Circuit affirmed the bankruptcy court’s order of substantive consolidation, noting that two non- debtor corporations “were but instrumentalities of the bankrupt with no separate existence of their own.” In re Bonham , 229 F.3d at 766-67. Similarly, in Giller v. Giller (In re Giller) , 962 F.2d 796 (8th Cir. 1992), the Eight Circuit affirmed an order substantively consolidating six corporate debtors where their sole or majority shareholder ignored corporate form and fraudulently transferred assets. In Eastgroup Prop. , 935 F.2d at 250, the Eleventh Circuit consolidated two debtors where, among other things, the debtors were commonly owned. They shared employees and facilities; funds were transferred between them; one debtor paid unsecured debts of the other; and, absent substantive consolidation, equity interest holders would have received a substantial distribution while a majority of creditors would have received only a small portion of their claims.
Although different tests have emerged to determine whether substantive consolidation is proper in a given bankruptcy case, two common themes can be identified. Courts will focus on the degree to which two or more entities are interrelated ( i.e. , substantial identity) and the reasonable expectations of the creditor at the time it extended credit ( i.e. , reliance on the separate credit of one entity). These themes will be evaluated in an equitable context and courts will be mindful of the effect that substantive consolidation will have on the bankruptcy estate and its creditors.