t was another long, unsuccessful baseball season for the Montreal Expos. Plagued (as that team has been for years) with rapidly declining attendance, a terrifically inhospitable and deteriorating ballpark,¹ sparse media coverage, uncertain ownership and a payroll only slightly higher than your neighborhood McDonald's, the Expos are sure to be the subject of some interesting ideas over the course of this off-season.

One of those ideas is called, cryptically enough, "contraction." It is the opposite of "expansion," the suspect strategy of adding new teams to the league (most recently, the Tampa Bay Devil Rays and Arizona Diamondbacks), a scheme that has arguably diluted the talent on all teams such that the caliber of overall league play has been diminished. Couple expansion with the widening disparity between the wealthy teams (like the New York Yankees, winners of four of the last five World Series) and the ones strapped for cash (hello, Montreal), and bad teams stay bad for years because they, by necessity, employ a disproportionate amount of the players who owe their major league careers entirely to the new jobs created by expansion.

Economists might think of the problem this way: Consumers of baseball enjoy widely disparate returns on their investments, based largely on the circumstance of which is their favorite team. Reducing the number of teams—"contraction"—may improve the quality of all remaining teams, benefiting all consumers irrespective of their favorite ball clubs. Major League Baseball is now said to be considering just such a move—eliminating as many as four teams and dispersing the best players of the eliminated teams to the remaining teams. Those players would then supplant the worst players on the remaining teams, all remaining teams would improve, and the quality of the entire league would improve. Consumers of baseball would enjoy a better product.²

Bankruptcy practitioners might think of the problem this way: Creditors of the baseball debtor enjoy widely disparate recoveries when the baseball distribution is made, based largely on the circumstance of where they live (i.e., which team they root for). But baseball creditors are, at bottom, creditors of Major League Baseball, not of one team. So, if the teams with the smallest recovery pool were thrown into a pot with the more lucrative teams—"substantive consolidation"—all creditors of baseball as a group would receive better recoveries.

In Alexander v. Compton (In re Bonham),³ the Ninth Circuit Court of Appeals has for the first time given bankruptcy practitioners (and, if they're open to attenuated analogy, baseball executives) the circuit's fundamentals of when it is appropriate for a bankruptcy court to order such a thing—the substantive consolidation of a debtor entity with other affiliated entities—or as the court put it, the Ninth Circuit's "abecedarian prerequisite to ordering substantive consolidation..."⁴

As the concept has long been understood, "substantive consolidation 'enabl[es] a bankruptcy court to disregard separate corporate entities, to pierce their corporate veils in the usual metaphor, in order to reach assets for the satisfaction of debts of a related corporation.'"⁵ The assets of the consolidated entities create a single pool from which all claims against all entities are satisfied. Duplicate claims against other consolidated entities and inter-company claims between the consolidated entities are extinguished.

Substantive consolidation has been used in many different settings, all of which ostensibly have in common what the D.C. Circuit once called the remedy's "sole aim: fairness to all creditors."⁶ Initially, substantive consolidation was sanctioned, albeit not expressly, by the Supreme Court, when an individual debtor had fraudulently conveyed assets to a corporation—of which he was the sole shareholder—essentially disregarding and abusing the corporate formalities.⁷ Earlier decisions approving substantive consolidation tended to arise from this type of intentional, strategic disregard of the corporate form and distinctions between affiliated entities, where maintaining the same legal fiction of separate corporate identities that the bad actor had ignored would work an injustice on the various creditors of the various entities.⁸ Many courts realized, however, that circumstances utterly devoid of untoward or strategic behavior might be suitable for substantive consolidation, particularly where the remedy is used "to avoid the expense or difficulty of sorting out the debtor's records to determine the separate assets and liabilities of each affiliated entity."⁹ In complex corporate structures (where the inter-company organizational chart looks something like the British royal family's genealogy), substantive consolidation of all the entities' assets and liabilities may be critical to the successful conclusion of a reorganization, since "the interrelationships of the group are hopelessly obscured and the time and expense necessary even to attempt to unscramble them so substantial as to threaten the realization of any net assets for all the creditors."¹⁰

More recently, "scrambled" corporate structures have given rise to substantive consolidation orders far more frequently than has the intentional abuse of the corporate form. Whereas several cases have used substantive consolidation to allow a trustee or creditors to avoid fraudulent transfers and preferences by and among consolidated entities for the benefit of all creditors of an overall "enterprise,"¹¹ the typical business structure used in certain recently troubled industries has caused substantive consolidation to be used to avoid the unwieldy (or impossible) task of figuring out which entity owns what, and who owes what to whom. For example, nursing home companies are typically structured such that a separate subsidiary owns and operates each of its many facilities, with additional subsidiaries providing services such as pharmacy and physical therapy. The inter-company obligations and downstream guarantees of debt at the parent company level would make a viable reorganization a staggeringly complicated task, so courts have been inclined to substantively consolidate all the entities for purposes of a joint plan of reorganization.¹²

The broadening of the range of circumstances in which substantive consolidation has been held to be appropriate likely caused the Second Circuit to distill earlier formulations of the necessary "criteria" for substantive consolidation¹³ into a more flexible yet more precise doctrine. In Union Savings Bank v. Augie/Restivo Baking Co.,¹⁴ the court interpreted most of the prior jurisprudence as "merely variants on two critical factors: (1) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, or (2) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors." Either factor can provide a sufficient basis for substantive consolidation.¹⁵

Other recent formulations—most notably from the Eighth¹⁶ and Eleventh¹⁷ Circuits—employ variants of a three-part inquiry: (1) a substantial identity between the entities to be consolidated, (2) the balance between the benefits to be obtained by consolidation and the harm to creditors, and (3) the harm of not consolidating the debtors. These approaches differ significantly from the Augie/Restivo approach from the Second Circuit in that some would argue that the latter approach seems more flexible and better suited to circumstances in which all creditors as a group will benefit from a consolidation in the face of irreconcilable "scrambling" of assets and liabilities in an integrated enterprise—an increasingly common phenomenon.

It is perhaps odd, then, that the Ninth Circuit—just now adopting a doctrinal approach to substantive consolidation for the first time in Bonham—would expressly embrace the arguably more "intent-neutral" Augie/Restivo approach under facts—an individual debtor's Ponzi scheme—that harken back to early substantive consolidation cases involving intentional fraud and abuse of corporate structures.

In Bonham, the "primary motivation" for the bankruptcy court's substantive consolidation order was to give the trustee the ability to prosecute avoidance actions against earlier Ponzi investors of one affiliated entity who had recouped at least part (and sometimes all) of their investments, for the benefit of those later investors of another affiliated entity that did not. But rather than use earlier formulations such as the Auto-Train or Eastgroup approaches, the Ninth Circuit adopted the two-fisted Augie/Restivo approach, calling it "more grounded in substantive consolidation and economic theory" and "more easily applied,"18 and concluding that the bankruptcy court had not erred in concluding that the Ponzi investors "could not have believed that they were dealing with separate entities" and that "the exercise of disentangling the affairs of [the debtor and its two corporate entities] would be needlessly expensive and possibly futile."¹⁹ In other words, the Ponzi scheme at issue in that case passed muster under either factor of the Augie/Restivo approach (although satisfaction of only one factor is needed). The "fairness to all creditors" (or, here, investors) was purportedly achieved by making earlier, successful investors put their returns back into the pot so that the later, unsuccessful investors could have a taste, too.

Those of us in the Ninth Circuit now have our very own substantive consolidation doctrine. Now that we won't have to survey all the other Circuit's approaches so extensively, our briefs may be shorter, and that's good. What is perhaps more interesting, however, is the message that the Bonham decision sends about what "fairness to all creditors" really is. At least in the Ponzi-scheme setting, is it really preferable—is it really fair—to have one group of investors (the "losers" in the Ponzi scheme) benefit at the expense of another group of investors (the "winners") when the only difference between them is the timing of their investment? Do we want our bankruptcy courts—courts of equity, as the Ninth Circuit reminds us in Bonham—shifting some of the disproportionate returns of the Ponzi scheme from those who may have had the good sense to get in and out at the beginning of the scheme to those who reasonably could be said to have borne the risk that the promise of 50 percent returns in 10 days²⁰ was too good to be true? In other words, are the beneficiaries of substantive consolidation in this situation deserving of the benefit substantive consolidation gives them, or does consolidation simply shift the windfall from one group to the other?

Compare this with the common scenario in which trade vendors unwittingly do business with woefully undercapitalized and grossly over-leveraged subsidiaries, and benefit from substantive consolidation that dilutes recoveries from other trade vendors who unwittingly did business with highly solvent affiliated subsidiaries. Neither group has gambled against substantial risk in the face of lofty potential returns; rather, in most instances, most trade vendors probably believed they were doing business with the parent company, not with one or another of its subsidiaries. Courts have become increasingly comfortable ordering substantive consolidation in this instance.

In the Ponzi-scheme setting, however, is the unfortunate investor somehow more worthy of a "fair return" than the fortunate one? Is it fair to deny some junk bond investors their unusually high returns because not every investor realizes those same returns?

This may be a tough call. An easier issue from an equity perspective is that the perpetrator of the scheme that created the disparity among creditors or investors should be the party most punished by substantive consolidation. Tearing down the inter-entity barriers that the debtor ignored in order to benefit at least the most prejudiced of creditors seems uncontroversial. The court in Bonham could have done only that by consolidating the debtor's assets with those of her two corporations for the sole benefit of the more unfortunate investors. But the court went a step further, and authorized the trustee to re-distribute investment returns more evenly among all investors. Is that what is most equitable?

Maybe baseball can help decide. Under the "contraction" concept, Expos fans lose their team, baseball fans in general benefit by improved teams throughout the league, but Yankees fans ultimately get an even better team. The group bearing the brunt of baseball's version of substantive consolidation are those fans most negatively affected by the original scheme—expansion—that caused the need for substantive consolidation in the first place. At least in the Ponzi-scheme setting, those most negatively affected by the scheme are the beneficiaries of substantive consolidation.

And that is probably the way it should be. Compared with one another in equity terms, baseball's "contraction" form of substantive consolidation is a strikeout, while the Ninth Circuit's Ponzi-scheme remedy is a run-scoring double in the gap.

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Footnotes

¹ The Expos play in Olympic Stadium (or as the Quebeçois call it, the Parc Olympique), the most notable edifice built for the 1976 Summer Olympic Games. Not only has the stadium's once-retractable roof long stopped retracting, concrete chunks have recently begun raining down upon the relatively few fans that still attend games there. The stadium is a decrepit reminder that Montreal is the only city maybe ever to have actually lost money in hosting the Olympics. Return to article

² Of course, there exists no small measure of disagreement about which teams would be wiped from the baseball landscape, but initially nearly everyone seems to agree on one. Expos fans (few as they are) really do not like this "contraction" idea. Return to article

³ 2000 U.S. App. LEXIS 24799 (9th Cir. 2000). Return to article

⁴ Thanks to Circuit Judge Thomas for this phrase, for making me dust off my thesaurus, and for giving me an appropriately catchy title for this article. Return to article

⁵ Id. at 21, quoting James Talcott Inc. v. Wharton (In re Continental Vending Machine Corp.), 517 F.2d 997, 1000 (2d Cir. 1975). Return to article

⁶ In re Auto-Train Corp., 810 F.2d 270, 276 (D.C. Cir. 1987). Return to article

⁷ See Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215 (1941). Return to article

⁸ See, e.g., In re Continental Vending Machine Corp., 517 F.2d 997, 1000 (2d Cir. 1975). Return to article

⁹ Auto-Train, 810 F.2d at 276. Return to article

¹⁰ Chemical Bank New York Trust Co. v. Kheel, 369 F.2d 845, 847 (2d Cir. 1966). Return to article

¹¹ See, e.g., First National Bank of Barnesville v. Rafoth (In re Baker & Getty Financial Svcs. Inc.), 974 F.2d 712, 720 (6th Cir. 1992); Auto-Train, 810 F.2d at 272-73; In re Kroh Bros. Dev. Co., 117 B.R. 499, 502 (W.D. Mo. 1989). Return to article

¹² The Unison HealthCare Corp. chapter 11 bankruptcy in Arizona, completed in early 1999, is an example of the effective use of substantive consolidation to facilitate the reorganization of 33 affiliated debtors. Return to article

¹³ An early seminal case, Fish v. East, 114 F.2d 177 (10th Cir. 1940), identified no fewer than 10 factors militating in favor of substantive consolidation, many of which had more to do with the disregard of corporate formalities situation than with the innocently "scrambled" corporate structure situation. Return to article

¹⁴ 860 F.2d 515, 517 (2d Cir. 1988). Return to article

¹⁵ Id.; see, also, In re Reider, 31 F.3d 1102, 1108 (11th Cir. 1994). Return to article

¹⁶ First National Bank of El Dorado v. Giller, 962 F.2d 796 (8th Cir. 1992). Return to article

¹⁷ Eastgroup Properties v. Southern Motal Assoc., 935 F.2d 245 (11th Cir. 1991). Return to article

¹⁸ Bonham, 200 U.S. App. LEXIS 24799 at 29. Return to article

¹⁹ Id. at 31-32. Return to article

²⁰ Id. at 3. Return to article