Consenting to a Relief Order Bars Trustee from later Substantive Consolidation
Rehmat A. Peerbhai and managed Amco Insurance Group (AIG), a holding company in the automobile insurance business. In 1992, Peerbhai incorporated a new company, American Insurance Agency (AIA), which sold automobile insurance as well. AIG became the parent entity and AIA the subsidiary, with Peerbhai owning all of the stock of both corporations. In September 2000, Peerbhai and AIG approached Wells Fargo for financing. Wells Fargo insisted the companies obtain independent audited financial statements as a condition of evaluating the lending requests. After reviewing the audited financial statements, Wells Fargo agreed to lend money to Peerbhai individually and to AIG, and extended a loan in the amount of $2.4 million to Peerbhai and AIG as co-borrowers, and a second loan in the amount $1.2 million to AIG alone. Wells Fargo required Peerbhai to execute a guaranty of the AIG loan, which he did on Sept. 21, 2000. AMCO at 1.
Just over a year later, in December 2001, AIG breached a material loan covenant with Wells Fargo, prompting Wells Fargo to file an action against Peerbhai and AIG to collect on the debts and for a restraining order against AIG in state court in January 2002. In response, both AIA and AIG filed chapter 7 petitions on Feb. 4, 2002. One week after the filing, Wells Fargo filed a motion to lift the automatic stay in the AIG case seeking to maintain its temporary injunction against AIG and to continue to pursue the state court litigation against Peerbhai. The motion was resolved by the entry of an Agreed Order Partially Lifting the Automatic Stay to Proceed in State Court Litigation on March 14, 2002 (Agreed Order), which expressly maintained the temporary restraining order against AIG and expressly permitted Wells Fargo to pursue state court remedies against Peerbhai individually. Peerbhai was not a debtor at the time the Agreed Order was entered. Id.
Substantive Consolidation Litigation
After entry of the Agreed Order, Wells Fargo proceeded against Peerbhai in the state court. The parties subsequently reached an agreement and executed a Limited Forbearance Agreement dated April 10, 2002, pursuant to which they filed an agreed judgment settling the state court litigation. The state court entered an Agreed Judgment on April 25, 2002, giving Wells Fargo a consensual lien on Peerbhai's homestead and other personally owned property, as well as a judgment against him in the total amount of $3,398,956.16. Wells Fargo agreed that it would not seek to enforce the judgment or otherwise pursue any of its rights and remedies thereunder until April 9, 2003. Id.
On July 11, 2002, the trustee for AIA filed an application for substantive consolidation, seeking to consolidate AIA and Peerbhai as a single debtor in bankruptcy, despite the fact that Peerbhai was still not a debtor at the time. The application sought to put Peerbhai into bankruptcy and to relate his filing back to AIA's petition date of Feb. 4, 2002 under theories of "single economic unit" and "single business enterprise." Needless to say, Wells Fargo objected to the application. For various reasons, the application was carried for quite some time, and on Dec. 11, 2002, Peerbhai filed a chapter 11 bankruptcy petition, which he later converted to a chapter 7 petition. The same chapter 7 trustee was appointed in each of these cases. AMCO at 2.
The application seeking substantive consolidation was tried in a two-day evidentiary hearing beginning on May 2, 2003, and concluding May 23, 2003. Id. The bankruptcy court determined, among other things, that (1) Peerbhai had engaged in a pattern of activity that was aimed at concealing proceeds of AIA's operations and sale of AIA assets from its creditors and Peerbhai's creditors; (2) Peerbhai made no meaningful distinction between his personal funds and those of AIA while AIA was an operating entity; (3) creditors of AIA dealt with Peerbhai and AIA as a single economic unit and did not rely on their separate identities in extending credit; (4) Peerbhai treated AIA as an alter ego and used the AIA corporate status to commit fraud against his personal creditors and AIA's creditors; and (5) Peerbhai and AIA did not observe the corporate formalities required by Texas law. Id.
Based on these findings, the court concluded that (1) the lack of financial records prevented the trustee from identifying and segregating the affairs of AIA and Peerbhai because there was no autonomy exercised by either of them; (2) substantive consolidation would protect AIA's creditors from receiving no recovery from AIA, which Peerbhai had looted; (3) Wells Fargo knew the facts and circumstances when the Limited Forbearance Agreement was entered, so substantive consolidation would not unfairly prejudice its interests; (4) Wells Fargo knew or should have known that AIA and Peerbhai were essentially one economic unit before the case was filed; (5) the affairs of AIA and Peerbhai were so entangled that substantive consolidation would benefit all creditors and unfairly prejudice none of them; and (6) substantive consolidation should be effective nunc pro tunc to the petition date of Feb. 4, 2002, because at all relevant times, Peerbhai and AIA operated as one financial entity. Id.
Wells Fargo appealed to the district court, arguing that the bankruptcy court exceeded its congressional and constitutional grant of authority when it entered the substantive-consolidation order for retroactive consolidation. Specifically, Wells Fargo argued that the U.S. Supreme Court abrogated the equitable remedy of substantive consolidation in Grupo Mexicano de Desarrollo S.A. v. Alliance Bond Fund Inc., 527 U.S. 308 (1999). In the alternative, if substantive consolidation remains a viable remedy, Wells Fargo argued that the bankruptcy court erred in allowing retroactive substantive consolidation for the nondebtor, that the audited financial statements it had relied on contained no evidence that AIA and Peerbhai's finances were hopelessly intertwined, and that the bankruptcy court had erred in making its alter ego findings under Texas law. The trustee responded that AIA was the operating entity and that Wells Fargo knew that Peerbhai had no real assets apart from AIA.
The district court rejected Wells Fargo's argument that Grupo Mexicano abrogated the remedy of substantive consolidation, stating that case "should not be interpreted to provide a safe haven for debtors" who take actions to conceal assets from their creditors. Wells Fargo Bank of Texas v. Sommers (In re AMCO Ins. Agencies, Inc.), No. 4:04-CV-00455, Ch. 7 Case No. 02-31265, Adv. Pro. No. 04-20841, slip op. at 9 (S.D. Tex. Sept. 6, 2004). The district court also held that retroactive substantive consolidation was not unfair to Wells Fargo and that the bankruptcy court had made an appropriate analysis and applied the correct standard in approving the retroactive status. Id. at 10-11. Finally, the district court held that the bankruptcy court properly applied Texas law on the issue of alter ego, and affirmed the bankruptcy court. Wells Fargo then appealed to the Fifth Circuit. Id. at 11-12.
Before the Fifth Circuit, Wells Fargo argued that under Grupo Mexicano the bankruptcy court lacked the requisite power and authority to order substantive consolidation, or, in the alternative, if the bankruptcy court had such power it applied the wrong standard to determine whether substantive consolidation was appropriate, and that the bankruptcy court erred in issuing its order of substantive consolidation nunc pro tunc.
Result and Reasoning
In reversing the lower courts and remanding the case, the Fifth Circuit focused on the fact that in March 2002 the trustee had consented to the entry by the bankruptcy court of the Agreed Order, which specifically maintained the temporary restraining order against AIA and permitted Wells Fargo to pursue its rights and remedies against Peerbhai. The Fifth Circuit held:
Because of this green light by the bankruptcy court, Wells Fargo expended its time and money to pursue the state court litigation until the suit concluded in the Limited Forbearance Agreement. Yet when Sommers later filed his motion for substantive consolidation, which the bankruptcy court in turn granted, he then sought to undo what he had earlier specifically authorized by applying the consolidation of the estates nunc pro tunc. In granting the motion, the bankruptcy court stated that "the avoidance of the liens granted to Wells Fargo by Peerbhai pursuant to the Limited Forbearance Agreement would simply return Wells Fargo to its position as of the petition date. We think it was a little late for this reversal of course (AMCO at 3).
The Fifth Circuit also disagreed with the bankruptcy court's rulings that under §105(a) it had the power to invalidate the effects of its order 20 months earlier, advising that §105(a) does not permit courts to "act as roving commission[s] to do equity." Id. at 4. Additionally, the Fifth Circuit noted its concerns with the substantive consolidation of a debtor with a nondebtor, which the nunc pro tunc order created. Id. at 5, n. 3. Further, the court instructed that the chapter 7 trustee "should have been more circumspect in requesting such an order given his earlier approval of the litigation that resulted in settlement terms that could not have been unexpected." Id. at 4. The court found that this was especially troubling in light of Wells Fargo's reliance on the agreement of the trustee and the approval of the court when it lifted the stay, and its investments of its time and money to obtain a predictable judgment against Peerbhai. Id. As a consequence, the effective abrogation of the Agreed Order would significantly prejudice Wells Fargo. Id. Based on its disposition of the case, the Fifth Circuit declined to address the question of whether the bankruptcy court had the power to order substantive consolidation after Grupo Mexicano. Id. at 5, n.5.
This case should be of some concern and guidance to trustees, and perhaps to all party litigants. In light of its holding, before consenting to the entry of an order granting relief requested by a creditor or party in interest, a trustee—and perhaps all other party litigants—should consider what rights and remedies are or may be affected by the agreement, and fashion a reservation of rights to be included in the order that would preserve the ability to pursue claims in the future. In addition, the Fifth Circuit's decision not to address the argument that Grupo Mexicano abrogated the remedy of substantive consolidation means that this issue is not yet resolved in this circuit, and still remains a potential basis for an objection to a motion to substantively consolidate estates. Finally, the case also indicates that if the remedy of substantive consolidation remains viable, the Fifth Circuit considers it a remedy to be used "sparingly."
1 In the Matter of AMCO Insurance; Rehmat Peerbhai, 2006 U.S. App. LEXIS 7934 (5th Cir. March 31, 2006).