Substantive consolidation is an equitable remedy often employed in bankruptcy cases to consolidate separate debtors or estates so that their assets and liabilities may be aggregated. See, e.g., In re Genesis Health Ventures Inc., 266 B.R. 591 (Bankr. D. Del. 2001); In re Circle Land and Cattle Corp., 213 B.R. 870 (Bankr. D. Kan. 1997). Substantive consolidation permits the court in cases involving related entities, under appropriate circumstances, to disregard the separate identity of entities, consolidate and pool their assets and liabilities, and treat them as though held and incurred by one entity. See, e.g., Eastgroup Properties v. Southern Motel Ass'n. Ltd., 935 F.2d 245, 248 (11th Cir. 1991). As a result of consolidation, a single entity or estate is created for the benefit of all creditors of the consolidated entities. See, e.g., In re Blair, 226 B.R. 502, 505 (Bankr. D. Maine 1998); In re Creditors Service Corp., 195 B.R. 680 (Bankr. S.D. Ohio 1996). Substantive consolidation also eliminates inter-debtor claims and duplicate claims against related debtors and combines creditors of consolidated debtors for purposes of voting on plans of reorganization. See, e.g., In re Standard Brand Paint Co., 154 B.R. 563, 569 (Bankr. C.D. Cal. 1993); Holywell Corp. v. Bank of New York, 59 B.R. 340, 347 (Bankr. S.D. Fla. 1986). Because substantive consolidation may have adverse effects upon the rights and interests of creditors and affiliated debtors, courts often impose a great deal of scrutiny before authorizing the substantive consolidation of debtors. See, e.g., Chemical Bank New York Trust Co. v. Kheel, 369 F.2d 845 (2nd Cir. 1966); In re Parkway Calabasas Ltd., 89 B.R. 832, 836 (Bankr. C.D. Cal. 1988); In re Lewellyn, 26 B.R. 246 (Bankr. D. Iowa 1982).

The power of the bankruptcy court to substantively consolidate debtors arises from the general equity powers granted to bankruptcy courts in §105 of the Bankruptcy Code. 11 U.S.C. §105(a); see, also, In re Bonham, 229 F.3d 750 (9th Cir. 2000); F.D.I.C. v. Colonial Realty Co., 966 F.2d 57 (2nd Cir. 1992); In re Augie/Restivo Baking Co. Ltd., 860 F.2d 515 (2nd Cir. 1988); In re Deltacorp Inc., 179 B.R. 773 (Bankr. S.D.N.Y. 1995); In re Drexel Burnham Lambert Group Inc., 138 B.R. 723 (Bankr. S.D.N.Y. 1992); In re Munford Inc., 115 B.R. 390 (Bankr. N.D. Ga. 1990); In re Tureaud, 45 B.R. 658, 662 (Bankr. N.D. Okla. 1985), aff'd., 59 B.R. 973 (N.D. Okla. 1986). Substantive consolidation is also discussed in the commentary to Bankruptcy Rule 1015, which provides for the joint administration of bankruptcy estates:

[c]onsolidation, as distinguished from joint administration, is neither authorized nor prohibited by this rule since the propriety of consolidation depends on substantive considerations and affects the substantive rights of the creditors of different estates.

---

Because the Code is silent concerning the application of substantive consolidation, courts have generally followed two circuit court tests to determine whether the application of substantive consolidation is warranted.

---

Fed. R. Bankr. P. 1015. However, courts have found that §1123(a)(5)(C) of the Code, which provides that a reorganization plan can provide for the "merger or consolidation of the debtor with one or more persons," authorizes substantive consolidation. 11 U.S.C. §1123(a)(5)(C). See In re Stone & Webster Inc., 286 B.R. 532 (Bankr. D. Del. 2002); In re Limited Gaming of America Inc., 228 B.R. 275 (Bankr. N.D. Okla. 1998); In re Standard Brand Paints Company, supra (stating the only reference in the Code to substantive consolidation is Code §1123(a)(5)(C)).

Because the Code is silent concerning the application of substantive consolidation, courts have generally followed two circuit court tests to determine whether the application of substantive consolidation is warranted. The first test by the U.S. Court of Appeals for the District of Columbia, as articulated in In re Auto-Train Corp., 810 F.2d 270 (D.C. Cir. 1987), looks for the party seeking to consolidate entities to show (1) a substantial identity between the two entities, (2) that consolidation is necessary to avoid some harm or realize some benefit, and (3) that consolidation heavily outweighs the harm to creditors who relied on the separate credit of one of the entities and who would be prejudiced by the consolidation. The Auto Train test was adopted by the Eleventh Circuit in Eastgroup Properties v. Southern Motel Ass'n. Ltd., supra. The second test, articulated by the Second Circuit in In re Augie/Restivo Baking Co. Ltd., supra, examines (1) whether creditors dealt with the entities as a single economic unit and did not reply on their separate identity in extending credit or (2) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors. The Augie/ Restivo test was adopted by the Ninth Circuit in In re Bonham, supra.

Substantive consolidation has also been extended by some courts in unusual circumstances to allow consolidation of debtors with non-debtors. See In re Lease-A-Fleet Inc., 141 B.R. 869 (Bankr. E.D. Pa. 1992); In re New Center Hospital, 179 B.R. 848 (Bankr. E.D. Mich. 1994); In re Munford Inc., supra. Generally, these courts have used the same tests promulgated for cases involving the consolidation of debtors. Id.

The use of substantive consolidation as a remedy has been called into question as a result of the Supreme Court's decision in Grupo Mexicano de Desarrollo S.A. v. Alliance Bond Fund Inc., 527 U.S. 308, 119 S.Ct. 1961 (1999). The Grupo Mexicano decision, which limits the federal courts to their equity jurisdiction as of 1789, raises some uncertainty as to whether bankruptcy courts have the power to authorize substantive consolidation as an equitable remedy.

The Grupo Mexicano Decision

In Grupo Mexicano, the Supreme Court held that, in the absence of a specific statute expanding the court's powers, a federal court sitting as a "court of equity" is limited to those equitable remedies that existed in the English Court of Chancery in 1789, the year that Congress enacted the First Judiciary Act.

Grupo Mexicano de Desarrollo S.A. (GMDSA) was a Mexican holding company that constructed and operated roadways through its subsidiaries. GMDSA participated in the Mexican government's Toll Road Concession Program, which was developed to facilitate the construction of intercity highways. The program allowed participating concessionaires such as GMDSA to arrange private financing for the construction of roads in return for the right to collect tolls. When toll revenues fell below anticipated levels, GMDSA undertook to raise money by selling $250 million in notes, $75 million of which were sold to the Alliance Bond Fund Inc. Five GMDSA subsidiaries guaranteed the notes, which were ranked pari passu with all of GMDSA's unsubordinated debt.

In June 1997, GMDSA confirmed that it was experiencing financial difficulty, and in August 1997, the company failed to make interest payments on the notes. The Mexican government responded by establishing the "toll road rescue program." Under the terms of the program, the Mexican government promised to issue toll road notes to GMDSA and concessionaires to reimburse them for unpaid construction receivables and expenses. In exchange for the toll road notes, the Mexican government would, over a period of time, assume ownership of the toll roads. In its third-quarter 1997 financial statement, GMDSA stated that it expected to receive $309 million in toll road notes.

In addition to the notes, GMDSA owed other creditors approximately $450 million. In August 1997, GMDSA began to renegotiate its debt with the Mexican bank, and in October 1997, GMDSA announced publicly that of its expected $309 million of toll road notes, it had assigned $100 million to the Mexican government and $17 million to former employees. Negotiations to restructure GMDSA's finances between GMDSA and the holders of the notes, which included Alliance, failed.

On Dec. 11, Alliance accelerated the principal amount due on the notes and the next day filed suit against GMDSA in the U.S. District Court for the Southern District of New York. The complaint alleged that GMDSA was at risk of insolvency, or currently insolvent, and that it was preferring its Mexican creditors "by its planned allocation of toll road notes to the payment of their claims and its transfer to them of toll road receivables, and that these actions would frustrate any judgment respondents could obtain." Alliance asserted a claim for breach of contract and demanded judgment for the amount due on the notes as well as a preliminary injunction to restrain GMDSA from assigning its toll road notes to other creditors.

The district court issued a temporary restraining order prohibiting GMDSA from assigning its rights to the toll road notes. On Dec. 23, under Rule 65 of the Federal Rules of Civil Procedure, the district court entered an order prohibiting GMDSA from dissipating, disbursing, transferring, conveying, encumbering or otherwise distributing or affecting Alliance's right to, interest in, title to or right to receive or retain any of the toll road notes. The court also ordered Alliance to post a bond. The Second Circuit affirmed, holding that the district court possessed the authority to issue a preliminary injunction prohibiting GMDSA from distributing assets not related to the pending litigation. Alliance Bond Fund. Inc. v. Grupo Mexicano de DeSarrollo S.A., 143 F.3d 688 (2d Cir. 1998), rev'd. and remanded, 527 U.S. 308 (1999).

The case was then appealed to the U.S. Supreme Court, where the primary issue before the court was whether or not, in a suit for money damages, the district court had the authority to grant a prejudgment preliminary injunction, enjoining the defendant from transferring assets as to which no lien or equitable interest had attached. The Supreme Court reversed and remanded, holding that a district court did not have the authority to issue such an injunction.

In the court's opinion, Justice Scalia, writing for a 5-4 majority, conducted a detailed historical analysis of the equity jurisdiction of federal courts and found that federal courts have substantially the same equity jurisdiction the English Court of Chancery had at the time the Constitution was adopted and the Judiciary Act of 1789 was enacted. Based on this premise, the court concluded that "the substantive prerequisites for obtaining an equitable remedy as well as the general availability of injunctive relief are not altered by [Rule 65] and depend on traditional principles of equity jurisdiction." Grupo Mexicano at 318 (quoting Charles Alan Wright, Arthur R. Miller and Mary Kay Kane, Federal Practice and Procedure §2941, p. 31 (2d ed. 1995)). According to the Court, the equitable powers granted by the Judiciary Act of 1789 did not include the ability of courts to create new remedies that extend beyond traditional equitable remedies. Grupo Mexicano at 322.

The narrow view of the federal courts' ability to fashion equitable remedies enunciated in Grupo Mexicano raises issues regarding the equitable powers of a bankruptcy court with respect to many issues, including its ability to substantively consolidate debtor entities.

In re Stone & Webster Inc.

The Grupo Mexicano decision and its effect on substantive consolidation and equitable remedies was recently reviewed and further defined by the U.S. Bankruptcy Court for the District of Delaware in In re Stone & Webster Inc., supra. The debtors in that case consisted of Stone & Webster, a Delaware holding company, and 72 direct and indirect subsidiaries.

On Aug. 10, 2001, the official unsecured creditors' committee in the case filed a consolidated liquidation plan for Stone & Webster and its 72 subsidiaries (the "debtors"). In an effort to have the issue of the propriety of consolidation addressed by the court prior to embarking on the confirmation process, the creditors' committee filed a motion for substantive consolidation of all the debtors into one estate. The outcome of the issue would have a significant effect on the amounts received by creditors of the different estates. According to the creditors' committee, the liquidation plan of the official committee of equity security-holders (equity committee) would provide creditors of some of the debtors' estates with a 100 percent recovery, and some of the debtors' shareholders would receive in excess $3 per share, while creditors of other of the debtors' estates would receive no more than 7 cents on the dollar. The creditors' committee's position was that with substantive consolidation, creditors of all of the debtors would receive significant recoveries from the aggregated estates.

In response, the equity committee moved for summary judgment on the issue of consolidation and argued that Grupo Mexicano applied to the equitable remedy of substantive consolidation in bankruptcy cases. The equity committee argued that the substantive consolidation remedy is not a general equity power granted to the bankruptcy courts under §105 of the Bankruptcy Code because the Supreme Court in Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 108 S.Ct. 963 (1988), held that §105 may be used only in furtherance of specific provisions of the Bankruptcy Code and may not be used to create substantive rights. The equity committee also raised a constitutional argument, stating that use of §105 as an independent basis for substantive consolidation would violate Article I of the U.S. Constitution as described in the Supreme Court's decision in Erie v. Tompkins, 304 US 64, 58 S.Ct. 817 (1938).

In his opinion, Chief Judge Walsh rejected the equity committee's argument by stating that the holding in Grupo Mexicano was not controlling on the issue of substantive consolidation or the authority of a bankruptcy court to grant the remedy of substantive consolidation. Chief Judge Walsh noted that "in Grupo Mexicano, the majority opinion strongly suggests that bankruptcy law provides a court with authority to grant remedies not administered by courts of equity at the time of the enactment of the Judiciary Act." Quoting Justice Scalia, the court's opinion states:

[W]hen there are indeed new conditions that might call for a wrenching departure from past practice, Congress is in a much better position than we both to perceive them and to design the appropriate remedy. Despite [the dissent's] allusion to the "increasing complexities of modern business relations," post, at 1977, and to the bygone "age of slow-moving capital and comparatively immobile wealth," we suspect there is absolutely nothing new about debtors trying to avoid paying their debts, or seeking to favor some creditors over others—or even about their seeking to achieve these ends through "sophisticated... strategies." The law of fraudulent conveyances and bankruptcy was developed to prevent such conduct; an equitable power to restrict a debtor's use of his unencumbered property before judgment was not.

Stone & Webster at 538 (quoting Grupo Mexicano, 527 U.S. at 322).

Further, Chief Judge Walsh rejected the equity committee's argument that the remedy of substantive consolidation is a substantive right that cannot be ordered by bankruptcy courts pursuant to §105 of the Bankruptcy Code. Chief Judge Walsh found "clear statutory authority in the Bankruptcy Code for substantive consolidation in chapter 11 cases" in §1123(a)(5) of the Code. Stone & Webster at 540. By noting that the phrase "one or more persons" of §1123(a)(5) can be a debtor, Chief Judge Walsh concluded that the language indicates congressional intent for a chapter 11 debtor to be able to merge or consolidate with debtors or entities during the reorganization process.

Based on these factors, the court held that substantive consolidation is expressly authorized by statute and that the decision of Grupo Mexicano cannot be read to prohibit substantive consolidation in a chapter 11 case. While the decision is important because it is the first reported decision to address the issue, its real importance extends well beyond the issue of substantive consolidation. In Stone & Webster, the court found that bankruptcy courts are not subject to the limitations in fashioning equitable remedies that govern other federal courts by reading Grupo Mexicano as expressly excepting bankruptcy proceedings from its reach. Moreover, Stone & Webster stands for the proposition that §105 gives a bankruptcy court an independent source of authority to fashion equitable remedies, even if not authorized by other provisions of the Code.

---

Footnotes

¹ The author gratefully acknowledges the assistance of William R. Firth III in the preparation of this article. Return to article