The message has been resounding for well over a year—bankruptcy lawyers who do not represent consumer debtors or their creditors should plan a long vacation. Chapter 11 cases (at least outside of Delaware and New York) have become as infrequent as a smile on Alan Greenspan's face,¹ resulting in a precipitous fall in the demand for attorneys schooled in business bankruptcy. Indeed, with so much money flowing into the financial markets, even workouts and turnarounds have become uncommon.

With such a depressing first paragraph, and autumn looming, you might be tempted to give the travel agent a call right now. Before you finish passing on that credit card number, however, I want to highlight a recent development in the world of accounting that may cause more than one of your corporate colleagues to come knocking at the door.

Even in our world of financial doom and gloom, news of structured finance (or securitization) has spread like wildfire.² Put simply, structured finance enables an originating entity whose debt securities have gone unrated or have been rated at less than investment grade, or who historically has relied on bank financing at secured loan rates, to obtain funding through an affiliated bankruptcy-remote entity whose debt securities do have an investment grade rating. This result is achieved because the risk of default is significantly reduced—the debt is owed and repaid by an entity that has been structured to reduce the risk of bankruptcy and to which assets that generate a predictable stream of income have been assigned absolutely.

Spurred at least in part by the market's affinity for structured finance, the Financial Accounting Standards Board (FASB) promulgated Statement of Financial Accounting Standards No. 125 (SFAS No. 125) two years ago. SFAS No. 125 requires that an assignor of financial assets³ surrender control over those assets in order to account for the transfer as a true sale. Paragraph 9(a) of SFAS No. 125 states one of several conditions that must be met in order to properly evidence this surrender of control: "The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership." This standard, however, has been found to be fraught with ambiguity⁴ and has raised serious questions as to the kind of evidence that entities must provide in order to effect a true sale of financial assets to a bankruptcy-remote entity.

In December 1997, the American Institute of Certified Public Accountants (AICPA) added some rather controversial clarity to this problem by releasing an auditing interpretation entitled The Use of Legal Interpretations as Evidential Matter to Support Management's Assertion That a Transfer of Financial Assets Has Met the Isolation Criterion in Paragraph 9(a) of Statement of Financial Accounting Standards No. 125 (SAS No. 73).⁵ Put succinctly, AICPA directed that, in order to account for a "complex" transfer of financial assets (occurring on or after January 1, 1998) as a sale under SFAS No. 125, auditors should require not only a "true sale at law" opinion but a non-consolidation opinion as well.⁶ AICPA further stated that a proper non-consolidation opinion must conclude that, "in a proceeding under the U.S. Bankruptcy Code in which the seller is the debtor, a court would not grant an order consolidating the assets and liabilities of the purchaser with those of the seller in a case involving the insolvency of the seller under the doctrine of substantive consolidation."⁷

While lawyers practicing corporate finance have come to master many of the standard "true sale" issues, substantive consolidation is a theory that can evade the grasp of even experienced bankruptcy attorneys. With more frequent demands for non-consolidation opinions being seen as a result of SFAS No. 125 and SAS No. 73, and with the consequent increase in the risk to which firms will be exposed, bankruptcy specialists can expect to encounter more requests for detailed advice in structuring asset-backed and other similar transactions.

I have heard more than one bankruptcy attorney, however, express concern about opining on a vague equitable doctrine in the already unpredictable sea of bankruptcy law. Some others have been more blunt—do bankruptcy judges even know why they substantively consolidate entities, or do they simply apply Justice Stewart's celebrated standard for identifying obscenity—"I know it when it see it"?⁸ These worries, of course, should not come as a surprise. Millions, if not billions, of dollars are on the line—both for the client and for the firm—and the pressure to give non-consolidation opinions in this era of securitization grows exponentially by the day. Phrases such as "if we refuse to give the opinion, the client will find another firm to do the deal" are seemingly becoming more and more common.

A dangerous response to these demands is to focus solely on the language of the opinion in the hope that difficult issues simply can be "assumed away."⁹ While an opinion does mean what its words say, as much time should be spent analyzing the structure of the deal as crafting opinion language. Bankruptcy lawyers must not devote so much time to debating the difference between opining that a court "should" or "would" not order substantive consolidation that bad facts go unnoticed and uncorrected. Of course, ferreting out such facts only can be done with a firm understanding of the law on substantive consolidation. For this reason, a brief "state of the doctrine" is warranted.

The authority to substantively consolidate entities in bankruptcy emanates not from an explicit provision in the Bankruptcy Code, but rather is derived from the court's general equitable powers.¹⁰ The standards for invoking the remedy thus have developed in the courts rather than through legislation. At present, three distinct tests can be identified.

The first may be deemed the "traditional test," which represents a synthesis of the "alter ego" and "piercing the corporate veil" theories followed under the Bankruptcy Act of 1898. First announced in In re Vecco Construction Industries Inc., 4 B.R. 407, 410 (Bankr. E.D. Va. 1980) (decided under the 1898 Act), the traditional test requires a court to weigh a series of factors: (1) the degree of difficulty in segregating and ascertaining individual assets and liabilities, (2) the presence or absence of consolidated financial statements, (3) the profitability of consolidation at a single physical location, (4) the commingling of assets and business functions, (5) the unity of interests and ownership between the various corporate entities, (6) the existence of parent and intercorporate guarantees on loans and (7) the transfer of assets without formal observance of corporate formalities. Bankruptcy judges, however, have not "mechanically applied" these factors but instead have "evaluated [them] within the larger context of balancing the prejudice resulting from the proposed order of consolidation with the prejudice the moving creditor alleges it suffers from debtor separateness."¹¹

During the years following Vecco, case law began to evolve "from looking at entanglement/bad acts as the justification for substantive consolidation to analyzing substantive consolidation in terms of balancing the benefits that substantive consolidation would bring against the harm substantive consolidation would cause."¹² In time, two competing methods for applying the doctrine developed on the circuit level.

The more relaxed standard is embodied in Drabkin v. Midland-Ross Corporation (In re Auto-Train Corporation), 810 F.2d 270, 276 (D.C. Cir. 1987). In Auto-Train, the Court of Appeals for the District of Columbia Circuit ruled that the movant must demonstrate (1) a substantial identity between the entities to be consolidated and (2) that consolidation is necessary to avoid some harm or to realize some benefit. The burden then shifts to an objecting creditor, who in turn must show (1) reliance on the separate credit of one of the entities and (2) that consolidation will prejudice its interests. If such proof is introduced, the court may order substantive consolidation only if the benefits "heavily" outweigh the harm.¹³

In Eastgroup Properties v. Southern Motel Association Ltd., 935 F.2d 245, 248-50 (11th Cir. 1991), the Court of Appeals for the Eleventh Circuit expressly adopted and then elaborated upon the Auto-Train test. The court noted that the movant may want to frame the argument using Vecco but cautioned that the seven factors should not be considered dispositive. In addition, the court characterized Auto-Train as part of "a 'modern' or 'liberal' trend toward allowing substantive consolidation."¹⁴

In Union Savings Bank v. Augie/Restivo Baking Company Ltd. (In re Augie/Restivo Baking Company Ltd.), 860 F.2d 515, 518-20 (2d Cir. 1988), the Court of Appeals for the Second Circuit construed the "modern trend" in a far more conservative light. Specifically, the court concluded that all of the factors enumerated under the traditional test could be reduced to (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. The court then stressed that, where neither of these factors exist, "a creditor cannot be made to sacrifice the priority of its claims against its debtor by fiat based on the bankruptcy court's speculation that it knows the creditor's interests better than does the creditor itself."¹⁵

Each of these three tests, then, differs significantly both in a substantive sense and in their predisposition for or against substantive consolidation. As a consequence, auditors likely will insist that all (particularly Auto-Train) have been addressed in a non-consolidation opinion proffered as evidence of "isolation" under SFAS No. 125. This demand, in turn, requires that bankruptcy attorneys be all the more diligent in dissecting the structure of deals on which they have been asked to opine. Attention to these facts, coupled with carefully chosen opinion language, all but ensures a reasoned opinion, which reduces the risks to both client and firm and, when noticed in the financial community, increases the probability that your vacation need not be so long.

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Footnotes

¹ The Eastern District of Virginia provides a notable example of the decline in chapter 11 cases: 479 in 1990, 644 in 1991, 549 in 1992, 507 in 1993, 285 in 1994, 317 in 1995, 295 in 1996, 235 in 1997, and 120 through July of 1998. See http://www.vaeb.uscourts.gov/stats/dist.htm. A similar drop in business cases is clear: 2196 in 1990, 2463 in 1991, 1358 in 1992, 1270 in 1993, 819 in 1994, 783 in 1995, 773 in 1996, 758 in 1997, and 351 through July of 1998. Id. (Return to text)

² For those who have ignored this trendy financing technique, a brief summary can be found in archives of the ABI Journal. See Sheryl A. Gussett, Bankruptcy Remote Entities in Structured Financings, 15 A.B.I.J. 14 (March 1996). For a more comprehensive discussion of the topic, one of the most readable treatises is still Mortgage-Backed Securities: Developments and Trends in the Secondary Mortgage Market, which is authored and updated annually by Ken Lore and Cam Cowan. (Return to text)

³ A financial asset is defined as "a contract that conveys to a second entity a contractual right (a) to receive cash or another financial instrument from a first entity or (b) to exchange other financial instruments on potentially favorable terms with the first entity." SFAS No. 125, • 243. (Return to text)

⁴ In the introduction to draft guidelines circulated earlier this year, FASB acknowledged that its staff "continues to receive a high number of inquiries on the appropriate application of certain provisions of that Statement." See FASB Special Report (Preliminary Draft), A Guide to Implementation of Statement 125 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, (April 30, 1998), http://www.rutgers.edu/Accounting/raw/fasb/draft/draftpg.html. (Return to text)

⁵ AICPA published this document in the February 1998 Journal of Accountancy. (Return to text)

⁶ FASB has made this conclusion all but inevitable. "An attorney's opinion that the transfer would be found to be a true sale at law may provide important evidence that the transferred assets have been isolated from the transferor but does not eliminate the need to consider all available evidence." FASB Special Report (Preliminary Draft), supra note 3, at • 9. FASB has insisted, moreover, that "[t]he requirement of paragraph 9(a) would not be satisfied simply because the likelihood of bankruptcy of the transferor is determined to be remote." Id. at • 10. The message to AICPA and its auditors is clear—demand a non-consolidation opinion. (Return to text)

⁷ SAS No. 73.13. (Return to text)

⁸ Jacobellis v. Ohio, 378 U.S. 144, 197 (1964) (Stewart, J., concurring). (Return to text)

⁹ In Kline v. First W. Gov't Securities Inc., 24 F.3d 480, 486 (3d Cir. 1994), cert. denied, 115 S. Ct. 613 (1994), the Court of Appeals for the Third Circuit woke up the bar when one of its panels ruled in a Rule 10b-5 action: "[The law firm] asserts as a matter of law that it cannot be held liable for an opinion letter in which it made explicit that it was basing its [tax] opinion on an assumed set of facts represented to it by its client and that it had conducted no independent investigation into whether those represented facts accurately reflected reality. We are unpersuaded by this argument...We have held that '[a]n opinion or projection, like any other representation, will be deemed untrue for purposes of the federal securities laws if it is issued without reasonable genuine belief or if it has no basis.'" (Return to text)

¹⁰ See Reider v. F.D.I.C. (In re Reider), 31 F.3d 1102, 1105-07 (11th Cir. 1994) (providing a thorough history of the doctrine under the Bankruptcy Act of 1898). (Return to text)

¹¹ In re Donut Queen Ltd., 41 B.R. 706, 709-10 (Bankr. E.D.N.Y. 1984). (Return to text)

¹² In re Standard Brands Paint Co., 154 B.R. 563, 568 (Bankr. C.D. Cal. 1993). (Return to text)

¹³ The Court of Appeals for the Eighth Circuit seemingly adopted the essence of this standard in First National Bank of El Dorado v. Giller (In re Giller), 962 F.2d 796, 799 (8th Cir. 1992). Without citing Auto-Train, the court directed that judges must consider the following factors: (1) the necessity of consolidation due to the interrelationship among the debtors, (2) whether the benefits of consolidation outweigh the harm to creditors, and (3) prejudice resulting from not consolidating the debtors. (Return to text)

¹⁴ Eastgroup Properties at 248. (Return to text)

¹⁵ Augie/Restivo at 520. (Return to text)