Substantive Consolidation of Non-debtor Entities Tag Youre in Bankruptcy

Substantive Consolidation of Non-debtor Entities Tag Youre in Bankruptcy

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One of the major concepts behind the Bankruptcy Code is the concept of an equal distribution among unsecured creditors. In fact, the Bankruptcy Code includes certain provisions to empower a trustee to equalize the distributions creditors receive. See, e.g., 11 U.S.C. §547 (preference actions).

In furtherance of the equal distribution concept, some courts have gone outside of the Bankruptcy Code's express provisions to apply "equitable" remedies, not the least of which is substantive consolidation. Substantive consolidation is a useful tool in certain cases and allows debtors to consolidate their assets and debts into a common pool, from which distributions are made to a consolidated creditor body, to reflect the reality of how some affiliated entities operate. See Eastgroup Properties v. Southern Motel Assoc. Ltd., 935 F.2d 245, 248 (11th Cir. 1991). Others have used equitable consolidation as a sword to forcefully combine assets and debts in an effort to create a larger asset pool to distribute equally in an attempt to ensure the equitable treatment of all creditors. See In re Augie/Restivo Baking Co., 860 F.2d 515, 518 (2d Cir. 1988).

When used as a sword, a trustee may seek to substantively consolidate a non-debtor entity. While the Bankruptcy Code provides for forcing an entity into bankruptcy, the procedure for doing so in a substantive consolidation scenario is not clear.

The Basis for Substantive Consolidation

As stated above, the Bankruptcy Code provides no statutory authority for substantive consolidation other than 11 U.S.C. §105(a). See Augie/Restivo, 860 F.2d at 518; Reider v. Federal Deposit Ins. Corp. (In re Reider), 31 F.3d 1102, 1105 (11th Cir. 1994). Although Federal Rule of Bankruptcy Procedure 1015 authorizes joint administration, Rule 1015 does not address substantive consolidation.

The authority for substantively consolidating a non-debtor with a debtor stems from the bankruptcy court's equitable powers found in §105(a), and from a small body of case law beginning with Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215, reh'g. denied, 313 U.S. 600 (1941). Post-Bankruptcy Code enactment, the concept of substantively consolidating two debtors is widely accepted. See Augie/ Restivo, 860 F.2d 515; Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270 (D.C. Cir. 1987); Woburn Assocs. v. Kahn (In re Hemingway Transp. Inc.), 954 F.2d 1 (1st Cir. 1992); Alexander v. Compton (In re Bonham), 229 F.3d 750 (9th Cir. 2000).

Less accepted is the substantive consolidation of non-debtor entities, the standard for which is a traditional alter-ego analysis. After all, the concept of substantively consolidating non-debtors arose from the non-bankruptcy remedy of "piercing the corporate veil," which makes the assets of one entity available to creditors of another entity if the former entity were an "alter ego" or "mere instrumentality" of the latter entity. See In re Standard Brands Paint Co., 154 B.R. 563, 567-68 (Bankr. C.D. Cal. 1993); see, also, In re Crabtree, 39 B.R. 718, 723-24 (Bankr. E.D. Tenn. 1984) (holding that the "amended petition does not add a second debtor to this case, but rather reflects the reality that [the non-debtor corporation] is simply the [debtor's] alter ego and an instrumentality used by him to conduct his financial affairs").

Thus, the particular facts must present an element of fraud, injustice or fundamental unfairness, and it is only under such limited circumstances that substantive consolidation of a non-debtor is appropriate. See In re Baker & Getty Financial Services Inc., 78 B.R. 139, 142 (Bankr. N.D. Ohio 1987) (consolidating three non-debtor individuals who formed a Ponzi scheme); In re New Center Hospital, 187 B.R. 560, 568-69 (E.D. Mich. 1995) (finding that the debtors and non-debtor corporations were alter egos); In re United Stairs Corp., 176 B.R. 359, 369-70 (Bankr. D. N.J. 1995) (holding that a non-debtor may be consolidated with a debtor where the debtor used non-debtor entities as instrumentalities of fraud). While the application of substantive consolidation to a non-debtor has increasingly wide acceptance, the appropriate procedure for doing so is not clear. After all, the act of substantively consolidating an entity is both an involuntary bankruptcy and an action that seeks to recover property.

Recognizing those issues, some argue that non-debtors should never be substantively consolidated with debtors because, inter alia, of (1) the lack of authority to consolidate a non-debtor under the Bankruptcy Code, (2) the contravention of the procedures for involuntary petitions under 11 U.S.C. §303 and (3) the problem of what type of notice is due to the creditors of the non-debtor. See In re Circle Land and Cattle Corp., 213 BR 870, 877 (Bankr. D. Kan. 1997); In re Lease-A-Fleet, 141 BR 869, 872-75 (Bankr. E.D. Pa. 1992).

Procedural and Due Process

Substantive consolidation, where based on an alter-ego theory, is analogous to a state law fraudulent-transfer cause of action, as both examine the business dealings between the debtor and non-debtor. In fact, an alter-ego claim mirrors a fraudulent-transfer claim in that they both seek to avoid fraudulent actions and bring property into the bankruptcy estate that would be property of the bankruptcy estate but for the fraudulent actions.

As such, it would seem more appropriate to bring such an action as an adversary proceeding and/or through the Bankruptcy Code's involuntary bankruptcy provisions set forth in §303. See In re Alpha & Omega Realty Inc., 36 B.R. 416, 417 (Bankr. D. Idaho 1984). In fact, most courts have held that the proper manner for seeking substantive consolidation is an involuntary bankruptcy petition. See In re R.H.N. Realty Corp., 84 B.R. 356, 358 (Bankr. S.D.N.Y. 1988) (holding that "to add [a non-debtor] would deprive [the non-debtor] of the opportunity of contesting the involuntary petition, as permitted under 11 U.S.C. §303(d) and (h)" and because "[t]his procedure offends fundamental due process requirements..."); Lease-A-Fleet, 141 B.R. at 872-75 (refusing to substantively consolidate a debtor with a non-debtor because substantive consolidation of a non-debtor circumvents procedures for involuntary bankruptcies under §303).

Substantive consolidation through an involuntary petition, however, overlooks a common premise in such circumstances: The non-debtor is typically not indebted to the bankruptcy estate and/or such "debt" is the subject of a bona fide dispute. As such, a bankruptcy estate may not have the requisite basis for an involuntary petition. See 11 U.S.C. §303(b). And when comparing the due process protections afforded under an involuntary petition vs. those afforded in an adversary proceeding, an adversary proceeding clearly offers more due-process protection than an involuntary petition. See In re Julien Co., 120 B.R. 930, 937 (Bankr. W.D. Tenn. 1990) (holding that an adversary proceeding or an involuntary petition is the appropriate procedure, not a contested matter).

While due-process concerns are readily apparent, not all courts agree that the due-process protections afforded under the adversary rules and/or §303 are necessary. In fact, certain courts have held that an adversary proceeding is not necessary, and that while an involuntary petition against the non-debtors would have been an appropriate way to proceed, it was not necessary. See, e.g., In re 1438 Meridian Place N.W. Inc., 15 B.R. 89, 95-6 (Bankr. D.C. 1981); In re Bonham, 226 B.R. 56, 93 (Bankr. D. Alaska 1998), aff'd. In re Bonham, 229 F.3d 750 (9th Cir. 2000).

Other courts have raised concerns regarding the proper notice due the creditors of the non-debtor. See Lease-A-Fleet, 141 B.R. at 873. This concern seems misplaced, as the proper notice would be the same notice given to such creditors of either an involuntary bankruptcy petition, or a state-law alter-ego/veil-piercing action: none. See, e.g., 11 U.S.C. §303; Fed. R. Bankr. P. 1007(a)(2), 1011(a). Only upon entry of the substantive consolidation order would notice to all such creditors be appropriate.

Of course, a court should consider the best interests of the creditors of both the debtor and the non-debtor in determining whether to substantively consolidate a non-debtor. See In re DRW Property Co., 82, 54 B.R. 489, 498 (Bankr. N.D. Tex. 1985) (finding that creditors of certain partnerships would be harmed by consolidation, the court refused to order the substantive consolidation of 85 voluntary chapter 11 debtor partnerships with 109 non-debtor partnerships). But that is an argument for the parties to make, just as they would in a state-law alter-ego/veil-piercing action.

Conclusion

To further complicate matters, in 1999 the U.S. Supreme Court reasoned that federal courts sitting in equity are without power to employ equitable remedies that were not available to the English Court of Chancery prior to 1789. See Grupo Mexicano de Desarollo S.A. v. Alliance Bond Fund Inc., 527 U.S. 308 (1999). While the Grupo Mexicano decision did not expressly reverse the Sampsell decision, substantive consolidation presumably was not used by the English Court of Chancery prior to 1789, and is arguably unavailable to federal courts using equitable powers. See Tucker, J. Maxwell, "Grupo Mexicano and the Death of Substantive Consolidation," 8 ABI L. Rev. 427-451 (2000).

While courts have yet to extend Grupo Mexicano to prohibiting substantive consolidation, it is a challenge waiting to occur. In the meantime, it is important for courts and practitioners to consider the proper due process protections due a non-debtor in a substantive consolidation action. After all, substantive consolidation seeks not only to take property, but to remove separate legal identities altogether.

Journal Date: 
Monday, December 1, 2003