Substantive consolidation of a non-debtor by a bankruptcy court is a practice that frequently evokes strong opinions. Often, this commentary is negative. The criticisms of commentators range from questioning the constitutional power to use such a remedy to concerns about the appropriate procedures to be followed when a party seeks to invoke this remedy. All of these questions merit full consideration, but sometimes the focus given to the potential problems of substantive consolidation of a non-debtor obscures the vitality of the remedy. There are many court decisions, both under the Bankruptcy Code and the old Act, that support the substantive consolidation of non-debtors. Many of these decisions grapple with, and reject, the commentators' criticism. This article collects and discusses the principal cases approving the power of a bankruptcy court to substantively consolidate a non-debtor with a debtor. This article will also deal with the cases in the minority that reject the application of the doctrine to non-debtors.

Background and General Authority

Courts usually respect the separateness of corporations. "Corporate separateness" means that a corporation is a legal entity distinct from its owners or other entities, and as a separate entity a corporation may own assets and become obligated on debts. But in a variety of different contexts, including cases where state law doctrines of "alter ego," "instrumentality" or "piercing the corporate veil" (collectively referred to here as "alter ego doctrines") are applied, the facts can lead courts to conclude that the principle of corporate separateness must give way. In bankruptcy, substantive consolidation (and sometimes the closely related alter ego doctrine) is used by bankruptcy courts to negate corporate separateness. As a general rule, when two or more entities are substantively consolidated by a bankruptcy court, all of their assets and debts are combined as though they were merged.² The majority rule is that a bankruptcy court has the power to order the consolidation of a non-debtor into a debtor using the principles of substantive consolidation.

Circuit Court Decisions Permitting Substantive Consolidation of Non-debtors

Since the enactment of the Code, at least one circuit court has squarely approved the bankruptcy court's power to order the substantive consolidation of non-debtor corporations into a debtor in a pending chapter 7 case. Alexander v. Compton (In re Bonham), 229 F.3d 750 (9th Cir. 2000). The Bonham court reviewed cases under the Act and the Code that authorized substantive consolidation generally, and stated that "[c]ourts have permitted the consolidation of non-debtor and debtor entities in furtherance of the equitable goals of substantive consolidation." Id. at 765. The court noted that, "[w]ithout the check of substantive consolidation, debtors could insulate money through transfers among intercompany shell corporations with impunity." Id. at 764.

Several other circuit courts of appeal implicitly approve, in varying degrees, the application of the doctrine of substantive consolidation to non-debtors. For example, in Creditors Services Corp. v. Cooley (In re Creditors Services Corp.), No. 98-3838, 1999 WL 519296 (6th Cir. July 15, 1999), the appeals court affirmed the district court's dismissal of an appeal because of untimely filings from the bankruptcy court's order substantively consolidating non-debtors.³ The court cited First Nat'l. Bank v. Rafoth (In re Baker & Getty Fin. Servs. Inc.), 974 F.2d 712, 721 (6th Cir. 1992), which involved an appeal from a preference action that raised the propriety of nunc pro tunc substantive consolidation of non-debtors. While the opinion in Baker & Getty Fin. Servs. does not contain a holding that substantive consolidation of non-debtors is authorized, the court's opinion certainly provides an endorsement of the doctrine and a reason for its existence: "The order of consolidation rests on the foundation that the assets of all the consolidated parties are substantially the same."⁴ In Gandy v. Gandy (In re Gandy), 299 F.3d 489, 499 (5th Cir. 2002), the Fifth Circuit affirmed the denial of motions to compel arbitration of claims brought in an adversary proceeding seeking, among other things, substantive consolidation of non-debtors, stating that "[w]hile we recognize that substantive consolidation is an extreme and unusual remedy and we intimate no view on the merits...substantive consolidation is a remedy available to a bankruptcy court that may be out of reach in arbitration." In Official Unsecured Creditors' Comm. v. Michaels (In re Marin Motor Oil Inc.), 689 F.2d 445, 477 (3d Cir. 1982), the Third Circuit ruled that the creditors' committee had standing to intervene in two adversary proceedings, one of which was "to extend the pending chapter 11 proceedings to include the Marins individually and the various Marin companies besides Marin Motor Oil. The trustee's complaint alleged that the various companies had been operated as a single economic unit, without observance of the requisite formalities; that the Marins had 'complete control' over the various companies; that the Marin's personal assets were inextricably intertwined with those of the companies; that Marin Motor Oil financed the other companies; and that the purpose and effect of forming the other companies was to delay and defraud creditors."

District Court and Bankruptcy Court Decisions Permitting Substantive Consolidation

Several district and bankruptcy courts have also held that the bankruptcy court has the power to consolidate non-debtors into a debtor. In White v. Creditors Service Corp. (In re Creditors Service Corp.), 195 B.R. 680 (Bankr. S.D. Ohio 1996), the bankruptcy court acknowledged that "substantive consolidation is similar to the state law remedy of piercing the corporate veil based on a finding that the entities are alter egos... Piercing the corporate veil, however, is not a prerequisite to the utilization of the bankruptcy law remedy of substantive consolidation." Id. at 689. After reviewing the facts against the widely cited substantive-consolidation factors of In re Vecco Construction Industries Inc., 4 B.R. 407, 410 (Bankr. E.D. Va. 1980), and performing the widely cited balancing test of In re Snider, 18 B.R. 230 (Bankr. D. Mass. 1982), among other cases, the court found that substantive consolidation of the non-debtors was warranted.

In Munford Inc. v. TOC Retail Inc. (In re Munford Inc.), 115 B.R. 390 (Bankr. N.D. Ga. 1990), the defendants filed a motion to dismiss the complaint seeking substantive consolidation of two non-debtors with the debtor. In support of their motion to dismiss, the defendants first contended that the debtor had not alleged all the elements required by the common-law "instrumentality" or "alter ego" theory. In response, the court held that the debtor was proceeding under a theory "distinct" from the instrumentality theory—that of substantive consolidation. The court reviewed many of the cases in this area, and decided to evaluate the debtor's factual allegations against the substantive consolidation factors, established in Union Sav. Bank v. Augie/Restivo Baking Co. (In re Augie/Restivo Baking Co.), 860 F.2d 515 (2d Cir. 1988). The court held that "[a]s long as the debtor can satisfy the pleading requirements of substantive consolidation, i.e., that assets are commingled and unseparable or that creditors have relied on the entities as a single unit and that assets should not be separated, then the debtor has correctly invoked its legal rights under these Code sections." Munford, 115 B.R. at 398.

The defendants also challenged the authority of the court to substantively consolidate a non-debtor, but the court found sufficient authority in the Supreme Court's decision in Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215 (1941), and the Second Circuit decision in Soviero v. Franklin National Bank, 328 F.2d 446 (2d Cir. 1964), stating that "the fact that these cases were decided under the 'instrumentality' theory does not diminish their importance...because, while they relied on different grounds for consolidation, the cases authorized the same remedy...the transfer of a non-debtor's assets into the debtor's estate." Munford, 115 B.R. at 397. Next, the defendants argued that §105 of the Code was not so broad to include "such an extreme remedy," in part since §303 (governing involuntary cases) provides a method to bring a non-debtor into bankruptcy. Id. The court disagreed, stating that substantive consolidation of a non-debtor is "substantially different from the involuntary petition remedy of §303." Id. In seeking the substantive consolidation of the non-debtor, the debtor was not trying to:

create an independent bankruptcy estate for [the non-debtor]...[the non-debtor] is not an insolvent entity... [T]he insolvency requirement of §303 would subvert the entire purpose of substantive consolidation in this case, which is to recover assets from a financially sound entity. Substantive consolidation, therefore, must be considered a remedy which is entirely independent of, and indeed inconsistent with, the involuntary petition remedy. Accordingly, it is recognized as an alternative means to bring a non-debtor's assets into a debtor's estate.

Id. at 397-98; accord, In re Alico Mining Inc., 278 B.R. 586, 588 (Bankr. M.D. Fla. 2002).⁵

The Munford court stated that substantive consolidation involving a non-debtor "is essentially a complex turnover proceeding because the debtor is asking the non-debtor affiliated entity to bring into the estate assets in which the debtor asserts an unseparable interest." Munford, 115 B.R. at 398.

In the case of In re Crabtree, 39 B.R. 718 (Bankr. E.D. Tenn. 1984), creditors sought to amend the involuntary petition (already resolved by the entry of an order for relief) to add to it a company owned 100 percent by the debtor, contending that it was the alter ego of the debtor. The debtor claimed that the "proper procedure" was for the creditors to first file an involuntary petition against the non-debtor and then move to consolidate. While the court acknowledged that such a procedure would be "acceptable," the court held that an involuntary petition followed by a motion to consolidate was not the exclusive method by which creditors could add an alter ego to the petition. Upon a review of the facts, the court found that the non-debtor was the alter ego of the debtor. The court also found that the affairs of the debtor and the non-debtor corporation were "so intermingled and entwined that their separate assets and liabilities cannot be ascertained, and any attempt to separate their financial affairs would consume substantial assets...with no...likelihood that such an effort would be successful." Crabtree, 39 B.R. at 721. The court found that amending the petition did not add a second debtor to the petition, "but rather reflects the reality that [the corporation] is simply Crabtree's alter ego and an instrumentality to conduct his financial affairs." Id. at 721. "[I]ts assets are properly part of his estate." Id. at 722.⁶

Cases Denying Substantive Consolidation of Non-debtors

A minority of courts have found that the principles of substantive consolidation cannot extend to a non-debtor, usually on concerns about jurisdiction or a possible conflict with the provisions of the Code for bringing an involuntary bankruptcy. In Helena Chemical Co. v. Circle Land & Cattle Corp. (In re Circle Land & Cattle Corp.), 213 B.R. 870 (Bankr. D. Kan. 1997), a creditor of the debtor filed a complaint alleging that a non-debtor was the alter ego of the debtor and should be substantively consolidated into the debtor. The court rejected reliance on "alter ego" jurisprudence and held that the plaintiff was required to allege facts sufficient under the bankruptcy doctrine of substantive consolidation. Since the plaintiff had not, it had failed to state a claim. But the court also stated that the non-debtor status of the defendant presented other problems. First, since the plaintiff was not a creditor of the defendant, it could not have initiated an involuntary proceeding against it, and second, since the defendant was a farmer, it was immune from an involuntary bankruptcy proceeding. More generally, the court was critical of cases that had permitted the substantive consolidation of a non-debtor: "The Code is devoid of any provision that can be construed to grant the court jurisdiction over a non-debtor party.... Using §105 [of the Code] to support an equitable order of substantive consolidation of a non-debtor with a debtor is, in effect, taking jurisdiction over the non-debtor corporation without express statutory authority. Yet, most bankruptcy cases hold that §105 is not a jurisdictional grant." Id. at 876. Because the court concluded it lacked jurisdiction, the plaintiff was not permitted to replead.

In the case of In re DRW Property Co., 54 B.R. 489 (Bankr. N.D. Tex. 1985), the debtor sought to substantively consolidate the debtor entities with 109 non-debtor partnerships, but the debtor failed to carry its burden of proof to support substantive consolidation. In addition, and without discussion, the court stated that it was "unaware of any statutory or common law authority to substantively consolidate debtor and non-debtor partnerships. The non-debtor partnerships are certainly well outside the scope of this court's jurisdiction." Id. at 497.

One other court has strongly questioned, but has not totally ruled out, the possibility that such relief could be granted under some theory. In Morse Operations Inc. v. Robins Le-Cocq Inc. (In re Lease-A-Fleet Inc.), 141 B.R. 869, 869 (Bankr. E.D. Pa. 1992), the court opined:

Because we believe that the involuntary substantive consolidation of the case of a debtor with the non-case of a non-debtor is a type of relief fraught with conceptual problems, we believe that such relief, if ever appropriate, should be granted in only extraordinary situations, notably when the debtor and non-debtor are alter egos of one another and/or have totally commingled their assets. Finding that Robins and the debtor have continually stood alone as totally distinct entities engaged in different businesses, and that no basis for this relief is stated, we will grant the motion and dismiss this proceeding.

Although its holding was based on a lack of facts that would support consolidation, the court offered some discussion of these "conceptual problems." Primarily, the court believed that a proceeding to consolidate a non-debtor with a debtor raises the potential for circumvention of the procedures for the commencement of an involuntary bankruptcy. In addition, the court was not exactly sure what relief should be granted in such a case; it seemed to the court to be "betwixt and between" the provisions of the Code.⁷

Several other decisions after the enactment of the Code express some doubt about the power to substantively consolidate a non-debtor. One of them, however, was decided purely on state-law grounds, and the court found that the trustee's complaint was "replete with the conclusions...but there are simply no, or grossly insufficient, facts offered in support...." Weinman v. Hamilton Props. Corp. (In re Hamilton), 186 B.R. 991, 1002 (Bankr. D. Colo. 1995). Another case, Goldman v. Haverstraw Associates (In re R.H.N. Realty Corp.), 84 B.R. 356 (Bankr. S.D.N.Y. 1998), is less clear, as the court first stated that "the plaintiffs presented no evidence" to support their request for substantive consolidation. The request for substantive consolidation was made in the context of an amendment to an already decided involuntary petition, which the court found offended notions of fundamental due process. State law alter ego claims were raised, but were found lacking.⁸

Another court, citing due-process concerns, dismissed a motion for substantive consolidation on the basis that the wrong procedure (a motion, rather than an adversary proceeding) was used. In re The Julien Co., 120 B.R. 930, 938 (Bankr. W.D. Tenn. 1990). At least one court has held that notice of a motion for substantive consolidation must be given to all creditors of the person or entity that is sought to be consolidated into another. See, e.g., United States v. AAPC Inc. (In re AAPC Inc.), 277 B.R. 785 (Bankr. D. Utah 2002). The court did not consider the potential harm that might be suffered by the defendant simply as a result of such notice.

Weight of Authority Favors Substantive Consolidation When Facts Warrant

A majority of courts permit the doctrine of substantive consolidation to be applied to a non-debtor. Concerns that the substantive consolidation of a non-debtor is inconsistent with §303 of the Code (governing the commencement of involuntary bankruptcies) have been answered by the Munford decision and others, which point out the distinction between those two remedies. Potentially more serious concerns about the limits of the equity powers of a bankruptcy court (expressed after the Supreme Court's decision in Grupo Mexicano de Desarrollo S.A v. Alliance Bond Fund Inc., 527 U.S. 308 (1999); see Tucker, J. Maxwell, "Grupo Mexicano and the Death of Substantive Consolidation," 8 Am. Bankr. Inst. L. Rev. 427 (2000)), have been rejected by at least four courts, either in the context of substantive consolidation or other examples of the bankruptcy court's equity powers.⁹

While it is sometimes stated that substantive consolidation is an unusual remedy, it is clear that the facts that make such a remedy necessary occur time and again. When those facts are demonstrated, most courts do not hesitate to grant the relief called for by such circumstances.

Footnotes

¹ Kit Weitnauer is a partner at Alston & Bird LLP and is resident in its Atlanta office. Return to article

² FDIC v. Colonial Realty Co., 966 F.2d 57, 60 (2d Cir. 1992); In re K-Tel Int'l Inc., 65 B.R. 594 (Bankr. D. Minn. 1986) (after substantive consolidation of two debtors, the two claims of a creditor, one a direct claim against one of the consolidated debtors, and one in substance a guarantee of that claim by the other of the two debtors, were merged into a single indivisible claim). Return to article

³ The appellants claimed that the appeal should be heard on the basis that "substantive consolidation is a rarely used, equitable judicial remedy, with no specific basis in the Code." The court responded: "We are not persuaded. Substantive consolidation is not so unprecedented as appellants claim that this court should review it to prevent some injustice. Substantive consolidation is a recognized equitable power of the bankruptcy courts granted in 11 U.S.C. §105(a)." Return to article

⁴ See, also, Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270, 276 (D.C. Cir. 1987) (In an earlier decision, the bankruptcy court had substantively consolidated a non-debtor with the debtor. Reviewing the authorities relating to substantive consolidation, the court stated, "[w]e assume, arguendo, that consolidation was proper," but went on to determine that substantive consolidation nunc pro tunc was not.). Return to article

⁵ See, also, Bracaglia v. Manzo (In re United Stairs Corp.), 176 B.R. 359 (Bankr. D. N.J. 1995) (non-debtors were mere instrumentalities; creditor has standing to assert substantive consolidation of non-debtor; substantive consolidation of non-debtor appropriate independent of a right to petition for an involuntary bankruptcy). Return to article

⁶ Several other cases have found that the consolidation of a non-debtor into the estate of a debtor may be proper under the appropriate factual showing, even though, in some of these cases, the proper factual showing was not made: Simon v. New Center Hosp. (In re New Center Hosp.), 187 B.R. 560 (E.D. Mich. 1995) (district court affirmed bankruptcy court's grant of summary judgment that consolidated non-debtors into the debtor but reversed the decision that substantive consolidation would be nunc pro tunc); Walter E. Heller & Co. v Langenkamp (In re Tureaud), 59 B.R. 973 (N.D. Okla. 1986); In re Alico Mining Inc., 278 B.R. 586, 588 (Bankr. M.D. Fla. 2002) (despite "initial misgivings" a review of the cases convinced the court to hold that satisfaction of the tests for substantive consolidation announced in Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270 (D.C. Cir. 1987) (and other cases), will permit substantive consolidation of non-debtor); In re Morfesis, 270 B.R. 28, 31 (Bankr. D. N.J. 2001) (court may order substantive consolidation of non-debtors, but evidence insufficient); Official Committee of Asbestos Claimants v. G-I Holdings Inc. (In re G-I Holdings Inc.), Case No. 01-30135 (RG), 2001 Bankr. LEXIS 2029 at *19 (Bankr. D. N.J. March 21, 2001) (noting that substantive consolidation between a debtor and non-debtor is permissible under appropriate circumstances, but finding the standards for substantive consolidation lacking in that case); In re Gucci, 174 B.R. 401, 413 (Bankr. S.D.N.Y. 1994) ("Although it is not a requirement that all the entities be debtors, it is most often the case that they are."); In re Cooper, 147 B.R. 678 (Bankr. D. N.J. 1992) (in prior proceedings, the trustee for husband and wife debtors determined that two corporations were alter egos of debtors and moved for an order "extending the Coopers' case to include [the corporations], and to substantively consolidate [them];" motion was granted); United States v. Fairfield Const. Co. (In re Fairfield Const. Co.), No. 90-04961-G, 1995 WL 434474 (Bankr. E.D. Mich. Sept. 12, 1991) (where two entities "acted as one they will be treated as one;" alter ego found; substantive consolidation ordered nunc pro tunc); Kroh Bros. Dev. Co. v. Kroh Bros. Mgmt. Co. (In re Kroh Bros Dev. Co.), 117 B.R. 499 (W.D. Mo. 1989) (affirming standing of trustee to bring substantive consolidation case against non-debtor and approving nunc pro tunc effect of substantive consolidation order); United Union of Roofers v. Ford (In re Ford), 54 B.R. 145 (Bankr. W.D. Mo. 1984) (evidence insufficient); In re 1438 Meridian Place N.W. Inc., 15 B.R. 89, 91 (Bankr. D.C. 1981) (movants sought to "amend the caption and pierce the corporate veil" to add non-debtors, alleging that the debtor was just one of several corporations, all of which were the "alter ego" of the owners of the debtor (two individuals). The court found that "all of these various corporations were and are, in fact, the alter ego of the principal officers...."). Return to article

⁷ See Raslavich v. Ira S. Davis Storage Co. (In re Ira S. Davis Inc.), 1993 Bankr. LEXIS 1383, at *12 (Bankr. E.D. Pa. 1993) ("We believe that the trustee misreads the tone of [Lease-a-Fleet] as suggesting that, if these elements are present, the relief of consolidating a debtor into the case of a non-debtor is appropriate. Rather, we meant to state, in [Lease-a-Fleet], that certain conceptual problems render such relief doubtful in any circumstances." [Id. at *12]. "[O]nly proof of extremely compelling facts has any potential of ultimate success." [Id. at *23]). Return to article

⁸ See, also, United States v. AAPC Inc. (In re AAPC Inc.), 277 B.R. 785 (Bankr. D. Utah 2002) (the court permitted the amendment of a claim for substantive consolidation, but stated that it would "seek input" on how the protections of §303 "may be defeated by a general statute such as 11 U.S.C. §105 for purposes of consolidating a non-debtor individual into a corporate bankruptcy."); In re Alpha & Omega Realty Inc., 36 B.R. 416 (Bankr. D. Idaho 1984) (court lacks jurisdiction over non-debtor, except perhaps if non-debtor was a "sham or functionally indistinguishable from the debtor," but facts are insufficient to support consolidation even if entity was also a debtor). Return to article

⁹ See In re Dow Corning Corp., 280 F.3d 648 (6th Cir. 2002) (non-consensual, non-debtor releases contained in a plan); In re American HomePatient Inc., 298 B.R. 152 (Bankr. M.D. Tenn. 2003) (substantive consolidation); In re Stone & Webster Inc., 286 B.R. 532 (Bankr. D. Del. 2002) (rejecting argument that Grupo Mexicano prohibits substantive consolidation for several reasons, including (1) specific references to the powers of the bankruptcy court (albeit in a different context) in the Grupo Mexicano opinion, (2) the general equitable powers of the bankruptcy court and (3) references to consolidation in 11 U.S.C. §1123(a)(5)(C)); Official Committee of Asbestos Claimants v. G-I Holdings Inc. (In re G-I Holdings Inc.), Case No. 01-30135 (RG), 2001 Bankr. LEXIS 2029 (Bankr. D. N.J. March 12, 2001) (rejecting, with limited reasoning, the argument that Grupo Mexicano impairs the remedy of substantive consolidation). Return to article