A recent decision by a panel of the Third Circuit in In re Owens Corning¹ severely limits the equitable remedy of substantive consolidation. The court characterizes substantive consolidation as an "extraordinary"² remedy that is only to be used in "seldom-seen situations"³ as "a last-resort."⁴ After a review of the law in other circuits, the Third Circuit announced its own version of the test for substantive consolidation and five "principles" upon which substantive consolidation depends, all of which will make it difficult, if not impossible, to obtain an order of substantive consolidation in that circuit absent consent from all parties in interest. In fact, the court notes that it takes a "nearly 'perfect storm'"⁵ to invoke substantive consolidation under the new test announced by it. Even more emphatically, the court rejects the "deemed consolidation"⁶ of this case, which the court considered a "ploy"⁷ where "the plan process would proceed as though assets and liabilities of separate entities were merged, but in fact they remain separate with the twist that the guarantees to the banks are eliminated."⁸

 

The Facts

The court summarized the facts as follows: Owens Corning, a Delaware corporation (OCD), and its subsidiaries comprise a multinational corporate group. Each subsidiary was a separate legal entity that observed governance formalities. Each had a specific reason to exist separately, each maintained its own business records, and the intercompany transactions were regularly documented. Although there may have been some "sloppy" bookkeeping, two OCD officers testified that the financial statements of all the subsidiaries were accurate in all material respects.⁹

At a time that it was facing growing asbestos liability, OCD sought a loan in order to make an acquisition. In 1997 the banks closed a $2 billion loan to OCD, which provided for guarantees from present or future subsidiaries having assets with a book value in excess of $30 million. Under the loan agreement, subsidiaries had to maintain themselves as separate entities and keep separate books and records. Subsidiaries were prohibited from merging into OCD. Three years later, OCD and 17 of its subsidiaries filed for chapter 11 reorganization. More than two years after the filing, OCD and certain creditor groups proposed a plan that was predicated on "deemed" substantive consolidation of the debtors and three nondebtor subsidiaries of OCD.¹⁰

Typically, this arrangement pools all assets and liabilities of the subsidiaries into their parent and treats all claims against the subsidiaries as transferred to the parent. In fact, however, the plan proponents sought a form of what is known as "deemed consolidation" under which a consolidation is deemed to exist for purposes of valuing and satisfying creditor claims, voting for or against the plan, and making distributions for allowed claims under it. Yet "the plan would not result in the merger of or the transfer or commingling of any assets of any of the debtors or nondebtor subsidiaries...[which] will continue to be owned by the respective debtors or nondebtors." Despite this, on the plan's effective date "all guarantees of the debtors of the obligations of any other debtor will be deemed eliminated, so that any claim against any such debtor and any guarantee thereof...will be deemed to be one obligation of the debtors with respect to the consolidated estate." Put another way, "the plan eliminates the separate obligations of the subsidiary debtors arising from
the guarant[e]es of the 1997 Credit Agreement."¹¹

The Third Circuit observed that the lower court had "concluded that there existed 'substantial identity between...OCD and its wholly-owned subsidiaries'"¹² and had determined that "'there [was] simply no basis for a finding that, in extending credit, the banks relied upon the separate credit of any of the subsidiaries.'"¹³ In the view of the lower court, "it was 'also clear that substantive consolidation would greatly simplify and expedite the successful completion of this entire bankruptcy proceeding. More importantly, it would be exceedingly difficult to untangle the financial affairs of the various entities.'"¹⁴ The banks appealed.¹⁵

Review of Substantive Consolidation Law

The Third Circuit first reviewed the law of substantive consolidation, "a construct of federal common law [that] emanates from equity."¹⁶ "The concept of substantively consolidating separate estates begins with a commonsense deduction. Corporate disregard as a fault may lead to corporate disregard as a remedy."¹⁷ The court acknowledged (or characterized) other remedies for acts of corporate disregard, such as ignoring the "corporate veil" of a subsidiary that has been so dominated by the parent that the subsidiary is its "alter ego," or recovering transfers to a subsidiary under fraudulent conveyance law, or equitably subordinating a corporate parent's claim against the subsidiary as a consequence of dominance that prejudices other creditors.¹⁸

The court then surveyed precedent, beginning with the Supreme Court's decision in Sampsell v. Imperial Paper & Color Corp.¹⁹ and continuing through the developments in the Second Circuit in the '60s and '70s before concluding that "most courts slipstreamed behind two rationales—those of the Second Circuit in Augie/Restivo and the D.C. Circuit in Auto-Train"²⁰—and that "there appears nearly unanimous consensus that it is a remedy to be used 'sparingly.'"²¹

Test for Substantive Consolidation

After articulating five principles that give the rationale for substantive consolidation (discussed below), the court announced its test for substantive consolidation:

In our court, what must be proven (absent consent) concerning the entities for whom substantive consolidation is sought is that (1) pre-petition they disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (2) post-petition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors.
Proponents of substantive consolidation have the burden of showing one or the other rationale for consolidation. The second rationale needs no explanation. The first, however, is more nuanced.²²

 

The Third Circuit explained the first rationale at some length. First, the court said that "[t]his rationale is meant to protect in bankruptcy the pre-petition expectation of creditors. The usual scenario is that creditors have been misled by the debtors' actions (regardless of whether those actions were intentional or inadvertent) and thus perceived incorrectly (and relied on this perception) that multiple entities were one."²³ The court went on to say that:

 

[a] prima facie case for [the first rationale] typically exists when, based on the parties' pre-petition dealings, a proponent proves corporate disregard creating contractual expectations of creditors that they were dealing with debtors as one indistinguishable entity. Proponents who are creditors must also show that, in their pre-petition course of dealing, they actually and reasonably relied on debtor's supposed unity. Creditor opponents of consolidation can nevertheless defeat a prima facie showing under the first rationale if they can prove they are adversely affected and actually relied on debtor's separate existence...²⁴ [W]e do not decide here whether such a showing by an opposing creditor defeats the quest for consolidation or merely consolidation as to that creditor.²⁵

 

The court provided a bit of gloss to the second rationale, which, the court said:

 

is at bottom one of practicality when the entities' assets and liabilities have been "hopelessly commingled." Without substantive consolidation, all creditors will be worse off (as Humpty Dumpty cannot be reassembled) or, even if so...only the professionals [will] profit... With substantive consolidation, the lot of all creditors will be improved....²⁶

Third Circuit's "Principles" for Substantive Consolidation

Perhaps an even more telling gloss on its test for substantive consolidation is found in the "principles" of substantive consolidation announced by the court:

What, then, are those principles? We perceive them to be as follows:

1. Limiting the cross-creep of liability by respecting entity separateness is a "fundamental ground rule." As a result, the general expectation of state law and of the Bankruptcy Code, and thus of commercial markets, is that courts respect entity separateness absent compelling circumstances [that] call equity (and then only possibly substantive consolidation) into play.
2. The harms substantive consolidation addresses are nearly always those caused by debtors (and entities they control) who disregard separateness. Harms caused by creditors typically are remedied by provisions found in the Bankruptcy Code (e.g., fraudulent transfers and equitable subordination).
3. Mere benefit to the administration of the case (for example, allowing the court to simplify other issues or to make post-petition accounting more convenient) is hardly a harm calling substantive consolidation into play.
4. Indeed, because substantive consolidation is extreme (it may affect profoundly creditors' rights and recoveries) and imprecise, this "rough justice" remedy should be rare and, in any event, one of last resort after considering and rejecting other remedies (for example, the possibility of more precise remedies conferred by the Bankruptcy Code).
5. While substantive consolidation may be used defensively to remedy the identifiable harms caused by entangled affairs, it may not be used offensively (for example, having a primary purpose to disadvantage tactically a group of creditors in the plan process or to alter creditor rights).²⁷

Application of the Principles and the Test to Owens Corning

Interestingly, the court first referred to these "principles" to decide the appeal:

With the principles we perceive underlie use of substantive consolidation, the outcome of this appeal is apparent from the outset. Substantive consolidation fails to fit the facts of our case and, in any event, a "deemed" consolidation cuts against the grain of all the principles.²⁸

The court started with the banks' bargain: "They loaned $2 billion to OCD and enhanced that credit of that unsecured loan indirectly by subsidiary guarantees... [T]he banks got 'structural seniority'... This kind of lending occurs every business day. To undo this bargain is a demanding task."²⁹

The court then turned to the first test (pre-petition disregard of corporate separateness) and stated "there is no evidence of the pre-petition disregard of the OCD's entities' separateness."³⁰ The court then stated: "To the contrary, OCD (no less than CSFB) negotiated the 1997 lending transaction premised on the separateness of all OCD affiliates."³¹ OCD "put in place" "ground rules" the banks "played by" that entitled the banks to look to the guarantors "for payment when the time comes."³² The court pointed to evidence that showed that the banks intended to obtain "structural seniority"³³ and that the banks knew "a great deal"³⁴ about the assets and debts of the subsidiaries. The court brushed aside the argument that the banks should show that they examined financial statements of a subsidiary in order to show reliance on the separateness of that debtor; instead, the court agreed with the banks that reliance on the "existence of separate entities"³⁵ was sufficient.

With respect to the second test (hopeless commingling), the court stated that there was no "meaningful" evidence on this point, which "likely" is why the parties and the district court spent "little time" on this alternative test.³⁶ But the Third Circuit spent quite some time on how this test should, and should not, be applied. The district court's expression of the test, that commingling will justify consolidation when "the affairs of the two companies are so entangled that consolidation will be beneficial,"³⁷ was erroroneous:

[C]ommingling justifies consolidation only when separate accounting for the assets and liabilities of the distinct entities will reduce the recovery of every creditor—that is, when every creditor will benefit from the consolidation. Moreover, the benefit to creditors should be from cost savings that make assets available rather than from the shifting of assets to benefit one group of creditors at the expense of another... The district court's test...suffers from the infirmity that it will almost always be met... [F]ollowing such a path misapprehends the degree of harm required to order substantive consolidation.
But no matter the legal test, a case for hopeless commingling cannot be made.³⁸

Even assuming that the district court's findings that it would be "exceedingly difficult to untangle the affairs of the various entities"³⁹ were correct, "they are simply not enough to establish [that] substantive consolidation is warranted. Neither the impossibility of perfection in untangling the affairs of the entities nor the likelihood of some inaccuracies in efforts to do so is sufficient to justify consolidation."⁴⁰

Finally, the court turned to "perhaps the most fatal flaw...that the consolidation was 'deemed' (i.e., a pretend consolidation for all but the banks)."⁴¹ The opinion asks:

If [the] debtor's corporate and financial structure was such a sham before the filing of the motion to consolidate, then how is it that post the plan's effective date this structure stays largely undisturbed, with the debtors reaping all the liability-limiting, tax and regulatory benefits achieved by forming subsidiaries in the first place?⁴²

In conclusion, the Third Circuit said that in this case "there is simply not the nearly 'perfect storm' needed to invoke"⁴³ substantive consolidation, and even if there were, "a 'deemed' consolidation...fails to even qualify for consideration."⁴⁴

Conclusion

Obviously, In re Owens Corning is an important case on substantive consolidation. Several things are clear. First, "deemed" consolidations (at least when that means that one creditor is the only party adversely impacted by substantive consolidation) are history in the Third Circuit. Banks around the world holding guarantees from subsidiaries are breathing a collective sigh of relief.

Given the Third Circuit's absolute rejection of this "deemed" consolidation, one has to wonder why it spilled so much ink on substantive consolidation generally—the court could have said that whatever substantive consolidation is, it can never be a "deemed" consolidation that does nothing but strip banks of structural seniority as a "ploy." But the court did much more, and as a result of its other pronouncements, proving a substantive consolidation case in the Third Circuit will be difficult if not impossible. First, the "single enterprise" approach to a substantive consolidation case, which is an appropriate shorthand for the lower court's "conclusions" about the facts, and the facts relied on by OCD in its brief on appeal, was not only not persuasive to this court, but was (apparently) the equivalent of no evidence.⁴⁵ Second, and perhaps most importantly, any creditor whose ox will be gored by substantive consolidation will be able to defeat substantive consolidation if that creditor can show that it dealt with a particular legal entity. In fact, all that would appear to be required is reliance upon the existence of a legal entity that has some assets, a fact situation that will almost always be true.

To be sure, substantive consolidation has never been an easy remedy to obtain. Courts recognize that the remedy benefits one (or more) group(s) of creditors to the detriment of one (or more) other groups of creditors, and for that reason, the remedy is imposed with caution. From a reading of this opinion, however, it would appear that the existence of any detriment to a group of creditors that relied on the existence of a separate legal entity will prevent a court from ordering substantive consolidation.

The Third Circuit's focus returns time and again to the legal existence of an artificial entity and compliance with the formalities associated with the creation and continuation of that legal entity, and the court appears to consider any other facts to be irrelevant. As a result, with respect to the equitable remedy of substantive consolidation in the Third Circuit, equity's principal weapon—an inquiry into the substance of corporate separateness—has been utterly defeated by form.

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Footnotes

¹ In re Owens Corning, ____ F.3d ____, 2005 WL 1939796 (3d Cir. 2005). At the time of this writing, petitions for rehearing had been filed but had not been ruled on. Return to article

² 2005 WL 1939796 at *1. Return to article

³ Id. Return to article

⁴ Id. Return to article

⁵ Id. at *14. Return to article

⁶ Id. Return to article

⁷ Id. at *1. Return to article

⁸ Id. Return to article

⁹ Id. Return to article

¹⁰ Id. at *2. Return to article

¹¹ Id. (footnotes and citations to the record below omitted). Return to article

¹² Id. at *3. Return to article

¹³ Id. Return to article

¹⁴ Id. Return to article

¹⁵ Id. The plan proponents moved to dismiss the appeal on the ground that the order below was not a final decision. The Third Circuit denied that motion, holding that it generally had jurisdiction to review appeals of substantive consolidation orders, and that it specifically did in this case. Return to article

¹⁶ Id. at *5. Return to article

¹⁷ Id. at *6. Return to article

¹⁸ Id. Return to article

¹⁹ 313 U.S. 215 (1941). Return to article

²⁰ 2005 WL 1939796 at *8. In In re Augie/Restivo Banking Co. Inc., 860 F.2d 515, 518-19 (2d Cir. 1988) (citations omitted), the Second Circuit set out the tests for substantive consolidation as follows:

An examination of those cases, however, reveals that these considerations are merely variants on two critical factors: (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.
With regard to the first factor, creditors who make loans on the basis of the financial status of a separate entity expect to be able to look to the assets of their particular borrower for satisfaction of that loan. Such lenders structure their loans according to their expectations regarding that borrower and do not anticipate either having the assets of a more sound company available in the case of insolvency or having the creditors of a less-sound debtor compete for the borrower's assets. Such expectations create significant equities. Moreover, lenders' expectations are central to the calculation of interest rates and other terms of loans, and fulfilling those expectations is therefore important to the efficiency of credit markets. Such efficiency will be undermined by imposing substantive consolidation in circumstances in which creditors believed they were dealing with separate entities...
The second factor, entanglement of the debtors' affairs, involves cases in which there has been a commingling of two firms' assets and business functions. Resort to consolidation in such circumstances, however, should not be Pavlovian. Rather, substantive consolidation should be used only after it has been determined that all creditors will benefit because untangling is either impossible or so costly as to consume the assets. Otherwise, for example, a series of fraudulent conveyances might be viewed as resulting in a "commingling" that justified substantive consolidation. That consolidation, because it would eliminate all inter-company claims, would prevent creditors of the transferor from recovering assets from the transferee. Commingling, therefore, can justify substantive consolidation only where "the time and expense necessary even to attempt to unscramble them [is] so substantial as to threaten the realization of any net assets for all the creditors," or where no accurate identification and allocation of assets is possible. In such circumstances, all creditors are better off with substantive consolidation.
The evidence of commingling of assets and business functions in the instant case in no way approaches the level of "hopeless...obscur[ity]" of "interrelationships of the group"...necessary to warrant consolidation....

In In re Auto-Train Corp. Inc., 810 F.2d 270, 276 (D.C. Cir. 1987) (citations omitted), the D.C. Circuit set out the following tests for substantive consolidation:

Although the Bankruptcy Code nowhere specifically authorizes consolidation of separate estates, courts may order consolidation by virtue of their general equitable powers. When they do so, it is typically to avoid the expense or difficulty of sorting out the debtor's records to determine the separate assets and liabilities of each affiliated entity. However, because every entity is likely to have a different debt-to-asset ratio, consolidation almost invariably redistributes wealth among the creditors of the various entities. This problem is compounded by the fact that liabilities of consolidated entities inter se are extinguished by the consolidation. Before ordering consolidation, a court must conduct a searching inquiry to ensure that consolidation yields benefits offsetting the harm it inflicts on objecting parties. The proponent must show not only a substantial identity between the entities to be consolidated, but also that consolidation is necessary to avoid some harm or to realize some benefit. At this point, a creditor may object on the grounds that it relied on the separate credit of one of the entities and that it will be prejudiced by the consolidation. If a creditor makes such a showing, the court may order consolidation only if it determines that the demonstrated benefits of consolidation "heavily" outweigh the harm. Return to article

²¹ 2005 WL 1939796 at *8. Return to article

²² Id. at *10 (footnote omitted). Return to article

²³ Id. at n. 19 (citations omitted). Return to article

²⁴ Id. at *10 (citations omitted). Return to article

²⁵ Id. at n. 22. Return to article

²⁶ Id. at n. 20 (citations omitted). Return to article

²⁷ Id. at *9-10 (citations omitted). Return to article

²⁸ Id. at *10. Return to article

²⁹ Id. Return to article

³⁰ Id. This "no evidence" conclusion may have come as something of a surprise to the district court, which had found as follows:

I have no difficulty in concluding that there is indeed substantial identity between the parent debtor OCD and its wholly-owned subsidiaries. All of the subsidiaries were controlled by a single committee, from central headquarters, without regard to the subsidiary structure. Control was exercised on a product-line basis. For example, the president of the insulating-systems business managed all aspects of the production, marketing and distribution of insulation products, regardless of whether those products were manufactured in a factory owned by OCD or by a foreign subsidiary. The officers and directors of the subsidiaries did not establish business plans or budgets, and did not appoint senior management except at the direction of the central committee (the "Natural Leadership Team"). Subsidiaries were established for the convenience of the parent company, primarily for tax reasons. All of the subsidiaries were dependent upon the parent company for funding and capital. The financial management of the entire enterprise was conducted in an integrated manner. No subsidiary exercised control over its own finances.

Owens Corning's brief on appeal devotes more than 20 pages to a recitation of evidence that would appear to support the district court's findings. To be sure, the bank's brief on appeal focuses on other facts, including the existence of boards of directors and corporate resolutions, and assets held in the name of subsidiaries, that could support a contrary finding. The Third Circuit never explains why the findings of the district court were given no weight. Return to article

³¹ Id. The district court found exactly the opposite: "In short, there is simply no basis for a finding that, in extending credit, the banks relied on the separate credit of any of the subsidiary borrowers." See fn. 30 above. Return to article

³² Id. Return to article

³³ Id. Return to article

³⁴ Id. at *11. Return to article

³⁵ Id. Return to article

³⁶ Id. Return to article

³⁷ Id. (emphasis in original). Return to article

³⁸ Id. at *11-12. Return to article

³⁹ Id. at *12. Return to article

⁴⁰ Id. Return to article

⁴¹ Id. at *13. Return to article

⁴² Id. Return to article

⁴³ Id. at *14. Return to article

⁴⁴ Id. Return to article

⁴⁵ Compare, e.g., In re Munford Inc., 115 B.R. 390 (Bankr. N.D. Ga. 1990). Return to article