Daily Development for Monday, February 6, 2006
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

BANKRUPTCY; SUBSTANTIVE CONSOLIDATION: Third Circuit narrows scope of substantive consolidation remedy. 

In re Owens Corning, 419 F. 3d 195 (3rd Cir. 2005) (cert pet pending)

This case, acknowledged by the court to an important one in a difficult area of law, deals with an issue that appears to be of central importance to many large financings (real estate and otherwise) today: whether separate corporate structures can be established so as to render them remote from economic difficulties, including bankruptcies, affecting related corporate entities.  In short, under what circumstances will a bankruptcy court or other court “consolidate” a group of related corporate entities into one entity for purposes of creditor’s claims or other issues?

The case is rendered all the more significant because it arises out of Delaware, the location of choice for many corporate entities and the jurisdiction selected in many choice of law clauses. 

It is further rendered significant by the fact that in this case the Federal District Court judge had ordered consolidation of corporate entities related to the bankrupt Owens Corning Corporation and thus put into jeopardy almost a billion dollars in guarantees provided to a consortium of banks (organized by Credit Suisse First Boston) that provided $2 billion to finance Owens Corning’s acquisition of Fiberboard Corporation in 1997. 

The court described Owens Corning, at the time of the financing, as a parent with subsidiaries consisting of a group of corporations and limited liability companies whihc compromised “a multinational corporate group.  Different entities within the group [had] different purposes.  Some for example, exist to limit liability concerns (such as those related to asbestos), others to gain tax benefits, and others have regulatory reasons for their formation.”   The court emphasized that, with a few exceptions which it dismissed as minor, the various subsidiaries had a separate corporate formality and existence, with separate boards of directors (with some overlapping members), payrolls, accounting, and functions.

 In connection with the financing, the Banks required guarantees from corporate entities that were part of the Owens Corning and Fibreboard business operations that had assets with a book value in excess of $30 million.  The subsidiaries agreed to maintain themselves as separate entities and not to merge into Owens Corning and to maintain separate financial records.  (Apparently, after that time, and even after the bankruptcy, there were some cash transfers among the subsidiaries for which no interest was paid and perhaps some other transfers of assets.  But the court indicated that these individual issues could be separately resolved, possibly through a fraudulent transfer approach, and did not impugn the overall separate character of the corporate organization.)

Three years later, Owens Corning and seventeen of its subsidiaries filed for bankruptcy in response to “mounting asbestos litigation.”

The creditor’s committee, perhaps dominated by tort plaintiff representatives, proposed a plan that would involved a “deemed consolidation” of all the Owens Corning entities into one financial entity for purposes of dealing with creditor’s claims.  This would eliminate the guarantees and leave the Banks as ordinary creditors competing with all the other creditors nipping at the consolidated assets for a share of their claims.  It would sweep into the bankruptcy assets of non-bankrupt entities.  This was the worst nightmare for the guaranteed banks, and they opposed vigorously.  The list of counsel on this matter takes up more than a page.

The District Court granted consolidation and this appeal ensued. 

Held: Reversed: The court concluded that substantive consolidation ought not to be used as a remedy here.

There were a number of procedural issues addressed by the court, that undoubtedly were important to the outcome.  This includes the argument that substantive consolidation ought not to be used in bankruptcy, at least without the unanimous consent of creditors.  But the focus of this note will be the discussion of the substantive consolidation issue itself. 

“Substantive consolidation, a construct of federal common law, emanates from equity. It ‘treats separate legal entities as if they were merged into a single survivor left with all the cumulative assets and liabilities (save for inter-entity liabilities, which are erased). The result is that claims of creditors against separate debtors morph to claims against the consolidated survivor.’. Consolidation restructures (and thus revalues) rights of creditors and for certain creditors this may result in significantly less recovery.

The court relied heavily on an article by Mary Elisabeth Kors, entitled Altered Egos: Deciphering Substantive Consolidation, 59 U. Pitt. L. Rev. 381, 383 (1998), which it described as “comprehensive and well-organized.”  It cited that article for the “commonsense deduction” that “corporate disregard s a fault may lead to corporate disregard as a remedy.” 

The court emphasized, however, that substantive consolidation is only one remedy to remedy the misuse of the entity form - what the court calls “corporate disregard.”  Other less draconian remedies, such as piercing of the corporate veil for individual purposes or transactions, declaring certain transactions to be fraudulent transfers in order to restore assets to a target entity, or the use of equitable subordination to set aside formal priorities in favor of a priority scheme deemed more equitable by a court.

The court noted that substantive consolidation, which involves a wholesale disregard of the entity structure of a set of business organizations, is a severe remedy that should be used only when other less invasive remedies are inadequate to achieve equity. 

“Each of these remedies has subtle differences. "Piercing the corporate veil" makes shareholders liable for corporate wrongs. Equitable subordination places bad-acting creditors behind other creditors when distributions are made. Turnover and fraudulent transfer bring back to the transferor debtor assets improperly transferred to another (often an affiliate). Substantive consolidation goes in a direction different (and in most cases further) than any of these remedies; it is not limited to shareholders, it affects distribution to innocent creditors, and it mandates more than the return of specific assets to the predecessor owner. It brings all the assets of a group of entities into a single survivor. Indeed, it merges liabilities as well. "The result," to repeat, "is that claims of creditors against separate debtors morph to claims against the consolidated survivor." [citation omitted]. The bad news for certain creditors is that, instead of looking to assets of the subsidiar!

 y with
 whom they dealt, they now must share those assets with all creditors of all consolidated entities, raising the specter for some of a significant distribution diminution.”


“No court has held that substantive consolidation is not authorized,  though there appears nearly unanimous consensus that it is a remedy to be used "sparingly." [citations and lengthy footnote omitted.]

The court reiterated that there is no “modern trend” toward increased use of the remedy.  The court also rejected the notion that there should be a series of tests or prerequisites to be satisfied.  Rather, courts should look at the overall picture.  In any event, it concluded, substantive consolidation ought not to be used only when it is convenient or leads to a desired remedy.  There must be the existence of the inappropriate disregard of business entity structure. 

The court identified certain guiding principles in deciding whether to use substantive consolidation.  First:  “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 calling equity (and even then only possible substantive consolidation) into play.”    The court stated as a second  guiding principle that “the harms substantive consolidation addresses are nearly always those caused by debtors (and entities that they control) who disregard separateness.   Harms caused by creditors typically are remed y by provisions found in the Bankruptcy Code, such as equitable subrogation and fraudulent transfer. 

The third principle stated by the court is that “mere benefit to the administration of the case . . . is hardly a harm calling substantive consolidation into play.”  As a fourth principle, because substantive consolidation is “rough justice” and so extreme, it should be used sparingly and only as a last resort.  Finally, it may only be used defensively, and not offensively “(for example, having a primary purpose to disadvantage tactically a group of creditors in the plan process or to alter creditor rights.)”

Once the court cited these principles, it was easy to predict what the outcome would be in this case. 

“The upshot is this.  In our Court what must be proven (absent consent) concerning the entities for whom substantive consolidation is sought is that (1) prepetition they disregarded separateness so significantly that creditors relied on the breakdown of entity borders and treated them as one legal entity, or (ii) postpetition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors.”

Of course, the creditor Banks in fact relied strongly on the preservation of corporate distinctions.  And, as with most tort claimants, it would be difficult for these claimants to show that asbestos plaintiffs relied upon a different corporate structure in becoming tort victims.  Nevertheless, the proponents of consolidation argued that the Banks themselves ignored the entity structure in the Owens Corning business structure because they did not require independent financial statements from each entity that served as a guarantor, did not monitor the entities, and did not obtain a non-consolidation legal opinion before making the loan. 

The court turned around the argument that the Banks did not separately examine the entities.  In fact, the court noted that the Banks knew a great deal about each entity, and how they developed their understanding and made their decisions was up to them.  More importantly, it is abundantly clear that the Banks relied significantly upon the entity structure and the preservation of these structures in the deal.  Indeed, it was the heart of the deal.  The fact that they did not require legal opinions, the court says, is meaningless.  (But it says this because the entities were not formed expressly for the financing, but were already in existence - leaving open the possibility - a happy one for Delaware lawyers - that demanding an opinion may be a significant factor in the analysis of whether a creditor relied upon separateness of entities in making a loan to a newly formed entity such as a “bankruptcy remote” borrower.)

As noted earlier, the court further concluded that whatever confusion existed in the transfer of assets among various entities postpetition could easily be remedied by approaches less severe than substantive consolidation. 

The court reserved its strongest statement until the end: It decried the approach of a “deemed consolidation” proposed here. 

“But perhaps the flaw most fatal to the Plan Proponents' proposal is that the consolidation sought was "deemed" (i.e., a pretend consolidation for all but the Banks). If Debtors' 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? In effect, the Plan Proponents seek to remake substantive consolidation not as a remedy, but rather a stratagem to "deem" separate resources reallocated to [Owens Corning] to strip the Banks of rights under the Bankruptcy Code, favor other creditors, and yet trump possible Plan objections by the Banks. Such "deemed" schemes we deem not Hoyle.”

Comment 1: A petition for certiorai has been filed but not yet acted upon.  If the U.S. Supreme Court should come down anywhere near where this opinion takes us, the dangers of substantive consolidation will largely disappear as an initial concern in financing transactions.  Lawyers and financiers will be able to structure entities that will carry debt and establish rules for separate identity that, if followed, will render them largely immune from consolidation.  Only subsequent carelessness (happily beyond the scope of the lawyer’s opinions at time of financing) will cause difficulties, and then only in the rarest of cases.

Comment 2: But bankruptcy cases may not arise exclusively in the Third Circuit, and the court does not appear to be applying exclusively Delaware law in reaching its equitable conclusions.  It appears we’re talking about general equity in bankruptcy, and, as we all know, this subject has many varied interpretations around the country.  In short, those relying on nonconsolidation as a precept in their financing plans have established an early lead in obtaining full legal recognition of their objectives.  The race is not yet fully run. 

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