Date: Mon, 6 Nov 2000
By: Patrick A. Randolph,
Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
randolphp@umkc.edu
(Editor's Note: This
report represents a combination of reports on the = case from Jim Stillman, the
Report's regular bankruptcy reporter, and Jack = Murray, who also provides
thoughtful commentaries on commercial bankruptcy = issues.)
BANKRUPTCY; PROPERTY OF
THE ESTATE; SUBSTANTIVE CONSOLIDATION: Chapter = 11 estates of a corporate
debtor and its wholly owned subsidiaries will be substantively consolidated
where the business of all three companies = has been conducted by the debtor's
board of directors and the companies have = been so closely intertwined in
their business and corporate relationships as to = be practically
indistinguishable.
In re Affiliated Foods,
Inc., 249 B.R. 770 (Bankr. W.D.Mo. 2000).
The power of a court to
substantively consolidate related cases falls = within the general equitable
powers of Bankruptcy Code =A7 105, which states = that "the court may
issue any order, process, or judgment that is necessary or appropriate to carry
out the provisions of this title." 11 U.S.C. =A7 = 105 (a). See F.D.I.C.
v. Colonial Realty Co., 966 P. 2d57, 59 (2d Cir. 1992).
Substantive consolidation
is an extraordinary remedy, and there is a presumption against its use. See In
re DRW Property Co., 54 B.R. 489, = 494 (Bankr. N.D. Tax 1985). There are
generally two critical issues; (1) = whether creditors dealt with the entities
as a single economic unit and did not = rely on their separate identity when
extending credit, and (2) whether the = affairs of the debtors are so entangled
that consolidation will benefit all = creditors. See Union Savings Bank v.
Augie/Restive Baking Co., Ltd., (In re = Augie/Restive Baking Co., Ltd.), 860
8.2d 515, 51820 (2nd Cir. 1988).
According to the court in
the instant case, the determination as to = whether separate bankruptcy estates
should be substantively consolidated is = "highly fact-specific," and
the factors to be considered include(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 if
the estates are not consolidated.
What makes this case most
interesting is that the debtor itself was the = party interested in the
consolidation and, of course, the party with the = greatest control over the
relevant evidence.
Having decided to seek
substantive consolidation in this case, the = debtors brought on a parade of
management witnesses who testified to their own = laxity in keeping financial
affairs separate among the companies. The = president testified, for example,
that "it would be a real nightmare" to separate = the costs among the
three companies. Some corporate literature referred = to one of the separate
companies as "a division" of another company. And, = perhaps most importantly,
there was no evidence that the objecting creditor had = relied on the credit of
either of the subsidiaries in the funding or = administration of the subject
liability. Consolidation here is consistent with the "more = modern or
liberal trend."
Reporters Comment 1
(Stillman): In a case with potential = reverberations for conduit real estate
lenders, especially those who require the formation = of single-purpose,
bankruptcy-remote borrowers,
Reporter's Comment 2
(Stillman): Published substantive consolidation = opinions are relatively rare.
This opinion is reported particularly because = it is such a good example of
how inside management can marshal evidence in = favor of consolidation, if it
so chooses. There is early precedent for the = view that companies can be
substantively consolidated even in the face of true = bona fide creditors
(i.e., those who relied on the separateness of the entities), = so long as some
special protection is accorded. See Fish v. East, 114 Fed. 2d = 177, 199 (10th
Cir. 1940); Carroll v. Stern, 223 Fed 723, 725 (6th Cir. 1915).
Reporter's Comment 3
(Murray): The purpose of substantive = consolidation is to ensure equitable
treatment of all creditors, and the effect of = substantive consolidation of
two or more bankruptcy estates is to make them one; = instead of several
separate legal entities with separate assets and liabilities, = the assets and
liabilities of the entities involved are pooled, and the = liabilities of the
entities involved are then satisfied from a common pool of = assets created
from the consolidation. A court may, for example, decide to substantively
consolidate a special purpose vehicle or entity with its affiliates if it
appears that the two entities are perceived by the = creditors as one entity
and the equities of the interest of the firm's creditors = are best served by a
consolidation. See, e.g., In re Stop & Go Co. of America, = Inc., 49 B.R.
743 (Bankr. D.Mass 1985)(substantive consolidation is an equitable = remedy in
which a court may combine the assets and liabilities of two or more = separate and
distinct legal entities in a common fund as if the assets and = liabilities belonged
to a single entity).
Reporter's Comment 4
(Murray): In connection with securitized = realestate financing transactions,
the rating agencies (Standard & Poor's, = Moody's, Duff & Phelps,
Fitch) customarily require a legal opinion to the effect that = in the event
certain of the borrower's affiliates (including its owner(s), any affiliated
property manager and any other affiliate with which the = borrower has material
contractual relations) were to go into bankruptcy, the = borrower's assets and
liabilities would not become subject to such proceedings as = a result of the
application of the bankruptcy doctrine of substantive = consolidation.
Depending on the
circumstances, an opinion may also be required to the = effect that the
borrower's assets would not become property of its owner's = bankruptcy estate
in the event the owner were to become a debtor under the = Bankruptcy Code.
Such an opinion also typically deals with the irrevocability (or = "true sale")
of the owner's transfers to the borrower and fraudulent = conveyance issues.
However, a prudent opinion about bankruptcy law usually says = very little, and
most lawyers are trained to avoid giving title opinions. = According to the
Report of the Committee on Corporations Regarding Legal Opinions = in Business
Transactions, Tribar Opinion Committee, Opinions in the = Bankruptcy Context,
46 The Bus. Lawyer 718, 720 (1991):
The lawyer will
occasionally be asked to render an opinion that the = company has "good
and valid title" to its assets. The Committee is of the view = that the
lawyer should almost never render such an opinion as to the title = to its assets.
For California real estate, the recipient should be satisfied = with a title
insurance policy, and in general, it is nearly impossible for = the lawyer to effectively
ascertain the status of title to most forms of = personal property.
Most nonconsolidation
opinions by attorneys are highly qualified and = are "reasoned
opinions" as opposed to "clean opinions."
Editor's Comment: More
typically, a debtor will not want to see all = the separate entities
consolidated, as all will not be in bankruptcy. Consequently, counsel for
parties operating in separate entities = normally will want to preserve their
independent status.
An important application
of this approach might be where an individual landowner elects to hold each of
his properties in a separate LLC, = creating a separate management entity which
he also controls. As most of the = decisions in this case will be made and
documented by a common manager, there will = be very few "indicia of
separateness," inviting a court to determine that all = the LLC's should
be consolidated in a single bankruptcy proceeding. In such = cases, difficult
though it may be, dealings (such as loans) among the LLC's = ought to be
carefully documented and carry "arms length" terms), to demonstrate =
that each entity is economically independent.
Editor's Comment 2: A
recent Ninth Circuit Opinion also has recognized = the possibility of
consolidation. In re Bonham, 2000 WL 1468752 (9th Cir. = 2000). (Not a real
estate case - creditors were able to force consolidation of = various debtor
entities for purpose of bringing together a large number of = fraudulent conveyance
claims against parties who were the first "investor = beneficiaries" of
a $53 million+ "Ponzi" scheme. In a Ponzi scheme, the first = investors
are paid off from the amounts contributed by subsequent investors, so as to = build
credibility, often luring the first investors into investing more in a subsequent
round. As investment typically are all used for this = purpose, and nothing is
invested in the alleged business purpose, Ponzi schemes = typically are
insolvent from an early date.)
Readers are urged to respond, comment, and argue with the daily
development or the editor's comments about it.
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