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.

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 1‑6, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Maria Tabor at the ABA. (312) 988 5590 or mtabor@staff.abanet.org

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