Ninth Circuit: Federal Law Governs Substantive Consolidation, And Supreme Court's Siegel Ruling Does Not Bar Consolidation Of Debtors And Nondebtors

Author:Mr Aaron Gober-Sims and Mark G. Douglas
Profession:Jones Day
 
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In Clark's Crystal Springs Ranch, LLC v. Gugino (In re Clark), 692 Fed. Appx. 946, 2017 BL 240043 (9th Cir. July 12, 2017), the U.S. Court of Appeals for the Ninth Circuit ruled that: (i) the remedy of "substantive consolidation" is governed by federal bankruptcy law, not state law; and (ii) because the Bankruptcy Code does not expressly forbid the substantive consolidation of debtors and nondebtors, the U.S. Supreme Court's decision in Law v. Siegel, 134 S. Ct. 1188 (2014), does not bar bankruptcy courts from ordering the remedy.

Substantive Consolidation

"Substantive consolidation" is an equitable remedy pursuant to which a bankruptcy court may order that the assets and liabilities of separate entities be treated as if they belonged to a single, combined entity.

The Bankruptcy Code does not expressly authorize substantive consolidation, but it recognizes that a chapter 11 plan may provide for the consolidation of a "debtor with one or more persons" as a means of implementation. See 11 U.S.C. § 1123(a)(5)(C). In addition, Fed. R. Bankr. P. 1015(b) provides that a bankruptcy court may direct that cases involving affiliated debtors be jointly administered ("procedural consolidation"), but the rule is silent regarding substantive consolidation.

A majority of courts have concluded that bankruptcy courts have the power to substantively consolidate debtor entities under section 105(a) of the Bankruptcy Code, which provides that a court "may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions" of the Bankruptcy Code. However, because forcing the creditors of one entity to share equally with the creditors of a less solvent entity is not appropriate in many circumstances, courts generally hold that substantive consolidation is an extraordinary remedy which should be used sparingly. See Buridi v. KMC Real Estate Investors, LLC (In re KMC Real Estate Investors, LLC), 531 B.R. 758 (S.D. Ind. 2015).

Different standards have been employed by courts to determine the propriety of substantive consolidation. Common to all of these tests is a fact-intensive examination and an analysis of consolidation's impact on creditors. For example, in Eastgroup Properties v. Southern Motel Assoc., Ltd., 935 F.2d 245 (11th Cir. 1991), the Eleventh Circuit adopted a modified version of the standard articulated by the District of Columbia Circuit in Drabkin v. Midland Ross Corp. (In re Auto-Train Corp., Inc.), 810 F.2d 270, 276 (D.C. Cir. 1987). According to this standard: (i) the proponent of consolidation must demonstrate that there is substantial identity between the entities to be consolidated and that consolidation is necessary to avoid some harm or to realize some benefit; and (ii) a creditor may object on the grounds that it relied on the entities' separate credit and will be prejudiced by consolidation, in which case the court can order consolidation only if it determines that the benefits of consolidation "heavily" outweigh the harm.

The Second Circuit established a somewhat different two-part disjunctive standard for gauging the propriety of substantive consolidation in Union Savings Bank v. Augie/Restivo Baking Co., Ltd. (In re Augie/Restivo Baking Co., Ltd.), 860 F.2d 515, 518 (2d Cir. 1988). There, the court concluded that the factual elements considered by the courts are "merely variants on two critical factors: (i) whether creditors dealt...

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