Substantive Consolidation: Adding Assets To The Bankruptcy Pot

Creditors may face an unrecognized risk from substantive consolidation, which is an equitable doctrine in bankruptcy permitting the consolidation of legally separate entities that are members of the same corporate or other affiliated group. It has the effect of combining the assets and liabilities of multiple debtors into a single bankruptcy estate, which can significantly alter the rights of the affected debtors' creditors. Typically, each debtor will have a different ratio of assets to debt, and in situations in which a court permits substantive consolidation, the creditors of a debtor with a higher asset-to-debt ratio will suffer at the expense of the creditors of a debtor with a lower asset-to-debt ratio. Substantive consolidation can even be used to pull a nonbankrupt, solvent debtor into the bankruptcy of a corporate parent or other affiliate.

In a business context, substantive consolidation poses a risk to any lender that extends credit to a corporation or other entity that is part of a larger corporate group. It is also relevant to securitization transactions and other financing transactions involving the sale of receivables, consumer finance contracts, or other assets through special-purchase vehicles (SPVs). Substantive consolidation has even been applied to consolidate the bankruptcy estates of spouses.1

To illustrate the potential effect of substantive consolidation, consider two affiliated companies, Company A and Company B. Company A is solvent with total assets of $10 million and total liabilities of $8 million, and Company B is insolvent with total assets of $5 million and total liabilities of $12 million. If Company B enters bankruptcy and is liquidated, its creditors would receive only approximately 40 cents on the dollar. Meanwhile, Company A is solvent and can pay its creditors in full. If, however, Company A and Company B are substantively consolidated into one bankruptcy estate, there would be $15 million of assets and $20 million of liabilities, resulting in each creditor receiving approximately 67 cents on the dollar. The creditors of Company B gain at the expense of Company A's creditors.2

The U.S. Bankruptcy Court for the Eastern District of Wisconsin recently ruled on a motion for substantive consolidation in In re Archdiocese of Milwaukee.3 That motion dealt with an attempt by a committee of unsecured creditors (the creditors' committee) to consolidate 210 separate, nonbankrupt parishes with the Archdiocese of Milwaukee for purposes of the Archdiocese's bankruptcy case. Although the case did not involve a financing or sale transaction, the decision discusses the legal standards courts apply to analyses of substantive consolidation. It is also the first case addressing substantive consolidation decided in the Eastern District of Wisconsin. This article discusses the Archdiocese of Milwaukee case in the context of a review of the current condition of substantive-consolidation doctrine.

Application of Substantive Consolidation in Financing Transactions

Any creditor that lends money to a member of an affiliated group should consider substantive consolidation's potential effect on its rights in the event of a bankruptcy of the borrower or any other member of the group.

Consider, for example, a borrower that has significant contingent liabilities relating to its historical operations. A lender may be willing to make a loan to the borrower if an affiliate of the borrower in an unrelated business with significant assets and no exposure to the contingent liabilities guarantees the loan. If the borrower subsequently files for bankruptcy, the guarantee of the solvent affiliate should protect the lender. However, if the borrower or its creditors (including the claimants with respect to the contingent liabilities) can pull the solvent affiliate into the bankruptcy estate through substantive consolidation, the value of the guarantee to the lender may be reduced or eliminated, significantly impairing the lender's recovery.

These are essentially the facts of In re Owens Corning,4 in which Owens Corning faced liabilities related to asbestos claims, and its bank lenders sought guarantees from subsidiaries not subject to the asbestos claims. When Owens Corning filed for bankruptcy, it and certain unsecured creditors proposed a reorganization plan predicated on obtaining substantive consolidation of the guarantor-subsidiaries. Substantive consolidation would have put at risk the guarantees negotiated by the lenders to protect themselves from the asbestos claims.5

The Archdiocese of Milwaukee's bankruptcy case, which we...