Lenders Feel the Sting of Substantive Consolidation

Although relatively uncommon, the substantive consolidation of two or more bankruptcy estates is an important tool available to a bankruptcy court overseeing the cases of related debtors whose financial affairs are hopelessly entangled. Deciding whether to apply this equitable remedy can be difficult. The court must conduct a factually intensive inquiry and carefully balance the competing concerns of all parties concerned. The ramifications of substantive consolidation for a bank group were the subject of a decision recently handed down by a Delaware bankruptcy court in In re Owens Corning.

Substantive Consolidation

The bankruptcy court is a court of "equity." Although the distinction between courts of equity and courts of law has largely become irrelevant in modern times, courts of equity have traditionally been empowered to grant a broader spectrum of relief in keeping with fundamental notions of fairness as opposed to principles of black-letter law. This means that a bankruptcy court can exercise its discretion to produce fair and just results "to the end that fraud will not prevail, that substance will not give way to form, that technical considerations will not prevent substantial justice from being done." One of the remedies available to a bankruptcy court in exercising this broad equitable mandate is the power to treat the assets and liabilities of two or more separate but related debtors as inhering to a single integrated bankruptcy estate. Employing this tool, courts "pierce the corporate veil" in order to satisfy claims of the creditors of the consolidated entities from their common pool of assets.

This remedy is referred to as "substantive consolidation." The Bankruptcy Code does not expressly countenance it. Rather, substantive consolidation is "a product of judicial gloss." Courts have consistently found the authority for substantive consolidation in the bankruptcy court's general equitable powers as set forth in section 105(a) of the Bankruptcy Code, which authorizes the court to "issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code]." Because of the dangers of forcing creditors of one debtor to share equally with creditors of a less solvent debtor, "substantive consolidation 'is no mere instrument of procedural convenience . . . but a measure vitally affecting substantive rights'" Accordingly, courts generally hold that it is to be used sparingly.

Different standards have been employed by courts to determine the propriety of substantive consolidation. All of them involve a fact-intensive examination and an analysis of consolidation's impact on creditors. For example, in Eastgroup Properties v. Southern Motel Assoc., Ltd., the Eleventh Circuit adopted, with some modifications, the standard enunciated by the District of Columbia Circuit in In re Auto-Train Corp., Inc. At the outset, the Eleventh Circuit emphasized, the overriding concern should be whether "consolidation yields benefits offsetting the harm it inflicts on objecting parties."

Under this standard, the proponent of substantive consolidation must demonstrate...