The Rationale Against Substantive Consolidation Of Nondebtor Entities: Florida On The Front Line

On January 10, 2012, a Florida bankruptcy court ruled in In re Pearlman, 462 B.R. 849 (Bankr. M.D. Fla. 2012), that substantive consolidation is purely a bankruptcy remedy and that it accordingly did not have the power to consolidate the estate of a debtor in bankruptcy with the assets and affairs of a nondebtor. In so ruling, the court staked out a position on a contentious issue that has created a widening rift among bankruptcy and appellate courts regarding the scope of a bankruptcy court's jurisdiction over nondebtor entities. The court's ruling is also contrary to a decision handed down by another Florida court less than a year previously in Kapila v. S & G Fin. Servs., LLC (In re S & G Fin. Servs. of S. Fla., Inc.), 451 B.R. 573 (Bankr. S.D. Fla. 2011).

SUBSTANTIVE CONSOLIDATION

Substantive consolidation streamlines the administration of interrelated bankruptcies by, among other things, eliminating intercompany claims between related debtors and duplicative claims asserted against multiple consolidated debtors. The Bankruptcy Code does not expressly authorize the remedy, although 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. Courts approving substantive consolidation typically authorize it 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 creditors of one entity to share equally with creditors of a less solvent debtor is not appropriate in many circumstances, courts generally hold that substantive consolidation is to be used sparingly and have labeled it an "extraordinary remedy."

Different standards have been employed by courts to determine the propriety of substantive consolidation. In Eastgroup Properties v. Southern Motel Association, Ltd., 935 F.2d 245 (11th Cir. 1991), for example, the Eleventh Circuit Court of Appeals articulated a standard for substantive consolidation requiring a showing that: (1) there is "substantial identity" between the entities to be consolidated; and (2) substantive consolidation "is necessary to avoid some harm or to realize some benefit."

Factors that may be relevant in satisfying the first requirement include the following:

(1) Fraud or other complete domination of the corporation that harms a third party;

(2) The absence of corporate...