Practical Business Guidelines for Dealing with Substantive Consolidation
In business, new legal entities are created for a variety of reasons, including tax planning, regulation, separation of dissimilar but related businesses, and creation of special purpose corporations, to name a few. The new legal entity may be completely dependent on the originating corporation or fully independent. Determining the exact point in the continuum of when and how legal entities are able to truly operate separately is much more difficult to define and articulate.
Creditors frequently make these evaluations in assessing the risks of doing business with multiple debtor companies. Bankruptcy courts are called upon to make these judgements of how businesses operate and represent themselves when asked to rule on substantive consolidation. This article will provide business guidelines for creditors to follow so they are prepared to negotiate better treatment in a plan of reorganization or to determine whether to support or fight a contested substantive consolidation motion.
Summary of the Elements of Substantive Consolidation
Substantive consolidation of two or more debtors' estates generally results in the consolidation of the assets and liabilities of those debtors. As a result of this consolidation, the following are eliminated: intercompany claims, subsidiary equity ownership interests, multiple and duplicative creditor claims, joint and several liability claims, and guarantees. Payment of all the debtors' claims are issued from a common fund.2 Substantive consolidation therefore, can result in unfair treatment of certain creditor constituencies. Accordingly, some courts have looked to an equitable test known as the "balancing of the equities" test to evaluate whether the benefits of consolidation outweigh the potential harm to creditors.3
The current trend has been to allow substantive consolidation more readily. The Eleventh Circuit observed:
[t]here is, however, a "modern" or "liberal" trend toward allowing substantive consolidation, which has its genesis in the increased judicial recognition of the widespread use of interrelated corporate structures by subsidiary corporations operating under a parent entity's corporate umbrella for tax and business purposes.4The following elements are most often cited in substantive consolidation cases:5
- parent owns all or a majority of the capital stock of the subsidiary;
- parent and subsidiary have common officers and directors;
- parent finances subsidiary;
- parent is responsible for incorporation of subsidiary;
- subsidiary has grossly inadequate capital;
- parent pays salaries, expenses or losses of subsidiary;
- subsidiary's business is primarily with the parent;
- subsidiary's assets were conveyed by parent;
- parent refers to subsidiary as its department or division;
- directors or officers of subsidiary take directions from the parent and do not act independently;
- corporate formalities and separateness are not observed;
- difficulty exists in segregating and ascertaining individual assets and liabilities;
- presence or absence of consolidated financial statements exists;
- profitability is consolidated at a single physical location;
- commingling of assets and business functions occurs;
- unity of interests and ownership exists between the various corporate entities;
- parent and inter-corporate guarantees are issued on loans;
- assets are transferred without formal observance of corporate formalities;
- parent assumes contractual obligations of subsidiaries;
- overhead, management, accounting and other related expenses are shared;
- the corporate entities maintain individual book entries for receivables and payables; and
- one operating account is utilized among several corporate entities, and there is an absence of appropriate accounting entries to record deposits and withdrawals by each entity from such account.
Substantive consolidation need not be supported by the presence of all the foregoing factors.6 Unfortunately, it is not possible to identify which of the factors is the most important in the eyes of the court, creditors or debtors in negotiating a plan or settlement in any particular case.
Know the Borrower
This may seem obvious. However, this is at the very core of any substantive consolidation dispute among debtors and creditors. Creditors often assess risk through financial analysis. Thus, it is worthwhile to examine the financial statement utilized in evaluating risk.
Most multiple debtor companies obtain only a consolidated audit. Consolidated financial statements are routinely issued by both private and public companies and may not be the financial statement of the actual customer. Therefore, if the creditor did not obtain consolidating financial statements (which will identify the balance sheet, income statement and cash flow statement for each of the legal entities within the consolidated group), it may be unclear exactly on what the creditor relied in making its initial and continued credit decisions. Inability to identify the legal entity with which the creditor did business generally precludes the creditor from understanding the priority of its claim, as well as determining which position will maximize recovery.
The debtor's management usually prepares consolidated financial statements. When the debtor's independent accounting firm audits the consolidated financial statements, there is no requirement that they "audit" the financials for individual entities. Rather the auditor examines the financial statements of the company as a whole, on a consolidated basis in keeping with the audit report to be issued.
In the AMRE7 case, a consolidated cash management system was utilized to consolidate cash for all the debtors, except for one, which was not substantively consolidated. Through this cash management system, collections from the subsidiaries were used to fund the operations of all the companies without regard to whether such entity generated adequate cash to fund its related expenses.
Interestingly, during the nine months prior to the bankruptcy filing, the booking of the primary cash balances on the separate entities' balance sheets vacillated between the parent, Amre Inc. (AMRE), and its largest operating subsidiary, American Remodeling Inc. (ARI), with apparently related changes in the intercompany accounts. Therefore depending on which month-end consolidated balance sheets were being analyzed, the cash was "owned" by different legal entities. In this instance almost all of the consolidated group's cash was reflected on the balance sheet of the parent as of the month-end closest to the filing. The reverse could have occurred as well. Needless to say, the question of who owned the cash was an issue during the proceedings. It should be recognized that booking cash on any particular legal entity's books, as of the date of the audit, would have been irrelevant since the cash of the consolidated group as a whole was believed to be fairly represented.
The same problem arose with the booking of other assets and liabilities, which appeared on various balance sheets, such as the value of license agreements, receivables, the headquarters lease and employee obligations, without consideration to the legal entity that signed the contract, generated the receivable or incurred the obligation. Therefore, the assets and liabilities reflected on consolidating balance sheets may not necessarily be representative of the actual assets and liabilities of the individual legal entity. This makes risk assessment and recovery analyses problematic. In AMRE, the best possible assumptions were utilized to perform the recovery analysis on an individual entity basis and on a consolidated basis. The recovery analysis, utilized in the substantive consolidation hearings, was prepared recognizing that each assumption could have required separate costly litigation for a final determination, which was not in the best interest of the creditors in maximizing recoveries. The parties to the contested substantive consolidation hearings ultimately settled, and such settlement is embedded in the plan of reorganization.
Based on this example, creditors should not assume that signing a contract with any parent company is a failsafe method of credit protection since the assets, profit and inherent value may just as easily reside in the subsidiaries as opposed to the parent.
Understand the Companies' Strategies and Operations
A warning sign of future substantive consolidation debates can be found whenever there is unprecedented growth, either through acquisition and/or investment. The lines between corporate legal entities can become blurred particularly when management becomes stretched too thin and wears too many hats. The accounting for how time is spent and the adherence to legal formalities are not central to a growth mode strategy.
Profiles of two conglomerates, L. J. Hooker et al. and AMRE et al., reveal that numerous corporations were created during their histories. Hooker set up special purpose corporations and managed them by similar groupings.8 AMRE, on the other hand acquired, merged and dissolved numerous legal entities. Both filed for chapter 11 protection and dealt with substantive consolidation in their chapter 11 liquidating plans of reorganization. Interestingly, both had corporate functions, centralized cash management systems and numerous trade names.
Pre-petition corporate expenses for both conglomerates were not always uniformly and consistently allocated to the subsidiaries. Post-petition administrative expenses, including professional costs, were paid out of the centralized cash management system, in accordance with court orders. However, no allocation of post-petition administrative expenses was ultimately necessary since each of the negotiated plans reached with the creditors resulted in substantively consolidating the entities with the settlement and compromise of claims and counter-claims between legal entities embedded in the respective plans.
An example of an instance where a creditor actively sought separation of a subsidiary and its parent can be found in the case of National Gypsum Co. (NGC) and its subsidiary, The Austin Co.(Austin). As the court explained:
Austin routinely bids on government or quasi-government projects, which require Austin to maintain a line of surety bonding. Prior to the [NGC] Petition Date, Seaboard Surety Company ("Seaboard") issued bonds on projects on which Austin bid on or on which Austin was performing work. The debtors [NGC and its parent Aancor] are indemnitors on the agreement of indemnity between Austin and Seaboard. As part of the consideration for Seaboard's issuance of bonds, NGC agreed to certain restrictions on the up-streaming cash from Austin, including agreements not to withdraw dividends, not to let shareholder equity dip below a certain level and not to allow Austin to pledge or dispose of its assets. After debtors filed their respective reorganization cases, Seaboard suspended issuance of new bonds for Austin. After extensive negotiations with Seaboard, an agreement was reached to reinstate the bonding line and in April 1991, the bankruptcy court authorized the debtors to execute a new indemnity agreement. The agreement was signed in May 1991. Seaboard then reinstated the bonding line.9
Austin also had separately audited financial statements, and executive compensation was generally based on the performance of Austin separate from NGC. The management of Austin contested selected historical intercompany entries charged by the parent. The separation of these entities was definitive, in part due to the creditor's efforts and requirements.
Update Credit Files and Retain Historical Data
It also should be recognized that while the reasons for the original extension of credit might be well documented, subsequent debtor actions may undermine the original credit decision. Therefore, creditors should maintain records to support their credit decision. It is also wise to update records periodically to monitor the credit so that the creditor can take action to protect its credit exposure.
Retain historical data, particularly documenting understandings reached with the debtor, as well as retaining old financials and Dun & Bradstreet (D&B) reports. Some retail creditors in the Hooker et al. case indicated that they relied on a blanket guaranty from the Australian parent as reported in D&Bs. These creditors were directed to file claims in the Australian proceeding, if they could produce the D&Bs they relied upon to extend credit. In the AMRE case, one of the creditors had an old D&B that confirmed representations made by management, when the creditor extended credit. D&B does not issue historical reports. Therefore a creditor should maintain enough historical records to support reliance and to argue for additional considerations, such as a guaranty.
These checks include:
- Does the name on the legal documents or the purchase orders match the financial statements in the credit files?
- Are there different business cards or letterhead utilized by different representatives of the debtor, especially in cases of multinational or U.S. conglomerates. Comparing the legal entity or trading names reflected on the cards is very revealing. Many global corporations transfer employees between legal entities and assign projects for multiple debtors. Blurred lines often result between legal entities. Accounting for the charges of such moveable personnel and among project teams is problematic. As soon as there is any inconsistency in the methodology and application of these charges, the intercompany accounts can be compromised and one debtor's value may be disproportionately utilized for the benefit of another.
- Are there significant changes in either the various balances on the financial statements, particularly the intercompany accounts from period to period, and by legal entity?Are there additions or dissolution of legal entities?
The degree of sophistication of the creditor, the size of the credit risk and/or the long history of the creditor/debtor relationship should not be presumed to obviate the need to document and test adherence to the guidelines described. Each substantive consolidation debate is so fact-intensive that each case will require the compiling of its own data and a comparison to the cases cited, which are never exactly the same.
A creditor armed with as much information as possible regarding the original credit decision and any changes the creditor observed while monitoring the companies' activities is in the most advantageous position in dealing with substantive consolidation issues.
1The author wishes to thank Steven McCartin and Scott McDonald of Gardere & Wynne, L.L.P. for the legal research and John Penn of Haynes and Boone, LLP for his critical review of this article. [Return to Text]
2F.D.I.C. v. Colonial Realty Co., 966 F.2d 57, 58-59 (2d Cir. 1992); Union Sav. Bank v. Augie/Restivo Baking Co. (In re Augie/Restivo Baking Co.), 860 F.2d at 518 (2d Cir. 1988); Chemical Bank New York Trust Co. v. Kheel, 369 F. 2d 845. 847 (2d Cir. 1966); In re Deltacorp Inc., 179 B. R. at 733,777 (Bankr. S.D.N.Y. 1995); In re Drexel Burnham Lambert Group Inc., 138 B. R. 723, 766 (Bankr. S.D.N.Y. 1992); In re Richton Int'l Corp., 12 B.R. 555, 556 (Bankr. S.D.N.Y, 1981) [Return to Text]
3Augie/Restivo, 860 F.2d at 519; In re DRW Property Co., 82, 54 B.R. 489, 495 (Bankr. N.D. Texas 1985); accord Holywell Corp. v. Bank of N.Y., 59 B. R. 340, 347 (S.D. Fla. 1986), appeal dismissed, 838 F.2d 1547 (11th Cir.), cert. denied, 488 U.S. 823 (1988); Richton, 12 B. R. at 558. [Return to Text]
5First Nat'l Bank of El dorado v. Giller (In re Giller), 962 F.2d 796, 798-99 (8th Cir. 1992); Eastgroup Properties, 935 F.2d at 250; Augie/Restivo, 860 F.2d at 815; Kheel, 369 F.2d at 846-47; Soviero v. Franklin Nat'l Bank of Long Island, 328 F.2d 446, 447-48 (2d Cir. 1964); Stone v. Eacho (In re Tip Top Tailors), 127 F.2d, 284, 88 (4th Cir.), cert. denied, 317 U.S. 635 (1942); In re Standard Brands Paint Co., 154 B.R., 563, 565 (Bankr. C.D. Cal. 1993); Drexel Burnham Lambert, 138 B.R. at 741; In re Murray Indus. Inc., 119 B.R. 820, 831 (Bankr. M.D. Fla. 1990); In re Tureaud, 45 B.R. 658, 662 (Bankr. N.D. Okla. 1985), aff'd. 59 B.R. 973 (N.D. Okla. 1986); In re Food Fair Inc., 10 B.R., 123, 126 (Bankr. S.D.N.Y. 1981); In re Vecco Constr. Indus., 4 B.R. 407, 410 (Bankr. E.D. Va. 1980). [Return to Text]
7AMRE Inc. [substantively consolidated with American Remodeling Inc., Facelifters Home Systems Inc. and Century 21 Home Improvements Inc.] under Case No. 397-30567-SAF-11 (Bankr. N.D. Tex.). [Return to Text]
8"Modified Second Amended Disclosure Statement of L J Hooker Corporation Inc. and all of its subsidiaries and United States Affiliates except Sakowitz Inc. Dated March 11, 1992" pages 3, 4, 70 and 71. [Return to Text]
9"First Amended and Restated Joint Disclosure Statement under §1125 of the Bankruptcy Code for Solicitation of Acceptances of the First Amended and Restated Joint Plan of Reorganization of National Gypsum Company and Aancor Holdings Inc." Dated September 4, 1992 filed in the United States Bankruptcy Court for the Northern District of Texas Dallas Division, page. 40. [Return to Text]