Substantive Consolidation Redux Owens Corning
As stated below, most courts have followed one of two circuit court opinions. Recently, the Third Circuit added to this split by issuing its opinion in In re Owens Corning. In doing so, the Third Circuit reversed a district court's order that substantively consolidated the bankruptcy estates of Owens Corning and certain of its affiliates and subsidiaries to the detriment of their pre-petition secured creditors.2 See In re Owens Corning, 419 F.3d 195 (3d Cir. 2005).
Though not necessarily revolutionary, the Owens Corning opinion raises the bar for substantively consolidating bankruptcy estates. In addition, the Owens Corning opinion has clarified that, despite factors discussed in other cases, the remedy of substantive consolidation requires a fact-intensive, case-by-case analysis that may or may not include the consideration of factors that other courts applied.
Auggie/Restivo and Auto-Train
Generally speaking, most courts have adopted the holdings of one of two opinions: Union Sav. Bank v. Augie/Restivo Baking Co. Ltd., (In re Augie/Restivo Baking Co. Ltd.), 860 F.2d 515 (2d Cir. 1988), or Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270 (D.C. Cir. 1987). In Augie/Restivo, the Second Circuit found that the competing "considerations are variants on two critical factors: (1) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit...or (2) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors." Augie/Restivo, 860 F.2d at 518 (internal citations omitted). The Augie/ Restivo court further held that it was impermissible for the bankruptcy court to substantively consolidate the two entities solely on the basis that substantive consolidation would benefit the creditors of both debtors in that "a proposed reorganization plan alone can [not] justify substantive consolidation." Augie/Restivo, 860 F.2d at 520.
In comparison, the D.C. Circuit held in Auto-Train that the appropriate test was the substantial identity of the entities irrespective of creditor reliance of the separateness of said entities, when the "demonstrated benefits of consolidation heavily outweigh the harm." Auto-Train, 810 F.2d at 276. Most courts and commentators view Auto-Train as having liberalized the standard for substantive consolidation. See, e.g., Owens Corning, 419 F.3d at 210.
While numerous other courts have issued opinions, which vary in their respective depth of analysis, most have adopted either Augie/Restivo or Auto-Train. See, e.g., Owens Corning, 419 F.3d at 207. The Third Circuit recognized and thoroughly discusses the precedence and prevalence of these differing standards, as well as the recurring reliance on the factors analyzed by subsequent courts and practitioners alike. Owens Corning, 419 F.3d at 205-10.
However, the Third Circuit felt that Auto-Train allowed "a threshold not sufficiently egregious and too imprecise for easy measure." Owens Corning, 419 F.3d at 210. Instead, the Third Circuit felt that the approach taken in Augie/Restivo was a more sound analytical avenue.
The Third Circuit, however, was careful to note that "courts consider many factors" when reviewing a substantive consolidation request, that such factors "vary (with degrees of overlap) from court to court," and that "[t]oo often the factors in a checklist fail to separate the unimportant from the important, or even to set out a standard to make the attempt" with the result often being a "rote following of a form containing factors where courts tally up and spit out a score without an eye on the principles that give the rationale for substantive consolidation." Owens Corning, 419 F.3d at 210. Based on the over-reliance of courts and practitioners on prior precedence, and the corresponding failure to realistically analyze the facts and circumstances of a specific case, the Third Circuit carefully crafted precedence that gives guidance but refrains from creating an inclusive list of factors for consideration.
The Owens Corning Standard
Instead of creating a list of factors to consider, the Third Circuit succinctly stated that "what must be proven (absent consent) concerning the entities for whom substantive consolidation is sought is that (1) pre-petition they disregarded separateness so significantly [that] their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (2) post-petition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors." Owens Corning, 419 F.3d at 211. "Proponents of substantive consolidation have the burden of showing that one or the other of these factors is satisfied." Owens Corning, 419 F.3d at 212.
While stating its alternate bases that a party seeking substantive consolidation must prove, the Third Circuit emphasized that it adopted an intentionally open-ended, equitable inquiry...to determine when to substantively consolidate two entities. Owens Corning, 419 F.3d at 210 (citing Nesbit v. Gears Unlimited, 347 F.3d 72 (3d Cir. 2003)). The Third Circuit refrained from adopting specific factors because it did not want future litigants to seize upon such factors and overly analyze what in some cases is largely irrelevant. Owens Corning, 319 F.3d at 210-12.
Indeed, "[d]iffering tests with...agreed ...factors run the risk that courts will miss the forest for the trees. Running down factors as a checklist can lead a court to lose sight of why we have substantive consolidation in the first instance...and often [to] identify a metric...by which [it] can [assess] the relative importance among the factors. Owens Corning, 319 F.3d at 211. Another court stated the matter more bluntly: "[A]s to substantive consolidation, precedents are of little value, thereby making each analysis on a case-by-case basis." In re Crown Machine & Welding Inc., 100 B.R. 25, 27-28 (Bankr. D. Mont. 1989).
Though not adopting or creating factors for review, the Third Circuit did give additional guidance. Specifically, the Third Circuit stated that certain basic "principles," not factors, would guide their determination. These guiding principles are:
- Limiting the cross-creep of liability by respecting entity separateness is a fundamental ground rule.
- The harms that substantive consolidation addresses are nearly always those caused by debtors (and entities they control) who disregard separateness. Harms caused by creditors typically are remedied by provisions found in the Code.
- Mere benefit to the administration of the case is hardly a harm calling substantive consolidation into play.
- Because substantive consolidation is extreme and imprecise, this "rough justice" remedy should be rare and, in any event, one of last resort after considering and rejecting other remedies.
- While substantive consolidation may be used defensively to remedy the identifiable harms caused by entangled affairs, it may not be used offensively (for example, having a primary purpose to disadvantage tactically a group of creditors in the plan process or to alter creditor rights).
As compared to the Eleventh Circuit, which indicated that its standard for substantive consolidation was intended to be more "liberal" than the older tests, the Third Circuit saw substantive consolidation as a defensive shield, as opposed to a sword, and one that should be sparingly used. Owens Corning, 419 F.3d at 215; Eastgroup, 935 F.2d at 248.
What one can further derive from the Third Circuit is that it does not want practitioners to regurgitate these principles as factors on a checklist that are determinative of whether or not to substantively consolidate bankruptcy estates. Instead, the Third Circuit has tried to explain the fundamentals behind substantive consolidation and emphasized that every case requires consideration of different factors.
Conclusion
Some might say that there are now three competing methods of balancing the benefits and harms of substantive consolidation: Augie/Restivo, Auto-Train and Owens Corning. However, Owens Corning intentionally avoided a balancing test and, in fact, somewhat restated Augie/Restivo.
Though some might criticize Owens Corning for not giving a "checklist" of factors for consideration that could, for example, be neatly addressed in a legal opinion, others will welcome the realistic view set forth therein. Indeed, Owens Corning should bring some comfort to those in structured finance, for example, due to the Third Circuit's realistic view of modern financial transactions and corporate structures. In other words, Owens Corning provides a bottom-line examination that raises the bar for substantively consolidating bankruptcy estates.
Footnotes
1 See White, Bruce H. and Medford, William L., "Substantive Consolidation of Nondebtor Entities: Tag, You're in Bankruptcy," Vol. XXII, No. 10, Am. Bankr. Inst. J. 46 (2003), which includes a more detailed discussion of substantive consolidation, the various opinions addressing substantive consolidation, and certain practice and procedure issues related to substantive consolidation. Return to article
2 Interestingly enough, the district court did not substantively consolidate the Owens Corning bankruptcy estates for all purposes (or at least, all creditors), but "deemed" the bankruptcy estates substantively consolidated as to certain secured creditors to alter the pre-petition secured credit facility and guaranty structure, which the Third Circuit found, quoting itself, "several zip (if not area) codes away from anything resembling substantive consolidation." Return to article