Third Circuit Cuts Substantive Consolidation Risk

The district court's substantive consolidation order, In re Owens Corning, 316 B.R. 168 (Bankr. D. Del. 2004), if allowed to stand, would have undermined the lenders' bargained-for structural seniority (by virtue of subsidiary guarantees) obtained in exchange for a $2 billion unsecured loan to the parent company. The Third Circuit, however, sought to avoid “chaos in the marketplace” and to strengthen the requirements for any future substantive consolidation order.

Substantive Consolidation

“Substantive Consolidation” is an equitable remedy. It “treats separate legal entities as if they were merged into a single survivor left with all the cumulative assets and liabilities … [.] [T]he result is that claims of creditors against separate debtors morph to claims against the consolidated survivor.” In re Genesis Health Ventures, Inc., 402 F.3d 416, 423 (3d Cir. 2005). Accord D.G. Baird, Elements of Bankruptcy, at 145 (3d rev. ed. 2001) (“Putting the assets and liabilities of two related firms into a single pool … [.]“).

Third Circuit Test

The Owens Corning court held that entities should be consolidated only if: “(i) [pre-bankruptcy] they disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (ii) [post-bankruptcy] their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors.” 2005 U.S. App. LEXIS 17150 at *38-*39 (citations omitted). It thus rejected the mechanical application of “prefixed factors,” used by some courts, to ascertain entity separateness. Id. at *35-*37 (citations omitted). Instead, the Third Circuit ordered an “intentionally open-ended, equitable inquiry” governed by the following principles: 1) Entity separateness must be respected as a “fundamental ground rule” of limited liability, absent special circumstances calling equity into play; 2) Substantive consolidation should be used to redress harms caused by debtors, not creditors (who are subject to other remedies such as fraudulent transfer avoidance and equitable subordination); 3) Administrative convenience cannot justify this remedy; 4) The “rough justice” wrought by substantive consolidation should be “rare and, in any event, one of last resort after considering and rejecting other remedies” that more precisely redress the harm at issue; and 5) Substantive consolidation cannot be used “offensively,” ie, as a tactic to disadvantage a creditor group or alter creditors' rights, but may be used “defensively to remedy the identifiable harms caused by entangled affairs … [.]” Id. at *35-*39 (citations omitted).

To establish a prima facie case for consolidation under part (i) of the test, the parties' [pre-bankruptcy] conduct must show “corporate disregard creating contractual expectations of creditors that they were dealing with debtors as one indistinguishable entity … [.] Proponents who are creditors must also show that, in their [pre-bankruptcy] course of dealing, they actually and reasonably relied on debtors' supposed unity.” 2005 U.S. App. LEXIS 17150 at *40-*41 (citations omitted). To defeat consolidation, however, creditors can show they are “adversely affected and actually relied on debtors' separate existence.” Id.

Owens Corning Deal Structure

According to the court, “the Banks loaned $2 billion to OCD (ie, the corporate parent) and enhanced the credit of that unsecured loan indirectly by subsidiary guarantees covering less than half the initial debt. What the Banks got … was 'structural seniority' — a direct claim against the guarantors (and thus against their assets levied on once a judgment is obtained) that other creditors of OCD did not have. This kind of lending occurs every business day.” 2005 U.S. App. LEXIS 17150 at *41.

Creditor Reliance on Separate Entities

The court found no evidence that the parties had disregarded the separateness of each entity prior to bankruptcy. To the contrary, the loan was predicated on the separateness of all of the OCD affiliates, and there was no allegation of bad faith. Id. at *42. The parties thus could not ignore the “ground rules” that they negotiated: “Playing by these rules means that obtaining the guarantees of separate entities, made separate by OCD's choice of how to structure the affairs of its affiliate group of companies, entitles a lender, in bankruptcy or out, to look to any (or all) guarantor(s) for payment when the time comes.” Id.

The district court mistakenly found that the lenders had relied upon the “substantial identity” among the parent and its subsidiaries. In fact, explained the Third Circuit, the banks and their professionals testified that the value of the subsidiary guarantees had been premised in part upon the entities' separateness. Id. at *42-*43 (further citations omitted).

No Entanglement of Affiliated Borrowers

Nor was there any question “which entity owns which principal assets and has which material liabilities.” 2005 U.S. App. LEXIS 17150 at *46. As the Third Circuit explained, the lower court had erred in holding that commingling justifies substantive consolidation “when the affairs of the two companies are so entangled that consolidation will be beneficial.” Id. at *47 (citation omitted) (emphasis in original). But, reasoned the Court of Appeals, ” … commingling justifies consolidation only when separately accounting for the assets and liabilities of the distinct entities will reduce the recovery of every creditor — that is, when every creditor will benefit from the consolidation. Moreover, the benefit to creditors should be from cost savings that make assets available rather than from the shifting of assets to benefit one group of creditors at the expense of another. Mere benefit to some creditors, or administrative benefit to the Court, falls far short.” Id.

'Deemed' Consolidation Doubtful

The Owens Corning reorganization plan was premised on a purported “deemed” consolidation: ” … the plan process would proceed as though assets and liabilities of separate entities were merged, but in fact they remain separate with the twist that the guarantees to the Banks are eliminated.” 2005 U.S. App. LEXIS 17150 at *5. For the banks, therefore, the consolidation was real and prejudicial. The court warned, however, that substantive consolidation cannot be used “ as a ploy to deprive one group of creditors of their rights while providing a windfall to other creditors.” Id. at *5-*6. Clarifying the doctrine of substantive consolidation, the court questioned whether “deemed” consolidation remains a viable plan strategy. Id. at *52-*53. It also stressed that any future consolidation attempts must be supported by convincing evidence of reasonable creditor expectations and the complete disregard of entity boundaries.

May The D.C. and Eleventh Circuits allow substantive consolidation more easily — if “(i) there is substantial identity between the entities to be consolidated; and (ii) consolidation is necessary to avoid some harm or realize some benefit.” See Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270, 276 (D.C. Cir. 1987); Eastgroup Properties v. Southern Motel Assoc., Ltd., 935 F.2d 245, 248 (11th Cir. 1991). Although other Circuit courts have addressed this issue, they generally follow the test promulgated in either Auto-Train or Augie/Restivo. 2005 U.S. App. LEXIS 17150 at *29-*30 (citations omitted). Even when an objecting creditor proves that it has relied upon an entity's separateness and would be prejudiced by consolidation, a bankruptcy court in these Circuits (covering D.C., Georgia, Alabama and Florida) may order substantive consolidation if the benefits of the remedy “heavily” outweigh its harms.

The Second and Ninth Circuits (covering New York, Connecticut, Vermont, California, Nevada, Arizona, Oregon, Washington, Idaho and Montana) impose a more stringent threshold for consolidation, requiring that: 1) creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit; or 2) the affairs of debtor are so entangled with those of its affiliates that consolidation will benefit all creditors. See In re Augie/Restivo Baking Company, Ltd., 860 F.2d 515, 519 (2d Cir. 1988); In re Bonham, 229 F.3d 750 (9th Cir. 2000) (adopts Augie/Restivo test).

The Third Circuit in Owens rejected the D.C./Eleventh Circuit test, reasoning as follows: “If an objecting creditor relied on the separateness of the entities, consolidation cannot be justified vis-'-vis the claims of that creditor.” [2005 U.S. App. LEXIS 17150 at *34 (citations omitted). Moreover, their test has “a threshold not sufficiently egregious and too imprecise for easy measure.” Id. Although approving the Second/Ninth Circuit approach, the Third Circuit stressed that only a complete collapse of entity separateness could justify substantive consolidation.

Petitions for Rehearing

The petitioners argue that Owens Corning should be reconsidered because of: 1) its “exceptional importance” (ie, there are less stringent tests in other Circuits); 2) its conflict with an earlier Third Circuit decision (In re Pittsburgh Rys., 155 F.2d 477 (3d Cir. 1946)); and because 3) it imposes an onerous test that will interfere with large Chapter 11 reorganizations. The petitioners also assert that the panel incorrectly rejected “deemed” consolidation under a nonconsensual plan, reasoning that all substantive consolidations are “deemed” because they do not effect a post-confirmation state law merger. In addition, they argue that the panel engaged in fact finding instead of applying the “clearly erroneous” standard of appellate review to the findings of District Judge Fullam. In so doing, according to the petitioners, the panel ignored overwhelming evidence that the banks relied upon OCD and its subsidiaries as a single enterprise and that there was inadequate factual support for the “structural seniority” allegedly sought by the banks. We find it hard to believe that these arguments had not already been considered by the court during the initial round of briefing and argument.

Greater Comfort

Owens was decided in the context of today's corporate financing techniques that rely on the premise that affiliates can and do legitimately function as separate entities. The panel attempted to dispel the notion, accepted by the D.C. and Eleventh Circuits, of a “liberal trend” toward the increased use of substantive consolidation. 2005 U.S. App. LEXIS 17150 at *33 and n. 15 (citations omitted). As it stands, Owens reduces the substantive consolidation risk in Delaware, New Jersey and Pennsylvania bankruptcy cases. More important, it provides greater comfort to the financial community.

Lenders won a victory on Aug. 15 when the Third Circuit limited the equitable remedy of substantive consolidation in the Owens Corning reorganization case. In re Owens Corning, ____ F.3d ___, 2005 U.S. App. LEXIS 17150*1 (3d Cir. 2005), amended by 2005 U.S. App. LEXIS 18043 (3d Cir. Aug. 23, 2005); further amended Sept. 2, 2005, petitions for reh'g en banc filed Aug. 29, 2005. Reversing the district court, the court held that “affiliated [debtor and non-debtor] entities” could not be “substantively” consolidated on the facts of the case before it. According to the court, the debtor and its allies sought substantive consolidation, a “last-resort remedy,” in order to “deprive one group of creditors [ie, the unsecured lenders] of their rights while providing a windfall to other creditors.” Id. at *5-*6. The future claimants' representative and a creditors' committee filed petitions for rehearing en banc on Aug. 29. Answers to those petitions were due to be filed by Sept. 12.

Practical Significance

The Owens Corning decision means that creditors can have greater assurance that a deal structure with subsidiary/affiliate credit support will be respected in a bankruptcy case. Moreover, the substantive consolidation remedy will be unavailable if it would unfairly harm certain creditors in order to benefit others.

The district court's substantive consolidation order, In re Owens Corning, 316 B.R. 168 (Bankr. D. Del. 2004), if allowed to stand, would have undermined the lenders' bargained-for structural seniority (by virtue of subsidiary guarantees) obtained in exchange for a $2 billion unsecured loan to the parent company. The Third Circuit, however, sought to avoid “chaos in the marketplace” and to strengthen the requirements for any future substantive consolidation order.

Substantive Consolidation

“Substantive Consolidation” is an equitable remedy. It “treats separate legal entities as if they were merged into a single survivor left with all the cumulative assets and liabilities … [.] [T]he result is that claims of creditors against separate debtors morph to claims against the consolidated survivor.” In re Genesis Health Ventures, Inc., 402 F.3d 416, 423 (3d Cir. 2005). Accord D.G. Baird, Elements of Bankruptcy, at 145 (3d rev. ed. 2001) (“Putting the assets and liabilities of two related firms into a single pool … [.]“).

Third Circuit Test

The Owens Corning court held that entities should be consolidated only if: “(i) [pre-bankruptcy] they disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (ii) [post-bankruptcy] their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors.” 2005 U.S. App. LEXIS 17150 at *38-*39 (citations omitted). It thus rejected the mechanical application of “prefixed factors,” used by some courts, to ascertain entity separateness. Id. at *35-*37 (citations omitted). Instead, the Third Circuit ordered an “intentionally open-ended, equitable inquiry” governed by the following principles: 1) Entity separateness must be respected as a “fundamental ground rule” of limited liability, absent special circumstances calling equity into play; 2) Substantive consolidation should be used to redress harms caused by debtors, not creditors (who are subject to other remedies such as fraudulent transfer avoidance and equitable subordination); 3) Administrative convenience cannot justify this remedy; 4) The “rough justice” wrought by substantive consolidation should be “rare and, in any event, one of last resort after considering and rejecting other remedies” that more precisely redress the harm at issue; and 5) Substantive consolidation cannot be used “offensively,” ie, as a tactic to disadvantage a creditor group or alter creditors' rights, but may be used “defensively to remedy the identifiable harms caused by entangled affairs … [.]” Id. at *35-*39 (citations omitted).

To establish a prima facie case for consolidation under part (i) of the test, the parties' [pre-bankruptcy] conduct must show “corporate disregard creating contractual expectations of creditors that they were dealing with debtors as one indistinguishable entity … [.] Proponents who are creditors must also show that, in their [pre-bankruptcy] course of dealing, they actually and reasonably relied on debtors' supposed unity.” 2005 U.S. App. LEXIS 17150 at *40-*41 (citations omitted). To defeat consolidation, however, creditors can show they are “adversely affected and actually relied on debtors' separate existence.” Id.

Owens Corning Deal Structure

According to the court, “the Banks loaned $2 billion to OCD (ie, the corporate parent) and enhanced the credit of that unsecured loan indirectly by subsidiary guarantees covering less than half the initial debt. What the Banks got … was 'structural seniority' — a direct claim against the guarantors (and thus against their assets levied on once a judgment is obtained) that other creditors of OCD did not have. This kind of lending occurs every business day.” 2005 U.S. App. LEXIS 17150 at *41.

Creditor Reliance on Separate Entities

The court found no evidence that the parties had disregarded the separateness of each entity prior to bankruptcy. To the contrary, the loan was predicated on the separateness of all of the OCD affiliates, and there was no allegation of bad faith. Id. at *42. The parties thus could not ignore the “ground rules” that they negotiated: “Playing by these rules means that obtaining the guarantees of separate entities, made separate by OCD's choice of how to structure the affairs of its affiliate group of companies, entitles a lender, in bankruptcy or out, to look to any (or all) guarantor(s) for payment when the time comes.” Id.

The district court mistakenly found that the lenders had relied upon the “substantial identity” among the parent and its subsidiaries. In fact, explained the Third Circuit, the banks and their professionals testified that the value of the subsidiary guarantees had been premised in part upon the entities' separateness. Id. at *42-*43 (further citations omitted).

No Entanglement of Affiliated Borrowers

Nor was there any question “which entity owns which principal assets and has which material liabilities.” 2005 U.S. App. LEXIS 17150 at *46. As the Third Circuit explained, the lower court had erred in holding that commingling justifies substantive consolidation “when the affairs of the two companies are so entangled that consolidation will be beneficial.” Id. at *47 (citation omitted) (emphasis in original). But, reasoned the Court of Appeals, ” … commingling justifies consolidation only when separately accounting for the assets and liabilities of the distinct entities will reduce the recovery of every creditor — that is, when every creditor will benefit from the consolidation. Moreover, the benefit to creditors should be from cost savings that make assets available rather than from the shifting of assets to benefit one group of creditors at the expense of another. Mere benefit to some creditors, or administrative benefit to the Court, falls far short.” Id.

'Deemed' Consolidation Doubtful

The Owens Corning reorganization plan was premised on a purported “deemed” consolidation: ” … the plan process would proceed as though assets and liabilities of separate entities were merged, but in fact they remain separate with the twist that the guarantees to the Banks are eliminated.” 2005 U.S. App. LEXIS 17150 at *5. For the banks, therefore, the consolidation was real and prejudicial. The court warned, however, that substantive consolidation cannot be used “ as a ploy to deprive one group of creditors of their rights while providing a windfall to other creditors.” Id. at *5-*6. Clarifying the doctrine of substantive consolidation, the court questioned whether “deemed” consolidation remains a viable plan strategy. Id. at *52-*53. It also stressed that any future consolidation attempts must be supported by convincing evidence of reasonable creditor expectations and the complete disregard of entity boundaries.

May The D.C. and Eleventh Circuits allow substantive consolidation more easily — if “(i) there is substantial identity between the entities to be consolidated; and (ii) consolidation is necessary to avoid some harm or realize some benefit.” See Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270, 276 (D.C. Cir. 1987); Eastgroup Properties v. Southern Motel Assoc., Ltd. , 935 F.2d 245, 248 (11th Cir. 1991). Although other Circuit courts have addressed this issue, they generally follow the test promulgated in either Auto-Train or Augie/Restivo. 2005 U.S. App. LEXIS 17150 at *29-*30 (citations omitted). Even when an objecting creditor proves that it has relied upon an entity's separateness and would be prejudiced by consolidation, a bankruptcy court in these Circuits (covering D.C., Georgia, Alabama and Florida) may order substantive consolidation if the benefits of the remedy “heavily” outweigh its harms.

The Second and Ninth Circuits (covering New York, Connecticut, Vermont, California, Nevada, Arizona, Oregon, Washington, Idaho and Montana) impose a more stringent threshold for consolidation, requiring that: 1) creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit; or 2) the affairs of debtor are so entangled with those of its affiliates that consolidation will benefit all creditors. See In re Augie/Restivo Baking Company, Ltd., 860 F.2d 515, 519 (2d Cir. 1988); In re Bonham, 229 F.3d 750 (9th Cir. 2000) (adopts Augie/Restivo test).

The Third Circuit in Owens rejected the D.C./Eleventh Circuit test, reasoning as follows: “If an objecting creditor relied on the separateness of the entities, consolidation cannot be justified vis-'-vis the claims of that creditor.” [2005 U.S. App. LEXIS 17150 at *34 (citations omitted). Moreover, their test has “a threshold not sufficiently egregious and too imprecise for easy measure.” Id. Although approving the Second/Ninth Circuit approach, the Third Circuit stressed that only a complete collapse of entity separateness could justify substantive consolidation.

Petitions for Rehearing

The petitioners argue that Owens Corning should be reconsidered because of: 1) its “exceptional importance” (ie, there are less stringent tests in other Circuits); 2) its conflict with an earlier Third Circuit decision (In re Pittsburgh Rys., 155 F.2d 477 (3d Cir. 1946)); and because 3) it imposes an onerous test that will interfere with large Chapter 11 reorganizations. The petitioners also assert that the panel incorrectly rejected “deemed” consolidation under a nonconsensual plan, reasoning that all substantive consolidations are “deemed” because they do not effect a post-confirmation state law merger. In addition, they argue that the panel engaged in fact finding instead of applying the “clearly erroneous” standard of appellate review to the findings of District Judge Fullam. In so doing, according to the petitioners, the panel ignored overwhelming evidence that the banks relied upon OCD and its subsidiaries as a single enterprise and that there was inadequate factual support for the “structural seniority” allegedly sought by the banks. We find it hard to believe that these arguments had not already been considered by the court during the initial round of briefing and argument.

Greater Comfort

Owens was decided in the context of today's corporate financing techniques that rely on the premise that affiliates can and do legitimately function as separate entities. The panel attempted to dispel the notion, accepted by the D.C. and Eleventh Circuits, of a “liberal trend” toward the increased use of substantive consolidation. 2005 U.S. App. LEXIS 17150 at *33 and n. 15 (citations omitted). As it stands, Owens reduces the substantive consolidation risk in Delaware, New Jersey and Pennsylvania bankruptcy cases. More important, it provides greater comfort to the financial community.