By: Donald L Swanson
Substantive consolidation of affiliated debtors is an extraordinary remedy that should be exercised with caution. And legal standards governing substantive consolidation should focus on the effects of consolidation on the creditors of each affiliated debtor.
A new opinion illustrates the substantive consolidation remedy and its application.
- The opinion is Guindi v. Avianca Holdings S.A. (In re Avianca Holdings S.A.), Case no. 21-cv-10118 in U.S. District Court for Southern New York (decided October 3, 2024).
Plan Confirmation
The affiliated Debtors are a large airline group in Latin America, consisting of 40 separate entities. The Bankruptcy Court confirms a joint Chapter 11 plan for all 40 entities, and creditors appeal.
Under the confirmed plan, 37 of the 40 Debtor entities are substantively consolidated. This has the effect of treating all assets and liabilities of all 37 entities “as though they were merged.”
In its plan confirmation order, the Bankruptcy Court finds that the 3 unconsolidated Debtors are properly excluded from substantive consolidation because, (i) they are not managed and governed by the same people who manage the consolidated Debtors, and (ii) they maintain their own books and records.
Substantive Consolidation on Appeal
Issues on appeal include, (i) whether substantive consolidation of the 37 affiliated Debtor entities is appropriate, and (ii) whether exclusion of the 3 affiliated Debtor entities from substantive consolidation is appropriate.
On appeal, the District Court rules that, unlike the 3 unconsolidated Debtors, the affairs of the 37 consolidated Debtors are hopelessly entangled so that their substantive consolidation is warranted.
–Substantive Consolidation Explained
Substantive consolidation combines the assets and the liabilities of separate bankrupt entities and treats them as if they belonged in a single entity.
Substantive consolidation usually results in, inter alia, pooling the assets of and claims against the consolidated entities; satisfying liabilities from the resultant common fund; eliminating inter-company claims; and combining the creditors of the companies for purposes of voting on reorganization plans.
–Second Circuit Authority
The Second Circuit, in In re Augie/Restivo Baking Co., Ltd., 860 F.2d 515 (2d Cir. 1988), explains that substantive consolidation may be justified after considering a number of factors, including the:
- presence or absence of consolidated financial statements;
- unity of interest and ownership among various corporate entities;
- degree of difficulty in segregating and ascertaining individual assets and liabilities;
- transfers of assets without formal observance of corporate formalities;
- commingling of assets and business functions;
- profitability of consolidation at a single physical location; and
- disregard of legal formalities.
However, these factors are merely variants on two critical and overarching factors:
- whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit; or
- whether the affairs of the debtors are so entangled that consolidation will benefit all creditors.
The satisfaction of either of these two prongs will support a request for substantive consolidation.
–Creditor Arguments
Creditors/Appellants argue that “many of the [Augie/Restivo] factors simply do not exist.” Such argument is misplaced, because:
- the more extensive listing of factors represent variations on the two broad factors; and
- either of the two broad factors is sufficient, alone, to support substantive consolidation.
In other words, (i) hopeless entanglement, on its own, may be sufficient to support substantive consolidation, and (ii) the BankruptcyCourt properly relied on that principle in confirming Debtors’ plan.
Creditors/Appellants also argue on appeal that, if substantive consolidation is allowed at all, then the 3 unconsolidated Debtors should be included in the consolidation. More specifically, they argue that excluding the 3 entities from consolidation is inequitable for creditors because those 3 entities are “the three most financially sound Debtors.”
- In other words, Debtors believe the exclusion of 3 debtors from the consolidation deprives certain creditors of meaningful avenues of recovery.
–Bankruptcy Court Findings
The BankruptcyCourt found that the 37 consolidated Debtors “operate as a single economic unity; share the same back-office functions . . . ; share numerous employees, officers, debtors, and shareholders; share significant overlaps in the creditors pools . . . ; share a headquarters; and utilize a centralized cash management system.”
The Bankruptcy Court therefore concluded, based on expert testimony, that:
- “untangling” the Consolidated Debtors “would be extremely difficult, expensive, and time-consuming”—requiring “millions of dollars and 20 years to accomplish”; and
- valuing the assets shared among all Consolidated Debtors, such as “spare parts” for airplanes, and figuring out to which Consolidated Debtor it should be attributed would be “a very complicated, long, drawn-out exercise.”
So, the record supports the inference that the consolidated Debtors are entangled in a manner such that “no accurate identification and allocation of assets is possible,” at least without consuming considerable resources that otherwise could be used to benefit creditors.
–Further Creditor Arguments Rejected
Creditors/Appellants argue, to the contrary, that the 37 consolidated Debtors:
- “maintain separate books and records, observe corporate formalities, each complies with varying local requirements, each has officers”;
- “many have distinct officers, individually own certain assets, document and record intercompany transfers and loans, and document their separate liabilities”;
- disentangling the Debtors’ assets would not be “impossible or so costly as to consume the assets” of the firms; and
- “Debtors have failed to identify each individual Debtor’s assets and liabilities and how they were being distributed.”
Such arguments do not withstand scrutiny, the District Court concludes, because:
- the portion of the record Creditors/Appellants cite (a financial advisor’s declaration) simply recites declarant’s qualifications and reviews Debtors’ operations; it does not describe separate operations with distinct recordkeeping; and declarant later supports substantive consolidation of the 37 debtors because their operations “are tightly integrated, such that untangling . . . would be difficult, time-consuming, and expensive”;
- Creditors/Appellants offer no expert testimony or other evidence that untangling the 37 Debtors’ operations would be easy, straightforward, or cost-effective; and
- Creditors’/Appellants’ observation that Debtors have not presented individualized accountings is consistent with a finding of hopeless disentanglement; and
- it is telling that Creditors/Appellants did not endeavor to provide such an accounting themselves.
So, Creditors’/Appellants’ arguments do not change the conclusion that substantive consolidation of 37 Debtor entities is appropriate.
–The 3 Unconsolidated Debtors
As for the 3 unconsolidated Debtors, evidence cited by Creditors/Appellants demonstrates that each has its separate “books and records” maintained by its “own accounting staff.”
- By contrast, the 37 consolidated Debtors’ finances are all tracked as part of “a general ledger,” with only “an attempt to create separate subledgers” for each consolidated Debtor—despite the fact that they were part of “an enterprise that’s completely integrated.”
Based on the evidence, the Bankruptcy Court properly found “no difficulty in disentangling” the 3 unconsolidated Debtors from the rest of the Debtors.
Editorial Comment
A number of decades ago, while representing a creditor, I opposed the substantive consolidation of related entities in bankruptcy. That representation preceded the cm/ecf system, so I can’t retrieve the documents.
But here’s what I remember about the facts:
- my client was a creditor of a single, nearly-solvent entity in bankruptcy and would be entitled to something close to payment in full from liquidation of that entity’s assets;
- other affiliated debtors in bankruptcy are insolvent by huge margins;
- the combined debtor group sought to substantively consolidate all the affiliated bankruptcy entities, including my client’s solvent debtor; and
- such substantive consolidation would, (i) throw my client’s claim into a pool of claims against all related debtors, and (ii) result in the payment of only a pittance on my client’s claim.
So, we opposed the substantive consolidation . . . and prevailed.
Since then, every time I see a substantive consolidation request, without a focus on the impact of consolidation on distributions to the creditors of the various debtors, my reaction is this:
- “Say what?!”
Conclusion
Substantive consolidation is an extraordinary remedy that should be approached with caution.
The opinion described above looks like it achieves a sensible result.
But the absence of any analysis or focus on the effects of substantive consolidation on the separate creditors of each entity is . . . troubling.
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