Substantive Consolidation of Non-debtor Entities Tag Youre in Bankruptcy

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Dec/Jan 2003

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One of the major concepts behind the Bankruptcy Code is the concept of an equal distribution among unsecured
creditors. In fact, the Bankruptcy Code includes certain provisions to empower a trustee to equalize the distributions
creditors receive. See, e.g., 11 U.S.C. §547 (preference actions).

In furtherance of the equal distribution concept, some courts have gone outside of the Bankruptcy Code's express
provisions to apply "equitable" remedies, not the least of which is substantive consolidation. Substantive
consolidation is a useful tool in certain cases and allows debtors to consolidate their assets and debts into a
common pool, from which distributions are made to a consolidated creditor body, to reflect the reality of how some
affiliated entities operate. See Eastgroup Properties v. Southern Motel Assoc. Ltd., 935 F.2d 245, 248 (11th Cir. 1991). Others have used
equitable consolidation as a sword to forcefully combine assets and debts in an effort to create a larger asset pool to
distribute equally in an attempt to ensure the equitable treatment of all creditors. See In re Augie/Restivo Baking
Co., 860 F.2d 515, 518 (2d Cir. 1988).

When used as a sword, a trustee may seek to substantively consolidate a non-debtor entity. While the
Bankruptcy Code provides for forcing an entity into bankruptcy, the procedure for doing so in a substantive
consolidation scenario is not clear.

<h3>The Basis for Substantive Consolidation</h3>

As stated above, the Bankruptcy Code provides no statutory authority for substantive consolidation other
than 11 U.S.C. §105(a). See Augie/Restivo, 860 F.2d at 518; Reider v. Federal Deposit Ins. Corp. (In re Reider),

31 F.3d 1102, 1105 (11th Cir. 1994). Although Federal Rule of Bankruptcy Procedure 1015 authorizes joint
administration, Rule 1015 does not address substantive consolidation.

The authority for substantively consolidating a non-debtor with a debtor stems from the bankruptcy
court's equitable powers found in §105(a), and from a small body of case law beginning with Sampsell v. Imperial
Paper & Color Corp., 313 U.S. 215, reh'g. denied, 313 U.S. 600 (1941). Post-Bankruptcy Code enactment, the
concept of substantively consolidating two debtors is widely accepted. See Augie/ Restivo, 860 F.2d 515; Drabkin
v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270 (D.C. Cir. 1987); Woburn Assocs. v. Kahn (In re
Hemingway Transp. Inc.), 954 F.2d 1 (1st Cir. 1992); Alexander v. Compton (In re Bonham), 229 F.3d 750 (9th
Cir. 2000).

Less accepted is the substantive consolidation of non-debtor entities, the standard for which is a traditional
alter-ego analysis. After all, the concept of substantively consolidating non-debtors arose from the non-bankruptcy
remedy of "piercing the corporate veil," which makes the assets of one entity available to creditors of another entity
if the former entity were an "alter ego" or "mere instrumentality" of the latter entity. See In re Standard Brands
Paint Co., 154 B.R. 563, 567-68 (Bankr. C.D. Cal. 1993); see, also, In re Crabtree, 39 B.R. 718, 723-24 (Bankr.
E.D. Tenn. 1984) (holding that the "amended petition does not add a second debtor to this case, but rather reflects
the reality that [the non-debtor corporation] is simply the [debtor's] alter ego and an instrumentality used by him to
conduct his financial affairs").

Thus, the particular facts must present an element of fraud, injustice or fundamental unfairness, and it is
only under such limited circumstances that substantive consolidation of a non-debtor is appropriate. See In re Baker
& Getty Financial Services Inc., 78 B.R. 139, 142 (Bankr. N.D. Ohio 1987) (consolidating three non-debtor
individuals who formed a Ponzi scheme); In re New Center Hospital, 187 B.R. 560, 568-69 (E.D. Mich. 1995)
(finding that the debtors and non-debtor corporations were alter egos); In re United Stairs Corp., 176 B.R. 359,
369-70 (Bankr. D. N.J. 1995) (holding that a non-debtor may be consolidated with a debtor where the debtor used
non-debtor entities as instrumentalities of fraud). While the application of substantive consolidation to a non-debtor
has increasingly wide acceptance, the appropriate procedure for doing so is not clear. After all, the act of
substantively consolidating an entity is both an involuntary bankruptcy and an action that seeks to recover property.

Recognizing those issues, some argue that non-debtors should never be substantively consolidated with
debtors because, inter alia, of (1) the lack of authority to consolidate a non-debtor under the Bankruptcy Code, (2)
the contravention of the procedures for involuntary petitions under 11 U.S.C. §303 and (3) the problem of what
type of notice is due to the creditors of the non-debtor. See In re Circle Land and Cattle Corp., 213 BR 870, 877
(Bankr. D. Kan. 1997); In re Lease-A-Fleet, 141 BR 869, 872-75 (Bankr. E.D. Pa. 1992).

<h3>Procedural and Due Process</h3>

Substantive consolidation, where based on an alter-ego theory, is analogous to a state law
fraudulent-transfer cause of action, as both examine the business dealings between the debtor and non-debtor. In fact,
an alter-ego claim mirrors a fraudulent-transfer claim in that they both seek to avoid fraudulent actions and bring
property into the bankruptcy estate that would be property of the bankruptcy estate but for the fraudulent actions.

As such, it would seem more appropriate to bring such an action as an adversary proceeding and/or
through the Bankruptcy Code's involuntary bankruptcy provisions set forth in §303. See In re Alpha & Omega
Realty Inc., 36 B.R. 416, 417 (Bankr. D. Idaho 1984). In fact, most courts have held that the proper manner for
seeking substantive consolidation is an involuntary bankruptcy petition. See In re R.H.N. Realty Corp., 84 B.R.
356, 358 (Bankr. S.D.N.Y. 1988) (holding that "to add [a non-debtor] would deprive [the non-debtor] of the
opportunity of contesting the involuntary petition, as permitted under 11 U.S.C. §303(d) and (h)" and because
"[t]his procedure offends fundamental due process requirements..."); Lease-A-Fleet, 141 B.R. at 872-75 (refusing to
substantively consolidate a debtor with a non-debtor because substantive consolidation of a non-debtor circumvents
procedures for involuntary bankruptcies under §303).

Substantive consolidation through an involuntary petition, however, overlooks a common premise in such
circumstances: The non-debtor is typically not indebted to the bankruptcy estate and/or such "debt" is the subject of
a bona fide dispute. As such, a bankruptcy estate may not have the requisite basis for an involuntary petition. See
11 U.S.C. §303(b). And when comparing the due process protections afforded under an involuntary petition vs.
those afforded in an adversary proceeding, an adversary proceeding clearly offers more due-process protection than an
involuntary petition. See In re Julien Co., 120 B.R. 930, 937 (Bankr. W.D. Tenn. 1990) (holding that an
adversary proceeding or an involuntary petition is the appropriate procedure, not a contested matter).

While due-process concerns are readily apparent, not all courts agree that the due-process protections
afforded under the adversary rules and/or §303 are necessary. In fact, certain courts have held that an adversary
proceeding is not necessary, and that while an involuntary petition against the non-debtors would have been an
appropriate way to proceed, it was not necessary. See, e.g., In re 1438 Meridian Place N.W. Inc., 15 B.R. 89, 95-6
(Bankr. D.C. 1981); In re Bonham, 226 B.R. 56, 93 (Bankr. D. Alaska 1998), aff'd. In re Bonham, 229 F.3d 750
(9th Cir. 2000).

Other courts have raised concerns regarding the proper notice due the creditors of the non-debtor. See
Lease-A-Fleet, 141 B.R. at 873. This concern seems misplaced, as the proper notice would be the same notice given
to such creditors of either an involuntary bankruptcy petition, or a state-law alter-ego/veil-piercing action: none. See,
e.g., 11 U.S.C. §303; Fed. R. Bankr. P. 1007(a)(2), 1011(a). Only upon entry of the substantive consolidation
order would notice to all such creditors be appropriate.

Of course, a court should consider the best interests of the creditors of both the debtor and the non-debtor
in determining whether to substantively consolidate a non-debtor. See In re DRW Property Co., 82, 54 B.R. 489, 498 (Bankr. N.D. Tex. 1985) (finding that creditors of certain
partnerships would be harmed by consolidation, the court refused to order the substantive consolidation of 85
voluntary chapter 11 debtor partnerships with 109 non-debtor partnerships). But that is an argument for the parties
to make, just as they would in a state-law alter-ego/veil-piercing action.

<h3>Conclusion</h3>

To further complicate matters, in 1999 the U.S. Supreme Court reasoned that federal courts sitting in
equity are without power to employ equitable remedies that were not available to the English Court of Chancery
prior to 1789. See Grupo Mexicano de Desarollo S.A. v. Alliance Bond Fund Inc., 527 U.S. 308 (1999). While the

Grupo Mexicano decision did not expressly reverse the Sampsell decision, substantive consolidation presumably
was not used by the English Court of Chancery prior to 1789, and is arguably unavailable to federal courts using
equitable powers. See Tucker, J. Maxwell, "Grupo Mexicano and the Death of Substantive Consolidation," 8 ABI
L. Rev. 427-451 (2000).

While courts have yet to extend Grupo Mexicano to prohibiting substantive consolidation, it is a
challenge waiting to occur. In the meantime, it is important for courts and practitioners to consider the proper due
process protections due a non-debtor in a substantive consolidation action. After all, substantive consolidation seeks
not only to take property, but to remove separate legal identities altogether.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Monday, December 1, 2003 - 12:00

Bankruptcy Rule

2003