Consenting to a Relief Order Bars Trustee from later Substantive Consolidation

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Jun 2006

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Citation

ABI Journal, Vol. XXV, No. 5, p. 32, June 2006

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The Fifth Circuit Court of Appeals recently held that substantive consolidation
of a corporate debtor with its nondebtor sole shareholder, nunc pro tunc
to the petition date of the corporate debtor, where the trustee had previously
consented to an agreed order lifting the automatic stay to permit a creditor
to pursue its state court remedies in the pending corporate debtor's case, was
an abuse of discretion. The court held that the trustee was bound by the terms
of the agreed order, and that the effective abrogation of that agreement would
unfairly prejudice the creditor, which, relying on the agreed order, had expended
time and money to obtain a consent judgment and a consensual lien, which would
have been voided by the bankruptcy court's order granting substantive consolidation.1

Facts
Rehmat A. Peerbhai and managed Amco Insurance Group (AIG), a holding company
in the automobile insurance business. In 1992, Peerbhai incorporated a new company,
American Insurance Agency (AIA), which sold automobile insurance as well. AIG
became the parent entity and AIA the subsidiary, with Peerbhai owning all of
the stock of both corporations. In September 2000, Peerbhai and AIG approached
Wells Fargo for financing. Wells Fargo insisted the companies obtain independent
audited financial statements as a condition of evaluating the lending requests.
After reviewing the audited financial statements, Wells Fargo agreed to lend
money to Peerbhai individually and to AIG, and extended a loan in the amount
of $2.4 million to Peerbhai and AIG as co-borrowers, and a second loan in the
amount $1.2 million to AIG alone. Wells Fargo required Peerbhai to execute a
guaranty of the AIG loan, which he did on Sept. 21, 2000. AMCO at 1.
Just over a year later, in December 2001, AIG breached a material loan covenant
with Wells Fargo, prompting Wells Fargo to file an action against Peerbhai and
AIG to collect on the debts and for a restraining order against AIG in state
court in January 2002. In response, both AIA and AIG filed chapter 7 petitions
on Feb. 4, 2002. One week after the filing, Wells Fargo filed a motion to lift
the automatic stay in the AIG case seeking to maintain its temporary injunction
against AIG and to continue to pursue the state court litigation against Peerbhai.
The motion was resolved by the entry of an Agreed Order Partially Lifting the
Automatic Stay to Proceed in State Court Litigation on March 14, 2002 (Agreed
Order), which expressly maintained the temporary restraining order against AIG
and expressly permitted Wells Fargo to pursue state court remedies against Peerbhai
individually. Peerbhai was not a debtor at the time the Agreed Order was entered.
Id.
Substantive Consolidation Litigation
After entry of the Agreed Order, Wells Fargo proceeded against Peerbhai in
the state court. The parties subsequently reached an agreement and executed
a Limited Forbearance Agreement dated April 10, 2002, pursuant to which they
filed an agreed judgment settling the state court litigation. The state court
entered an Agreed Judgment on April 25, 2002, giving Wells Fargo a consensual
lien on Peerbhai's homestead and other personally owned property, as well as
a judgment against him in the total amount of $3,398,956.16. Wells Fargo agreed
that it would not seek to enforce the judgment or otherwise pursue any of its
rights and remedies thereunder until April 9, 2003. Id.
On July 11, 2002, the trustee for AIA filed an application for substantive
consolidation, seeking to consolidate AIA and Peerbhai as a single debtor in
bankruptcy, despite the fact that Peerbhai was still not a debtor at the time.
The application sought to put Peerbhai into bankruptcy and to relate his filing
back to AIA's petition date of Feb. 4, 2002 under theories of "single economic
unit" and "single business enterprise." Needless to say, Wells
Fargo objected to the application. For various reasons, the application was
carried for quite some time, and on Dec. 11, 2002, Peerbhai filed a chapter
11 bankruptcy petition, which he later converted to a chapter 7 petition. The
same chapter 7 trustee was appointed in each of these cases. AMCO at 2.
The application seeking substantive consolidation was tried in a two-day evidentiary
hearing beginning on May 2, 2003, and concluding May 23, 2003. Id. The
bankruptcy court determined, among other things, that (1) Peerbhai had engaged
in a pattern of activity that was aimed at concealing proceeds of AIA's operations
and sale of AIA assets from its creditors and Peerbhai's creditors; (2) Peerbhai
made no meaningful distinction between his personal funds and those of AIA while
AIA was an operating entity; (3) creditors of AIA dealt with Peerbhai and AIA
as a single economic unit and did not rely on their separate identities in extending
credit; (4) Peerbhai treated AIA as an alter ego and used the AIA corporate
status to commit fraud against his personal creditors and AIA's creditors; and
(5) Peerbhai and AIA did not observe the corporate formalities required by Texas
law. Id.

Based on these findings, the court concluded that (1) the lack of financial
records prevented the trustee from identifying and segregating the affairs of
AIA and Peerbhai because there was no autonomy exercised by either of them;
(2) substantive consolidation would protect AIA's creditors from receiving no
recovery from AIA, which Peerbhai had looted; (3) Wells Fargo knew the facts
and circumstances when the Limited Forbearance Agreement was entered, so substantive
consolidation would not unfairly prejudice its interests; (4) Wells Fargo knew
or should have known that AIA and Peerbhai were essentially one economic unit
before the case was filed; (5) the affairs of AIA and Peerbhai were so entangled
that substantive consolidation would benefit all creditors and unfairly prejudice
none of them; and (6) substantive consolidation should be effective nunc
pro tunc to the petition date of Feb. 4, 2002, because at all relevant times,
Peerbhai and AIA operated as one financial entity. Id.
Wells Fargo appealed to the district court, arguing that the bankruptcy court
exceeded its congressional and constitutional grant of authority when it entered
the substantive-consolidation order for retroactive consolidation. Specifically,
Wells Fargo argued that the U.S. Supreme Court abrogated the equitable remedy
of substantive consolidation in Grupo Mexicano de Desarrollo S.A. v. Alliance
Bond Fund Inc., 527 U.S. 308 (1999). In the alternative, if substantive
consolidation remains a viable remedy, Wells Fargo argued that the bankruptcy
court erred in allowing retroactive substantive consolidation for the nondebtor,
that the audited financial statements it had relied on contained no evidence
that AIA and Peerbhai's finances were hopelessly intertwined, and that the bankruptcy
court had erred in making its alter ego findings under Texas law. The trustee
responded that AIA was the operating entity and that Wells Fargo knew that Peerbhai
had no real assets apart from AIA.
The district court rejected Wells Fargo's argument that Grupo Mexicano
abrogated the remedy of substantive consolidation, stating that case "should
not be interpreted to provide a safe haven for debtors" who take actions
to conceal assets from their creditors. Wells Fargo Bank of Texas v. Sommers
(In re AMCO Ins. Agencies, Inc.), No. 4:04-CV-00455, Ch. 7 Case No. 02-31265,
Adv. Pro. No. 04-20841, slip op. at 9 (S.D. Tex. Sept. 6, 2004). The district
court also held that retroactive substantive consolidation was not unfair to
Wells Fargo and that the bankruptcy court had made an appropriate analysis and
applied the correct standard in approving the retroactive status. Id.
at 10-11. Finally, the district court held that the bankruptcy court properly
applied Texas law on the issue of alter ego, and affirmed the bankruptcy court.
Wells Fargo then appealed to the Fifth Circuit. Id. at 11-12.

Before the Fifth Circuit, Wells Fargo argued that under Grupo Mexicano
the bankruptcy court lacked the requisite power and authority to order substantive
consolidation, or, in the alternative, if the bankruptcy court had such power
it applied the wrong standard to determine whether substantive consolidation
was appropriate, and that the bankruptcy court erred in issuing its order of
substantive consolidation nunc pro tunc.
Result and Reasoning
In reversing the lower courts and remanding the case, the Fifth Circuit focused
on the fact that in March 2002 the trustee had consented to the entry by the
bankruptcy court of the Agreed Order, which specifically maintained the temporary
restraining order against AIA and permitted Wells Fargo to pursue its rights
and remedies against Peerbhai. The Fifth Circuit held:
<blockquote>
Because of this green light by the bankruptcy court, Wells Fargo expended
its time and money to pursue the state court litigation until the suit concluded
in the Limited Forbearance Agreement. Yet when Sommers later filed his motion
for substantive consolidation, which the bankruptcy court in turn granted,
he then sought to undo what he had earlier specifically authorized by applying
the consolidation of the estates nunc pro tunc. In granting the motion,
the bankruptcy court stated that "the avoidance of the liens granted
to Wells Fargo by Peerbhai pursuant to the Limited Forbearance Agreement would
simply return Wells Fargo to its position as of the petition date. We think
it was a little late for this reversal of course (AMCO at 3).
</blockquote>
 The Fifth Circuit also disagreed with the bankruptcy court's rulings that
under §105(a) it had the power to invalidate the effects of its order 20
months earlier, advising that §105(a) does not permit courts to "act
as roving commission[s] to do equity." Id. at 4. Additionally, the
Fifth Circuit noted its concerns with the substantive consolidation of a debtor
with a nondebtor, which the nunc pro tunc order created. Id. at
5, n. 3. Further, the court instructed that the chapter 7 trustee "should
have been more circumspect in requesting such an order given his earlier approval
of the litigation that resulted in settlement terms that could not have been
unexpected." Id. at 4. The court found that this was especially
troubling in light of Wells Fargo's reliance on the agreement of the trustee
and the approval of the court when it lifted the stay, and its investments of
its time and money to obtain a predictable judgment against Peerbhai. Id.
As a consequence, the effective abrogation of the Agreed Order would significantly
prejudice Wells Fargo. Id. Based on its disposition of the case, the
Fifth Circuit declined to address the question of whether the bankruptcy court
had the power to order substantive consolidation after Grupo Mexicano.
Id. at 5, n.5.

This case should be of some concern and guidance to trustees, and perhaps to
all party litigants. In light of its holding, before consenting to the entry
of an order granting relief requested by a creditor or party in interest, a
trustee—and perhaps all other party litigants—should consider what
rights and remedies are or may be affected by the agreement, and fashion a reservation
of rights to be included in the order that would preserve the ability to pursue
claims in the future. In addition, the Fifth Circuit's decision not to address
the argument that Grupo Mexicano abrogated the remedy of substantive
consolidation means that this issue is not yet resolved in this circuit, and
still remains a potential basis for an objection to a motion to substantively
consolidate estates. Finally, the case also indicates that if the remedy of
substantive consolidation remains viable, the Fifth Circuit considers it a remedy
to be used "sparingly."
<blockquote> </blockquote>

<hr>
<h3>Footnotes</h3>

1 In the Matter of AMCO Insurance; Rehmat Peerbhai, 2006 U.S. App.
LEXIS 7934 (5th Cir. March 31, 2006).

Journal Authors

Daniel W. Sklar

Journal Date

Thursday, June 1, 2006 - 12:00

Bankruptcy Rule

2006

none