Defendants in an avoidance action who have only contingent claims lack standing to appeal a substantive consolidation order, even though it obliterated two of their defenses, according to a 2-1 opinion on May 16 by the Eighth Circuit.
The appeal arose from the massive Thomas Petters Ponzi scheme. The chapter 11 trustee initiated avoidance actions for billions of dollars against several lenders. Over the lenders’ objections, the bankruptcy court substantively consolidated Petters’ main company with several special purpose entities.
When the lenders appealed, the district court dismissed the appeals for lack of standing. The lenders appealed again, contending they were “aggrieved persons” because substantive consolidation eradicated two of their defenses to the avoidance actions. They lost again in the court of appeals, with the majority opinion written by Circuit Judge Duane Benton.
Citing the usual rule that appellate standing is narrower than Article III standing, Judge Benton said that “any potential pecuniary harm to the lenders is several steps removed and not a ‘direct’ pecuniary impact.” Before the lenders would suffer “pecuniary harm,” Judge Benton said the trustee must win, the lenders must pay the judgments in full, and the lenders must file valid claims resulting from the judgments.
The loss of affirmative defenses, the majority held, causes only indirect harm. Judge Benton added that the “lenders’ interest in avoiding liability is antithetical to the primary purposes of the Bankruptcy Code.”
In dissent, Circuit Judge Kermit E. Bye said that the loss of affirmative defenses should make them “persons aggrieved.”
Judge Bye said that substantive consolidation gave standing to the trustee to bring additional avoidance actions because it created dozens of actual creditors on whose behalf the trustee could sue. Substantive consolidation also ended the lenders’ “good faith” defenses because they became initial transferees, not subsequent transferees.
Judge Bye would have given standing to the lenders because removing defenses imposed an additional burden on their ability to defend.
Presumably, Judge Bye would not have dissented were consolidation without prejudice to the lenders’ defenses. Despite the majority’s opinion on standing to appeal, one wonders whether substantive consolidation indeed obliterated the defenses.
Consolidation is designed to aid creditors by facilitating distributions when corporate affairs are hopelessly intermingled. Consolidation is not generally viewed as a mechanism for a trustee to sidestep defenses in avoidance actions. Perhaps some judge down the line will hold that substantive consolidation cannot prejudice lenders’ defenses.