A bankruptcy filing by one company does not necessarily mean that its affiliates will also file for bankruptcy. It is common for a financially distressed company to file for bankruptcy while its financially sound affiliates continue business operations in the ordinary course. The bad news, however, is that a court may disregard a company’s decision not to file for bankruptcy in connection with an affiliate bankruptcy filing if the company is managed and operated in a manner that disregards the corporate separateness between it and affiliates(s) that have filed for bankruptcy. Consequently, the assets of a non-debtor company may be made available to satisfy creditors of affiliates in the bankruptcy cases of those affiliates. However, the good news is that while such “substantive consolidation” of non-debtors with debtors is possible, it is generally unlikely. Indeed, if a single creditor of the non-debtor company will be harmed by the substantive consolidation of such company with affiliates in bankruptcy, the risk of such substantive consolidation becomes relatively remote. This scenario recently played out in a case pending in the Western District of Oklahoma. See In re Stewart, Adv. No. 16-1117, Doc. No. 163 (Bankr. W.D. Okla. Aug. 17, 2017).
The Debtors were two individuals who derived all of their income from various companies that they owned. None of the companies owned by the Debtors were included in the bankruptcy cases, keeping those companies’ assets outside of the bankruptcy court’s jurisdiction and unavailable to help satisfy creditors’ claims. Seeking to increase recovery on its claim, a creditor of the Debtors — SE Properties (“SEP”) — commenced an adversary proceeding seeking to substantive consolidate eight of the Debtors’ businesses (the “Non-Debtor Companies”) with and into the Debtors’ bankruptcy cases. SEP asserted substantive consolidation was appropriate based on the following allegations:
• The Non-Debtor Companies were operating as a single enterprise, sharing employees and office space.
• Corporate formalities to maintain the separation between the Debtors and the Non-Debtor Companies were not followed.
• Cash from certain of the Non-Debtor Companies was used indiscriminately to fund other Non-Debtor Companies that were in need of cash at the time. The transfers were not reflected in any sort of loan documentation and were never paid back.
• As a result of the intercompany transfers, the assets and liabilities of the Non-Debtor Companies were hopefully commingled.
• The Debtors personally guaranteed loans to the Non-Debtor Companies and used them as their “personal piggy banks.”
• The Debtors created many of the Non-Debtors Companies solely to allow the Debtors to transfer their assets and interests to the Non-Debtor Companies, outside the reach of the Debtors’ creditors.
Kirkpatrick, a creditor of one of the Non-Debtor Companies, intervened in the adversary and filed a motion to dismiss, asserting, among things, that the bankruptcy court could not invoke its equitable powers to establish jurisdiction over a non-debtor entity.
Standard for Substantive Consolidation of a Non-Debtor
The bankruptcy court approved Kirkpatrick’s motion to dismiss but gave SEP 15 days to file an amended complaint, “reluctantly recogniz[ing] that under very limited circumstances, [the court] had the discretion, to be exercised sparingly on a highly fact-specific case-by-case basis, to substantively consolidate a debtor’s estate with non-debtors.” To successfully substantively consolidate the assets of a non-debtor with those of debtors, the court held that a party seeking to do so must show:
1. A substantial identity between the entities (hopeless commingling of the entities’ assets);
2. Consolidation is necessary to avoid some harm or to realize some benefit;
3. That if a creditor objects on the grounds that it relied on the separate credit of one of the entities to its prejudice, consolidation may be ordered only if the benefits heavily outweigh the harm; and
4. That consolidation was for the benefit of all creditors and that benefits of consolidation outweigh any resulting harm to general creditors of the entities.
The Power of Creditors
After SEP filed an amended complaint, a different creditor of a Non-Debtor Company filed a statement with the court noting that it did not think substantive consolidation was appropriate because recovery to creditors like it, who held claims solely against a Non-Debtor Company, “will be diluted to a meaningless amount” by claims held by SEP against the Debtors. The creditor further stated that it “did not bargain to compete with all of the [Debtors’] personal creditors when it entered into transactions with [the Non-Debtor Company] and should not now be forced to compete with those creditors for what will likely be an already limited pool of [Non-Debtor Company] assets.”
The bankruptcy court found that the creditor’s statement was “highly significant, if not determinative,” and ultimately dismissed the complaint. Citing In re Circle Land & Cattle Corp., 213 B.R. 870, 875-76 (Bankr. D. Kan. 1997), the court concluded “Better, we think, to ask are any creditors going to be hurt by this consolidation and, if the answer to that is yes (or more properly, if the one seeking consolidation cannot prove the opposite), consolidation should be denied in almost every case.”
Lenders can help reduce the risk of substantive consolidation by including language in their transaction documents that demonstrate they are relying on the separate nature of a borrower from its affiliates. “Separateness covenants” in the organization documents or transactional documents are helpful as well. Finally, it may be beneficial to require the appointment of independent directors or managers at the borrower to ensure that a bankruptcy filing by an affiliate would not automatically result a decision by borrower to file for bankruptcy as well. Absent these types of protections, the normally high hurdle for substantive consolidation may inadvertently be lowered.