The ruling from the United States Supreme Court in Official Representatives of the Bondholders and Trade Creditors of Debtors Owens Corning v. Credit Suisse First Boston, 126 S. Ct. 1910 (2006)on May 1, 2006, declining to review the Third Circuit Court of Appeals ruling denying substantive consolidation in the Owens Corning bankruptcy, gives good reason to review the concept of substantive consolidation. Substantive consolidation is a bankruptcy concept that comes from "federal common law," permitting a bankruptcy court to treat a group of affiliated companies as if they are one, merging their assets and liabilities for purposes of the bankruptcy proceeding. This concept even allows the court to merge non-bankruptcy affiliates with the bankruptcy affiliates if the court finds that substantive consolidation is required. Generally, a debtor in bankruptcy must be found not to be operating its affiliated companies as separate entities, therefore it would be unfair to the creditors of weaker affiliates not to have the advantage of the assets of stronger affiliates in the bankruptcy. There have been two lines of cases on substantive consolidation. One line of cases sets out very broad standards for imposing substantive consolidation, and the other line of cases sets out elaborate and specific standards.
In the Owens Corning bankruptcy the debtor and the creditors committee wanted to treat Owens Corning and approximately 17 of its subsidiaries as if they were one company for purposes of voting on a plan of reorganization, and for purposes of utilizing the assets of all of the related companies to pay claims. This would mean that one could look to the assets of Owens Corning and all 17 subsidiaries as the source for repayment of the claims against Owens Corning or any of its subsidiaries (most arising from asbestos claims). The problem was that Owens Corning had borrowed $2 billion from a consortium of lenders lead by Credit Suisse to make an acquisition at a time when Owens Corning was already in financial difficulty. The loan was specifically guaranteed by a number of the more solvent of the Owens Corning subsidiaries. If the substantive consolidation were allowed, it would have voided the guaranties given to Credit Suisse and the other lenders since the entire group of companies would have been treated as if they were one company.
Even more disturbing for the Credit Suisse bank group, while the Owens Corning plan of reorganization would have treated all of the subsidiaries and Owens Corning as one company for purposes of claims and the distribution of assets, it did not provide for an actual merger of all entities after reorganization. This is a so-called "deemed" substantive consolidation. In its analysis the Third Circuit spent a great deal of time reviewing the fact that the structure of the Credit Suisse loan facility was very purposeful in requiring the guaranty of the substantial affiliates of Owens Corning and the problems with Owens Corning's credit at the time of the Credit Suisse loan, which eventually lead to the bankruptcy filing. The court also spent extensive time reviewing sections of the credit agreement, which required that the guaranties be maintained in all circumstances. The court drew the correct conclusion that the major purpose of the plan of reorganization and the deemed substantive consolidation was to deprive the Credit Suisse group and the other lenders in its group from exclusive access to the assets of the guarantors and use those assets for the greater good of the entire Owens Corning creditor group.
While the bankruptcy court and the United States District Court had upheld the "deemed" substantive consolidation, the Third Circuit struck down the entire concept of a "deemed" substantive consolidation, and then placed very specific limitations on the use of substantive consolidation generally.
The Third Circuit Court of Appeals makes several important rulings:
1. Substantive consolidation should rarely be used.
2. The courts should respect the existence of separate entities as long as:
a. The entities are legitimate entities under state law, and
b. The entities are operated in a way so as to cause them to be separate (keeping separate books and records of accounts, etc.).
3. Substantive consolidation is not appropriate to remedy situations involving creditors where other provisions of the bankruptcy code (such as preferential transfer or fraudulent conveyance) can be used to seek the appropriate remedy.
4. Because of the adverse impact substantive consolidation generally has on creditors, it should never be used merely to affect an easier administration of a bankruptcy proceeding.
5. The court also found that substantive consolidation should only be used as a defensive weapon with corporations that are so entangled that there is no way of separating their businesses and their assets, but should never be used offensively to attack rights of creditors, such as the guarantee by subsidiaries, as in Owens Corning case.
The Third Circuit held that "In our Court what must be proven (absent consent) concerning the entities for whom substantive consolidation is sought is that (i) prepetition, they disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (ii) postpetition, their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors."
The point for lenders is that at least in the Third Circuit substantive consolidation is truly a nuclear option and there are very few cases in which it should be granted.
This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.
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