Restructuring

Contributed by Victoria Vron
As soon as the Third Circuit issued its decision in In re Owens Corning, 419 F.3d 195 (3d Cir. 2005), the decision was heralded as the death knell for substantive consolidation, especially “deemed” substantive consolidation.  In this installment of Throwback Thursday, we take a look back at the Owens Corning decision that prompted much speculation about the future of substantive consolidation.
Substantive consolidation is a judicially created equitable doctrine that treats separate legal entities as if they were merged into a single survivor, with all the assets and liabilities (other than inter-entity liabilities and guarantees, which are extinguished) permanently becoming assets and liabilities of the consolidated survivor.  “Deemed” substantive consolidation is a variant of this remedy.  Although it does not result in a permanent consolidation of assets and liabilities of the separate legal entities, “deemed” substantive consolidation treats such assets and liabilities as having been consolidated only for purposes of allowing and satisfying creditor claims, voting on a plan and making distributions; after the chapter 11 plan is consummated, the legal entities continue to operate separately with their own assets and liabilities.
Substantive consolidation (and even “deemed” substantive consolidation) can be a very important tool in restructuring certain debtors, especially where there are many affiliated debtors and their assets and liabilities are difficult to disentangle.  Substantive consolidation (whether actual or “deemed”), however, can harm certain creditors.  For example, creditors of a debtor with many assets (or few liabilities) that is consolidated with its more insolvent affiliates could potentially see their recoveries decline significantly.  Moreover, because substantive consolidation eliminates guarantees involving consolidated debtors, substantive consolidation can impair the rights of creditors who relied on those guarantees.
For these reasons, although courts have approved substantive consolidation for decades, they have noted that it is a remedy that should be used sparingly.  Most courts have followed either the Second Circuit’s Augie/Restivo approach to substantive consolidation or the D.C. Circuit’s Auto-Train approach.  The Augie/Restivo approach looks at (i) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, or (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors.  The Auto-Train approach, on the other hand, looks at whether there is a substantial identity of the entities and allows consolidation in spite of creditor reliance on separateness when the demonstrated benefits of consolidation heavily outweigh the harm.
In Owens Corning, the Third Circuit weighed in on its preferred approach to substantive consolidation.  There, the debtor sought approval for “deemed” substantive consolidation of affiliated entities in anticipation of its plan of reorganization.  Lenders that made a $2 billion prepetition unsecured loan to the parent entity, which loan was guaranteed by certain of the subsidiaries, objected to substantive consolidation claiming that they relied on the separateness of the entities when making the loan.  If approved, the “deemed” substantive consolidation would have eliminated the lenders’ guarantees, thus presumably reducing the lenders’ aggregate recovery on their claims.
The Third Circuit, while stating that it favored the Augie/Restivo approach, outlined its own test for determining whether to approve substantive consolidation.  In setting forth the test, the court looked at five principles behind substantive consolidation and why, as a result, this remedy should be used sparingly: (i) limiting the cross-creep of liability by respecting entity separateness is a fundamental ground rule; (ii) the harms substantive consolidation addresses are nearly always those caused by debtors; (iii) mere benefit of administration of the case is hardly a harm calling substantive consolidation into play; (iv) substantive consolidation should be a rare remedy and one of last resort after considering and rejecting other remedies; and (v) while substantive consolidation may be used defensively to remedy the identifiable harms caused by entangled affairs, it may not be used offensively.
Based on these principles, the court held that, in the Third Circuit, what must be proven (absent consent) is that (i) prepetition the entities to be consolidated disregarded separateness so significantly that 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.
Applying this test to the facts in Owens Corning, the court found that substantive consolidation was not appropriate in that case.  First, there was no evidence that prepetition the entities disregarded separateness.  Second, there was no meaningful evidence provided of hopeless commingling of debtors’ assets and liabilities, i.e., there was no evidence that the commingling would reduce the recovery of every creditor.  Finally, the court also noted that the most fatal flaw was that the substantive consolidation was only “deemed,” which the court found to be completely inconsistent with the principles of substantive consolidation.  If the debtors’ corporate and financial structure was such a sham prepetition, why would it remain largely intact post-effective date?  Thus, the court viewed the debtors’ request for “deemed” substantive consolidation simply as an offensive tool to strip the lenders of their rights in favor of other creditors.
It was likely this comment about “deemed” substantive consolidation (and the more stringent test) that led commentators to speculate that Owens Corning will bring an end to “deemed” substantive consolidation, if not most substantive consolidation.  Although we have not undertaken an exhaustive review of all substantive consolidation decisions entered after Owens Corning, anecdotal evidence shows that while its use as an offensive tool to disadvantage certain creditors has likely (and appropriately) been curtailed, substantive consolidation, even “deemed” substantive consolidation, is still alive and well.
Why is this the case?  First, the Owens Corning test only applies to non-consensual substantive consolidation.  Thus, absent objections, courts, even in the Third Circuit, rarely inquire into the merits of substantive consolidation or “deemed” substantive consolidation.  For planning purposes, this, of course, puts the onus on the proponent of substantive consolidation to make sure that its planned use of substantive consolidation will not invite objections.  The primary way to achieve this is to make sure that no creditor will be materially harmed by the consolidation.
Second, the one scenario the Owens Corning court recognized is possible, but did not address, is partial substantive consolidation.  The court left open the possibility that if any creditor reasonably relied on the separateness of a particular debtor, consolidation would still be approved but such creditor would receive a distribution equal to what it would have received absent substantive consolidation.  Although the court did not opine as to whether such partial consolidation is appropriate, it was skeptical that facts could arise that would make this scenario likely.  Id. at 210.  Despite the court’s skepticism, we believe that there could be cases where this type of partial substantive consolidation could work.  For example, as we reported in an earlier post, the court in In re Jennifer Convertibles, Inc., 2011 Bankr. LEXIS 342, *30 (Bankr. S.D.N.Y. Feb. 4, 2011), recently held that “deemed” substantive consolidation could be approved if the debtor pays any creditors harmed by the consolidation what they would have received absent substantive consolidation.
Thus, notwithstanding the Owens Corning decision, with proper plan structuring, substantive consolidation can still be used to reduce the administrative cost of implementing multiple plans, thus maximizing value for creditors.