Bankruptcy Court for the Southern District of New York Offers Practical Solution in Substantive Consolidation Conundrum

Contributed by Edward Wu
The Bankruptcy Court for the Southern District of New York recently issued a decision in the case of In re Jennifer Convertibles, Inc., Case No. 10-13779 (ALG) [Docket No. 487] (Feb. 4, 2011) that provided the debtors with a proverbial “silver lining” to the cloud that appeared to overshadow their plan.  The decision provides a practical roadmap as to how a debtor whose plan is premised on substantive consolidation may confirm its plan even where it cannot prove substantive consolidation is appropriate, but the advice may be limited in application.
Substantive consolidation is a judicially created equitable doctrine that permits a court in a bankruptcy case to consolidate or merge one or more related entities, as well as their assets and liabilities, thereby creating a single estate from which claims are satisfied.  In the chapter 11 plan process, debtors are often “deemed” substantively consolidated for the purposes of allowing and satisfying creditor claims, voting on a plan and making distributions.  The debtors’ assets and liabilities are treated as though there were an actual substantive consolidation, but the legal entities are not actually consolidated or merged.  Although substantive consolidation greatly eases the administration of complex chapter 11 cases, it also can disadvantage certain creditors who otherwise would have received a greater distribution from a particular debtor that has greater assets (or less liabilities) than the other debtors.  For this reason, the Second Circuit held in In re Augie/Restivo Baking Co., 860 F.2d 515, 518 (2d Cir. 1988) that substantive consolidation requires (i) creditors to have dealt with the debtor entities as a single economic unit without relying on the debtors’ separateness in extending credit or (ii) the affairs of the debtors to be so entangled that consolidation will benefit all creditors.
In Jennifer Convertibles, a creditor, Ashley Furniture Industries, Inc., objected to the debtors’ chapter 11 plan providing for “deemed” substantive consolidation on the basis that, among other reasons, substantive consolidation was not appropriate with respect to one of the debtors, Hartsdale Convertibles, Inc.  In the decision, Judge Gropper noted that the debtors never introduced any evidence as to whether the Hartsdale creditors relied upon the separate identity of the debtors in extending credit (the first prong of the Second Circuit’s test).  He then stated that, while it would be difficult for the debtors to unscramble their finances, the second prong of the Second Circuit’s test was not met because the debtors did not introduce evidence that separate accounting was impossible or detrimentally expensive to all creditors.
Even though the Second Circuit’s test was not satisfied, Judge Gropper stated that substantive consolidation is a flexible concept and that a principal consideration of the doctrine is whether creditors are adversely affected by consolidation and whether such adverse effects could be eliminated.  The court also noted that courts have the authority to order less than complete consolidation.  Examining the plan, the court found that that substantive consolidation was largely irrelevant for Hartsdale’s principal creditors (including Ashley) because the debtor’s plan proposed to give them the benefits of their bargain (including the debtor’s assumption of certain license and leases with those creditors).  The court further concluded that only a relatively few trade creditors holding an aggregate of approximately $94,000 in claims could be adversely affected by the consolidation.  The debtors, however, had failed to show that those creditors were “being treated appropriately” as a result of the proposed substantive consolidation.  Compounding the problem was the fact that the debtors could not prove that the “best interests” test of section 1129(a)(7) of the Bankruptcy Code was satisfied (i.e., that each holder of an impaired class of claims or interests that has rejected a plan would receive under the plan at least as much as if the debtor were liquidated).  The court explained that, if the debtors had proved substantive consolidation were warranted, then a separate liquidation analysis for Hartsdale would not have been required or appropriate.  Given that the debtors had not established that Hartsdale could be substantively consolidated, a separate liquidation analysis was necessary.
The court, however, provided the debtors with a remedy for their substantive consolidation conundrum:  either the debtors could provide for payment in full of Hartsdale’s relatively few trade creditors and immediately confirm the plan as to Hartsdale and the other debtors or, alternatively, the debtors could introduce further evidence to establish that substantive consolidation was appropriate under the Second Circuit’s test and submit a separate liquidation analysis for Hartsdale.
Judge Gropper’s suggestion that the debtors might pay the trade creditors in full was a sensible solution to the debtors’ substantive consolidation dilemma, where the trade creditors at issue were owed less than $100,000, collectively, and the debtors presumably had the liquidity to satisfy the claims in full.  In other cases, however, payment in full – or even providing the creditors with the “benefit of their bargains” – might not be a realistic possibility.  In those cases, as the court in Jennifer Convertibles suggested, a debtor will be required to prove it meets the traditional elements of substantive consolidation.