R2D2’s Affiliates Might Be Safe from Substantive Consolidation, but Some Nondebtors in the Ninth Circuit Might Get Pulled Over to the “Dark Side”

Contributed by Rich Mullen
Exactly how powerful are the equitable powers of bankruptcy judges?  While bankruptcy practitioners may regard bankruptcy judges as Jedi masters, to what extent can bankruptcy courts use the Force on nondebtors?  This is especially a concern when use of a bankruptcy court’s equitable powers can pull nondebtors over to the “dark side” and substantively consolidate them with their debtor affiliates.  It is not often that bankruptcy courts consider the substantive consolidation of nondebtors, but two bankruptcy courts in the Ninth Circuit recently have issued bench rulings concerning such issues.  In In re R2D2, the Bankruptcy Court for the Central District of California denied the motion to substantively consolidate several debtors and nondebtors, stating that the request did not “even come close.”  In contrast, the Bankruptcy Court for the Eastern District of Washington, in In re LLS America, stated that the case “crie[d] out for substantive consolidation” and granted the motion to substantively consolidate the estates of several nondebtors with the estate of the debtor.
In reaching opposite conclusions, both bankruptcy courts applied In re Bonham, the Ninth Circuit’s leading case on substantive consolidation.  The Ninth Circuit’s test is similar to the tests that have been adopted in the Second Circuit and the Third Circuit, and permits substantive consolidation if creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, or if the affairs of the entities are so entangled that consolidation would benefit all creditors.
In re R2D2
In R2D2, the chapter 11 trustee sought to consolidate the bankruptcy estates of five debtor companies and several nondebtor companies that were each owned by a film producer (Hollywood film financier David Bergstein, not George Lucas!).  At the hearing, the chapter 11 trustee argued that the transactions among the various debtor and nondebtor companies were not well-documented and that the various debtor and nondebtor companies commingled assets as part of a corporate “shell game” that was impossible to disentangle.  The trustee’s principal evidence apparently was that one of the film producer’s debtor companies would incur debt obligations, several of the other debtors and nondebtors would guarantee those obligations, and then the proceeds would disbursed throughout the enterprise of single-purpose entities.  In addition, the trustee pointed out that the consolidated tax returns of the various debtor and nondebtor companies were “largely blank,” materially incomplete, and inaccurate.
Certain creditors of the debtor and nondebtor companies opposed the motion arguing, among other things, that the entities each had legitimate and specific business purposes (such as producing individual films and serving as a holding company for rights in individual films), an enterprise of single-purpose entities was a typical business structure for the entertainment industry, and the various entities were not engaged in a shell game.  The creditors further argued that the entities were not hopelessly entangled because, with the appropriate diligence, they were able to discern the assets and liabilities of each company.
The court denied the motion to substantively consolidate the various debtors and nondebtors without reading its analysis into the record.  While the court did note that some entanglement existed among the entities, it concluded that the chapter 11 trustee had not presented enough evidence to establish either of the requirements of Bonham.
In re LLS America
In LLS America, the chapter 11 trustee sought to consolidate the bankruptcy estates of the debtor and several of its nondebtor affiliated companies.  The trustee argued that each of the companies was owned by one individual, and all the companies were used to perpetrate a Ponzi scheme to make pay-day loans to unsuspecting customers.  The trustee further argued that an examiner had spent several months inspecting the records of the various entities and had concluded that the operation of those entities was intertwined and their funds commingled.  Finally, the trustee argued that substantive consolidation would save the estate from incurring the expense of having to unwind and pursue claims against each entity individually.  Certain of the nondebtor entities and creditors of such entities opposed the motion, arguing, among other things, that each of the nondebtors maintained a distinct identity and was, in fact, an on-going and thriving business.  One nondebtor argued, for example, that it was created to look after the enterprise’s administrative books and records, and that it also maintained its own records, which reflected liabilities being paid and income being earned.
In the end, the bankruptcy court consolidated the several estates, pulling the nondebtors’ estates into the bankruptcy case of LLS America.  The court stated that “one could conclude there was a Ponzi scheme,” but did not conclude that one existed.  It did determine, however, that both parts of the Bonham test had been met and that the estates of the nondebtors would be substantively consolidated.  In reaching this conclusion, the bankruptcy court found that the several companies shared a “common business purpose” and had commingled their financial affairs, which the bankruptcy court concluded was evidenced by numerous transfers to, from, and among the various entities that served no business purpose or had a business purpose with little relationship to the dollar amounts transferred.  The court held that substantive consolidation was appropriate as it would create one proceeding encompassing all the assets of the enterprise that can be used to pay all the creditors who relied upon the financial wherewithal of the various entities.
After the court issued its bench ruling, a group of creditors filed an objection to the proposed order arguing, among other things, that the bankruptcy court did not have constitutional authority to enter an order granting the motion for substantive consolidation in light of the Supreme Court’s recent holding in Stern v. Marshall.  After the court allowed supplemental briefing, it determined  that substantive consolidation is a core matter within the meaning of the Bankruptcy Code because it does not exist outside of the context of a bankruptcy case and is premised upon the goal of a ratable and fair distribution to creditors, which is one of the fundamental goals and purposes of the federal bankruptcy scheme.  Ultimately, the court concluded that it had constitutional authority to enter an order granting substantive consolidation.
Interestingly, neither the R2D2 court nor the LLS America court addressed whether there should be a higher standard in determining whether to consolidate nondebtors with debtors.  This question may eventually be answered by the Ninth Circuit, however, as the consolidated nondebtors in LLS America have appealed the bankruptcy court’s decision.  Few cases have actually substantively consolidated the estates of nondebtors with that of debtors.  As is the case with both of these rulings, the failure of each court to issue a formal opinion on the issue and the fact-specific nature of the inquiries mean that both decisions provide little additional guidance on the issue of the substantive consolidation of nondebtors.  We will, of course, report back on any further developments.