Substantive consolidation: A tale of two cases

Editor: Michael D. Koppel, CPA/PFS/CITP

When there is a “piercing of the corporate veil,” a legal decision has been made to treat the rights and duties of a corporation as the rights and liabilities of its shareholders. The same concept can apply to the parents in a consolidation or stakeholders in a partnership or limited liability company (LLC). It is a vertical decision. However, another concept, substantive consolidation, can be used by courts to consolidate the assets of entities that are not in a vertical chain.

One of the best definitions of “substantive consolidation” is from Andrew Brasher’s treatise Substantive Consolidation: A Critical Examination (unpublished, available at www.law.harvard.edu: “Substantive consolidation is the pooling of the assets and liabilities of technically distinct corporate entities.”

A very important distinction can be seen in the last four words, “technically distinct corporate entities.” In other words, a substantive consolidation can involve entities that are not part of a vertical chain. This distinction can also be seen in Helena Chem. Co. v. Circle Land and Cattle Corp. (In re Circle Land and Cattle Corp.), 213 B.R. 870 (Bankr. D. Kan. 1997), where the court observed (quoting Epstein, et al., 1 Bankruptcy 26 (West 1992)):

Substantive consolidation should not be confused with either the corporate law concept of piercing the corporate veil or the bankruptcy law concept of joint administration. Unlike piercing the corporate veil, substantive consolidation does not seek to hold shareholders liable for acts of their incorporated entity. [Note: A substantive consolidation applies to all types of business entities.]

What does substantive consolidation actually mean? First, it is important to remember that a substantive consolidation is used by a Bankruptcy Court to consolidate the assets and liabilities of affiliated entities in bankruptcy. No specific provision in the U.S. Bankruptcy Code would allow for substantive consolidation. It is a judicially created doctrine derived from general equitable powers of Bankruptcy Courts pursuant to Section 105(a) of the Bankruptcy Code (11 U.S.C. §105(a)). Because there is no clear statutory guidance for how a bankruptcy judge determines if a trustee’s request to apply substantive consolidation should be granted, each case is different.

One recent case is Lassman v. Cameron Construction LLC (In re Cameron Construction & Roofing Co.), No. 15-01121(Bankr. D. Mass. 12/14/16),in which the trustee asked the court to consolidate a construction corporation and a separate LLC that were majority owned and controlled by the same person who owned the real property the corporation used in its business.The court determined that the trustee would have to demonstrate that the assets and liabilities of the entities were “so intertwined that it would be impossible, or financially prohibitive, to disentangle their affairs” and the potential benefits of consolidation outweighed “any potential harm to interested parties.” In this case the trustee was able to show that:

• There was no written lease for the property between the corporation and the LLC;
• Amounts paid as rent appeared to have been above fair market value (FMV);
• Amounts paid to the spouse of the majority owner of the entities were above FMV and were paid disproportionately by the LLC;
• Work done by employees of the operating company for the benefit of the LLC were apparently not paid for; and
• Ownership of the LLC was significantly disproportionate to the capital contributed.

It is important to note that the two related entities maintained separate books and records, filed separate tax returns, and made all required annual filings.

The judge ruled in favor of the trustee so the assets and liabilities could be used to satisfy the creditors’ claims in bankruptcy.

Another case is Spradlin v. Beads and Steeds Inns, LLC (In re Howland), No. 16-5499 (6th Cir. 1/3/17). This case is different in that the individuals were in bankruptcy, not the entity. The individuals operated a horse farm/bed and breakfast in Kentucky; the property was owned by their LLC. In December 2010, they sold the property to an unrelated third party. It was not disputed whether the sale was for FMV. However, the individuals and their LLC then leased the property back from the buyer for $1,000 per month, which was considered approximately 25% of FMV. Two years later, the individuals filed for bankruptcy. The trustee brought an adversarial action against the buyer, alleging the transfer of the property from the LLC to the buyer was fraudulent and done to evade the individuals’ creditors. Because the LLC was not a party to the bankruptcy, the trustee argued that a reverse piercing of the corporate veil should apply. The judge rejected this argument for multiple reasons.

The trustee then argued for substantive consolidation, maintaining that the individuals and the operating entity were the same. The court noted (quoting In re Owens Corning, 419 F.3d 195, 211 (3d Cir. 2005)) that for a substantive consolidation to apply, the trustee must allege that:

(i) prepetition [the entities sought to be consolidated] 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. [In re Howland, slip op. at 10]

The judge again rejected the trustee’s argument “because, even accepting the allegations as true, the proposed complaint failed to adequately plead a claim for substantive consolidation” (id. at 3). The trustee appealed the decision to both the district and appeals courts and lost both times.

In re Howland is important to any bankruptcy trustee: It is clearly an example of the importance of “form.” The judges ruled against the trustee because the LLC was not named in the bankruptcy petition, and there was no indication that the assets were so comingled that they could not be separated.

In re Cameron Construction is important to businesses, their stakeholders, and their creditors. As an attorney for the defendant indicated, “I would say that it is typical in the real estate and business bar that when you have an operating company operating out of a site and they acquire that site, you typically would have a second entity formed” (In re Cameron Construction, slip op. at 5). He went on to explain why this was especially important in this situation. However, as the case demonstrates, keeping a clear division between the entities is vital.

As noted above, the court indicated the need to avoid the entities’ being seen as “intertwined.” Creditors have to understand that in a substantive consolidation, some creditors win and others lose. The importance of obtaining collateral and personal guarantees before lending money cannot be overstated.

EditorNotes

Michael D. Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

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