The doctrine of substantive consolidation (generally- the power of a bankruptcy court to consolidate the assets and liabilities of affiliated entities in bankruptcy) is a recognized remedy exercised by bankruptcy courts – one that strikes fear into the hearts of many lenders. Justifiably so. The doctrine can be employed to order the substantive consolidation of related-debtor entities in bankruptcy and it can also be employed to substantively consolidate the assets of a debtor in bankruptcy with those of a related entity that is not a debtor in bankruptcy. Picture this: A parent entity files for bankruptcy and all the goodies are in a series of subsidiaries and the companies have never respected corporate niceties. The bankruptcy court presiding over the bankruptcy of the debtor-parent entity orders that the non-bankrupt SPE borrower will be dragged into bankruptcy and its assets used to satisfy the creditors of both the SPE borrower and the parent. Ta da. Who can forget how throughout the bankruptcy of GGP and the workout of many of the loans on its malls back in the days following the financial crisis of 2008, the specter of a possible substantive consolidation motion hung over the proceeding? It never happened, but it certainly impacted outcomes.
But hold the panic for a moment. First let’s do a quick refresher on the doctrine of substantive consolidation:
- Substantive consolidation is a judicially created doctrine derived from the general equitable powers of bankruptcy courts pursuant to Section 105(a) of the Bankruptcy Code. As there is no bright line rule, several tests have been developed to determine on a case-by-case basis whether substantive consolidation is warranted.
- A court may order substantive consolidation where, prior to bankruptcy (particularly in the eyes of creditors), two or more entities look and act like a single entity and should therefore be treated as a single debtor in bankruptcy. To make this determination, courts will consider facts such as: (i) the structure of the entities which are or may be the subject of substantive consolidation, (ii) the relationships and/or dealings between the entities, and (iii) the impact of substantive consolidation on creditors of each entity, including whether such creditors would be unfairly prejudiced by substantive consolidation.
Issues around substantive consolidation have been a mainstay of advising clients (both borrowers and lenders) in commercial real estate transactions for years. Commercial real estate financings commonly require covenants in the loan documents and organizational documents which operate to mitigate the risks of substantive consolidation and, more broadly, bankruptcy. A borrower is typically formed as an SPE governed by covenants contained in the loan documents and organizational documents which address separateness and bankruptcy remoteness. The delivery of a non-consolidation opinion letter (which is a reasoned analysis of the facts of a particular loan and borrower structure concluding that based on such facts and structure a bankruptcy court would not order substantive consolidation) also gives a lender additional comfort regarding a borrower’s separateness and the bankruptcy remoteness of the structure agreed upon. Lest we forget- neither the SPE covenants nor a legal opinion make a borrower bankruptcy proof. A general covenant package and general structure only mitigate the risk of a bankruptcy filing; they do not prevent it.
Two recent cases, a District of Massachusetts Bankruptcy Court case and a Sixth Circuit Court of Appeals case, serve, at the very least, as a reminder that substantive consolidation issues and risks are alive:
- In Donald R. Lassman v. Cameron Construction LLC (In re Cameron Construction & Roofing Co., Inc.) (Bankr. D. Mass. 2016) (available here), the court ordered substantive consolidation. The Chapter 7 trustee sought to consolidate the debtor, a roofing company, with a related, non-debtor entity which owned the real estate that debtor used to operate its business. The court noted that substantive consolidation would be permitted only if it was established that the assets and liabilities of the entities seeking to be consolidated 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.” The principal facts warranting substantive consolidation were: (a) there was no lease agreement between the two parties for the use of the real estate, (b) the rent paid by the debtor to the non-debtor for the real estate was at above market rates, (c) all of the employees of the non-debtor worked exclusively for the debtor with no contract between the parties for debtor’s use of the non-debtor’s employees and (d) the parties had common ownership and only minimally observed corporate formalities.
- In contrast, in Phaedra Spradlin v. Beads and Steeds Inns, LLC (In re: Matthew Lowell Howland and Meagan Larae Howland) (6th Cir. 2017) (available here), an unpublished opinion, the court did not grant substantive consolidation. The Chapter 7 trustee challenged the transfer of real estate owned by the debtor, a married couple, to a related non-debtor which was subsequently sold to a third-party purchaser. The court considered whether the entities sought to be consolidated had disregarded corporate separateness “so significantly that their creditors relied on the breakdown of entity borders and treated them as one legal entity” or whether post- petition the assets of the two entities were so “hopelessly scrambled” that separating them would hurt creditors. The court found that the entities did not significantly disregarded corporate separateness, the creditors were not mislead by any financial information nor were they mislead into believing that the two entities were one in the same.
These two cases highlight that:
- Substantive consolidation is a powerful tool in a bankruptcy court’s arsenal to gather assets to improve creditors’ recovery. It is real.
- It is very important to conduct thorough diligence on the borrower and its structure and assets with special attention to affiliated contracts and dealings, cash management and other indicia of separateness; and
- The inclusion of customary SPE covenants in the loan documents and the organizational documents of the SPE borrower, specifically addressing the observation of corporate formalities and negative covenants regarding contracts and other dealings with affiliates is crucial.
Look, bankruptcy courts are like a man with a hammer. Everything looks like a nail. Bankruptcy courts have a predilection to reorganizing debtors. It’s what they do. Consequently, at least at the beginning of each case, the court may demonstrate a certain amount of sympathy to any motion to consolidate. Consolidation brings the promise of more assets to the table and enhances opportunities to craft a workable reorganization. However, if the facts are clear and show that the enterprises in question are indeed legally and operationally separate, that they are really not two pockets on the same pair of pants, it is unlikely that consolidation will be ordered. While perhaps a bit facetious, substantive consolidation is a little like Justice Potter’s definition of pornography, “you know it when you see it.” In some measure, and certainly in hindsight, successful substantive consolidation cases look pretty obvious. If multiple entities really are not separate, if creditors would be damaged by maintaining the fiction of separateness, if it would be difficult to unscramble the financial position and results of operation of these enterprises, then substantive consolidation indeed may be in your future.
So, we’ll end with this: It’s important for commercial real estate lenders to ensure that their transactions are properly structured to minimize the risk of consolidation. Particularly as the cycle is getting long in the tooth, interest rates are increasing and the likelihood of non-performance goes up, failure to pay attention to these issues may result in sadness.