312-263-2200

The courts are divided on whether substantive consolidation can occur with a nondebtor. 2 Collier on Bankruptcy ¶105.09[1][c] (15th ed.rev.2005).  Some courts have allowed such consolidation. See, e.g., Fish v. East, 114 F.2d 177 (10th Cir.1940) (analyzing substantive under the Act); Soviero v. Franklin Nat’l Bank, 328 F.2d 446 (2d Cir.1964); Federal Deposit Insurance Corp. v. Hogan (In re Gulfco Investments Corp.), 593 F.2d 921, 928 (10th Cir.1979); Walter E. Heller & Co. v. Langenkamp (In re Tureaud), 59 B.R. 973 (N.D.Okla.1986); In re Alico Mining, Inc., 278 B.R. 586 (Bankr.M.D.Fla.2002) (Court had jurisdiction to substantively consolidate estate of Chapter 11 corporate debtor with estate of corporate nondebtor.); In re American Camshaft Specialties, Inc., 410 B.R. 765, 786 (Bankr.E.D.Mich.2009) (“[T]he weight of authority holds that §105 can be used to order substantive consolidation, even of a non-debtor with a debtor.”); and In re Logistics Information Systems, Inc., 432 B.R. 1, 12 (D.Mass.2010) (“Within this circuit, bankruptcy courts have approved the application of substantive consolidation to non-debtors, often in cases in which the non-debtor is a subsidiary or alter ego of the debtor.”)

Others courts, while allowing substantive consolidation, have done so with the caveat that “as careful as the courts must be in allowing substantive consolidation of debtors to occur …, the caution must be multiplied exponentially in a situation where a consolidation of a debtor’s case with a non-debtor is attempted.” Morse Operations, Inc. v. Robins Le-Cocq, Inc. (In re Lease-A-Fleet, Inc.), 141 B.R. 869, 872 (1992); and In re Amco Ins., 444 F.3d 690, 696 n.3 (5th Cir.2006) (“Substantive consolidation should be ordered with more caution than normal.”).

Still other courts have held that bankruptcy courts simply do not have subject matter jurisdiction over the non-debtor, thus precluding substantive consolidation. They note that Section 105 of the Bankruptcy Code is not a jurisdictional grant, and further argue that substantive consolidation should not be used to circumvent the involuntary bankruptcy petition procedures of Section 303 of the Bankruptcy Code. Helena Chem. Co. v. Circle Land & Cattle Corp. (In re Circle Land & Cattle Corp.), 213 B.R. 870, 876-77 (Bankr.D.Kan.1997); and In re Howland, 518 B.R. 408 (Bankr.E.D.Ky.2014) (Even if trustee alleges plausible basis for substantively consolidating debtors with their closely-held LLC, court would not utilize its equitable power to consolidate debtors with LLC that had not yet filed for bankruptcy, thereby effectively placing LLC in involuntary bankruptcy case without the protections normally attending involuntary petition, especially where trustee sought such consolidation nunc pro tunc to petition date.)

In re Stewart, 571 B.R. 460, 471 (Bankr.W.D.Okla.2017) apparently followed this second line of thought, noting that “[t]he Court agree[d] with the majority of authorities that under very limited circumstances it has the discretion, to be exercised sparingly, to substantively consolidate a debtor’s estate with non-debtors, thus resolving the threshold issue presented to the Court as to its authority.”  However, the court noted that when an effort is made to substantively consolidate a debt with a non-debtor, certain special notice issues need to be met.  It noted that “[c]ourts have stated that, at a minimum, due to the nature of substantive consolidation of debtor and non-debtor entities, notice must be provided to all creditors, and such creditors must have an opportunity to be heard,” quoting In re S & G Fin. Servs. of South Florida, Inc., 451 B.R. 573, 585 (Bank.S.D.Fla.2011).  Again citing to S & G Fin. Servs. of South Florida, Inc., 451 B.R. at 585, it stated that “[w]ith respect to substantive consolidation hearings, the notice must be given in such a manner that it is likely to reach its intended audience. Second, the content of the notice must reasonably inform the recipient of the nature of the upcoming proceeding.”  It then concluded, without resolving the question, as follows:

Thus, it may well be that all the owners and creditors of the Non–Debtors need not be named as party defendants for this action to go forward so long as they are afforded due process by receiving some type of notice of SEPH’s intended action to place the Non–Debtors in bankruptcy.

Id. at 473.

In In re Pearlman, 462 B.R. 849 (Bankr.M.D.Fla.2012). the court stated that Section 105 of the Bankruptcy Code only gives bankruptcy courts the power to do what is necessary or appropriate to accomplish the goals of the Bankruptcy Code.  The section does not give bankruptcy courts unfettered power.  “Bankruptcy courts cannot and should not simply drag unwilling entities that never chose to file bankruptcy into a bankruptcy forum simply because it is expedient and will help one party or another.”  Pearlman, 462 B.R. at 854.  See also, In re Cordia Communications Corp., 2012 WL 379776 (Bankr.M.D.Fla.).

Further, Pearlman stated that allowing substantive consolidation of non-debtors under §105(a) circumvents the stringent procedures and protections relating to involuntary bankruptcy cases imposed by §303Section 303 authorizes an involuntary petition of an entity, provided specific rules are followed to protect the putative debtor.  For example, a minimum claim amount is required to even initiate an involuntary proceeding.  If the movant clears this first hurdle, and the number of claimholders is significant, the movant must obtain a consensus of at least three other claimholders to ensure the action is supported and justified.  The stakes of hastily forcing a party into involuntary bankruptcy are high because if the protective requirements of §303 are not met, a court can hold all petitioning creditors liable for costs, attorneys’ fees, and damages.  Given the significant protections §303 provides to debtors facing involuntary bankruptcy, and the lack of commensurate protections for substantive consolidation, “forcing a non-debtor into bankruptcy via substantive consolidation circumvents these strict requirements and is in contravention of [the Code].”  Section 105 of the Bankruptcy Code only allows a bankruptcy court to take actions “necessary or appropriate” to achieve a stated statutory goal.  The section certainly does not and should not allow a bankruptcy court to circumvent statutory protections built into the code.  Id. at 854-55.

Finally, the court noted that state law provides remedies for parties who can establish that a non-debtor entity truly is an “alter ego” of a voluntary debtor.  In essence, by piercing the corporate veil, the party proves that the two entities legally are the same, not two different entities.  Therefore, they are not really debtor and non-debtor, but one.  Id. at 855.

In In re Concepts America, Inc., 2018 WL 2085615 (Bankr.N.D.Ill.) the also ruled that substantive consolidation with a non-debtor entity was not possible.  It started its analysis by noting that the aspect that makes the substantive consolidation so extraordinary is that there is no section of the Bankruptcy Code that specifically provides for it.  Rather, “It is considered a ‘rough justice remedy [that] should be rare and, in any event, one of last resort after considering and rejecting other remedies.’” Id. at *3 (quoting, In re Owens Corning, 419 F.3d 195, 211 (3rd Cir.2005)).  And the Seventh Circuit has shown a distinct lack of enthusiasm for a bankruptcy court’s use of §105 and for creating rights based entirely on considerations of equity. Id. at *4, (citing Matter of Chicago, Milwaukee, St. Paul and Pacific R. Co., 791 F.2d 524, 528 (7th Cir.1986)).  The court then quoted Professor Douglas G. Baird as follows:

The absence of any clear statutory authority in the Bankruptcy Code throws into question the viability of the doctrine in an appellate court that focuses on the language of the Bankruptcy Code and refuses to look beyond it. Substantive consolidation is, as the term suggests, a substantive power.  In the view of some courts, substantive powers such as this are permitted only to the extent that they grow out of substantive provisions of the Bankruptcy Code.  Courts have stated again and again that substantive powers cannot be derived from section 105 of the Bankruptcy Code.

Id. at *5, (quoting Baird, Douglass G., Substantive Consolidation Today, 47 B.C.L.Rev. 5, 19 (emphasis in original).

For the above reasons, the court found that, were it presented with the question, the Seventh Circuit would not allow substantive consolidation of a bankrupt debtor with entities that are not under the protection of the Bankruptcy Code. Id. at *6.

However, there were other reasons for not allowing such consolidation.  First, a procedure already exists for forcing an entity to enter into bankruptcy – i.e., §303.  Indeed, in Concepts America, the debtor’s own bankruptcy case began as an involuntary case.  “Using §105 to accomplish the same end, without the protections and rules of §303, based on a notion that the court is acting equitably, is to exceed the confines of the Code.” Id.  The court noted that substantively consolidating a non-debtor with a debtor effectively forces the non-debtor into an involuntary bankruptcy proceeding without an opportunity for its creditors to participate.

Second, the trustee had a similar remedy available under state law, i.e., alter ego/piercing corporate veil.  The court noted that Illinois law permits veil piercing when two separate prongs are met: (1) there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and (2) circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. Id. at *7.

Finally, the court noted that even if substantive consolidation of non-debtor entities is ultimately permitted, the complaint in this case did not allege that the non-debtor creditors received notice of the trustee’s claim for relief.  “Courts have stated that, at minimum, due to the nature of substantive consolidation of debtor and non-debtor entities, notice must be provided to all creditors, and such creditors must have an opportunity to be heard.” Id. (quoting S & G Fin. Servs. of South Florida, Inc., 451 B.R. at 585).

“[T]he creditors of [the non-debtor defendant] will not be deprived of their nonbankruptcy expectations without notice and a hearing.  Each [of the non-debtor[s] creditors] must be served with a copy of the complaint so that each creditor will have the opportunity to participate in the adjudication of this issue.” Mukamal v. Ark Capital Group, LLC (In re Kodsi), 2015 WL 222493, *2 (Bankr.S.D.Fla. Jan. 14, 2015).  After all, “[t]he overriding equitable consideration is that consolidation will benefit all creditors, both those of the current debtors and those to be forcibly made debtors.” Manchester v. Kretchmar (In re Kretchmar), 579 B.R. 924, 932 (Bankr.W.D.Okla.) (emphasis in original).

Id.

 

Matthew T. Gensburg
[email protected]