Creditors may face an unrecognized risk from substantive consolidation, which is an equitable doctrine in bankruptcy permitting the consolidation of legally separate entities that are members of the same corporate or other affiliated group. It has the effect of combining the assets and liabilities of multiple debtors into a single bankruptcy estate, which can significantly alter the rights of the affected debtors’ creditors. Typically, each debtor will have a different ratio of assets to debt, and in situations in which a court permits substantive consolidation, the creditors of a debtor with a higher asset-to-debt ratio will suffer at the expense of the creditors of a debtor with a lower asset-to-debt ratio. Substantive consolidation can even be used to pull a nonbankrupt, solvent debtor into the bankruptcy of a corporate parent or other affiliate.
In a business context, substantive consolidation poses a risk to any lender that extends credit to a corporation or other entity that is part of a larger corporate group. It is also relevant to securitization transactions and other financing transactions involving the sale of receivables, consumer finance contracts, or other assets through special-purchase vehicles (SPVs). Substantive consolidation has even been applied to consolidate the bankruptcy estates of spouses.1
To illustrate the potential effect of substantive consolidation, consider two affiliated companies, Company A and Company B. Company A is solvent with total assets of $10 million and total liabilities of $8 million, and Company B is insolvent with total assets of $5 million and total liabilities of $12 million. If Company B enters bankruptcy and is liquidated, its creditors would receive only approximately 40 cents on the dollar. Meanwhile, Company A is solvent and can pay its creditors in full. If, however, Company A and Company B are substantively consolidated into one bankruptcy estate, there would be $15 million of assets and $20 million of liabilities, resulting in each creditor receiving approximately 67 cents on the dollar. The creditors of Company B gain at the expense of Company A’s creditors.2
The U.S. Bankruptcy Court for the Eastern District of Wisconsin recently ruled on a motion for substantive consolidation in In re Archdiocese of Milwaukee.3 That motion dealt with an attempt by a committee of unsecured creditors (the creditors’ committee) to consolidate 210 separate, nonbankrupt parishes with the Archdiocese of Milwaukee for purposes of the Archdiocese’s bankruptcy case. Although the case did not involve a financing or sale transaction, the decision discusses the legal standards courts apply to analyses of substantive consolidation. It is also the first case addressing substantive consolidation decided in the Eastern District of Wisconsin. This article discusses the Archdiocese of Milwaukee case in the context of a review of the current condition of substantive-consolidation doctrine.
Application of Substantive Consolidation in Financing Transactions
Any creditor that lends money to a member of an affiliated group should consider substantive consolidation’s potential effect on its rights in the event of a bankruptcy of the borrower or any other member of the group.
Benjamin G. Lombard, Cornell 1992, is a shareholder in the business law practice group of Reinhart Boerner Van Deuren s.c., Milwaukee. His practice focuses on securities, mergers and acquisitions, public offerings, private placements, and other financing arrangements, including structured finance. He frequently speaks to audiences of in-house counsel, corporate executives, and tax professionals on topics including compliance with securities laws and best practices for corporate governance.
Peter C. Blain, Georgetown 1978, is head of the corporate reorganization practice group of Reinhart Boerner Van Deuren s.c., Milwaukee. He is a Fellow in the American College of Bankruptcy, is cochair of the Bankruptcy Subcommittee of the Eastern District of Wisconsin Bar Association, and is a past chair of the State Bar of Wisconsin’s Bankruptcy, Insolvency, and Creditors Rights Section and chair of the Milwaukee Bar Association’s Bankruptcy Section.
Consider, for example, a borrower that has significant contingent liabilities relating to its historical operations. A lender may be willing to make a loan to the borrower if an affiliate of the borrower in an unrelated business with significant assets and no exposure to the contingent liabilities guarantees the loan. If the borrower subsequently files for bankruptcy, the guarantee of the solvent affiliate should protect the lender. However, if the borrower or its creditors (including the claimants with respect to the contingent liabilities) can pull the solvent affiliate into the bankruptcy estate through substantive consolidation, the value of the guarantee to the lender may be reduced or eliminated, significantly impairing the lender’s recovery.
These are essentially the facts of In re Owens Corning,4 in which Owens Corning faced liabilities related to asbestos claims, and its bank lenders sought guarantees from subsidiaries not subject to the asbestos claims. When Owens Corning filed for bankruptcy, it and certain unsecured creditors proposed a reorganization plan predicated on obtaining substantive consolidation of the guarantor-subsidiaries. Substantive consolidation would have put at risk the guarantees negotiated by the lenders to protect themselves from the asbestos claims.5
The Archdiocese of Milwaukee’s bankruptcy case, which we describe in more detail below, also involved tort claims and an attempt to reach assets of solvent affiliates to satisfy claims in the Archdiocese’s bankruptcy estate.
Another area in which substantive consolidation can pose a risk to creditors is the use of SPVs in securitization and other asset-financing transactions. An SPV is a newly created entity with no operating history that could result in potential liabilities. The SPV is typically structured to be “bankruptcy remote” so it is unlikely to be subject to a bankruptcy proceeding itself. An SPV is usually a corporation, limited liability company, or other type of entity formed as an affiliate of the party seeking financing (frequently called an “originator”) for the sole purpose of facilitating the financing.
In a simple receivables-financing arrangement, the originator will sell the receivables to the SPV, which will in turn sell the receivables to the financing source. [See Figure 1 for an example of a simple SPV structure.] In a securitization transaction, the originator will sell assets to the SPV, which in turn will sell securities (typically bonds or other sorts of debt obligations as well as equity interests) backed by the SPV’s assets to investors. If an SPV is consolidated with the originator’s bankruptcy estate, the assets sold to the SPV would be available to the originator’s creditors, posing a significant potential risk to the lenders to or investors in the SPV.
Simple Special-Purpose Vehicle (SPV) Structure
The financing source may also form its own SPV to purchase the assets from the originator’s SPV. [See Figure 2.] In that case, the financing source’s SPV should not be at risk of consolidation with a bankruptcy of the originator or the originator’s SPV. However, the originator’s SPV will often retain contractual obligations to the financing source, such as representations and warranties regarding the quality of the assets, as well as reserves to support those obligations. Substantive consolidation of the originator and its SPV in such a case could still harm the financing source.6
Substantive Consolidation under the Bankruptcy Code
The Bankruptcy Code does not expressly authorize substantive consolidation. Rather, the authority for a bankruptcy court to order substantive consolidation lies in its general equitable powers under section 105(a) of the Bankruptcy Code (11 U.S.C. § 105(a)). Substantive consolidation has its origins in cases involving corporate veil-piercing. Under the state common-law doctrine of piercing the corporate veil, a court will examine the relationship between two entities to determine whether one is a mere “instrumentality” or “alter ego” of the other and whether one entity’s use or domination of the other is unjust or inequitable to creditors.7
From these origins, substantive consolidation has developed into a distinct legal doctrine under federal bankruptcy law. As with veil-piercing, substantive consolidation continues to be based in part on circumstances in which there is significant identity and insufficient separation between legal entities. However, substantive consolidation includes additional considerations, relevant to the bankruptcy court’s equitable powers, relating to the harm and benefit to the bankruptcy estate and the creditors.
Structure of Financing Source SPV to Purchase Assets from Originator’s SPV
A major issue with substantive consolidation is the lack of uniformity in the applicable standards. Courts have developed several tests to determine whether to approve substantive consolidation. Most courts have stated that substantive consolidation is an extraordinary remedy that should be used sparingly, and some of the tests reflect this approach by rejecting substantive consolidation in situations in which any creditor relied on the separate identity of the debtors in extending credit and would be prejudiced by substantive consolidation.
Other courts have adopted the so-called liberal trend by weighing various factors and permitting substantive consolidation if the benefits will outweigh the harm, even if consolidation would harm some individual creditors. The factors weighed by courts following the liberal trend are often amorphous and inconsistent in their application. Some of these factors address the interconnectedness of the entities and the observance of corporate formalities, including factors such as the presence or absence of consolidated financial statements, existence of intercorporate loan guarantees, commingling of assets and liabilities, and common officers or directors.8 Other factors reflect practical balancing concerns such as the degree of difficulty in segregating and ascertaining individual assets and liabilities, and gross undercapitalization.
None of these tests indicate which factors are most important or how many must be satisfied to result in substantive consolidation.9 Faced with such uncertain tests, it can be difficult to determine in advance the risk of substantive consolidation applying to a given corporate structure.
The Archdiocese of Milwaukee’s Bankruptcy
The Archdiocese of Milwaukee filed for bankruptcy under Chapter 11 of the Bankruptcy Code on Jan. 4, 2011. The Archdiocese’s bankruptcy followed years of litigation based on claims and lawsuits brought by sexual abuse victims against the Archdiocese. After the failure of mediation and settlement negotiations with the plaintiffs in the lawsuits, the Archdiocese commenced its Chapter 11 case.
The Archdiocese is a nonstock corporation operating pursuant to Wis. Stat. chapter 181. It serves a region that includes 10 counties in southeastern Wisconsin. Within this region are 210 parishes. Each parish was formed as a separate civil corporation. Other than a few parish corporations that are wholly owned by religious orders, the parish corporations were all organized and operate pursuant to Wis. Stat. section 187.19,10 which provides for the separate incorporation of Roman Catholic parishes in Wisconsin.
As prescribed by the statute, each parish corporation has a designated board of trustees and owns its own property, finances its own activities, manages its own assets, and is responsible for its own corporate activities. The Archdiocese provides certain services and pastoral care to the parish corporations, and the Archdiocese’s sources of revenue include parish assessments.11
The parish corporations did not seek bankruptcy relief and were not included as debtors in the Archdiocese’s Chapter 11 case. In an attempt to use the assets of each parish to satisfy creditor claims, the creditors’ committee moved to substantively consolidate the parish corporations into the Archdiocese’s bankruptcy estate.12
The Court’s Decision in Archdiocese of Milwaukee
The court in the Archdiocese of Milwaukee case began by noting that “resort to substantive consolidation should be used ‘sparingly’” and substantive consolidation is an “extraordinary remedy.”13 It then cited a law review article to highlight the relationship between substantive consolidation and veil-piercing doctrine, stating that “[s]ubstantive consolidation is appropriate when ‘an individual or corporation completely dominates a group of affiliated entities, ignores corporate formalities and shuffles money between them as if the entities are mere departments of a larger operation or little more than ‘corporate pockets.’”14 Consistent with that law review article, the court stated that two tests have emerged in the federal courts to determine whether substantive consolidation is appropriate.
Sample Covenants on Separate Existence
An agreement for the purchase by a special-purchase vehicle (SPV) of receivables or other assets will typically contain an acknowledgment by the parties that they are both relying on the SPV’s identity as a legal entity that is separate from the originator. The agreement will also contain specific covenants supporting the separate existence of the originator and the SPV, including that each party will:
- Pay its own operating expenses from its own funds;
- Conduct business in its own name (including that all of each party’s business correspondence, invoices, checks, and other communications will be in its own name);
- Maintain its own separate books and records;
- Maintain separate bank accounts and not commingle funds;
- Maintain its assets separately in a manner that facilitates their identification and segregation from those of the other party;
- Have separate and independent directors and officers, strictly observe corporate formalities in its operations, and obtain proper authorization for its actions;
- Compensate its own employees for services from its own funds;
- Maintain an arm’s-length relationship with the other party;
- Not hold its credit or assets as being available to satisfy the obligations of others;
- At all times be adequately capitalized to engage in the transactions contemplated by the agreement; and
- Prepare separate financial statements and ensure that any consolidated financial statements have notes that clearly state that the SPV is a separate entity and that its assets are available first and foremost to satisfy the claims of creditors of the SPV.
The first test is referred to as the Auto-Train test and is generally consistent with the liberal trend. The Auto-Train test requires the proponent to show 1) “a substantial identity between the entities to be consolidated,” and 2) “that consolidation is necessary to avoid some harm or realize some benefit.…”15
The first prong of the Auto-Train test relies on the amorphous multifactor tests of the liberal trend. The second prong does not impose much of a burden on the proponent of substantive consolidation. If the proponent makes such a showing, “a creditor can object on the grounds that it relied on the separate credit of one of the entities and that it will be prejudiced by the consolidation.… If a creditor makes such a showing, the court may order consolidation only if it determines that the demonstrated benefits of consolidation ‘heavily’ outweigh the harms.”16 Consistent with the “liberal trend,” the Auto-Train test allows consolidation even if it would prejudice a creditor who relied on the separateness of a debtor, if the court can determine that the benefits of consolidation heavily outweigh the harm.
The second test referred to by the court in the Archdiocese of Milwaukee case, known as the Augie/Restivo test, focuses on two factors: 1) “whether creditors dealt with the entity as a single economic unit and ‘did not rely on their separate identity in extending credit,’” and 2) “whether the affairs of the debtors are so entangled that consolidation will benefit all creditors.…”17
Under the Augie/Restivo test, the first factor is not satisfied if any creditor relied on the separateness of one of the debtors and thus would be prejudiced by the consolidation. The second factor should only apply if the level of entanglement is so great that treating the debtors as separate is not practical and consolidation would benefit all creditors. Because the Augie/Restivo test does not authorize a court to generally weigh the harms versus the benefits of consolidation, it should be harder to satisfy than the Auto-Train test.
In Archdiocese of Milwaukee, the Bankruptcy Court did not choose between the Augie/Restivo test and the Auto-Train test. Instead, the court concluded that the creditors’ committee failed to show facts supporting consolidation under either of the tests and ultimately determined that “[g]iven the prejudice to the non-debtor Parishes and their creditors that would result from substantive consolidation,” it would not be proper to grant such a remedy.18
Potential Effect of the Archdiocese of Milwaukee Case
Although the bankruptcy court in the Archdiocese of Milwaukee case did not follow either the Augie/Restivo test or the Auto-Train test, there were some signs that the court may indeed apply substantive consolidation sparingly. First, without much discussion, the court seemed to apply a high standard for finding substantial identity of the parties, consistent with the court’s rejection of the creditors’ committee’s veil-piercing arguments.
Second, the court placed the burden on the creditors’ committee to show that creditors did not rely on the separate identity of the Archdiocese and the parishes in extending credit. Reliance on separateness is an element of the Augie/Restivo test, and placing the burden of proof on the party seeking substantive consolidation reduces the risk of substantive consolidation. It also avoids the more uncertain multifactor balancing test or the weighing of harms versus benefits. The court also emphasized the prejudice to the parishes and their creditors that would result from substantive consolidation.
The importance of separate identity to the tests used for substantive consolidation highlights the need to carefully document the separateness of the related entities in situations in which a party seeks to avoid substantive consolidation. Financing transactions using SPVs already often include terms in the transaction documents regarding separateness. [See Sidebar for examples of such terms.] Lenders that extend credit to an entity that is part of a larger corporate group should also consider the degree of separateness of the borrower from related entities. On an ongoing basis, the parties to the transaction should make sure that the representations, warranties, covenants, and other terms of the transaction documents regarding separateness are scrupulously followed. If the parties are careful to maintain separateness and avoid entanglement of the assets and liabilities of the different entities, substantive consolidation should be unlikely.
1 See In re Steury, 94 B.R. 553 (Bank. N.D. Ind. 1988).
2 This discussion assumes that all creditors have equal priority in the bankruptcy estate. The effect of substantive consolidation on security interests and priority of claims is a complex topic, but there is a risk that a creditor’s security could be adversely affected by substantive consolidation. A debtor may also seek substantive consolidation in a reorganization under the Bankruptcy Code to provide the debtor with greater wherewithal to successfully emerge from bankruptcy.
3 In re Archdiocese of Milwaukee, 483 B.R. 693 (Bankr. E.D. Wis. 2012).
4 In re Owens Corning, 419 F.3d 195 (3d Cir. 2005).
5 In the Owens Corning case, the bankruptcy court granted the consolidation motion based on substantial identity between Owens Corning and its wholly owned subsidiaries, a failure by the bank lenders to show that they relied on the separate credit of the subsidiary guarantors, and the difficulty in untangling the financial affairs of the various entities. In re Owens Corning, 316 B.R. 168 (Bankr. D. Del. 2004). The Third Circuit Court of Appeals reversed that decision on appeal. 419 F.3d 195.
6 Another issue that must be considered in securitization and other financing transactions involving a sale of assets is whether the transaction involves a true sale under the Uniform Commercial Code or is actually a loan. See Peter V. Pantaleo et al., Rethinking the Role of Recourse in the Sale of Financial Assets, The Business Lawyer, Nov. 1996.
7 See, e.g., Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215 (1941); Fish v. East, 114 F.2d 177 (10th Cir. 1940).
8 See In re Vecco Constr. Indus. Inc., 4 B.R. 407 (Bankr. E.D. Va. 1980); In re Drexel Burnham Lambert Grp., 138 B.R. 723, 764 (Bankr. S.D.N.Y. 1992).
9 The Third Circuit Court of Appeals in the Owens Corning case criticized the multifactor tests under the liberal trend because they too often “fail to separate the unimportant from the important, or even to set out a standard to make the attempt.” In re Owens Corning, 419 F.3d 195, 205, 210 (3d Cir. 2005).
10 In re Archdiocese of Milwaukee, 483 B.R. at 696.
12 The committee also sought a declaration that the parish corporations are alter egos of the Archdiocese such that the court could “pierce the corporate veil” and use assets of the parish corporations to satisfy the Archdiocese’s liabilities.
13 In re Archdiocese of Milwaukee, 483 B.R. at 699-700 (citation omitted).
14 Id. at 699 (citing Seth D. Amera & Alan Kolod, Substantive Consolidation: Getting Back to Basics, 14 Am. Bankr. Inst. L. Rev. 1, 37 (2006)).
15 Id. at 699 (citing Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270, 286 (D.C. Cir. 1987)).
17 Id. at 700 (citing In re Augie/Restivo Baking Co., 860 F.2d 515, 518 (2d Cir. 1988)).
18 Id. at 700. The court also rejected the committee’s alter-ego claim under Wisconsin law.