U.S. courts generally agree that the substantive consolidation should be applied sparingly, and even more so when substantive consolidation of debtors with non-debtors is sought. While many opinions address the grounds for substantive consolidation, very few cases address standing and notice issues when the sought for consolidation is of non-debtor entities. The Oklahoma bankruptcy court recently addressed these two issues in SE Property Holdings, LLC v. Stewart.

The chapter 7 trustee of the Stewart debtors did not seek substantive consolidation, but rather pursued fraudulent transfer claims against the non-debtors. SE Property, a creditor of the debtors, filed a complaint seeking the substantive consolidation of the non-debtors who were sued by the trustee. A bank creditor of the non-debtors learned of the complaint and filed a motion to dismiss arguing, among other things, that the plaintiff, as a non-creditor of the non-debtors, has no standing to seek substantive consolidation of the non-debtors and that the plaintiff’s failure to notice the non-debtors’ creditors violates these creditors’ rights to due process.

On the standing issue, the court noted the existence of a split in the case law and followed the majority view that a creditor has standing to seek substantive consolidation in situations where the prosecution of such relief would not interfere with the bankruptcy trustee’s power to pursue claims for the benefit of all of the estate’s creditors. In the case at hand, the court found that the trustee is pursuing a narrower path for recovery and clearly has elected not to pursue the substantive consolidation remedy. As a result, allowing a creditor to seek consolidation would not interfere with the exercise by the trustee of his own rights.

On the notice issue, the court noted that notice must be given to creditors of the non-debtor entities and they must be provided with an opportunity to be heard. While the court was not required to frame exactly the nature and form and notice to be given (since it held that the complaint had to be dismissed for failure to state a claim), it did note that the concept of due process is flexible and therefore, the creditors of the non-debtors must receive “some type of notice,” although naming them as defendants may not be necessary since naming them may impose on them legal expenses, unwanted publicity or other hardship.

The notice issue may create another significant barrier to accomplishing substantive consolidation of debtors and non-debtors. When all of the entities sought to be consolidated are debtors, their lists of creditors are easily available. That may not be the case for non-debtors. Case law will surely develop as to the length to which parties must go to identify these creditors and as to the form and method of giving an appropriate notice.

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