In general, substantive consolidation allows for the assets and liabilities of affiliated debtor entities to be consolidated and disbursed as if the assets were held and the liabilities were owed by a single legal entity. Unlike joint administration, which promotes procedural convenience and efficiency without affecting the substantive rights of creditors, substantive consolidation can force creditors of a solvent debtor to share in the debtors’ aggregate asset pool in parity with creditors of less solvent debtors.

Because substantive consolidation can have a significant, adverse effect on the recovery of unsecured creditors, courts have fashioned a strict standard, primarily focused on creditor expectations, to warrant the remedy’s application. For example, in In re Augie/Restivo Baking Co., Ltd., the Second Circuit articulated a two-fold, disjunctive test which considers “(i) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, or (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors.” In a recent decision, however, a bankruptcy court in the Southern District of New York indicated that in cases where substantive consolidation does not pose a threat to creditors’ rights, the strict Augie/Restivo standard may not apply.

In re Jennifer Convertibles

In In re Jennifer Convertibles Inc., Case No. 10-13779 (Bankr. S.D.N.Y. Feb. 4, 2011), the Bankruptcy Court for the Southern District of New York was asked to confirm a plan based on the “deemed” substantive consolidation of the debtors’ estates. With an eye toward the practicalities and effects of consolidation under the proposed plan, the court provided a solution that allowed the debtors to confirm a substantive consolidation plan despite the debtors’ inability to demonstrate that substantive consolidation was warranted under the Augie/Restivo standard.

Background

One of the Jennifer Convertibles debtors, Hartsdale Convertibles, Inc. (“Hartsdale”), operated six full-line furniture stores under the Ashley Furniture HomeStore brand (the “Ashley Stores”). The debtors’ joint plan of reorganization was premised on a “deemed” substantive consolidation of the debtors’ estates, solely for purposes of voting, confirmation and making distributions under the plan. A primary supplier to the Ashley Stores along with its affiliate filed the only opposition to confirmation.  

The debtors’ proposed consolidation affected only a small number of Hartsdale’s creditors — specifically, the deficiency created by the proposed substantive consolidation affected creditors of Hartsdale holding less than $100,000 out of a total $1.6 million in trade debt. The plan objectors maintained, inter alia, that the plan did not satisfy Bankruptcy Code section 1129(a)(3)’s good faith requirement because the debtors sought substantive consolidation in order to disadvantage Hartsdale’s creditors. The plan objectors also asserted that the plan did not satisfy the “best interests test” of section 1129(a)(7), which requires that the creditors of each debtor receive at least what they would receive in a chapter 7 liquidation of the debtors’ estates. These objections as to the treatment of Hartsdale’s creditors under the plan were the only objections to the debtors’ substantive consolidation.  

The Court’s Analysis and Holding

The Jennifer Convertibles court found that substantive consolidation was not justified under the Augie/Restivo standard. According to the court, the debtors did not introduce any evidence with regard to the first prong of the Augie/Restivo test as to the expectations of Hartsdale’s creditors in extending credit. In addition, the court recognized that while it would be difficult for the debtors to unscramble their finances, the debtors failed to introduce evidence that separate accounting was “impossible or detrimentally expensive to all creditors.” Despite the deficiency in the record, however, the court noted that substantive consolidation is a flexible concept, principally concerned with whether creditors are adversely affected by consolidation and, if so, whether the adverse effects can be eliminated.  

Although most of Hartsdale’s large creditors would be unaffected by the plan’s contemplated substantive consolidation, the debtors failed to demonstrate that Ashley’s trade creditors would be treated appropriately as a consequence of the consolidation. While the court found no evidence that the debtors purposely sought to disadvantage Hartsdale’s creditors through the proposed consolidation, it determined that the plan failed to satisfy the “best interests of creditors” requirements under section 1129(a)(7) with regard to the Hartsdale creditors. Moreover, the court reasoned that in the absence of proof that substantive consolidation was appropriate under the Augie/Restivo standard, a separate liquidation analysis would be necessary to establish that none of the trade creditors of Hartsdale would receive less under the plan than in liquidation pursuant to chapter 7.  

The court did not end its analysis there, however. Rather, the court suggested that the debtors could cure this bar to confirmation in one of two ways. First, the debtors could provide payment in full to Hartsdale’s trade creditors and immediately confirm the plan as to all creditors, including those holding claims against Hartsdale. Alternatively, the debtors could supplement the record on the issue of substantive consolidation and submit a separate liquidation analysis for Hartsdale. Either option would promote the underlying purpose of substantive consolidation: ensuring the equitable treatment of creditors.

Conclusion

Substantive consolidation is generally viewed as an extraordinary remedy and courts have been reluctant to order substantive consolidation except in very limited circumstances. A court, however, may consider the underlying rationale for the creditor protections embodied in the standard and relax that standard to permit substantive consolidation where those protections are not necessary or may be addressed in alternative ways.