In Clark’s Crystal Springs Ranch, LLC v. Gugino (In re Clark), 692 Fed. Appx. 946, 2017 BL 240043 (9th Cir. July 12, 2017), the U.S. Court of Appeals for the Ninth Circuit ruled that: (i) the remedy of "substantive consolidation" is governed by federal bankruptcy law, not state law; and (ii) because the Bankruptcy Code does not expressly forbid the substantive consolidation of debtors and nondebtors, the U.S. Supreme Court’s decision in Law v. Siegel, 134 S. Ct. 1188 (2014), does not bar bankruptcy courts from ordering the remedy.

Substantive Consolidation

"Substantive consolidation" is an equitable remedy pursuant to which a bankruptcy court may order that the assets and liabilities of separate entities be treated as if they belonged to a single, combined entity.

The Bankruptcy Code does not expressly authorize substantive consolidation, but it recognizes that a chapter 11 plan may provide for the consolidation of a "debtor with one or more persons" as a means of implementation. See 11 U.S.C. § 1123(a)(5)(C). In addition, Fed. R. Bankr. P. 1015(b) provides that a bankruptcy court may direct that cases involving affiliated debtors be jointly administered ("procedural consolidation"), but the rule is silent regarding substantive consolidation.

A majority of courts have concluded that bankruptcy courts have the power to substantively consolidate debtor entities under section 105(a) of the Bankruptcy Code, which provides that a court "may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions" of the Bankruptcy Code. However, because forcing the creditors of one entity to share equally with the creditors of a less solvent entity is not appropriate in many circumstances, courts generally hold that substantive consolidation is an extraordinary remedy which should be used sparingly. See Buridi v. KMC Real Estate Investors, LLC (In re KMC Real Estate Investors, LLC), 531 B.R. 758 (S.D. Ind. 2015).

Different standards have been employed by courts to determine the propriety of substantive consolidation. Common to all of these tests is a fact-intensive examination and an analysis of consolidation’s impact on creditors. For example, in Eastgroup Properties v. Southern Motel Assoc., Ltd., 935 F.2d 245 (11th Cir. 1991), the Eleventh Circuit adopted a modified version of the standard articulated by the District of Columbia Circuit in Drabkin v. Midland Ross Corp. (In re Auto-Train Corp., Inc.), 810 F.2d 270, 276 (D.C. Cir. 1987). According to this standard: (i) the proponent of consolidation must demonstrate that there is substantial identity between the entities to be consolidated and that consolidation is necessary to avoid some harm or to realize some benefit; and (ii) a creditor may object on the grounds that it relied on the entities’ separate credit and will be prejudiced by consolidation, in which case the court can order consolidation only if it determines that the benefits of consolidation "heavily" outweigh the harm.

The Second Circuit established a somewhat different two-part disjunctive standard for gauging the propriety of substantive consolidation in Union Savings Bank v. Augie/Restivo Baking Co., Ltd. (In re Augie/Restivo Baking Co., Ltd.), 860 F.2d 515, 518 (2d Cir. 1988). There, the court concluded that the factual elements considered by the courts are "merely variants on two critical factors: (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."

Factors that may be relevant in satisfying the first requirement include the following:

  1. Fraud or other complete domination of the corporation that harms a third party;
  2. The absence of corporate formalities;
  3. Inadequate capitalization of the corporation;
  4. Whether funds are put in and taken out of the corporation for personal rather than corporate purposes;
  5. Overlap in ownership and management of affiliated corporations;
  6. Whether affiliated corporations have dealt with one another at arm’s length;
  7. The payment or guarantee of debts of the dominated corporation by other affiliated corporations;
  8. The commingling of affiliated corporations’ funds; and
  9. The inability to separate affiliated corporations’ assets and liabilities.

Id. at 518–19. The Augie/Restivo test was adopted by the Ninth Circuit in Bonham v. Compton (In re Bonham), 229 F.3d 750 (9th Cir. 2000). Many other circuit and lower courts have adopted tests similar to the Augie/Restivo and Eastgroup standards. In In re Owens Corning, 419 F.3d 195 (3d Cir. 2005), the Third Circuit opted for an "open ended, equitable inquiry" rather than a factor-based analysis, as employed by many courts, in reversing lower court rulings approving "deemed" consolidation of 18 debtors and three nondebtor subsidiaries under a plan.

Substantive Consolidation of Debtors and Nondebtors

Although the majority of courts have held that the substantive consolidation of debtor entities is permitted in certain cases, they disagree as to whether the substantive consolidation of debtors and nondebtors should be permitted. Some courts have concluded that such substantive consolidation is appropriate on the basis of: (i) section 105’s broad grant of authority; (ii) a bankruptcy court’s ability to assert personal and subject matter jurisdiction over nondebtors; and/or (iii) a bankruptcy court’s mandate to ensure the equitable treatment of all creditors. See, e.g., Lassman v. Cameron Constr. LLC (In re Cameron Constr. & Roofing Co.), 565 B.R. 1, 10 (Bankr. D. Mass. 2016); In re S&G Fin. Servs., 451 B.R. 573, 579–82 (Bankr. S.D. Fla. 2011); Simon v. ASIMCO Techs., Inc. (In re Am. Camshaft Specialties, Inc.), 410 B.R. 765, 786 (Bankr. E.D. Mich. 2009); Walls v. Centurion Asset Mgmt., Inc. (In re Bolze), 2009 BL 157145, *4 (Bankr. E.D. Tenn. July 23, 2009); Dominion Fin. Corp. v. Morfesis (In re Morfesis), 270 B.R. 28, 31 (Bankr. D.N.J. 2001).

Other courts have held that the substantive consolidation of debtors and nondebtors is inappropriate because: (i) bankruptcy courts lack jurisdiction over nondebtors; and/or (ii) substantive consolidation of debtors and nondebtors circumvents the procedures concerning involuntary bankruptcies set forth in section 303 of the Bankruptcy Code. See, e.g., Official Comm. of Unsecured Creditors v. Archdiocese of Saint Paul & Minneapolis, 562 B.R. 755, 762 (D. Minn. 2016); In re Pearlman, 462 B.R. 849, 854 (Bankr. M.D. Fla. 2012); Helena Chem. Co. v. Circle Land & Cattle Corp. (In re Circle Land & Cattle Corp.), 213 B.R. 870, 877 (Bankr. D. Kan. 1997); In re Hamilton, 186 B.R. 991, 993 (Bankr. D. Colo. 1995).

The Ninth Circuit addressed the propriety of substantively consolidating an individual debtor and nondebtor entities in Clark.

Clark

In 2008, Jay P. Clark (the "Debtor") created a trust (the "Trust") for the benefit of his children. The Debtor was both the grantor and the trustee of the Trust. Shortly afterward, the Debtor created an Idaho limited liability company (the "LLC" and, together with the Trust, the "Defendants") to own a ranching operation. The LLC was a single-member, member-managed limited liability company, and its sole member and manager was the Trust. Even though the Debtor was the de facto "manager" of the ranch, he was neither the member nor the manager of the LLC. In March 2012, the Debtor filed a voluntary chapter 12 petition in the District of Idaho, stating in the petition that he was doing business as the LLC. In May 2013, the bankruptcy court granted a creditor’s motion to convert the Debtor’s case to a chapter 7 liquidation.

In June 2013, the chapter 7 trustee filed an adversary complaint against the Defendants, alleging various claims in an effort to bring certain assets of the LLC into the Debtor’s bankruptcy estate. In this complaint, the chapter 7 trustee sought, among other things: (i) a finding that, because the LLC and the Trust were alter egos of the Debtor under Idaho law, the assets of the LLC and the Trust should be treated as assets of the Debtor’s bankruptcy estate; and (ii) substantive consolidation of the assets and liabilities of the Debtor, the LLC, and the Trust.

Noting that the alter ego claim was a remedy rather than a cause of action and that it was "tantamount to a request for substantive consolidation," the bankruptcy court analyzed the chapter 7 trustee’s arguments concerning the alter ego claim in the context of the chapter 7 trustee’s request for substantive consolidation. The court applied the Augie/Restivo factors and determined that: (i) because the Debtor commingled his personal, financial, and operational affairs with the affairs of the Trust and the LLC, creditors generally dealt with the Debtor and the LLC as a single economic unit; and (ii) the affairs of the Debtor, the LLC, and the Trust were so entangled that unraveling them would require significant time, effort, and expense. On the basis of those findings, the bankruptcy court concluded that substantive consolidation benefited creditors and outweighed any potential harm.

The Defendants appealed the bankruptcy court’s order to the Ninth Circuit Bankruptcy Appellate Panel, arguing, among other things, that: (i) bankruptcy courts lack the power to substantively consolidate debtors and nondebtors under the U.S. Supreme Court’s ruling in Siegel; (ii) the bankruptcy court erred by not considering the Defendants’ separate property rights under Idaho law, as mandated by the Supreme Court’s decision in Butner v. United States, 440 U.S. 48 (1979); and (iii) the bankruptcy court erred in granting substantive consolidation.

In Siegel, the Supreme Court reversed a bankruptcy court’s order under section 105(a) that expressly contravened another provision of the Bankruptcy Code (section 522, which specifies exempt property). The Supreme Court explained that although section 105(a) allows a bankruptcy court to issue orders "necessary or appropriate" to carry out the provisions of the Bankruptcy Code, it is "hornbook law" that section 105(a) does not allow a bankruptcy court to "override explicit mandates of other sections of the Bankruptcy Code." Siegel, 134 S. Ct. at 1192.

In Butner, the Supreme Court held that "Congress has generally left the determination of property rights in the assets of a bankrupt’s estate to state law." Butner, 440 U.S. at 54.

The bankruptcy appellate panel affirmed the bankruptcy court’s ruling. First, the court held that, because the Bankruptcy Code does not expressly forbid the substantive consolidation of nondebtor entities, the Defendants’ reliance on Siegel was inapposite. Next, the court rejected the argument that the bankruptcy court should have considered property rights under Idaho law. The court reasoned that, because substantive consolidation (1) is designed to remedy injury caused by entities which disregard separateness, and (2) does not exist outside bankruptcy, "the law of substantive consolidation is federal bankruptcy law and is not dependent upon state law concepts."

Finally, the court held that the record supported the bankruptcy court’s decision to substantively consolidate the Defendants. It wrote that "the commingling of assets and the operation of the Trust and the LLC without any formality demonstrate[d] a close interrelationship between Debtor and the Trust and the LLC," and concluded that the Debtor failed to show the separateness of himself, the LLC, and the Trust after the chapter 7 trustee satisfied his initial burden. The Defendants appealed to the Ninth Circuit.

The Ninth Circuit’s Ruling

A three-judge panel of the Ninth Circuit affirmed in an unpublished ruling. The panel agreed with the lower courts that Siegel was not implicated because the Bankruptcy Code does not expressly forbid substantive consolidation. According to the Ninth Circuit panel, "Bankruptcy courts retain equitable power to grant substantive consolidation notwithstanding Congress’s amendment of the Code without codifying that power." The Ninth Circuit also rejected the Defendants’ argument that the bankruptcy court was required to consider Idaho property law, simply stating that "[t]he law of substantive consolidation is governed by federal bankruptcy law, not state law."

In an earlier decision—Alexander v. Compton (In re Bonham), 229 F.3d 750 (9th Cir. 2000)—the Ninth Circuit ruled that debtors and nondebtors can be substantively consolidated. Consistent with Bonham, the Ninth Circuit panel in Clark held that the following factors supported the bankruptcy court’s substantive consolidation order: the Debtor’s control over the LLC and the Trust; the Debtor’s personal liability for the LLC’s liabilities; the lack of records tracking the LLC’s distributions to the Debtor; and the LLC’s payments for the Debtor’s personal expenses.

Outlook

Among the circuit courts of appeal, only the Ninth Circuit has explicitly held that a bankruptcy court has the power to substantively consolidate debtor and nondebtor entities. Other circuits have addressed the issue only tangentially. See Spradlin v. Beads & Steeds Inns, LLC (In re Howland), 674 Fed. Appx. 482 (6th Cir. 2017) (affirming lower court orders denying a trustee’s motion to file an amended complaint in a turnover proceeding predicated on substantively consolidating debtors with nondebtors because the complaint did not adequately state a claim for substantive consolidation); Wells Fargo Bank of Tex. N.A. v. Sommers (In re Amco Ins.), 444 F.3d 690 (5th Cir. 2006) (holding that the bankruptcy court erred in ordering substantive consolidation of the debtor and nondebtor nunc pro tunc, but declining to address whether the court had the power to grant substantive consolidation); Soviero v. Franklin Nat’l Bank of Long Island, 328 F.2d 446 (2d Cir. 1964) (affirming a turnover order disregarding the corporate separateness of the debtor and 13 nondebtor affiliates that were instrumentalities of the debtor in a case under the former Bankruptcy Act of 1898).

Unfortunately, Clark is unlikely to provide much in the way of useful guidance on this issue. The decision contains little analysis and relies heavily on the lower courts’ reasoning as well as the Ninth Circuit’s earlier ruling in Bonham.

For example, the Ninth Circuit did not satisfactorily explain why the substantive consolidation of debtors and nondebtors does not violate section 303 of the Bankruptcy Code by effectively bringing a nondebtor into bankruptcy without complying with section 303’s involuntary bankruptcy petition requirements—thus arguably running afoul of Siegel. In this regard, the Ninth Circuit simply stated that the fact that there are "other ways to bring non debtors into a bankruptcy case also does not render substantive consolidation in conflict with express provisions of the Code."

It remains to be seen whether Clark will appreciably impact the reluctance of most courts to substantively consolidate debtors with nondebtors.