A popular line of thinking among bankruptcy practitioners and commentators holds that substantive consolidation – the combining of assets and liabilities of a debtor and another debtor or non-debtor entity to satisfy creditor claims against both entities ratably from the resulting pool – is an equitable remedy of judicial invention with no specific foundation in the Bankruptcy Code. Many courts seem to agree with this view, with few even attempting to find a statutory basis for substantive consolidation outside of the court’s broad authority to issue orders under section 105(a) of the Bankruptcy Code.

However, a recent Michigan bankruptcy court decision upsets this conventional thinking, finding statutory authority for substantive consolidation by combining provisions found in sections 542(a) and 502(j) of the Bankruptcy Code. Judge Jeffrey R. Hughes’ decision in In re Cyberco Holdings, Inc., 431 B.R. 404 (Bankr. W.D. Mich. 2010), is potentially groundbreaking in its attempt to “legitimize” substantive consolidation by removing the substantive consolidation analysis from, in the court’s words, “amorphous notions of equity and dubious interpretations of Section 105” and placing it within a statutory framework. But its reasoning may ultimately lead to fewer estates being substantively consolidated because it also holds that only trustees have standing under section 542(a). This may significantly limit availability of the remedy to creditors seeking substantive consolidation.

Facts and Procedural History

Cyberco involved Huntington National Bank’s motions seeking substantive consolidation of two related chapter 7 debtors. Cyberco Holdings, Inc. was an information technology infrastructure company that began as a legitimate enterprise but ultimately engaged in a massive fraud that led banks, leasing companies and other lenders to lend money for the purchase of fictitious computer equipment from Cyberco’s affiliate through common ownership, Teleservices Group, Inc. After receiving funds directly from the financing companies, Teleservices channelled money to Cyberco in order to extend the scheme and finance the lavish lifestyles of the entities’ owners.

Huntington had been a prepetition lender to Cyberco, which was able to significantly reduce its exposure during the months leading up to the collapse of the scheme and the subsequent chapter 7 filings of both Cyberco and Teleservices. Ultimately, the chapter 7 trustees for both entities filed avoidance actions against Huntington related to its receipt of allegedly preferential and fraudulent transfers.

In response, Huntington sought to have the two estates substantively consolidated because they had been under common ownership and control and had acted in concert to perpetuate the fraud. Substantive consolidation was attractive to Huntington in part because a combination of the two estates would have resulted in the netting out of some of the allegedly avoidable transfers it had received.

Analysis and Statutory Authority for Substantive Consolidation

The Cyberco court noted the modern “liberal” approach among courts toward allowing substantive consolidation under section 105(a), but discarded it, ultimately finding a statutory basis for the remedy in the Bankruptcy Code and common law support among cases decided under the old Bankruptcy Act of 1898 and the Bankruptcy Code. Section 105(a) has long been a source of controversy under the Bankruptcy Code, with some disputing whether the key language of the section – (“[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”) – permits the court broad discretion to fashion whatever remedies it sees fit. Some believe that interpreting section 105(a) so broadly opens the door for inconsistent adjudication and abuse, and they argue that the section cannot be used to fashion remedies that are not rooted in other substantive sections of the Bankruptcy Code. The court quoted a widely followed Second Circuit case, In re Augie/Restivo Baking Co., 860 F.2d 515, 518 (2d Cir. 1988), which refers to substantive consolidation as having “no express statutory basis but is a product of judicial gloss,” to summarize the popular position that substantive consolidation is a remedy of judicial invention under section 105(a).

The court then analyzed prominent Bankruptcy Act substantive consolidation cases, including Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215, 216-217, 61 S. Ct. 904, 906 (1941). But instead of agreeing with the approach of the Third Circuit in In re Owens Corning, 419 F.3d 195, 206 (3rd Cir. 2005), and similar cases, which seem to view Sampsell as the genesis for substantive consolidation as an equitable remedy, Judge Hughes found the beginning of his statutory support for substantive consolidation in Sampsell. He noted that under the Bankruptcy Act, “property of the estate” included property that had been fraudulently transferred out of the estate. This broad definition of property effectively extended the bankruptcy court’s reach beyond the boundaries of the estate, sometimes allowing it to exercise jurisdiction over the property of non-debtors via turnover proceedings.

In other words, prior to the enactment of the Bankruptcy Code, substantively consolidating a non-debtor with a debtor was actually accomplished by turnover actions and was not simply the “product of judicial gloss.” The court found similar support in other Bankruptcy Act cases. This history provided an informative backdrop for section 542(a) of the Bankruptcy Code, which provides in relevant part:

… an entity … in possession, custody, or control, during the case, of property that the trustee may use, sell, or lease under section 363 of this title … shall deliver to the trustee, and account for, such property or the value of such property, unless such property is of inconsequential value or benefit to the estate. 11 U.S.C. § 542(a).

Under the Bankruptcy Code, section 541(a)(1) broadly defines property of the estate: “Except as provided in subsections (b) and (c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case.” The Cyberco decision argued that section 541(a)(1)’s broad scope renders section 542(a) unnecessary unless it is read to provide “broader authority to reach out and take control of the estate’s property in the possession of others.” Cyberco, 431 B.R at 420, citing U.S. v. Whiting Pools, Inc., 462 U.S. 198, 206-07 nn.13, 15, 103 S. Ct. 2309, 2314-15 nn. 13, 15 (1983).

A claim that has been allowed or disallowed may be reconsidered for cause. A reconsidered claim may be allowed or disallowed according to the equities of the case. 11 U.S.C. § 502(j).

The court reasoned that through 502(j), creditors of the non-debtor would be guaranteed an opportunity to assert claims against the enlarged estate.

Outcome: Only Trustees Have Standing to Seek Substantive Consolidation

Through the combination of two distinct Bankruptcy Code sections, Judge Hughes found statutory authority for allowing substantive consolidation. However, he denied Huntington’s two motions seeking substantive consolidation for lack of standing. Under section 542(a), it is clear that only the trustee has standing to seek turnover of estate property. So rather than encourage the spread of substantive consolidation by “legitimizing” it with what may be viewed as a more solid statutory foundation, the Cyberco court may have significantly restricted the availability of the remedy by limiting its availability only to trustees and debtors in possession.