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Substantive Consolidation − Recent Decisions Examine a Bankruptcy Court’s Ability to Augment a Debtor’s Estate

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Two recent opinions concerning the law of substantive consolidation should be of interest to business owners and commercial real estate market participants. The doctrine of substantive consolidation allows a bankruptcy court, in certain circumstances, to augment the assets of a debtor’s bankruptcy estate with the assets of others affiliated with the debtor. The two decisions both involved efforts by chapter 7 trustees to substantively consolidate the assets of related, non-debtor entities with the bankruptcy estate administered by each trustee.

In the Massachusetts decision, Lassman v. Cameron Construction LLC (In re Cameron Construction & Roofing Co., Inc.) (Bankr. D. Mass. 2016), the Bankruptcy Court allowed substantive consolidation. In contrast, in the unpublished Sixth Circuit decision in Spradlin v. Beads And Steeds Inns, LLC (In re: Matthew Lowell Howland and Meagan Larae Howland) (6th Cir. 2017) substantive consolidation was not allowed as the Court determined the trustee did not satisfy the burden of alleging sufficient facts. These opinions serve as an important reminder of the significant equitable power that bankruptcy courts wield. That power affects the fate not only of debtors and their creditors, but the rights and obligations of related parties and their creditors as well.

From a commercial real estate perspective, the decisions are noteworthy because real estate lenders often require, as a condition to closing, the establishment of a single purpose borrowing entity governed by certain separateness provisions. The goal of such a structure is to protect the lender from the substantive consolidation of its borrower with affiliated non-borrower entities who file or are forced into bankruptcy.

Financings employing such structures typically also require borrower’s counsel to deliver a so-called “non-consolidation opinion” to the lender. Such opinions are based on a review of the relevant loan documentation, relevant borrower organizational documentation, factual certifications from borrower’s management, and an exhaustive review of applicable bankruptcy law governing substantive consolidation.

In the Massachusetts case, the chapter 7 trustee of the debtor sued a related entity seeking to hold the related entity responsible for the debts of the debtor. The Court determined that the trustee had demonstrated that there was a “substantial identity between the entities to be consolidated.” Not only did common ownership exist, the two entities regularly intermingled their assets and only minimally observed corporate formalities. Other facts suggested an excessive salary paid by the debtor to the related entity for the benefit of the insider’s spouse.

In the case giving rise to the Sixth Circuit decision, the chapter 7 trustee of a married couple sought to invoke the theory of substantive consolidation in order to challenge the transfer of real property once owned by the couple, but transferred by them to a related entity and then again, by the related party to a third party buyer.

Unlike the Massachusetts Bankruptcy Court decision which resulted after a full trial, the Sixth Circuit decision resulted from an appeal of lower court decisions granting motions to dismiss the trustee’s allegations on the basis that her complaint did not contain sufficient factual allegations to support her theory of substantive consolidation. The Sixth Circuit held that the trustee’s complaint fell “far short of demonstrating a significant disregard of corporate separateness” such that creditors of either entity relied on the breakdown and treated the entities as one. The Court found it fatal that the trustee failed to allege the entities “distributed misleading financial information to creditors, failed to accurately record their transactions with creditors or otherwise misled creditor into believing they were dealing with them as one indistinguishable entity.”

In sum, in determining whether substantive consolidation is appropriate, courts have not employed a “bright line” test, but rather have identified and developed various factors to be considered, including those noted above. The Massachusetts Bankruptcy Court decision is a good example of a court evaluating such factors in an equitable manner in reaching its conclusion about the appropriateness of consolidation on the facts presented. The decision is now on appeal and it will be interesting to see how the decision fares when an appellate decision is rendered.

The Sixth Circuit decision stands as an example of the procedural hurdles existing in any litigation. Facts may have existed in that case for a fact-finder to evaluate, but the lower courts determined (and the Sixth Circuit affirmed) that bare allegations of harm to creditors is not sufficient for a court to conduct a trial on the issue of substantive consolidation.

This advisory was prepared by John G. Loughnane, a partner in Nutter’s Business Department. For more information, please contact John or your Nutter attorney at 617.439.2000.

This advisory is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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