Substantive Consolidation (Part 1): What Is The Statutory Authority? (In re Cyberco)

By: Donald L Swanson

The legal basis for a substantive consolidation of two bankruptcy debtors is uncertain.  Many opinions find bankruptcy court authority for substantive consolidation in this language of 11 U.S.C. § 105(a):

• “The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”

But the use of § 105 to expand bankruptcy court powers has always been suspect.

So, here is an opinion providing a different statutory basis for substantive consolidation—namely, § 542’s turnover provisions: In re Cyberco Holdings, Inc., 431 B.R. 404 (Bankr. W.D. Mich. 2010).

What follows is a summary of the In re Cyberco analysis.

Procedural Background

Company A and Company B have common ownership.

Both Company A and Company B end up in Chapter 7, and the Chapter 7 trustee for each debtor pursues Chapter 5 avoidance actions against Bank for pre-petition transfers, (i) between Company A and Company B, and (ii) involving third parties.

In response, Bank seeks substantive consolidation of the two bankruptcy cases into a single bankruptcy estate, arguing that substantive consolidation would:

• combine the assets of the two bankruptcies into a single bankruptcy estate and allow all creditors of both debtors to share equally from the common pool; and
• eliminate all avoidance claims against Bank involving transfers between Company A and Company B.

After trial, Bank’s substantive consolidation motion is denied.

Facts

Bank is one of many victims of a massive fraud perpetrated through Company A and Company B by their common owners.

Bank loaned more than $16 million to Company A, believing Company A to be a fast growing, high-tech company on the cutting edge and with a global reach.

The fraud works like this:

• Company A represents to prospective lenders that it needs loans to buy equipment from Company B;
• Company A obtains the loans but never purchases any equipment;
• instead:
  • Company A’s lenders forward money to Company B on the mistaken belief that Company B has something to sell; and
  • Company B, then, funnels the money back to Company A for making payments back to lenders; and
• the result is that millions and millions of dollars pass through accounts at Bank, which are the subject of avoidance claims.

Meanwhile, as the fraud starts coming to light, Company A pays its multi-millions of dollars of outstanding loans from Bank down to $600,000—via payments from Company B with funds generated through the fraud scam.

Substantive Consolidation—Roots of Authority

In its broadest sense, substantive consolidation:

• treats separate legal entities as if they were merged into a single survivor, with all the cumulative assets and liabilities (save for inter-entity liabilities, which are erased); but
• pinning down the exact authority that empowers a bankruptcy court to impose such a remedy has been illusive; and
• the Bankruptcy Code itself makes no reference to “substantive consolidation” and the term “consolidate” or “consolidation,” standing alone, appears in only two places.

Nonetheless, modern courts are wont to say that substantive consolidation is permitted under the Bankruptcy Code through § 105(a), which, in pertinent part, provides:

• “The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”

But it is just as often said that substantive consolidation is to be viewed as “a product of judicial gloss.”  And courts regularly regard their ability to order substantive consolidation as deriving from an equitable power that predates the Bankruptcy Code.

Substantive consolidation traces its roots to the Bankruptcy Act of 1898, which contained no express statutory authorization—instead, consolidation authority was implied from a bankruptcy court’s general equitable powers.  For example, a substantive consolidation of a parent corporation and its subsidiaries:

• arises from a bankruptcy trustee’s right to seize assets held in the name of another person that, in fact, belong to the bankruptcy estate;
• frequently takes the form of a turnover proceeding—to recover assets (e.g., by piercing the corporate veil) that have belonged to the bankruptcy estate all along; and
• the Bankruptcy Act of 1898 contained no specific turnover provision—so turnover remedies were, under that Act, a judicial innovation.

Combining Assets: § 542 Turnover Orders

As noted above, turnover orders under the Bankruptcy Act of 1898 were a judicial innovation—that’s because such Act has no turnover provision. 

Under the Bankruptcy Code, by contrast, turnover orders are explicitly authorized: 11 U.S.C. § 542 is titled “Turnover of property to the estate” and says that a person in possession of bankruptcy estate assets “shall deliver to the trustee, and account for, such property or the value of such property.”

The result is that courts today should to look to § 542, not § 105, as the statutory source for seizing assets of a third person on grounds of substatntive consolidation.  That’s because:

• reliance upon equity as an alternative to § 542 flies in the face of the oft repeated admonition that “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code”;
• substantive consolidation is a substantive power; and
• courts have stated again and again that substantive powers cannot be derived from 11 U.S.C. § 105.

Combining Debts: Equitable Allowance Under § 502(j)

Courts cannot be indifferent, in substantive consolidation, to the negative impact on innocent creditors.

11 U.S.C. § 502(j) provides:

• “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” (emphasis in original).

In other words, § 502(j) could be used in a substantive consolidation to protect a creditor that is harmed: 

• a creditor of an entity that is substantively consolidated with another entity may or may not have a cognizable claim against the prevailing party; but
• if it does not, Section 502(j) would nonetheless permit that creditor a claim if the equities permit, which would be the case in a substantive consolidation under the theory that the two entities were in fact one in the same all along.

Misnomer & What About Individuals?

The name, substantive consolidation, is a misnomer, because “consolidation” suggests an actual merger of the two entities as opposed to simply the rearrangement of the entities’ assets and liabilities.

The word “consolidation” makes sense when one entity is merged into another entity’s bankruptcy estate, since each entity is a legal fiction to begin with.

But what if a natural person is involved?  It would be absurd to treat the individual as having become one with the bankruptcy estate of another person through merger.

So, the better approach is, in all circumstances, to view consolidation as arising from the specific turnover section of the Bankruptcy Code (§ 542) that results in nothing more than a realignment of assets and liabilities within the affected group.

Consolidations as Settlements

Substantive consolidations are often voluntary processes among two or more related debtors.

In many such cases, consolidations are more properly viewed as negotiated settlements of turnover disputes between related debtors. 

Case administration under the Bankruptcy Code is based upon trustee empowerment, not court orders: it is the trustee (or debtor-in-possession (“DIP”)), as opposed to the court, who is charged with acting on behalf of the estate, with the court intervening only in those instances where its involvement is required.

So, the appropriate question to ask, for substantive consolidation, is this: whether bankruptcy law requires the court to review what is proposed before the trustee or DIP can actually proceed.

If trustees/DIPs of related bankruptcy estates have agreed upon a proposed consolidation, that proposal should be treated as a settlement of disputes over the allocation of assets and debts between them.  And such a settlement requires bankruptcy court approval under Fed.R.Bankr.P. 9019(a), with notice to creditors and other interested parties and an opportunity to object.

The standard for evaluating any objection would be a “balancing of the equities” between the harm or prejudice to creditors from consolidation against what happens if the debtors remain separate.

Creditor Standing to Compel Consolidation?

Bank does not have standing under § 542 to pursue substantive consolidation, the Court declares.  

Granted, some bankruptcy courts have ordered substantive consolidation under a creditor’s motion.  But such cases, (i) are silent on the specific issue of creditor standing, (ii) fail to offer any meaningful analysis of such standing, or (iii) justify the conclusions reached under principles associated with derivative standing (which principles are not asserted here).

However, Bank still has recourse.  The respective bankruptcy trustees for Company A and Company B have filed motions to approve settlements that include:

• the the assets of Company B being treated as if those assets had belonged Company A all along; and
• Company B’s estate relinquishing property that otherwise might be available to only its own creditors.

Bank has already objected to the proposed settlements and will have the opportunity, in due course, to explain why its objection should be sustained. However, that is for another day.

Conclusion

That’s an interesting analysis.  And it’s one that makes sense.

Series of 5 Articles

This article is the first in a series of five articles. The additional four articles in this series are on the following consolidation-related subjects:

• Part 2–derivative standing for creditors to seek substantive consolidation;
• Part 3–protecting creditors of a consolidated-but-solvent debtor;
• Part 4–what about substantively consolidating individuals; and
• Part 5–substantively consolidating bankruptcy debtors with non-debtors.

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