Substantive Consolidation (Part 3): Protecting Creditors Of A Consolidated-But-Solvent Debtor

By: Donald L Swanson

In In re Cyberco Holdings, Inc., 431 B.R. 404 (Bankr. W.D. Mich. 2010), the Bankruptcy Court holds that the statutory basis for substantive consolidation is the Bankruptcy Code’s turnover provision (§ 542)—not the § 105(a) equitable powers provision.  [See this linked article, which was the first in this series of five articles.]

The In re Cyberco Court also addresses the interests of creditors in the substantive consolidation context.  What follows is, (i) a summary of the Bankruptcy Courts discussion of such creditor interests, and (ii) an illustrative opinion on the subject.

What About Creditors?

The In re Cyberco opinion raises this question about creditors:

• What is to be done with the creditors of the targeted entity who (i) could have received a substantial dividend from liquidation of the targeted entity, but (ii) would receive little-to-nothing after consolidation?

And the In re Cyberco opinion gives this answer:

• under concepts of equity, provision must be made for such creditors. 

That’s because courts under the 1898 Act clearly afforded relief to such creditors. In Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215 (1941), for example, the U.S. Supreme Court approved, at least implicitly, the lower court’s decision to give priority to creditors of the targeted corporation who had dealt with it in good faith.

11 U.S.C. § 502(j)

The In re Cyberco opinion adds this statutory anchor, under the Bankruptcy Code, for such relief to creditors—11 U.S.C. § 502(j), which says: 

• “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).[Fn. 1]

The In re Cyberco opinion explains:

• a creditor of a consolidated entity may or may not have a cognizable claim against the other entity in the consolidation; but
• if it does not, § 502(j) allows that creditor a claim if the equities permit it—and the equities would seem to permit such relief whenever there has been a wholesale seizure by the bankruptcy estate of another entity’s assets on the theory that the two were in fact one and the same all along.

In re Giller

An older opinion, out of the Eighth Circuit Court of Appeals, reaches the same result . . . but under the auspices of § 105(a).  Such opinion is, In re Giller, 962 F.2d 796 (8th Cir. 1992).

—Giller Facts

Giller is the sole or majority shareholder of six corporations.

Giller files a voluntary Chapter 11 bankruptcy petition, and the trustee for Giller’s estate thereafter files voluntary Chapter 11 bankruptcy petitions for the six related corporations (the “Six Debtors”).

The Six Debtors move to substantively consolidate their Chapter 11 cases, and one Creditor objects.

—Giller Consolidation

After a two-day hearing, the Bankruptcy Court substantively consolidates all of the Six Debtors.  In doing so, it makes these findings:

• Giller abused the Six Debtors’ corporate forms and caused transfers among the Six Debtors that might be avoidable as fraudulent conveyances or preferences;
• only one of the Six Debtors is solvent, so the six Debtors can’t afford to pursue the avoidance claims; and
• the “only hope” of obtaining money for unsecured creditors is to substantively consolidate the Six Debtors and use the combined assets to finance the avoidance lawsuits.

—Giller Protecting Creditors

The Bankruptcy Court in Giller recognized that creditors of the one solvent Debtor might be harmed by consolidation.  So, the Bankruptcy Court:

• left open the possibility that creditors of the one solvent debtor might be classified separately from, and treated more generously than, creditors of the other Six Debtors.

On appeal, the District Court affirms, as does the Eighth Circuit Court of Appeals.

Unfortunately, none of the opinions from the three Giller courts (Bankruptcy, District or Eighth Circuit) provides any statutory basis or rationale for treating creditors of the solvent debtor more favorably than creditors of the other Six Debtors.

But, fortunately, the In re Cyberco opinion provides the statutory anchor for doing so: § 502(j).

Conclusion

Protecting creditors of a solvent (or nearly solvent) debtor from the effects of consolidation with insolvent debtors is an important part of any substantive consolidation process.  That’s a message of In re Cyberco and of In re Giller.

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Footnote 1.  11 U.S.C. 502(j) provides in its entirety: “(j) 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. Reconsideration of a claim under this subsection does not affect the validity of any payment or transfer from the estate made to a holder of an allowed claim on account of such allowed claim that is not reconsidered, but if a reconsidered claim is allowed and is of the same class as such holder’s claim, such holder may not receive any additional payment or transfer from the estate on account of such holder’s allowed claim until the holder of such reconsidered and allowed claim receives payment on account of such claim proportionate in value to that already received by such other holder. This subsection does not alter or modify the trustee’s right to recover from a creditor any excess payment or transfer made to such creditor.”

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