Substantive Consolidation (Part 4): What About Consolidating Individuals?

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.]

Consolidating Individual & Corporation?

But In re Cyberco also discusses the problem of including an individual debtor in substantive consolidation like this:

• describing the substantive consolidation phenomenon as a “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 idea of a targeted debtor being merged into the prevailing debtor’s estate may make sense, when each debtor is a corporation or some other legal fiction to begin with;
• but what if the estate’s target is a natural person—what if the trustee of a corporate debtor were to set sights on an individual shareholder who had used the corporation to segregate the individual’s liabilities from the individual’s assets?
• it would be absurd to treat the individual as having become one with the bankruptcy estate through a merger—the better approach is to view the effort as a § 542 turnover process resulting in nothing more than the realignment of assets and liabilities within the affected group.

So, In re Cyberco supports the idea of substantively consolidating the bankruptcy estates of an individual and an entity owned and controlled by that individual

Question:  Which confirmation and discharge standards would apply, after substantive consolidation in a standard Chapter 11 case, when the consolidated estates are of (i) an individual, and (ii) an entity?  Those standards differ in various respects, including:

• standards for individuals require, (i) a five-years plan (§ 1129(a)(15)), and (ii) granting a discharge only after all plan payments are made (§ 1141(d)(5)(A)); or
• standards for entities allow for (i) substantial consummation of a plan shortly after confirmation (§ 1101(2)), and (ii) granting a discharge upon plan confirmation (1141(d)(1))?

Answer: Presumably, the standards for individual debtors would control in standard Chapter 11 cases, after substantive consolidation of an individual’s bankruptcy estate with that of an entity.  But who actually knows?

Consolidating Two Individuals?

Or what if the substantive consolidation effort involves the separate bankruptcy estates of two individuals?  Can the estates of two individuals be substantively consolidated? 

• The answer is, “Yes,” according to this opinion: Boellner v. Dowden, 612 Fed. Appx. 399 (8th Cir. 2015).

However, it is noteworthy that the two individual debtors in Boellner are married and that § 302 of the Bankruptcy Code explicitly authorizes a joint bankruptcy filing “by an individual . . . and such individual’s spouse.” 

Question:  Might the Boellner ruling have been different, if the two individuals were not married?

Answer:  Presumably, the answer is, “Yes.”  But who knows?

What follows is a summary of Boellner.

—Boellner Proceedings

Samuel and Marilyn are married.  But they file separate Chapter 7 petitions in Eastern Arkansas.

The Chapter 7 trustee for both cases moves for substantive consolidation of their respective Chapter 7 estates.  The Bankruptcy Court grants the trustee’s motion, the Eighth Circuit BAP affirms, and the Eighth Circuit Court of Appeals affirms as well.

—Bellner Facts

Before filing bankruptcy, Samuel and Marilyn had jointly withdrawn funds from IRAs—$240,519.00 in 2011 and $210,399.16 in 2012.

On the petition date, the two individuals share a checking account, several credit cards, and a leased car.  They also owe state and federal taxes, as well as attorney’s fees they had incurred defending a civil case.

• In the civil case, (i) plaintiffs obtain a $571,303.96 judgment against both Samuel and Marilyn, jointly and severally, and (ii) one plaintiff obtains an additional $325,600.00 judgment against Samuel.

Also on the petition date, Samuel and Marilyn live separately: (i) Marilyn’s home is unencumbered and valued at $450,000.00, and (ii) Samuel’s home is subject to a mortgage and is being surrendered to the mortgage holder.

Samuel and Marilyn have separate insurance policies, separate interests in businesses, separate annuities and separate IRAs, with Samuel owning annuities and IRAs valued at more than $700,000.00.

Samuel and Marilyn each have individual credit card debts.

—Bellner Arguments & Ruling

The trustee and creditors argue that:

• the two debtors’ assets, liabilities, and handling of financial affairs are substantially the same; and
• allowing the two debtors to maintain separate bankruptcy estates would prejudice creditors because the debtors could stack federal and state exemptions—something they could not do if their cases are consolidated.

Samuel and Marilyn argue that substantive consolidation is not warranted because they have separate assets, separate liabilities, separate IRAs and annuities, and separate monthly expenses.

Debtors’ attorney explains the reason for filing separately, rather than jointly: to allow Samuel to claim exemptions under federal law and Marilyn to claim exemptions under state law.  They argue that:

• substantive consolidation would require them to choose, together, either federal exemptions or state exemptions; and
• Samuel claims his annuities and IRAs as exempt under 11 U.S.C. § 522(d), while Marilyn claims her home as exempt under Arkansas state law.

The Bankruptcy Court grants the trustee’s motion and orders substantive consolidation. 

—Bellner Analysis

Substantive consolidation of two bankruptcy estates means the assets and liabilities of both debtors are pooled.

In assessing the propriety of substantive consolidation, a court must determine:

• whether there is a substantial identity between the assets, liabilities, and handling of financial affairs between the debtor spouses; and
• whether harm will result from permitting or denying consolidation.

Ultimately, the court must be persuaded that creditors will suffer greater prejudice in the absence of consolidation than debtors (and any objecting creditors) will suffer from its imposition.

As to substantial identity, the bankruptcy court carefully reviewed the statements of financial affairs and the bankruptcy schedules—the only evidence submitted by the parties—which allowed the bankruptcy court to identify the joint assets and joint liabilities.  In reviewing the evidence, the Bankruptcy Court:

• remarked on the peculiarity of the claim that Marilyn owned her home, yet Samuel claimed ownership of the couple’s household goods;
• the Debtors’ separate statements of financial affairs indicate that they had jointly withdrawn funds from IRAs; and
• so, the evidence establishes substantial identity.

As to a comparison of harm, the Bankruptcy Court relied upon the Debtors’ statements of financial affairs and bankruptcy schedules in determining that:

• the creditors will suffer great prejudice because, if the exemptions are allowed to be stacked, the creditors will in all likelihood receive no distribution or significantly less distribution than they would if this is a joint case; and
• in other words, if Marilyn is permitted to exempt her home under Arkansas law and Samuel is permitted to exempt his IRAs and annuities under federal law, their separate estates will have significantly less value than if their cases are substantively consolidated—which would force the Debtors to choose, together, between federal or state exemptions.

The Eighth Circuit Court of Appeals concludes that the bankruptcy court did not abuse its discretion in ordering substantive consolidation.

Conclusion

Substantive consolidation of the bankruptcy estates of an individual and a related entity seems to be permitted.  But what confirmation and discharge standards should apply, in a standard Chapter 11 case, after consolidation?  That remains to be seen.

Substantive consolidation of bankruptcy estates of two individuals is expressly authorized for married couples, under 11 U.S.C. § 302.  But can the separate bankruptcy estates of individuals, who are not married to each other, be consolidated?  That remains to be seen. 

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