Substantive Consolidation (Part 5): Consolidating Bankruptcy Debtors With Non-Debtors

Consolidated but not the same? (Photo by Marilyn 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.]

In re Cyberco also recognizes that:

“Some courts have extended the doctrine of substantive consolidation to nondebtor entities”; but
such decisions are based upon an assumption that “is fundamentally flawed.”

What follows is a summary of two separate opinions that illustrate how differences arise in consolidating non-debtors with a bankruptcy debtor:

a Ninth Circuit opinion allowing substantive consolidation of a non-debtor entity with a bankruptcy debtor’s estate; and
an Eighth Circuit opinion rejecting a request for such a substantive consolidation.

Ninth Circuit Opinion

The Ninth Circuit opinion is Alexander v. Compton (In re Bonham), 229 F.3d 750 (9th Cir. 2000).

—Bonham Facts

A failed Ponzi scheme is operated by Individual Debtor through two wholely-owned Corporations. The Corporations’ stated purpose is to purchase frequent flier miles from various airlines at a discount and then use them to acquire airline tickets for sale to the public at a profit.

Later, Individual Debtor issues, through Corporations, short-term investment contracts with promised returns of 20% to 50% over short periods of time (typically, from 10 days to 8 months).

The airline ticket sales business does not generate sufficient revenue to cover the debt service on the investment contracts. So, Individual Debtor transfers investment income from one investor directly to another investor, and between Corporations, to satisfy prior investment contracts.

Then, a group of investors in the Corporations file an involuntary Chapter 7 against Individual Debtor to collect on unpaid investment contracts. Individual Debtor agrees to the petition, and the Bankruptcy Court appoints a Chapter 7 Trustee.

1,111 proofs of claim are filed in Individual Debtor’s bankruptcy for over $ 53 million. The Chapter 7 Trustee files over 600 adversary proceedings against investors to avoid fraudulent transfers. The investors challenge the standing of the Individual Debtor’s Chapter 7 Trustee, to avoid transfers made by Corporations.

In response, the Chapter 7 Trustee moves for substantive consolidation of Individual Debtor’s bankruptcy estate with the Corporations’ non-debtor estates.

After trial, the Bankruptcy Court orders substantive consolidation of the Corporations with Individual Debtor’s bankruptcy estate, to assure that the overcompensated initial investors share in the losses suffered by subsequent investors.

Investors appeal to the District Court, which reverses. And so appeal is made to the Ninth Circuit—which affirms the Bankruptcy Court’s substantive consolidation and reverses the District Court reversal.

—Bonham Rationale

The Ninth Circuit:

declares that, “We must decide whether a bankruptcy court may order substantive consolidation of two non-debtor corporations”;
concludes that, “The bankruptcy court did not err in substantively consolidating the estates”;
explains that, “Courts have permitted the consolidation of non-debtor and debtor entities in furtherance of the equitable goals of substantive consolidation”; and
concludes, further, that, “In light of the multiplicity of investors and claims and the lack of cooperation” from Individual Debtor, “the bankruptcy court did not clearly err in determining that the exercise of disentangling the affairs” of Individual Debtor and Corporations “would be needlessly expensive and possibly futile.”

Eighth Circuit Opinion

This Eighth Circuit opinion, by contrast, denies the substantive consolidation of non-debtors with a bankruptcy debtor’s estate: In re Archdiocese of St. Paul & Minnesota, 888 F.3d 944 (8th Cir. 2018).

—Archdiocese Ruling

The Official Committee of Unsecured Creditors (the “Committee”) seeks substantive consolidation of the Archdiocese (bankruptcy “Debtor”) with over 200 affiliated non-profit and non-debtor entities (the “Targeted Entities”).

In extraordinary circumstances, a bankruptcy court’s broad equitable powers grant it authority to substantively consolidate. Such powers, however, are limited by explicit statutory provisions, such as 11 U.S.C. § 303(a), which protects bona fide non-profit organizations from involuntary bankruptcy.

Due to their non-profit status, the Bankruptcy Court rules, the Targeted Entities are entitled to the protections of § 303(a) against involuntary bankruptcy and, therefore, cannot be consolidated with Debtor against their will.

Both the District Court and the Eighth Circuit affirm on appeal.

—Archdiocese Facts

Archdiocese is an entity of the Roman Catholic Church, covering the Saint Paul and Minneapolis metropolitan area.

Originally established in the mid-to-late 1800s, there are now over 180 parishes in the Archdiocese as well as several schools and related organizations. The ecclesiastical and civil leader of the Archdiocese is the Archbishop, appointed by the Pope. Each parish has a pastor, who is appointed and subject to removal by the Archbishop.

In May 2013, the state of Minnesota enacts the Minnesota Child Victim’s Act, allowing individuals with previously time-barred claims to bring civil lawsuits for a period of three years. As a result, hundreds of claims of clergy sexual abuse are filed against the Archdiocese.

—Archdiocese Rationale

In their request for substantive consolidation, the Committee alleges:

the majority of Debtor’s assets are held by the Targeted Entities;
Debtor has “direct control and supervision in all material aspects” of the Targeted Entities; and
therefore, the assets of the Targeted Entities should be treated as the assets of Debtor.

The Eighth Circuit recognizes the Bankruptcy Court’s authority to substantively consolidate debtor entities. And a number of other courts recognize the substantive consolidation of multiple debtors. The Eighth Circuit explains:

as substantive consolidation requires the creditors of one entity to share equally with the creditors of a potentially less solvent entity (which can unfairly disadvantaging some creditors), it is an extraordinary remedy that is to be invoked sparingly;
the appropriateness of the substantive consolidation remedy must be determined on a case-by-case basis after a searching review of the record;
so far, only the Ninth Circuit has directly addressed the substantive consolidation of debtors with non-debtors—in In re Bonham.

The Eighth Circuit declares that “we must first decide if the court has the authority to substantively consolidate Debtor with over 200 affiliated non-profit non-debtors.” It adds that the broad, catch-all equitable powers conferred under 11 U.S.C. § 105(a) do not allow a bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code.

Accordingly, the Eighth Circuit rules:

11 U.S.C. § 303(a) does not allow for these non-profit entities to be involuntary bankruptcy debtors;
granting substantive consolidation, over the objections of the Targeted Entities, would necessarily pull non-profit entities into bankruptcy involuntarily in contravention of § 303(a); and
the Bankruptcy Court properly decided it did not have legal authority to substantively consolidate Debtor and the Targeted Entities, because § 303(a) prevents the use of § 105(a) to force truly independent non-profit entities into involuntary bankruptcy.

Conclusion

It appears that a non-debtor can be substantively consolidated with a bankruptcy debtor, but the analysis and determination appear to be on a case-by-case basis.

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