This post is part of an occasional series highlighting a project finance article or news item from the past. It is often interesting and thought provoking to look back on these items with the perspective of months, years or decades of further experience.
With this installment, we turn to an article that was published in the October 2005 issue of the Project Finance NewsWire and was co-written by Christy Rivera, counsel in Chadbourne's Bankruptcy group.
Are Subsidiaries Really Bankruptcy Remote?
BY N. THEODORE ZINK, JR. AND CHRISTY RIVERA
A US appeals court decision in August is a reminder to lenders that there is a danger that even a “bankruptcy remote” borrower can have its assets swept up in a bankruptcy proceeding involving a parent company or other affiliate.
A bankruptcy court might “substantively consolidate” the borrower with the company in bankruptcy.
That is what happened initially in a bankruptcy case involving Owens Corning. Fortunately for lenders, the appeals court reversed the lower court decision that the entities should be consolidated.At the same time, the court reaffirmed that anyone advocating substantive consolidation has a significant evidentiary burden to bear when requesting a bankruptcy court to disregard the boundaries between separate, but related, legal entities.
Substantive Consolidation
A corporation is a recognized legal entity distinct from its owners and other affiliates.This separateness, a recognized feature of corporate law, is generally respected by courts.
However, in a variety of contexts, courts may conclude that the principle of corporate separateness should give way to right some wrong or to achieve some other benefit. In bankruptcy cases, substantive consolidation developed to overcome corporate separateness.
A primary goal of the US bankruptcy code is equality of distribution.The primary purpose of substantive consolidation is, likewise, to ensure the equitable treatment of all creditors. Substantive consolidation allows bankruptcy courts to combine the assets and liabilities of separate (but related) legal entities into a single pool and treat them as though they belong to a single entity.
Creditors of the various entities must then look to the consolidated pool for the repayment of their various claims.
Substantive consolidation does not necessarily benefit all creditors. Because different debtors within a related group are likely to have different asset-liability ratios, substantive consolidation may significantly disadvantage creditors holding claims against the financially stronger members of the group.Courts have recognized that substantive consolidation may often result in a harsh redistribution of value to some creditors at the expense of others and, therefore, substantive consolidation is an extraordinary remedy that must be exercised sparingly.
The courts have developed several principal frameworks in which to consider whether substantive consolidation is appropriate in a particular case. A line of cases decided shortly after the enactment of the bankruptcy code relies primarily on the presence or absence of certain “elements” that are identical or similar to factors relevant to “piercing the corporate veil”and “alter ego” theories.More recent cases take such elements into account within the context of a balancing test in which the interests of those parties objecting to substantive consolidation are considered. In a balancing test analysis, creditors may defeat substantive consolidation by demonstrating they relied on the separate credit of each debtor and would be prejudiced by such consolidation.The adverse effect on creditors who oppose substantive consolidation appears to have a greater degree of significance than mere proof of the substantive consolidation “elements.”
The most stringent test, and that recently adopted by the appeals court in the Owens Corning case, provides the following alternative tests to determine whether substantive consolidation is appropriate. One test is whether creditors dealt with the entities as a single economic unit and did not rely on their separate identities in extending credit.The other is whether the entities’ affairs are so commingled that substantive consolidation will benefit all creditors.This formulation is discussed in more detail in the following discussion about the Owens Corning case.
Owens Corning
Owens Corning and 17 of its wholly-owned subsidiaries filed for chapter 11 bankruptcy protection in October 2000 in the case of mounting asbestos claims.The creditors in the case included, among others, asbestos claimants, bondholders, and bank lenders under a $1.6 billion credit line.
Several years after the bankruptcy filing,Owens Corning (together with asbestos claimants and others) proposed a reorganization plan conditioned on court approval of the substantive consolidation of 18 related debtor and non-debtor entities.The motion sought consolidation for chapter 11 plan voting and distribution purposes only, thus preserving the corporate structure for all other purposes.The banks objected to the proposed consolidation.
At the crux of the consolidation issue was the undisputed fact that Owens Corning’s “significant subsidiaries”— those domestic subsidiaries having assets with an aggregate book value of more than $30 million — gave the banks guarantees when the credit line was first extended in 1997. As a result of the guarantees, while asbestos claimants held claims only against either Owens Corning or one other entity, and holders of Owens Corning’s public debt held claims only against Owens Corning, the banks held claims against each of the separate guarantors as well as Owens Corning. Accordingly, if the assets were substantively consolidated and the guarantees thereby nullified, the banks would be forced to share in the common pool of assets with asbestos and other claimants.
In concrete financial terms, the banks believed they would lose more than $1 billion in recoveries if the assets of all the companies were substantively consolidated.
A federal district court — the first court to hear the case — found that substantive consolidation was warranted. There are 13 federal judicial circuits — or regions — in the United States. The district court adopted a test for substantive consolidation that was developed by the US appeals court for the District of Columbia circuit, which covers the nation’s capital.
That test requires someone seeking substantive consolidation to demonstrate both substantial identity among the entities to be consolidated, and substantive consolidation is necessary to avoid some harm or realize some benefit. If this showing is made, then the burden shifts to the party opposed to consolidation to show that it relied on the separate credit of one of the entities to be consolidated,and it will be prejudiced by substantive consolidation.
The district court that heard the Owens Corning case is in the third judicial circuit. In August, the US appeals court for that circuit rejected the test the district court used to decide on consolidation. It turned instead to the test used in the second circuit.
Under that test, anyone seeking substantive consolidation must demonstrate that either , before the bankruptcy, the entities disregarded separateness so significantly that their creditors relied on the breakdown of entity borders and treated them as one legal entity, or the entities’ assets and liabilities are so hopelessly commingled that the expense of separating them would adversely affect the recovery of all creditors.
The appeals court also reviewed several “principles” that it suggested substantive consolidation, if used, should advance.The court said that a “fundamental ground rule” is to limit the cross-creep of liability by “respecting entity separateness.” It directed courts to “respect entity separateness absent compelling circumstances.” It called substantive consolidation a remedy of “last resort after considering and rejecting other remedies.” It said substantive consolidation should typically address harm caused by the debtors (and not harm caused by the creditors) and that mere benefit to the administration of the case is not sufficient to invoke substantive consolidation.
After establishing the framework for its review, the court addressed the first test by asking whether there was disregard of corporate separateness. It found that there was no such disregard because Owens Corning and the banks negotiated the original lending transaction premised on the separateness of all the Owens Corning subsidiaries. Owens Corning cannot create the ground rules on corporate structure one day and ignore them the next, the court said.The fact that the banks did not require a review of individual internal credit metrics for each Owens Corning subsidiary was not determinative of the issue.The banks premised their credit extension on facts they knew about the guarantor subsidiaries as a group.The banks knew, for example, that each guarantor subsidiary had assets of at least $30 million, that collectively the guarantor subsidiaries had assets worth more than $900 million, and that the guarantor subsidiaries had little or no debt.At the end of the day, it was irrelevant that the banks did not receive independent financial statements for each guarantor.
The appeals court also said it was irrelevant that the banks did not request a legal opinion from counsel that substantive consolidation was unlikely to occur were any of the borrowers subject to bankruptcy. This type of lending with subsidiary guarantees is common.The court said the banks’ requirement of guarantees from certain subsidiaries was evidence that the banks actually relied on the separateness of the entities in making the loan.
The court then turned to the second prong of the analysis and addressed hopeless entanglement. The standard is that “commingling justifies consolidation only when separately accounting for the assets and liabilities of the distinct entities will reduce the recovery of every creditor.” The court easily found that hopeless entanglement did not exist here.The court was not impressed by the argument that the companies had not always accounted accurately for intercompany transactions. It said,“imperfection in intercompany accounting is assuredly not atypical in large, complex company structures.”
Analysis
The district court’s opinion seemed born of necessity — as the only way to get an Owens Corning plan confirmed — and not of thorough legal analysis.
The judge ignored the fact that Owens Corning strictly adhered to corporate formalities, that application of the harm/benefit analysis should have disregarded the potential salutary effect of consolidation and that a $1 billion loss to the banks was certainly prejudicial. In reversing the substantive consolidation ordered by the lower court judge, the appeals court gave weight to each of these facts and validated the lending and due diligence practices of the banks.
Although the appeals court adopted a more stringent substantive consolidation test, we believe the specific test applied is less important than a thorough and thoughtful analysis that pays appropriate deference to the corporate form.We believe that the test applied by the appeals court and the general principles enunciated by that court are consistent with the overwhelming majority of reported decisions on substantive consolidation.
Lenders should draw comfort from the appeals court’s opinion. Among other things, the court validated the current day practice of obtaining subsidiary guarantees in connection with lending arrangements and limited the due diligence that lenders need to be able to demonstrate if faced with a request for substantive consolidation. For example, lenders need not obtain independent financial statements for each guarantor to demonstrate they relied on the corporate separateness of entities so long as they can demonstrate that they received detailed information from the parent about the subsidiaries.