August/September 2004

Practitioners who regularly advise financially distressed corporations -- and who periodically guide those corporations through bankruptcy or liquidation cases -- clearly understand the general requirement that such corporations must consider the best interests of (and, indeed, may owe a fiduciary duty to) creditors. Concepts like the “zone of insolvency” and the ramifications of being in the “zone of insolvency” are well known, and should be carefully explained to clients at the very first meeting. But a related concept that may have far-reaching implications both to creditors and equity holders of the client – the concept of substantive consolidation-- is not as well-known to many practitioners. Unfortunately, its significance may not be properly explained to clients until too late in the restructuring process.

Substantive consolidation is the judicial doctrine by which bankruptcy courts have ordered the assets and liabilities of two or more separate and distinct – but related – legal entities to be combined into a single pool. The doctrine emanates from the bankruptcy court’s general equitable powers under section 105 of the Bankruptcy Code. Courts most often resort to substantive consolidation in situations where the operations or relationships of multiple debtors are so intertwined and obscured that they cannot reasonably be untangled or, alternatively, where the time and expense necessary to untangle them would likely erode recovery of net assets for all creditors and create substantial delays in effecting a distribution to creditors.

When multiple debtors are substantively consolidated, their combined assets, for practical and legal purposes, are merged into a single fund (i.e., the sole, surviving consolidated debtor) from which all claims against all of the debtors are satisfied. As a result of substantive consolidation, duplicate claims against multiple debtors and claims by one debtor against another are eliminated. Similarly, secured or unsecured claims against any of the debtors are treated as secured or unsecured claims against the consolidated debtor.

Substantive consolidation may result in some creditors receiving more than they would potentially have received in the absence of substantive consolidation. The reverse could also be true. This occurs because each of the debtors to be consolidated has its own asset and liability ratio, which would otherwise produce a specified recovery to that entity’s creditors. If the recovery by creditors of a particular entity would exceed the recovery to those same creditors under substantive consolidation, those creditors are worse off by the amount their recovery decreases. On the other hand, creditors who would have received little or nothing from a particular debtor will benefit from the merger of their debtor’s assets and liabilities with a debtor that has a more favorable asset-to-liability ratio. In fact, this divergence in treatment between what creditors would receive with and without substantive consolidation, in large part, will govern which side a particular creditor takes in a substantive consolidation fight. Not surprisingly, creditors who benefit from substantive consolidation will argue it is appropriate, while creditors whose recoveries will be harmed will argue it is inappropriate. Implicit in the decision to substantively consolidate, however, is the conclusion that the benefit accruing to the majority of creditors outweighs the harm to any particular creditor whose recovery will be limited as a result of consolidation.

Substantive consolidation may also result in the increase or elimination of share-holder value. For example, a parent company may hold all of its operating businesses through subsidiaries with significant trade and non-trade debt, but may be cash rich and debt free at the parent level. Absent substantive consolidation, shareholders of the parent company could realize the entire value of the cash. But, with substantive consolidation, that value would have to be shared with creditors of the substantively consolidated operating businesses.

Because of the potential detriment or windfall to creditors and shareholders of the prospective consolidated debtors, bankruptcy courts considering a substantive consolidation request proceed on a case-by-case basis, examining the individual facts and circumstances that are presented. These same facts and circumstances must be considered by a practitioner counseling financially distressed entities. Only if the client understands the likelihood and ramifications of substantive consolidation can it make an informed judgment about the course of action to pursue that satisfies its fiduciary obligations to shareholders and, for corporations that are insolvent or in the zone of insolvency, to creditors.

To provide this critical advice to a client, the practitioner must undertake an investigation of the manner in which the debtors have conducted their affairs. The investigation should encompass interviews with the debtors’ management, in-house and external counsel, financial advisors or creditors committees, and analysis of public and non-public documents and information, including public relations materials and website disclosures that reflect how the respective debtors hold themselves out to the public. For example, does each company comply with corporate formalities? Does each company maintain separate accounting records? Or, does the parent (along with its subsidiaries) tout that it is one big, happy company and the subsidiaries are divisions, not separate corporate entities? The facts elicited from the investigation should assist the practitioner in advising the client whether substantive consolidation is in the best interests of the creditor body as a whole and should be embraced by the client.

The elements of substantive consolidation to be investigated, as developed and refined by the courts, include:

While the forgoing factors are simply stated in theory, the actual application of these factors can be problematic. Consider some of the large, highly-publicized cases where the principal debtor purportedly has hundreds of related legal entities - some substantive operating businesses and other allegedly “shell” corporations (with some of those entities having substantial assets and others having primarily debt). Transfers between the entities for cash, inventory, expense allocation or other items may or may not have been recorded or documented properly. To properly account for the real assets and liabilities of each individual entity, and to accurately estimate potential creditor recoveries, the intercompany accounting must be unwound. Unfortunately, the debtors’ financial records or systems often are incomplete or inadequate, and employees with knowledge of the transactions and relationships may no longer be available to assist in unwinding inter-company accounting. Fighting a substantive consolidation battle could distract the debtors’ management and professionals and tax the estate’s already insufficient resources – thereby delaying (and perhaps eroding completely) distribution to creditors – with-out necessarily enhancing overall recoveries.

The advisor to the financially distressed debtor needs to take all of these factors into consideration in determining whether to advise the debtor to pursue a substantive consolidation strategy or, if a substantive consolidation motion has been filed by another party, to advise the debtor how to respond to such motion. But, the right course of action is not always apparent, because what may benefit the creditors and shareholders of one debtor may ultimately not benefit the creditors of a related debtor that the advisor also represents. Similarly, the fiduciary dilemma this situation presents for management and the boards of directors of the respective companies is equally complex. None-the less, a wise advisor should ensure that its client clearly understands the concept of substantive consolidation when making vital restructuring decisions that affect its future and recoveries to creditors or stakeholders.