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Non-Debtor Substantive Consolidation: Do Recent Cases Signal a Judicial Preference for State Law Claims?

It is not unusual for a creditor of a debtor to cry foul that a non-debtor affiliate has substantial assets, but has not joined the bankruptcy. In some cases, the creditor may assert that even though its claim, on its face, is solely against the debtor, the debtor and the non-debtor conducted business as a single unit, or that the debtor indicated that the assets of the non-debtor were available to satisfy claims. In these circumstances, the creditor would like nothing more than to drag that asset-rich non-debtor into the bankruptcy to satisfy its claims. Is that possible?

By way of background, jurisprudence varies on whether bankruptcy courts have the power to consolidate a bankruptcy debtor with a non-debtor. Even those courts that have permitted consolidation have done so with trepidation, calling the remedy “extreme” or “extraordinary,” and that the power is to be used “cautiously” or “sparingly.”  In many cases, courts expressly provide that the burden to consolidate a non-debtor with a debtor is a heavier one than to consolidate two debtors.

Two courts recently addressed whether it is possible for a non-debtor to be consolidated into the bankruptcy of an affiliated debtor, or whether such attempts are dead-on-arrival. First, the Eighth Circuit Court of Appeals in Official Committee of Unsecured Creditors v. Archdiocese of Saint Paul & Minneapolis (In re Archdiocese of Saint Paul & Minneapolis), held that because Section 303(a) of the Bankruptcy Code protected non-profit entities from involuntary bankruptcy filings, non-profit non-debtors could not be substantively consolidated into a debtor’s bankruptcy. Second, the United States Bankruptcy Court of the Northern District of Illinois, in Audette v. Jasemir (In re Concepts Am., Inc.), went even further and held that substantive consolidation of a non-debtor was barred under all circumstances in the Seventh Circuit. While both cases determined that the remedy of substantive consolidation was not available, they also each suggested that state law alter ego or piercing claims may provide the creditor an alternative remedy. In so doing, it is possible that courts are signaling a judicial preference for state law claims and remedies over substantive consolidation when a non-debtor is involved.

In re Archdiocese of Saint Paul & Minneapolis

The Archdiocese of Saint Paul and Minneapolis (the “Archdiocese”) filed for bankruptcy to manage and resolve hundreds of sexual abuse claims asserted against it after the state of Minnesota enacted legislation allowing previously time-barred claims to be filed. The Official Committee of Unsecured Creditors (the “Committee”), whose constituency included the abuse claimants, alleged that most of the Archdiocese’s assets were held by affiliated entities such as parish corporations, schools, cemeteries, foundations, and other non-profit entities, and that because those assets were controlled by the Archdiocese, they should be consolidated into the bankruptcy of the Archdiocese.

The Bankruptcy Court converted the Committee’s motion for substantive consolidation to an adversary proceeding and allowed the parties to submit briefs on whether the proceeding should be dismissed. Following such briefing, and oral argument, the Bankruptcy Court granted the motion for dismissal, reasoning that Section 303(a) prohibited the requested consolidation. The District Court affirmed.

The Eighth Circuit, applying a de novo standard of review, affirmed the Bankruptcy Court decision. In so doing, the panel recognized a bankruptcy court’s ability to substantively consolidate multiple debtors. When applied to non-debtors, however, the panel was much more skeptical of a bankruptcy court’s power to substantively consolidate. The dispositive factor for the Eighth Circuit proved to be the argument that a bankruptcy court may not use Section 105(a) to contravene another section of the Bankruptcy Code. Specifically, the Eighth Circuit found that allowing substantive consolidation of a non-debtor based on Section 105(a) would contravene the Section 303(a) prohibition on forcing non-profit entities into involuntary bankruptcies. Thus, the panel concluded that the Bankruptcy Court had correctly denied the Committee’s request to consolidate the Archdiocese with the related non-profit entities.

Although the Eighth Circuit found that substantive consolidation of a non-profit non-debtor was impermissible, it did leave open the possibility for creditors to try to reach the assets of a non-profit non-debtor through state law claims, such as alter ego or fraud-based claims. On the facts of the case, however, the panel noted that the Committee had not argued alter ego; therefore, the availability of that remedy was left for another day.

In re Concepts America, Inc.

Approximately one month after the decision in Archdiocese of Saint Paul & Minneapolis, the United States Bankruptcy Court for the Norther District of Illinois issued an even more restrictive decision involving substantive consolidation, holding that the remedy is not available against any non-debtors in the Seventh Circuit.

The debtor in Concepts America was the holding and management company (the “Holding Company”) for a group of restaurants that were controlled, operated and directly or indirectly owned by two individuals, each of whom owned 50% of the stock of the Holding Company. Many of the factors traditionally relied upon by courts in a substantive consolidation analysis were present. The restaurants and the Holding Company (as well as other entities) held themselves out as a single economic unit, the various entities had common ownership and management, financial statements were consolidated, agreements among entities were not arms-length, funds were commingled,  corporate formalities were not maintained, and there were inter-company guarantees (although some courts have determined that the presence of guarantees weighs against a finding of consolidation).

The Bankruptcy Court acknowledged that while other circuits allowed substantive consolidation of non-debtors with debtors in appropriate circumstances, the Seventh Circuit had not considered the issue. The Bankruptcy Court thus considered the relevant question to be: “[w]ould the Seventh Circuit follow its sister Circuits and hold that the equitable remedy of substantive consolidation of non-debtors is permitted?”

The Bankruptcy Court relied on several cases in which the Seventh Circuit took a negative view toward a broad application of Section 105 – most notably Judge Easterbrook’s opinion in In re Kmart involving the doctrine of necessity – and a 2005 article on substantive consolidation written by Professor Douglas G. Baird that was published in the Boston College Law Review, to justify its conclusion: substantive consolidation of non-debtors is not a remedy available to a court sitting the Seventh Circuit.

While the Bankruptcy Court held that substantive consolidation was unavailable, it suggested, similarly to the Eighth Circuit, that an alter ego or ‘piercing the corporate veil’ theory might be appropriate (unlike the Archdiocese case, the movant in Concepts America included an alter ego count). Thus, in two recent decisions, courts went out of their way to suggest the availability of state law claims as an alternative to substantive consolidation. This may just be a coincidence, or it may be a trend. Perhaps it is the increased scrutiny that jurisdictional issues have received in recent years when parties attempt to bring claims against parties not otherwise before the court. Or perhaps it is the additional Supreme Court authority that Section 105 cannot be used to contravene other sections of the Bankruptcy Code. In either event, it is fair to ask if there is a growing judicial preference for state law claims as an alternative to substantive consolidation of non-debtors.

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