United States: The Rationale Against Substantive Consolidation Of Nondebtor Entities: Florida On The Front Line

On January 10, 2012, a Florida bankruptcy court ruled in In re Pearlman, 462 B.R. 849 (Bankr. M.D. Fla. 2012), that substantive consolidation is purely a bankruptcy remedy and that it accordingly did not have the power to consolidate the estate of a debtor in bankruptcy with the assets and affairs of a nondebtor. In so ruling, the court staked out a position on a contentious issue that has created a widening rift among bankruptcy and appellate courts regarding the scope of a bankruptcy court's jurisdiction over nondebtor entities. The court's ruling is also contrary to a decision handed down by another Florida court less than a year previously in Kapila v. S & G Fin. Servs., LLC (In re S & G Fin. Servs. of S. Fla., Inc.), 451 B.R. 573 (Bankr. S.D. Fla. 2011).

SUBSTANTIVE CONSOLIDATION

Substantive consolidation streamlines the administration of interrelated bankruptcies by, among other things, eliminating intercompany claims between related debtors and duplicative claims asserted against multiple consolidated debtors. The Bankruptcy Code does not expressly authorize the remedy, although it recognizes that a chapter 11 plan may provide for the consolidation of a "debtor with one or more persons" as a means of implementation. Courts approving substantive consolidation typically authorize it under section 105(a) of the Bankruptcy Code, which provides that a court "may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions" of the Bankruptcy Code. However, because forcing creditors of one entity to share equally with creditors of a less solvent debtor is not appropriate in many circumstances, courts generally hold that substantive consolidation is to be used sparingly and have labeled it an "extraordinary remedy."

Different standards have been employed by courts to determine the propriety of substantive consolidation. In Eastgroup Properties v. Southern Motel Association, Ltd., 935 F.2d 245 (11th Cir. 1991), for example, the Eleventh Circuit Court of Appeals articulated a standard for substantive consolidation requiring a showing that: (1) there is "substantial identity" between the entities to be consolidated; and (2) substantive consolidation "is necessary to avoid some harm or to realize some benefit."

Factors that may be relevant in satisfying the first requirement include the following:

SPLIT OF AUTHORITY

There is a split of authority as to whether a bankruptcy court has the power to substantively consolidate debtors with nondebtors. The majority rule, whose adherents include the Ninth Circuit Court of Appeals and lower courts in the Sixth, Tenth, and Eleventh Circuits, permits such a consolidation under appropriate circumstances, with the caveat that increased caution should be exercised in assessing the propriety of the remedy. These courts have held that they have the power to substantively consolidate debtor and nondebtor entities on the basis of: (i) section 105's broad grant of authority; (ii) a court's ability to assert personal and subject-matter jurisdiction over nondebtors; and (iii) the bankruptcy court's mandate to "ensure the equitable treatment of all creditors." Other courts hold otherwise, citing jurisdictional concerns and/or ruling that substantive consolidation should not be used to circumvent the involuntary bankruptcy petition requirements and procedures of the Bankruptcy Code.

Pearlman

Certain creditors of Louis J. Pearlman ("Pearlman"), a manager and producer of boy bands such as the Backstreet Boys and *NSYNC, filed involuntary chapter 7 cases against Pearlman and 10 affiliated entities (collectively, the "debtors") in 2007 in Florida, contending, among other things, that the debtors were the perpetrators of a massive Ponzi scheme. Later, after the cases were converted to chapter 11, a trustee appointed in the cases filed hundreds of adversary proceedings seeking to recover millions of dollars in transfers made by the debtors as part of the scheme to individuals, banks, law firms, and vendors.

In that litigation, the trustee alleged that one or more of the debtors made transfers to the defendants in repayment of the obligations of other Pearlman entities (both debtors and nondebtors). Because the payor-debtor entities arguably did not receive any value in exchange for these payments, the trustee argued, the transfers were constructive fraudulent transfers subject to avoidance under section 548(a)(1) (B) of the Bankruptcy Code. Certain defendants seeking to ward off liability for these "wrongful payor" claims moved to substantively consolidate the debtors' estates as well as the assets of certain Pearlman-related nondebtor entities.

In an earlier ruling, the bankruptcy court had held that substantive consolidation of the debtors' estates was appropriate because their financial affairs were "inextricably interwoven." In this ruling, the court then addressed whether the same remedy could be exercised to consolidate the nondebtor entities with the debtors.

THE BANKRUPTCY COURT'S DECISION

The court ruled that it could not consolidate the debtor and nondebtor entities, providing three bases for its decision. First, the bankruptcy court explained, section 105 gives bankruptcy courts the authority to do only what is necessary or appropriate to accomplish the goals of the Bankruptcy Code; it is not a grant of "unfettered power." It is not within a court's section 105 powers, the court wrote, to "drag unwilling entities that never chose to file bankruptcy into a bankruptcy forum simply because it is expedient and will help one party or another."

Second, the court reasoned that allowing the substantive consolidation of debtors with nondebtor entities would "circumvent" the procedures laid out in the Bankruptcy Code for involuntary bankruptcies. Section 303 provides strict requirements for when and how an unwilling party can be placed into bankruptcy. "[F]orcing a non-debtor into bankruptcy via substantive consolidation," the court observed, "circumvents these strict requirements and is in contravention of" the Bankruptcy Code. The court concluded that it would be outside the scope of section 105's grant of authority for a bankruptcy court to circumvent such statutory provisions.

Finally, the court explained, state law already provides a remedy for parties who can establish that a nondebtor entity is an "alter ego" of a debtor. By "piercing the corporate veil," a court can disregard the separateness of related corporate entities under circumstances where the entities are "mere instrumentalities" of one another—a standard quite similar to the test applied for substantive consolidation. To pierce the corporate veil under Florida law, the court noted, a claimant must prove that: (1) the shareholder dominated and controlled the corporation to such a degree that the corporation did not have an independent existence and shareholders were the alter egos of the corporation; (2) the corporate form was used fraudulently or for an improper purpose; and (3) this fraudulent or improper use of the corporate form caused injury to the claimant. Although this showing is a difficult one to make in keeping with a "high regard for corporate ownership," the court wrote, the alter-ego remedy under state law is an "alternative to substantive consolidation that protects a non-debtor's corporate identity without usurping the protections of the Bankruptcy Code."

OUTLOOK

Pearlman is notable because of the limitations the bankruptcy court imposed on its powers under section 105 to assert jurisdiction over nondebtors. It is also noteworthy because the bankruptcy court in S & G Financial reached the exact opposite result less than a year earlier. In S & G Financial, the court denied a motion to dismiss a chapter 7 trustee's complaint seeking to substantively consolidate a debtor and two of its nondebtor affiliates. The court wrote that "it is well within this Court's equitable powers to allow substantive consolidation of entities under appropriate circumstances, whether or not all of those entities are debtors in bankruptcy" and that "this Court has jurisdiction over non-debtor entities to determine the propriety of an action for substantive consolidation insofar as the outcome of such proceeding could have an impact on the bankruptcy case." The Pearlman court rejected both of these rationales.

In S & G Financial, the court was dissatisfied with the alternatives (an involuntary petition under section 303 or a state-law veil-piercing suit). Requiring an involuntary petition instead of a motion for substantive consolidation, the court reasoned, would "defeat" the rationale for substantive consolidation: "to recover assets from a financially sound affiliated entity." In addition, the court distinguished between substantive consolidation and veil piercing, as the former does not require a finding that a nondebtor entity is an alter ego of the debtor.

The Pearlman court cited S & G Financial, but only in a footnote as an example of a case in which substantive consolidation of nondebtor entities was permitted. That sister bankruptcy courts in the same circuit are so at odds with respect to this issue highlights the wider controversy simmering in bankruptcy and appellate courts nationwide. As noted, among the circuit courts of appeal, only the Ninth Circuit has explicitly held that a bankruptcy court has the power to substantively consolidate debtor and nondebtor entities. No other circuit court has had occasion to rule on the issue. Conflicting rulings like Pearlman and S & G Financial suggest that appellate courts at the highest levels may soon be called upon to weigh in on this important issue.

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