In a major victory for lenders, the U.S. Court of Appeals for the Third Circuit has reversed a ruling that had expanded the equitable doctrine of substantive consolidation. The Third Circuit articulated a heightened standard for substantive consolidation in In re Owens Corning, No. 04-4080 (3rd Cir., August 15, 2005), that likely will be influential to bankruptcy courts across the country.

In 1997, Credit Suisse First Boston, as agent for a syndicate of lenders (collectively, the "Banks"), extended a $2 billion unsecured loan to Owens Corning and certain of its subsidiaries. The loan was enhanced by guarantees from certain other Owens Corning subsidiaries, which provided the Banks with direct claims against the guarantors in the event of a default.

In October 2000, Owens Corning and 17 of its subsidiaries filed for protection under chapter 11 of the Bankruptcy Code. Two years later, the debtors and various other unsecured creditor groups proposed a plan of reorganization that was predicated upon the substantive consolidation of the debtors. These unsecured creditors held claims that were structurally subordinated to the Banks’ direct claims against the guarantor subsidiaries, and therefore, the creditors would have received a lesser distribution than the Banks if the debtors’ estates were not substantively consolidated. By substantively consolidating the debtors estates, all unsecured creditors, including the Banks, would share the assets of the guarantor subsidiaries pro rata.

The district court entered an order that allowed for the substantive consolidation of the Owens Corning debtors. The district judge found that the distinctions between the debtor-subsidiaries had been blurred, the Banks had not proven their reliance on the separate credit of the subsidiary guarantors, and that substantive consolidation would simplify and expedite a successful reorganization. The Banks appealed the district court’s order.

The Third Circuit recognized there were no decisions on point within the circuit and provided an extensive analysis of the tests and standards relating to substantive consolidation found in other jurisdictions. The court declined to create its own check list of factors or another test that might lead courts to "miss the forest for the trees," and instead articulated certain "principles" that should guide the analysis of whether substantive consolidation is appropriate and equitable.

These principles are as follows:

  • Respect for corporate entity separateness is a fundamental rule.
  • The harms substantive consolidation addresses is almost always caused by debtors that disregard corporate formalities.
  • Administrative convenience does not give rise to substantive consolidation.
  • Substantive consolidation is a "rough justice" remedy that should be rare and used as a last resort.
  • Although substantive consolidation may appropriately be used defensively to remedy harm resulting from entangled corporate affairs, it may not be used offensively (e.g., to disadvantage a group of creditors or alter creditor rights).

The court further held that proponents of substantive consolidation carry the burden of proving that the entities to be substantively consolidated either (i) so significantly disregarded corporate separateness pre-petition that creditors relied on the breakdown of entity borders and treated them as one legal entity, or (ii) their assets and liabilities became so entangled postpetition that separating them would be prohibitive and harmful to all creditors. On the other hand, creditor opponents to substantive consolidation "defeat a prima facie showing under the first rationale if they can prove they are adversely affected and actually relied on debtors’ separate existence."

Applying these principles, the Court held that substantive consolidation in the Owens Corning case was inappropriate because it was being used as a sword rather than a shield.

This article is presented for informational purposes only and is not intended to constitute legal advice.