November 3, 2017
Substantive consolidation is an equitable doctrine that permits a bankruptcy court, under certain circumstances, to disregard distinctions between parent companies, subsidiaries and affiliates that operate together as a corporate group. In some instances, bankruptcy courts will formally dissolve and combine the assets and liabilities of all or a portion of the entities within a corporate family, so that all assets and liabilities are actually pooled together into a single entity. More commonly, however, bankruptcy courts will permit a “deemed consolidation” of debtors, so that creditors of various entities within a corporate group simply assert their claims and vote as if assets and liabilities of the consolidated group belonged to a single entity for plan voting and distribution purposes only, but the corporate group’s elaborate structure will survive the bankruptcy case. Notwithstanding the Third Circuit’s influential opinion in In re Owens Corning—which called substantive consolidation an “extraordinary remedy” that is only rarely called for[1] and expressed strong skepticism that a deemed consolidation is ever permissible on a non-consensual basis—consensual consolidation of entities in bankruptcy, for purposes of administrative convenience and cost savings, remains a fairly common feature of corporate Ch. 11 cases.
Two recent cases may signal a renewed viability of substantive consolidation claims in non-consensual proceedings, as well. In re ADPT DFW Holdings, LLC, __ B.R. __, 2017 WL 4457439 (Bankr. N.D. Tex. Sept. 29, 2017) and Official Comm. of Unsecured Creditors of HH Liquidation, LLC v. Comvest Group Holdings, LLC (In re HH Liquidation, LLC), 2017 WL 4457404 (Bankr. D. Del. Oct. 4, 2017), each involve requests to substantively consolidate multiple subsidiaries and affiliates seeking to reorganize or liquidate in Chapter 11. ADPT DFW Holdings shows that courts may be willing to consider a more lenient standard for substantive consolidation when the proposed consolidation includes a large number of affiliated entities, while the HH Liquidation opinion displays a potential willingness to order substantive consolidation if the court believes certain entities were purposefully undercapitalized, even without evidence that corporate formalities were disrespected, and notwithstanding evidence that such consolidation would harm certain creditors.
The Northern District of Texas Bankruptcy Court’s opinion in ADPT DFW Holdings demonstrates that, at least in the Fifth Circuit, a court may apply a more lenient standard in deciding whether affiliated debtors with a large, complex corporate structure should be substantively consolidated. The court authorized the “deemed consolidation” (i.e., consolidation for the limited purpose of voting and distribution under the plan) of 140 affiliated debtors, consisting of the parent company Adeptus Health Inc., two intermediate holding companies, Adeptus Health LLC and First Choice ER, LLC, and 137 operating companies which were direct and indirect subsidiaries of First Choice ER, over the objection of an unsecured creditor.[2] Secured creditors (the “Deerfield Parties”) held claims in excess of $228 million pursuant to a prepetition credit agreement and there was an undisputed finding by the debtors’ financial advisor that the debtors’ assets were worth between $113 million and $137 million.[3] Only 80 of the debtors were liable on the $228 million of secured indebtedness. However, the court found there was evidence that, of the 60 remaining debtors, 49 were inactive or had no assets, and the remaining 11 did not have any material value.[4] Additionally, all 140 debtors were liable under a $70 million post-petition DIP loan from the Deerfield Parties. The plan provided that the Deerfield Parties would exchange their secured claim for all of the equity of the debtors. The only recovery for unsecured creditors, which included the Deerfield Parties’ $191.8 million deficiency claim, would be from a litigation trust which would receive all causes of action of the debtors, $3 million in initial funding and would likely receive another $3 million of debt financing. The court found there was evidence that a number of the causes of action that would be transferred to the litigation trust were either jointly owned by all of the debtors or would be difficult to allocate between the debtors’ various estates.
The plan provided that, solely for voting and distribution purposes, all 140 debtor entities would be substantively consolidated. An unsecured creditor with a $5 million disputed claim objected to this “deemed consolidation.” While recognizing that substantive consolidation is “an extreme and unusual remedy and should be used sparingly,”[5] the court noted that there should be a more liberal standard for so called “mega-bankruptcy” cases involving complex corporate structures.[6] Specifically, the court emphasized that this case involved 140 debtors, while Owens Corning involved only 18 debtors, stating:
While there is no magic number that should necessarily change the legal analysis surely all reasonable minds must recognize that having 140 related debtors in bankruptcy together is rare and creates unique challenges in order to both: (a) protect stakeholders’ legal rights, but at the same time (b) preserve limited resources and not unnecessarily drive up administrative expenses.[7]
By contrast, the Owens Corning opinion had stated “[f]or obvious reasons, we are loathe to entertain the argument that complex corporate families should have an expanded substantive consolidation option in bankruptcy.”[8]
The opinion notes that the Fifth Circuit has not adopted a standard for substantive consolidation and surveyed the tests used from other circuits, which included:
In ordering substantive consolidation, the court did not decide which test was appropriate, finding that substantive consolidation was warranted under either test and stated:
The preponderance of the evidence reflected that creditors tended to deal with the Debtors as a single economic unit and did not rely on their separate identity in extending credit. The preponderance of the evidence reflected that the liabilities and contracts of the Debtors were a “tangled mess” to try to unsort. Rephrased, the preponderance of the evidence reflected that creditors usually treated the Debtors as one legal entity. The preponderance of the evidence reflected that separating the Debtors would be prohibitive and hurt all creditors. The court is left to conclude that consolidation will benefit all creditors. There was no evidence of prejudice to any particular creditor. None whatsoever.[11]
It is notable, however, that while the court made a finding that the assets of the debtors were a “tangled mess,” it appears most of the work to separate the assets and liabilities of each entity had already been done by the debtors’ financial advisor in preparing schedules and statements of financial affairs for each entity.[12] Indeed, the assets, liabilities and operations of the 60 debtors not liable under the debtor’s prepetition credit agreement were sufficiently untangled for the court to make a finding that none of these entities had material assets or operations.[13]
The opinion further asserts that it was irrelevant whether the plan proposed actual substantive consolidation or only “deemed consolidation” and that “[n]o reported cases have singled this out as a special circumstance that would impact either negatively or positively the substantive consolidation analysis.”[14] Interestingly, the Owens Corning opinion that the court discusses in detail addressed nonconsensual “deemed consolidation,” stating “perhaps the most flaw most fatal to the Plan Proponents’ proposal is that the consolidation sought was ‘deemed’ (i.e., a pretend consolidation for all but the Banks)” and that “[s]uch deemed schemes we deem not Hoyle.”[15]
It is important to note that the ADPT DFW Holdings court emphasizes in numerous places that, because the Deerfield Parties were undersecured, and the primary distribution to unsecured creditors would be on account of the causes of action owned by all of the debtors’ estates, substantive consolidation did not harm any creditor in this case.[16] The court could have explicitly limited its holding under the harm-balancing test and held that, in this circumstance, deemed consolidation was appropriate because no creditor was harmed, particularly since the primary asset unsecured creditors could recover from were causes of action jointly owned by all of the debtors. However, it did not do so, and, accordingly, practitioners should be aware that, at least in the Fifth Circuit, (i) there may be a greater risk of substantive consolidation to large corporate groups of debtors and (ii) nonconsensual “deemed consolidation” may be granted under a broader set of circumstances than previously thought.
The Delaware bankruptcy court’s opinion in HH Liquidation demonstrates that, while substantive consolidation may be rarely granted, if a creditor can convincingly argue that the debtors have purposefully undercapitalized certain entities, it may be difficult to dismiss claims for substantive consolidation at the summary judgment stage. The case involves an attempt to substantively consolidate the holding-company debtor Haggen Holdings, LLC (“Holdings”) and its subsidiary debtors, all of which were operating companies of 146 grocery stores (the “OpCo Entities”), with affiliated non-debtors who owned and leased the stores to the Opco Entities (the “PropCo Entities”).[17] In February 2015, Holdings and its subsidiaries (“Haggen”) acquired the operational assets (including leases with third parties) for 146 grocery stores and placed the operational assets into the OpCo Entities (the “Acquisition”).[18] As part of the Acquisition, Haggens also acquired the real estate for 67 of the stores, of which 53 were located on property owned in fee simple by the sellers and 14 on property subject to long term ground leases. Twenty-eight of these properties were placed in the PropCo Entities, and the remaining 39 were sold to two third parties who entered into long term leases with the OpCo Entities.[19] Holdings guaranteed the OpCo Entities performance under these agreements.[20]
The creditors committee (the “Committee”) filed an adversary proceeding against Haggen and its shareholders (the “Defendants”) requesting, among other claims, substantive consolidation of Holdings and the OpCo entities with the non-debtor PropCo entities.[21] The Defendants moved for partial summary judgment on the substantive consolidation claims arguing that (i) substantive consolidation is an extreme remedy which courts should rarely employ and (ii) substantive consolidation would reduce the recovery of the creditors of Holdings from 100% to as little as 21%, while granting a windfall to creditors of the OpCo entities, who would receive a 20% recovery rather than nothing,[22] and (iii) it was not permissible to substantively consolidate debtors with non-debtors.[23]
At the outset, the court noted that Owens Corning does not prohibit substantive consolidation between debtor and non-debtor entities, stating that “the great weight of cases authorizes substantive consolidation of debtors and non-debtors[.]”[24] In denying summary judgment, the court observed that this was a problem the Defendants created themselves by segregating the operational assets from the real property assets Haggen acquired in the Acquisition, stating that, in a matter of a few months after the Acquisition, “the OpCo Entities were bankrupt and are unable to pay unsecured creditors anything while the PropCo Entities are flush with money. The Court and the OpCo Entities’ creditors need to see evidence at trial of why and how this happened.”[25] Regarding the argument that Holdings’ creditors would be harmed, while creditors of the OpCo Entities would receive a windfall, the court stated that both the Committee and the Defendants would have an opportunity to prove at trial what they knew and relied on and that, after trial “the Court will be in a better position to determine the creditors’ recovery rights. It is premature for the Court to make the determination on substantive consolidation now.”[26]
The HH Liquidation opinion is notable because it does not cite the Owens Corning two-part test for substantive consolidation, and there did not appear to be any showing that either (a) pre-petition, the entities to be consolidated “disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity,” or (b) post-petition, the “assets and liabilities [of such entities] are so scrambled that separating them is prohibitive and hurts all creditors.”[27] Instead, the court appeared to hold that it was not appropriate to grant summary judgment because it appeared that, in structuring the OpCo Entities and the PropCo Entities, Defendants had underfunded the OpCo Entities to the benefit of the PropCo Entities.[28]
These cases demonstrate that, in certain circumstances, substantive consolidation may not be as rare a remedy as commonly believed. Specifically, practitioners advising a large number of potential affiliated debtors should be aware that ADPT DFW Holdings may be cited to argue a more lenient standard for substantive consolidation should apply. Additionally, those advising clients considering an OpCo/PropCo structure should be cognizant of the potential risk of substantive consolidation based solely on undercapitalizing OpCo entities.
[1] 419 F.3d 195, 211 (3d Cir. 2005) (“[B]ecause substantive consolidation is extreme (it may affect profoundly creditors’ rights and recoveries) and imprecise, this ‘rough justice’ remedy should be rare and, in any event, one of last resort after considering and rejecting other remedies”).
[2] ADPT DFW Holdings, 2017 WL 4457439, at *1-2.
[7] Id. at *12 (emphasis in original).
[8] Owens Corning, 419 F.3d at 215.
[9] ADPT DFW Holdings, 2017 WL 4457439, at *9.
[11] Id. at *14 (emphasis in original).
[12] Id. at *13 (“there was credible evidence that preparing separate Schedules and SOFAs was very difficult for the Debtors’ financial advisors.”).
[14] ADPT DFW Holdings, 2017 WL 4457439, at *14.
[15] Owens Corning, 419 F.3d at 216.
[16] See, e.g., ADPT DFW Holdings, 2017 WL 4457439, at *12 (finding that a “hugely significant observation is that” no one challenged the valuation of the debtors assets at roughly $100 million below the secured debt, and, of the debtors who not liable under the secured debt facility, none had any material value.); Id. at *14 (“There was no evidence of prejudice to any particular creditor. None whatsoever.”); Id. at *14 (“[P]articularly since the causes of action that will produce most of the recovery to stakeholders have been determined to be owned by all Debtor estates—the court approves substantive consolidation.”).
[17] HH Liquidation, 2017 WL 4457404, at *3.
[22] The opinion does not address any potential harm to the creditors of the PropCo Entities, but, consolidation of the PropCo Entities with Holdings and the OpCo Entities would presumably also harm the creditors of the PropCo Entities.
[23] HH Liquidation, 2017 WL 4457404, at *3.
[27] Owens Corning, 419 F.3d at 211.
The following Gibson Dunn lawyers assisted in preparing this client update: Matthew K. Kelsey, Samuel A. Newman, Daniel B. Denny and Dylan S. Cassidy.
Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following:
Matthew K. Kelsey – New York (+1 212-351-2615, [email protected])
Samuel A. Newman – Los Angeles (+1 213-229-7644, [email protected])
Daniel B. Denny – Los Angeles (+1 213-229-7646, [email protected])
Please also feel free to contact the following practice group leaders:
Business Restructuring and Reorganization Group:
Michael A. Rosenthal – New York (+1 212-351-3969, [email protected])
Jeffrey C. Krause – Los Angeles (+1 213-229-7995, [email protected])
Robert A. Klyman – Los Angeles (+1 213-229-7562, [email protected])
David M. Feldman – New York (+1 212-351-2366, [email protected])
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