In re Raejean S. Bonham dba World Plus
Bankruptcy No. F95-00897
Unofficial Web Site
On April 10, 1998 Bankruptcy Judge Herbert A. Ross issued an 89 page memorandum decision granting the trustee's Motion for Substantive Consolidation. Because of the length of the decision, it is broken into two parts, linkedthrough the Table of Contents. Part I contains the Introduction and Facts; Part II contains the Issues, Legal Analysis and Conclusion. NOTE: Formatting here is slightly different than in the printed version because of the limitations of hypertext markup language, the formatting code for the World Wide Web.
THIS IS PART II
GO TO PART I
UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF ALASKA
605 West 4th Avenue, Room 138, Anchorage, AK 99501-2296 (Phone
907/271-2655)
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In re |
Case No. F95-00897-HAR |
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RAEJEAN BONHAM, aka Jean Bonham, aka Jeannie Bonham, dba World Plus, Debtor(s) |
MEMORANDUM DECISION FOR ALLOWANCE OF SUBSTANTIVE CONSOLIDATION |
The principal issues are:
Part 4.1 of this Memorandum Decision is introductory, spelling out some of the basics.
In Part 4.2, I discuss the distinction between the federal bankruptcy concept of substantive consolidation and the state law theories of alter ego, corporate veil piercing and reverse piercing.
I have included a long section, about 33 pages in Parts 4.3, 4.4 and 4.5 of this Memorandum Decision to review the case law of substantive consolidation: (a) pre-Code, (b) after the 1978 Bankruptcy Code became effective, and (c) relating specifically to non-debtor consolidation. In these sections, I do not attempt to any great degree to reflect on how these cases relate to the Bonham, WPI and APFC facts.
Rather, in Part 4.6 (relating to procedure), Part 4.7 (discussing the merits of substantive consolidation in this case), and Part 4.8 (discussing the nunc pro tunc or effective date issue), I will attempt to relate the law to the specific case before the court.
4.1. A Bankruptcy Court Has Authority to Order Substantive Consolidation of Entities (Usually All of Them Debtors) in an Appropriate Case-
Substantive consolidation has long been part of the fabric of bankruptcy law. 2 Collier on Bankruptcy, ¶ 105.04[2], fn18 (Matthew Bender 15th ed rev 1998):
Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215, 61 S. Ct. 904, 85 L. Ed. 1293 (1940). In Sampsell, the Court upheld the bankruptcy referee's consolidation of the estate of the individual debtor with the assets of a nondebtor corporation which was wholly owned by the debtor and his family. In upholding consolidation, the Court noted that the "power of the bankruptcy court to subordinate claims or to adjudicate equities arising out of the relationship between the several creditors is complete." 313 U.S. 215, 219, 61 S. Ct. 904, 907, 85 L. Ed. 1293, 1298.
Sampsell involves the merger of the assets and claims of separate estates (including the estate of a non-debtor).
The source of the authority to substantively consolidate has been found in the general equitable powers of the court, now embodied in 11 USC § 105(a). Sampsell; In re Augie/Restivo Baking Co., Ltd., 860 F2d 515, 518 (2nd Cir 1988); Matter of Munford, 115 BR 390, 397 (Bankr ND Ga 1990).
Thus, in general, there is little doubt that a bankruptcy court has authority to grant substantive consolidation of separate bankruptcy estates into one estate. Also, in what appears to be a slight majority of the cases which have decided the issue, courts have held that the estate of a non-debtor can be consolidated into that of a debtor under the appropriate circumstances.
"[Substantive consolidation] involves the pooling of the assets and liabilities of two or more related entities; the liabilities of the entities involved are then satisfied from the common pool of assets created by consolidation." Eastgroup Properties v Southern Motel Assoc., Ltd., 935 F2d 425, 428 (11th Cir 1991). There are winners and losers in the process. The creditors of the poorer estates may benefit from the pooling of assets of a more solvent estate, and those from the more financially solvent estates will be diluted. Flora Mir Candy Corp. v R. S. Dickson & Co., 432 F2d 1060, 1062-63 (2nd Cir 1970).
Substantive consolidation should not be used as a mere device of convenience, e.g., to overcome accounting difficulties, where it would unfairly impair the vested rights of some of the creditors. In re Augie/Restivo Baking Co., Ltd., 860 F2d 515, 518 (2nd Cir 1988); Flora Mir Candy Corp., 432 F2d at 1062. Because of the possibility for such inequities, it should be used sparingly. Chemical Bank New York Trust Co. v Kheel, 369 F2d 845, 847 (2d Cir 1966); Matter of New Center Hospital, 187 BR 560, 567 (ED Mich 1995). In general, a court should be convinced that injustice would occur absent consolidation. See, In re Snider Bros., Inc., 18 BR 230, 235 (Bankr D Mass 1982), analyzing Soviero v Franklin Nat'l Bank, 328 F2d 446 (2d Cir 1964).
However, the rights of a class of creditors of one of the entities can be protected, even though the cases are substantively consolidated. Not all classes of creditors have to be treated equally. For example, the security interest of a creditor in the assets of one of the entities may be protected so the interest is not diluted (nor improved) by the consolidation. In re Continental Vending Machine Corp., 517 F2d 997, 1001 (2nd Cir 1972); In re Tureaud, 45 BR 658 (Bankr ND Okla 1985), affd 59 BR 973 (1986).
The only sections of the 1978 Bankruptcy Code which even mention substantive consolidation are 11 USC § 302(b), involving the joint cases of spouses, and § 1123(a)(5)(C), stating that a chapter 11 plan may provide for the consolidation or merger of a debtor with one or more persons.
FRBP 1015(b) allows the court to order joint administration of certain related debtors, but the Advisory Notes make it clear that substantive consolidation is neither authorized or prohibited by the rule. Thus, the doctrine of substantive consolidation has been shaped by the case law as I have outlined in Parts 4.3, 4.4, and 4.5 of this Memorandum Decision.
After reading many of these cases, I tend to agree with the court that said precedent alone is of limited value because of the diversity of factual patterns. In re Reider, 31 F3d 1103, 1108 (11th Cir 1994). The results in the cases are fact driven.
4.2. Substantive Consolidation Should be Distinguished from State Law Alter Ego Remedies-
The parties opposing substantive consolidation have all been sued by the trustee to recover funds on various avoidance theories. They are defendants in the Bonham Recovery Actions (the BRA), the lead case for case management purposes under complex litigation procedures. Among the defenses they have raised is that the trustee is attempting to enforce an alter ego remedy which is not a prerogative of the bankruptcy trustee. They argue that the right to pursue this remedy belongs to the individual creditors of WPI and APFC, corporations which RaeJean Bonham used to obtain a large part of the investments she received before she was shut down in late 1995. In other words, they say the trustee has no standing to pursue avoidance claims.
Some of these defendants cite Williams v California 1st Bank, 859 F2d 664 (9th Cir 1988), In re Ozark Restaurant Equipment Co., Inc., 816 F2d 1222 (8th Cir 1987), cert den 484 US 848, 108 SCt 147 (1987); and Caplin v Marine Midland Grace Trust Co., 406 US 416 (1972), as dispositive because the trustee has no authority to assert a creditor's individual rights against WPI and APFC under Alaska law. They cite Croxton v Crowley Maritime Corp., 817 P2d 460, 466 (Alaska 1991), for the proposition that Alaska has rejected reverse piercing of a corporate entity. See, Docket Entry 1105, Supplemental Memorandum in Opposition to Trustee's Motion For Substantive Consolidation Re: Alter Ego Issues (filed by Randolph Haines for various defendants).
Others make similar arguments. See, Docket Entry 1108, Joinder and Supplement to "Response and Objection to Trustee's Motion for Substantive Consolidation" (filed by Brad Ambarian for various defendants). They cite Norman v Nichero Gyogyo Kaisha, Ltd., 645 P2d 191, 196 (Alaska 1982); Arctic Contractors, Inc. v State of Alaska, 573 P2d 1385, 1386 (Alaska 1978); Martin v Maldonado, 572 P2d 763, 773 (Alaska 1977).
The trustee need not dispute these cases because they do not address the federal bankruptcy law concept of substantive consolidation, and deal only with the state law regarding alter ego, piercing and reverse piercing of corporate entities.
The difference between corporate veil piercing and the bankruptcy concept of substantive consolidation is succinctly stated by J. Stephen Gilbert, Note: Substantive Consolidation in Bankruptcy: A Primer, 43 Vand L Rev 207, 218 and fn 77-81:
2. Misplaced Analogy to Corporate LawThe factors evaluated on a motion for substantive consolidation appear similar to an analysis of piercing the corporate veil. Like piercing the corporate veil, substantive consolidation ignores artificial structures legally defining the consolidated entities. Ultimately, however, such an analogy is misplaced because the corporate law doctrine of limited liability is not involved. Rather, substantive consolidation is more like the corporate law notion of enterprise liability because substantive consolidation does not seek to hold shareholders liable for the acts of their incorporated entity. [FN79] Substantive consolidation more closely resembles the bankruptcy rule of subordination because competition for the consolidated assets is between creditors alone. Thus, substantive consolidation ignores artificial legal structures but looks only to the combined assets of the consolidated entities for satisfaction of all claims against the collective group. [footnotes omitted]
See, In re Creditors Services Corp., 195 BR 680, 689 (Bankr SD Ohio 1996); In re Kroh, 117 BR 499, 501-2 (WD Mo 1989) ("The result [the bankruptcy judge] reaches may be close to the practice forbidden in Ozark Restaurant, but it is distinctly different."); In re DRW Property Co. 82, 54 BR 489, 496 fn2 (Bankr ND Tex 1985).
The law of substantive consolidation is federal bankruptcy law. In some cases, an alter ego analysis is involved in determining if entities should be consolidated. The use of an alter ego analysis does not, however, deprive the bankruptcy court of jurisdiction to consider substantive consolidation.
4.3. Early Development of the Case Law of Substantive Consolidation-
The law of substantive consolidation has been developed over the course of almost 60 years in a number of circuit and lower court cases. In this Part 4.3 of this Memorandum Decision, I will discuss some of the pre-Code cases. Many, but not all, of these pre-Code cases involve the consolidation of the estates of entities that were already debtors. Some of the most important ones involve the substantive consolidation of non-debtors.
In Part 4.4, I will review some of the circuit cases and key lower court cases decided after the 1978 Bankruptcy Code.
After that, in Part 4.5, I will focus on the case law under the 1978 Bankruptcy Code involving the consolidation of non-debtor entities with existing bankruptcy debtor estates. These are mostly lower court opinions.
Here is a thumbnail sketch of some of the key concepts which arise from the seminal pre-Code cases. Substantive consolidation was fashioned as a device to combat the commission of fraud upon creditors which might go uncorrected in its absence. See, e.g., Sampsell v Imperial Paper, in which consolidation was used to thwart a non-debtor from walking away with the assets which rightfully should have belonged to a bankrupt corporation, but were obtained through fraudulent transfers by insiders.
Substantive consolidation was also used as a practical device where the identity of assets and liabilities of separate entities were badly intermingled by poorly kept accounting records, disregard of corporate formalities, and sloppy business procedures in general. The accounting cost of untangling these estates might well eat up the amount available for creditors, so consolidation was a practical way to maximize the recovery for the creditors.
There is, however, a need to balance these worthy goals of overcoming fraud or maximizing the recovery where the entities are hopelessly entangled, so that they do not overshadow or defeat the vested rights of innocent creditors.
Circuit Judge Friendly of the 2nd Circuit took a conservative approach, giving more deference to the secured creditors (or, those with guaranties, for example) than the general body of unsecured creditors, even though the bottom line for the total recovery might be less. This is discussed in the Kheel and Flora Mir Candy Corp. cases reviewed later in this Part 4.3.
Over time, the circuit courts and some lower courts have developed some tests or guidelines to determine if substantive consolidation is appropriate in a given case. These tests vary slightly, but it is fair to say the decision in a given case is heavily dependent on the facts of the individual case. Some of the tests are discussed in Part 4.4.
Here are the earlier cases. As they are reviewed, many of the facts found in Part 2 concerning RaeJean Bonham, WPI, and APFC should come to mind. It is not difficult to see the application of these cases to Bonham.
Fish v East- One of the earliest cases is Fish v East, 114 F2d 177 (10th Cir 1940). The court approved substantive consolidation of a non-debtor which was an "instrumentality" of the debtor.
The case, like the Bonham case, involved the consolidation of a non-debtor. There was a motion to consolidate a wholly owned subsidiary, Tiger Placers Company (Placer), and a related partnership, Blue Ridge Co., with the debtor parent, Royal Tiger Mines Company (Mines).
Although there was a commonality of principals in Mines and Placer, when Mines began having financial difficulties and could not raise funds, the principals bailed out of Mines and transferred assets to Placer and Blue Ridge, also owned by the insiders. The effect was to divert assets from the Mines' creditors in a very manipulative way. The 10th Circuit affirmed consolidation, indicating, Id. at 191:
Corporate entity may be disregarded where not to do so will defeat public convenience, justify wrong or protect fraud. [citations omitted] The board of each company was at all times made up of members of the dominating group of their employees or their attorneys.
. . . The instrumentality rule here has application. The determination as to whether a subsidiary is an instrumentality is primarily a question of fact and degree. The following determinative circumstances are recognized:
(1) The parent corporation owns all or majority of the capital stock of the subsidiary. (2) The parent and subsidiary corporations have common directors or officers. (3) The parent corporation finances the subsidiary. (4) The parent corporation subscribes to all the capital stock of the subsidiary or otherwise causes its incorporation. (5) The subsidiary has grossly inadequate capital. (6) The parent corporation pays the salaries or expenses or losses of the subsidiary. (7) The subsidiary has substantially no business except with the parent corporation or no assets except those conveyed to it by the parent corporation. (8) In the papers of the parent corporation, and in the statements of its officers, 'the subsidiary' is referred to as such or as a department or division. (9) The directors or executives of the subsidiary do not act independently in the interest of the subsidiary but take direction from the parent corporation. (10) The formal legal requirements of the subsidiary as a separate and independent corporation are not observed.
Sampsell v Imperial Paper & Color Corp.- See, discussion in Part 4.2 of this Memorandum Decision. In Sampsell v Imperial Paper & Color Corp., 313 US 215, 61 S Ct 904, 85 L Ed 1293 (1940), substantive consolidation was approved to circumvent the debtor's fraudulent transfer of assets to a non-debtor entity held by insiders.
Stone v Eacho- Another earlier case was Stone v Eacho, 127 F2d 284 (4th Cir 1942), reh den 128 F2d 16 (4th Cir 1942), cert den 317 US 635 (1942). Tip Top Tailors, a New Jersey corporation, was a bankrupt in a Delaware bankruptcy. Its subsidiary, also named Tip Top Tailors, was a bankrupt in a separate Virginia proceeding.
The Delaware trustee sought to consolidate the cases. Both corporations were insolvent. The Virginia corporation was almost completely financed through the parent New Jersey store, which maintained the inventory, did the actual tailoring, and paid the bills. The court found that the subsidiary was not treated as a separate entity and the creditors dealt with the parent and subsidiary as one. The court said, Id. at 288:
It is well settled that courts will not be blinded by corporate forms nor permit them to be used to defeat public convenience, justify wrong or perpetrate fraud, but will look through the forms and behind the corporate entities involved to deal with the situation as justice may require. [citations omitted]
Not only is this done for the purpose of holding a stockholder or parent corporation for debts created by an insolvent corporate agent or subsidiary which is a mere instrumentality of the stockholder or parent, but also for the purpose of allowing the creditors of the stockholder or parent to reach assets held by such a subsidiary. [citations omitted]
Soviero v Franklin National Bank- Soviero v Franklin National Bank of Long Island, 328 F2d 446 (2nd Cir 1964), is the first of three important 2nd Circuit cases regarding substantive consolidation.
A bankruptcy trustee of Raphan Carpet Corporation sought the adjudication of assets of thirteen separate corporations, each having "Raphan" in its corporate name. Although the corporations filed separate tax returns and kept separate books, they were done by the same accountants. The corporations were run very loosely. There were no minutes. The principals of the corporations treated them as a consolidated business. All the affiliated corporations issued consolidated financial statements on which they listed their assets without separation.
Though suppliers shipped to affiliated corporations, all the billing was to the bankrupt. The bankrupt paid for advertising, labor, insurance, and other costs. The court said, Id. at 448:
It is difficult to imagine a better example of commingling of assets and functions and of the flagrant disregard of corporate forms than as here demonstrated by the bankrupt. One gains the distinct impression that the bankrupt held up the veils of the fourteen collateral corporations primarily, if not solely, for the benefit of the tax gatherer, but otherwise completely disregarded them. Even Salome's could not have been more diaphanous. On these facts, we are convinced that the claims of individual corporate entities advanced for the Affiliates and Realty are 'without color of merit, and a mere pretense.' [citations omitted]
Chemical Bank New York Trust Co. v Kheel- In Chemical Bank New York Trust Co. v Kheel, 369 F2d 845 (2nd Cir 1966), a shipping magnate owned a number of corporations engaged in the shipping trade. All were in Chapter X under the Bankruptcy Act. Reorganization was not successful and a reorganization trustee was in the process of liquidation. The trustee sought to consolidate and Chemical Bank opposed the motion.
The corporations were operated very loosely as figureheads for the shipping magnate. No attention was paid to corporate formalities. Funds were transferred back and forth in a very complex pattern, and in a manner which would have been very difficult to trace.
Chemical Bank was trustee for bondholders under a secured indenture. Chemical Bank questioned the referee's decision to order consolidation where it was not shown that Chemical Bank had dealt with all the corporations as a unit. The court said, however, Id. at 847:
We find no such limitation on the power of the reorganization court. See Soviero, Trustee v. Franklin National Bank of Long Island, 328 F.2d 446 (2nd Cir. 1964); Stone v. Eacho, 127 F.2d 284 (4th Cir.), rehearing denied 128 F.2d 16, cert. denied 317 U.S. 635, 63 S.Ct. 54, 87 L.Ed. 512 (1942). While the record in the Soviero case indicates that there was evidence that the Bank had dealt with the bankrupt and its affiliates as one, the opinion does not make this a necessary foundation for the result. Moreover, we have here an additional factor not present in Soviero or Stone v. Eacho, the expense and difficulty amounting to practical impossibility of reconstructing the financial records of the debtors to determine intercorporate claims, liabilities and ownership of assets. The power to consolidate should be used sparingly because of the possibility of unfair treatment of creditors of a corporate debtor who have dealt solely with that debtor without knowledge of its interrelationship with others. Yet in the rare case such as this, where the interrelationships of the group are hopelessly obscured and the time and expense necessary even to attempt to unscramble them so substantial as to threaten the realization of any net assets for all the creditors, equity is not helpless to reach a rough approximation of justice to some rather than deny any to all.
While Circuit Judge Friendly concurred, he criticized the majority's reasoning as focusing too much on the complexities of the accounting at the expense of the rights of individual creditors who might have dealt separately with certain of the corporations. He concurred with the result, however, on the ground that Chemical Bank apparently did not establish such a reliance which he apparently thought was its obligation to prove.
Flora Mir Candy Corp. v R.S. Dickson & Co.- The third landmark 2nd Circuit case is Flora Mir Candy Corp. v R. S. Dickson & Co., 432 F2d 1060 (2nd Cir 1970), authored by Judge Friendly. In this case, Judge Friendly's deference to the creditors' reliance on the assets of one of the corporate entities prevailed, notwithstanding a situation where the books and records were extremely difficult to sort out.
Debentures had been issued by Meadors, Inc., six years before it was acquired by an intermediate corporate buyer. Subsequently, Meadors was sold to Flora Mir Candy Corporation, which was engaged in a corporate acquisition program. About 7_ years after the debentures had been issued by Meadors, Flora Mir and related companies, including Meadors, filed for Chapter XI in the Southern District of New York. Prior to the bankruptcies, however, the Meadors' bondholders had sued several of the Flora Mir companies and Meadors for fraud in a South Carolina court.
The substantive consolidation would have diluted the bondholders' recovery. It would have had the effect of eliminating the intercompany transfers and allowed other creditors to share in any recovery which was rightfully the bondholders.
It was argued in favor of substantive consolidation that it would result in a much quicker arrangement than working through the complexities of an accounting. Although a speedy reorganization might have been desirable, the court held that a quicker or easier arrangement should not be accomplished at the expense of Meadors' debenture holders.
The principal to be derived is that the complexities of untangling the accounting is insufficient reason in some cases to grant substantive consolidation where creditors' vested rights are harmed in the process.
In re Gulfco Investment Corporation- Similarly, in In re Gulfco Investment Corporation, 593 F2d 921 (10th Cir 1979), a court was faced with a convoluted corporate structure as shown on an organizational chart at the end of the case. Id. at 932. A trial court had ordered consolidation, but the 5th Circuit reversed. The bankruptcy court principally based its decision to grant substantive consolidation on the complex accounting issues and difficulties in evaluating intercompany accounts and determining the assets and liabilities of each corporation. The bankruptcy court found that accounting difficulties were of such a magnitude that they outweighed any individual equitable problems that might have occurred.
The consolidation in Gulfco, however, would have eliminated the security interests of some creditors and also eliminated certain guarantees made by one of the debtor corporations to secure the debt of another debtor corporation. The 5th Circuit held that the trial court had not given enough weight to the rights of the secured claimants and the guarantees. Where the corporation guarantees the debts of a sub or affiliate, a creditor is deprived of multiple recoveries from the various layers of corporations by their consolidation. In the consolidation, the creditor is reduced to one claim. The court held that this should not be done except in compelling circumstances. The circumstances, though severe, were not compelling enough to override the creditors' rights which would have been diluted in the consolidation process.
4.4. Substantive Consolidation Cases Under The Bankruptcy Code-
After the adoption of the 1978 Bankruptcy Code, the courts have struggled to articulate a test to govern whether to grant substantive consolidation. I will discuss two of the leading circuit court cases and a few of the often cited bankruptcy court cases.
The circuit court cases which attempted to articulate a test to determine if substantive consolidation is appropriate are In re Augie/Restivo Baking Co., Ltd. from the 2nd Circuit and Eastgroup Properties v Southern Motel Assoc., Ltd. from the 11th Circuit. There are no 9th Circuit cases requiring that a particular test be used. The bankruptcy court cases are In re Snider from Massachusetts and In re Vecco from Virginia.
In re Vecco Construction Industries, Inc.- In In re Vecco Construction Industries, Inc., 4 BR 407 (Bankr ED Va 1980), the court attempted to fashion a general test based on the pre-Code cases discussed in part 4.3. The parent and four subsidiaries were engaged in the concrete construction business in different locations and in providing labor for those businesses. Over a year before the bankruptcy, the parent had acquired all the assets of the subs in a de facto consolidation. After filing chapter XI for the parent and chapter 11s for the subsidiaries, the debtors moved to substantively consolidate. The motion was unopposed. The court endorsed the "liberal trend" in allowing consolidations from the widespread use of interrelated corporations operating under the parent's shield for tax and business purposes. Vecco at 409.
And, the court came up with a seven-part test to determine if a case should be substantively consolidated, Vecco at 410:
First, the degree of difficulty in segregating and ascertaining individual assets and liability. Second, the presence or absence of consolidated financial statements. Third, the profitability of consolidation at a single physical location. Fourth, the commingling of assets and business functions. Fifth, the unity of interests and ownership between the various corporate entities. Sixth, the existence of parent and inter-corporate guarantees on loans. Seventh, the transfer of assets without formal observance of corporate formalities.
In re Snider Bros., Inc.- In In re Snider Bros., Inc., 18 BR 230 (Bankr D Mass 1982), the creditors' committees of six integrated, family-run businesses involved in purchasing and slaughtering beef, sought substantive consolidation. Only a secured creditor objected. The separate companies operated in different phases of the beef industry, and kept separate books. They operated from one location. There were intercompany loans and guarantees. The committees sought consolidation so the businesses could be better marketed.
The objecting secured creditor's complaint that it would be diluted by $70,000 was not refuted, but the committees argued that the bank had dealt with the debtors as a unit.
The court denied substantive consolidation. Acknowledging the attempt of some courts, like Vecco Construction, to set out a test based on various criteria, the court said, Id. at 234:
I find that the only real criterion is . . . the economic prejudice of continued debtor separateness versus the economic prejudice of consolidation. There is no one set of elements which, if established, will mandate consolidation in every instance. Moreover, the fact that corporate formalities may have been ignored, or that different debtors are associated in business in some way, does not by itself lead inevitably to the conclusion that it would be equitable to merge otherwise separate estates.
The commingling of assets and flagrant disregard of corporate forms is not, itself, enough to justify consolidation. Rather, it is "the injustice to creditors if consolidation is not permitted." Id. at 235. The proponent of consolidation must show the harm which arose from the intermingling or the unity of interest. Id. at 238.
Once a proponent has established a case for substantive consolidation, it is still possible to raise a defense that, Id. at 238:
. . . there is still the matter of the defense that the benefits of consolidation do not outweigh the harm to be caused to the objector. A creditor who has looked solely to the credit of its debtor and who is certain to suffer more than minimal harm as a result of consolidation may be entitled to denial of a request for consolidation.
Thus, consolidation was denied, even without reference to the objection of the secured creditor. The corporations had not been flagrant in disregarding corporate formality. They kept separate books. Their method of operation was similar to many family-run businesses.
Augie/Restivo Baking Co., Ltd.- In re Augie/Restivo Baking Co., Ltd., 860 F2d 515 (2nd Cir 1988), involved the bankruptcies of several corporations. Before they combined operations, Augie's Baking Company, Ltd. and Restivo Brothers Bakers, Inc. operated separately in different boroughs in New York City. Augie's Baking sold its stock to Restivo and the company adopted the Augie/Restivo name. Augie's Baking had been financed by Union Bank and Restivo was heavily financed by Manufacturers Hanover Trust Company (MHTC). No formal merger had ever taken place. The land that Augie's Baking owned was still in its name. Accounts had not been formally transferred.
After the combination, the new Augie/Restivo operated in its own name and did not use Augie's separate name. After the bankruptcy case was filed, numerous cash collateral orders between Augie/Restivo and MHTC were entered into with a result that all of its prepetition accounts receivable claims had been transferred to priority administrative claims under the cash collateral orders.
Apparently, it was necessary to seek consolidation to confirm a plan because Union Bank objected. It objected on the grounds that a consolidation would have diluted its recovery. The circuit court agreed with Union Bank. It reviewed the 2nd Circuit cases, which are outlined in Part 4.3 of this Memorandum. It distilled the cases into the following test, Augie/Restivo at 518:
An examination of those cases, however, reveals that these considerations are merely variants on two critical factors: (i) whether creditors dealt with the entities as a single economic unit and "did not rely on their separate identity in extending credit," or (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors. [citations omitted]
The court found that the affairs were not so entangled that they could not be understood without enormous effort (i.e., not nearly as bad as those in Chemical Bank New York v Kheel), and determined that Union Bank had in fact dealt with Augie's Baking as a separate entity. For that reason, consolidation was denied.
Eastgroup Properties v Southern Motel Assoc., Ltd.- In Eastgroup Properties v Southern Motel Assoc., Ltd., 935 F2d 245 (11th Cir 1991), Gainsville P-H Properties (GPH) and Southern Motel Association (SMA) were commonly owed. They filed chapter 11 cases, but were converted to chapter 7 cases. The chapter 7 trustee sought to substantively consolidate them. Eastgroup, a creditor of SMA, objected.
SMA and GPH operated out of the same office, and GPH employees performed services for SMA. They had written agreements about the operation of eleven motel properties, five of which SMA had leased from Eastgroup. GPH paid some of SMA's obligations and there were intercompany transfers.
On what appears to be rather weak evidence, the bankruptcy court granted the motion for substantive consolidation, to prevent the SMA equity holders from realizing a bankruptcy dividend while the GPH creditors would not be paid. In fact, the mathematics of the SMA and GPH cases indicated that both cases were administratively insolvent, let alone paying prepetition creditors or equity holders.
In Eastgroup Properties, the court noted, at 248-49:
There is, however, a "modern" or "liberal" trend toward allowing substantive consolidation, which has its genesis in the increased judicial recognition of the widespread use of interrelated corporate structures by subsidiary corporations operating under a parent entity's corporate umbrella for tax and business purposes. [footnote omitted]
The 11th Circuit Court then stated the test it would use, adopting a standard set out in In re Auto-Train Corp., 810 F2d 270, 276 (DC Cir 1987). Eastgroup said, at 249:
Under this standard, the proponent of substantive consolidation must show that (1) there is substantial identity between the entities to be consolidated; and (2) consolidation is necessary to avoid some harm or to realize some benefit. When this showing is made, a presumption arises "that creditors have not relied solely on the credit of one of the entities involved." Once the proponent has made this prima facie case for consolidation, the burden shifts to an objecting creditor to show that (1) it has relied on the separate credit of one of the entities to be consolidated; and (2) it will be prejudiced by substantive consolidation. . . . Finally, if an objecting creditor has made this showing, "the court may order consolidation only if it determines that the demonstrated benefits of consolidation 'heavily' outweigh the harm." [omitting internal and citations]4.5. Substantive Consolidation of Non-Debtors Under the Bankruptcy Code.-
Some of early substantive consolidation cases involved the consolidation of non-debtors. These include Sampsell v Imperial Paper Corp., 313 US 215, 61 SCt 904 (1941); Fish v East, 114 F2d 177 (10th Cir 1940); and Soviero v Franklin National Bank of Long Island, 328 F2d 446 (2nd Cir 1964).
Since the inception of the 1978 Bankruptcy Code, over a dozen cases have considered the issue of substantively consolidating non-debtors into an existing bankruptcy case. These cases have built on the pre-Code cases described in Part 4.3 and those decided since the 1978 Bankruptcy Code went into effect, such as those described in Part 4.4.
Most of the non-debtor cases acknowledge that consolidating a non-debtor's estate with the case of an existing debtor is a much more sensitive matter than consolidating existing debtors. If substantive consolidation of existing bankruptcy debtors is to be applied cautiously, even more care should be taken with respect to consolidating non-debtors. See, Christopher J. Predko, Note: Substantive Consolidation Involving Non-Debtors: Conceptual and Jurisdictional Difficulties In Bankruptcy, 41 Wayne Law Review, 1741 (Summer 1995). Nonetheless, there are cases in which substantive consolidation of non-debtors is the appropriate procedure and/or remedy under the given facts.
A few of the cases discuss the procedural anachronisms which may arise (e.g., how to give notice to the non-debtor's creditors of the procedure and when is the "order for relief?").
Some of the cases discuss whether the equitable powers of a bankruptcy court under 11 USC § 105(a) stretch so far as to permit substantive consolidation of non-debtors. There is discussion in some cases whether substantively consolidating non-debtors subverts the involuntary bankruptcy provisions of 11 USC § 303.
Here is a sample of the non-debtor cases:
Cases allowing substantive consolidation of non-debtors are:
- In re 1438 Meridian Place, N.W., Inc., 15 BR 89 (Bankr DC 1981)
- In re Crabtree, 39 BR 718 (Bankr ED Tenn 1984)
- In re Tureaud, 45 BR 658 (Bankr ND Okla 1985), affd 59 BR 973 (1986)
- Matter of Baker & Getty Financial Services, Inc., 78 BR 139 (Bankr ND Ohio 1987)
- In re Munford, Inc., 115 BR 390 (Bankr ND Ga 1990)
- Matter of New Center Hospital, 187 BR 560 (ED Mich 1995)
- In re United Stairs Corp., 176 BR 359 (Bankr D NJ 1995)
- In re Creditors Services Corp., 195 BR 680 (Bankr SD Ohio 1996)
Cases not allowing substantive consolidation of non-debtors are:
- In re Alpha & Omega Realty, Inc., 36 BR 416 (Bankr D Ida 1984)
- In re DRW Property Co. 82, 54 BR 489 (Bankr ND Tex 1985)
- In re R.H.N. Realty Corp., 84 BR 356 (Bankr SDNY 1988)
- In re Julien Co., 120 BR 930 (Bankr WD Tenn 1990)
- In re Lease-A-Fleet, 141 BR 869 (Bankr ED Pa 1992)
- In re Circle Land and Cattle Corp., 213 BR 870, 877 (Bankr D Kan 1997)
In re 1438 Meridian Place, N.W., Inc.- In In re 1438 Meridian Place, N.W., Inc., 15 BR 89 (Bankr DC 1981), the court had a contested matter before it in which creditors sought to substantively consolidate the debtor's estate with other non-debtor corporations and the non-debtor individuals who owned the corporations. Nick and Miranda Rangoussis owned about eight corporations in the Washington, DC area. Each corporation operated a separate rental property. After various tenants obtained a $34,000 judgment against one of the corporations, it filed chapter 11. The tenants then sought to bring in the other corporations as well as the Rangoussises individually. Much like the trustee in Bonham, the creditors in Meridian sought to disregard the corporate veil and amend the caption to include the non-debtor entities.
The individual corporations, although they each operated separate properties, used a common bank account for income and expenses. The account paid the personal bills of the Rangoussises also. The accounting records were in such disarray that, although these were separate rental properties, there were no accounting records or way to identify the income and expenses of each separate property. Most of the corporate formalities had been disregarded.
On the basis of this record, the court found that substantive consolidation was appropriate. In doing this, the court addressed two arguments against consolidation raised by the debtor and non-debtor targets. First, they argued that the issue should be addressed in an adversary proceeding under the former FRBP 701. Secondly, they said that to bring them into the bankruptcy arena, the movants should have proceeded by way of an involuntary petition pursuant to 11 USC § 303.
The court did not read the requirements of the former FRBP 701 as requiring an adversary proceeding. Nor, was an involuntary petition necessary, although it would have been an appropriate way to proceed. The burden of proof was on the creditors seeking to bring in the non-debtor entities, but here they had established the right by showing: (a) a failure to observe corporate formalities; (b) absence of relevant corporate financial records; (c) under-capitalization; (d) principal officers dominating all the corporations; and, (e) commingling of funds.
With respect to the contention that the only appropriate procedure would have been involuntary protection under 11 USC § 303, the court said, Id. at 95:
This assertion misses the mark completely. The tenant creditors are in fact creditors of only 1438 Meridian Place, N.W., and they could not comply with the mandated requirements of 11 U.S.C. § 303(b). . .
The creditors in the Bonham bankruptcy argue that trustee Compton should have promptly filed voluntary petitions for WPI and APFC. This disregards the chaotic state of the records, and the difficulty in getting information from RaeJean Bonham. It was only after an enormous forensic accounting effort that the trustee could see the forest for the trees.
In re Crabtree- In In re Crabtree, 39 BR 718 (Bankr ED Tenn 1984), creditors sought to have a corporation added to the caption of an individual case and its assets consolidated in the individual case. This was based on an alter ego claim. In this case, the individual debtor was the sole shareholder of West Knoxville Investment Company, Inc. (WKIC), the non-debtor corporation. No creditors objected to the motion.
The court found that WKIC was the alter ego of Crabtree because he was the sole shareholder, guaranteed the corporation's debts, the corporation operated with little formality, and the financial affairs of Crabtree and the corporation were financially intermingled. The corporation acted as a shell nominee for procuring loans for Crabtree's investment schemes. "The affairs of Crabtree and West Knoxville Investment Company, Inc., are so intermingled and entwined that their separate assets and liabilities cannot be ascertained, and any attempt to separate their financial affairs would consume substantial assets of the estate with no considerable likelihood that such an exercise would be successful." Id. at 721.
The court held that it would amend the caption of the case to add WKIC nunc pro tunc as of July 14, 1983 (apparently the date of filing the involuntary petition). The court said: "The amended petition does not add a second debtor to this case, but rather reflects the reality that West Knoxville Investment Company, Inc. is simply Crabtree's alter ego and an instrumentality used by him to conduct his financial affairs." Id. at 721. Likewise, the court approved the use of a motion to accomplish this, citing In re 1438 Meridian Place, N.W., Inc. and In re Auto-Train Corp. (the bankruptcy case which was later affirmed at In re Auto-Train Corp., 810 F2d 270 (DC Cir 1987).
In re Tureaud- The next case in which the court approved substantive consolidation of a non-debtor is In re Tureaud, 45 BR 658 (Bankr ND Okla 1985). This matter was also commenced by motion for substantive consolidation, as opposed to an adversary. This time, the motion was brought by the chapter 11 trustee. The court held that substantive consolidation would simplify and facilitate the administration of the assets and liabilities of the various entities. No secured creditor would be harmed because security interests were not being eliminated, nor was the status of secured creditors being changed. Regarding the court's power to consolidate, it said at 662: "Under its general equitable powers, 11 U.S.C. § 105(a), a bankruptcy court may substantively consolidate affiliate corporations within a pending case when the assets and liabilities of different entities are dealt with as if the assets were held by, and the liabilities were incurred by a single entity." In support of this conclusion, the court discussed Sampsell, Fish v East, and Matter of Gulfco.
Matter of Baker & Getty Financial Services, Inc.- A case which bears some similarity to the facts of the Bonham case, is Matter of Baker & Getty Financial Services, Inc., 78 BR 139 (Bankr ND Ohio 1987). In that case, Philip Cordek caused three corporations to be formed; Baker & Getty Financial Services, Inc., Baker & Getty Diversified, Inc., and Baker & Getty Securities, Inc. None of them were actually licensed to be broker dealers, however. Nonetheless, the three corporations engaged in a Ponzi scheme to obtain investments on the promise of quick turnovers.
Involuntary chapter 7 cases were brought against the three corporations, who did not contest. The creditors filed a motion to substantively consolidate the three cases with the non-debtors, Philip and Suzan Cordek. The Cordeks did not oppose.
Cordek had freely used the assets of the debtors for his own purposes before the bankruptcy petitions were filed. The court explained, Id. at 140-141:
There were five bank accounts which were used by CORDEK for business and personal matters. Three of the accounts were opened in the name of "BAKER & GETTY DIVERSIFIED". Two of the accounts were personal accounts of CORDEK. On numerous occasions, corporate funds were used for personal matters. For example, corporate funds were used by CORDEK to: (1) purchase automobiles; (2) repay his educational loans; (3) purchase a boat which was eventually titled in his wife's name; (4) buy furniture, jewelry and other personalty; (5) pay for a home located near Cleveland, Ohio, and improvements to that home; and (6) pay for hotel rooms for guests attending his wedding. Conversely, personal funds were used to satisfy corporate obligations. [reference to exhibits omitted] CORDEK testified at a hearing on this Motion that the bank accounts were used interchangeably.
The only objection was First National Bank of Barnesville. The bank had loaned over $1 million to a Byron Rice, a regular business customer, to allow him to make a loan with Cordek to purchase various investments, which were to have been sold in a short time at supposed profit.
The bank was aware that Cordek was associated with Baker & Getty, but assumed that the matter was a personal one rather than the business of Baker & Getty. The bank was satisfied with Rice's assets as security for the loan because of its long business relationship with Rice, but nonetheless required Cordek to be a signatory on the note.
Within 90 days of the involuntary petitions, the bank had received $200,000 in payment from Cordek and the perfection of a security interest in certain of the Cordeks' property. The bank was the only one to oppose consolidation of the Cordeks' estates as of the date of the involuntary filings, because their payments were received within 90 days and might have been considered preferential under 11 USC § 547.
The court had no problem finding that this was an appropriate case for substantive consolidation. It determined it must consider the bank's rights as the Cordeks' personal creditor against the interests of other creditors. Most of the major creditors of Cordek were also creditors of the corporate debtors.
The court explained its reasoning, Id. at 142-143:
However, according to uncontroverted testimony, the Bank relied wholly on Mr. Rice's assets and reputation and not on Mr. Cordek's assets or reputation in approving the August, 1986 loan. It is only now that the Bank declares their reliance on Mr. Cordek's personal assets. Furthermore, the Bank's actions fail to validate their claim of reliance on CORDEK's individual assets. The Bank failed to: (1) timely perfect its liens; (2) perform an adequate title search; or (3) conduct a sufficient credit investigation of Mr. Cordek. The Bank's failure to take these actions is inconsistent with their alleged dependence upon Mr. Cordek's assets. Thus, the Bank will not suffer severe prejudice from a consolidation order since there is no showing it relied on CORDEK's assets in consenting to the loan.
However, even if the Bank were deemed to be prejudiced by the consolidation, the Corporate Creditors appear to be similarly situated, making it equitable to treat them the same. The advantages of consolidation outweigh any prejudice the Bank might experience.
In re Munford, Inc.- In re Munford, Inc., 115 BR 390 (Bankr ND Ga 1990), was not a case where the court ultimately approved substantive consolidation, but rather where the court indicated that an adversary complaint sufficiently stated a case for substantive consolidation, which should be heard on the merits. In the decision, Judge W. Homer Drake gave an excellent analysis of the case law. Munford operated about 500 convenience stores in the south. It licensed the right to operate the stores under the name of "Majik Market" to TOC Retail, Inc. Majik Market Management Corporation (MMMC) was created to manage the operations of both Munford and TOC. Munford and TOC were being acquired in a complicated financial transaction by the Panfida Group through intermediaries. MMMC, with the approval of the bank underwriting the financing, was to provide management services to Munford and TOC.
The complaint for consolidation alleged that by virtue of the closing process, which was still under way at the time of the bankruptcy, TOC and MMMC had become entangled in the business operations of Munford. They shared telephone systems, inventory acquisitions, fleet leasing, advertising, computer systems, and MMMC really operated Munford and TOC as a combined entity. All the business decisions were made on the basis of TOC and Munford collectively. The insurance for the companies was combined. Funds were transferred back and forth between the companies in a manner that had little relationship to the actual benefit or burdens of the respective parties.
Munford contended that the business functions of the several companies could not be separated without physical division of the operations, records, and personnel, and it would result in an economic loss. Finally, Munford claimed he could not prepare, with any degree of competence, financial statements which would be necessary for a successful reorganization unless the businesses, Munford, TOC and MMMC, were substantively consolidated. In denying the motion to dismiss, the court noted that consolidation need not be based only on the "instrumentality" theory. It could be based on a finding that it would be more equitable under the circumstances of the particular case. Munford at 394:
Munford's theory of recovery is distinct from the consolidation available under the "instrumentality" theory. As will be discussed in more detail below, substantive consolidation may be based on a finding that it would be more equitable to all of the parties to allow consolidation under the circumstances of the case, In re Tureaud, 59 B.R.973, 975-76 (N.D.Okl.1986); In re Baker & Getty Fin. Serv. Inc., 78 B.R. 139, 142 (Bankr.N.D.Oh.1987); In re Snider Bros., Inc., 18 B.R. 230, 234 (Bankr.D.Mass.1982), by showing that the affairs of the entities are inextricably intertwined or that creditors dealt with them as a single economic unit, and does not require a finding of fraud or intent to hinder or delay creditors.
The defendants also challenged the court's authority to consolidate the debtor's assets with those of a non-debtor. The defendants questioned the use of 11 USC § 105(a), the statute defining the court's general equitable powers, and suggested that 11 USC § 303 was the appropriate manner to bring about the results sought. The court rejected these arguments. Munford at 396-398. Notwithstanding case law in other areas indicating that a bankruptcy court's equitable powers cannot be expanded under § 105(a) to create a right where none is provided for or implied in the bankruptcy code, the court cited the long history of substantive consolidation under equitable powers. The court found that substantive consolidation was ingrained in the fabric of bankruptcy law, beginning with Sampsell v Imperial Paper Corp. and Soviero v Franklin National Bank. It also found that substantive consolidation is a different process than that sought by § 303, and substantive consolidation does not circumvent the requirements of § 303.
In re United Stairs Corp.- In In re United Stairs Corp., 176 BR 359 (Bankr D NJ 1995), the chapter 7 trustee and First Fidelity Bank filed an adversary proceeding against several affiliated non-debtor corporations as well as their principals.
Before bankruptcy, First Fidelity had sued United Stairs for defaulting on several million dollars in loans. First Fidelity was aggressively pursuing the litigation and, after receiving a default judgment, sought to restrain certain transfers by United Stairs to Excel Cabinet Corporation and Spiral Leasing Corporation, corporations owned ostensibly by the daughter of Louis Manzo (the principal of United Stairs) and his sister respectively. Transfers of equipment had been made to these corporations for nominal amounts. Before the property could be recovered, however, United Stairs filed bankruptcy.
The court found authority under 11 USC § 105(a) to substantively consolidate a non-debtor entity with a debtor under the appropriate circumstances. The court said, Id. at 368-69:
While many consolidation cases involve the consolidation of entities already in bankruptcy, it is accepted that a non-debtor entity may be consolidated with a debtor under appropriate circumstances. Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215, 61 S.Ct. 904, 85 L.Ed. 1293 (1941); see also In re 1438 Meridian Place, N.W., Inc., 15 B.R. 89 (Bankr.D.D.C.1981); and In re Crabtree, 39 B.R. 718 (Bankr.E.D.Tenn.1984). In Sampsell the Supreme Court found that substantive consolidation of a non-debtor corporation with the individual bankrupt's estate was proper where the transfer of property to the non-debtor corporation was not in good faith but was made for the purpose of placing it beyond the reach of the original debtor's creditors, and where the effect of the transfers was to hinder, delay or defraud the individual's creditors. Id. 373 U.S. at 218-19, 61 S.Ct. at 906-07; see also Patrick C. Sargent, Bankruptcy Remote Finance Subsidiaries: The Substantive Consolidation Issue, 44 Bus.Law 1223, 1233-36 (1989) (discussing the consolidation of debtor subsidiaries).Consolidation, of course, is a power that should be used sparingly. Snider Bros., 18 B.R. at 234. This power is not an "instrument of procedural convenience, but a measure vitally affecting substantive rights." Id. See Matter of Flora Mir Candy Corp., 432 F.2d 1060, 1062 (2nd Cir. 1970); Chemical Bank New York Trust Co. v. Kheel, 369 F.2d 845, 847 (2nd Cir. 1966). Substantive consolidation should be considered with extreme caution and granted only in extraordinary situations. In re Lease-A-Fleet, Inc. v. Robins Le-Cocq, Inc., 141 B.R. 869, 872-73 (Bankr. E.D. Pa. 1992).
While this court is mindful of the seriousness of the remedy of consolidation, this is a case where extraordinary circumstances exist and an examination of the equities requires extension and substantive consolidation. Where the debtor and non-debtor entities are alter egos of each other extraordinary circumstances are present. Lease-A-Fleet, 141 B.R. at 872- 73. In this case, no one but Louis Manzo, acting as president of United Stairs, had any knowledge of the operations of the various businesses. Manzo treated each of them as an instrumentality; using raw materials, employees, physical space, telephone and even stationary as needed regardless of the corporate niceties. Similar to the debtor's actions in Sampsell, the transfers of property to Spiral and Excel were not in good faith but were made for the purpose of placing United Stairs' assets beyond the reach of its creditors. Sampsell, 313 U.S. at 218-19, 61 S.Ct. at 906-07.
After discussing the criteria for determining whether a case should be substantively consolidated and the various tests that courts have fashioned to deal with the issue, the court said that, Id. at 369:
. . . while such tests may be helpful in some analyses this court adopts the ultimate test of balancing of the equities. In doing so, the court must weigh the economic prejudice of continued debtor separateness against the economic prejudice of substantive consolidation. In re Cooper, 147 B.R. 678, 682 (Bankr.D.N.J.1992); In re Snider Bros., Inc., 18 B.R. 230, 234 (Bankr.D.Mass.1982). This determination must be sui generis. In re Augie/Restivo, 84 B.R. at 321, quoting 5 Collier on Bankruptcy, ¶ 1100.06, p. 1100-33 (15th Ed. 1985).
The court had no problem in finding that the trustee and First Fidelity had established a right to substantively consolidate the non-debtor corporations with the debtor.
Matter of New Center Hospital- The summary judgment approving substantive consolidation in an adversary proceeding was affirmed in part in Matter of New Center Hospital, 187 BR 560 (ED Mich 1995). The consolidation was sought by the Internal Revenue Service and the Department of Housing and Urban Development against debtor hospital and a number of alleged alter egos. The bankruptcy court granted summary judgment on the basis that the medical corporations and hospital acted as alter egos of one another and that substantive consolidation was warranted. It ordered the consolidation nunc pro tunc to the date of the appointment of a chapter 11 trustee. The district court affirmed the consolidation, but remanded the nunc pro tunc portion.
Although the bankruptcy court relied on Michigan case law to determine if an alter ego situation existed under the facts, the substantive consolidation was not ordered under the state alter ego policy, but under the bankruptcy court's equitable powers under 11 USC § 105(a). Id. at 567.
Having found that the debtors and non-debtor corporations were alter egos, the court found that the bankruptcy court was correct in determining that the affairs of the debtors and non-debtors were so entangled as to warrant substantive consolidation. The bankruptcy court found under the Augie/Restivo test that there was sufficient evidence of creditors dealing with the entities as a unit and sufficient entanglement to make the business affairs of the debtors and non-debtor corporations "inextricably intertwined that untangling the affairs would be either impossible or too costly to the estate." Id. at 569. The district court found that under an Auto-Train analysis "the facts also support a finding of substantial identity&endash;the alter ego issue." The court also determined that because the United States was the largest creditor, the benefits of consolidation outweighed the detriments.
On the issue of the appropriate date to fix the consolidation of the non-debtors, the district court reversed. It did this on the basis principally of Auto-Train, because there had been insufficient inquiry into the possible harm to creditors who might have dealt separately with the non-debtor corporations as of a certain date.
In re Creditors Services Corp.- In In re Creditors Services Corp., 195 BR 680 (Bankr SD Ohio 1996), the court substantively consolidated a chapter 7 corporate debtor with non-debtor entities and with an individual owning all of the debtor's shares. The debtor was in the collection business. It had allowed the bar date on various collections for Consolidated Freightways of Delaware, Inc. to pass. Consolidated Freightways obtained a large judgment against the debtor prior to the bankruptcy, but the bankruptcy was filed before collection of the Consolidated Freightways' judgment could proceed.
The business, at the time of the bankruptcy, was run by Kathleen Cooley. She was the sole shareholder of the debtor. She was also the principal in a number of other collection businesses, most of which operated as corporations.
The court gave a detailed analysis of the intricate involvement of all the parties and concluded that: (a) most of the entities operated out of the same location at one time; (b) the debtor bought insurance for all the entities; (c) some of the employees performed work for one entity and were paid by another; (d) some of the non-debtor entities retained debtor's funds postpetition; (e) there were undocumented loans made by principals to various of the entities and by the entities among themselves; (f) payment of Ms. Cooley's salary for services to one of the non-debtor corporations was made by the debtor for a "management fee;" (g) one of the non-debtors sold the debtor's furniture postpetition; (h) there was no rational allocation of the rent paid by the debtor and non-debtor entities to the non-debtor which owned the real estate; (i) some of the non-debtors failed to pay any rent at all; (j) significant salaries were received by officers in the years just before the filing, with transfers back of some of those sums in the form of loans without the benefit of any documentation; and (k) the debtor made payments on Ms. Cooley's personal credit cards.
The court acknowledged that there was no specific statutory authority for a bankruptcy court to substantively consolidate entities, but noted that many courts had found a broad equitable power to do so under 11 USC § 105(a), citing Munford, Tureaud, and New Center Hospital, 179 BR 848, 853 (Bankr ED Mich 1994), affd in part, rev'd in part, 187 BR 560 (ED Mich 1995). While the remedy of substantive consolidation is similar to piercing the corporate veil, it is not the same. Creditors Services at 689:
Practically, substantive consolidation is similar to the state law remedy of piercing the corporate veil based on a finding that the entities are alter egos. See J. Stephen Gilbert, Note, Substantive Consolidation in Bankruptcy: A Primer, 43 Vand.L.Rev. 207 (1986); In re Cooper, 147 B.R. at 683-84. Piercing the corporate veil, however, is not a prerequisite to the utilization of the bankruptcy law remedy of substantive consolidation. In re Munford, 115 B.R. at 394, citing In re Tureaud, 59 B.R. at 975-76; In re Snider, Inc., 18 B.R. 230, 234 (Bankr.D.Mass.1982). The bankruptcy remedy of substantive consolidation ensures the equitable distribution of property to all creditors, while on the other hand, piercing the corporate veil is a limited merger for the benefit of a particular creditor. See In re Cooper, 147 B.R. at 683-84.
The court also noted, as almost all other courts have, that the remedy of substantive consolidation is extreme and should be exercised with great care. It involves consolidating the assets and liabilities of separate entities into one. This should not be a mere instrument of convenience, but only done where considered absolutely necessary and where the benefits outweigh any injury to affected creditors. Id. at 689.
In re Alpha & Omega Realty, Inc.- The first case denying substantive consolidation of non-debtors is In re Alpha & Omega Realty, Inc., 36 BR 416 (Bankr D Ida 1984). In this terse opinion, the court questioned whether 11 USC § 105(a) could be used as authority for substantive consolidation of non-debtors. The court declined to follow 1438 Meridian Place, N.W., Inc. Part of its rationale was that the Supreme Court's Marathon Pipe Line case indicated that the expanse of jurisdiction of the bankruptcy court envisioned by the 1978 Bankruptcy Code had been substantially diminished. The court said, Id. at 417:
I also question the conclusion of that court that nondebtor parties can essentially be declared involuntary debtors through use of a "veil piercing" theory, especially when raised by motion and not through either an adversary proceeding or involuntary petition under § 303 with their attendant protections.
The trustee in Bonham was, of course, not in a position to bring involuntary petitions against WPI or APFC since he was not a creditor. Some opponent's of the trustee's motion to consolidate suggest he should have filed voluntary proceedings against WPI and APFC. I will discuss this in Part 4.6.
In re DRW Property Co. 82- A more thoughtful opinion is In re DRW Property Co. 82, 54 BR 489 (Bankr ND Tex 1985). Donald R. Walker, a real estate developer, sought substantive consolidation of 85 partnerships that had filed voluntary chapter 11 cases with 109 non-debtor limited partnerships, principally for economy in proposing a plan and to obtain federal income tax advantages.
Walker was a substantial real estate investor, developer, and syndicator in the early 1980's. The 109 non-debtor partnerships each operated separate properties and were used for investment vehicles to obtain financing. There were several types of partnerships, some simple and some more complex.
Notwithstanding the rapid expansion of his business, their accounting and financial management functions lagged. The investments made by individuals were difficult to trace to a specific partnership. The funds for each project were ultimately channeled into a central cash management account, and weaker projects were supported by stronger ones.
The strongest argument for consolidation was the almost hopeless entanglement of the records of the 109 partnerships. The court noted the holding in Chemical Bank New York Trust Co. v Kheel, where the interrelationships of the group were hopelessly obscured and the expense of unscrambling them would have substantially jeopardized the recovery of any funds for creditors.
Ultimately, the court found that the Kheel test might be applicable with respect to the accounting for the partnership interest of the various limited partners (i.e., the equity interest), but, although difficult, it was possible to trace the income and expense from each project (i.e., the creditors' interest). There were sufficient records to track the income and expense of each project, although it might cost $2 million in accounting fees to straighten out.
The court found that substantive consolidation was not warranted because it appeared that if the assets were consolidated it would be to the detriment of the creditors of those projects which were strong and could pay the creditors, and to the benefit of those which were weak and could not. Thus, the court focused on the creditors' rights as opposed to the equity holders and determined that the right to substantive consolidation was not established. Additionally, the court questioned the ability to substantively consolidate for the purpose of obtaining the tax benefit the debtor sought by the application.
In the Bonham case, there are no substantial assets in either WPI or APFC, and the estate will only benefit from the avoidance recoveries.
In re R.H.N. Realty Corp.- In re R.H.N. Realty Corp., 84 BR 356 (Bankr SDNY 1988), is cited by some courts as an example of a case where a court found it had no jurisdiction to consider substantive consolidation of a non-debtor into a pending case.
R.H.N. Realty Corp. was an involuntary chapter 7 proceeding. A creditor and the trustee filed a complaint. One of the counts in the complaint, which only the creditor and not the trustee asserted, was for a declaration that the non-debtor was an alter ego. The creditor sought a judgment against the non-debtor for the benefit of the creditor only, and not the estate. Subsequently, the creditor moved to state a count for substantive consolidation of the estate of the non-debtor with the estate of the debtor.
Thus, the only issue was whether a motion to amend should be granted. The court acknowledged the authority of a bankruptcy court to substantively consolidate the affairs of parties when they are so intertwined as to make it impossible to administer them as separate entities. Id. at 358. The court indicated that substantive consolidation should be applied with great caution and particularly when nunc pro tunc consolidation is sought.
The grounds for denial of the motion appeared to be that insufficient "evidence" was stated for the amendment. However, the court did add the following, Id. at 359:
Moreover, the order for relief has already been entered against the debtor corporation. To amend the caption so as to add Haverstraw as a co-debtor would deprive Haverstraw of the opportunity of contesting the involuntary petition, as permitted under 11 U.S.C. § 303(d) and (h). This procedure offends the fundamental due process requirements of the Fourteenth Amendment. See Mullane v. Central Hanover Bank and Trust Company, 339 U.S. 306, 70 S.Ct. 652, 94 L.Ed. 865 (1950). For this reason alone, the plaintiffs' cross-motion must be denied.
These few sentences are the only reason for denying substantive consolidation. The court did not explain how this squared with its earlier acknowledgment that substantive consolidation was an admitted part of bankruptcy jurisprudence. Nor did the court consider that there might be methods of giving notice to the creditors of the non-debtor which would accord with due process.
In re Julien Co.- The court in In re Julien Co., 120 BR 930 (Bankr WD Tenn 1990), dismissed a motion for substantive consolidation made by the chapter 11 trustee on procedural grounds. The court felt that the matter should have been brought by an adversary or through another device such as an involuntary petition pursuant to 11 USC § 303. The facts in the opinion are rather sparse. The trustee's motion sought to amend the petition in order to identify the debtor as "Julien J. Hohenberg d/b/a The Julien Company."
The court briefly discussed, but did not analyze the factual allegations made by the chapter 11 trustee supporting an alter ego approach to substantive consolidation. After analyzing a number of the earlier substantive consolidation cases, the court said, Id. at 936-37:
This Court does not conclude that a bankruptcy court should never order substantive consolidation or that it lacks the equitable authority to do so in an appropriate factual environment. However, the bankruptcy court should cautiously exercise that authority only when the facts demand it. In those cases discussed herein where the debtor has been consolidated with other bankruptcy debtors, the remedy or results are not offensive to this Court when the facts demonstrate that the debtors were in fact one entity or were so intertwined as to be indistinguishable and when the result is equitable for the creditors of each estate. But, this Court has great difficulty with the present facts where the corporate debtor's Trustee attempts to say that the debtor is not in fact a corporation and that therefore the nondebtor individual's assets are property of the debtor's estate. It is troublesome for the debtor to pierce its own veil and deny its corporate existence and conclude that as a result Mr. Hohenberg's assets belong to the debtor.
The attempted remedy is more offensive because it is sought by motion rather than by adversary proceeding.
The court also alluded to the fact that the trustee perhaps did not have standing to pursue the alter ego claim against Mr. Hohenberg, citing Caplin v Marine Midland Grace Trust Co. of N.Y., 406 US 416, 92 SCt 1678 (1972), and similar cases. In making this reference, the Julien court failed to recognize the distinction between veil piercing as a state law doctrine versus substantive consolidation as a bankruptcy doctrine recognized by virtue of a supreme court opinion, and a number of circuit and bankruptcy courts. See, the discussion at Part 4.2 of this Memorandum Decision.
In re Lease-A-Fleet, Inc.- Perhaps the most articulate case to voice the concerns about consolidating a non-debtor with a debtor's case, is In re Lease-A-Fleet, Inc., 141 BR 869 (Bankr ED Pa 1992). Unfortunately, the case is colored by the judge's obvious distaste for the plaintiff. He believed the plaintiff was both over-litigious and was seeking substantive consolidation for some unspecified advantage which neither he nor any other creditor could fathom.
Nonetheless, the court went through a discussion of the criteria for substantive consolidation, Id. at 871-72, and a thoughtful discussion of the conceptual difficulties of consolidating a non-debtor at 872-76.
One of the conceptual problems alluded to was what type of notice was due to creditors. In that case, the court required notice to be given to all creditors of the non-debtor corporation. Additionally, substantive consolidation of non-debtors might circumvent the procedures for involuntary cases under 11 USC § 303.
The court also noted the difficulty in applying certain protections for debtors, or rights given to them. For example, how to apply § 362 regarding the automatic stay, or the avoiding powers under §§ 542-549.
In essence, the court points out that those courts which have allowed substantive consolidation had not fully explored the possible ramifications of the "what ifs." The court said, Id. at 874:
It is therefore not surprising to this court to find that placing an involuntary non-debtor consolidatee in such an unusual circumstance, betwixt and between the Bankruptcy Code, should be reserved for unusual circumstances which might justify such a conceptually-strange measure.
In re Circle Land and Cattle Corp.- The judge in In re Circle Land and Cattle Corp., 213 BR 870 (Bankr D Kan 1997), strongly disputed that the bankruptcy court has authority under § 105(a) to consolidate the estate of a non-debtor into a debtor's pending bankruptcy case. The court first noted that the oversecured creditor who had sought the consolidation had mistaken its remedies. The creditor referred to the state corporate law of piercing a corporate veil. The court said, Id. at 874:
State corporate law authored the alter ego doctrine. Federal bankruptcy law conceived substantive consolidation, the doctrine of joining the estates of bankrupt entities. The two doctrines are distinguished in a well-regarded bankruptcy treatise discussing administrative and substantive consolidation, on the one hand, and piercing-the-corporate-veil jurisprudence and merger, on the other:"Substantive consolidation should not be confused with either the corporate law concept of piercing the corporate veil or the bankruptcy law concept of joint administration. Unlike piercing the corporate veil, substantive consolidation does not seek to hold shareholders liable for acts of their incorporated entity. A corporate law concept closer to substantive consolidation is merger of two corporations under state law." [footnote omitted]
The Circle Land court also did not reflect on or explain the fact that the Supreme Court in Sampsell and a circuit court in Soviero permitted substantive consolidation of non-debtors.
The adversary complaint for substantive consolidation spelled out a number of grounds which might typically be considered in an alter ego argument. The opinion has a section entitled "Substantive Consolidation Law" aligned with Headnotes 6 through 8 at pages 875-76. There, the court cites some of the older cases such as Stone v Eacho and Soviero v Franklin National Bank of Long Island. Then, in another section of the opinion entitled "Consolidating a Non-Debtor," the court cites a number of cases which have approved consolidation and state that they all disregard § 303's requirements. Id. at 876:
Nevertheless, the bankruptcy decisions upon which Helena relies have consolidated a non-debtor with a debtor using § 105 in disregard of § 303's requirements. See In re 1438 Meridian Place, N.W., 15 B.R. 89 (Bankr. D.D.C. 1981); In re Crabtree, 39 B.R. 718 (Bankr. E.D. Tenn. 1984); In re Tureaud, 45 B.R. 658 (Bankr. N.D. Okla. 1985); In re Munford, Inc., 115 B.R. 390 (Bankr. N.D. Ga. 1990); In re Fairfield Construction Co., 1995 WL 434474, 1991 Bankr. LEXIS 1395 (E.D. Mich. 1991); In re New Center Hospital, 179 B.R. 848 (Bankr. E.D. Mich. 1994); In re United Stairs Corp., 176 B.R. 359 (Bankr. D.N.J. 1995). In effect, these courts have used § 105 as a grant of subject matter jurisdiction.
To counter these decisions, the judge cited a group of contrary cases. Id. at 877:
Contrary to those decisions that permit substantive consolidation of a non-debtor with a debtor, others have refused to take jurisdiction over a non-debtor for substantive consolidation purposes. See In re Alpha & Omega Realty, Inc., 36 B.R. 416 (Bankr. D. Idaho 1984); In re DRW Property Co. 82, 54 B.R. 489 (Bankr. N.D. Tex. 1985); In re R.H.N. Realty Corp., 84 B.R. 356 (Bankr.S.D.N.Y.1988); In re Julien Co., 120 B.R. 930 (Bankr. W.D. Tenn.1990); In re Lease-A-Fleet, 141 B.R. 869 (Bankr. E.D. Pa.1992); In re Ira S. Davis, Inc., 1993 WL 384501, 1993 Bankr. LEXIS 1383 (E.D. Pa. 1993); In re Hamilton, 186 B.R. 991 (Bankr. D. Colo.1995). These decisions question whether bankruptcy courts have subject matter jurisdiction over non-debtor corporations for purposes of substantive consolidation, and they reason that consolidation of a non-debtor is contrary to the Code limitations for involuntary bankruptcy petitions. I agree with the reasoning of these decisions.
I believe this is an over-broad reading of some of these cases. For example, DRW Property is not a case where the judge ruled that substantive consolidation was improper, but that it should be used very conservatively. In re Julien acknowledged the authority of a bankruptcy court to substantively consolidate, but questioned the procedure that had been chosen. Likewise, In re Lease-A-Fleet, though very skeptical about most cases qualifying for substantive consolidation of non-debtors, did not rule out the situation where there might be such a case under the right facts.
4.6. Motion is Appropriate to Determine the Substantive Consolidation Issue-
All those parties opposing substantive consolidation are Bonham Recovery Actions (BRA) defendants in adversary proceedings in which the trustee seeks to avoid transfers and recover payments made to the defendants by WPI, APFC, and/or Bonham. They argue that the trustee's presentation of the substantive consolidation motion as a contested matter, instead of by an adversary proceeding or voluntary petitions against WPI and APFC, is procedurally improper. See, e.g., the BRA defendants' joinder and supplement to Response and Objection to Trustee's Motion For Substantive Consolidation, Docket Entry 1108, filed by Brad Ambarian for various defendants.
They cite In re Julien Co., 120 BR 930 (Bankr WD Tenn 1990) and In re Alpha & Omega Realty Inc., 36 BR 416 (Bankr D Idaho 1984), discussed in Part 4.5 of this Memorandum Decision. In Julien, a chapter 11 trustee sought to bring in an individual and amend the caption to reflect this. Unlike Mr. Julien, a non-debtor who fought substantive consolidation, the Bonham trustee, WPI, and APFC do not contest consolidation. Indeed, WPI and APFC are disenfranchised corporations, without tangible assets. The only hope of recovery for the creditors of any of these three entities is from consolidation and the avoidance actions brought by the trustee.
Alpha & Omega is a brief decision in which the court, alluding to the reduced jurisdiction of bankruptcy courts after Marathon Pipe Line, said that the proper procedure was using an 11 USC § 303 involuntary petition. See, also, In re R.H.N. Realty Corp., 84 BR at 359.
In Bonham, the trustee was not in a position to file an involuntary petition. However, similar to the Alpha & Omega rationale, the objecting parties indicate that he should have filed a voluntary petition and, failing to do that, should not be allowed to substantively consolidate WPI and APFC.
The problem with this argument is that the trustee came into the case in late 1995, without any knowledge of the operation. The trustee is a certified public accountant, and immediately began a forensic investigation. Bonham, WPI, and APFC, he discovered, kept no standard accounting records to guide him, had no computer records, and the records that were available were incomplete. He met stonewalling at almost every point from RaeJean Bonham. He did not come into this case with perfect knowledge of the background, but only developed this after months of arduous investigation, including tedious analysis and inputting records into a data base.
In a case where Bonham, WPI, and APFC are alter egos, restricting the procedure for recovery of avoidable transfers by a requirement that the trustee file voluntary cases for WPI and APFC will work an injustice on the creditors who might otherwise receive a dividend in bankruptcy. No doubt if he had, there would be challenges to his authority to have done so, based on the uncertainty of corporate ownerships, since the corporate formalities were not observed.
More importantly, when the trustee began to accumulate sufficient knowledge to have filed a voluntary proceeding for WPI and APFC, a significant amount of time had passed since the involuntary was filed against RaeJean Bonham on December 19, 1995. The facts show that her Ponzi activities were on the decline during 1995. By being relegated to the later date of the voluntary petition, the trustee would have missed the time limit to bring fraudulent transfer actions under 11 USC § 548 against many of the transfers which occurred during the height of Bonham's activities.
Substantive consolidation may be sought by different parties. Sometimes the trustee or debtor-in-possession seeks it. Often, it is a creditor. The important thing, for due process purposes, is notice and an opportunity to be heard. An adversary proceeding would have been a cumbersome way to bring this issue to the court. Should the trustee have named the 600 BRA defendants in one large adversary? How would they have been served? With individual subpoenas or by notice? Who would have represented their interests?
In the present case, the trustee used the most effective procedure &endash; a motion. Notice was served on all BRA defendants and responses were received opposing consolidation in about 200-300 of the individual adversary proceedings. The trustee, anticipating FRCivP 56(f) type motions, sought early on to make the documents of the debtor available. While this has proved to be a cumbersome task, it is not through lack of effort by the trustee to make the documents available.
This is not a one-on-one situation where the trustee seeks to bring in a non-debtor entity and the non-debtor opposes. In such a case, the matter has often been by an adversary because the logistics are simple &endash; serve one party. Even in a case where an adversary is used, a court has seen that the rights of creditors of the non-debtor must be addressed. The court in In re Lease-A-Fleet, 141 BR 869, 873 (Bankr ED Pa 1992), discussed in Part 4.5, notwithstanding the fact that an adversary had been used, required separate notice to the creditors of the non-debtor corporation. The procedure adopted by the Bonham trustee closely approximates the one required in Lease-A-Fleet to protect creditors who were not actual parties to the pending adversary proceeding.
Many of the non-debtor consolidation cases discussed in Part 4.5 of this Memorandum Decision were prosecuted as motions. Although it was often not an issue in some of the cases, other courts specifically held that a proceeding need not be by adversary rules or an involuntary petition. In re 1438 Meridian Place, N.W., Inc., 15 BR at 94-95; In re Crabtree, 39 BR at 721 (motion acceptable instead of involuntary petition). The court in Meridian distinguished the relief sought by substantive consolidation from the type which had to be brought under FRBP 701, the predecessor of FRBP 7001. While some aspects of consolidation may have traits akin to FRBP 7000(1) regarding the delivery of property of a trustee, or 7001(9) declaratory judgment, the relief is distinct from the relief sought in those rules.
I will overrule the objection to the motion procedure chosen by the trustee to accomplish consolidation of WPI and APFC.
4.7. Application of Law to Determine If WPI and APFC Should be Substantively Consolidated With the RaeJean Bonham Case-
The two key questions in this matter are: (a) should WPI and APFC, non-debtors, be consolidated with the Bonham estate, and if so, (b) should the effective date be the petition date for Bonham, or the date of the motion to consolidate? I will discuss the first question in Part 4.7 of this Memorandum Decision, and discuss the effective date in Part 4.8 (although this issue blurs into Part 4.7).
To answer these questions, it is important to distinguish the two types of creditors involved in this case. First, there are the creditors of the Bonham, WPI, and APFC estates whose claims will be paid something (probably less than fifty-cents on the dollar) if there are assets recovered by the trustee. I will call this type of creditor a "Claimant." Secondly, there are creditors of WPI, APFC, and Bonham who were paid prepetition, but are subject to avoidance claims (such as for fraudulent transfers). I will call this type of creditor a "Target."
Though not applicable to the Bonham case, other cases may have Targets, not because they are subject to avoidance actions, but because any bankruptcy recovery may be diluted by consolidation of assets with those of a financially weaker debtor. If consolidation is not granted, nunc pro tunc, in Bonham, there will be nothing to dilute.
Most of the case law regarding substantive consolidation is an attempt to balance the rights of Claimants and Targets. Simplistically, the Claimants first must make their case for substantive consolidation (e.g., by showing why consolidation is fair or just because of the intermingling of assets, alter ego behavior, fraud, etc.), and then the Targets must show why consolidation, which might otherwise be appropriate, should be denied (e.g., because of a reliance on the separate entity, unfair dilution of recovery if consolidation occurs, etc.).
Some creditors of Bonham are both Claimants and Targets because they had not been paid in full by WPI or APFC prepetition, but had received some payments within the avoidance period. Many Targets in Bonham are willing to give up the right to be a Claimant because they do not want to pay the trustee in whole dollars to recover only a small percentage of the amount from the trustee in a dividend. Thus, some Claimants who are also BRA defendants (Targets), are willing to withdraw their proofs of claim (their right to be Claimants) to get their BRA adversary proceedings out of the bankruptcy court by claiming the right to jury trial to be heard in the United States District Court where they feel they will fare better at defeating the trustee's avoidance action.
Some of the Claimants are not BRA defendants (Targets), but are creditors who may have invested in and never received any repayment from WPI or APFC. Also included among the Claimants is Delta Air Lines with a $2,000,000 claim. These Claimants will get distributions from any avoidance recoveries made by the trustee and have every incentive to see the cases substantively consolidated, nunc pro tunc as of December 19, 1995. Otherwise, they stand to get nothing.
There is no question that consolidation will help, and not prejudice, a Claimant under the facts of the Bonham case. Conversely, Targets, unless they can raise some defense to the trustee's avoidance actions, will be harmed &endash; they will have to pay any judgments against them to the bankruptcy trustee. Whether it is fairer to consolidate or not is what this long Memorandum Decision is about. Either way, there will be a lot of pain involved. There are, unfortunately, "widows and orphans" in both the Claimant and Target groups. The trustee is attempting to see that the Claimants recover as much as possible. The Targets' goal is just the opposite.
The Claimants, represented by the trustee, have made a strong prima facie case for consolidation of WPI and APFC with the existing estate of RaeJean Bonham. Under almost any of the tests devised by the courts in the cases mentioned in Parts 4.3-4.5 of this Memorandum Decision, the Claimants (or the trustee on their behalf) can make a compelling prima facie case for substantive consolidation. Whether there are sufficient countervailing reasons which can be established by the Targets to deny consolidation is the subject of Part 4.8.
The reasons for consolidation are, first, the financial affairs of Bonham, WPI and APFC are hopelessly entangled. Second, the Claimants were enticed into investing in a fraudulent Ponzi scheme, and the funds were used to pay other investors (Targets) in the Ponzi scheme and to support Bonham and her family. Third, neither Bonham, WPI, nor APFC has any significant assets to cover the millions of dollars in claims, and Bonham, WPI and APFC should be treated as alter egos to allow a recovery to Claimants.
Some of the specific facts to show that WPI and APFC were alter egos of Ms. Bonham are:
These facts show that WPI and APFC were really the alter egos of Ms. Bonham, or in the vernacular of the earlier cases cited in Part 4.3 of this Memorandum Decision, that they were the "instrumentalities" of Bonham, and the financial affairs of the three were hopelessly entangled. They also show the use of the corporations for a fraudulent purpose. As such, the three should be treated as one entity and consolidated. See, Fish v East, Sampsell v Imperial Paper & Color Corp., Stone v Eacho, Soviero v Franklin National Bank, Chemical Bank New York Trust Co. v Kheel, discussed in Part 4.3; In re Vecco Construction Industries, Inc., Eastgroup Properties v Southern Motel Assoc., Ltd., discussed in part 4.4; and, In re 1438 Meridian Place, N.W., Inc., In re Crabtree, Matter of Baker & Getty Financial Services, Inc., In re Munford, Inc., In re United Stairs Corp., and In re Creditors Services Corp., discussed in Part 4.5.
Applying the probing analysis suggested in In re Snider Bros., Inc., 18 BR 230, 234 (Bankr D Mass 1982) (see, Part 4.4), I have compared the economic prejudice of continued separateness of WPI, APFC and Bonham to any prejudice from their consolidation. No Claimant will be prejudiced by consolidation. The Claimants will get nothing without consolidation.
Snider admonishes that mere commingling of assets is not enough to justify consolidation, Id. at 235, but harm must be shown by the intermingling of assets, Id. at 238. This can be shown. Bonham promoted a fraudulent investment scheme &endash; a Ponzi scheme. Claimants were induced to invest funds. There funds were channeled, according to some unknown whim or scheme of Bonham, between WPI and APFC. She freely used some of the funds for her own purposes while the Ponzi scheme made the WPI and APFC enterprises hopelessly insolvent. No Claimant can truly trace where his or her funds were used. Did they go to pay APFC contracts or expenses, WPI contracts or expenses, or to Bonham? Likewise, no Target can truly trace the source of the Target's prepetition payment. Were their funds received from WPI or APFC, or just funneled through these entities?
Under the Snider analysis, consolidation is justified. It then becomes the burden of those opposing consolidation to show that the benefits of consolidation are outweighed by the harm. Snider at 238. I have found in ¶¶ 2.12.4-2.12.8 that a reasonable reliance has not been established. I will discuss this further in Part 4.8 of this Memorandum Decision.
Under either the Augie/Restivo or Eastgroup Properties tests discussed in Part 4.5, consolidation is justified. To reiterate the Augie/Restivo test, after examining the historical and more recent case law, the court said, Id. at 518:
An examination of those cases, however, reveals that these considerations are merely variants on two critical factors: (i) whether creditors dealt with the entities as a single economic unit and "did not rely on their separate identity in extending credit," or (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors. [citations omitted]
Certainly the affairs of Bonham, WPI and APFC were hopelessly entangled. Also, Targets apparently dealt with WPI and APFC interchangeably, dealing solely through RaeJean Bonham. There was an overall pattern of shuffling of funds between WPI and APFC, and a haphazard assignment of investment contracts to either WPI or APFC at Bonham's whim. The Targets appear to have relied on the exorbitant return as opposed to any particular corporate identity. The trustee has established the right to substantive consolidation under the Augie/Restivo test.
The Eastgroup test is, Id. at 249:
[T]he proponent of substantive consolidation must show that (1) there is substantial identity between the entities to be consolidated; and (2) consolidation is necessary to avoid some harm or to realize some benefit. When this showing is made, a presumption arises "that creditors have not relied solely on the credit of one of the entities involved." Once the proponent has made this prima facie case for consolidation, the burden shifts to an objecting creditor to show that (1) it has relied on the separate credit of one of the entities to be consolidated; and (2) it will be prejudiced by substantive consolidation. . . . Finally, if an objecting creditor has made this showing, "the court may order consolidation only if it determines that the demonstrated benefits of consolidation 'heavily' outweigh the harm." [omitting internal and citations]
The facts I have outlined indicate that WPI and APFC were alter egos of Bonham. The harm to be avoided is having those Targets who were lucky enough to be paid within the avoidance period with funds, the source of which (WPI or APFC) is undeterminable, keep those funds, including the exorbitant profit, to the detriment of those Claimants who were unlucky enough not to have been paid. The benefit, is having those funds returned to the consolidated bankruptcy estates for equitable distribution to the unsecured creditors.
The question remains, should those Targets who benefitted from payments from the Ponzi scheme be protected from a nunc pro tunc consolidation? I will discuss this in Part 4.8.
4.8. Should the Consolidation be Nunc Pro Tunc to Original Filing Date?-
One of the most important issues in the substantive consolidation motion is the effective date. The involuntary bankruptcy against RaeJean Bonham was filed on December 19, 1995. The Trustee's Motion For Order Confirming That Assets And Liabilities Of Bonham, World Plus And Atlantic Pacific Funding Corp Are Subject To Administration, For Joint Administration And For Substantive Consolidation Of Estates And To Amend Caption, was not filed until a year later on January 22, 1997 (Docket Entry 731).
Some defendants in the BRA argue that the effective date for substantive consolidation should be no earlier than January 22, 1997.
On December 19, 1995, the date of the involuntary petition against RaeJean Bonham, her operations had been, in essence, shut down by the Alaska Division of Securities. Both WPI and APFC had been decertified by their respective states, Alaska and Nevada. During the final year of Bonham's operation, her Ponzi scheme was beginning to unwind and the rate of new investments was declining. See, ¶ 2.6.4.
If the effective date for the purpose of substantive consolidation for WPI and APFC is January 22, 1997, the one-year statute of limitations under 11 USC § 548(a) would only cover transfers made after January 22, 1996. In other words, no fraudulent transfer under § 548 would be recoverable for payments on contracts nominally with WPI or APFC.
In re Auto-Train Corp.- The BRA defendants principally rely on In re Auto-Train Corp., 810 F2d 270 (DC Cir 1987). I conclude, however, even applying the Auto-Train test, that substantive consolidation should be effective on December 19, 1995.
The issue in Auto-Train was whether funds transferred by Railway Services Corporation (Railway), a wholly owned subsidiary of Auto-Train, to Midland-Ross Corporation were a preference under 11 USC §547. The dispute arose out of a transaction in which Ronsco Supply Company, Inc. brokered a deal for the sale of some railroad equipment from Midland-Ross to Marine Industries, Ltd. Because Marine Industries was a Canadian company, for some reason Midland-Ross could not deal directly with Marine. Ronsco proposed that Railway be used as an intermediary.
Ronsco, as Marine's agent, submitted a purchase order for the railroad equipment to Railway. Railway, in turn, submitted its own purchase order to Midland-Ross, the manufacturer.
The railroad equipment was shipped directly to Marine in Canada. Marine transferred about $500,000 to Railway. This included the purchase price and shipping charges totaling about $495,000, plus a $5,000 commission for Railway. Railway transferred the funds to Midland-Ross, less the $5,000 commission, over the period of June 11, 1980, through July 15, 1980.
On September 8, 1980, Auto-Train filed a voluntary chapter 11. On November 10, 1980, the chapter 11 trustee filed a motion to amend the caption of the Auto-Train petition and add Railway as a named party. The bankruptcy court conducted a hearing on November 21, 1980, and ordered the substantive consolidation of Railway into the Auto-Train estate effective as of September 8, 1980, the date of the Auto-Train voluntary petition.
The trustee then sought to avoid the transfer under § 547 of the Bankruptcy Code as preferential. Among the defenses, Midland-Ross claimed that the court had no authority to order a nunc pro tunc consolidation. The bankruptcy court held that nunc pro tunc consolidation was appropriate, and that issue was eventually appealed to the Circuit Court for the District of Columbia.
The trustee argued that nunc pro tunc consolidation reflected the facts as they really existed, that Railway had no existence separate from Auto-Train. The issue of substantive consolidation was not contested by Midland-Ross, only its nunc pro tunc application. The D.C. Circuit Court said that the criteria for determining whether to substantively consolidate were not precisely the same as those for determining the effective date of the consolidation.
Focusing first on whether or not a bankruptcy court should order consolidation, and not what the appropriate effective date should be, the court said, Id. at 276:
Before ordering consolidation, a court must conduct a searching inquiry to ensure that consolidation yields benefits offsetting the harm it inflicts on objecting parties. See, e.g., In re Snider Bros., Inc., 18 B.R. 230, 237-38 (Bankr. D. Mass.1982). The proponent must show not only a substantial identity between the entities to be consolidated, but also that consolidation is necessary to avoid some harm or to realize some benefit. Id.; see also Flora Mir Candy Corp. v. R.S. Dickson & Co., 432 F.2d at 1063; Chemical Bank New York Trust Co. v. Kheel, 369 F.2d at 847. At this point, a creditor may object on the grounds that it relied on the separate credit of one of the entities and that it will be prejudiced by the consolidation. See Chemical Bank New York Trust Co. v. Kheel, 369 F.2d at 848 (Friendly, J., concurring). If a creditor makes such a showing, the court may order consolidation only if it determines that the demonstrated benefits of consolidation "heavily" outweigh the harm. In re Continental Vending Machines Corp., 517 F.2d at 1001. [internal and end citations omitted]
The court found that there was an additional and slightly different balancing process before a court could order nunc pro tunc consolidation. This is because a nunc pro tunc order would subject certain transferees to avoidances which might have lapsed if a later date for consolidation were fixed. Id. at 276. An important factor in determining the appropriate date is a transferee's reliance on an entity's apparent separateness. Otherwise, in any group of affiliated corporations, "a sign of weakness in any member of a family of corporations would lead creditors to descend on each member, strong or weak, to claim their pound of flesh." Id. at 277.
A rule automatically adopting a nunc pro tunc date would make creditors reluctant to deal with financially troubled companies. It would also hinder the ability of sound companies to help their weaker affiliates out of a predicament. The court announced the following test, Id. at 277:
In light of these considerations, a court should enter a consolidation order nunc pro tunc only when it is satisfied that the use of nunc pro tunc yields benefits greater than the harm it inflicts. This inquiry will closely parallel that conducted with respect to consolidation. Because the consolidation proceeding will already have established a substantial identity between the entities to be consolidated, this inquiry begins with the proponent of nunc pro tunc making a showing that nunc pro tunc is necessary to achieve some benefit or avoid some harm. Following this showing, a potential preference holder may challenge the nunc pro tunc entry of the consolidation order by establishing that it relied on the separate credit of one of the entities to be consolidated and that it will be harmed by the shift in filing dates. If a potential preference holder meets this burden, the court must then determine whether the benefits of nunc pro tunc outweigh its detriments. [footnote omitted]
The court held that Railway was a legitimate corporation, and notwithstanding the fact that it had acted as a middleman in the Midland-Ross and Marine transaction, Midland-Ross was justified in relying, and had relied, on Railway's separate existence. Railway dealt with the public as an entity separate from Auto-Train. Midland-Ross had even extended credit to Railway after Auto-Train filed its bankruptcy. Railway had also filed an S-1 registration statement with the SEC, indicating its assets, liabilities, and operations were separate from Auto-Train's. Thus, the order of a nunc pro tunc consolidation was reversed, and Midland-Ross's payment to Railway was not within the 90-day preference period.
Baker & Getty Financial Services, Inc.- Refusing to follow Auto-Train, the 6th Circuit in Baker & Getty Financial Services, Inc., 974 F2d 712, 721 (6th Cir 1992), found that the distinction between whether a case should be substantively consolidated or not to begin with, was so close to the test proposed by Auto-Train to determine the effective date that adopting this distinction would not be wise. It permitted a consolidation effective as of the original petition date. This case involved the same facts discussed in Matter of Baker & Getty Financial Services, Inc., 78 BR 139 (Bankr ND Ohio 1987), discussed in Part 4.5.
Matter of Evans Temple Church- Baker & Getty Financial Services, Inc. relied on the reasoning of Matter of Evans Temple Church of God In Christ and Community Center, 55 BR 976 (Bankr ND Ohio 1986).
In Evans, a pro se debtor, Evans, had filed an individual case on February 23, 1984. He filed an amended petition, improperly joining himself and a corporate debtor, Evans Temple Church. Later still, a proper corporate case was filed for Evans Temple Church. The individual case and corporate case were ultimately substantively consolidated.
A prepetition transfer by the corporate debtor was within the 90-day preference period if the date of the earlier individual petition date was used. On the other hand, the proper corporate filing was well after the preference period had expired. The defendant in the preference action had received notice in both cases.
Thus, the court had the issue before it which exists in the Bonham case, about whether the date of original filing should be used to determine if a transfer was made within the proscribed avoidance period (e.g., one year for a § 548 fraudulent transfer).
The court found it would be appropriate to use the date of the original filing, stating, Id. at 982-83:
We have found no authority on the issue of whether a debtor who files a petition for relief under the Bankruptcy Code subsequent to the filing by an affiliate may avail itself of the earlier date for purposes of the preference provisions when the cases are later substantively consolidated. So far as we can tell, no decision on this issue has ever been reported. However, an analysis of the purposes behind the doctrine of substantive consolidation and of the preference provisions leads us to conclude that the latter-filing debtor may avail itself of the earlier filing date.If the reasons for substantively consolidating two cases filed under the Code is to protect the unsecured creditors of both debtors where the assets and liabilities of the debtors are so intermingled as to make them substantially the same, and if the purpose of the preference provisions is to assure equality of distribution among all creditors, then it logically follows that where two cases are substantively consolidated upon a determination by the Court that the assets and liabilities of each debtor are not clearly separable, the preference provisions require us to treat the creditors of both debtors in substantially the same manner. In order for us to do so, we must assign a like filing date to both Debtors for purposes of the preference provisions. We hold that the Church may avail itself of the February 23, 1984, filing date for purposes of determining whether the payment to Carnegie Body constituted a preference under Section 547.
We believe our conclusion to lie within the spirit and purposes of the Bankruptcy Code. Moreover, we do not believe our conclusion to be manifestly unfair to Carnegie or Associates. When Evans filed his first individual pro se petition on February 23, 1984, both Carnegie and Associates were listed as creditors. Neither Carnegie nor Associates denied that it was a creditor of Evans individually. In the pleadings, Carnegie refers to all actions taken by Debtors as undertaken by "Reverend Willie Evans, II, and/or Evans Temple Church of God in Christ and Community Center, Inc." If the parties herein cannot attribute actions to the separate Debtors, it seems to us that the only fair and reasonable conclusion is that Evans and the Church are substantially the same Debtor and that the Church must be permitted to avail itself of the February 23, 1984, filing date. Only by doing so will all creditors be protected.
These facts are analogous to the reality of Bonham's Ponzi operations. The creditors dealt principally with her, and she arbitrarily assigned WPI or APFC to the investment contract.
In re Kroh Brothers Development Co.- In In re Kroh Brothers Development Co., 117 BR 499 (WD Mo 1989), the court affirmed a decision by the bankruptcy court which, after applying the Auto-Train test, nonetheless found that substantive consolidation nunc pro tunc was approved. The court said, Id. at 502:
Nunc pro tunc consolidation would make it possible for a trustee to pursue an action under §§ 547 and 548, so the first requirement [of the Auto-Train test], benefit to the estate, is satisfied.
The Kroh court then considered whether the objecting party had relied on the independent credit of a non-debtor entity which was later consolidated without objection. If the date of the nunc pro tunc application were used, the payment to the objecting creditor would have been within the preference period. If the later date, when substantive consolidation was granted, were used, the payment would have been safe from the avoidance action.
The bankruptcy court found that the original debtor, and the non-debtor who was consolidated at a later date, had a practice of commingling their bank accounts. They had virtually no independent existence from one another. The subsequently added non-debtor had no employees, office, or separate bank account. It derived all its income from dealings with the original debtor. No evidence was offered by the objecting creditor that he or she had relied on the credit of the subsequently added non-debtor.
In the Bonham case, the BRA defendants are hard put to say that they relied on WPI or APFC, and not Bonham. This was a key person operation, and all investments were handled by Bonham personally. Funds were indiscriminately transferred back and forth between WPI and APFC. Creditors who sent the check in might use WPI's name as payee only to have it endorsed over to APFC at Bonham's whim. This whim apparently was guided in part by her hope of avoiding state securities regulations.
Investors who did have a contract with one entity, e.g., WPI, were often paid by the other, APFC. Even under the Auto-Train test, there was no realistic reliance solely on the credit of either WPI or APFC. Since those entities are alter egos of RaeJean Bonham, the effective date of the substantive consolidation should be the date of the involuntary proceeding, December 19, 1995.
The clients of attorneys George Goerig, John Burns, Michael MacDonald, Bruce Davison, Brad Ambarian, and Rebecca Copeland filed boiler-plate declarations asserting a reliance, but giving no details. Therefore, I credit them with little weight. See, ¶¶ 2.12.4-2.12.8.
There were two businesses run by Bonham: a ticket sales business that did no better than break even (see, ¶ 2.4), and an investment business which turned over large sums of money (see, ¶ 2.6). If the facts were that the BRA defendants in fact invested funds that were used in the ticket sales business and had been paid by the ticket sale business, they would have a good argument for avoiding a nunc pro tunc consolidation. In reality, however, their investment was, knowingly or unknowingly, in an illegal Ponzi scheme. If they were not paid by a legitimate ticket sales business, but by the pyramid of funds from subsequent Ponzi scheme investors, then their situation is different than Ronsco in Auto-Train. There is fairness in treating the Targets like the Claimants, and allowing the equitable distribution features of the Bankruptcy Code to operate for both Claimants and Targets rather than have the Claimants bear the entire burden of Bonham's Ponzi scheme.
I conclude that consolidation of WPI and APFC should be effective as of December 19, 1995.
Substantive consolidation of WPI and APFC with the Bonham estate will be ordered effective as of December 19, 1995.
The court will enter a separate order to accomplish this, but first seek the advice of the parties at the next BRA status conference regarding the form of the order and such issues as to whether additional notices are necessary to the creditors of WPI and APFC, and what the form should be.
DATED: April 10, 1998
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/s/ Herbert A. Ross |
TRUSTEE'S MOTION FOR SUBSTANTIVE CONSOLIDATION
On January 22, 1997, Cabot Christianson, special counsel for the trustee, filed a Trustee's Motion For Order Confirming That Assets And Liabilities Of Bonham, World Plus And Atlantic Pacific Funding Corp Are Subject To Administration, For Joint Administration And For Substantive Consolidation Of Estates And To Amend Caption (Docket Entry 731) ["Motion to Consolidate"]. This motion is supported in part by the Affidavit of Larry D. Compton (Docket Entry 732), Exhibits to the Affidavit, Nos. 1 through 82 (Docket Entry 733), and the Supplemental Affidavit Of Larry D. Compton with attached Exhibits 84 through 100 (Docket Entry 1281). The trustee's motion was vigorously opposed by pro se creditors/investors, as well as members of the Joint Defense Committee (JDC). The trustee supplemented his motion and responded to the oppositions. The table listed below sets forth all the relevant pleadings regarding the trustee's motion.
|
DE # |
FILED |
TITLE |
FILED BY |
|---|---|---|---|
|
731 |
01/22/97 |
Trustee's Motion For Order Confirming That Assets And Liabilities Of Bonham, World Plus And Atlantic Pacific Funding Corp Are Subject To Administration, For Joint Administration And For Substantive Consolidation Of Estates And To Amend Caption ["Motion to Consolidate"] |
Cabot Christianson for Trustee |
|
732 |
01/22/97 |
Affidavit Of Larry D. Compton |
Larry Compton, Trustee |
|
733 |
01/22/97 |
Exhibits To Motion to Consolidate |
Cabot Christianson for Trustee |
|
746 |
01/24/97 |
Opposition To Motion To Consolidate |
William Satterberg |
|
895 |
02/21/97 |
Opposition To Motion To Consolidate |
William Satterberg |
|
905 |
03/03/97 |
Opposition To Motion To Consolidate |
Robert Darling, Pro Se |
|
906 |
03/03/97 |
Memorandum In Support Of Opposition To Motion To Consolidate |
Robert Darling, Pro Se |
|
914 |
03/10/97 |
Response To Opposition To Motion To Consolidate |
Kenneth & Donna Wooten, Pro Se |
|
1032 |
03/17/97 |
Joint Defense Counsel's Procedural Objection To Motion To Consolidate |
John Burns |
|
1051 |
03/24/97 |
Response And Objection To Motion To Consolidate |
Randy Haines for Carter, Dunlap, et al |
|
1105 |
04/21/97 |
Supplemental Memorandum In Opposition To Motion To Consolidate Re: Alter Ego Issues |
Randy Haines for Carter, Dunlap, et al |
|
1107 |
04/21/97 |
Appendix Of Supplemental Authorities Re: Opposition To Motion To Consolidate |
Ronald Goss |
|
1108 |
04/21/97 |
Joinder And Supplement To Response And Objection To Motion To Consolidate |
Brad Ambarian |
|
1150 |
05/05/97 |
Trustee's Reply To Procedural Objections To Motion To Consolidate [Re: DE#1032, 1051, 1105, & 1108] |
David Bundy for Trustee |
|
1151 |
05/05/97 |
Trustee's Reply To Objections To Motion To Consolidate [Re: DE# 746, 895, 905, 914, 1032, 1051, 1105, 1107, & 1108] |
David Bundy for Trustee |
|
1170 |
05/16/97 |
Delta Air Lines, Inc.'s Partial Joinder In Motion To Consolidate |
Jon Dawson for Delta Air Lines |
|
1177 |
05/21/97 |
Trustee's Supplemental Memorandum Re: Motion To Consolidate |
Cabot Christianson for Trustee |
|
1178 |
05/21/97 |
Statement Of Genuine Issues Of Material Fact Re: Motion To Consolidate |
Brad Ambarian |
|
1281 |
05/23/97 |
Supplemental Affidavit Of Larry D. Compton |
Cabot Christianson for Trustee |
|
1304 |
05/28/97 |
Statement Of Uncontested Facts |
Cabot Christianson for Trustee |
|
1319 |
06/06/97 |
Trustee's Proposed Findings of Fact and Conclusions of Law |
Gary Spraker for Trustee |
|
1328 |
06/20/97 |
Objections To Trustee's Proposed Findings of Fact |
Brad Ambarian |
|
1329 |
06/20/97 |
Defendants' Proposed Findings of Fact and Conclusions of Law Re: Motion To Consolidate |
Lewis & Roca |
|
1342 |
07/03/97 |
Trustee's Reply To Objection To Proposed Findings Of Fact And Objection To Defendants' Proposed Findings And Conclusions Re: Motion To Consolidate |
Cabot Christianson for Trustee |
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