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Leveraging Substantive Consolidation,
Piercing the Veil, and Alter Ego
in Bankruptcy Proceedings Maximizing Creditor Recovery From or Asset Protection
for Debtor's Shareholders and Related Entities
Today’s faculty features:
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TUESDAY, AUGUST 5, 2014
Presenting a live 90-minute webinar with interactive Q&A
Gary M. Kaplan, Partner, Farella Braun + Martel, San Francisco
Benjamin G. Lombard, Shareholder, Reinhart Boerner Van Deuren, Milwaukee
Ariel Weissberg, Managing Partner, Weissberg and Associates, Chicago
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FOR LIVE EVENT ONLY
Leveraging Substantive Consolidation, Piercing the
Veil, and Alter Ego in Bankruptcy Proceedings
GARY M. KAPLAN, Farella Braun + Martel LLP
gkaplan@fbm.com
415.954.4940
August 5 2014
Alter Ego Doctrine & Elements
• "The alter ego doctrine arises when a plaintiff comes into
court claiming that an opposing party is using the corporate
form unjustly and in derogation of the plaintiff's interests. In
certain circumstances the court will disregard the corporate
entity and will hold the individual shareholders liable for the
actions of the corporation.” Mesler v. Bragg Mgmt. Co., 39
Cal.3d 290, 300 (1985)
• Alter ego claim generally requires: (1) unity of interest and
ownership such that separate personalities of corporation and
shareholder no longer exist, and (2) if acts are treated as
those of corporation alone, an inequitable result will follow."
Mesler, 39 Cal.3d at 300
5
Alter Ego Doctrine & Elements
• Factors courts consider in alter ego analysis:
• Commingling of funds and assets
• Identical ownership (direct or indirect) of the
entities
• Use of the same offices and employees
• Disregard of corporate formalities
• Identical directors and officers
• Corporation is mere shell or conduit for affairs of
the individual or other entity
6
Alter Ego Doctrine & Elements
• While California case law has applied alter ego doctrine to
corporations, a member of an LLC can be held personally
liable for obligations of LLC under comparable circumstances
pursuant to a California statute.
• Cal. Corp. Code §17101(b): “A member of a limited liability
company shall be subject to liability under the common law
governing alter ego liability, and shall also be personally
liable under a judgment of a court or for any debt, obligation,
or liability of the limited liability company, whether that liability
or obligation arises in contract, tort, or otherwise, under the
same or similar circumstances and to the same extent as a
shareholder of a corporation may be personally liable for any
debt, obligation, or liability of the corporation . . .”
7
Pursuit Of Alter Ego Claims By
Bankruptcy Trustee Or Creditor
• Bankruptcy trustee stands in shoes of bankrupt
corporation and has standing to bring any suit that
debtor could have brought had it not filed
bankruptcy. When trustee has standing to assert a
claim, such standing is exclusive and divests all
creditors of power to bring same claim
• Recent 9th Circuit case addressing rights of trustee
and creditors to assert alter ego claims: Ahcom
Ltd. v. Smeding, 623 F.3d 1248 (9th Cir. 2010)
8
Pursuit Of Alter Ego Claims By
Bankruptcy Trustee Or Creditor
• Ahcom holding: individual creditor of corporation in
bankruptcy has standing to assert claim against
sole shareholder on alter ego theory
• Overruled cases holding alter ego claim is property
of estate that only trustee (rather than creditor) can
assert if it alleges injury to corporation (e.g., CBS,
Inc. v. Folks (In re Folks), 211 B.R. 378 (B.A.P. 9th
Cir. 1997) & In re Davey Roofing, Inc., 167 B.R.
604 (Bankr. C.D. Cal. 1994))
9
Pursuit Of Alter Ego Claims By
Bankruptcy Trustee Or Creditor
• Ahcom: "California law does not recognize an alter ego claim
or cause of action that will allow a corporation and its
shareholders to be treated as alter egos for purposes of all
the corporation’s debts." 623 F.3d at 1250.
• 9th Circuit relied on California Supreme Court decision in
Mesler v. Bragg Mgmt. Co., 39 Cal.3d 290 (1985) for this
finding
• However, Ahcom court recognized that trustee can bring
action on behalf of debtor where company injured due to
conduct by shareholders typical of that alleged in alter ego
claims (e.g., action for conversion, fraudulent transfer) without
utilizing alter ego remedy
10
Pursuit Of Alter Ego Claims By
Bankruptcy Trustee Or Creditor
• Case law suggesting alter ego claims can be
pursued for creditors collectively under Chapter 11
plan of reorganization
• In re Tribune Co., 2011 Westlaw 514220 (Bankr. D.
Del 2011): Even though bankruptcy trustee cannot
pursue claims belonging to individual creditors,
Plan may appoint litigation trustee to prosecute
alter ego claims on their behalf
11
Pursuit Of Alter Ego Claims By
Bankruptcy Trustee Or Creditor
• Ahcom arguably misconstrues California law in
stating "no California court has recognized a free-
standing general alter ego claim," as that is what
California Supreme Court did in Mesler
• Mesler actually reversed lower court and ruled
plaintiff should have been allowed to proceed on
alter ego claim: "In the case at bar the court should
have permitted plaintiff to plead the alter ego
issue." (39 Cal. 3d at 297)
12
Pursuit Of Alter Ego Claims By
Bankruptcy Trustee Or Creditor
• Following Mesler and progeny, California courts continue to
recognize alter ego claims. E.g., Zoran v. Chen, 185
Cal.App. 4th 799 (2010) (reversing summary judgment for
defendant on alter ego claims based on genuine factual
issues regarding whether defendant's domination and control
of corporation gave rise to unity of interest); Doney v. TRW,
33 Cal.App 4th 345 (1995) (relying on Mesler and recognizing
viability of alter ego claims against parent company for acts of
subsidiary)
• Alternative strategy: Trustee assertion of alter ego claim in
state court (if state law allows such claims) because Ahcom is
federal court decision not binding on state courts
13
Pursuit Of Alter Ego Claims By
Bankruptcy Trustee Or Creditor
• Recent California Court of Appeals decision
generally following Ahcom: Shaoxing County
Huayue Import & Export v. Bhaumik, 191 Cal.App.
4th 1189 (Jan. 18, 2011)
• Holding: individual creditor of corporation in
bankruptcy could pursue alter ego claims against
shareholder, rather than such claims only being
assertable by bankruptcy trustee
14
Pursuit Of Alter Ego Claims By
Bankruptcy Trustee Or Creditor
• However, California Court of Appeal recognized
bankruptcy trustee's right to pursue alter ego
theories on behalf of company based on
shareholder's injury to the corporation:
• "The trustee of a bankrupt corporation can maintain
an action against a defendant based on an alter
ego theory if there is some allegation of injury to
the corporation that gives the corporation a right of
action against the defendant."
15
Pursuit Of Alter Ego Claims By
Bankruptcy Trustee Or Creditor
• Strategy to avoid dismissal of alter ego claim based on
Shaoxing court finding that “no California court has
recognized a freestanding general alter ego claim that would
require a shareholder to be liable for all of a company’s
debts” (quoting Ahcom): plead as declaratory relief claim
• Alternative: Frame alter ego claim against shareholder under
trustee’s Bankruptcy Code §544(b) “strong arm” powers
(allowing trustee to step into shoes of creditor who could
avoid debtor’s transfer of property or incurrence of obligation)
• E.g., assert claim for fraudulent transfer (under Bankruptcy
Code or state law), if can establish either actual intent to
hinder, delay or defraud creditors or lack of reasonably
equivalent value exchanged and insolvency at time of transfer
16
Pursuit Of Alter Ego Claims By
Bankruptcy Trustee Or Creditor
• Alternative: Trustee claim for breach of fiduciary duty based on facts giving rise to alter ego claim, in view of case law (e.g., Berg & Berg Enterprises, LLC v. Boyle, et al., 178 Cal.App.4th 1020 (2009); North American Catholic Educ. Programming Found. Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007)) holding that creditors have no direct claims for breach of fiduciary duty but that such derivative claims instead belong to corporation (assertable by trustee)
• Alternative: Trustee can seek to substantively consolidate assets of shareholder (even if not in bankruptcy) with those of corporate debtor (pursuant to 9th Circuit’s decision in U.S. Bancorp Mortg. Co. v. Bonner Mall Partnership, 2 F.3d 899 (9th Cir. 1993) and comparable authority), as facts giving rise to alter ego claim frequently overlap elements for substantive consolidation (e.g., commingling of assets and liabilities)
17
Contact Information
Gary Kaplan
Partner, and Chair of Restructuring,
Insolvency & Creditors Rights Group
Farella Braun + Martel LLP
235 Montgomery Street, 17th Floor
San Francisco, CA 94104
gkaplan@fbm.com
415.954.4940
18
Strafford Webinars:
Piercing the Corporate
Veil in Bankruptcy Ariel Weissberg, Esq.
Weissberg and Associates, Ltd.
401 South LaSalle Street
Suite 403
Chicago, IL 60605
(312) 663-0004
Ariel@weissberglaw.com
www.weissberglaw.com
August 5, 2014
Introduction: Topics To Be
Discussed
• Bankruptcy Court Jurisdiction
• General Overview of Piercing the Corporate Veil Cause of Action
• Historical
• Elements
• Combination of Equitable and Legal Remedy
• Standing
• Chapter 7 Trustee or Chapter 11 Trustee
• Derivative Standing
• Jury Trial
• Burden of Proof
• Clear and Convincing or Preponderance of the Evidence
• Piercing the Corporate Veil: Factors
20
Bankruptcy Court Jurisdiction
• Article III of the U.S. Constitution
• 28 USC §157(b)(2)(C)
• Northern Pipeline Construction Co. v. Marathon Pipeline Co., 458 U.S. 50, 102 S. Ct. 2858, 73 L.
Ed.2d 598 (1982)
• Bankruptcy Amendments and Federal Judgeship Act of 1984, Pub. L. No. 98-353, 98
Stat. 333 (“1984 Act”)
• Commodity Futures Trading Commission v. Schor, 478 U.S. 833, 106 S. Ct. 3245, 92 L. Ed.2d
675 (1986)
• Granfinanciera S.A. v. Nordberg, 492 U.S. 33, 109 S. Ct. 2782, 106 L. Ed. 2d 26 (1989)
• Stern v. Marshall, 564 U.S. 2, 131 S. Ct. 2594 (2011)
• Exec. Benefits Ins. Agency, Inc. v. Arkison, 702 F.3d 553 (9th Cir. 2012)
• Wellness International Network, Limited v. Sharif, 727 F.3d 751 (7th Cir. 2013)
• Exec. Benefits Ins. Agency, Inc. v. Arkinson, 573 U.S.__ (2014) 21
United States Supreme Court
Piecing the Corporate Veil Cases
• Dole Food Co. v. Patrickson, 538 U.S. 468 (2003)
• Pepper v. Litton, 308 U.S. 295, 60 S. Ct. 238, 84 L. Ed. 281
(1939)
• Bangor Punta Operations, Inc. v. Bangor & Aroostook R. Co.,
417 U.S. 703, 94 S. Ct. 2578, 41 L. Ed. 2d 418 (1974)
22
Predominant Business
Organizations
• Limited Liability Company
• Limited Liability Partnership
• Corporation
• General Partnership
• Limited Partnership (General Partner)
• Sole Partnership
• “Piercing Corporate Veil”
• Breach of Fiduciary Duty by Directors and Officers when Business Organization is insolvent
23
Standing
• Koch Ref. v. Farmers Union Cent. Exch., Inc., 831 F.2d 1339 (7th Cir. 1987)
• Official Committee v. RF Lafferty & Co., 267 F. 3d 340 (3d Cir. 2001)
• Steyr-Daimler-Puch of America Corp. v. Pappas, 852 F. 2d 132 (4th Cir. 1988)
• Lumpkin v. Envirodyne Industries, Inc., 933 F. 2d 449 ( 7th Cir. 1991)
• In re: Ozark Restaurant Equipment Co., Inc., 816 F. 2d 1222 (8th Cir. 1987)
• Kalb, Voorhis & Co. v. American Financial Corp., 8 F. 3d 130 (2d Cir. 1993) (Applying Texas Law)
• Board of Trustees of Teamsters v. Foodtown, Inc., 296 F. 3d 164 (3d Cir. 2002)
24
Derivative Standing
• Fogel v. Zell, 221 F.3d 955 (7th Cir. 2000)
• In re: Adelphia Communications Corp., 544 F.3d 420 (2d Cir. 2008)
• In re: Trailer Source, Inc., 555 F.3d 231 (6th Cir. 2009)
• In re: Lauer, 98 F.3d 378 (8th Cir. 1996)
• In re: Racing Services, Inc., 540 F.3d 892 (8th Cir. 2008)
• Official Committee of Unsecured Creditors of Cybergenics Corp. ex rel. Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d Cir. 2003)
25
Jury Trial
• Granfinanciera S.A. v. Nordberg, 492 U.S. 33, 109 S. Ct.
2782, 106 L. Ed. 2d 26 (1989)
• Wm. Passalacqua Builders v. Resnick Developers, 933 F. 2d
131 (2d Cir. 1991)
• Koch Ref. v. Farmers Union Cent. Exch., Inc., 831 F.2d 1339
(7th Cir. 1987)
26
Burden of Proof: Clear and
Convincing or Preponderance of
the Evidence • Trustees, Nat. Elevator Industry Pension v. Lutyk, 332 F. 3d
188 (3d Cir. 2003)
27
Piercing the Corporate Veil
• An equitable remedy to disregard the corporate entity and
impose personal liability on a corporation’s shareholders.
• Van Dorn v. Future Chem. & Oil Corp (7th Cir.): Two prong
test: A corporation is pierceable when
• (1) There is such “unity of interest and ownership” that the
separate personalities of the individual and corporation cease to
exist, and
• (2) When adhering to the fiction of a separate corporation
existence would sanction a fraud or injustice.
28
Mere Instrumentality
• In Main Bank of Chicago v. Baker, the Illinois Supreme Court rephrased the second prong such the corporation must be “so controlled and its affairs so conducted that it is a mere instrumentality of another.”
• Mere Instrumentality
• Fontana v. TLD Builders (2nd Dist.):
• A corporation is a mere instrumentality when it is merely the alter ego or business conduit of another person or entity.
• For example, an entity or individual who uses a corporation as a method of conducting his or her business.
29
Badges of Fraud
BADGES OF FRAUD
• Inadequate capitalization;
• Failure to issue stock;
• Failure to observe corporate formalities;
• Nonpayment of dividends;
• Insolvency of the debtor corporation;
• Nonfunctioning of officers or directors;
• Absence of corporate records;
• Commingling of funds;
• Diversion of assets from the corporation by or to
a stockholder, or other person or entity to the
detriment of creditors;
• Failure to maintain arms’ length relationships
among related entities; and
• Whether the corporation was merely a façade for
the operation of the dominant stockholders.
• Used in the analysis of both prongs.
• Numerosity is not required.
• Fontana v. TLD Builders (2nd Dist.): The
Court will not base its decision on a single
factor, but examine several factors and the
totality of the circumstances
30
Undercapitalization
• Undercapitalization alone in not sufficient to pierce the corporate veil.
• Browning-Ferris Industries of Illinois v. Ter Maat, (7th Cir.) Undercapitalization is rarely if ever the sole factor in a decision to pierce the corporate veil.
• Fontana v. TLD Builders (2nd Dist.):
• Compare the amount of capital to the amount of business to be conducted and the obligations to be fulfilled.
• Held: Loans made by shareholders to the corporation and a $4 million line of credit with a bank did not show adequate capitalization, but rather, inadequacy of capitalization and an indication that the initial capitalization was insufficient to conduct the corporation’s affairs.
• Laborers' Pension Fund v. Lay-Com, Inc. et al., 580 F.3d 602 (7th Cir. 2009). Held: Adequate capitalization exists when a corporation has sufficient equity without considering loaned funds or encumbered assets.
31
Failure to Observe Corporate
Formalities
• Failure to observe corporate formalities is not a ground for imposing personal liability on an LLC member.
• For corporations, evidence of a failure to follow corporate formalities includes some of the badges of fraud:
• Commingling
• Absence of Corporate Records
• Other Badges
• Failure to issue stock (stock certificate)
• Nonpayment of Dividends
• Nonfunctioning of Officers or Directors
• No decision-making role
• Shareholder’s control over corporation/ Officers renders them nonfunctioning 32
Commingling
• Sea-Land Services, Inc. v, Pepper Source (7th Cir.): Commingling found when
shareholder used the bank accounts of all of these corporations to pay
personal expenses, including alimony, child support, education expenses
for his children, automobile maintenance, and healthcare for his pet.
• Jay Steinberg v. Helen Buczynski (7th Cir.): Funds were not commingled
where shareholders paid some of their personal expenses with checks
issued by the corporation. the shareholders “took no more than what
would have been a reasonable amount in salary, merely omitting the
formality of having salary checks issued to them and paying the personal
expenses in question by personal check.”
33
Absence of Corporate Records
• Particularly tricky in “one-man” corporations: corporations where one person is the sole shareholder, director, and manager.
• Jay Steinberg v. Helen Buczynski (7th Cir.): There was not a failure to follow corporate formalities despite the fact that the entity never held formal shareholder meetings or kept corporate minutes, and paid some of their personal expenses with checks issued by the corporation.
• Gallagher v. Recono Builders (1st Dist.): Defendant failed to follow corporate formalities because there were no corporate resolutions, meetings were undocumented, and the defendant failed to produce any corporate books
34
Reverse Piercing
• A variation of traditional veil piercing.
• Subjects the corporation to liability for the acts of its shareholders.
• Generally arises when a shareholder’s creditors try to reach the assets of the corporation.
• Scholes v. Lehmann (7th Cir.): Reverse piercing is ordinarily possible only in one-man corporations, since if there is more than one shareholder, seizing the corporation’s assets to pay a shareholder’s debts would be a wrong to the other shareholders.”
35
Reverse Piercing: The Test
• Reverse piercing is appropriate when
• (1) an insider owns all, or substantially all, of the stock, and
• (2) the insider treats the property as his or her own, and
• (3) no shareholder or creditor would be adversely affected.
36
Veil Piercing & LLCs
• Illinois LLCs are governed by the Limited Liability Company Act (“LLCA”).
• Originally provided: a member of an LLC would not be liable for any act, debt, obligation, or liability of the LLC to the extent that a shareholder of an Illinois corporation would be liable under analogous circumstances.
• Amended to provide: “The debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of a company solely by reason of being or acting as a member or manager.”
• Specifically provides: An LLC’s failure to observe corporate formalities is not a ground for imposing personal liability on its members or managers
• Case law is sparse, but has resulted in two approaches: Pro-LLC piercing and Against LLC Piercing.
37
Non-Pierceable: The Puleo
Approach
• Puleo v. Topel
• Appellate Court for the First District of Illinois considered piercing the veil of an LLC that was administratively dissolved for failing to report.
• Held: an individual member or manager of an LLC was not personally liable for obligations incurred by the entity after it was dissolved relying on
• The amended LLCA providing for no personal liability, and on LLCA § 10-10(d), which provides that an LLC may assign personal liability to its members by including a provision to that effect in its articles of organization, or if a member consents to the imposition of such liability in writing
• Arguable that this protection goes beyond the protections enjoyed by shareholders of a corporation.
38
Pierceable
• Westmeyer v. Flynn (1st Dist.): The Court declined to
follow the First District’s reasoning in Puleo and noted
that § 10-10 of the LLCA “does not bar the other bases
for corporate veil piercing, including alter ego, fraud and
undercapitalization.”
• Several Bankruptcy Courts in the Northern District of
Illinois have followed this approach.
39
Leveraging Substantive Consolidation,
Piercing the Corporate Veil, and Alter
Ego in Bankruptcy Proceedings
Benjamin G. Lombard
Reinhart Boerner Van Deuren s.c.
1000 North Water Street, Suite 1700
Milwaukee, WI 53202
414-298-1000
blombard@reinhartlaw.com
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 40
Substantive Consolidation
What is substantive consolidation?
• Substantive consolidation is an equitable doctrine in bankruptcy which permits the
consolidation of legally separate entities as if they were merged into a single survivor
with all of their assets and liabilities pooled.
• The Bankruptcy Code does not expressly authorize substantive consolidation. Instead,
the authority for a bankruptcy court to order substantive consolidation lies in its
general equitable powers under Section 105(a) of the Bankruptcy Code.
• Substantive consolidation has its origins in the state law concept of piercing the
corporate veil, although it has developed into a distinct doctrine under federal
bankruptcy law. As with piercing the corporate veil, a key consideration is whether
there is too much identity between separate entities and a failure to follow proper
formalities for each entity.
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 41
Substantive Consolidation
What is effect of substantive consolidation?
• In substantive consolidation, the assets of two or more affiliated entities are pooled,
intercompany claims are eliminated and creditors have claims against the pool of
assets in the bankruptcy estate.
• Substantive consolidation can be used to pull a solvent entity into the bankruptcy
estate of an affiliate.
• If an affiliated entity is consolidated with a debtor's bankruptcy estate, the automatic
stay and other provisions of bankruptcy law will apply.
• Creditors of the affiliated entity may also be left with an unsecured claim to the
estate's aggregate assets together with other creditors rather than a secured claim to
the affiliated entity's assets.
• Substantive consolation can result in a windfall to creditors of an insolvent entity and a
penalty to creditors of a solvent entity.
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 42
Substantive Consolidation
When may substantive consolidation apply?
• The risk of substantive consolidation should be considered anytime a creditor extends
credit to an entity relying on it to be separate from its affiliates.
• Substantive consolidation is relevant to securitization transactions and other structured
financing transaction involving the sale of receivables, consumer finance contracts
and other assets through special purpose vehicles (SPVs).
• It may also apply in more typical lending contexts, which is in fact where most of the
case law has arisen. Consider the basic facts of In re Owens Corning, 419 F.3d 195 (3rd
Cir. 2005).
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 43
Substantive Consolidation
When may substantive consolidation apply? (continued)
• Owens Corning and its subsidiaries were a multinational corporate group with
numerous related entities in different lines of business.
• A number of the Owens Corning entities faced continuing liability concerns due to
asbestos-related claims and litigation.
• A group of banks were willing to make a loan to Owens Corning despite the asbestos
risk, but only because of certain "credit enhancements."
• Most notably there were solvent entities in the corporate group without exposure to
asbestos claims. The banks required guarantees from these entities.
• When Owens Corning filed for reorganization under Chapter 11 of the Bankruptcy
Code due to the asbestos-related liability, it proposed a plan predicated on
substantive consolidation of the solvent guarantors. Substantive consolidation would
"benefit" the bankruptcy estate by providing it with a larger pool of assets for the
reorganization.
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 44
Substantive Consolidation
What are the tests for substantive consolidation?
• Courts have developed multiple tests for substantive consolidation, and as a result
there is little uniformity in its application.
• Many courts state that substantive consolidation is an extraordinary remedy that
should be used sparingly, but other courts applying a "liberal trend" may more readily
apply substantive consolidation.
• Although there may be many differing details in the tests applied by the courts, courts
and commentators have increasingly referenced two main competing tests.
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 45
Substantive Consolidation
What are the tests for substantive consolidation? (continued)
• The Augie/Restivo Test. Stricter tests that truly apply substantive consolidation sparingly, and
generally reject substantive consolidation if any creditor relied on the separateness of the
entities. The seminal case for the stricter test is In re Augie/Restivo Baking Co., 860 F.2d 515
(2nd Cir. 1988). Owens Corning is a more recent case that critiques the competing tests and
adopts a stricter test.
• The Auto-Train Test. More liberal tests may apply substantive consolidation if the benefits of
consolidation outweigh (or "heavily outweigh") the harms, even if an objecting creditor relied
on the separateness of one of the entities and will be prejudiced. The "Auto-Train" test
reflects approach. Drabkin v. Midland Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270
(D.C.Cir. 1987).
• Some courts following the liberal trend permit consolidation based on a list of factors relating
to separateness and do not necessarily take creditor reliance on separateness or prejudice
into account. E.g., In re Vecco Constr. Indus., Inc., 4 B.R. 407 (Bankr. E.D. Va. 1980).
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 46
Substantive Consolidation
What are the elements of the Auto-Train test?
• The proponent of substantive consolidation must show:
° "a substantial identity between the entities to be consolidated"; and
° "that consolidation is necessary to avoid some harm or realize some benefit".
• If the proponent makes such a showing, "a creditor can 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."
• If the creditor makes such a showing, the court may order consolidation only if it
determines that the demonstrated benefits of consolidation "heavily" outweigh the
harms.
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 47
Substantive Consolidation
What are the elements of the Augie/Restivo test?
• Whether creditors dealt with the entity as a single economic unit and did not rely on
their separate identity in extending credit.
° This factor is not satisfied if any creditor relied on the separateness of one of the
debtors, and thus would be prejudiced by the consolidation.
• Whether the affairs of the debtors are so entangled that consolidation will benefit all
creditors.
• As the Augio/Restivo test does not authorize a court to generally weigh the harm
versus the benefits of consolidation, it should be harder to satisfy than the Auto-Train
test.
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 48
Substantive Consolidation
Example of weighing an enumerated list of factors for substantive consolidation - In re Vecco
Constr. Indus., Inc., 4 B.R. 407, 410 (Bankr. E.D. Va. 1980), where the count listed the following factors:
• The degree of difficulty in segregating and ascertaining individual assets and liabilities.
• The presence or absence of consolidated financial statements.
• The profitability of consolidation at a single physical location.
• The commingling of assets and business functions.
• The unity of interest and ownerships between various corporate entities.
• The existence of parent and inter-corporate guaranties on loans; and
• the transfer of assets without formal observance of corporate formalities.
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 49
Substantive Consolidation
What are best practices to reduce the risk of substantive consolidation?
• Each entity should pay its own operating expenses from its own funds.
• Each entity should conduct business in its own name (including all of its business
correspondence, invoices, checks and other communications).
• Each entity should maintain its own separate books and records.
• Each entity should maintain separate bank accounts and not commingle funds.
• Each entity should maintain its assets separately in a manner that facilitates their
identification and segregation from those of the other party.
• Each entity should have its own directors and officers, observe corporate formalities in
its operations and obtain proper authorization for its actions.
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 50
Substantive Consolidation
What are best practices to reduce the risk of substantive consolidation? (continued)
• Each entity should compensate its own employees for services from its own funds.
• Each entity should maintain an arms' length relationship with the other, and properly
document all inter-company transactions.
• Each entity should not hold its credit or assets as being available to satisfy the
obligations of the others.
• Each entity should be adequately capitalized to engage in its business transactions.
• Each entity should prepare separate financial statements and ensure that any
consolidated financial statements have notes that clearly state that they are separate
entities and that their assets are available first and foremost to satisfy the claims of their
own creditors.
©2014 All Rights Reserved
Reinhart Boerner Van Deuren s.c. 51
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