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First Impressions: 9th Circuit Rules that Notice of Proposed Substantive Consolidation Must Be Given to Creditors of Non-Debtor

In Leslie v. Mihranian (In re Mihranian), 937 F.3d 1214 (9th Cir. 2019), the U.S. Court of Appeals for the Ninth Circuit considered whether the creditors of a non-debtor must be given advance notice of a motion to substantively consolidate the non-debtor with the bankruptcy estate of a debtor. In an apparent matter of first impression among the circuits, the Ninth Circuit ruled that such notice is required.

Substantive Consolidation

Substantive consolidation is an equitable remedy pursuant to which a bankruptcy court may order that the assets and liabilities (for ease of reference, the "estates") of separate entities be treated as if they belonged to a single, combined entity.

The Bankruptcy Code does not expressly authorize substantive consolidation, but it recognizes that a chapter 11 plan may provide for the "merger or consolidation of the debtor with one or more persons" as a means of implementation. See 11 U.S.C. § 1123(a)(5)(C). In addition, Fed. R. Bankr. P. 1015(b) provides that a bankruptcy court may direct that cases involving affiliated debtors be jointly administered, but the rule is silent regarding substantive consolidation.

A majority of courts have concluded that bankruptcy courts have the power to substantively consolidate debtor entities under section 105(a) of the Bankruptcy Code, which provides that a court "may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions" of the Bankruptcy Code. Forcing the creditors of one entity to share equally with those of another, however, "is considered 'a rough justice remedy that should be rare and, in any event, one of last resort after considering and rejecting other remedies.'" Audette v. Kasemir (In re Concepts America, Inc.), 2018 WL 2085615, *3 (Bankr. N.D. Ill. May 3, 2018) (quoting In re Owens Corning, 419 F.3d 195, 211 (3d Cir. 2005)).

Different standards have been employed by courts to determine the propriety of substantive consolidation. For example, in Eastgroup Properties v. Southern Motel Assoc., Ltd., 935 F.2d 245 (11th Cir. 1991), the Eleventh Circuit adopted a modified version of the standard articulated by the District of Columbia Circuit in Drabkin v. Midland Ross Corp. (In re Auto-Train Corp., Inc.), 810 F.2d 270, 276 (D.C. Cir. 1987). According to this standard: (i) the proponent of consolidation must demonstrate that there is substantial identity between the entities to be consolidated and that consolidation is necessary to avoid some harm or to realize some benefit; and (ii) a creditor may object on the grounds that it relied on the entities' separate credit and will be prejudiced by consolidation, in which case the court can order consolidation only if it determines that the benefits of consolidation "heavily" outweigh the harm.

The Second Circuit established a somewhat different two-part disjunctive standard for gauging the propriety of substantive consolidation in Union Savings Bank v. Augie/Restivo Baking Co., Ltd. (In re Augie/Restivo Baking Co., Ltd.), 860 F.2d 515, 518 (2d Cir. 1988). There, the court concluded that the factual elements considered by the courts 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."

Factors that may be relevant in satisfying these requirements include the following:

(1)      Fraud or other complete domination of the corporation that harms a third party;

(2)      The absence of corporate formalities;

(3)      Inadequate capitalization of the corporation;

(4)      Whether funds are put in and taken out of the corporation for personal rather than corporate purposes;

(5)      Overlap in ownership and management of affiliated corporations;

(6)      Whether affiliated corporations have dealt with one another at arm's length;

(7)      The payment or guarantee of debts of the dominated corporation by other affiliated corporations;

(8)      The commingling of affiliated corporations' funds; and

(9)      The inability to separate affiliated corporations' assets and liabilities.

Id. at 518–19. The Augie/Restivo test was adopted by the Ninth Circuit in Bonham v. Compton (In re Bonham), 229 F.3d 750 (9th Cir. 2000). Many other circuit and lower courts have adopted tests similar to the Augie/Restivo and Eastgroup standards. In Owens Corning, 419 F.3d at 210, however, the Third Circuit opted for an "open-ended, equitable inquiry" rather than a factor-based analysis, as employed by many courts, in reversing lower court rulings approving "deemed" consolidation of 18 debtors and three nondebtor subsidiaries under a plan.

Substantive Consolidation of Debtors and Non-Debtors

Although most courts have held that the substantive consolidation of debtor entities is permitted under appropriate circumstances, they disagree as to whether the substantive consolidation of debtors and non-debtors should ever be allowed. Some courts have concluded that such substantive consolidation is appropriate on the basis of: (i) section 105's broad grant of authority; (ii) a bankruptcy court's ability to assert personal and subject matter jurisdiction over nondebtors; and/or (iii) a bankruptcy court's mandate to ensure the equitable treatment of all creditors. See, e.g., Bonham, 229 F.3d at 769–71; In re Stewart, 603 B.R. 138, 150 (Bankr. W.D. Okla. 2019); In re Falls Event Ctr. LLC, 600 B.R. 857, 868 (Bankr. D. Utah 2019); In re AAA Bronze Statues & Antiques, Inc., 598 B.R. 27, 32 (Bankr. N.D. Fla. 2019); Lassman v. Cameron Constr. LLC (In re Cameron Constr. & Roofing Co.), 565 B.R. 1, 10 (Bankr. D. Mass. 2016); Simon v. ASIMCO Techs., Inc. (In re Am. Camshaft Specialties, Inc.), 410 B.R. 765, 786 (Bankr. E.D. Mich. 2009); Walls v. Centurion Asset Mgmt., Inc. (In re Bolze), 2009 BL 157145, *4 (Bankr. E.D. Tenn. July 23, 2009); Dominion Fin. Corp. v. Morfesis (In re Morfesis), 270 B.R. 28, 31 (Bankr. D.N.J. 2001); see also Clark's Crystal Springs Ranch, LLC v. Gugino (In re Clark), 692 Fed. Appx. 946, 2017 BL 240043 (9th Cir. July 12, 2017) (because the Bankruptcy Code does not expressly forbid the substantive consolidation of debtors and non-debtors, the U.S. Supreme Court's decision in Law v. Siegel, 571 U.S. 415 (2014), does not bar bankruptcy courts from ordering the remedy).

Other courts have held that the substantive consolidation of debtors and non-debtors is inappropriate because, among other things, it circumvents the procedures concerning involuntary bankruptcies set forth in section 303 of the Bankruptcy Code. See, e.g., In re Archdiocese of Saint Paul & Minneapolis, 888 F.3d 944, 951 (8th Cir. 2018) (involving non-profit non-debtors, against which an involuntary petition may not be filed); Concepts America, 2018 WL 2085615, *6; In re Pearlman, 462 B.R. 849, 854 (Bankr. M.D. Fla. 2012); Helena Chem. Co. v. Circle Land & Cattle Corp. (In re Circle Land & Cattle Corp.), 213 B.R. 870, 877 (Bankr. D. Kan. 1997); In re Hamilton, 186 B.R. 991, 993 (Bankr. D. Colo. 1995).

Notice to Non-Debtor's Creditors Required?

Courts disagree over whether the creditors of a non-debtor must be given notice of a motion to substantively consolidate the non-debtor with a debtor's bankruptcy estate. The majority view is that such notice is required in the interests of fairness to all creditors whose substantive rights will be seriously impacted. See, e.g., Fid. & Deposit Co. of Md. v. U.S. Bank N.A. (In re Kimball Hill, Inc.), 2014 WL 5615650, at *4 (N.D. Ill. Nov. 4, 2014); SE Prop. Holdings, LLC v. Stewart (In re Stewart), 571 B.R. 460, 473 (Bankr. W.D. Okla. 2017); Mukamal v. Ark Capital Grp., LLC (In re Kodsi), 2015 WL 222493, at *2 (Bankr. S.D. Fla. Jan. 14, 2015); Kapila v. S&G Fin. Servs, LLC (In re S&G Fin. Servs. of S. Fla., Inc.), 451 B.R. 573, 585 (Bankr. S.D. Fla. 2011); cf. Concepts America, 2018 WL 2085615, at *7 (even if substantive consolidation of debtors with non-debtors were permitted, notice to the non-debtor's creditors would be required).

However, some courts, representing the minority view, have granted substantive consolidation without requiring notice to the putative consolidated entity's creditors. See, e.g., Farmers & Traders State Bank of Meredosia v. Magill (In re Meredosia Harbor & Fleeting Serv., Inc.), 545 F.2d 583, 589 (7th Cir. 1976) (in a case under the former Bankruptcy Act, ruling that post-consolidation notice to a debtor subsidiary's creditors of consolidation with the debtor-parent was sufficient as a matter of due process); Simon v. New Ctr. Hosp. (In re New Ctr. Hosp.), 187 B.R. 560, 566 (E.D. Mich. 1995) (ruling that the bankruptcy court did not err when it ordered substantive consolidation without affording notice to the non-debtor's creditors because the debtor and the non-debtor were alter egos "and the business dealings of the non-debtor Appellants and Debtor were so inextricably intertwined that no entity that had extended credit to the alter egos of the Debtor could reasonably be said to be without notice."); In re Baker & Getty Fin. Servs., Inc., 78 B.R. 139, 143 (N.D. Ohio 1987) (noting that "[t]he possibility of prejudice to other personal creditors" of the individual debtors to be substantively consolidated with the corporate debtor "is more problematical," but concluding that, after consolidation, "both notice and the opportunity for hearing can be accorded these creditors in the context of the consolidated proceeding."); see also S&G Financial, 451 B.R. at 585 n.14 (noting that this approach is the "minority view").

Mihranian

Medical doctor Mardiros Mihranian (the "debtor") filed a chapter 7 case in the Central District of California in December 2013. In 2015, the chapter 7 trustee commenced adversary proceedings in the bankruptcy court seeking to avoid more than $2 million in fraudulent transfers allegedly made by the debtor to his ex-wife, their two sons, the debtor's medical business and his long-time office manager (collectively, the "non-debtors"), none of which were in bankruptcy. In an effort to achieve the same result by other means, the trustee also filed a motion in 2016 seeking to substantively consolidate the debtor's estate with the estates of the non-debtors.

The bankruptcy court dismissed the adversary proceedings because the trustee failed to establish that the debtor was the initial transferor of the funds. A bankruptcy appellate panel affirmed those rulings on appeal.

The bankruptcy court also denied the trustee's substantive consolidation motion. The court found that: (i) the trustee had not proven that the debtor's assets were entangled with the non-debtors' assets to such an extent that substantive consolidation was warranted; and (ii) the trustee failed to notify the non-debtors' creditors of the substantive consolidation motion. A bankruptcy appellate panel affirmed this ruling as well on the ground of lack of notice. The trustee appealed to the Ninth Circuit.

The Ninth Circuit's Ruling

The Ninth Circuit affirmed.

Writing for the court, Judge Watson (sitting by designation) explained that, although the Ninth Circuit "permit[s] substantive consolidation of both debtor and non-debtor entities," the court has not yet determined whether notice to the non-debtors' creditors is required.

Judge Watson determined that several considerations supported a notice requirement:

(i) Ninth Circuit case law regarding consolidation of two or more debtors' estates "supports extending a notice requirement to a putative consolidated non-debtor's creditors, who should be afforded just as much—if not more—notice as a putative consolidated debtor's creditors";

(ii) The majority of courts considering the issue in other circuits have ruled that a non-debtor's creditors must be notified in advance;

(iii) If substantive consolidation is an equitable remedy the "sole aim" of which is "fairness to creditors," notice and an opportunity to be heard must be given to a non-debtor's creditors and not just to the non-debtors themselves;

(iv) The requirement that notice be provided "to the actual parties whose substantive rights will be 'seriously affected'" is logical so that they can have an opportunity to be heard; and

(v) The test for substantive consolidation adopted by the Ninth Circuit in Bonham "essentially requires notice to the putative consolidated parties' creditors" because it places the burden on an objecting creditor "to overcome the presumption that it did not rely on the separate credit of the putative consolidated entities."

Judge Watson rejected the trustee's argument that he provided notice to the same extent that notice was given in Bonham. In Bonham, Judge Watson explained, the putative consolidated parties' creditors were notified of the substantive consolidation motion, whereas the trustee in Mihranian notified the non-debtors, but not their creditors.

Outlook

With Mihranian, the Ninth Circuit joined the majority camp in the dispute over notice to a non-debtor's creditors of a motion to substantively consolidate the non-debtor's estate with a debtor's bankruptcy estate. This approach comports with the principle that substantive consolidation must be fair to all creditors, but it places an added burden on the party seeking consolidation to identify the non-debtor's creditors. As noted by the Ninth Circuit in Mihranian, however, this information can readily be obtained through discovery.

Although the Ninth Circuit's decision is for all intents and purposes a matter of first impression among the circuits, the Ninth Circuit cites a Seventh Circuit decision—Meredosia—among the minority approach rulings that do not require notice to a non-debtor's creditors of proposed substantive consolidation. In Meredosia, a parent and its subsidiary each filed a case under chapter XI of the former Bankruptcy Act and asked the court to consolidate their cases.

The court granted the motion on the petition date. Notice of the bankruptcy case as well as the consolidation was given to all creditors of both debtors two weeks later. A lender to the subsidiary that was a defendant in preference and lien avoidance litigation argued that: (i) because only the parent was "adjudicated bankrupt," the subsidiary was not a "debtor" to which the avoidance laws applied; and (ii) no notice of the consolidation was given to the subsidiary's creditors. The Seventh Circuit rejected these arguments, finding that consolidation was requested by both debtors and that the subsidiary's creditors were given notice of the consolidation (albeit after the fact). Because the Seventh Circuit addressed the notice issue only tangentially in Meredosia, the Ninth Circuit's ruling in Mihranian can fairly be characterized as a matter of first impression.

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A version of this article was published in Lexis Practice Advisor and Law360­. It has been reprinted here with permission.

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