Substantive Consolidation for Non-Debtor

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Bankruptcy is often thought of as a voluntary undertaking, but as discussed in earlier blogs, that isn’t always the case.  Under certain circumstances set forth in 11 USC § 303, debtors can be forced into Chapter 7 or Chapter 11 bankruptcy involuntarily by their creditors.  This is called an involuntary bankruptcy case.  Bankruptcy courts are currently grappling with a different type of involuntary involvement in a bankruptcy proceeding: substantive consolidation of a non-debtor.

Substantive Consolidation

Substantive consolidation is a remedy that allows two distinct debtor entities to be administered as one.  In other words, the assets and liabilities of the debtors entities are treated as they would be if the two entities were actually one business entity.  This process is considered by courts to an “extraordinary remedy” to be “used sparingly.”  This is in part, because creditors of the more financially fit entity often end up receiving less than they would have if they proceeded against the entity in its unconsolidated state.

Courts have imputed this power from 11 USC §105, which states in pertinent part, “The court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title….” Because the grant of the power to substantively consolidate is not explicitly granted, there is some controversy regarding whether it exists.  Courts are split.

Substantive Consolidation in Florida

The 11th Circuit, the federal district that encompasses Florida, permits substantive consolidation and in Eastgroup Properties v.  Southern Motel Association, it set forth a two-part test for determining the propriety of utilizing the remedy.  Under the test, the one seeking consolidation must show “(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.”   A number of factors are analyzed to determine whether each part of the standard is met.  In other words, it’s a fact intensive inquiry.

The Non-Debtor

What is less clear under Florida bankruptcy law, is whether a non-debtor entity can be substantively consolidated with a debtor entity.  The Middle District in in re Alico Mining found that it can be but only where the proponent of the consolidation can show evidence that the entities are the “alter ego” of each other.  In other words, that the two entities are essentially operating as a single entity.

The Southern District in in re S & G Financial Services, came to the opposite.  It’s reasoning emphasized that allowing substantive consolidation of a nonentity would allow the proponent of the consolidation to essentially force the non-debtor entity into involuntary bankruptcy without having to follow the procedures and meet the requirements set forth in 11 USC § 303.

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