Understand the complexities and nuances of the Bankruptcy Code to better advise clients and prepare for court.
By Stephanie Cumings
Nov. 13 — Individuals who haven't filed for bankruptcy can be drawn into the bankruptcy of a business if their financial affairs are too entangled .
The district court in this case acknowledged that this process, known as substantive consolidation, is more often used to bring a business into another business's bankruptcy or into an individual's bankruptcy, but there is less precedent for roping in a non-debtor individual. But Judge Manuel L. Real said the concept was the same and should be applied to non-debtor individuals if that means a fairer outcome for creditors.
The companies and related individuals in this case said they were “involved in the business of ‘investing in real estate,' although they [did] not explain in any detail how the investments work or what the function was of so many different business names,” according to the bankruptcy court. After one of the companies filed for bankruptcy, creditor Bank of America sued to substantively consolidate the case with the other related companies and people.
The bankruptcy court agreed that 10 non-debtors, including three individuals, should be retroactively consolidated into the debtor's bankruptcy. The bankruptcy court said that “the financial affairs of the entities and individual defendants [were] so entangled that they constitute[d] a single enterprise.” The court said that the individual defendants were the “ring masters behind the labyrinthine system of transactions and transfers of properties that can only be untangled if the individuals use of accounts and property transfers are included.” The individual defendants appealed, arguing that the court had impermissibly applied substantive consolidation to non-debtor individuals.
In bankruptcy, substantive consolidation allows courts to consolidate the estates of other debtors or non-debtors when their financial affairs are sufficiently intermingled. Without this power, “debtors could insulate money through transfers among inter-company shell corporations with impunity,” the district court said.
Circuit courts have different approaches when determining if substantive consolidation is appropriate, but they generally agree that prejudice to the creditors in the absence of consolidation must outweigh prejudice to the entities being consolidated, according to research conducted by Bloomberg BNA. As the district court in this case noted, in Alexander v. Compton (In re Bonham), 229 F.3d 750 (9th Cir. 2000), the Ninth Circuit adopted a test that contains two factors: “(1) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit; or (2) whether the affairs of the debtor are so entangled that consolidation will benefit all creditors.”
In this case, the bankruptcy court relied on the second factor in finding substantive consolidation was warranted. The district court said this finding was “supported by 70 pages of findings of fact,” which found that “[t]he entanglement ranged from the admitted ‘common account' to every other aspect of [d]ebtor's business operations: its non-decision makers; its business model; its business address; and its post office boxes and who controls them.”
The bankruptcy court also found that it would take “tens of thousands” of dollars for experts to untangle the financial accounts. Furthermore, the debtor and the defendants would avoid requests for financial records or provide altered or incomplete records when asked by the bankruptcy court, and so the district court said that efforts to untangle their finances would likely be “futile.”
The defendants argued that neither the Ninth Circuit nor the U.S. Supreme Court have ever allowed the consolidation of a non-debtor individual.
“While this may be true, the Bankruptcy Code generally does not recognize a difference between organizational entities or human beings,” the court said. “For example, Title 11 U.S.C. § 109(b), which defines who may be a debtor in bankruptcy, makes no distinction between individuals and corporations for purposes of Chapter 7. ... Because the whole concept of substantive consolidation is premised on the goal of obtaining a fair outcome for creditors, which is one of the goals and purposes of the federal bankruptcy scheme, this [c]ourt finds no difference between the substantive consolidation of non-debtor corporate entities or nondebtor individuals when such consolidation is necessary to protect creditor's rights and prevent injustice.”
The court also rejected the defendants' argument that consolidating the individuals would violate the requirements for involuntary bankruptcy. The court said that substantive consolidation and involuntary bankruptcy are “two separate and distinct principles” with different requirements.
Finally, the court said there were no genuine issues regarding the facts of the case, and that there was “overwhelming evidence of purposeful entanglement.”
The Second Circuit addressed a similar issue in FDIC v. Colonial Realty Co., 966 F.2d 57 (2d Cir. 1992), in which the court held that two individuals who were debtors could have their bankruptcies consolidated with a corporate entity debtor, according to research conducted by Bloomberg BNA. The Second Circuit court rejected the FDIC's argument that “substantive consolidation springs from the equitable doctrine of piercing the corporate veil, which authorizes a court to disregard the corporate fiction when it shields or advances fraud, and therefore should not be invoked to merge the estates of individuals,” finding that “the comparison of the two doctrines is not entirely apt.” The court found “no basis” for a “blanket proscription” on applying substantive consolidation to individuals. The Second Circuit makes no meaningful distinction between debtor individuals and non-debtor individuals in this opinion.
The Second Circuit also rejected the argument that the Bankruptcy Code prohibits the consolidation of non-spousal individuals. Both the Eighth and Eleventh Circuits have found that substantive consolidation can be used to consolidate the cases of debtor spouses.
David S. Kupetz, Jason Daniel Balitzer, and Steven Frederick Werth of Sulmeyer Kupetz PC, Los Angeles, represented the appellants.
Natalie B. Daghbandan, Richard Poole Steelman, Jr., and Sharon Z. Weiss of Bryan Cave LLP, Santa Monica, Calif., represented Bank of America.
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