McNeill and Slaugh Weigh in on Notice and the Death of Nondebtor Substantive Consolidation

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The Possible Death of Nondebtor Substantive Consolidation

Last year, we wrote an article discussing the split of authority surrounding a bankruptcy court’s ability to substantively consolidate a debtor with a nondebtor.¹ Since that time, several courts have further addressed the availability of this remedy. While most of those decisions have found that nondebtor substantive consolidation is appropriate in the right circumstances, all of them have imposed significant practical limitations that effectively make nondebtor substantive consolidation all but impossible.

Imposing Practical Limitations on Nondebtor Substantive Consolidation

The first of these decisions arises out of the involuntary Chapter 7 bankruptcies of David and Terry Stewart. In these cases, SE Property Holdings LLC, or SEPH, the petitioning creditor, sought to substantively consolidate the debtors’ bankruptcy estates with nine nondebtor entities in which the Stewarts served in a managerial role or held an interest.² Kirkpatrick Bank, a creditor of nondebtor Raven Resources LLC but not the debtors, opposed the substantive consolidation, arguing that consolidation would dilute its recovery against Raven.³ After acknowledging the split of authority over a bankruptcy court’s ability to order nondebtor substantive consolidation, the court sided with the majority view, holding that “under very limited circumstances it has the discretion, to be exercised sparingly, to substantively consolidate a debtor’s estate with non-debtors.”⁴

Next, the court found that although the complaint unquestionably alleged sufficient facts to support a lack of entity separateness, it failed to make sufficient allegations to demonstrate that “all creditors” would benefit from the consolidation.⁵ In particular, the complaint failed to identify any creditor of the nondebtors and did not notify the unsecured creditors of the nondebtors of the substantive consolidation suit.⁶ Because the recoveries to creditors of Raven would be diluted by the substantive consolidation, this “major equitable consideration” should have been addressed in the complaint.⁷ Moreover, the only known creditor of the nondebtors, Kirkpatrick, was actively opposing the proposed consolidation.⁸ Accordingly, the court dismissed the complaint for failure to state sufficient facts to support substantive consolidation.

Perhaps more importantly, the court found that while creditors of the nondebtors were not necessarily indispensable parties, they must be “afforded due process by receiving some type of notice [of the attempted substantive consolidation].”⁹ Although it was premature for the court to decide what type of notice would be required, the court noted that to succeed on the merits, the movant must be able to demonstrate that “adequate notice was given not only to the Non-Debtors but also to the Non-Debtors’ creditors and owners.”¹⁰

After Stewart 1, SEPH filed an amended complaint attempting to add the necessary allegations it lacked in the original complaint. The primary new allegation was that the only other creditor of the nondebtors, besides Kirkpatrick, would benefit from substantive consolidation.¹¹ That creditor, however, filed a statement in opposition to substantive consolidation. The court found this opposition “highly significant, if not determinative,” and dismissed the complaint, this time with prejudice.¹² Ultimately, that decision was vacated, based on the identification of numerous additional creditors of the nondebtors.¹³ With these creditors now identified, the burden once again fell upon SPEH to “plead facts alleging how these now-identified creditors will be benefitted, or at least not harmed, by substantive consolidation.”¹⁴

Following the Stewart cases, the Ninth Circuit BAP held that a Chapter 7 trustee’s failure to serve creditors of the nondebtor targets with his substantive consolidation motion “deprived them of an opportunity to be heard.”¹⁵ “This alone precluded substantive consolidation.”¹⁶ Moreover, the trustee failed to provide any evidence that substantive consolidation would benefit such creditors, especially when the trustee “did not know who those creditors were or the nature of their debt.”¹⁷

Refusing to Expand Nondebtor Substantive Consolidation

While the courts above provided significant procedural limits on the remedy of nondebtor substantive consolidation, other recent cases have refused to expand the relief in certain factual scenarios. For example, U.S. Bankruptcy Judge Janice D. Loyd, the same judge that authored the opinions in Stewart, held that substantive consolidation should not be used to consolidate an individual nondebtor with an individual debtor.¹⁸ Likewise, the Eighth Circuit affirmed a bankruptcy court ruling that substantive consolidation was not available to consolidate a debtor with a nonprofit nondebtor because it would violate the restriction on involuntary petitions against such entities in Section 303(a) of the Bankruptcy Code.¹⁹

Finally, U.S. Bankruptcy Judge Pamela Hollis, predicting how the Seventh Circuit would rule, found that nondebtor substantive consolidation was not permissible in the Seventh Circuit.²⁰ Even if it were, Judge Hollis ruled that creditors of the nondebtor entities must be served with a copy of the substantive consolidation complaint.²¹ To permit the court to analyze the effect of substantive consolidation on these “innocent third parties,” the complaint must allege “who the affected creditors are, whether they are aware of the proceeding, and whether they have been given an opportunity to be heard.”²²

The End of Nondebtor Substantive Consolidation?

In each of the foregoing cases, regardless of their ultimate view as to the permissibility of nondebtor substantive consolidation, the courts indicated that a complaint seeking nondebtor substantive consolidation must detail the effect of substantive consolidation on the creditors of the nondebtors. Some went even further, suggesting that the complaint must contain allegations regarding the nature of the claims held by such creditor²³ and whether the creditor was given notice of the substantive consolidation complaint.²⁴ Regardless of the required allegations, these courts insist that adequate notice of the attempted substantive consolidation must be provided to the creditors of the nondebtor. Arguably, notice must be provided to the owners of the nondebtor as well, at least in situations where the assets of the nondebtor are sufficient to pay all its creditors in full.²⁵

In practice, these due process notice requirements are extremely onerous. Even information regarding the identity of creditors of a financially healthy entity is not readily available. Moreover, most of the entities that would be subject to substantive consolidation complaints will be privately held, so if notice to the owners is also required, the identity of those owners may need to be discovered as well, at least where someone other than the debtor and its principles own the equity of the nondebtor target. Even if the identities of these third parties can be obtained, acquiring their addresses for notice purposes will require additional information. As anyone who has spent time preparing a Chapter 11 petition can attest, obtaining the names and addresses of all of an entity’s creditors is unquestionably a significant undertaking. Acquiring details surrounding the nature of the claims of those creditors will require an even further undertaking.

Given the proprietary nature of an entity’s creditor list, the most likely path to obtain this information is to seek discovery from the nondebtor itself. Because a party seeking to substantively consolidate nondebtors with a debtor is required to allege such information in the complaint — i.e. before the discovery process takes place — the complaint is likely to be dismissed prior to discovery being served. Any effort to acquire the information via a Rule 45 subpoena would similarly fail, at least where the nondebtor is a party to the dispute.²⁶

Without the typical discovery devices, a party seeking substantive consolidation may aim to use Bankruptcy Rule 2004 to acquire information regarding the nondebtor’s creditors in advance of filing a complaint. That process is no guarantee of success, however, as it will require the party seeking substantive consolidation to first demonstrate that 1) it is a “party in interest,” and 2) the examination that it seeks relates “only to the acts, conduct, or property or the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor’s estate, or the debtor’s right to discharge.”²⁷ In Chapter 11 cases, the examination may also relate to the “operation of any business and the desirability of its continuance,” or any plan-related matters, including issues relating to financing a plan. Legitimate purposes for this discovery include “discovering assets, examining transactions, and determining whether wrongdoing has occurred.”²⁸

While Rule 2004 discovery is “broad and unfettered,” it is not without its limits.²⁹ Examination of a nondebtor is only allowed if the moving party can demonstrate “good cause” — that is the “examination is necessary to establish the claim of the party seeking the examination.”³⁰ Courts have applied this “good cause” standard in a sliding scale manner, meaning that the requisite level of good cause required to satisfy the standard “will vary depending on the potential intrusiveness involved.”³¹ Narrow inquiries that are focused on the target entity’s relationship with the debtor will therefore require less of a showing of “good cause” than inquiries that seek more general information, which are inherently “more intrusive and present a greater potential for abuse.”³² Courts have yet to address whether a request for a nondebtor’s creditor list would constitute good cause, but one could foresee a court at least hesitating to grant such a request if the target entity alleges that its creditor list constitutes confidential commercial information.³³ At minimum, the threat of such exposure may slide the scale toward requiring a higher “good cause” showing.

Assuming that hurdle can be cleared, the movant must also convince the bankruptcy court to exercise jurisdiction over the nondebtor party. Whether a bankruptcy court can, or should, exercise personal jurisdiction over an entity that has not filed a claim against the debtor is beyond the scope of this article, but in this post-Stern climate, the nondebtor target can raise these arguments to erect additional roadblocks on the path to substantive consolidation. Even if the movant can survive these challenges and obtains the discovery it seeks, discovery itself is expensive. If the party seeking substantive consolidation is required to pursue this process for multiple nondebtor targets, the additional time and expense involved may prove to be prohibitive.

With the additional costs discussed above, as well as the costs of providing notice to all creditors of the nondebtor,³⁴ a creditor seeking substantive consolidation may lack the financial wherewithal to fund such an undertaking. Even for a Chapter 7 trustee, these added costs may outweigh the potential benefits of substantive consolidation. Given that substantive consolidation, and especially nondebtor substantive consolidation, is already viewed as an extreme remedy that should only be applied in narrow circumstances,³⁵ parties facing these additional costs are likely to think twice before pursuing substantive consolidation.

Conclusion

Although many courts permit substantive consolidation of a debtor and a nondebtor absent unusual circumstances, recent decisions have erected practical hurdles to limit its availability. New requirements regarding notice to creditors of the nondebtor and allegations regarding how such creditors will benefit from the consolidation require the moving party, as an initial step, to identify those creditors and obtain information about their claims. Because this information is not typically publicly available for companies outside of bankruptcy, parties seeking to substantively consolidate a nondebtor with a debtor will need to get creative to acquire this information before proceeding with a substantive consolidation motion. Even if this information is obtainable, the additional costs involved in acquiring it and serving all creditors of the nondebtor will likely deter all but the most strident parties from pursuing the “extraordinary remedy” of nondebtor substantive consolidation.

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R. Stephen McNeill and D. Ryan Slaugh are associates at Potter Anderson & Corroon LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

¹ See generally R. Stephen McNeill & D. Ryan Slaugh, Non-Debtor Substantive Consolidation: The Tensions of Form and Substance, 2017 Ann. Surv. Of Bankruptcy Law 5 (Sept. 2017).

² SE Property Holdings LLC v. Stewart (In re Stewart), 571 B.R. 460, at 462 (Bankr. W.D. Ok. 2017) [hereinafter Stewart 1].

³ Id. at 471.

⁴ Id.

⁵ Id. (emphasis in original).

⁶ Id.

⁷ Id. at 471-72.

⁸ Id. at 472.

⁹ Id. at 473 (emphasis in original).

¹⁰ Id. (emphasis added).

¹¹ SE Property Holdings LLC v. Stewart (In re Stewart), 2017 WL 3575698, at *5 (Bankr. W.D. Ok. Aug. 17, 2017).

¹² Id. at *5-6.

¹³ SE Property Holdings LLC v. Stewart (In re Stewart), 2017 WL 5565227, at *4 (Bankr. W.D. Ok. Nov. 17, 2017).

¹⁴ Id. at *5.

¹⁵ Leslie v. Mihranian (In re Mihranian), 2017 WL 6003345, at *4 (9th Cir. B.A.P. Dec. 4, 2017).

¹⁶ Id.

¹⁷ Id. at *5.

¹⁸ Manchester v. Kretchmar (In re Kretchmar), 579 B.R. 924, 935 (Bankr. W.D. Ok. 2018). Judge Loyd also found that the complaint failed to allege that the proposed consolidation would benefit the creditors of the nondebtors, only that the nondebtors’ assets were sufficient to pay all their creditors in full along with the creditors of the debtors. Id.

¹⁹ Off. Cmte. of Unsecured Creditors v. Archdiocese of Saint Paul & Minneapolis (In re Archdiocese of Saint Paul & Minneapolis), 888 F.3d 944, 953 (8th Cir. 2018).

²⁰ Audette v. Kasemir (In re Concepts Am. Inc.), 2018 WL 2085615, at *6 (Bankr. N.D. Ill. May 3, 2018).

²¹ Id. at *7 (citing Mukamal v. Ark Capital Group, LLC (In re Kodsi), 2015 WL 222493, at *2 (Bankr. S.D. Fla. Jan 14, 2015).

²² Id. at *8.

²³ See Mihranian, 2017 WL 6003345, at *5 (suggesting that the trustee must provide both the name of the creditors and the nature of their debts).

²⁴ See Concepts Am. Inc., 2018 WL 2085615, at *8 (requiring allegations of notice and an opportunity to be heard).

²⁵ See Stewart 1, 571 B.R. at 473 (suggesting that notice must be provided to the non-debtor’s “creditors and owners”); Cf Kretchmar, 579 B.R. at 935 (declining to accept an inference that substantive consolidation is warranted when the non-debtor’s assets are sufficient to pay creditors of both entities).

²⁶ See McLean v. Prudential Steamship Co. Inc., 36 F.R.D. 421, 425 (E.D.Va. 1965) (noting that “it is unthinkable that the effect of Rule 34 can be emasculated by the use of Rule 45”); see also Hasbro Inc. v. Serafino, 168 F.R.D. 99, 100 (D. Mass. 1996) (“[W]hile the language of Rule 45 ... may ... not be crystal clear, it is apparent ... that discovery of documents from a party, as distinct from a non-party, is not accomplished pursuant to Rule 45.”).

²⁷ Fed. R. Bankr. P. 2004(a).

²⁸ In re Enron Corp., 281 B.R. 836, 840 (Bankr. S.D.N.Y. 2002).

²⁹ See In re Millennium Lab Holdings II LLC, 562 B.R. 614, 626 (Bankr. D. Del. 2016).

³⁰ Id. at 627.

³¹ In re Countrywide Home Loans Inc., 384 B.R. 373, 393 (Bankr. W.D. Pa. 2008).

³² Id.

³³ See 11 U.S.C. § 107(b)(1) (“On request of a party in interest, the bankruptcy court shall ... protect an entity with respect to [confidential commercial information].”).

³⁴ While not addressed in the cases discussed herein, the logic of these cases would also seem to require the movant to provide notice of the substantive consolidation complaint to all creditors of the debtor as well, not just the parties to the complaint or those that have entered their appearance pursuant to Bankruptcy Rule 2002. Although this list is easier to obtain, the movant must account for these additional expenses as well.

³⁵ See Stewart 1, 571 B.R. at 471 (noting that nondebtor substantive consolidation should be used sparingly and only in “very limited circumstances”).

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This article was originally published on September 24, 2018 by Law360.

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