In the Owens Corning case, the Third Circuit Court of Appeals reversed an Order of the Delaware District Court substantively consolidating Owens Corning, certain of its subsidiaries that had received a $2 billion unsecured loan, and other subsidiaries that had guaranteed repayment of the loan. In Re Owens Corning, No, 04-4080, 2005 WL 1939796 (3d. Cir. Aug. 15, 2005).

A syndicate of banks had made the loan to Owens Corning and some of its subsidiaries. Other Owens Corning subsidiaries gave guarantees as a credit enhancement. In an attempt to deal with huge asbestos claims against the parent and some of its non-guarantor subsidiaries, Owens Corning and 17 of its subsidiaries commenced Chapter 11 cases. Owens Corning and various unsecured creditors proposed a reorganization plan based on obtaining substantive consolidation of the debtors and several non-debtor subsidiaries that had issued guarantees. Specifically, the plan provided for a “deemed” consolidation that would have created a consolidation for purposes of valuing and satisfying creditor claims, voting for or against the plan, and making distributions for allowed claims, but would also have allowed the debtors to emerge from bankruptcy with their separate corporate identities intact.

The Third Circuit set forth a test similar to that used by the Second Circuit in Union Sav. Bank v. Augie/Restivo Baking Co., Ltd. (In re Augie/Restivo Baking Co., Ltd.), 860 F. 2d 515 (2d Cir. 1988). In doing so, the Court narrowed the latitude for imposing the equitable remedy of substantive consolidation by stating five principles that must be advanced by substantive consolidation:

  1. Courts must show respect for entity separateness.
  2. Substantive consolidation must address harms caused by debtors, not creditors, who disregard separateness.
  3. The harm must be greater than mere difficulty in the administration of separate estates.
  4. Substantive consolidation must be a remedy of last resort after exhausting the more precise remedies authorized by the Bankruptcy Code.
  5. Substantive consolidation may only be used defensively and not offensively by one group of creditors against another group.

The Third Circuit stated that a “deemed” consolidation would violate all of the above principles, referring to it as “a pretend consolidation for all but the Banks”. Owens Corning, 2005 WL 1939796 at *13. Articulating a disjunctive two prong test, the Court stated that in order for substantive consolidation to be granted, the proponents of substantive consolidation must prove that the entities to be consolidated (i) have disregarded separateness prepetition to the extent that their creditors treated them as one legal entity and relied on that understanding or (ii) have assets and liabilities that were so intermingled postpetition that separating them is prohibitive and harmful to all creditors. Id., 2005 WL 1939796 at *10.

Addressing the first prong of its test, the Court found no prepetition disregard of entity separateness. The Court was not persuaded that because the syndicate did not receive separate financial statements for each of the entities during the negotiating process, it must have intended to deal with them as one entity. The Court noted that, even assuming the syndicate did not have access to separate financial statements, the syndicate did have a great deal of information about the subsidiaries and was free to use whatever information it considered appropriate in making the loan. The Court stated that substantive consolidation is designed to protect the prepetition expectations of creditors from situations such as those in which they have been misled by the debtors’ actions (whether intentional or inadvertent).

As to the second prong of the test, the Court found no meaningful evidence of postpetition commingling of Debtors’ assets and liabilities severe enough to justify consolidation. The Court found that the District Court had erred in concluding that substantive consolidation would be justified by a benefit to the aggregate estate. Instead, consolidation would be justified only when every creditor would benefit from cost savings that make more assets available rather than from shifting assets from one group of creditors to another. Substantive consolidation is a defensive remedy to address identifiable harms, not an offensive tactic to be used by one group over another or an equitable alternative to pursuit of fraudulent transfer claims.

The Court showed regard for the fact that the loan transaction had a very common structure, which it was loathe to undo. In concluding its opinion, the Court stated that to undo this quotidian transaction would cause chaos in the marketplace.

The text of the full opinion can be found at the Third Circuit site

Written by: Kerry Galvin