Creditors servicing troubled and/or bankrupt borrowers are forced to navigate numerous obstacles and pitfalls as they work to protect their investments and loans. Included in this vast array of concerns is the significant impact that the concept of substantive consolidation, and the significant impediments it levies on a creditor’s right to recovery in bankruptcy proceedings. In recent Chapter 11 bankruptcy cases, crafty debtors (and on occasion even subordinate co-creditors) have sought to impede creditors through an even more convoluted variant of substantive consolidation, dubbed “deemed substantive consolidation.”
What is Substantive Consolidation?
Substantive consolidation can be used to consolidate a debtor with its affiliated entities so that they are treated as a single entity and asset/liability pool. Any inter-company claims or separate obligations and guarantees of the debtor and its consolidated affiliates are eliminated, and all assets of the debtor and its affiliates are consolidated. Any creditor claims against the debtor and/or the affiliates are treated as claims against the common assets of the consolidated debtor. Although there are no hard and fast elements to substantive consolidation, it is commonly accepted as an equitable remedy that may be appropriate whenever it will benefit the debtors’ estate without betraying the legitimate expectations of the debtors and their respective creditors. Essentially, it is a benefit/prejudice analysis that employs a fact based inquiry and is tailored to the unique nature of each case. As if this concept did not impose enough difficulty for creditors in planning and servicing accounts, the recent development of what has been termed “deemed substantive consolidation” compounds these issues.
In some recent Chapter 11 bankruptcy cases, debtors (and on occasion co-creditors) have proposed a variant of substantive consolidation known as “deemed substantive consolidation.” Essentially, “deemed substantive consolidation” operates like substantive consolidation in that a consolidation of the debtors is “deemed” to exist for purposes of valuing and satisfying creditor claims, voting for or against the plan, and making distributions for allowed claims under the plan. Additionally, all guarantees and inter-company liabilities are eliminated, and any claims against affiliates or guarantors are considered obligations of the “consolidated” estate. However, no actual merger or commingling of any assets of any parties, affiliates, and/or subsidiaries occurs while the action allows the assets of each separate entity to be used to satisfy claims of creditors of all the entities.
Courts and Creditors Should Denounce Deemed Substantive Consolidation
Deemed substantive consolidation has been criticized by several courts and creditors. The United States Bankruptcy Court for the Northern District of Indiana utterly denounced the idea of “deemed substantive consolidation” finding that it did not exist within the provisions of the Bankruptcy Code. In its ruling, the court relied on traditional interpretations of merger (one entity subsumes another that is thereby dissolved) and consolidation (a new entity is created and the old companies extinguished). The court did not stop with this discussion of merger and consolidation. The Court went on to affirmatively state that “the concept of ‘deemed substantive consolidation’ is not a legal concept.” Creditors’ opposition to “deemed substantive consolidation” is not without warrant, the possibility of substantive consolidation imposes great strain on a lender’s due diligence process when investigating the financial viability and creditworthiness of certain borrowers. If the concept is followed, diligent lenders must not only look to the financials of the particular entity, but the existence and financial states of any affiliates and subsidiaries. Confounding substantive consolidation with a legal nullity that is similar in name but not substance would only further expand the labyrinth known as U.S. bankruptcy law.
 In re Owens Corning, 419 F.3d 195, 210 (3d Cir. 2005); see also, In re Murray Indus., Inc., 119 B.R. 820, 829 (Bankr. M.D. Fla. 1990).
 In re T-L Brywood, LLC, Case No. 13-21804 (Bankr. N.D. Ill. September 07, 2013).
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