Chapter II, B. Effects of Substantive Consolidation

• Jurisdiction: United States

B. Effects of Substantive Consolidation

The sole aim of substantive consolidation, as described by the Ninth Circuit in In re Bonham, is "fairness to all creditors."⁵¹ It may accomplish this by "pool[ing] both the assets and liabilities of the consolidated entities and treat[ing] them as the same in satisfying the claims of the creditors."⁵² However, the pooling of assets and liabilities of multiple entities can modify the substantive rights of creditors and other third parties in a number of ways.

1. Intercompany Claims

First, substantive consolidation eliminates intercompany claims among the consolidated entities.⁵³ Intercompany claims are claims held by one debtor against another debtor. Complex interconnected business organizations regularly make transactions amongst themselves, and one of the effects of substantive consolidation is "the pooling of the assets and liabilities of the consolidated entities and the satisfaction of claims from the common fund."⁵⁴ As the court explained in In re World Access, "[a]s a result [of substantive consolidation,] intercompany claims are eliminated and wealth is redistributed among the creditors of the various entities, because every entity is likely to have a different asset-to-liability ratio.⁵⁵ Determining the validity of such claims can be a costly affair that sometimes can result in litigation. Eliminating such claims therefore may be beneficial to creditors by reducing the potential claims pool. It also may be fairer to creditors in situations where entities have moved assets internally within their organizational structure to be held by companies with less liabilities so as to protect the value of such assets. Duplicative claims of creditors against multiple entities are also eliminated.⁵⁶

2. Guaranty Claims

Second, guaranties, like intercompany claims, are eliminated when the guarantor is consolidated with the entity for which it is providing a guaranty. Some courts have reasoned that the existence of a guaranty weighs in favor of substantive consolidation because it indicates an identity of interest among the debtors to be consolidated.⁵⁷ Other courts have relied upon the existence of guaranties as definitive evidence of corporate separateness.⁵⁸ Guaranties, however, may also serve as evidence that a creditor had knowledge of different entities' corporate separateness because they were able to deal with and contract with the entities as separate units.⁵⁹

The court in Matter of Gulfco Inv. Corp. explained that guaranties "do not constitute a secured interest."⁶⁰ The court further clarified that "[i]n the event that a creditor has claims against a number of debtor corporations growing out of the same transaction, it is entitled to receive only one satisfaction."⁶¹ The court goes on to explain that "[i]f the debtor corporations are treated as separate entities and a creditor remains unsatisfied, the creditor is entitled to have any guaranties considered as claims," but that "[o]nce the consolidation has been ordered, the subject guaranties, which represent multiple claims, are necessarily eliminated."⁶² This means that "an unsecured creditor has only one claim per transaction to be satisfied from the pooled resources."⁶³

The elimination of guaranty claims is most likely to prejudice the debtors' secured lenders, who often have collateral pledges or guaranties from all entities in the corporate structure. Often, these lenders are one of only a few creditors of nonoperating affiliates, and they have priority in their collateral with respect to the debtor's assets. Nevertheless, because of the single-satisfaction rule, if the lender is secured in all the assets of all the debtors, the lender should still receive the same distribution from the pooled assets as it would from the separate...