William C. Blasses, Redefining Into Reality: Substantive Consolidation of Parent Corporations and Subsidiaries

• Citation: Vol. 24 No. 2
• Publication year: 2011

REDEFINING INTO REALITY: SUBSTANTIVE CONSOLIDATION OF PARENT CORPORATIONS AND SUBSIDIARIES

INTRODUCTION

Substantive consolidation is a bankruptcy procedure that redefines multiple bankruptcy estates into a single bankruptcy estate.¹This redefinition results in the estate's assets and liabilities being added together to create a new bankruptcy estate.²Creditors with claims against any of the separate estates receive a claim against the new estate.³Although substantive consolidation is not limited to any certain legal entities, this Comment considers substantive consolidation solely in the context of parent corporations and their corporate subsidiaries because the relationships between parent corporations and subsidiaries are different than those between other legal entities.⁴Subsidiaries, by definition, are owned by their parent corporations.⁵This ownership gives the parent corporations a substantial amount of influence over their subsidiaries. Hence, some courts have found that some subsidiaries are "mere instrumentalities" of their parent corporations, their relationships being more like that between a person and their limbs than between distinct individuals.⁶

This relationship increases the likelihood that creditors could reasonably be led to believe that the parent corporation and its subsidiaries were one entity and therefore should be considered when evaluating whether substantive consolidation should be allowed.

The main rationale behind applying substantive consolidation to certain cases is to promote equity.⁷Substantive consolidation promotes equity when it redefines bankruptcy estates to better reflect the intent exhibited by the respective creditors in their dealings with the entities.⁸Courts have developed various tests to determine the cases in which ordering substantive consolidation would promote equity.⁹Presently no single test has been universally embraced as the best method to promote equity consistently.

Most recently the Third Circuit Court of Appeals created a new test that seems to have combined the previous approaches.¹⁰The Third Circuit chose to create a new test because the court feared that previous tests created inconsistent outcomes that ignored equity.¹¹Instead of reworking the tests or creating a new test in an attempt to pursue an equitable outcome, the court created its test to limit the ability of bankruptcy courts to allow substantive consolidation.¹²The test is inappropriate for parent corporations and subsidiaries because it creates an unwarranted predisposition against substantive consolidation and fails to consider the power that a parent corporation has over its subsidiaries.

This Comment advocates a new test specifically for evaluating whether substantive consolidation should be ordered for parent companies and their subsidiaries. This new test uses both subjective and objective components to carefully evaluate whether substantive consolidation would best fulfill the creditors' expectations. It minimizes inconsistency while taking into account the parent corporation's influence. The new test better promotes equity by improving on the current tests' flaws that hamper a court's ability to determine creditors' expectations.

This Comment is divided into six parts. Part I describes the parent- subsidiary relationship and the effects of substantive consolidation on this relationship. Part II describes the creation of substantive consolidation. Part III evaluates the avenues of support that legitimize the use of substantive consolidation. Part IV examines the circumstances surrounding the creation of the three current substantive consolidation tests. Part V outlines the current tests' flaws. Part VI outlines a new test for determining whether parent corporations and subsidiaries should be substantively consolidated.

I. CORPORATE RELATIONSHIPS AND SUBSTANTIVE CONSOLIDATION

The relationship between a parent corporation and its subsidiary is complex and different from the relationships between other types of entities. It is important to evaluate the differences and acknowledge that parent corporations and their subsidiaries should be treated differently when considering whether to order the entities' substantive consolidation. The following two subsections serve to provide an overview and summary of two important considerations relevant to this Comment: the uniqueness of the parent-subsidiary relationship and the effects of substantive consolidation.

A. The Close Relationships Between Parent Corporations and Their

Subsidiaries

Interaction with corporations and subsidiaries is a daily occurrence for many people, but the distinctions between a parent corporation and a subsidiary are rarely apparent. Suppose a person searching for a new automobile logs onto the Ford Motor Company's website. That person would be offered a choice between eight different automobile brand names.¹³That same person could also decide to purchase one of the listed automobiles of a certain brand and proceed to obtain financing from one of the links provided on that website.¹⁴These options and services are the result of the cooperation of many different legal entities, including a multitude of subsidiaries.¹⁵

Subsidiaries have a close relationship with the parent corporation. A subsidiary is defined as "a corporation in which a parent corporation has a controlling share."¹⁶In the above example, Ford Motor Company was the parent corporation. From a practical standpoint, the relationship between parent corporations and subsidiaries is symbiotic. The parent corporation owns the majority, if not all, of the subsidiary's stock.¹⁷This investment by the parent company has two direct effects. First, it allows the parent corporation to completely control the subsidiary corporation, just as the parent corporation's shareholders control the parent corporation, using it to advance the parent corporation's interests within an industry on a transactional level.¹⁸Second, the investment gives the parent corporation a stake in the performance of the subsidiary because the value of the parent company's interest is directly affected by the performance of the subsidiary.¹⁹Although subsidiaries are legally recognized as separate and distinct entities, in reality the effects of parent corporation ownership sometimes result in a blurring of the lines that causes third parties to believe that the separate entities are actually one unit.²⁰

The uniqueness of these relationships is an important consideration as substantive consolidation is a radical process that serves to give effect to the expectations of creditors. The following section illustrates the dramatic effects of substantive consolidation.

B. Substantive Consolidation's Effects

When a corporation and its subsidiaries file for chapter 11 bankruptcy, they do so as separate legal entities.²¹The filings create "bankruptcy estates" that are completely separate and distinct regardless of closeness of the relationships between the parent corporation and its subsidiaries. Ironically, unlike bankruptcies of truly separate and distinct legal entities, the bankruptcy cases of the parent corporation and its subsidiaries are typically "administratively consolidated," with one judge presiding over the case and the same lawyers representing all of the debtors.²²Despite this fact, "the separateness of the legal entities is preserved."²³

The separate division of the bankruptcy estates can result in the creditors of both the corporation and the subsidiaries being treated differently in bankruptcy proceedings than they would have been if the parent corporation and subsidiaries were still solvent.²⁴Although creditors, relying on the closeness of the entities, might have extended credit to the parent corporation in the form of a loan that benefits both the parent company and its subsidiaries, typically this possibility, and the creditors' expectations are completely ignored in bankruptcy;²⁵the creditors are forced to collect solely from the parent corporation.²⁶The result is inequitable as the creditors are forced to deal with an estate in bankruptcy comprised of merely a part of the unit to which the creditors believed they had extended credit. As a result of this inequitable practice, the creditors who had extended credit based on the entities as a unit but receive more based on the subsidiaries' bankruptcy estates being separate, receive a windfall.²⁷Creditors who extended credit based on the entities' unity collect less and suffer unforeseen losses.²⁸

Bankruptcy courts address this departure from reality by using substantive consolidation to redefine the petitioner, which ends up redefining the bankruptcy estates.²⁹Substantive consolidation allows the court to ignore the separateness of the bankruptcy estates.³⁰The assets and liabilities of the parent corporation and its subsidiaries are no longer separate but are treated as a larger combined bankruptcy estate.³¹The effects of substantive consolidations are dramatic, but no parties are more affected than the entities' creditors.

The differences between the traditional bankruptcy estate and the substantively consolidated bankruptcy estate primarily affect unsecured creditors.³²Although a debtor parent corporation might seem to benefit from consolidation because its subsidiaries' assets can be used to pay off its debts, the use of the assets diminishes the subsidiaries' equity and therefore decreases the value of the parent corporation's ownership interest in the subsidiaries' stock.³³Fully secured creditors, likewise, are not affected because they still retain the value of their security interest. Unsecured creditors, on the other hand, have to deal with changes in both the amount of assets remaining in the estate and the amount of creditors vying for those assets. ³⁴

The difference in actual collection for unsecured creditors can be substantial but is limited to the distribution of the remaining assets.³⁵For example, three unsecured...