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Third Circuit Recognizes Importance of Lender Reliance on Entity Separateness in Substantive Consolidation

September 2005

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In a recent opinion, the Third Circuit addressed the equitable remedy of substantive consolidation in bankruptcy cases.1 In In re Owens Corning, No. 04-4080 __F.3d__, 2005 WL 1936796 (3d Cir. Aug. 15, 2005),2 the Third Circuit reversed and remanded a decision of the district court approving the “deemed” substantive consolidation of bankruptcy estates of Owens Corning (“OCD”), a Delaware corporation with those of its wholly-owned subsidiaries. In its ruling, the Third Circuit adopted the following standard: Substantive consolidation of two or more entities is warranted (absent consent) when either “(i) prepetition they disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (ii) postpetition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors.”3 In our view, the Owens Corning decision provides greater certainty to creditors in the lending community that rely on the separateness of affiliated entities for transactions dealing with entities formed, and bankruptcy cases brought, in Delaware, New Jersey, Pennsylvania and the U.S. Virgin Islands.

“The Owens Corning decision underscores the importance of properly structured and well-documented loan transactions that clearly establish reliance on the separateness of borrower entities.”

The District Court Proceeding

Prior to bankruptcy, a syndicate of banks (the “Banks”) extended a $2 billion unsecured loan to OCD and certain of its subsidiaries - with guarantees of other OCD subsidiaries enhancing the credit.4 In anticipation of a plan of reorganization, OCD sought a “deemed” consolidation of the assets and liabilities of OCD with those of its subsidiaries. The “deemed” consolidation would allow OCD’s plan process to proceed as though the assets and liabilities of OCD and its subsidiaries were merged for purposes of valuing and satisfying creditor claims and making distributions under the plan, thus, eliminating the separate obligations of the OCD subsidiaries arising from the aforesaid guarantees.

The district court, over the objection of the Banks, granted OCD’s motion to consolidate and ordered the consolidation of the OCD estates. The district court concluded that there existed “substantial identity between… OCD and its wholly-owned subsidiaries” and that “there [was] simply no basis for finding that, in extending credit, the Banks relied upon the separate credit of any of the subsidiary guarantors.” In the district court’s view, substantive consolidation would also greatly simplify and expedite the entire bankruptcy proceeding.

Application of the Third Circuit Standard

The Third Circuit disagreed, however, and reversed the district court’s decision. In applying the above-referenced standard, the Third Circuit concluded that substantive consolidation in Owens Corning was not warranted based on the facts of the case:

To begin, the Banks did the “deal world” equivalent of “Lending 101.” They loaned $2 billion to OCD and enhanced the credit of that unsecured loan indirectly by subsidiary guarantees covering less than half the initial debt. What the Banks got in lending lingo was “structural seniority”- a direct claim against the guarantors (and thus against their assets levied on once a judgment is obtained) that other creditors of OCD did not have. This kind of lending occurs every business day. To undo this bargain is a demanding task.

The Third Circuit stated that a party seeking substantive consolidation typically proves a prima facie case under the first test for substantive consolidation “when, based on the parties’ prepetition dealings, a proponent proves corporate disregard creating contractual expectations of creditors that they were dealing with debtor as one indistinguishable entity” and “also show[s] that, in their prepetition course of dealing, they actually and reasonably relied on debtors’ supposed unity.” Such prima facie case can be rebutted by a creditor opposed to substantive consolidation if such creditor “can prove they are adversely affected and actually relied on debtors’ separate existence.”5

Applying the first test for substantive consolidation addressing prepetition activities, the Court found “no evidence of the prepetition disregard of the OCD entities’ separateness” noting that the “testimony presented by both the Banks and the Debtors makes plain the parties’ intention to treat the entities separately.” The Court further addressed testimony from attorneys and bankers involved in negotiating the relevant credit agreement and noted that their testimony “reflected their assessment of the value of the guarantees as partially derived from the separateness of the entities.” Indeed, OCD conceded that the structure of the credit agreement and the subsidiary guarantees were “premised on an assumption of separateness.”

As the Court further concluded:

No principled, or even plausible, reason exists to undo OCD’s and the Banks’ arms-length negotiation and lending arrangement, especially when to do so punishes the very parties that conferred the prepetition benefit–a $2 billion loan unsecured by OCD and guaranteed by others only in part. To overturn this bargain, set in place by OCD’s own pre-loan choices of organizational form, would cause chaos in the marketplace, as it would make this case the Banquo’s ghost of bankruptcy.

The Third Circuit thus recognized the importance of pre-bankruptcy lending arrangements specifically intended to ensure separateness.

Further, in looking at the postpetition activities of the OCD debtors under the second test, the Court held that there “is no meaningful evidence postpetition of hopeless commingling of Debtors’ assets and liabilities.” The Court rejected the district court’s conclusion that commingling of assets alone justifies consolidation when “the affairs of the two companies are so entangled that consolidation will be beneficial,” (emphasis in original) finding that “commingling justifies consolidation only when separately accounting for the assets and liabilities of the distinct entities will reduce the recovery of every creditor-that is, when every creditor will benefit from the consolidation.” On the basis of the record before the Third Circuit in Owens Corning, OCD did not meet its burden to demonstrate that OCD’s affairs were tangled such that the cost of untangling them would be so high relative to the objecting creditors’ assets that such creditors, among other creditors, would benefit from consolidation.

Effect of Owens Corning

The lesson to be learned by lenders from the Owens Corning decision is that the Third Circuit will defer to the lender’s prepetition reliance upon the separateness of distinct and independent legal entities before it will disregard corporate structure and merge the assets and liabilities of such entities into one estate for the benefit of all creditors. The Third Circuit’s understanding of the realities of real world structured finance transactions supports the standard set forth in its opinion. The Owens Corning decision underscores the importance of properly structured and well-documented loan transactions that clearly establish reliance on the separateness of borrower entities. In that regard, the Owens Corning case should provide lenders who consistently rely on such separateness comfort through the uncertainties of the bankruptcy process.



1 Generally, substantive consolidation is an equitable remedy used by bankruptcy courts where the court treats the assets and liabilities of at least two separate but affiliated entities as if such assets and liabilities were merged into a single entity.

2 On Monday, August 29, 2005, attorneys for bond holders and trade creditors requested a rehearing, en banc. A date for the requested hearing has not been set.

3 This standard is similar to the standard adopted in the Second Circuit in Union Sav. Bank v. Augie/Restivo Baking Co., Ltd. (In re Augie/Restivo Baking Co., Ltd.), 860 F.2d 515, 516-17 (2d Cir. 1988) (reducing the traditional factors previously utilized for substantive consolidation to two critical factors, “whether creditors dealt with the entities as a single economic unit and, ‘did not rely on their separate entity in extending credit,’ . . . [or] whether the affairs of the debtors are so entangled that consolidation will benefit all creditors”).

4 It is important to note that, in the credit agreement, the Banks negotiated for provisions designed to not only limit the ways in which OCD could deal with its subsidiaries but also protect the separateness of OCD and its subsidiaries. Specifically, the Banks required each subsidiary of OCD to maintain its status as a separate entity, observe governance formalities, have a specific purpose for existing separately, maintain its own books and records, prepare separate accounting and financial records, pay its own expenses from its own accounts, and routinely and adequately document intercompany transactions, including payment of interest on intercompany obligations.

5 The Third Circuit, however, left open the question of whether such a showing by a creditor opposing substantive consolidation defeats substantive consolidation entirely or merely consolidation as to that creditor.


This Alert was written by Jonathan I. Lessner, Victoria Counihan, Kelly A. Herring, C. Michael Terribile, Kimberly A. Ladig and Brian L. Colborn in the Delaware office. Please contact Mr. Lessner, Ms. Counihan, Ms. Herring, Mr.Terribile, Ms. Ladig or Mr. Colborn at 302.661.7000 or your Greenberg Traurig liaison, if you have any questions regarding the subject matter of this Alert.

© 2005 Greenberg Traurig

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