United States: Florida Bankruptcy Court Substantively Consolidates Debtor And Non-Debtor Entities

The Bankruptcy Code does not explicitly authorize the equitable remedy of "substantive consolidation"—i.e., treating the assets and liabilities of two or more related entities as if they belonged to a single, consolidated bankruptcy estate. However, it is well recognized that a bankruptcy court has the authority to order such relief under appropriate circumstances in the exercise of its broad equitable powers when each of the original entities are already debtors subject to the court's jurisdiction. However, some courts have taken the remedy a step further and consolidated debtors in bankruptcy with their non-debtor affiliates. The exercise of this extraordinary power is a rare event that requires both the unique facts to justify the remedy and a court that is willing to do so.

These factors recently coalesced when the U.S. Bankruptcy Court for the Southern District of Florida granted a bankruptcy trustee's motion to substantively consolidate the estates of a debtor and several of its non-debtor affiliates in In re No Rust Rebar, Inc., 2023 WL 4497328 (Bankr. S.D. Fla. July 12, 2023). The bankruptcy court held that substantive consolidation was appropriate because, among other things, all of the companies were controlled by an individual who operated the group as a single enterprise; the companies did not recognize corporate formalities; and their assets, liabilities, and affairs were hopelessly intertwined.

Substantive Consolidation

Substantive consolidation is an equitable remedy pursuant to which a bankruptcy court may order that the assets and liabilities (for ease of reference, the "estates") of separate entities be treated as if they belonged to a single, combined entity.

The Bankruptcy Code does not expressly authorize substantive consolidation, but it recognizes that a chapter 11 plan may provide for the "merger or consolidation of the debtor with one or more persons" as a means of implementation. See 11 U.S.C. § 1123(a)(5)(C). In addition, Rule 1015(b) of the Federal Rules of Bankruptcy Procedure (the "Bankruptcy Rules") provides that a bankruptcy court may direct that cases involving affiliated debtors be jointly administered, although the rule is silent regarding substantive consolidation. The Advisory Committee Note to Bankruptcy Rule 1015(b) states that "[c]onsolidation, as distinguished from joint administration, is neither authorized nor prohibited by this rule since the propriety of consolidation depends on substantive considerations and affects the substantive rights of the creditors of the different estates." 1983 Advisory Committee Note to Fed. R. Bankr. P. 1015 (reprinted in Collier on Bankruptcy App. 1015[1] (16th ed. 2023)).

A majority of courts have concluded that bankruptcy courts have the power to substantively consolidate debtor entities under section 105(a) of the Bankruptcy Code, which provides that a court "may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions" of the Bankruptcy Code. Forcing the creditors of one entity to share equally with those of another, however, is considered "a rough justice remedy that should be rare and, in any event, one of last resort after considering and rejecting other remedies." In re Owens Corning, 419 F.3d 195, 211 (3d Cir. 2005).

There is no unifying rule or approach to assess whether substantive consolidation is an appropriate remedy. The Second Circuit has established the closest to a standard-bearer test, developing a two-part disjunctive standard for gauging the propriety of substantive consolidation in Union Savings Bank v. Augie/Restivo Baking Co., Ltd. (In re Augie/Restivo Baking Co., Ltd.), 860 F.2d 515 (2d Cir. 1988). There, the court concluded that the factual elements considered by the courts are "merely variants on two critical factors: (i) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, ... or (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors." Id. at 518. According to Augie/Restivo, factors that may be relevant in satisfying these requirements include the following:

(1) Fraud or other complete domination of the corporation that harms a third party;

(2) The absence of corporate formalities;

(3) Inadequate capitalization of the corporation;

(4) Whether funds are put in and taken out of the corporation for personal rather than corporate purposes;

(5) Overlap in ownership and management of affiliated corporations;

(6) Whether affiliated corporations have dealt with one another at arm's length;

(7) The payment or guarantee of debts of the dominated corporation by other affiliated corporations;

(8) The commingling of affiliated corporations' funds; and

(9) The inability to separate affiliated corporations' assets and liabilities.

Id. at 518–19. The Augie/Restivo test was adopted by the Ninth Circuit in Bonham v. Compton (In re Bonham), 229 F.3d 750 (9th Cir. 2000).

Many other circuit and lower courts have adopted tests similar to the Augie/Restivo standard. For example, in Eastgroup Properties v. Southern Motel Assoc., Ltd., 935 F.2d 245 (11th Cir. 1991), the Eleventh Circuit initially applied the following seven-factor test set forth in In re Vecco Const. Indus., Inc., 4 B.R. 407 (Bankr. E.D. Va. 1980):

(1) The presence or absence of consolidated financial statements.

(2) The unity of interests and ownership between various corporate entities.

(3) The existence of parent and intercorporate guarantees on loans.

(4) The degree of difficulty in segregating and ascertaining individual assets and liabilities.

(5) The existence of transfers of assets without formal observance of corporate formalities.

(6) The commingling of assets and business functions.

(7) The profitability of consolidation at a single physical location.

Eastgroup, 935 F.2d at 250. However, the Eleventh Circuit also considered five additional factors that could be relevant to the analysis, including:

(1) the parent owning the majority of the subsidiary's stock; (2) the entities having common officers or directors; (3) the subsidiary being grossly undercapitalized; (4) the subsidiary transacting business solely with the parent; and (5) both entities disregarding the legal requirements of the subsidiary as a separate organization.

Id. at 251 (citations omitted).

In Owens Corning, however, the Third Circuit opted for an "open-ended, equitable inquiry" rather than a factor-based analysis. Owens Corning, 419 F.3d at 210.

Substantive Consolidation of Debtors and Non-Debtors

Although most courts have held that the substantive consolidation of debtor entities is permitted under appropriate circumstances, they disagree as to whether the substantive consolidation of debtors and non-debtors is permissible under the Bankruptcy Code. In Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215 (1941), the U.S. Supreme Court "tacitly approved" substantive consolidation of a non-debtor entity with a debtor event though it reversed a Ninth Circuit decision affirming an order consolidating the estates. See Bonham, 229 F.3d at 764 (noting that "the substantive consolidation of two estates was first tacitly approved by the Supreme Court [in Sampsell] in the context of a debtor who had abused corporate formalities and allegedly made fraudulent conveyances of the debtor shareholder's assets to the corporation").

Some courts have concluded that such substantive consolidation is appropriate on the basis of: (i) section 105's broad grant of authority; (ii) a bankruptcy court's ability to assert personal and subject matter jurisdiction over non-debtors; and/or (iii) a bankruptcy court's mandate to ensure the equitable treatment of all creditors. See, e.g., id. at 769–71; In re Stewart, 603 B.R. 138, 150 (Bankr. W.D. Okla. 2019); In re Falls Event Ctr. LLC, 600 B.R. 857, 868 (Bankr. D. Utah 2019); In re AAA Bronze Statues & Antiques, Inc., 598 B.R. 27, 32 (Bankr. N.D. Fla. 2019); Lassman v. Cameron Constr. LLC (In re Cameron Constr. & Roofing Co.), 565 B.R. 1, 10 (Bankr. D. Mass. 2016); Simon v. ASIMCO Techs., Inc. (In re Am. Camshaft Specialties, Inc.), 410 B.R. 765, 786 (Bankr. E.D. Mich. 2009); Walls v. Centurion Asset Mgmt., Inc. (In re Bolze), 2009 BL 157145, *4 (Bankr. E.D. Tenn. July 23, 2009); Dominion Fin. Corp. v. Morfesis (In re Morfesis), 270 B.R. 28, 31 (Bankr. D.N.J. 2001); see also Clark's Crystal Springs Ranch, LLC v. Gugino (In re Clark), 692 F. App'x 946 (9th Cir. 2017) (because the Bankruptcy Code does not expressly forbid the substantive consolidation of debtors and non-debtors, the U.S. Supreme Court's decision in Law v. Siegel, 571 U.S. 415 (2014), does not bar bankruptcy courts from ordering the remedy).

Other courts, however, have held that the substantive consolidation of debtors and non-debtors is inappropriate because, among other things, it circumvents the procedures concerning involuntary bankruptcies set forth in section 303 of the Bankruptcy Code. See, e.g., In re Archdiocese of Saint Paul & Minneapolis, 888 F.3d 944, 951 (8th Cir. 2018) (involving nonprofit non-debtors, against which an involuntary petition may not be filed); In re Concepts America, Inc., 2018 WL 2085615, at *6 (Bankr. N.D. Ill. May 3, 2018); In re Geneva ANHX IV LLC, 496 B.R. 888, 901 (Bankr. C.D. Ill. 2013); In re Pearlman, 462 B.R. 849, 854 (Bankr. M.D. Fla. 2012); Helena Chem. Co. v. Circle Land & Cattle Corp. (In re Circle Land & Cattle Corp.), 213 B.R. 870, 877 (Bankr. D. Kan. 1997); In re Hamilton, 186 B.R. 991, 993 (Bankr. D. Colo. 1995).

Even among those courts permitting substantive consolidation between debtors and non-debtors, some have observed that "substantive consolidation of a debtor with a non-debtor should be used sparingly and has a higher burden of proof than debtor-to-debtor consolidation." In re Caribbean Auto Mart of St. Croix, Inc., 2021 WL 2419986, *11 (Bankr. D.V.I. June 11, 2021); accord Simon v. ASIMCO Techs., Inc. (In re Am. Camshaft Specialties, Inc.), 410 B.R. 765, 786 (Bankr. E.D. Mich. 2009); Morse Operations, Inc. v. Robins LE-COCQ, Inc. (In re Lease-A-Fleet, Inc.), 141 B.R. 869, 872-74 (Bankr. E.D. Pa. 1992).

No Rust Rebar

No Rust Rebar presented a bankruptcy court with exactly the type of facts that could satisfy the high burden of proof necessary to consolidate a debtor with a non-debtor affiliate. Don Smith ("Smith") was the founder and owner of No Rust Rebar, Inc. (the "debtor"), a company engaged in the manufacture and sale of structural reinforcement products, particularly rebar, made from basalt fibers. He was also the founder of various related companies, including Raw Materials Corp. ("RMC"), Raw Energy Materials Corp. ("REM"), Global Energy Sciences, LLC ("GES"), and (purportedly) Raw, LLC ("Raw"), all of which were involved in some way in the production, sale, and development of basalt fiber products.

The debtor was created in 2015 with a $1.2 million investment from Robert Bryan ("Bryan"). In July 2015, the debtor contracted to purchase a Florida manufacturing facility. Because the debtor lacked the financing necessary to acquire the property, it assigned the right to purchase the facility to Green Tech Development, LLC ("Green Tech"), purportedly in exchange for an option to purchase the facility. No written option agreement was ever signed, and Green Tech later denied that it had granted the debtor a purchase option. Green Tech purchased the facility in January 2016, although the debtor continued in possession of the premises.

After Green Tech, as the property owner, refused to sign applications for the necessary permits to begin manufacturing at the facility, the debtor executed, but never recorded, a $400,000 mechanic's lien against the property in favor of its affiliate RMC, which also operated from the facility. Smith later testified that he did so to make the property "less enticing" to Green Tech.

In November 2016, the debtor sought to exercise its purported purchase option for the facility, but Green Tech refused to sell. The debtor then sued Green Tech in state court for specific performance (the "Property Dispute"). Green Tech countersued for damages in the amount of $1.95 million.

In December 2016, Smith founded Raw as a holding company, but Raw was actually a fictitious name for the debtor. In January 2017, Smith resurrected an older entity—GES—to hold his intellectual property, including trademark and brand licenses associated with his basalt rebar products. The following month, Smith caused various affiliated entities to grant PayMeOn, Inc. ("PayMeOn") an exclusive license to sell basalt rebar in Florida and the Caribbean. Although the debtor provided machinery, basalt fibers, and finished inventory as part of the deal, it received no consideration in exchange. Instead, RMC received $2.4 million from PayMeOn, and Raw received 10 million shares of PayMeOn's publicly traded stock.

In 2019, the ability of the debtor and its affiliates to do business in the facility was effectively eliminated after the electric power utility turned off service at the site due to nonpayment. In the four years that the debtor and its affiliates conducted business, Smith routinely transferred money among the companies with little or no documentation and otherwise failed to comply with corporate formalities for each of the entities. The companies also failed to keep books and records reflecting their separate assets and liabilities.

The debtor filed for protection under subchapter V of chapter 11 on March 5, 2021, in the U.S. Bankruptcy Court for the Southern District of Florida. The debtor's schedules were inaccurate and inconsistent in detailing the debtor's assets and liabilities, including intercompany claims. Shortly afterward, the debtor removed the Property Dispute to the bankruptcy court. The only creditor claims filed or listed in the chapter 11 case were: (i) Green Tech's $1.95 million claim arising from the Property Dispute; (ii) a secured claim for approximately $1 million arising from a mortgage on the manufacturing facility; and (iii) approximately $75,000 in claims asserted by various governmental entities for taxes, water service, and other items.

In April 2021, as part of a settlement agreement related to the PayMeOn licensing deal, Raw agreed to sell its 10 million PayMeOn shares for $1.2 million to an unaffiliated entity, which remitted the purchase price to Smith because Raw did not have its own bank account. No bankruptcy court approval was sought for the sale and related settlement. Smith claimed that no such approval was necessary because the deal involved Raw rather than the debtor, even though Raw was a fictitious company.

In May 2022, the bankruptcy court granted Green Tech's motion to convert the debtor's chapter 11 case to a chapter 7 liquidation. Shortly afterward, the chapter 7 trustee filed a motion to substantively consolidate the debtor with non-debtors RMC, REM, GES, and Raw (collectively, the "Target Companies").

The Bankruptcy Court's Ruling

The bankruptcy court granted the trustee's motion.

U.S. Bankruptcy Judge Peter D. Russin explained that a bankruptcy court's general equitable powers under section 105(a) of the Bankruptcy Code include the power to substantively consolidate various estates, but only "sparingly and only when the proponent can show that it is necessary to achieve a fair and equitable distribution of the debtors' collective assets." No Rust Rebar, 2023 WL 4497328, at *5. That power extends to the consolidation of both debtors and non-debtors, as "implicitly recognized" by the Supreme Court in Sampsell and as "expressly approved by many other courts." Id.

In assessing the propriety of substantively consolidating the Target Companies, the court applied the Eastgroup standard and factors. Among other things, Judge Russin found that: (i) segregating and ascertaining the entities' individual assets was "sufficiently difficult," and their assets and business functions were "hopelessly commingled"; (ii) because the entities operated from the same location, commingled funds in bank accounts (if they even had any), and used the same corporate emblem, and because Smith was the principal, majority shareholder, president, and representative of each of the affiliated companies, the companies had a "unity of interest and ownership"; (iii) Smith utilized the companies "in concert to achieve their strategic financial goals"; and (iv) the companies failed to maintain corporate formalities, including with respect to the transfer of assets, and disregarded the legal requirements of corporate separateness. Id. at **6-10.

According to Judge Russin, although the Target Companies were given an opportunity to rebut the conclusion that consolidation was appropriate under the circumstances, none did so in any substantive way, but rather made merely procedural arguments.

The bankruptcy court rejected the Target Companies' argument that substantive consolidation must be sought in an adversary proceeding rather than by motion, concluding that, in accordance with relevant caselaw, a court "may substantively consolidate a non-debtor with a bankruptcy debtor by motion." Id. at *11 (citing cases). The court also found that notice of the motion to the Target Companies was adequate to satisfy due process concerns.

Finally, the bankruptcy court concluded that the Target Companies were collaterally estopped from contesting many of the factual findings and legal issues posed by the trustee's motion because, among other things, such findings and legal issues had already been litigated in the context of Green Tech's motion to convert the debtor's chapter 11 case to a chapter 7 liquidation.

Outlook

Despite the unusual nature of the relief granted by the court, No Rust Rebar does not break any new ground regarding substantive consolidation in bankruptcy. Rather, the court's decision reinforces the unusual facts necessary to warrant such relief. In so doing, the decision reinforces several important principles.

First, although the bankruptcy court held that it had the power to substantively consolidate debtors with their non-debtor affiliates even though the Bankruptcy Code does not explicitly authorize the remedy, that interpretation has been rejected by some other bankruptcy courts.

Second, the ruling reaffirms the standard and factors that are customarily applied by courts in the Eleventh Circuit faced with motions to substantively consolidate debtor and non-debtor entities.

Third, No Rust Rebar indicates that a formal adversary proceeding is not necessary to seek substantive consolidation.

Finally, the bankruptcy court emphasized that where substantive consolidation is sought with respect to non-debtors, such non-debtors must be given notice of the motion and an opportunity to be heard as a matter of due process.

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