Bankruptcy Court allows for substantive consolidation of debtor and nondebtor.

By: Andrew G. Lizotte

Occasionally, a person or company in bankruptcy (the debtor) and a related person or company allow their financial affairs to become a bit too entangled. In these circumstances, bankruptcy courts may impose several remedies, one of which is substantive consolidation. Substantive consolidation effectively provides for the merger or combination of the assets and liabilities of two separate entities to benefit creditors who may have treated them as one.

Cameron Construction & Roofing, Inc. (CCR), a debtor, performed construction related services. Its main assets available to satisfy creditor claims were tools and vehicles used in the roofing business. Cameron Construction LLC (the LLC), a related party, owned the real estate upon which CCR operated and the LLC’s operating agreement provided that it was to engage in the business of owning, managing and developing real estate and related activity. Each company employed about 15 workers but the LLC employees were effectively performing services for which CCR was formed. The LLC did not invoice CCR for the services performed and there was no subcontract. CCR used the LLC premises, but there was no lease. The “rent” paid by CCR was used to pay the LLC employees to perform services benefiting CCR. The principal’s wife was paid primarily by the LLC although her services largely benefited CCR. CCR’s workers compensation premiums would have been higher had the LLC employees been on its payroll. Each of the these factors supported the inference that LLC was really indistinguishable from CCR.

In determining whether substantive consolidation of two or more entities is appropriate, courts look to whether there is a “substantial identity” of the two parties, whether consolidation is necessary to avoid some harm or realize some benefit and, if a creditor will be prejudiced, whether the benefits of consolidation heavily outweigh the harm. Although some courts have been hesitant to approve consolidation of a nondebtor and a debtor (as opposed to two debtors in bankruptcy), the Cameron court found substantive consolidation appropriate in this circumstance.

Parties operating related enterprises should be aware of the additional remedies that may be imposed in favor of creditors in the event that one or more of the entities experiences financial distress. A related party that may otherwise appear to be financially healthy may be called to satisfy the claims against the bankrupt entity. Failure to observe corporate formalities can carry heavy consequences. The mere observance of filing separate tax returns and separate annual reports (as was done in the Cameron case) may not be sufficient. Transactions between the related parties should be properly documented and observed, clear lines should be drawn to distinguish the operations of the entities, and corporate governance formalities should be maintained.

The case is In re Cameron Construction & Roofing Co., Inc., Case No. 14-13723-JNF, U.S. Bankruptcy Court, Dist. Of Massachusetts