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In a ruling that could prove to be worth nearly $1.9 billion for a group of banks, a federal appeals court has ruled that the judge overseeing the massive bankruptcy of Owens Corning improperly ordered a “substantive consolidation” of the company and all of its nonbankrupt subsidiaries. The ruling in In re Owens Corning is a huge victory for a group of 43 banks led by Credit Suisse First Boston who argued that their $2 billion in loans — issued before the company went bankrupt — were guaranteed by Owens Corning’s more financially healthy subsidiaries. The banks suffered a setback in 2004 when Senior U.S. District Judge John P. Fullam granted a motion for substantive consolidation, saying he had concluded that there was “substantial identity” between Owens Corning and all of its wholly owned subsidiaries. Fullam, an Eastern District of Pennsylvania judge who was specially assigned to handle the Delaware bankruptcy, rejected the banks’ argument that they had relied on the separate credit of the subsidiary guarantors. He also found that it would be “exceedingly difficult to untangle the financial affairs of the various entities,” and that it was “clear that substantive consolidation would greatly simplify and expedite the successful completion of this entire bankruptcy proceeding.” Now a unanimous three-judge panel of the 3rd U.S. Circuit Court of Appeals has ruled that Fullam was too quick to order a substantive consolidation and that, in the case of Owens Corning, it should never have been allowed. “Because substantive consolidation is extreme (it may affect profoundly creditors’ rights and recoveries) and imprecise, this ‘rough justice’ remedy should be rare and, in any event, one of last resort after considering and rejecting other remedies,” U.S. Circuit Judge Thomas L. Ambro wrote. Ambro, in an opinion joined by Judges Jane R. Roth and Julio M. Fuentes, found that while many of the other federal appellate courts have addressed the issue, the 3rd Circuit has so far said very little. Filling that jurisprudential void, Ambro outlined several “principles” that must be considered when deciding whether to order a substantive consolidation. One “fundamental ground rule,” Ambro said, is “limiting the cross-creep of liability by respecting entity separateness.” That principle, Ambro said, is founded on the “general expectation” of state law and of the Bankruptcy Code, as well as commercial markets, that courts “respect entity separateness absent compelling circumstances.” Although substantive consolidation is designed to address “harms,” Ambro found that those harms “are nearly always those caused by debtors (and entities they control) who disregard separateness.” And judicial economy is never a valid justification for substantive consolidation, Ambro found. “Mere benefit to the administration of the case (for example, allowing a court to simplify a case by avoiding other issues or to make post-petition accounting more convenient) is hardly a harm calling substantive consolidation into play,” Ambro wrote. And as a rule, Ambro said, substantive consolidation must be treated always as a shield and never as a sword. “While substantive consolidation may be used defensively to remedy the identifiable harms caused by entangled affairs, it may not be used offensively (for example, having a primary purpose to disadvantage tactically a group of creditors in the plan process or to alter creditor rights),” Ambro wrote. With those principles in mind, Ambro announced a two-part test that must be satisfied whenever a party in bankruptcy seeks substantive consolidation. “In our court what must be proven � concerning the entities for whom substantive consolidation is sought is that (1) pre-petition they disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (2) post-petition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors,” Ambro wrote. The party seeking substantive consolidation, Ambro said, has “the burden of showing one or the other rationale for consolidation.” Applying that test to Owens Corning, Ambro found that the debtor’s lawyers fell short. The evidence, Ambro said, showed that Owens Corning had established a series of subsidiary companies that each had a separate purpose and that “each subsidiary was a separate legal entity that observed governance formalities.” For example, Owens-Corning Fiberglass Technology Inc. was created as an intellectual property holding company to which Owens Corning assigned all of its domestic intellectual property. The subsidiary then licensed the intellectual property back to Owens Corning in return for royalty payments. “This structure served to shield OCD’s intellectual property assets (valued at over $500 million) from liability,” Ambro noted. Another subsidiary, IPM Inc., was incorporated as a “passive Delaware investment holding company” to consolidate the investments of foreign subsidiaries, effectively shielding the foreign subsidiaries’ investments from Owens Corning’s liability and vice versa. Ambro found that the banks had relied on the separateness of the subsidiaries in its structuring of the $2 billion loan. “The banks did the ‘deal world’ equivalent of ‘Lending 101.’ They loaned $2 billion to Owens Corning and enhanced the credit of that unsecured loan indirectly by subsidiary guarantees covering less than half the initial debt,” Ambro wrote. “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 Owens Corning did not have.” As a result, Ambro said, Owens Corning and the other parties in the bankruptcy pressing for substantive consolidation “cannot now ignore, or have us ignore, the very ground rules Owens Corning put in place.” Ambro found that Fullam was incorrect when he concluded there was “substantial identity” between Owens Corning and its subsidiaries. Fullam also erred, Ambro said, when he concluded that the banks had not relied on the separateness of the subsidiaries. “The banks knew a great deal about these subsidiaries. For example, they knew that each subsidiary guarantor had assets with a book value of at least $30 million � that the aggregate value of the guarantor subsidiaries was over $900 million and that those subsidiaries had little or no debt,” Ambro wrote. In his closing paragraphs, Ambro explained why Fullam’s ruling was fundamentally unfair. “Substantive consolidation at its core is equity. Its exercise must lead to an equitable result. ‘Communizing’ assets of affiliated companies to one survivor to feed all creditors of all companies may to some be equal (and hence equitable). But it is hardly so for those creditors who have lawfully bargained pre-petition for unequal treatment by obtaining guarantees of separate entities,” Ambro wrote. “No principled, or even plausible, reason exists to undo Owens Corning’s and the banks’ arms-length negotiation and lending arrangement, especially when to do so punishes the very parties that conferred the pre-petition benefit — a $2 billion loan unsecured by Owens Corning and guaranteed by others only in part.” Invoking the Bard, Ambro found that overturning such a bargain — which was premised on Owens Corning’s corporate structure — would “cause chaos in the marketplace, as it would make this case the Banquo’s ghost of bankruptcy.” (In Shakespeare’s “Macbeth,” Banquo is one of Macbeth’s best friends who pledges allegiance to Macbeth as long as his reputation is not lost. Macbeth fears Banquo because it was prophesied that Banquo’s offspring would be kings, and therefore hires murderers to kill him. When Banquo’s ghost appears at a banquet, it is a manifestation of Macbeth’s guilty conscience.) The opinion lists 44 lawyers who participated in the appeal. Attorney Martin J. Bienenstock of Weil Gotshal & Manges in New York argued the case for the banks. Attorney Charles O. Monk II of Saul Ewing’s Baltimore office argued on behalf of Owens Corning and its subsidiaries. Attorney J. Andrew Rahl of Anderson Kill & Olick in New York argued on behalf of the official committee of unsecured creditors.

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