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On Aug. 15, a panel of the 3rd U.S. Circuit Court of Appeals reversed an order of the Delaware District Court substantively consolidating Owens Corning with its various subsidiaries. In re Owens Corning, Docket No. 04-4080, 2005 U.S. App. LEXIS 17150 (3d Cir. 2005), reversing, In re Owens Corning, 316 B.R. 168 (D. De. 2004). The panel’s opinion is significant because it’s the circuit’s first opinion on substantive consolidation under the Bankruptcy Code enacted in 1978, and the panel went to great lengths to set forth certain boundaries and policy considerations that practitioners should keep in mind when applying the extreme, last-resort remedy of substantive consolidation. Substantive consolidation is an equitable doctrine that “treats separate legal entities as if they were merged into a single survivor with all the cumulative assets and liabilities … [t]he result is that claims of creditors against separate debtors morph to claims against the “consolidated survivor.” See Owens Corning, 2005 LEXIS 17150, at 22. “The bad news for certain creditors is that, instead of looking to assets of the subsidiary with whom they dealt, they now must share those assets with all creditors of all consolidated entities, raising the specter for some of a significant distribution diminution.” See id. 26 In 1997, a syndicate of banks led by Credit Suisse First Boston (Banks) loaned Owens Corning $2 billion which Owens Corning used to acquire Fibreboard Corp. As a condition of the loan, the banks required that Owens Corning’s subsidiaries execute guarantees which gave the banks structural seniority and direct claims against the guarantors for payment default. The banks viewed such guarantees as credit enhancements, without which the loans to Owens Corning would not have been made. Facing mounting asbestos liabilities, Owens Corning and seventeen of its subsidiaries (debtors) filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code in the Delaware Bankruptcy Court in 2000. The debtors and certain creditor groups (plan proponents) proposed a plan of reorganization for Owens Corning predicated on consolidating the debtors with three nondebtor Owens Corning subsidiaries. However, unlike substantive consolidation which merges the assets and liabilities of all entities, the plan proponents sought only “deemed consolidation” which would have consolidated all entities only for purposes of valuing and satisfying creditor claims, voting for or against a plan, and making distributions for allowed claims, but would not have resulted in the actual merger, transfer or commingling of any assets of any of the debtors or nondebtor subsidiaries, all of which would have continued to be owned by the respective debtors and nondebtor subsidiaries. The effect of the deemed consolidation was that it “eliminates the separate obligations of the subsidiary debtors arising from the guarantees of the 1997 Credit Agreement” and, in effect, eliminate the structural priority the banks negotiated through the subsidiary guarantees thus rendering the banks’ claims pari passu with the debtors’ unsecured asbestos claimants and bondholders. Id. at 12 Historically, courts addressing substantively consolidation issues have followed the analysis contained in either In re Augie/Restivo Baking Co., Ltd., 860 F.2d 515 (2nd Cir. 1988), or In re Auto-Train Corp., 810 F.2d 270, 276 (D.C. Cir. 1987). Augie/Restivo sets forth a list of factors that courts should consider when determining whether to substantively consolidate separate entities, but focuses 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.” Owens Corning, 2005 LEXIS 17150, at30 (citations omitted). Although Auto-Train shares many of the same hallmarks as the Augie/Restivo analysis, it differs in that the most significant factor is “substantial identity” of the entities. For instance, Auto-Train allows consolidation notwithstanding creditor reliance on separateness when the “demonstrated benefits of consolidation ‘heavily’ outweigh the harm.” Id. (internal citations omitted). Relying on a combination of the Augie/Restivo and Auto-Train analyses, the District Court granted the plan proponents’ motion for “deemed substantive consolidation” over the banks’ objection. The District Court concluded that a “substantial identity between … [Owens Corning] and its wholly-owned subsidiaries” existed and that “there [was] simply no basis for finding that, in extending credit, the banks relied upon the separate credit of any subsidiary guarantors.” Owens Corning, 316 B.R. at 171-72. The District Court based its “substantial identity” conclusion on the fact that (i) all of the subsidiaries were controlled by a single committee, (ii) control was exercised on a product-line basis, (iii) the officers and directors of the subsidiaries did not establish business plans or budgets, (iv) the subsidiaries were created for the convenience of the parent company, and (v) the financial management of the entire enterprise was conducted in an integrated manner. See id. at 171. Supporting its finding of no reliance by the banks, the District Court noted that: (i) each bank’s commitment was to the entire enterprise; (ii) the decision as to whether funds would be borrowed by the parent or the subsidiaries was made by the borrower, not the banks; (iii) Owens Corning financial reporting was done on a consolidated basis, and only consolidated information was provided to the banks; and (iv) the banks knew that each guarantor had assets with a book value of at least $30 million, but the banks had no information about the debts of such subsidiaries. See id. at 172. Further, the District Court found that substantive consolidation was appropriate because it would “simplify and expedite the successful completion of this entire bankruptcy proceeding … and it would be exceedingly difficult to untangle the financial affairs of the various entities.” See id. at 171. In reviewing the District Court’s opinion, the panel reviewed Augie/Restivo, Auto-Train and the principles underlying the remedy of substantive consolidation. These principles include: (i) absent compelling circumstances, courts are required to respect separateness; (ii) the harm substantive consolidation addresses is nearly always that caused by debtors who disregard separateness; (iii) mere benefit to the administration of the case does not justify substantive consolidation; (iv) substantive consolidation is “extreme” and imprecise, and should be used rarely and as remedy of last resort after considering and rejecting other remedies; and (v) substantive consolidation may not be used offensively, i.e., having a primary purpose of disadvantaging tactically a group of creditors in the plan process or altering creditors’ rights. See Owens Corning, 2005 LEXIS 17150, at 38. With these considerations in mind, the panel set forth its test for substantive consolidation: proponents of consolidation must prove either that: (i) prepetition, the entities disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one or; (ii) postpetition, their assets and liabilities are so scrambled that separating them is cost prohibitive and hurts all creditors. See id. Further, to make a prima facie case for substantive consolidation, a proponent must show, based on prepetition conduct: (i) corporate disregard creating contractual expectations of creditors that they were dealing with the debtors as one indistinguishable entity; and (ii) they actually and reasonably relied on the debtors’ alleged unity. This is significant because the panel has effectively limited the remedy of substantive consolidation to creditors whose claims are based on contractual rights. See id. at 40, n.21 (“Tort and statutory claimants, who, as involuntary creditors . . . did not rely on anything in becoming creditors … are excluded, leaving only those creditors who contract with an entity for whom consolidation is sought.” (Citation omitted)). Opponents of consolidation can defeat a prima facie showing by establishing that they are adversely affected and actually relied on the debtors’ separateness. See id. Applying the above test to Owens Corning’s case, the panel held the plan proponents failed to prove either rationale for substantive consolidation. First, the panel found there was no prepetition disregard of separateness because, among other things: (i) the 1997 loan transaction and guarantees were premised on the separateness of all Owens Corning affiliates; (ii) the banks specifically bargained for the guarantees; and (iii) the banks knew that each subsidiary had a net worth of at least $30 million. The panel rejected the argument of the plan proponents that the banks could not have relied on the separateness because they were only provided consolidated financial information for all debtors holding that creditors are free to employ whatever metrics they believe appropriate in determining whether to extend credit, so long at the credit decision was based on the existence of separate entities. The panel further found that consolidation was also inappropriate under the second rationale because there was no evidence that the debtors’ affairs were so entangled that every creditor would benefit from consolidation. Significantly, the panel further held that the benefit to creditors should be from cost savings that make assets available rather than from the shifting of assets to benefit one group of creditors at the expense of another. In addition, the concept of “deemed consolidation” appears dead on arrival in the 3rd Circuit as the panel referred to it as “perhaps the flaw most fatal” to the plan. The panel questioned how the debtors’ corporate structure could be such a sham prepetition that consolidation was warranted, yet upon confirmation, such structure remains largely unchanged, with the debtors retaining all of the benefits of the corporate structure, but the banks losing their guarantees. See id. at 52-53. The panel viewed this as evidence that substantive consolidation was being used as a strategy to strip the banks of their rights in favor of other creditors. In sum, substantive consolidation remains a constrained tool of equity which may be utilized in bankruptcy courts within the 3rd Circuit, subject to the following conditions: (1) evidence must support the result and consolidation cannot merely be “deemed”; (ii) is only available to creditors whose claims are contractual in nature; (iii) can only be employed as a shield, not a sword; (iv) must benefit all creditors; and (v) cannot be employed against a party that reasonably relied on separateness. William S. Katchen is a partner and Michael F. Hahn is an associate with Duane Morris of Newark, N.J. The views expressed in this article are solely those of the authors and do not necessarily reflect the opinions of Duane Morris, its partners and associates, or clients. The authors represented parties in the Owens Corning reorganization cases, but did not participate in the appeal.

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