In the past, Distressed Debt Investing has republished articles from the American Bankruptcy Institute that I think are particularly pertinent to market participants (buy side, sell side). The article below, written by Mark Kronfeld as well as Vincent Indelicato and Chris Theodoridis (both of Proskauer Rose, frequent contributors to the blog) is an amazing piece that pulls many examples from cases that have been highly relevant, and contentious, to buysiders in the past. Enjoy!
Blurring The Lines: The Murkiness of Corporate Separateness in Chapter 11 (1)
The doctrine of corporate separateness is one of the bedrock principles of American corporate law and has long served as the default presumption where courts adjudicate matters involving multiple legal entities. (2) As a general rule, a corporation is not liable for the debts of another corporate entity (even its parent, subsidiaries, or affiliates). (3)
The principle of corporate separateness is generally only challenged when debtors encounter financial distress. Not surprisingly, the question of corporate separateness has emerged as a fertile source of debate in many recent bankruptcy cases. But nothing about chapter 11 alters the landscape; the default presumption of corporate separateness continues to persist in bankruptcy. (4) While bankruptcy courts routinely consolidate chapter 11 cases of affiliated debtors for administrative purposes, joint administration does not in any way shatter the corporate separateness of each debtor. (5)
A number of exceptions to this default presumption, however, arise in the bankruptcy setting. For example, affiliated debtors pledge their assets to secure postpetition financing in most cases, regardless of which debtors need or use the proceeds, and centralized cash management systems frequently allow each debtor to use affiliated debtors’ cash, with intercompany claims only sometimes being assessed or protected. Further, corporate entities (typically affiliates) often agree, by contract, to be liable for the debts of another entity by providing a guaranty. Alternatively, specific statutes such as the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) and the Employee Retirement Income Security Act (ERISA) may give rise to exceptions from corporate separateness. (6)
Perhaps the most far-reaching exception to the doctrine of corporate separateness in chapter 11 lies in the ability of a bankruptcy court to substantively consolidate the assets and liabilities of numerous distinct legal entities and treat them as if they belong to one single entity. (7) Some courts have attempted to make the test for substantive consolidation objective (8), while other courts weigh benefits against burdens (9), creating confusion about how a court will weigh different factors. Other controversial exceptions to corporate separateness include successor liability, control person liability, and corporate veil piercing.
Even in the absence of substantive consolidation or other exceptions to corporate separateness, various forms of relief granted in bankruptcy cases sometimes treat entities as if they have been substantively consolidated. This article highlights four examples in the bankruptcy context where the lines separating corporate entities have arguably been blurred.
A. Section 1129(a)(10) - Per Plan or Per Debtor?
Under Bankruptcy Code section 1129(a)(10), if a class of claims is impaired under a plan, then at least one non-insider impaired class must vote to accept the plan. Although the Bankruptcy Code is arguably clear that each debtor’s plan must have at least one impaired accepting class, some decisions have raised the question of whether in a multi-debtor case, section 1129(a)(10) imposes a “per debtor” or “per plan” requirement?
The Delaware bankruptcy court in In re Tribune Co., 464 B.R. 126 (Bankr. D. Del. 2011) and In re JER/Jameson Mezz Borrower II LLC, 461 B.R. 293 (Bankr. D. Del. 2011) explicitly rejected the joint plan or “per plan” approach and ruled that the impaired accepting class requirement of section 1129(a)(10) applies to each individual debtor. In Tribune, the court noted that the plan emphasized the separateness of the debtors’ estates and did not provide for substantive consolidation. (10) The court further noted that other sections of 1129(a) clearly include all debtors under a joint plan and section 1129(a)(10) must be read consistently. (11) Lastly, the court observed that administrative convenience is simply insufficient to “disturb the rights of impaired classes of creditors of a debtor not meeting confirmation standards.” (12)
By contrast, in In re Transwest Resort Properties, No. 10-37134 (Bankr. D. Ariz. Dec. 16, 2011), the court confirmed a joint plan with one impaired accepting class of creditors at only one of the debtors under the plan, over the objection of the mezzanine lender. Although the mezzanine lender appealed, the District Court dismissed the appeal on equitable mootness grounds leaving the section 1129(a)(10) issue undecided.
Similarly, in In re Charter Communications, 419 B.R. 221 (Bankr. S.D.N.Y. 2009), the court adopted a “per plan” approach to section 1129(a)(10) permitting use of one impaired accepting class for one debtor to count as an impaired accepting class for an affiliated debtor. (13) The court reasoned that the “evidence support[ed] a finding that the business of Charter [was] managed by CCI on an integrated basis making it reasonable and administratively convenient to propose a joint plan.” (14) Charter settled before an appellate court ruled.
The relevant inquiry in the context of 1129(a)(10) jurisprudence focuses on whether bankruptcy courts should respect the corporate separateness of multiple debtors for the purposes of fulfilling plan confirmation requirements. As corporate separateness is “the rule [and] not the exception,” (15) corporate separateness should be respected barring an established exception supported by evidence. Moreover, absent substantive consolidation, permitting creditors of one debtor entity to cram down creditors of an entirely different debtor entity arguably causes an untenable disenfranchisement of those aggrieved creditors and does not encourage consensual global plans.
B. Bankruptcy Remote Special Purpose Vehicles
Within a corporate enterprise, Special Purpose Vehicles (SPVs) are often created to be insulated from the financial condition of the remaining enterprise. SPVs are commonly structured to be “bankruptcy remote” in an effort to protect creditors from becoming entangled in a bankruptcy case. But recent case law shows bankruptcy remoteness does not equate to being bankruptcy proof.
In Gen. Growth Props., Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), the debtors comprised a large commercial real estate enterprise. Among the affiliated entities were numerous bankruptcy remote SPVs. The SPV lenders believed the SPVs to be bankruptcy proof because the SPVs’ independent boards of directors were picked by the lenders, and those directors could not authorize a bankruptcy filing without the lenders’ consent. Immediately before the corporate enterprise filed for bankruptcy, however, the debtors replaced the SPVs’ independent directors with new directors. The new directors then authorized the bankruptcy filings for the SPVs without the lenders’ consent.
Although many of the SPVs did not need bankruptcy relief, the court denied the lenders’ motion to dismiss the bankruptcy cases of the SPVs, holding, among other things, the interests of the enterprise as a whole could be considered in determining whether to file individual SPVs. While “[n]othing in [the court’s] opinion implie[d] that the assets and liabilities of any of the [debtors] could properly be substantively consolidated with those of any other entity,” (16) the court was clear that individual chapter 11 cases are not to be viewed in a black box simply because the debtors are separate corporate entities. Whether future cases will take the holding in General Growth one step further remains to be seen.
C. Section 510(b) of the Bankruptcy Code
When applied in the multi-debtor context, section 510(b) of the Bankruptcy Code can potentially lead to outcomes that conflict with the notion of corporate separateness. Section 510(b) of the Bankruptcy Code provides:
For the purpose of distribution under this title, a claim . . . for damages arising from the purchase or sale of a security of the debtor or an affiliate of the debtor . . . shall be subordinated to all claims or interests that are senior to or equal to the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock.11 U.S.C. § 510(b).
In Lernout & Hauspie Speech Products, N.V., 264 B.R. 336 (Bankr. D. Del. 2001) (“L&H”), the court held that the claim against the subsidiary debtor arising from the purchase by the claimant of the parent debtor’s equity securities, must be subordinated to general unsecured claimants in the subsidiary, but may be treated pari passu for distribution purposes with other equity security holders of the subsidiary, even though the claimant never owned any of the subsidiary’s equity. The court acknowledged the ambiguity in the language of section 510(b) but relied on policy arguments, its interpretation of legislative history and pre-Code case law. (17)
The ambiguity in section 510(b) arises from two phrases: “arising from the purchase or sale of a security of the debtor or an affiliate of the debtor” and “represented by such a security.” The key question is as follows: against which debtor entity should the subordinated claim be asserted? The language “such a security” suggests that one should “follow the security” to assert the subordinated claim against the same entity that issued the underlying security. This was the argument advanced by the debtor in L&H. (18)
However, the language “debtor or an affiliate” has been interpreted by some, including the claimant in L&H, to permit a claim subordinated under section 510(b) to be asserted against one debtor entity even though the security giving rise to the 510(b) claim was issued by a different debtor entity (albeit an affiliate). (19) The L&H court ruled in favor of the claimant.
A similar outcome was reached in VF Brands, Inc., 275 B.R. 725, 726-727 (Bankr. D. Del. 2002), in which the court appears to take that position that section 510(b) mandates that subordinated claims held by a subsidiary’s shareholders be treated on a par with the claims of the parent’s shareholders. The court noted that “[t]he language of section 510(b) applies equally to claims arising from purchase of the stock of an affiliate, including a subsidiary, of the debtor as it does to the purchase of stock of the debtor itself.” (20)
Based on this interpretation, courts may interpret section 510(b) to allow subordinated claims against any debtor entity as long as the underlying security was issued by one of that debtor’s affiliates. This broad interpretation of section 510(b) seems to treat separate debtor entities as interchangeable, which some may argue is inconsistent with the principle of corporate separateness.
D. Multiple Claims Arising from a Single Transaction
The notion that different debtors may be liable for the same obligation because of joint and several liability or guarantees is not controversial. In such instances, all the creditor’s claims will generally be allowed in their full amount subject to the qualification that the creditor may not recover in the aggregate more than the full amount owed to the creditor. (21)
But what happens when a single transaction triggers a series of transfers causing multiple claims by different creditors to be asserted against a single debtor? In such instances, commonly seen in the “double-dip bond” context, multiple claims are typically allowed even when they arise from a single originating transaction because the claims are asserted by separate creditor entities. (22) Yet recoveries from multiple claims arising from a single transaction continue to emerge as sources of dispute in recent high profile chapter 11 cases, including Lehman Brothers, General Motors, and AbitibiBowater.
A common example is where a creditor possesses (i) a direct claim against a debtor finance subsidiary based upon the subsidiary’s issuance of debt held by the creditor and (ii) a guaranty claim held by the same creditor against the subsidiary’s parent, also a debtor entity, based upon the parent’s guaranty of the debt issued by the subsidiary. Often the same subsidiary will assert a separate claim against the parent guarantor either because the subsidiary has loaned the proceeds of the debt issuance to the parent guarantor or because the subsidiary was a Nova Scotia “Unlimited Liability Company.” (23) This incremental claim asserted by the subsidiary against the parent guarantor enhances recoveries of the subsidiary’s creditors.
In cases similar to the example above, some have argued that the guarantee claim held by the creditor is duplicative of the intercompany claim asserted by the subsidiary against the parent. Although courts have not yet ruled directly on this issue, to conflate the two distinct claims would arguably require the court to consider the concept of corporate separateness mere form and not substance.
Conclusion
Despite the bedrock principle of corporate separateness, modern bankruptcy jurisprudence demonstrates several irreconcilable viewpoints that blur the lines separating corporate entities. An awareness and understanding of where the lines blur is critical to a creditor’s ability to assess and calculate the risks inherent in the bankruptcy process.
Footnotes
(1) The authors would like to thank Martin Bienenstock and Philip Abelson of Proskauer Rose LLP for their assistance in connection with this article.
(2) See, e.g., On-Line Servs., Ltd. V. Bradley & Riley PC (In re Internet Navigator, Inc.), 301 B.R. 1, 6 (B.A.P. 8th Cir. 2003) (“[T]his Court is unwilling on this record to capsize the fundamental bulwark of corporate law that the corporate entity is separate and distinct from its individual members.”).
(3) See, e.g., United States v. Bestfoods, 524 U.S. 51, 61 (1998) (“[i]t is a general principle of corporate law deeply ‘ingrained in our economic and legal systems’ that a parent corporation . . . is not liable for the acts of its subsidiaries.”).
(4) See, e.g., AL Tech Specialty Steel Corp. v. Allegheny Int. Credit Corp., 104 F.3d 601, 608 (3d Cir. 1997) (in bankruptcy, absent certain exceptions, affiliated entities “must be considered separate entities”).
(5) See, e.g., Bunker v. Peyton (In re Bunker), 312 F.3d 145, 153 (4th Cir. 2002) (“Joint administration does not affect the substantive rights of either the debtor or his or her creditors.”).
(6) See 12 U.S.C. § 1815(e)(1)(A) (FIRREA cross-guarantee provision imposing liability on any bank owned by a bank holding company for losses caused by the failure of a sister bank); 29 U.S.C. § 1082(b)(2) (ERISA provision imposing joint and several liability on all members of a controlled group).
(7) See FDIC v. Colonial Realty Co., 966 F.2d 57, 58 (2d Cir. 1992).
(8) See, e.g., In re Owens Corning, 419 F.3d 195 (3d Cir. 2005); In re Augie/Restivo Baking Co., 860 F.2d 515 (2d Cir. 1988).
(9) See, e.g., Eastgroup Properties v. Southern Motel Assoc., Ltd., 935 F.2d 245 (11th Cir. 1991).
(10) In re Tribune Co., 464 B.R. at 182.
(11) Id.
(12) Id.
(13) Charter Communications, 419 B.R. at 226.
(14) Id.
(15) Anderson v. Abbott, 321 U.S. 349, 362 (1944).
(16) Gen. Growth Prps., 409 B.R. at 69.
(17) L&H, 264 B.R. at 341-345.
(18) Id. at 341.
(19) Id.
(20) VF Brands, 275 B.R. at 727.
(21) See In re Gessin, 668 F.2d 1105, 1107 (9th Cir. 1982) (creditor’s claim against guarantor not reduced by amount received from principal debtor).
(22) See Northwestern Mutual Life Ins. Co. v. Delta Air Lines, Inc. (In re Delta Air Lines, Inc.), 608 F.3d 139, 149 (2d Cir. 2010) (ruling where “claims arise under agreements (1) between different parties, (2) addressing different events, and (3) providing for different remedies,” the claims are allowed in full against the debtor and rejecting the proposition that “a single loss can only give rise to a single claim in bankruptcy”); see also Mark P. Kronfeld, “The Anatomy of a Double-Dip” XXXI ABI Journal 2, 24-25, 68-69, March 2012.
(23) Companies Act, R.S.N.S., 1989, c. 81, s. 135.
