Non-consolidation of special purpose entities with the seller of financial assets is a prerequisite of every properly structured securitization transaction.
On May 1, the United States Supreme Court denied the petition for writ of certiorari filed by the Official Representative of the Bondholders and Trade Creditors of Owens Corning, Inc. with respect to the U.S. Court of Appeals for the Third Circuit decision regarding substantive consolidation. As a result of the Supreme Court’s denial of review, the guidelines for determining whether substantive consolidation is appropriate will now be settled in the Third Circuit. Likewise, the case has profound and wide ranging precedential implications in terms of validating substantive consolidation in other circuits.
In August 2005, the Third Circuit reversed the district court ruling that had treated Owens Corning and its units as a single entity under a policy of substantive consolidation, which would have combined the company’s assets with those of three subsidiaries. In rejecting the lower court’s ruling, the Third Circuit emphasized, and to a large extent reiterated, a myriad of principles to be applied in an analysis of substantive consolidation relevant to structured finance transactions.
In reaching its decision, the Third Circuit articulated a two-part test (one applied to events and expectations prior to the bankruptcy filing and the other applied to facts and circumstances after the pendency of the bankruptcy case) that must be satisfied whenever a party in bankruptcy seeks substantive consolidation. First, the court will determine whether the parties disregarded corporate separateness to such a degree that, pre-petition, the creditors had treated the parent and its affiliates as one single legal entity. Second, it will consider whether, post-petition, the assets and liabilities of the parent and its affiliates were so entangled that separating them is prohibitive and prejudices all creditors. In rendering its decision, the Third Circuit reiterated the prevailing view that the burden of proof is upon the proponents of substantive consolidation.
The first part of the test, the “pre-petition test,” requires a demonstration that the proponent of substantive consolidation is a creditor of the debtor and that the creditor actually and reasonably relied upon the unified entity. Opponents to substantive consolidation need only prove that they are adversely affected by substantive consolidation and that they actually relied on the debtors’ separate existence in order to defeat a prima facie showing of the first element. In applying the first part of the test to the facts of the Owens Corning lending arrangement, the Third Circuit determined that, pre-petition, the company had negotiated the transactions premised on the separateness of all of its affiliates, and the fact that the bank group insisted on guarantees from affiliates demonstrated the creditors’ intention to treat the companies as separate entities.
The second part of the test, the “post-petition test,” is based in practicality and is aimed at addressing situations where the entities’ assets and liabilities have been “hopelessly” commingled (i.e., to such a degree that it is impossible to determine separate ownership). A fundamental consideration under this rationale is whether untangling the commingled assets and liabilities will be beneficial (i.e., increased recovery) to all of the debtors’ creditors or just some of them. In applying the second part of the test to the bank group’s financing structure, the Third Circuit found there was no meaningful evidence of post-petition commingling of the debtor’s assets that would justify substantive consolidation.
In essence, the Third Circuit found no plausible reason to vitiate a fairly typical bank lending arrangement that had been negotiated at arm’s length, particularly when doing so would grievously punish the very parties that conferred the pre-petition benefit on the company by extending the loan.
The Third Circuit set out the following five principles that should direct the application of both prongs of the test and provide the basis for limiting the extraordinary remedy of substantive consolidation:
- Respect for corporate separateness: Respecting entity separateness is a fundamental ground rule that requires the bankruptcy court to recognize entity separateness absent compelling equitable exigent circumstances.
- Necessity for substantive consolidation almost always debtor inflicted: The harm to be remedied by substantive consolidation is almost always caused by the debtor rather than the creditors the consolidation would affect.
- Mere benefit to the administration of the case not justification for substantive consolidation: Courts should refrain from ordering substantive consolidation solely because it would simplify a case or aid in post-petition accounting.
- Remedy of last resort: Because substantive consolidation is an extreme remedy that may profoundly impact creditors’ rights and recoveries, it should be used sparingly and only as a last resort after considering and rejecting other less severe remedies.
- Defensive rather than offensive use: Substantive consolidation should only be used defensively as a shield in order to rectify harms caused by entangled affairs and should not be used offensively to disadvantage creditors or alter creditors’ rights.
The Third Circuit emphasizes adherence to these principles rather than the “imprecise tests and rigid elements” that other courts have often applied. As a result of its decision in Owens Corning, the Third Circuit has made it clear that it will defer to a lender’s pre-petition reliance upon the separateness of distinct and independent legal entities before it will order substantive consolidation.
The Supreme Court normally grants certiorari (i.e., agrees to hear a given case) in special circumstances, when federal appellate courts are in conflict, when lower courts have decided significant novel federal constitutional questions or when a state court has rendered a decision on a constitutional question that may conflict with Supreme Court precedent. Review on certiorari is discretionary and is not a matter of right. Due to the writ of certiorari’s discretionary nature, its denial normally does not carry any implication regarding the Supreme Court’s view of the merits of the case or its approval of the lower court’s decision. However, when the Supreme Court denies this writ, the lower court’s decision stands unaffected, such that the Supreme Court’s denial, after due consideration, is often considered
a “light-weight precedent” in terms of its binding impact on lower courts.
The application of substantive consolidation to a particular case is, of necessity, tied closely to the facts involved and largely defined by case law. Securitization transactions expressly and emphatically rely on a combination of explicit corporate separateness, mandated separateness of assets and built-in protections against substantive consolidation.
Due to the substantial dollar amounts involved in the Owens Corning bankruptcy case, the high-profile nature of the proceeding and the fact that substantive consolidation was vigorously disputed rather than consensual, the Third Circuit’s ruling and the Supreme Court’s denial of certiorari merit attention and should be considered within the ambit of any non-consolidation analysis. As a matter of practice, law firms that render non-consolidation legal opinions should consider mentioning the decision in the opinion text. However, because the Owens Corning decision reiterates the established legal analysis and adheres to the prevailing precedents rather than portending a significant departure from long-standing principles of structuring deals, the decision provides a reaffirmation of those principles and methods of analysis. Consequently, the Third Circuit’s ruling and Supreme Court’s denial in this case will undoubtedly provide reassurance to the law firms that render, and to the investors, bond insurers and underwriters that receive and rely on, standard non-consolidation opinions in structured finance transactions. Nevertheless, it is important not to take the correct application of case law for granted. Special purpose entities need to be operated in the manner set forth in securitization agreements in order for their protection afforded by the structure to be recognized.