When multiple affiliated entities’ financial affairs are so entangled that they cannot be separated, a substantive consolidation may be allowed. In this article, we’ll define the term “substantive consolidation” and explain how it works. 

Key Takeaways

• Substantive consolidation is an equitable remedy in which a bankruptcy court pools the assets and liabilities of a debtor with one or more of its affiliates
• Substantive consolidation is rarely allowed because it benefits one entity’s creditors at the expense of the others’
• Substantive consolidation is not governed by the Bankruptcy Code but rather by the bankruptcy courts
• When deciding whether or not to allow substantive consolidation, the bankruptcy courts typically seek to understand the extent to which the entities’ assets and liabilities can or can not be separated, as well as how much the benefits of substantive consolidation to creditors would outweigh the harms

What Is Substantive Consolidation?

Substantive consolidation is the combining of multiple bankruptcy estates into a single estate. The bankruptcy court pools the assets and liabilities of a debtor with those of its affiliates. This is done for the purpose of paying claims that belong to creditors of both debtors. It is usually done with parent companies, subsidiaries, and affiliates.

There is no specific authorization for substantive consolidation under the Bankruptcy Code. It is under the bankruptcy court’s authority to substantively consolidate affiliated entities. 

What Happens Under Substantive Consolidation?

When multiple entities are substantively consolidated, the following things happen:

• Intercompany claims among the entities are eliminated
• The assets of the consolidated entities are pooled
• The claims of creditors against each entity are treated as against the common pool of assets

Courts rarely allow substantive consolidation because it results in creditors of the poorer estate sharing with creditors of the richer estate. Because each entity has a different debt-to-asset ratio, one entity’s creditors benefit at the expense of another entity’s creditors. As a result, the benefit conferred on one set of creditors and the harm suffered by another group of creditors must be justifiable. 

When Can Substantive Consolidation Happen?

Because the Bankruptcy Code doesn’t have prescribed standards for substantive consolidation, bankruptcy courts have developed their own standards to control and manage this process. As such, there have been multiple and sometimes conflicting tests for determining whether entities should be substantively consolidated. That being said, four types of factors have emerged as relevant.

• Record keeping - The entities should have separately identified assets and liabilities and separate accounting records and financial statements

• Operations - The entities should be economically independent from their equity holders

• Transactions - The entities’ transactions with affiliates should be on commercially reasonable terms with limited creditor support by affiliates 

• Benefits and harms - The benefits of substantive consolidation should outweigh the prejudice to creditors that will result

In short, in making decisions about whether or not to allow a substantive consolidation, bankruptcy courts seek to determine whether the entities’ assets and liabilities can be separated and whether they can conduct business as a standalone entity. If it is found that entities’ assets and liabilities are hopelessly entangled, substantive consolidation may be considered.