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