In re Pearlman: Bankruptcy Code Does Not Permit Substantive Consolidation of Non-debtors | Practical Law

In re Pearlman: Bankruptcy Code Does Not Permit Substantive Consolidation of Non-debtors | Practical Law

The US Bankruptcy Court for the Middle District of Florida held in In re Pearlman that the Bankruptcy Code does not permit it to substantively consolidate debtors with non-debtor entities.

In re Pearlman: Bankruptcy Code Does Not Permit Substantive Consolidation of Non-debtors

by PLC Finance and Practical Law Bankruptcy & Restructuring
Published on 09 Feb 2012 • USA (National/Federal)
The US Bankruptcy Court for the Middle District of Florida held in In re Pearlman that the Bankruptcy Code does not permit it to substantively consolidate debtors with non-debtor entities.
On January 10, 2012, the US Bankruptcy Court for the Middle District of Florida held in In re Pearlman that it lacked the authority to substantively consolidate debtors with non-debtor entities.

Background

The trustee of the debtors' estate was appointed because Pearlman had used the debtor entities to perpetrate a Ponzi scheme. The trustee had filed hundreds of fraudulent conveyance actions, alleging that the debtor entities had made payments but the recipients did not receive reasonably equivalent value in return (an essential element of a successful fraudulent conveyance action) because the entities had repaid one another's debts (otherwise known as "wrong payor actions"). In response to the trustee's motions, some of the debtor entities, who are defendants in the fraudulent conveyance actions, sought to substantively consolidate the debtors' estate with non-debtor, Pearlman-controlled entities.
Substantive consolidation may be ordered only when there is a substantial identity between the entities to be consolidated and when it is necessary to avoid some harm or to realize some benefit. An objecting party must show that it relied on the separate existence of the entities in extending credit or that it will be prejudiced by the consolidation.

Court's Reasoning

Courts are split over whether the Bankruptcy Code permits substantive consolidation of non-debtors' assets and liabilities with those of a debtor's estate. Courts that permit consolidation of debtors and non-debtors rely on section 105 of the Bankruptcy Code, which allows a bankruptcy court to "issue any order, process or judgment that is necessary or appropriate to carry out the provision of [the Bankruptcy Code]." The court in Pearlman, however, disagreed and sided with courts that hold that substantive consolidation is a bankruptcy-specific remedy that cannot be used to reach the assets of non-debtors, reasoning that:
  • Bankruptcy courts may only use their broad powers under section 105 to accomplish the goals of the Bankruptcy Code. Bringing an unwilling non-debtor into a bankruptcy proceeding simply because it would help another party is not one of the goals of the Bankruptcy Code.
  • Permitting substantive consolidation of non-debtors under section 105 would preclude the application of the strict protections against involuntary bankruptcy cases provided for under section 303 of the Bankruptcy Code. A section 303 involuntary petition requires a minimum claim amount and the consensus of at least three other claim holders to show that the petition is supported and justified. These protections would be irrelevant if a court could draw a non-debtor into a bankruptcy case through section 105.
  • Parties can pierce the corporate veil to show that a non-debtor entity is really just the alter ego of a debtor, allowing the non-debtor to be reached because the non-debtor is actually the same entity as the debtor. The alter-ego theory provides an alternative means to reach the non-debtor while leaving the Bankruptcy Code protections intact.

Practical Implications

This case serves as a reminder of the limits of substantive consolidation in a bankruptcy proceeding, as well as the importance courts place on preserving the protections provided under the Bankruptcy Code. In particular, the court in Pearlman highlights that there are alternatives available to debtors to force non-debtor entities into bankruptcy, such as the state law remedy of piercing the corporate veil, and that debtors should not be allowed to use the shortcut of substantive consolidation to achieve this.
For more on substantive consolidation, see Practice Notes, Chapter 11 Plan Process: Overview: Substantive Consolidation and Securitization: The SPV: Substantive Consolidation.
For more on piercing the corporate veil, see Practice Note, Piercing the Corporate Veil.

Court Documents