Page 96 - Bankruptcy Volume 1

here. This listing provides a broad framework of items that are routinely addressed in making a substan-
tive consolidation determination. Attorneys directing the bankruptcy normally decide which of the tests
and factors to focus on, but accountants can provide valuable assistance by researching these areas as di-
rected by legal counsel.

There are several legal tests used by various circuit courts to determine whether substantive consolida-
tion is permissible:

1. D.C. Circuit Test in Auto-Train. In 1987, the Court of Appeals for the District of Columbia ar-
ticulated a three-part analysis for substantive consolidation. The court found that a bankruptcy
court could only order substantive consolidation if all three of the following conditions were sat-
isfied. First, the court must find the existence of a "substantial identity between the entities to be
consolidated." Second, the bankruptcy court must find that "consolidation is necessary to avoid
some harm or to realize some benefit." Third, if a creditor makes a showing that it "relied on the
separate credit of one of the entities and that it will be prejudiced by consolidation," then the
bankruptcy court can only grant substantive consolidation if it finds that "the demonstrated bene-
fits of consolidation ‘heavily’ outweigh the harm." However, in its opinion, the court of appeals
did not help define the term "substantial identity," nor did it provide any guidance on how con-
solidation could avoid harm or realize benefit. SeeDrabkin v. Midland-Ross Corp. (Auto-Train
Corp.), 810 F.2d 270 (D.C. Cir. 1987).

2. Second Circuit Test in Augie/Restivo. Just a year later, the Second Circuit changed course by
employing a more substantive test in determining which outcome would be more equitable to all
creditors. The court set forth what it perceived to be two critical factors: (a) whether creditors
dealt with the entities as a single economic unit and "did not rely on their separate identity in ex-
tending credit,"... or (b) "whether the affairs of the debtors are so entangled that consolidation
will benefit all creditors." The court also set forth policy rationale for the first factor by noting
that the fulfillment of creditors’ expectations is "important to the efficiency of credit markets."
The court noted that creditors’ expectations determined the terms of a borrower’s loan. The court
concluded that creditors’ expectations "create significant equities" and that efficiency would be
destroyed by substantively consolidating estates when the entities’ creditors, in extending credit
to their respective debtors, relied on the separateness of the entities themselves. The resulting test
is seen as more restrictive and more definite than Auto Train in the application of substantive
consolidation. See Union Sav. Bank v. Augie/Restivo Baking Co., 860 F.2d 515 (2d Cir. 1988).

3. Eleventh Circuit test in Eastgroup Properties. In Eastgroup Properties v. Southern Motel Assoc.,
Ltd., the Eleventh Circuit adopted a modified version of the standard articulated by the District
of Columbia Circuit in Auto-Train Corp., under which the proponent of consolidation must
demonstrate that (a) there is substantial identity between the entities to be consolidated and (b)
consolidation is necessary to avoid some harm or to realize some benefit. See Eastgroup Props.
v. S. Motel Assoc., Ltd., 935 F.2d 245 (11th Cir. 1991).

4. Third Circuit Test in Owens Corning. In 2005, the Third Circuit recognized substantive consoli-
dation and developed its own test in Owens Corning. It held that, with respect to those entities
for whom substantive consolidation is sought, consolidation proponents must demonstrate that:
(a) prepetition, these entities disregarded separateness so significantly that their creditors relied
on the breakdown of entity borders and treated them as one legal entity; or (b) postpetition, these
entities’ assets and liabilities are so scrambled that separating them is so cost-prohibitive as to
adversely affect the recovery of all creditors. The Third Circuit also reviewed several principles
that it suggested substantive consolidation seeks to advance. Focusing on the severity of substan-

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