LEGAL NOTES

Secured Lender, The, Nov/Dec 2005 by Helfat, Jonathan N, Kohn, Richard M

In re Owens Corning, 419 F.3d 195 (3rf Cir. 2005) (Third Circuit denies substantive consolidation.)

In a significant victory for lenders, a three-judge panel of the Third Circuit has reversed a Delaware district court's grant of substantive consolidation, in the process adopting arguably the strictest test for substantive consolidation of any U.S. Court of Appeals to date. The CFA had urged just such a result in the amicus brief it filed in the case.

In Owens Corning, CSFB was the agent for a group of banks under a [$2 billion] facility to Owens Corning. Although unsecured, the facility was "structurally senior" to substantially all of the other creditors of the debtors (including certain bondholders and future asbestos claimants) due to the fact that the bank group held guaranties from various affiliates of Owens Corning. seeking to deny the banks the benefit of their guaranties, the debtors, bondholders, and future asbestos claimants (the "Appellees") all urged that the corporate separateness of all of the Owens Corning companies should be disregarded, and that their assets should be pooled and applied to pay the claims of all the creditors (including, of course, the claims of the bondholders and future asbestos claimants). The result of the requested substantive consolidation would have been to dramatically reduce the bank group's dividend in the Chapter 11 cases, and to award a windfall to the bondholders and future asbestos claimants. Notwithstanding that fact, the U.S. district court granted the motion.

In a comprehensive, thoughtful and broadly worded decision, the Third Circuit reversed. First, it rejected the substantive consolidation standard urged by the Appellees (and adopted by an alarming number of courts including, arguably, the district court in Owens Corning): the flexible, "balancing of the equities" test originally set out by the D.C. Circuit in In Re Auto-Train, 810 F.2d 270 (D.C. Cir. 1987). In doing so, the Third Circuit held that Auto-Train allows a threshold "not sufficiently egregious and too imprecise for easy measure." Owens Corning, 419 F.3d at 210. The Third Circuit also rejected the factorbased analysis often used by courts in conjunction with the Auto-Train test, and proposed by the Appellees, stating that "factors in a check list fail to separate the unimportant from the important" and "in rote following of a form containing factors where courts tally up and spit out a score without an eye on the principles that give the rationale for substantive consolidation (and why, as a result, it should so seldom be in play)." Id Finally, the Third Circuit fundamentally rejected the assertion, again urged by some courts and the Appellees, of a "liberal trend" toward the increased use of substantive consolidation. Id. at 209 n. 15.

Instead, the Third Circuit adopted a test for substantive consolidation that is substantially similar, but even clearer and more stringent, than the "competing" test set forth by the second Circuit in In Re Augie/Restivo, 860 F.2d 515,518 (2d Cir. 1988), which had been the strictest substantive consolidation test prior to the decision in Owens Corning. The Third Circuit held that substantive consolidation can be granted only if one of two circumstances can be proven: ( 1 ) reliance by the creditor proponents of substantive consolidation; or (2) hopeless commingling of the assets of the estates the proponents are seeking to consolidate. To prove reliance, the creditor proponents of substantive consolidation must show both (a) corporate disregard creating contractual expectations that the proponents were dealing with the debtors as one, indistinguishable entity and (b) that, in their course of dealing, the proponents actually and reasonably relied on the debtors' supposed unity. To prove hopeless commingling, the proponents must show that the assets and liabilities of the debtors are hopelessly commingled - so scrambled that separating them is cost-prohibitive, and thus would hurt allcreditors.

Critically, the court held that, even if the proponents of substantive consolidation can show reliance or hopeless commingling, a creditor opposing substantive consolidation can defeat it if the creditor can prove that it relied upon the debtors' separate existence. In other words, reliance by a creditor opponent of substantive consolidation is an absolute bar thereto under Owens Corning.

Applying this test, the Third Circuit concluded that the district court should be reversed. First, the court held that the Appellees could not prove that they relied on the debtors' alleged corporate unity. second, the court held that the Appellees could not prove hopeless commingling, ruling that mere alleged defects in the inter-company accounting system of the debtors were insufficient to prove that the assets and liabilities of the debtors were even tangled, let alone in such a manner that in attempting to untangle them would cost so much that it would be better for every creditor, including the bank group, to not do so. Indeed, the court specifically noted that it would cost only a fraction of the bank group's claim to do the work. Finally, the court ruled that, even if the Appellees had proven reliance or hopeless commingling, the bank group had proven its reliance on the separateness of the Owens Corning debtors. In doing so, the Third Circuit forcefully rejected the Appellees' claim that it should look to subjective evidence of the bank group's intent, holding that the reliance inquiry is "not an inquiry into lenders' internal credit metrics;" rather, it is "about the fact that the credit decision was made in reliance on the existence of separate entities." Owens Corning, 419 F.3d at 213-214. Thus, because the lenders had specifically contracted to have the credit support of the subsidiary debtors in the form of their guaranties, the Third Circuit ruled that the bank group had relied on the separate existence of such subsidiaries.