There are numerous reasons why a company might use more than one entity for its operations or organization: to silo liabilities, for tax advantages, to accommodate a lender, or for general organizational purposes. Simply forming a separate entity, however, is not enough. Corporate formalities must be followed or a court could effectively collapse the separate entities into one. A recent opinion by the United States Bankruptcy Court for the District of Massachusetts, Lassman v. Cameron Construction LLC provides a cautionary tale for companies that ignore critical guidelines necessary to maintain separateness.

Substantive consolidation is an equitable remedy in bankruptcy that has the effect of consolidating the assets and liabilities of separate entities into a single entity. Substantive consolidation is a highly unpredictable area of law; courts have developed no fewer than five different tests. While the cases are inherently fact-specific, common factors have emerged to provide some guidance.

In Cameron Construction & Roofing Co., the debtor operated a roofing company. Its primary assets at the time of its Chapter 7 bankruptcy were vehicles and tools, which were not sufficient to pay its creditors. Twelve years before the bankruptcy, the debtor’s majority owner formed a separate limited liability company (“LLC”) to own the real estate where the debtor operated its business, a common and reasonable strategy considering the environmental concerns with the property. The debtor and LLC maintained some corporate formalities, including filing separate tax returns and annual statements, and issuing separate W-2 statements for employees.

Nevertheless, over time, the role of the LLC evolved into more than a simple real estate holding company. It leased the property to the debtor at above-market rates and employed and paid the salaries of workers that performed services exclusively for the debtor (allegedly to avoid the debtor paying higher workers’ compensation premiums). Neither the debtor nor the LLC documented their intercompany transactions. Moreover, the debtor and the LLC apparently did not provide any notice of their separateness to their respective creditors.

Ultimately, the court found consolidation of the debtor and the LLC (a non-debtor) to be appropriate. Key to the court’s decision was a finding that there was a “substantial identity” between the debtor and the LLC. The court highlighted several of the more common substantive consolidation factors: common ownership of the debtor and the LLC, a lack of corporate formalities, and the absence of formal agreements between the entities (of note, even if there had been a formal lease between the debtor and the LLC, the above-market rent would have been problematic since agreements between entities should be similar to those available on an arms-length basis with unaffiliated third parties). The court also considered the benefit and harm to creditors resulting from consolidation, finding that no creditor of the LLC would be harmed by consolidation while creditors of the estate would benefit.

There are dozens of steps that companies can take to maintain proper separateness, signal to their creditors that only a particular entity’s assets are available to satisfy its liabilities, and decrease the likelihood that a court disregards a chosen corporate structure. The debtor in Cameron Construction & Roofing Co. and its related LLC took some of these steps, but ignored many others. These steps must be followed as much as possible or else companies operating related entities may unwittingly fall into the substantive consolidation trap.

In a recent decision (“Energy Future Holdings”) poised to have wide-reaching implications, the Third Circuit Court of Appeals reversed the decisions of the Bankruptcy and the District Courts to hold that a debtor cannot use a voluntary Chapter 11 bankruptcy filing to escape liability for a “make-whole” premium if express contractual language requires such payment when the borrower makes an optional redemption prior to a date certain. In so doing, the Third Circuit expressly rejected the reasoning of the Southern District of New York in the Momentive decisions, which reviewed similar language and held that no “make-whole” was due. The Momentive decisions are under advisement by the Second Circuit Court of Appeals, setting the stage for a potential circuit split.

In Energy Future Holdings, the debtor (“EFIH”) filed for bankruptcy for the explicit purpose of refinancing the debt at favorable interest rates (saving over $13 million per month) and avoiding its obligation to pay the make-whole premiums to both its first and second lien noteholders.  Several weeks after the bankruptcy filing, EFIH executed this strategy and the noteholders objected.  Both lower courts approved of EFIH’s actions, finding that the section of the indenture that accelerated the debt upon bankruptcy did not mention the make-whole payment, therefore none was due.

The Third Circuit took a different view of the two relevant provisions in the indentures: Section 3.07, which provided that at any time before December 1, 2015 the notes could be redeemed for 100% of the principal amount plus, inter alia, the make whole payment, and Section 6.02, which provided that upon a bankruptcy filing, all outstanding notes are due and payable immediately.

The Third Circuit found that these two provisions are not at odds with each other, and that New York law requires that that both provisions be given effect. The concept of “redemption” (as opposed to prepayment), under both New York and federal law, is not limited to only repayments of debt that predate its maturity; rather, redemption includes both pre-and post-maturity repayments of debt.  The redemption by EFIH was optional, despite the automatic acceleration of the debt under Section 6.02, as (i) EFIH voluntarily filed for bankruptcy, (ii) EFIH could have reinstated the accelerated notes’ original maturity date, and (iii) EFIH redeemed the notes over the noteholders’ objections.  To the Third Circuit, after reviewing the relevant indentures and the facts of the payments, “Redemptions, not prepayments, occurred here, they were at the election of EFIH, and they occurred before the respective dates [in the indentures].”

It remains to be seen whether the Second Circuit will agree with the analysis of the Third Circuit concerning almost identical operative sections of the respective indenture agreements, or whether it will uphold the lower courts’ decisions in Momentive. Under the Third Circuit’s holding, however, borrowers in that jurisdiction seeking the ability to avoid payment of the make whole upon acceleration of the debt need to make that expressly clear in the governing contract.

A recent opinion issued by the United States District Court for the Northern District of Illinois reminds us that corporate veil-piercing liability is not exclusive to shareholders. Anyone who is in control of and misuses the corporate structure can be found liable for the obligations of the corporation.  The facts of this case, however, did not support personal liability for veil-piecing.

In Seamans v. Hoffman, et al., the court was asked to find a former owner (Tauriac) of a debt collection agency personally liable for a violation of the Fair Debt Collection Practice Act (FDCPA).  Tauriac had recently sold the business but remained in control of the business bank account in order to reconcile and appropriately allocate between the pre- and post-sale receivables—the pre-sale receivables were owed to Tauriac per the terms of the sale transaction.

During this reconciliation period, the company attempted to collect a debt from an individual who had gone through a bankruptcy proceeding in which the debt was discharged. The individual, alleging violations of the FDCPA, sued and obtained a default judgment against the company and Tauriac.  Tauriac got the default judgment overturned and pursued the merits of her defense.

As an initial matter, the court recognized that under normal circumstances, “officers and shareholders of a debt collection [company] generally cannot be held liable for violations of the FDCPA.” An exception exists, however, if there is a basis to pierce the corporate veil.  Thus, if an individual exerts sufficient control and dominance over the entity and misuses the corporate structure, personal liability may be found.

Here, apart from the control Tauriac had over the business bank account pursuant to the terms of the sale agreement, she did not exhibit any other indicia of control or dominance over the corporation: she did not manage employees, she did not manage collection efforts, she did not interact, post-sale, with the company (other than with respect to the bank account), there was no evidence that she comingled her assets with those of the company, or otherwise used corporate assets to pay her expenses. In short, she did not disregard the corporate entity to use it as a mere instrumentality for personal gain.  Absent these indicia of control or evidence of personal use, there can be no personal liability for corporate obligations under a veil-piercing theory.

The take-away from this case is that there could be situations where a non-shareholder is held liable under a veil-piercing theory, if control, dominance and misuse are present.

In an earlier blog piece we reported on the Third Circuit’s 2015 decision in In re Jevic Holding Corp. where the Court approved a settlement, implemented through a structured dismissal, which allowed junior creditors to receive a distribution prior to senior creditors being paid in full.  The decision was appealed and the Supreme Court agreed to hear the case and decide whether structured dismissals are permissible in bankruptcy.  More to come…

By LEN WEISER-VARON and BILL KANNEL

Today’s U.S. Supreme Court decision in Commonwealth of Puerto Rico v. Franklin California Tax-Free Trust puts an end to one of Puerto Rico’s multi-pronged efforts to deleverage itself.  Given the comprehensiveness of the First Circuit’s intermediate appellate opinion upholding the district court’s invalidation of Puerto Rico’s Recovery Act, it was surprising that the highest court took the case, a decision apparently prompted by Justice Sotomayor’s interest in obtaining a reversal.  Comments of some other Justices at oral arguments raised the possibility of Sotomayor attracting a majority for the proposition that the preemption provisions of Section 903 of the U.S. Bankruptcy Code were inapplicable to Puerto Rico, but in the end only Justice Ginsburg joined what turned out to be Sotomayor’s dissenting opinion in a 5-2 ruling upholding the relegation of the Recovery Act to the dustbins of history.

As  we have written previously, the Recovery Act was damaged goods from the beginning: even if the fairly clear preemption argument had not prevailed, the Contracts Clause constraints on non-federal bankruptcy legislation would have severely constrained, if not eliminated, the effective use of  the Recovery Act to break bond contracts. In any event, the Recovery Act, and the Supreme Court’s decision, were  a couple weeks away from being moot, as it appears evident that Congress will pass PROMESA, the federal oversight and debt restructuring legislation that has always constituted the logical legal mechanism for those favoring a less chaotic denouement to Puerto Rico’s debt woes.

BY STEPHEN M. WEINER

Price disparities among hospitals pose one of the more intractable issues for policy makers, regulators and the government. That they exist is indisputable. Why they exist is a source of much contention.  And the issue creates great disunity within the hospital world, causing fissures especially between academic medical centers and community hospitals.

Continue Reading Tackling the Dragon of Hospital Price Disparity: Massachusetts’s On-Going Efforts to Address Price Equity

Shareholders who received nearly $8 billion from the Tribune Company leveraged buyout (LBO) do not have to give back that money as a constructive fraudulent transfer. Although the possibility remains that the creditors can recover this money through the pending intentional fraudulent transfer claims, which are much more difficult to prove, the Second Circuit recently held that the Bankruptcy Code preempts creditors from recovering under state constructive fraud theories when shareholders receive distributions under securities contracts effectuated through financial institutions.

Continue Reading TRANQUIL WATERS ONCE AGAIN IN THE SAFE HARBOR: Bankruptcy Safe Harbor Protects Shareholders From State Constructive Fraud Claims

A recent bankruptcy court decision from the influential Southern District of New York permitted a debtor to reject executory contracts with midstream gathers as an exercise of sound business judgment. In In re Sabine Oil & Gas Corporation, the court issued an advisory ruling in which it determined that certain provisions of the rejected contracts were not covenants that ran with the land, and thus could be rejected thereby relieving the debtor of a financial hardship.

Continue Reading Oil, Gas and Mineral Companies Take Note: Agreements Purporting to “Run with the Land” may be Rejected in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

A few thoughts on Tuesday’s oral arguments before the U.S. Supreme Court in the litigation over whether Puerto Rico’s Public Corporations Debt Enforcement and Recovery Act, an insolvency statute for certain of its government instrumentalities, is void, as the lower federal courts held, under Section 903 of the U.S. Bankruptcy Code:

Continue Reading You Can Lead a Horse to Water, But You Can’t Call it an Airplane: Supreme Court Oral Arguments Suggest Puerto Rico’s Recovery Act May Recover

While secured creditors are entitled to special rights in bankruptcy, those rights may differ depending on whether creditors have a statutory or consensual lien on their collateral.  This is primarily because section 552(a) of the Bankruptcy Code provides, in part, that “property acquired by the estate or by the debtor after the commencement of the case is not subject to any lien resulting from any security agreement . . . .”  In other words, consistent with the concept that a debtor receive a ‘fresh start’ following a bankruptcy discharge, section 552(a)* strips certain secured creditors of liens in the post-petition property received by a debtor.  However, section 552(a) does not apply if a creditor is secured by a statutory lien; a statutory lien ‘flops over’ the petition date and attaches to post-petition receipts of a debtor.

Continue Reading Statutory Liens vs. Consensual Liens: Why it Matters and When it may Not