Substantive Consolidation

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.