In re Owens Corning

Court of Appeals for the Third Circuit
2005 WL 1939796, 419 F.3d 195 (2005)

ELI5:

Rule of Law:

Substantive consolidation is a rare, last-resort equitable remedy that is only permissible when either (1) prepetition, affiliated entities disregarded their separateness so significantly that creditors relied on them as a single entity, or (2) postpetition, their assets and liabilities are so hopelessly commingled that separating them would be prohibitively costly and harm all creditors.

Facts:

Owens Corning (OCD) and its subsidiaries were structured and operated as separate legal entities, each observing corporate formalities and maintaining its own business records for specific liability, tax, or regulatory purposes.
In 1997, OCD, facing significant asbestos liability and a poor credit rating, sought a $2 billion loan to finance an acquisition.
A syndicate of banks, represented by agent Credit Suisse First Boston (CSFB), agreed to provide the unsecured loan.
A critical condition for the loan, which the Banks would not have made otherwise, was that certain OCD subsidiaries with substantial assets provide "absolute and unconditional" guarantees of payment.
These guarantees provided the Banks with "structural seniority," giving them a direct claim against the assets of the separate guarantor subsidiaries.
The Credit Agreement negotiated by the parties explicitly required the subsidiary guarantors to maintain their existence as separate entities, keep separate financial records, and prohibited them from merging with OCD.

Procedural Posture:

Owens Corning (OCD) and seventeen of its subsidiaries ('the Debtors') filed for Chapter 11 bankruptcy reorganization in federal court.
The Debtors and certain unsecured creditor groups ('the Plan Proponents') proposed a reorganization plan contingent upon the substantive consolidation of the Debtors and three non-debtor subsidiaries.
The Banks, through their agent CSFB, objected to the motion for consolidation, arguing it would improperly eliminate their subsidiary guarantees.
The U.S. District Court, after withdrawing the reference from the Bankruptcy Court, heard the motion and granted the request for substantive consolidation.
CSFB, as appellant, appealed the District Court's order to the U.S. Court of Appeals for the Third Circuit on behalf of the Banks (appellees).

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Issue:

Does the equitable remedy of substantive consolidation permit a court to disregard express, bargained-for subsidiary guarantees when the creditor specifically relied on the separate corporate structures in extending credit and the entities' financial affairs are not hopelessly commingled?

Opinions:

Majority - Ambro, Circuit Judge.

No. Substantive consolidation does not permit a court to disregard bargained-for rights when a creditor relied on corporate separateness. This extreme remedy is reserved for two exceptional circumstances: (1) where debtors disregarded their own corporate forms to such an extent that creditors treated them as a single entity prepetition, or (2) where the entities' finances are so hopelessly scrambled postpetition that untangling them would harm all creditors. Here, the evidence shows the opposite of the first rationale; the Banks specifically and reasonably relied on the separateness of the OCD subsidiaries to obtain guarantees as a condition of the loan. The record also lacks any evidence of the 'hopeless commingling' required for the second rationale. Furthermore, the proposed 'deemed' consolidation is an impermissible offensive tactic to strip the Banks of their bargained-for rights rather than a defensive remedy for a harm caused by the debtors.

Analysis:

This is a landmark decision in the Third Circuit, establishing a strict, two-part test for the application of substantive consolidation and explicitly rejecting more liberal balancing tests. The ruling strongly affirms the principle of corporate separateness and protects the expectations of sophisticated creditors who bargain for specific credit enhancements like third-party guarantees. By characterizing substantive consolidation as a remedy of last resort to be used 'sparingly,' the court significantly raises the bar for debtors seeking to pool assets and liabilities over the objection of a creditor. The decision will make it much more difficult to use consolidation as a strategic tool to alter creditor rights in a reorganization plan, thereby promoting certainty in commercial lending.

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