Substantive Consolidation: When Abuse Goes Too Far An LLC Will Not Shield Assets

In re Carroll, 520 B.R. 491 (Bankr. M.D. La. 2014) –

A chapter 7 trustee sought to substantively consolidate the bankruptcy estates of individual chapter 7 debtors with the separate bankruptcy estate of their wholly owned limited liability company (LLC).  Only the debtors, and none of the creditors, objected to substantive consolidation.

To set the stage, one of the debtors admitted in a deposition that “she and her husband formed [the LLC] intending to give the company all their assets to protect the property from creditors.”

Immediately after formation of the LLC, the debtors transferred their residence, including a house and seven acres of property, to the LLC in exchange for 10,000 ownership units.  A month later they transferred most of the rest of their property, including antiques and collectibles, automobiles, a motorcycle, an airplane and additional property, for an additional 10,000 ownership units.  They briefly retained a five-acre parcel of land that was already subject to foreclosure, but after paying the balance owed to the mortgagee transferred the land to the LLC in exchange for an additional unit of membership.  In the meantime, the debtors continued to treat all of the LLC’s assets as their own.

Subsequently, there were a variety of confusing transfers intended to shield their assets.  For example, they transferred the land from the LLC to their son, their son borrowed $50,000 from a bank using the land as collateral, and then the son deposited the loan proceeds into the LLC’s checking account – where the funds were accessible to the debtors for use in paying personal expenses.  The son later retransferred the land to the LLC by a quit claim deed, which was not recorded until ten months after it was executed, which just happened to be the day that the LLC filed chapter 7.  The stated consideration for the various transfers was $10.

Similarly, after a bank obtained a judgment against the debtors, immediately before a sheriff’s sale of their residence the son quit claimed the residence back to the LLC.  Eight months later the LLC retransferred the residence by quit claim to the debtors, who filed bankruptcy the next day in order to stay the sheriff’s sale.

The bankruptcy schedules filed by the debtors and the LLC also reflected a confused state of affairs:  Initially the individual debtors stated that they did not own any household goods or furnishings, while the LLC’s schedules included $8,000 in household goods and furnishings – despite the fact that these items were supposedly transferred to the debtors’ daughters several years before.  The debtors then amended their schedules to include the household goods and furnishings.

When separate bankruptcy cases are substantively consolidated, the assets and liabilities of the separate debtors are combined in a single pool as though they were one entity.  Courts find authority for substantive consolidation in Section 105(a) of the Bankruptcy Code, which provides that the “court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”  A determination of whether substantive consolidation is justified requires a fact intensive analysis.

One traditional test considers factors including:

(1)  the degree of difficulty in segregating and ascertaining individual assets and liabilities;

(2)  the presence or absence of consolidated financial statements;

(3)  the profitability of consolidation at a single physical location;

(4)  the commingling of assets and business functions;

(5)  the unity of interest and ownership between the various corporate entities;

(6)  the existence of parent and inter-corporate guaranties on loans; and

(7)  The transfer of assets without formal observance of corporate formalities.

A second approach involves balancing the effect of consolidating the cases on creditors against the benefits of consolidation.  Two critical factors are whether creditors relied on the separate identity of the debtors in extending credit, and whether the affairs of the debtors are so entangled that consolidation would benefit creditors.

The court reviewed the facts of this case under both tests, and not surprisingly, concluded that the cases should be substantively consolidated.

Although the facts of this case did not fit neatly into the traditional factors (i.e. factors 2, 3 and 6 were not relevant, and only factors 1 and 7 squarely fit the facts), the court had no difficulty determining that substantive consolidation was appropriate – and it is not difficult to see why that should be the case.  It is useful to remember that the traditional factors do not provide a bright line litmus test, and the absence of factors does not provide assurance that a court will not find that substantive consolidation is appropriate.  This is something that is of particular interest when preparing and negotiating substantive consolidation opinions for a financing.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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