Business Law

Ninth Circuit holds motion for substantive consolidation with non-debtors requires notice to creditors of the non-debtors.

The following is a case update analyzing a recent case of interest:

SUMMARY

In Leslie v. Mihranian (In re Mihranian), 937 F.3d 1214 (9th Cir. 2019), in a unanimous opinion, a panel of the U.S. Court of Appeals for the Ninth Circuit affirmed the U.S. Bankruptcy Appellate Panel for the Ninth Circuit in holding that a party moving to substantively consolidate non-debtors with a debtor must give notice of the motion to creditors of the non-debtors as well as the debtor, its creditors and the non-debtors.  The opinion can be found here.

FACTS

The chapter 7 trustee brought adversary proceedings against various parties apparently related to the debtor to set aside various transfers as fraudulent conveyances.  He later also moved in the chapter 7 case to substantively consolidate the estates of the same non-debtor defendants with that of the debtor.  In taking these steps, the trustee evidently made little effort to use discovery available to him (presumably by examinations under Rule 2004 of the Federal Rules of Bankruptcy Procedure) either to learn about the historical relationships and transactions between the non-debtors and the debtor or to obtain current information on the identity of the creditors of the non-debtors. 

After permitting several amended complaints, the bankruptcy court ultimately dismissed the adversary proceedings because the trustee could not establish that the debtor was the initial transferor of the assets at issue.  That court also denied the motion to consolidate because the trustee, who had failed to conduct a preliminary investigation into the facts, did not show the kind of relationships and transactions between the debtor and non-debtors that would support substantive consolidation.  The court also expressed concern about whether the trustee had given notice of the motion to the creditors of the non-debtors, but did not rule on the issue because its ruling on entanglement of the estates disposed of the motion.

The trustee appealed to the BAP.  The BAP affirmed on the ground that the trustee failed to give notice of the motion to the non-debtors’ creditors.  The trustee appealed to the Ninth Circuit, which affirmed the BAP.

REASONING

The Ninth Circuit began by noting that in Franklin v. Compton (In re Bonham), 229 F.2d 750 (9th Cir. 2000), it had adopted the disjunctive two-prong test for substantive consolidation employed by the Second Circuit:  (1) whether creditors treated the various subject parties as a single entity in extending credit or (2) whether the affairs of the subject parties are so entwined that all creditors will benefit from substantive consolidation because the time, expense and prospects for disentangling them will cause the creditors more harm than good. 

With that backdrop, the Ninth Circuit noted that since Ninth Circuit case law provides for noticing all creditors of two existing debtors for a motion to consolidate them, noticing the creditors of non-debtors for such a motion seems to follow.  It added that the majority rule across the country requires noticing creditors of the non-debtors. 

Next, the Ninth Circuitpointed out that in Bonham it had characterized substantive consolidation as an equitable procedure designed to promote fairness for all affected creditors.  Hence, all implicated creditors should have a chance to have a say in the matter about what is fair and why.  By the same token, since substantive consolidation may have a serious effect on the rights of the creditors of the estates, those creditors should have an opportunity to protect their rights.  Finally, the Ninth Circuit observed that in the case of the first prong of the Bonham test, when a moving party makes the requisite showing, the burden shifts to individual creditors to show that they did not, in fact, deal with the debtor and non-debtor(s) as a single entity.  Hence, it stands to reason that they must have notice of the proceeding to have a chance to make their case for themselves. 

AUTHOR’S COMMENTARY

This is the correct decision.  Although the cost and time of identifying and giving notice to the non-debtors’ creditors may be oppressive at times, it is a central tenet of our legal system that parties have a chance to participate in any legal proceeding that may have a meaningful effect on their legal rights.  Consider, for example, the cost of class action notice in terms of identifying as much as possible the members of a class and then giving some kind of notice, even if only publication notice.  In fact, it is surprising that there is a minority rule to the contrary at all.  Any other approach has the unsavory flavor of allowing certain parties to, in effect, make decisions for others about their legal rights without the latter’s knowledge or participation, a prospect that is in general anathema to the American legal system. 

A couple of additional points are perhaps worth considering.  First, would publication notice be appropriate under the right circumstances?  It has been used for plan confirmation hearings, for example, at least to try to reach creditors not reasonably identifiable from the debtor’s records.  See generally Mullane v. Central Hanover Bank & Trust Co., 339 U.S. 306, 314 (1950) (due process requirement of “notice reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objections” and holding that publication notice may be permissible where information on addresses of interested parties is not reasonably available).  Second, debtors-in-possession or trustees should be thoughtful about whether to incur the cost of using Rule 2004 exams to lay the groundwork for avoidance or other claims, balancing the cost against an assessment of the information they already have.  In Mihranian, it appears the trustee made no meaningful effort to acquire information to underwrite his complaints or to identify potentially interested creditors. 

These materials were written by Adam Lewis of Morrison & Foerster LLP in San Francisco (alewis@mofo.com).  Editorial contributions were provided by Kyra Andrassy of Smiley Wang-Ekvall, LLP in Costa Mesa (kandrassy@swelawfirm.com). 

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