Sixth Circuit Denies Substantive Consolidation; In re Howland

Sixth Circuit Denies Substantive Consolidation; In re Howland

Last week the Sixth Circuit Court of Appeals issued its opinion in In re Howland, addressing whether a trustee could assert substantive consolidation as a mechanism for merging the assets of an LLC into the bankruptcy estate of its members.  As did the Bankruptcy and the District Courts below, the Sixth Circuit rejected this effort. Phaedra Spradlin v. Beads and Steeds Inns, LLC (In re Howland), ___ Fed. App’x ___, No. 16-5499, 2017 WL 24750, 2017 U.S. App. LEXIS 222 (6th Cir. Jan. 3, 2017).  A review of the decision of the Bankruptcy Court (Judge Schaff) is available AT THIS LINK.  A review of the decision of the District Court (Judge Caldwell) affirming the decision of the Bankruptcy Court is available AT THIS LINK.

As a point of disclosure, Stoll Keenon Ogden and particularly Adam Back represented the defendants in this action.

The facts underlying the dispute, as set forth by the Sixth Circuit, were as follows:

Matthew and Meagan Howland are the debtors in this personal bankruptcy case. In June 2007, they entered into a contract to buy a 133-acre farm in Lancaster, Kentucky, for $1.6 million. One month later, the Howlands assigned their interest in the purchase agreement to Meadow Lake Horse Park, a limited liability corporation they had recently formed under Kentucky law. They also personally guaranteed the loan Meadow Lake later obtained in order to purchase the farm.

For the next three years, the Howlands operated a horse farm and bed and breakfast on the property. In November 2010, the Howlands made a $760,000 payment on Meadow Lake's mortgage for no consideration. Then, a month later, Meadow Lake sold the property to Beads and Steeds Inns, LLC, a corporation formed by a third party for the sole purpose of purchasing the farm. The purchase price was $800,000, roughly half of what Meadow Lake paid just three years earlier. Along with the sale, the two parties entered into a $1,000-a-month lease agreement (about one-fourth the market rate), which allowed Meadow Lake and the Howlands to continue operating the horse farm and bed and breakfast.

Two years later, saddled with unmanageable debt, the Howlands filed for personal bankruptcy. The bankruptcy court appointed plaintiff, Phaedra Spradlin, as trustee of the debtors' estate. In her role as trustee, Spradlin filed this adversarial action against Beads and Steeds. Spradlin alleged that the December 2010 transfer from Meadow Lake to Beads and Steeds was fraudulent, done to evade the Howlands' creditors.

Beads and Steeds moved for judgment on the pleadings, observing that the trustee alleged that Meadow Lake—not the debtors, personally—engaged in the 2010 transfer. It argued that the trustee therefore failed to state a claim under the governing fraudulent transfer provisions, both of which required a “transfer of an interest of the debtor in property.” See 11 U.S.C. § 544(b)(1) (emphasis added); see also 11 U.S.C. § 548(a)(1)(B). The trustee responded that she could pierce the corporate veil in reverse and thereby treat Meadow Lake and the debtors as a single entity. 

      The trustee sought leave to file an amended complaint alleging substantive consolidation. That motion was denied by the trial court on the basis that the tendered complaint failed to adequately plead substantive consolidation. 2017 WL 24750, *2. The Sixth Circuit, in considering the matter, began by noting that “[a]lthough similar in some ways to veil piercing, substantive consolidation is a distinct concept unique to bankruptcy law.” 2017 WL 25750, *6. Whereas veil piercing is a mechanism for imposing vicarious liability, substantive consolidation “brings all assets of a group of entities into a single survivor. Indeed, it merges liabilities as well.” and in effect “treats separate legal entities as if they were merged into a single survivor.” Id.

      In reliance upon In re: Owens Corning, the Howland court wrote that:

To state a claim for substantive consolidation, the trustee must allege:

(i) prepetition [the entities sought to be consolidated] disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or

(ii) post-petition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors. Id.

      Looking to the proposed amended complaint, it was found that it fell “far short of demonstrating a significant disregard of corporate separateness such that the debtor’s and Meadow Lake’s creditors relied on the breakdown and treated them as one.” 2017 WL 24750, *6. Specifically:

Missing are any allegations that the debtors or Meadow Lake distributed misleading financial information to creditors, failed to accurately record their transactions with creditors, or otherwise misled creditors into believing they were dealing with them as one indistinguishable entity. Id.

      Having disposed of the first element of the Owens Corning test, it being focused upon pre-petition activities, the Sixth Circuit turned its attention to the question of post-petition scrambling of assets. In this instance, the trustee was hoist on the petard of the errors identified by the trustee. Specifically:

Moreover, the proposed complaint simply does not allege that the debtors’ and Meadow Lake’s assets are hopeless are “hopelessly scrambled.” Paragraph fifteen alleges that the debtors listed Meadow Lake’s debts as their own, the implication being that even the debtors could not distinguish between their assets and Meadow Lake's. However, the very fact that the trustee can make this allegation - i.e., highlight the debtors’ mistake of listing another entity’s debt as their own - demonstrates that she can, in fact, distinguish the debtors’ assets from Meadow Lake’s. 2017 WL 24750, *7.

      The court went on to note that substantive consolidation does not exist to address the alleged harm that creditors will be injured because of a reduction in the distributions to them.

      In footnote 3 to the decision, the court noted that the trustee argued for the application of the test for substantive consolidation set forth in In re: Owings Corning, and that the defendants responded thereto. On that basis, “Because the parties do not brief the issue, and because the trustee’s claim fails under the standard she proffers, it is unnecessary to decide whether the Owens Corning test sets forth the best articulation of the substantive consolidation elements.” 2017 WL 24750, footnote 3.