United States: SDNY District Court Upholds Substantive Consolidation To Eliminate Guarantee Claims

The Bottom Line

The District Court for the Southern District of New York (the "District Court"), in In re Republic Airways Holdings Inc., 582 B.R. 278 (S.D.N.Y. March 28, 2018), affirmed the Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court") decision that substantive consolidation of two debtors would not discriminate against two creditors.  The creditors had separate claims against the operating subsidiary (based on leases) and the parent (based upon a guarantee).  The case is interesting as the subsidiary Debtor had unique defenses it could assert against the claims under New York contract law whereas the parent Debtor had given an unconditional guarantee of the subsidiary Debtor's obligations, and likely could not assert those same defenses.  The Chapter 11 plan eliminated the guarantee claim.  The two creditors argued that their claim against the parent Debtor was worth substantially more than the claim against the subsidiary Debtor.  To solve the objection, the Bankruptcy Court required that the Debtors modify the Chapter 11 plan to provide the creditors with an option to "opt-out" of the treatment under a substantive consolidation scenario.  The creditors objected that they should get the benefit of the higher recovery from substantive consolidation without giving up the guarantee claim.  The Bankruptcy Court and District Court disagreed, dismissing the creditors' contentions of unfair discrimination, improper application of the Augie/Restivo factors and inadequate disclosure.

What Happened

Republic Airways Holdings Inc. ("Republic"), the parent Debtor, and Shuttle America Corporation, ("Shuttle" and together with Republic, the "Debtors") filed for bankruptcy and rejected several aircraft leases.  The rejection triggered a liquidated damages provision for which the two creditors, Wells Fargo Bank Northwest, N.A. and ALF VI, Inc. (collectively, "Residco") claimed total damages of $57 million.

The Debtors proposed a plan which substantively consolidated Republic and Shuttle.  The Debtors reasoned that substantive consolidation would provide unsecured creditors with a forty-five cents on the dollar recovery versus a two cents on the dollar recovery absent consolidation.  However, Residco alleged its claim was worth significantly less because consolidation would eliminate Residco's claim against Republic. Residco argued its guarantee claim was worth $50 million, whereas the underlying lease claim was only $7 million.

In response to Residco's objection to substantive consolidation, the Debtors revised the plan to include a carve-out that allowed Residco two options. Under Option A, Residco could opt into substantive consolidation and lose its guarantee claims and get forty-five cents on the dollar for its allowed lease claims. Alternatively, under Option B, it could opt out of substantive consolidation, retain both its lease and guarantee claims, but only receive what it "would have recovered on both its lease and guarantee claims if the plan consolidation did not take place." 582 B.R. at 281. The carve-out also provided, "if Residco chose to opt out of substantive consolidation, the Debtors would bear the burden of proving the estimated percentage distributions that would have been received if substantive consolidation had not occurred."  Id. (In other words, the burden of proving the lower distribution on the guarantee claim was not shifted to the creditors).  Option B would require the parties to endure a costly claims process that would reduce the value of all creditors' claims.

Ultimately, Residco's arguments boiled down to three objections.  First, Residco argued the Debtors discriminated against them and they should have received a third option – an Option C – that provided for the economic benefits of substantive consolidation (e.g., the 45% distribution) with the elimination of only overlapping guarantee claims (which did not apply to Residco).  To address the fairness question, the District Court reasoned:  "The core question is about the baseline for fair treatment and the distinction between benefit and harm.  In other words, is Residco seeking to avoid being treated worse than other creditors, or is it seeking an added benefit beyond that afforded to other creditors?" Id. at 282.  The District Court found that because Republic had guaranteed over 90% of all other lease claims, the vast majority of other creditors also had non-overlapping claims and liquidating damages provisions similar to Residco and, as such, many creditors would have benefited from a higher claim amount by asserting their non-overlapping claim against the parent Debtor.  However, the higher recovery under substantive consolidation only worked by eliminating all guarantee claims – thereby allowing for the 45% recovery.  As such, there was no realistic "Option C" available.  The only viable options were the two proposed by the Debtors and Residco could elect its treatment once its claims were allowed and determined.  The District Court observed that Residco was essentially asking for special treatment, which the District Court found would be unfair and inequitable: "Residco's argument boils down to the notion that it should have gotten special treatment: whereas all creditors, including those holding non-overlapping guarantee claims, gave up their guarantee claims in order to get a higher recovery, Residco is taking the position that it should have been allowed to keep its guarantee claims and still get a higher recovery.  But the Second Circuit has held that substantive consolidation does not have to benefit all creditors:  all that is required is that it does not harm creditors.Id.  at 283 (emphasis added).  Additionally, in light of the great lengths the Bankruptcy Court went to in order to minimize unfairness to Residco (through the opt-out), the District Court dismissed Residco's argument that the Debtors used substantive consolidation "offensively" to circumvent Residco's claim.  In doing so, the District Court reasoned that elimination of guarantees is a typical component of substantive consolidation plans. 

Second, Residco argued the Bankruptcy Court did not properly apply the two Augie/Restivo factors for substantive consolidation: (1) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit, and (2) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors. Id. at 284 (citing In re Augie/Restivo Baking Co., 860 F.2d 515, 518 (2d Cir. 1988)).  The District Court found Residco lacked standing to challenge the propriety of substantive consolidation because the carve-out it was offered negated any potential prejudice from substantive consolidation. The District Court held that, in any event, the Bankruptcy Court committed no clear error in applying the Augie/Restivo factors.

Lastly, Residco argued the carve-out was inserted without disclosures required under 11 U.S.C. §1127(c) and 11 U.S.C. § 1125.  The District Court swiftly dismissed this argument as the Bankruptcy Court had already reasoned it could not have proposed the carve-out earlier because it was added specifically to address Residco's claim and objection to the Chapter 11 plan.

Why the Case is Interesting

In cases like this where the creditor is relying on the guarantee as a potential source of its recovery, the creditor should not hang its hat solely on an unconditional guarantee from one debtor entity, especially where the claim against the affiliated entity may be subject to limitations or defenses.  This case highlights the importance of creditor diligence into the separateness of entities where the creditor is relying on a parent or subsidiary guarantee for its recovery.  While Residco was able to negotiate the carve-out, its recovery was still significantly limited by its inability to assert its non-overlapping guarantee claims while consolidating the debtors.  The District Court reasoned that substantive consolidation need not benefit all creditors – all that is required is that it not harm creditors.  Additionally, the Court noted on more than one occasion that that Residco waited a long time to object. Creditors are cautioned not to wait until the eleventh hour to object to substantive consolidation. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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