By Michael D. Koppel, CPA, PFS, CITP, MBA
Retired Partner at Gray, Gray & Gray, LLP
People who own multiple businesses are often advised to keep them as separate entities for legal and financial reasons. The same advice applies to companies that set up separate entities for real estate ownership purposes. Separation is an important way to protect the assets of each entity. Except when that protection is breached by a legal concept known as substantive consolidation.
Substantive consolidation is a technique used in bankruptcy proceedings that allows the court (in certain circumstances) to augment the assets of a debtor’s bankruptcy estate with assets of other, separate entities. In other words, the court may be able to provide additional relief to creditors of the bankrupt entity by using assets from another business (or businesses) that, while technically independent, have a relationship to the bankrupt business.
Whether two entities are independent is, of course, a matter of degree and judgment. The entities must operate separately and independently. A recent Massachusetts bankruptcy court case allowed the assets of a legally separate entity (an LLC which owned real estate) to be used to satisfy creditors of a corporation in bankruptcy because the judge ruled the appearance of “arms length” independence was not maintained, including no formal lease and commingling of funds.
Let’s look at an example. Company X has total assets of $5 million dollars and total liabilities of $12 million when it files for bankruptcy. This leaves about 40 cents on every dollar available to pay creditors. Keep in mind that there are often different classes of creditors in a bankruptcy case, which determines who gets paid first, as well as other guarantees and collateral to consider.
However, Company X has an affiliated entity, Company Y, which is solvent, with $10 million in assets and $8 million in liabilities. Should the two companies be substantively consolidated into a single bankruptcy estate, it would have $15 million in assets and $20 million in liabilities. This would boost the amount available to the creditors of Company X to 67 cents on the dollar. But the gains made by the creditors of Company X come at the expense of the creditors of Company Y, as the assets of that entity are reduced by the bankruptcy.
Although substantive consolidation is not a new concept we may see more such efforts to link the assets of supposedly independent entities, particularly when it comes to ownership of real estate.
We will be hosting a webinar on Thursday, August 10, on various real estate tax issues and will be covering substantive consolidation in more detail then.
If you have any questions on substantive consolidation or other issues please contact Gray, Gray & Gray at 781-407-0300.