Augie/Restivo Baking Co., Ltd., In re

• Decision Date: 24 October 1988
• Docket Number: No. 1302,D,1302
• Parties: , Bankr. L. Rep. P 72,482 In re AUGIE/RESTIVO BAKING COMPANY, LTD., Augie's Baking Company, Ltd., Debtors. UNION SAVINGS BANK, Appellant, v. AUGIE/RESTIVO BAKING COMPANY, LTD., Augie's Baking Company, Ltd., Manufacturers Hanover Trust Company, Ltd., Appellees. ocket 88-5014.
• Court: U.S. Court of Appeals — Second Circuit

Page 515

860 F.2d 515

18 Bankr.Ct.Dec. 852, Bankr. L. Rep. P 72,482

In re AUGIE/RESTIVO BAKING COMPANY, LTD., Augie's Baking

Company, Ltd., Debtors.

UNION SAVINGS BANK, Appellant, v. AUGIE/RESTIVO BAKING COMPANY, LTD., Augie's Baking Company, Ltd., Manufacturers Hanover Trust Company, Ltd., Appellees.

No. 1302, Docket 88-5014.

United States Court of Appeals, Second Circuit.

Argued Aug. 17, 1988.

Decided Oct. 24, 1988.

Robert S. Arbeit, Hauppauge, N.Y. (Steven G. Pinks, Jonathan W. Lipshie, Pinks, Brooks, Stern & Arbeit, Hauppauge, N.Y., of counsel), for appellant.

Brian M. Cogan, New York City (Daniel H. Golden, Sanford P. Rosen, Bonnie J. Schindel, Stroock & Stroock & Lavan, New York City, of counsel), for appellees and debtors.

Before WINTER and MINER, Circuit Judges, and BILLINGS, District Judge. ^*

WINTER, Circuit Judge:

This appeal concerns the substantive consolidation of two bankruptcy proceedings. We reverse because the consolidation impairs the rights of certain creditors, principally Union Savings Bank ("Union"), which extended credit to Augie's Baking Company, Ltd. ("Augie's"), before Augie's had any relationship with Restivo Brothers Bakers, Inc. ("Restivo"). In turn, it also unfairly benefits later creditors of Restivo and Augie/Restivo, principally Manufacturers Hanover Trust Company ("MHTC"), who were aware of the debtors' separate corporate status.

BACKGROUND

Prior to 1985, Augie's and Restivo were two unrelated family-run wholesale bakeries. Augie's was located on Long Island in Central Islip and was a borrower of appellant Union. Restivo was based in Queens and was a borrower of MHTC. Between July 1983 and September 1984, Union loaned Augie's approximately $2.1 million, secured by a mortgage on Augie's real property in Central Islip, to finance an apparently improvident expansion.

In early November 1984, Augie's borrowed an additional $300,000 from Union, secured by its inventory, equipment and accounts receivable. Union was at the time unaware that Augie's had commenced negotiations with Restivo. On November 27, 1984, Augie's and Restivo entered into an agreement providing for Restivo's acquisition of all of Augie's stock in exchange for fifty percent of Restivo's stock. In the agreement, Augie's represented that it had receivables of over $630,000 and equipment and inventory valued at over $1.9 million. No provision for the legal transfer of Augie's real property or equipment to Restivo was made, and no such transfer occurred. Augie's thus remains the owner of that property.

After the exchange of stock on January 1, 1985, Restivo changed its name to Augie/Restivo Baking Company, Ltd. ("Augie/Restivo") and moved its manufacturing operations and some of its equipment from Brooklyn to Augie's plant in Central Islip. Augie's affairs were wound up and Restivo became the sole operating company, keeping a single set of books and issuing financial statements under the name Augie/Restivo. Augie's was not dissolved, however. From January through April 1985, MHTC extended further credit to Augie/Restivo in the amount of $750,000. MHTC also sought and received a guarantee of Augie/Restivo's obligations from Augie's, including a subordinated mortgage on Augie's real property in Central Islip in the sum of $750,000. By March 1986, MHTC had advanced a total of approximately $2.7 million to Augie/Restivo. During the period January 1985 through March 1986 various other firms extended trade credit to Augie/Restivo.

In April 1986, Augie/Restivo and Augie's were forced into bankruptcy. Union was listed as a creditor of Augie's only. Following the consolidation of the cases for procedural purposes, Augie/Restivo and MHTC entered into a series of more than twenty-five "cash collateral" stipulations, in which it was agreed that Augie/Restivo's accounts receivable constituted cash collateral (as defined in 11 U.S.C. Sec. 363(a) (1982 & Supp. IV 1986)). The cash collateral was placed in a special account at MHTC from which MHTC agreed to make loans to Augie/Restivo in a sum equivalent to the cash collateral deposits. The loans were secured by the assets of Augie/Restivo, as debtor-in-possession, and carried a super-priority administrative expense status. Over time, the cash collateral stipulations were renewed in greater and greater amounts until eventually the entire amount of MHTC's pre-petition loans to Augie/Restivo, $2.7 million, had been converted to post-petition super-priority administrative debt, secured by Augie/Restivo's accounts receivable and by the subordinated mortgage on Augie's real property.

On November 30, 1987, the debtors agreed, conditioned upon confirmation of a reorganization plan, to sell their assets to Leon's Bakery for approximately $7.5 million. Apparently because Union could prevent confirmation of such a plan with regard to Augie's, the debtors moved for substantive consolidation of the two cases on December 17, 1987. Union opposed the motion. The bankruptcy court judge granted the motion on February 5, 1988, 84 B.R. 315, finding that Augie's and Restivo had merged and that the contemplated sale of assets to Leon's was in the interests of the creditors of both companies.

After the consolidation motion was granted, the proposed sale fell through because of difficulty in obtaining financing. If the consolidation stands, the equity in Augie's assets will be used to pay the debts of Augie/Restivo and Restivo, including the $2.7 million super-priority administrative debt to MHTC and certain priority tax liabilities in a sum over $1.2 million. Although Union's loan secured by the mortgage on Augie's real property will continue to have priority as to that property, Union's subsequent now undersecured $300,000 loan will be subordinated to MHTC's super-priority administrative debt. Union appealed the substantive consolidation to the district court, and Judge Weinstein affirmed.

DISCUSSION

Substantive consolidation has no express statutory basis but is a product of judicial gloss. ¹ See, e.g., In re Commercial Envelope Mfg. Co., 3 B.C.D. 647 (Bankr.S.D.N.Y.1977). Substantive consolidation usually results in, inter alia, pooling the assets of, and claims against, the two entities; satisfying liabilities from the resultant common fund; eliminating inter-company claims; and combining the creditors of the two companies for purposes of voting on reorganization plans. See 5 Collier on Bankruptcy Sec. 1100.06, at 1100-32 n. 1 (L. King ed. 15th ed. 1988). The effect in the present case is, as stated, to subordinate Union's undersecured claims against Augie's to MHTC's super-priority administrative claims. Because of the dangers in forcing creditors of one debtor to share on a parity with creditors of a less solvent debtor, we have stressed that substantive consolidation "is no mere instrument of procedural convenience ... but a measure vitally affecting substantive rights," Flora Mir Candy Corp. v. R.S. Dickson & Co., 432 F.2d 1060, 1062 (2d Cir.1970), to "be used sparingly." Chemical Bank New York Trust Co. v. Kheel, 369 F.2d 845, 847 (2d Cir.1966).

The sole purpose of substantive consolidation is to ensure the equitable treatment of all creditors. Numerous considerations have been mentioned as relevant to determining whether equitable treatment will result from substantive consolidation. See, e.g., In re Continental Vending Machine Corp., 517 F.2d 997, 1001 (2d Cir.1975) (whether creditors knowingly deal with corporations as unit), cert. denied sub nom. James Talcott, Inc. v. Wharton, Trustee, 424 U.S. 913, 96 S.Ct. 1111, 47 L.Ed.2d 317 (1976); Flora Mir, 432 F.2d 1060 (whether one debtor was independent of other debtor when certain securities issued; whether creditor dealt only with one debtor and lacked knowledge of its relationships with others; whether interrelationships of group were closely entangled); Kheel, 369 F.2d 845 (whether entanglement of business affairs of related corporations was so extensive that the cost of untangling would outweigh any benefit to creditors); In re Donut Queen, Ltd., 41 B.R. 706 (Bankr.E.D.N.Y.1984) (presence or absence of consolidated financial statements; difficulty in segregating individual debtors' assets and liabilities; existence of parent and inter-corporate guarantees on loans; unity of interests and ownership; existence of transfers of assets without observance of corporate formalities; profitability of consolidation at single physical location); In re Richton Int'l Corp., 12 B.R. 555 (Bankr.S.D.N.Y.1981) (same); In re Food Fair, 10 B.R. 123 (Bankr.S.D.N.Y.1981) (same). An examination of those cases, however, reveals that these considerations are merely variants on two critical factors: (i) whether creditors dealt with the entities as a single economic unit and "did not rely on their separate identity in extending credit," 5 Collier on Bankruptcy Sec. 1100.06, at 1100-33; see also Flora Mir, 432 F.2d at 1062-63; Kheel, 369 F.2d at 847; Soviero v. Franklin Nat. Bank, 328 F.2d 446 (2d Cir.1964) (consolidation proper where creditors dealt with debtor and its affiliates as if they were one corporation and failed to demonstrate reliance on credit of any separate judicial entity); In re D.H. Overmyer, 2 B.C.D. 412 (Bankr.S.D.N.Y.1976); or (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors, Kheel, 369 F.2d at 847; Commercial Envelope, 3 B.C.D. at 649-52.

With regard to the first factor, creditors who make loans on the basis of the financial status of a separate entity expect to be able to look to the assets of their particular borrower for satisfaction of that loan. Such lenders structure their loans according to their expectations regarding that borrower and do not anticipate either having the assets of a more sound company available in the case of insolvency or having the creditors of a less sound debtor compete for the borrower's assets. Such expectations create significant equities. ...