The Power of Substantive Consolidation in Ponzi Cases

Posted by Kathy Bazoian Phelps

A trustee in bankruptcy may seek the substantive consolidation of a nondebtor entity or individual with the debtor to bring into the estate the assets of the nondebtor that may have been concealed from the debtor’s creditors.

For example, in In re Bonham, 229 F.3d 750 (9th Cir. 2000), the Ninth Circuit granted the trustee’s substantive consolidation request and the assets of the nondebtor entity became property of the estate.  Similarly, in In re S & G Financial Services of South Florida, 451 B.R. 573 (Bankr. S.D. Fla. 2011), the court ordered substantive consolidation when sought by the trustee to make assets of a nondebtor entity available for the creditors of the debtor.

Recently, however, the bankruptcy court in the Louis Pearlman Ponzi case declined to grant substantive consolidation of a nondebtor entity.  In re Pearlman, 462 B.R. 849 (Bankr. M.D. Fla. 2012).  In that case, the request to substantively consolidate the nondebtor entities with the debtors was made not by the trustee, but rather by the defendants in fraudulent transfer actions that the trustee had filed.  Granting substantive consolidation would have effectively terminated the trustee’s fraudulent transfer claims because, upon consolidation, the consolidated estate would be deemed to have received equivalent value for its transfer through the payment of its debt.  See First Nat’l Bank of El Dorado v. Giller (In re Giller), 962 F.2d 796, 799 (8th Cir. 1992).

The Pearlman court discussed the split of authority on whether substantive consolidation of nondebtor authorities is appropriate, but then declined to permit substantive consolidation of nondebtor entities in that case.  The court commented, “Bankruptcy courts cannot and should not simply drag unwilling entities that never chose to file bankruptcy into a bankruptcy forum simply because it is expedient and will help one party or another.”

In earlier rulings, the Pearlman bankruptcy court had held that although it was appropriate to substantively consolidate debtor entities, it was inappropriate to limit the consolidation by preserving fraudulent transfer claims as among the consolidated entities.  In re Pearlman, 450 B.R. 219 (Bankr. M.D. Fla. 2011); Kapila v. Integra Bank, N.A. (In re Pearlman), 2011 Bankr. LEXIS 1740 (Bankr. M.D. Fla. Apr. 26, 2011).

In this recent Pearlman decision, however, the court was unwilling to extend substantive consolidation  relief to nondebtor entities and therefore did not eliminate the fraudulent transfer claims against the moving parties.

Substantive consolidation is a remedy used offensively by trustees to bring in assets of other entities for administration and also defensively by fraudulent transferee defendants to try to avoid liability by substantively consolidating away and thereby eliminating the claims against them.

Issues relating to substantive consolidation and the impact of consolidation on fraudulent transfers in Ponzi scheme cases are discussed in The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes.