[By Nikshetaa Jain]

The author is a 2nd Year student at The National Law University, Odisha.

1. Introduction

Corporate groups have grown immensely due to the various legal, tax and business benefits they provide to the owners. However, the structure of corporate groups is very complex, and it is often difficult to make clear distinctions between the ownership and management patterns. This difficulty becomes more pertinent when two or more companies belonging to the same corporate group go into liquidation since there are no provisions in the Indian Bankruptcy Code (hereinafter “IBC”), providing for combined liquidation of such companies. This lacuna in the IBC became more visible during the resolution proceedings of Videocon, Amtek, Adel, Aircel and Jaypee. Thus, there was a need to develop a framework for group insolvency in India. For this purpose, the Working Group on Group Insolvency was constituted, and it submitted its recommendations in the form of a report in 2019.

The report suggested several mechanisms which could be used for group insolvency. One of the suggestions of the report was that provisions for substantive consolidation might be developed but at a later stage. However, the Court had applied the doctrine of substantive consolidation in the Videocon case. Since there is no legislative framework in the IBC for applying the doctrine, the courts have a broad discretion to apply the doctrine. Thus, there is a need to develop a framework for the application of this doctrine.

While formulating a framework for substantive consolidation, guidance can be taken from foreign jurisdictions as group insolvency is a relatively new concept in India. In this article, the author tries to analyse the doctrine of substantive consolidation in light of the themes discussed in the landmark judgment of Owens Corning.

2. Meaning of Substantive Consolidation

Substantive consolidation is a process wherein the assets and liabilities of two companies belonging to the same corporate group are combined so that the companies are treated as a single entity. The results of this process is similar to a merger as creditors of the distinct entities now become the creditors of the consolidated estate of the entire corporate group.

3.  Substantive Consolidation in light of the themes of Owens Corning Case

Since there are no provisions for group insolvency in India, reliance is placed on foreign jurisdictions where substantive consolidation has been used commonly in group insolvency cases. In USA, substantive consolidation has been developed due to judicial interpretation. Owens Corning case has majorly contributed to the jurisprudence on substantive consolidation. The themes laid down in the case of Owens Corning are one of the most important principles which govern the application of this doctrine in the USA. In October, 2005 Owens Corning, a corporation and its subsidiaries filed for reorganization under the US Bankruptcy Code and subsequently developed a reorganization plan based on substantive consolidation of all the subsidiaries. The District Court granted a motion for substantive consolidation considering the administrative efficiencies of the doctrine. However, on appeal, the Third Circuit reversed the District Court’s decision and laid down the five themes which must be given due consideration while applying the doctrine of substantive consolidation.

The first theme is to respect the rule of entity separateness and to use the doctrine of substantive consolidation only in exceptional cases. Limited liability and entity separateness are the most fundamental principles of corporate law. The structure of corporate groups has become the most preferred due to the fundamental principles of limited liability and separateness of entity, forming the core of the business operations. The principles of limited liability and entity separateness cannot be violated merely because it is difficult to untangle the financial affairs of various companies in the corporate group. The Courts are more reluctant to use this doctrine when a country follows the entity theory. The entity theory presumes that one entity of the corporate group cannot be liable for the debts of the other members of the same group. English laws follow the principle of entity theory,[i] and since most of the Indian laws are based primarily on the English laws, it is safe to assume that India also follows the entity approach. The Working Group also suggests that the doctrine of substantive consolidation, if adopted in the Indian insolvency law, should be applicable in a limited manner. Thus, the first theme can be applied in India as well.

The second theme is that substantive consolidation is a remedy for those harms caused by the shareholders who have abused the principles of separateness. The doctrine of substantive consolidation was developed as a remedy for the creditors who had suffered harm due to abuses of the corporate form. Majority of the harms are caused to the creditors due to the fraudulent activities undertaken by an entity under the garb of corporate law principles. If the principles of corporate law would lead to fraud or injustice, then the equitable principle will apply in the form of substantive consolidation. This theme is in consonance with ‘creditor in possession’, an objective of the Indian insolvency law,  as substantive consolidation places the creditors in control of the assets of all the companies of the corporate group in case of abuse of corporate law principles. Substantive consolidation is suitable where an entity completely controls or dominates the corporate group of entities and transfers money between different entities as if the entities are mere departments of the group.

The third theme is that mere benefit in the administration of a case cannot be the sole ground for applying the doctrine of substantive consolidation. Substantive consolidation cannot be granted merely on the ground that it is necessary for formation of a reorganization plan. Since any decision to consolidate the assets and liabilities of two or more entities of a corporate group affects the rights of both the debtors and the creditors, substantive consolidation should be applied only after a detailed examination of the rights and interests of the parties involved.[ii] In India, substantive consolidation was used for the first time when companies of the Videocon group were consolidated in 2019. However, no test has been developed by the Court. Therefore, there is a need to develop a list of factors for applying substantive consolidation in cases of group insolvency in India.

Since the framework of group insolvency in India is in developmental stages, guidance can be taken from the international insolvency law. The UNCITRAL Legislative Guide on Insolvency Law lists down the following factors while determining the liability of related companies in a corporate group:- the degree to which the administration, management and finances of the companies are interlinked, the conduct of the related company towards creditor of the insolvent company, whether creditors considered the two or more business entities as one economic unit and whether the actions of the related company have led to insolvency. However, the UNCITRAL Legislative Guide Part III limits the use of substantive consolidation to two cases. Firstly, if the Court is satisfied that the assets or liabilities of the group members are mixed in such a manner that it is difficult to identify the ownership of assets and liabilities without disproportionate expenses or delay; secondly, if the Court is satisfied that the entities of the same group are engaged in fraudulent activity, and substantive consolidation is essential to rectify such activity.

In the USA, the courts have considered the following factors while applying the doctrine of substantive consolidation- hindrance or fraud on creditors, bona fide reliance of creditors on the entire corporate group, the intermingling of corporate estates and accounts, and if the consolidation would be in the interest of the creditors.[iii] Consent of the creditors is a crucial factor as the pooling of the assets and liabilities interferes with the existing rights of the creditors, and even the courts are reluctant to violate the principles of corporate law. In consonance with this statement is the fourth theme which states that substantive consolidation must not be used in a manner which is detrimental for a group of creditors. The consolidation order must not benefit a part of creditors at the expense of the other.

The fifth theme states that substantive consolidation should be used as the last resort after rejecting the other remedies available in group insolvency cases. The UNCITRAL Legislative Guide Part III had suggested three methods for group insolvency: extension of liability, contribution order and substantive consolidation. Thus, the contribution order and extension of liability are some of the alternatives to substantive consolidation.

4. Conclusion

The doctrine of substantive consolidation has been often confused with the doctrine of the lifting of the corporate veil. Lifting of the corporate veil means holding the shareholders liable for the acts of the entity in cases of fraud or injustice to the creditors whereas substantive consolidation does not make the shareholders liable for the actions of the entity and involves the pooling of assets and liabilities of all the entities.

In India, the doctrine of substantive consolidation has been used only once and thus, it shows that courts respect the fundamental principles of corporate law and the entity approach. Substantive consolidation is a remedy for the creditors and must be used only if it furthers the objective of ‘creditor in possession’ as envisaged in the IBC. To ensure that this doctrine is not used in a detrimental manner, there is a need to develop a list of factors to be considered while applying this doctrine. Guidance can be taken from the UNCITRAL Legislative guide as it allows the use of this doctrine only in extraordinary situations and thus keeping the corporate law principles intact.

Endnotes

[i] J. Maxwell Tucker, Substantive Consolidation: The Cacophony Continues, 18 AM. BANKR. Inst. L. REV. 89 (2010) (hereinafter ‘Tucker 2010’).

[ii] Stephen J. Taylor, Practical Difficulties in Handling Group Insolvencies in The Challenges of Insolvency Law Reform in the 21^st Century: Facilitating Investment and Recovery to Enhance Economic Growth, 199 (Henry Peter et al ed., 2006).

[iii] Eric A. Webber, Consensual Substantive Consolidation: Comments on the Working Papers of Professor Skeel and Dr. Staehelin in The Challenges of Insolvency Law Reform in the 21^st Century: Facilitating Investment and Recovery to Enhance Economic Growth, 199 (Henry Peter et al ed., 2006).