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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. Two considerations are: (i) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit or (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors.
Before it had any relationship with Brothers Bakers, Inc. ("Restivo"), Augie's Baking Company, Ltd. (“Augie’s”) borrowed from appellant Union Savings Bank ("Union"). At the time, Union was unaware that Augie’s had commenced negotiations with Restivo. Augie’s and Restivo subsequently merged (debtors); 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. Subsequently, Augie/Restivo loaned from appellee Manufacturers Hanover Trust Company ("MHTC"). Augie/Restivo and Augie’s were forced into bankruptcy. Union was listed as a creditor of Augie's only. The debtors then agreed, conditioned upon confirmation of a reorganization plan, to sell their assets to another company. The debtors moved for substantive consolidation of the two cases because Union could prevent confirmation of the plan. Their motion was granted and upheld by the bankruptcy court, which held that Augie's and Restivo had merged and that the contemplated sale of assets was in the interests of the creditors of both companies. Union challenged the decision.
Was substantive consolidation proper under the circumstances of the case at bar?
On appeal, the court determined that the course of dealing and expectations did not justify consolidation because both appellant and appellee assumed that they were dealing with separate entities and that appellant's claims were superior to that of appellee. The court reversed the bankruptcy court's decision because consolidation impaired the rights of certain creditors, principally appellant, which extended credit to Augie’s before it had any relationship with Restivo. It also unfairly benefitted later creditors of the merged companies, principally appellee, who were aware of the debtors' corporate status.