Branch Banking and Trust Co. v. R&S St. Rose Lenders, LLC et al

Filing 90

ORDER that the bankruptcy court's order denying the motion for substantive consolidation (ECF No. 1 at 5-84) is AFFIRMED. The clerk of court is instructed to close this case. Signed by Judge Andrew P. Gordon on 1/8/17. (Copies have been distributed pursuant to the NEF: cc USBC - MMM)

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UNITED STATES DISTRICT COURT

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DISTRICT OF NEVADA

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IN RE R & S ST. ROSE LENDERS, LLC

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Debtor.
_______________________________

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BRANCH BANKING AND TRUST,
Appellant,

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Case No. 2:16-cv-00707-APG
OPINION AFFIRMING THE
BANKRUPTCY COURT’S ORDER
DENYING SUBSTANTIVE
CONSOLIDATION

v.
R & S ST. ROSE LENDERS, LLC, et al.,
Appellants.
Appellants Branch Banking and Trust (BB&T) and Commonwealth Land Title Insurance

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Company (Commonwealth) appeal the bankruptcy court’s order denying their request to

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substantively consolidate the bankruptcy estates of debtors R & S St. Rose Lenders, LLC

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(Lenders) and R & S St. Rose, LLC (St. Rose). Substantive consolidation is an equitable tool that

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allows a bankruptcy court to combine the assets and liabilities of separate but related legal entities

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into a single pool from which all claims against the consolidated debtors are satisfied and inter-

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company claims are extinguished. The upshot in this case is that if Lenders’ and St. Rose’s

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estates are substantively consolidated, an inter-company secured debt of $12 million would be

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extinguished, putting BB&T in first priority position to recover the proceeds from a sale of

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property in St. Rose’s estate. If substantive consolidation is denied, Lenders’ estate, against

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which BB&T has no claim, would receive the sale proceeds.

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The Ninth Circuit adopted a two-factor test in In re Bonham to guide the determination of

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whether substantive consolidation is appropriate. Under the Bonham factors, the bankruptcy

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court considers: “(1) whether creditors dealt with the entities as a single economic unit and did

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not rely on their separate identity in extending credit; or (2) whether the affairs of the debtor are

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so entangled that consolidation will benefit all creditors.” 229 F.3d 750, 766 (9th Cir. 2000). The

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bankruptcy court previously denied substantive consolidation under both factors. On a prior

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appeal, the district court affirmed denial of consolidation under the second factor but remanded

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for reconsideration under the first factor. After holding an evidentiary hearing, the bankruptcy

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court again denied substantive consolidation. BB&T and Commonwealth appeal that second

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denial. I affirm the bankruptcy court’s order denying substantive consolidation.

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I. BACKGROUND

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The facts are largely undisputed. Debtors Lenders and St. Rose are owned and operated

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(through intermediary companies) by Saiid Forouzan Rad and R. Phillip Nourafchan. Rad and

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Nourafchan formed St. Rose for the sole purpose of acquiring a piece of property in Henderson,

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Nevada, which they planned to sell within a year to Centex Homes. They formed Lenders for the

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sole purpose of creating an entity through which private individuals could loan money to St. Rose

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to help purchase the property.

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In 2005, St. Rose purchased the property through a $29 million loan from Colonial Bank,

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N.A. (the “Acquisition Loan”). This loan was secured by a first deed of trust encumbering the

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property. Rad and Nourafchan personally guaranteed the Acquisition Loan.

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To complete the purchase, St. Rose also received a $12 million loan, purportedly from

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Lenders. This loan was evidenced by a promissory note and secured by a second position deed of

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trust on the property (the “Lenders DOT”). Although the loan nominally was from Lenders, at

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that time Lenders had no assets, no separate books and records, and no bank account. Instead,

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Rad and Nourafchan obtained the funds through loans from their friends and family. The

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individual lenders’ checks to fund the $12 million loan were not made out to Lenders. Instead,

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the checks were made out to St. Rose or another entity of Rad and Nourafchan’s, R & S

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Investment Group, LLC. St. Rose deposited the funds into its bank accounts or directly into

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escrow. Lenders issued promissory notes to the individual lenders. Despite Lenders’ obligation

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to pay interest under the promissory notes, from 2005 to 2008 St. Rose made the interest

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payments to the individual lenders. St. Rose (and not Lenders) also issued tax forms to the

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individual lenders showing the interest payments. The promissory note between Lenders and St.

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Rose required St. Rose to make annual interest payments to Lenders, but St. Rose never made

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those payments. The Lenders DOT secured the $12 million promissory note, but the individual

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lenders actually advanced over $19 million to St. Rose.

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Centex chose not to buy the property. St. Rose and Colonial Bank executed a

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modification of the Acquisition Loan to extend the maturity date. As a condition of that

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modification, Colonial Bank required Lenders to subordinate the Lenders DOT. Lenders did so,

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and both the modification and the subordination agreements were recorded.

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St. Rose and Colonial Bank subsequently took a second loan from Colonial Bank for

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approximately $43 million (the “Construction Loan”). This loan was intended to pay off the

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Acquisition Loan and to construct improvements on the property. The loan was secured by a

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deed of trust on the property and by Rad and Nourafchan’s personal guarantees. Colonial Bank

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expected that it would obtain a first position deed of trust on the property to secure repayment of

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the Construction Loan. Colonial Bank’s escrow instructions to Nevada Title Company required a

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first position deed of trust and conditioned disbursements under the loan on Colonial Bank having

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a first position deed of trust. To obtain that first position, Lenders would have had to agree to

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subordinate the Lenders DOT to the Construction Loan deed of trust. Commonwealth issued title

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insurance to Colonial Bank for the Construction Loan.

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In 2008, the project was failing and Colonial Bank commenced foreclosure on the

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property under the Construction Loan deed of trust. During this process, it was discovered that

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the Lenders DOT was in first priority position because it had never been subordinated or

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reconveyed even though that was a requirement of the Construction Loan’s escrow and funding.

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On July 9, 2008, Nevada Title sent an email to Rad requesting reconveyance of the Lenders DOT.

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Rad did not execute the subordination agreement and instead asked Nevada Title what position

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the Lenders DOT was on the property. Nevada Title responded on September 5, 2008, informing

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Rad that the Lenders DOT was in priority position over the Construction Loan.

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The next business day, Lenders created a separate balance sheet and shortly thereafter
obtained a bank account for the first time. Additionally, St. Rose and Lenders’ financial records

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were updated to reclassify the debt owed to the individual lenders that previously was booked to

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St. Rose to instead be reported as Lenders’ obligation. Tax liabilities also were shifted from St.

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Rose to Lenders.

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In 2009, Colonial Bank went into receivership and BB&T became its successor in interest.

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In 2011, Lenders and St. Rose filed separate petitions for bankruptcy. BB&T and

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Commonwealth moved for substantive consolidation of the two debtors’ cases. The bankruptcy

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court denied the motion. As to the first Bonham factor, the bankruptcy court found that the

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debtors “are clearly related entities, and as they acknowledge, it is apparent that they were sloppy

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with certain corporate formalities during the period in which the underlying business transactions

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transpired.” ECF No. 34 at 86. The bankruptcy court nevertheless concluded that Colonial Bank

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did not treat the debtors as a single economic unit when it entered into the Construction Loan. In

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reaching that conclusion, the bankruptcy court adopted findings made by a Nevada state court in

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separate litigation. Id. at 86-87. The bankruptcy court also found that BB&T did not meet its

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burden of showing that the individual lenders dealt with St. Rose and Lenders as a single

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economic unit. According to the bankruptcy court, BB&T’s evidence was based on assumptions

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about what the individual lenders thought when they sent their payments to St. Rose instead of to

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Lenders and when they accepted the interest payments from St. Rose instead of from Lenders. Id.

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at 87. The court therefore held BB&T had not shown Colonial Bank or the individual lenders

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treated the debtors as a single economic unit. Id.

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As to the second Bonham factor, the bankruptcy court held that BB&T had not shown

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that the two debtors’ affairs were so entangled that consolidation would benefit the creditors

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because the entities divided their assets in 2008, and thus separation of the two entities’ assets had

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already occurred. Id. at 88. Finally, the bankruptcy court concluded that substantive

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consolidation would not be in the best interest of all creditors, as BB&T was attempting to use it

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as a means to undermine the state court’s factual finding that the Lenders DOT was in a priority

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position over the Construction Loan deed of trust. Id. at 89. The bankruptcy court therefore

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denied substantive consolidation. Id.

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BB&T and Commonwealth appealed that denial. In the meantime, the bankruptcy court

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approved the sale of the property for approximately $13 million. St. Rose’s bankruptcy plan,

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which the bankruptcy court had confirmed, provided for payment of the sale proceeds to Lenders

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as the first priority position on the property.
Senior District Judge Lloyd George remanded the bankruptcy court’s order denying

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substantive consolidation with instructions to decide whether consolidation was warranted under

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the first Bonham factor. Judge George affirmed the bankruptcy court’s ruling that the second

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Bonham factor did not support substantive consolidation. However, Judge George found the

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bankruptcy court made two errors related to the first Bonham factor. First, he concluded the

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bankruptcy court erred by relying on a finding of fact by the state court; he remanded for

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reconsideration of the first Bonham factor “without reliance on or reference to the state court

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order.” ECF No. 34 at 137-38. Second, Judge George found the bankruptcy court erred by

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discounting BB&T’s evidence about how the individual lenders treated the debtors. He took

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issue with the bankruptcy deeming BB&T’s arguments merely “assumptions . . . based on

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conjecture,” rather than reasonable inferences from the evidence. Id. 138-39. Judge George thus

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remanded for the bankruptcy court to resolve whether BB&T and Commonwealth “met their

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burden under the first Bonham factor as it concerns all creditors, not merely Colonial Bank.” Id.

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at 140.

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Finally, Judge George addressed the purpose substantive consolidation would serve. Id.

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He stated that “the sole aim of substantive consolidation is fairness to all creditors; the equitable

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treatment of all creditors.” Id. That does not mean the “best interest of all of the creditors, but an

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equitable treatment of and fairness to all creditors.” Id. He noted that the best interest of some

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creditors may be to receive treatment that is unfair to other creditors, but substantive

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consolidation is concerned with the equitable treatment of all creditors. “Such inequitable

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treatment can arise through the continued recognition of a claim created between entities when

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both entities disregarded corporate formalities and commingled assets.” Id. at 141. Judge George

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did not make this equitable determination himself, instead remanding to the bankruptcy court to

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do so. Id.

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On remand, the bankruptcy court held a multi-day evidentiary hearing and again denied

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the motion for substantive consolidation. The evidence established that the largest single creditor

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by dollar amount was Colonial Bank. The bankruptcy court found that Colonial Bank did not

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treat Lenders and St. Rose as a single economic unit in relation to the Construction Loan because

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Colonial Bank was aware of the Lenders DOT and it expressly required Lenders to subordinate its

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DOT in connection with the prior modification of the Acquisition Loan. Colonial Bank also

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required the subordination of the Lenders DOT for the Construction Loan. The bankruptcy court

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thus made the factual finding that Colonial Bank dealt with Lenders and St. Rose as separate

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economic units. ECF No. 1 at 72. However, it found that every other creditor, consisting of the

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individual lenders who loaned money to Lenders, treated Lenders and St. Rose as a single

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economic unit. Id. at 75. The bankruptcy court also found that Colonial Bank did not rely on

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Lenders’ separate assets in making the Construction Loan to St. Rose, while the individual

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lenders were “indifferent” to Lenders’ separate existence when they loaned funds to the project

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and did not rely on the assets of either entity when making their loans. Id. at 76-77.

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Evaluating these findings in context of the first Bonham factor, the bankruptcy court ruled

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that Colonial Bank treated St. Rose and Lenders as separate economic units and did not rely on

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Lenders’ assets in making the Construction Loan to St. Rose, so the first Bonham factor was not

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met with respect to Colonial Bank. However, the bankruptcy court found the first Bonham factor

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might be satisfied by the individual lenders because they treated St. Rose and Lenders as a single

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economic unit and they relied on the sale of the property for repayment of their loans, not on the

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assets of either entity.

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Faced with these two types of creditors, the bankruptcy court concluded that Colonial

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Bank’s treatment of the debtors was the “most significant” because its claim “far exceeds the

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claims of the individual lenders.” Id. at 77. Colonial Bank’s loan file demonstrated that Colonial

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Bank would look to the sale of the property and the guarantees by Rad and Nourafchan for loan

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repayment. Id. According to the bankruptcy court, this evidence “permits only one inference

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critical to the substantive consolidation analysis: Colonial Bank never expected to have the assets

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of Lenders available to satisfy the Construction Loan.” Id. The bankruptcy court thus concluded

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the first Bonham factor was not met. Id. at 78.

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The bankruptcy court also considered whether substantive consolidation would ensure the

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equitable treatment of all creditors even if the individual lenders’ treatment of St. Rose and

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Lenders as a single economic unit controlled. Id. at 78. The bankruptcy court concluded that

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Colonial Bank’s expectation was to be protected by its title insurance if it did not receive a first

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deed of trust. Id. at 79. According to the bankruptcy court, the individual lenders expected to

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have their loans repaid from the sale of the property, some expected that their interests were

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secured by a deed of trust on the property, and they expected to be paid on their claims in the

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Lenders’ bankruptcy proceeding. Id. at 80. The bankruptcy court noted these expectations likely

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would not be met if the court substantively consolidated the bankruptcy estates because the net

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result would be that the inter-company loan and related DOT would be extinguished, thus putting

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BB&T in first position through the Construction Loan. Id.

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The bankruptcy court also addressed the statement in Judge George’s remand order that

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inequitable treatment may arise through continued recognition of a claim between entities when

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both entities disregarded corporate formalities. Id. The bankruptcy court noted that Lenders had

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been formed in 2005 and the Lenders note encompassed the funds the individual lenders provided

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for St. Rose to acquire the property. Id. According to the bankruptcy court, “[t]here simply is no

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evidence supporting the conclusion that the evils occasioned by disregarding corporate formalities

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and commingling assets exist with respect to the [Lenders] Note.” Id. at 80-81.

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The bankruptcy court thus concluded that substantive consolidation “would be contrary to

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the expectations of Colonial Bank and the individual lenders,” and “substantive harm would be

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visited upon the Lenders estate because the proceeds of the Property sale likely would go entirely

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to BB&T on its secured claim and would be unavailable to satisfy any of the claims of the

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individual lenders.” Id. at 82. According to the bankruptcy court, although substantive

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consolidation might be in BB&T and Commonwealth’s best interests, it “would come at the

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expense of the individual lenders” and “[t]hat result would not be equitable to all creditors.” Id.

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The bankruptcy court thus concluded that even if the first Bonham factor was satisfied,

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substantive consolidation was not warranted. Id.

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In this present proceeding before me, BB&T and Commonwealth again appeal the

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bankruptcy court’s denial of substantive consolidation. First, they contend that the bankruptcy

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court erred as a matter of law by focusing on how the largest creditor by dollar amount treated the

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debtors instead of how the largest number of creditors treated them. Second, they argue that the

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bankruptcy court’s factual finding that Colonial Bank treated Lenders and St. Rose as separate

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economic units was clearly erroneous because Colonial Bank did not rely on St. Rose’s or

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Lenders’ credit in making the decision to fund the Construction Loan. Rather, they argue,

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Colonial Bank relied on both the value of the property against which it would have a deed of trust

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and the creditworthiness of guarantors Rad and Nourafchan. Third, they assert that the

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bankruptcy court erred by concluding substantive consolidation would frustrate the expectations

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of the individual lenders because those lenders expected they would recover only after the

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Colonial Bank loan was repaid, and thus the individual lenders took the risk that the sale of the

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property would not generate proceeds sufficient to repay their loans. Fourth, Appellants contend

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that denying substantive consolidation rewards Rad and Nourafchan’s inequitable plan to

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manufacture corporate formalities only after they learned that the Lenders DOT was not

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subordinated to Colonial Bank’s Construction Loan deed of trust as it should have been. Finally,

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Commonwealth argues that the bankruptcy court erred by considering whether BB&T and

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Commonwealth have other sources of recovery, such as title insurance or guarantees.

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Appellee St. Rose1 responds that the bankruptcy court used the correct legal standard

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when it concluded that the first Bonham factor was not met where the largest creditor by dollar

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amount did not treat the debtors as a single economic unit. Second, St. Rose contends the

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Appellees St. Rose Lenders, LLC; the Creditor Group; and R & S Investment Group filed
joinders in St. Rose’s brief. ECF Nos. 82-84.

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bankruptcy court’s correctly held that the debtors did not deal with the two debtors as a single

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economic unit given that Colonial Bank (1) entered into the two loans with only St. Rose and not

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Lenders, (2) did not consider Lenders’ assets when deciding whether to make the loans, and (3)

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expressly required Lenders to subordinate the Lenders DOT in connection with the Construction

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Loan. St. Rose argues substantive consolidation would be inequitable because Colonial Bank

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obtained title insurance in the event it did not have a first position deed of trust, Colonial Bank

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did not expect to have Lenders’ assets to satisfy the Construction Loan, the individual lenders

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expected to be repaid when the property was sold, and there was no evidence that the individual

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lenders expected to be in second position behind the Construction Loan (as opposed to the

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Acquisition Loan). Finally, St. Rose contends the bankruptcy court did not rely on alternative

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sources of recovery when making its determination.

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II. JURISDICTION

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I first must consider the “threshold jurisdictional issue” of whether the bankruptcy court’s

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order denying substantive consolidation is a final and appealable order under 28 U.S.C. § 158. In

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re Bonham, 229 F.3d at 760-61. I apply a “pragmatic approach” under which a bankruptcy court

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order “is considered to be final and thus appealable where it 1) resolves and seriously affects

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substantive rights and 2) finally determines the discrete issue to which it is addressed.” Id. at 761

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(quotation omitted).

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Under Bonham, “substantive consolidation orders are final and appealable under

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§ 158(a).” Id. at 762. In Bonham, the bankruptcy court’s order granted substantive consolidation.

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Id. at 760. But here the bankruptcy court denied consolidation. The Sixth Circuit has held that

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the denial of substantive consolidation is not a final and appealable order. See In re Cyberco

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Holdings, Inc., 734 F.3d 432, 440 (6th Cir. 2013). Even if Bonham’s jurisdictional holding does

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not uniformly apply to orders denying substantive consolidation, here the denial of substantive

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consolidation resolves and seriously affects substantive rights. There is no dispute that the only

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asset for either debtor’s estate is the proceeds from the sale of the property. The decision whether

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to consolidate has dispositive impact on who may claim those proceeds. Consequently, in the

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context of this case, I have jurisdiction to review the order denying substantive consolidation

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because that decision seriously affects the parties’ substantive rights and finally determines the

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discrete issue of whether the bankruptcy estates should be substantively consolidated. In any

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event, I would grant leave to appeal the bankruptcy court’s order to the extent it is interlocutory.

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28 U.S.C. § 158(a)(3) (granting district courts jurisdiction to hear appeals from interlocutory

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bankruptcy orders with leave of the court).

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III. STANDARD OF REVIEW

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I review de novo the bankruptcy court’s conclusions of law. In re Rains, 428 F.3d 893,
900 (9th Cir. 2005). I review the bankruptcy court’s factual findings for clear error. Id. The

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bankruptcy court’s factual findings are clearly erroneous only if they “leave the definite and firm

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conviction” that the bankruptcy court made a mistake. Id. (quotation omitted). Under clear error

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review, if the bankruptcy court’s findings are “plausible in light of the record viewed in its

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entirety,” I may not reverse them even if I would have “weighed the evidence differently.”

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Anderson v. City of Bessemer City, N.C., 470 U.S. 564, 574 (1985). In other words, “[w]here

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there are two permissible views of the evidence, the factfinder’s choice between them cannot be

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clearly erroneous,” particularly where the decision rests on a credibility determination. Id. at 574-

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75. But if documents or objective evidence so contradict a witness’s testimony, or testimony is

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“so internally inconsistent or implausible on its face that a reasonable factfinder would not credit

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it,” then I may find clear error even if the bankruptcy court’s findings are based on a credibility

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determination. Id. at 575. I may affirm the bankruptcy court’s decision “on any ground fairly

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supported by the record.” In re Warren, 568 F.3d 1113, 1116 (9th Cir. 2009).

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IV. ANALYSIS

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Bankruptcy courts have the power to substantively consolidate bankruptcy estates. In re

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Bonham, 229 F.3d at 763. This power arises from the bankruptcy court’s “general equity powers

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as expressed in § 105 of the Bankruptcy Code.” Id. at 763-64. The bankruptcy court has

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“complete” power to “subordinate claims or adjudicate equities arising out of the relationship

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between the several creditors . . . .” Id. at 764 (quoting Sampsell v. Imperial Paper & Color

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Corp., 313 U.S. 215, 219 (1941)).

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Substantive consolidation “combine[s] the assets and liabilities of separate and distinct—

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but related—legal entities into a single pool and treat[s] them as though they belong to a single

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entity.” Id. It is akin to piercing the corporate veil. Id. The net effect is that the assets are

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consolidated and “create a single fund from which all claims against the consolidated debtors are

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satisfied; duplicate and inter-company claims are extinguished; and, the creditors of the

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consolidated entities are combined for purposes of voting on reorganization plans.” Id.; In re

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Owens Corning, 419 F.3d 195, 205 (3d Cir. 2005) (“The result is that claims of creditors against

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separate debtors morph to claims against the consolidated survivor.”) (quotation omitted).

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Because it “restructures (and thus revalues) rights of creditors,” consolidation may result in some

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creditors recovering significantly more or less than they would absent consolidation. In re Owens

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Corning, 419 F.3d at 205.

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There is “[n]o uniform guideline for determining when to order substantive

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consolidation.” In re Bonham, 229 F.3d at 765. Instead, the decision must rest on “a searching

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review of the record, on a case-by-case basis” with an eye toward the doctrine’s primary purpose

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of ensuring “the equitable treatment of all creditors.” Id. (quotation omitted). But fairness does

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not necessarily mean equal distribution. For example, a creditor who “bargained prepetition for

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unequal treatment” by, for example, “obtaining guarantees of separate entities,” may not be

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treated equitably by substantive consolidation. In re Owens Corning, 419 F.3d at 216. (citing

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Chem. Bank N.Y. v. Kheel, 369 F.2d 845, 848 (2d Cir. 1966) (Friendly, C.J., concurring)

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(“Equality among creditors who have lawfully bargained for different treatment is not equity but

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its opposite . . . .”)).

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Although it is a case-by-case inquiry, the Ninth Circuit adopted a two-factor test in In re

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Bonham to guide the determination of whether substantive consolidation is appropriate. Under

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the Bonham factors, the bankruptcy court considers: “(1) whether creditors dealt with the entities

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as a single economic unit and did not rely on their separate identity in extending credit; or (2)

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whether the affairs of the debtor are so entangled that consolidation will benefit all creditors.” Id.

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at 766 (quotation omitted) (adopting the test set forth by the Second Circuit in In re Augie/Restivo

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Baking Co., Ltd., 860 F.2d 515, 519 (2d Cir. 1988)). “The first factor . . . is based on the

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consideration that lenders structure their loans according to their expectations regarding th[e]

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borrower and do not anticipate either having the assets of a more sound company available in the

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case of insolvency or having the creditors of a less sound debtor compete for the borrower’s

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assets.” Id. (quotation omitted). The second factor supports consolidation “only where the time

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and expense necessary even to attempt to unscramble them [is] so substantial as to threaten the

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realization of any net assets for all the creditors or where no accurate identification and allocation

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of assets is possible.” Id. (quotation omitted). Either factor is sufficient to support substantive

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consolidation. Id.

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Two broad themes animate this inquiry: (1) “whether there is a disregard of corporate

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formalities and commingling of assets by various entities,” and (2) how the benefits from

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substantive consolidation balance against the harms it would cause. Id. at 765. The bankruptcy

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court should resort to substantive consolidation “sparingly.” Id. at 767 (quotation omitted).

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A. The Bankruptcy Court Did Not Err in Applying the First Bonham Factor

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1. The Bankruptcy Court Did Not Apply the Wrong Legal Standard.

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BB&T and Commonwealth argue that the bankruptcy court erred as a matter of law by

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applying the wrong legal standard. They argue the bankruptcy court misconstrued the remand

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order’s instructions to mandate that the first factor could be met only if every single creditor dealt

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with the debtors as a single economic unit. They also contend the bankruptcy court should have

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decided the first factor based on how the largest number of creditors treated the debtors rather

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than on how the largest creditor by dollar amount treated them.

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The bankruptcy court did not require, as a condition of the first Bonham factor being met,

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that every creditor dealt with the debtors as a single economic unit. Rather, it identified two

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classes of creditors, one that treated the debtors as separate economic units (Colonial Bank) and

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one that treated the debtors as a single unit (the individual lenders). The bankruptcy court then

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determined that Colonial Bank’s treatment was most significant because it was the largest creditor

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by dollar amount. The bankruptcy court therefore did not apply an incorrect legal standard of

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mandating every creditor treat the debtors as a single economic unit.

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Moreover, I reject BB&T and Commonwealth’s position that, as a matter of law, the first

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Bonham factor must always be determined by the largest number of creditors rather than the

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creditors owed the largest dollar amount. Although some cases refer to how the majority of

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creditors treated the subject entities, none stated this was a requirement as a matter of law. See In

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re The Lodge at Big Sky, LLC, 454 B.R. 138, 143 (Bankr. D. Mont. 2011) (finding the first factor

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supported consolidation where the evidence showed that “all creditors, with perhaps the exception

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of [one]” treated the entities as a single unit); In re Waksberg, No. BAP CC-14-1102-DTASP,

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2014 WL 5285648, at *7 (B.A.P. 9th Cir. Oct. 15, 2014) (stating that the bankruptcy court found

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the “bulk” of creditors dealt with the entities as the same); In re LLS Am., LLC, No. BAP EW-11-

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1524-DHPA, 2012 WL 2042503, at *11 (B.A.P. 9th Cir. June 5, 2012) (analyzing the first factor

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based on a group of creditors who were “overwhelmingly the largest creditor body both in

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number and in dollar amount”).

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I disagree with BB&T and Commonwealth that the largest number of creditors controls

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the first factor. That argument is contrary to Bonham’s instruction that substantive consolidation

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is a case-by-case inquiry. It is contrary to equitable principles generally. A bankruptcy court

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should not be constrained in evaluating the equities in a particular case by requiring it to be

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governed by an inflexible rule that may not fit the facts of the case before it.

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Finally, not all courts have judged the first factor merely by a creditor count. Indeed, the

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very case Bonham relied on to adopt its two-factor test (In re Augie/Restivo Baking Co., Ltd.)

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found substantive consolidation was inappropriate even though, numerically speaking, more

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creditors treated the subject entities as a single economic unit. 860 F.2d at 519. There, the

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creditor objecting to consolidation made a loan to one of the subject entities based solely on that

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entity’s financial condition and without knowledge of the other entity. Id. at 519. Another

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creditor likewise dealt with the two entities as separate. Id. The Second Circuit concluded that

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the fact that there were many other creditors2 who believed that they were dealing with a single

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entity did not justify consolidation, particularly where substantive consolidation would have been

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inequitable to one of the creditors who did not treat the subject entities as a single unit. Id.

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The Ninth Circuit bankruptcy appellate panel in Waksberg (one of the cases on which

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BB&T and Commonwealth rely) reached a similar conclusion. There, the “bulk” of creditors

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dealt with the entities as one. 2014 WL 5285648, at *7. The bankruptcy appellate panel

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concluded that this factual finding “arguably supported” substantive consolidation under the first

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part of the first factor. Id. at *11. But the panel remanded because it would be inequitable to

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consolidate where the objecting creditor, who did not treat the corporate and individual debtors as

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a single economic unit and did not have a right to file a claim in the individual debtor’s

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bankruptcy case, would recover less following consolidation. Id.

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In this case, the bankruptcy court applied the correct rule of law.

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2. The Bankruptcy Court’s Factual Findings Are Not Clearly Erroneous.
BB&T and Commonwealth argue that the bankruptcy court’s factual finding—that

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Colonial Bank treated Lenders and St. Rose as separate economic units—was clearly erroneous

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because Colonial Bank did not rely on St. Rose’s or Lenders’ credit in making the decision to

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fund the Construction Loan. However, the record supports the bankruptcy court’s finding.

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Colonial Bank was aware of Lenders prior to entering into the Construction Loan and it treated

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Lenders as a separate economic unit. It required Lenders to subordinate the Lenders DOT as a

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term of the modification of the Acquisition Loan. It also required Lenders to subordinate the

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Lenders DOT as a term of distribution of the Construction Loan funds. Colonial Bank did not

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look to Lenders’ assets as a source of possible recovery in the event St. Rose did not repay the

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Construction Loan. Instead, it based its decision on St. Rose’s asset (the property) and Rad and

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Nourafchan’s guarantees. There is no evidence Colonial Bank considered or treated St. Rose and

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The bankruptcy court referred to it as “the world-at-large” treating the two entities as a single
economic unit. In re Augie/Restivo Baking Co., Ltd., 84 B.R. 315, 321 (Bankr. E.D.N.Y. 1988).

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Lenders as a single economic unit. The bankruptcy court’s factual finding therefore is more than

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plausible in light of the entire record.

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B. The Bankruptcy Court Did Not Err in Weighing the Equities

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BB&T and Commonwealth argue the bankruptcy court erred by concluding substantive

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consolidation would frustrate the expectations of the individual lenders. According to the

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appellants, the individual lenders expected they would recover only after Colonial Bank was

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repaid, and thus the lenders took the risk that the sale of the property would not generate proceeds

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sufficient to repay their loans. BB&T and Commonwealth also contend that substantive

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consolidation would reward Rad and Nourafchan’s inequitable plan to manufacture corporate

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formalities only after they learned that the Lenders DOT was not subordinated to the Construction

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Loan deed of trust as it should have been.

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The primary purpose of substantive consolidation is ensuring the equitable treatment of all

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creditors. However, equity in the context of substantive consolidation does not mean saving

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creditors or third parties from their own mistakes that do not arise out of either the debtors’ abuse

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of the corporate form or how creditors treated the debtors. BB&T would be in the same position

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it is in now even if Rad and Nourafchan had “dotted every i and crossed every t” with respect to

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corporate formalities. Colonial Bank expected to be paid first and the individual lenders expected

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to be paid after Colonial Bank. But those expectations were defeated because no one ensured that

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Lenders had subordinated or reconveyed the Lenders DOT. That is not due to a lack of corporate

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separateness or the individual lenders treating St. Rose and Lenders as a single economic unit,

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and it is not a problem substantive consolidation was designed to solve. Thus, the bankruptcy

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court did not err in holding that there was “no evidence supporting the conclusion that the evils

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occasioned by disregarding corporate formalities and commingling assets exist with respect to the

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[Lenders] Note.” ECF No. 1 at 80-81.

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C. The Bankruptcy Court Did Not Err by Relying on Other Sources of Recovery

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Finally, Commonwealth argues that the bankruptcy court erred by considering whether

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BB&T and Commonwealth have other sources of recovery, such as title insurance or guarantees.

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However, the bankruptcy court disclaimed that it was considering other sources of recovery. ECF

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No. 1 at 81-82. Even if the bankruptcy court erred by considering Colonial Bank’s expectation

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that it would be protected by title insurance or guarantees, I may affirm on any ground supported

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by the record. As discussed above, the bankruptcy court did not err in finding the first Bonham

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factor was not met. Additionally, the bankruptcy court did not err by finding the equities did not

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support substantive consolidation.

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V. CONCLUSION

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IT IS THEREFORE ORDERED that the bankruptcy court’s order denying the motion for
substantive consolidation (ECF No. 1 at 5-84) is AFFIRMED. The clerk of court is instructed
to close this case.
DATED this 8th day of March, 2017.

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ANDREW P. GORDON
UNITED STATES DISTRICT JUDGE

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