The non-consolidation of special purpose entities with the seller of financial assets is a prerequisite of every properly structured securitization transaction.

On May 1, the United States Supreme Court denied the petition for a hearing filed by a creditors committee of Owens Corning, Inc. with respect to the Third Circuit Court of Appeals' decision regarding substantive consolidation. As a result, the guidelines for determining whether substantive consolidation is appropriate are now settled in the Third Circuit. Likewise, the case has profound and wide-ranging precedential implications in terms of validating substantive consolidation in other circuits.

Last August, the U.S. Court of Appeals for the Third Circuit reversed the district court ruling that had treated Owens Corning and its units as a single entity under a policy of substantive consolidation, which would have combined the company's assets with those of three subsidiaries. In rejecting the lower court's ruling, the Third Circuit emphasized, and to a large extent reiterated, a myriad of principles to be applied in an analysis of substantive consolidation that are relevant in application to structured finance transactions.

In reaching its decision, the Third Circuit articulated a two-part test that must be satisfied whenever a party in bankruptcy seeks substantive consolidation. The first part of the test, the "pre-petition test," requires a demonstration that the proponent of substantive consolidation is a creditor of the debtor and that the creditor actually and reasonably relied upon the unified entity. Opponents to substantive consolidation need only prove that they are adversely affected by substantive consolidation and that they actually relied on the debtors' separate existence in order to defeat a prima facie showing of the first element. In this case, the Third Circuit determined that, pre-petition, the company had negotiated the transactions premised on the separateness of all of its affiliates and the fact that the bank group insisted on guarantees from affiliates demonstrated the creditors' intention to treat the companies as separate entities.

The second test, the "post-petition test," is based in practicality and is aimed at addressing situations where the entities' assets and liabilities have been "hopelessly" commingled. A fundamental consideration under this rationale is whether untangling the commingled assets and liabilities will be beneficial (i.e., increased recovery) to all - or just some - of the debtors' creditors. In applying the second part of the test to the bank group's financing structure, the Third Circuit found that there was no meaningful evidence of post-petition commingling of the assets of Owens Corning that would justify substantive consolidation.

In essence, the Third Circuit found no plausible reason to vitiate a fairly typical bank lending arrangement that had been negotiated at arm's length, particularly when doing so would grievously punish the very parties that conferred the pre-petition benefit on the Company by extending the loan.

The Third Circuit emphasizes adherence to its two part test in tandem with established principles of substantive consolidation analysis rather than the "imprecise tests and rigid elements" that have often been applied by other courts. As a result of its decision, the Third Circuit has made it clear that it will defer to a lender's pre-petition reliance upon the separateness of distinct and independent legal entities before it will order substantive consolidation.


The application of substantive consolidation to a particular case is, of necessity, tied closely to the facts involved and is largely defined by case law. Securitization transactions expressly and emphatically rely on a combination of explicit corporate separateness, mandated separateness of assets, and built-in protections against substantive consolidation.

Due to the substantial dollar amounts involved in the Owens Corning bankruptcy case, among other reasons, the Third Circuit's ruling and the Supreme Court's denial of certiorari merit attention and should be considered within the ambit of any nonconsolidation analysis. Because the Owens Corning decision reiterates the established legal analysis and adheres to the prevailing precedents, rather than portending a significant departure from long standing principles of structuring deals, the decision provides a reaffirmation of those principles and methods of analysis. Consequently, the Third Circuit's ruling and Supreme Court's denial of certiorari in Owens Corning will undoubtedly provide reassurance to the law firms that render, and to the investors, bond insurers and underwriters that receive and rely on, standard nonconsolidation opinions in structured finance transactions. Nevertheless, it is important not to take the correct application of case law for granted. Special purpose entities need to be operated in the manner set forth in securitization agreements in order for their protection afforded by the structure to be recognized.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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