In Re: Garden Ridge Corp.

NOT PRECEDENTIAL
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 09-1261
IN RE: GARDEN RIDGE CORPORATION, et al.,
Debtor,
DANIEL FERGUSON,
Appellant.
On Appeal from the United States District Court
for the District of Delaware
(D. C. No. 1-06-cv-00213)
District Judge: Honorable Gregory M. Sleet
Argued on November 9, 2009
Before: AMBRO, GARTH and ROTH, Circuit Judges
(Opinion filed: July 9, 2010)
William D. Sullivan, Esquire (Argued)
Sullivan, Hazeltine, Allinson, LLC
4 East 8 th Street, Suite 400
Wilmington, DE 19801
Counsel for Appellant Daniel Ferguson
Pauline K. Morgan, Esquire
Joseph M. Barry, Esquire (Argued)
Sean T. Greecher, Esquire
The Brandywine Building
1000 West Street, 17 th Floor
Wilmington, DE 19801
Ian S. Fredericks, Esquire
Skadden, Arps, Slate, Meagher & Flom
One Rodney Square
P. O. Box 636
Wilmington, DE 19899
David B. Stratton, Esquire
Pepper Hamilton
1313 Market Street, Suite 5100
P. O. Box 1709
Wilmington, DE 19899-1709
Counsel for Appellee Garden Ridge Corporation
Christian M. Thompson, Esquire
Connolly, Bove, Lodge & Hutz
1007 North Orange Street
P. O. Box 2207
Wilmington, DE 19899
Counsel for Appellee Concord Mall, LTD Partnership
James C. Carignan, Esquire
David M. Fournier, Esquire
Pepper Hamilton
1313 Market Street, Suite 5100
P. O. Box 1709
Wilmington, DE 19899-1709
Counsel for Appellee Official Committee of Unsecured Creditors
David M. Klauder, Esquire
United States Department of Justice
Office of the Trustee
844 King Street, Suite 2207
Lockbox 35
Wilmington, DE 19801
Counsel for Appellee United States Trustee
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OPINION
ROTH, Circuit Judge:
Daniel Ferguson, a creditor of the Garden Ridge debtors, appeals the District
Court’s denial of his setoff claim under sections 362(d) and 553(a) of the United States
Bankruptcy Code. We will affirm.
I. Background
Because we write primarily for the parties, we only briefly recite the facts. In
2001, Garden Ridge Management, Inc., hired Ferguson as an executive employee.
Ferguson’s employment contract included severance pay of $250,000 and reimbursement
of $60,000 in relocation expenses. Upon commencing employment, Ferguson borrowed
$250,000 from Garden Ridge, L.P., under the terms of a written promissory note. In
2003, Garden Ridge Management, Inc., terminated Ferguson’s employment. Ferguson
filed a state law contract claim for damages of $310,000 (severance pay of $250,000 and
relocation expenses of $60,000). Garden Ridge, L.P., later filed an action against
Ferguson in federal court for collection on the $250,000 promissory note.
In 2004, Garden Ridge Management, Inc., and six related corporate entities filed
for bankruptcy protection under Chapter 11. On March 29, 2005, the debtors filed a
proposed reorganization plan including a request for substantive consolidation.
Substantive consolidation “treats separate legal entities as if they were merged into a
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single survivor left with all the cumulative assets and liabilities.” In re Owens Corning,
419 F.3d 195, 205 (3d Cir. 2005). The proposed plan allowed the debtors to reserve all
legal and equitable defenses, but deemed the assets and liabilities of all Garden Ridge
debtors merged with the assets and liabilities of Garden Ridge, L.P. (A-473.) On April
28, 2005, the Bankruptcy Court confirmed the proposed substantive consolidation in the
plan because the debtors, in effect, functioned as a single entity.1 (A-591 to -592.)
Ferguson, whose state law action was automatically stayed by the bankruptcy filing
under 11 U.S.C. § 362, asserted a claim against the bankruptcy estate for $310,000.
Claiming the existence of mutual debts – i.e., Ferguson’s debt of $250,000 and Garden
Ridge’s debt of $310,000 – Ferguson brought a setoff claim under state law, which would
place him in the position of an unsecured creditor for $60,000 ($310,000 less $250,000).
(Bankr. D.I. 1518, Apr. 13, 2005); see 11 U.S.C. § 553(a). Garden Ridge objected to
Ferguson’s setoff claim for lack of mutuality because the transactions involved two
separate Garden Ridge entities. Ferguson’s breach of contract claim related solely to his
employment by Garden Ridge Management, Inc., an entity that employed all of Garden
Ridge’s staff. Ferguson’s promissory note was held by Garden Ridge, L.P., an entity that
operated Garden Ridge’s stores and paid Garden Ridge Management, Inc., a fee for use of
its employees.
1
On the date of confirmation, Ferguson’s claim for damages against Garden
Ridge Management, Inc., and his loan with Garden Ridge, L.P., were at issue between the
parties.
4
Ferguson argues that, even if Garden Ridge Management, Inc., and Garden Ridge,
L.P., were separate entities when he transacted with them, the Bankruptcy Court’s
confirmation of substantive consolidation effectively merged the entities, thereby creating
mutuality for setoff purposes.
II. Discussion
The District Court had jurisdiction pursuant to 28 U.S.C. § 158(a)(1) over the
appeal from the Bankruptcy Court, which had jurisdiction pursuant to 28 U.S.C. § 157(b).
We have jurisdiction over this appeal pursuant to 28 U.S.C. §§ 1291 and 158(d). The
District Court’s determinations are subject to plenary review. In re Prof’l Ins. Mgmt., 285
F.3d 268, 282-83 (3d Cir. 2002). The Bankruptcy Court’s factual determinations are
reviewed for clear error and its legal determinations are reviewed de novo. Id.
Setoff rights arise under the common law of equity and “allow[] entities that owe
each other money to apply their mutual debts against each other, thereby avoiding the
absurdity of making A pay B when B owes A.” Citizens Bank v. Strumpf, 516 U.S. 16, 19
(1995) (internal quotation marks omitted). To perfect a setoff claim, the party asserting
setoff rights must prove the debts between the creditor and debtor are mutual. See In re
APF Co., 264 B.R. 344, 354 (Bankr. D. Del. 2001); see also In re Czyzk, 297 B.R. 406,
409 (Bankr. D.N.J. 2003).
The question presented is whether substantive consolidation created mutuality for
setoff purposes even though, absent substantive consolidation, the element of mutuality
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would not have otherwise been satisfied. The debts of Ferguson and Garden Ridge, Inc.,
would only be mutual if Garden Ridge, Inc., and Garden Ridge, L.P., had disregarded
their entity separateness, a question the Bankruptcy Court did not decide when it
confirmed the reorganization plan because the then-prevailing standard for substantive
consolidation did not require such a finding. This Court’s subsequent decision in Owens
Corning, which held that substantive consolidation is appropriate when debtors disregard
their entity separateness, 419 F.3d at 211, does not operate as an ex post facto finding that
the Garden Ridge entities disregarded the entity separation. Whether the Garden Ridge
entities lost their mutuality defense because they disregarded entity separateness when
dealing with Ferguson is a factual question not resolved at the time of substantive
consolidation and raised for the first time in this adversarial proceeding.
The element of mutuality is not satisfied for two related reasons. First, as the
Bankruptcy Court found, the record does not support Ferguson’s claim that, when he dealt
with Garden Ridge Management, Inc., and Garden Ridge, L.P., he believed they were
alter egos because they had acted in disregard of their corporate separateness. Second,
the Bankruptcy Court’s factual determination that Ferguson was employed by Garden
Ridge Management, Inc., and not Garden Ridge, L.P., has support in the record and is not
clearly erroneous. Ferguson was an executive of Garden Ridge and understood its
business operations. His debt to Garden Ridge, L.P., cannot be setoff against his claim
against Garden Ridge Management, Inc., because those debts are not mutual.
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Although substantively consolidated with the other Garden Ridge entities, Garden
Ridge, L.P., preserved its defense to Ferguson’s setoff claim on grounds of lack of
mutuality. In the reorganization proceeding, the Bankruptcy Court approved a
substantive consolidation provision allowing the Garden Ridge debtors to retain all “legal
or equitable defense[s] that the Debtors had immediately prior to the Petition Date.” (A-
483 (Reorganization Plan, Art. VIII(F), p. 36).) The controversy between Ferguson and
the Garden Ridge entities was live at the time of the Chapter 11 proceeding, so the
Garden Ridge entities must have consented to the substantive consolidation provision
confirmed by the Bankruptcy Court with the mutuality defense in mind. Had Owens
Corning been precedent when the Garden Ridge entities were substantively consolidated
on April 28, 2005, the Bankruptcy Court might have considered other factors in
determining the appropriateness of that relief. But because Owens Corning was not
decided until August 15, 2005, the Bankruptcy Court’s prior confirmation of substantive
consolidation should not defeat the mutuality defense preserved here.
III. Conclusion
For the reasons stated above, we will affirm the judgments of the Bankruptcy
Court and District Court.
AMBRO, Circuit Judge, dissenting
This case turns on the meaning of substantive consolidation, a topic we addressed
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in In re Owens Corning, 419 F.3d 195 (3d Cir. 2005). Unlike Owens Corning, here we
are not confronted with a dispute over whether such a strong equitable remedy for a
reorganization is appropriate, as neither side wants to undo the deemed consolidation
contained in the debtors’ Plan of Reorganization. See id. at 211 (recognizing that deemed
consolidation is consensual).2 The only question is whether Ferguson is entitled to
benefit from that consolidation in the form of a setoff. Because I believe the substantive
consolidation here necessarily destroyed a mutuality defense to setoff, I would reverse the
judgment of the District Court (which affirmed the Bankruptcy Court’s decision) and
allow Ferguson to claim a setoff.
Substantive consolidation . . . “treats separate legal entities as if they were
merged into a single survivor left with all the cumulative assets and liabilities
(save for inter-entity liabilities, which are erased). The result is that claims of
creditors against separate debtors morph to claims against the consolidated
survivor.” Consolidation restructures (and thus revalues) rights of creditors
and for certain creditors this may result in significantly less recovery.
....
Substantive consolidation . . . affects distribution to innocent creditors . . . .
The bad news for certain creditors is that, instead of looking to assets of the
subsidiary with whom they dealt, they now must share those assets with all
creditors of all consolidated entities, raising the specter for some of a
significant distribution diminution.
2
My colleagues conflate a deemed consolidation with consolidation to remedy a pre-
petition disregard of entity separateness. The former must have the consent of interested parties.
While the latter conceivably may be consensual, it typically is achieved by a Court finding over
objection (in which the Bankruptcy Court would consider the principles set out in Owens
Corning). Thus, any reference in the majority’s opinion to “disregard[ing] entity separateness
. . . [as] a factual question” is not relevant here.
8
Id. at 205–06 (quoting Genesis Health Ventures, Inc. v. Stapleton (In re Genesis Health
Ventures, Inc.), 402 F.3d 416, 423 (3d Cir. 2005)). In short, substantive consolidation is a
blunt instrument that has a profound effect on creditors’ rights.
As a result of the substantive consolidation of the Garden Ridge debtors, all assets
and all liabilities of all debtors were deemed the assets and liabilities of Garden Ridge,
L.P., “for all purposes related to the Plan,” and “each and every Claim filed or to be filed
shall be deemed filed against the Consolidated Debtors, and shall be deemed one claim
against and obligation of the Consolidated Debtors.” J.A. 473 (Reorganization Plan, Art.
VI). The effect of this consolidation is extraordinary; while some of the individual
Garden Ridge debtors could claim the “I do not owe you” defense to creditors of other
individual Garden Ridge debtors prior to consolidation, that defense was no longer
available after consolidation.
For example, assume companies X, Y, and Z are independent legal entities. X
borrows only from Bank A, Y borrows only from Bank B, and Z borrows only from Bank
C. Bank A can only collect from company X, for companies Y and Z do not owe Bank A
any money. Indeed, if Bank A tried to collect from companies Y and Z, each would
simply respond “I do not owe you” and refuse to pay.
However, assume that companies X, Y, and Z file for bankruptcy and are
substantively consolidated into debtor XYZ. The assets of companies X, Y, and Z thus
are pooled into XYZ. So are the liabilities. Hence, Banks A, B, and C all have claims
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against XYZ. Whereas before consolidation Bank A did not have any claim against the
assets of companies Y or Z, it now does. Furthermore, while it used to have the sole
claim against the assets of company X, it now shares those assets with Banks B and C.
This is how “[c]onsolidation restructures (and thus revalues) rights of creditors and for
certain creditors this may result in significantly less recovery.” Owens Corning, 419 F.3d
at 205.
The situation is no different in this case. Ferguson had a claim against one of the
Garden Ridge debtors (which, if proven, is a liability of that debtor). He also owed
money to a different one of the Garden Ridge debtors (so it is an asset of that other
debtor). For ease of administering the debtors’ reorganization, a deemed consolidation
ignores walls of separation in the claims process. This is the essence of the consensual
tack taken. Fortunately for Ferguson (and unfortunately for some of Garden Ridge’s
other creditors), this means that he now has a claim against the consolidated debtor,
Garden Ridge, L.P., as well as a debt to that same consolidated debtor. By virtue of the
deemed consolidation, the debts are now deemed mutual.
As the majority recognizes, setoff rights “allow[] entities that owe each other
money to apply their mutual debts against each other, thereby avoiding the absurdity of
making A pay B when B owes A.” Citizens Bank of Md. v. Strumpf, 516 U.S. 16, 18
(1995) (internal quotation marks omitted). As a consequence of the deemed
consolidation, Ferguson owes Garden Ridge, L.P., and Garden Ridge, L.P., owes
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Ferguson. Accordingly, Ferguson is entitled to a setoff.
My colleagues believe, however, that this result is side-stepped when the Plan
buries a single sentence in another section that the debtors retain all “legal or equitable
defense[s] . . . [they] had immediately prior to the Petition Date” that are “not specifically
waived or relinquished by th[e] Plan,” and the Plan does neither specifically. See J.A.
483 (Reorganization Plan, Art. VIII.F). My response is that substantive consolidation by
definition destroys the mutuality defense—it turns assets and liabilities of individual
entities into assets and liabilities of a single consolidated entity. The “I do not owe you”
defense is necessarily destroyed, and there is no mutuality barrier to setoff. Garden Ridge
may find this outcome distasteful, but it is a side effect of the strong medicine of
substantive consolidation. Its effect “restructures . . . the rights of creditors,” Owens
Corning, 419 F.3d at 205, occasionally aiding one like Ferguson. That is the nature of the
beast.3
What does this case mean in practice? The majority opinion allows the debtors to
play “heads I win, tails you lose” with Ferguson. The debtors apparently are consolidated
only when Ferguson owes them money, but not when they owe him money. Instead of
potentially offsetting $250,000 of mutual debt (“real dollars,” i.e., 100 cents on the dollar)
and leaving Ferguson with an unsecured $60,000 claim (“bankruptcy dollars,” i.e., if the
3
The majority here concludes the “Garden Ridge entities must have consented to the
substantive consolidation provision.” As they proposed it, no doubt they consented. If the
majority meant that Ferguson consented, it is true that he did not object to the proposal of a
deemed consolidation, likely because he perceived it as removing an obstacle to his setoff claim.
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claim is allowed, only a portion of each dollar is paid) against the consolidated debtors,
under my colleagues’ reading Ferguson owes $250,000 (“real dollars”) to the
consolidated debtors and has an unsecured $310,000 claim (“bankruptcy dollars”) against
them.
Going forward, creditors are forewarned that debtor Jekyll seeking a deemed
consolidation for claims purposes may become debtor Hyde when it comes to the
consequences of that consolidation. For these reasons, I respectfully dissent.
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