As lenders prepare for a world with an increased risk of borrower failures, liquidations, and bankruptcies, many have begun focusing on requiring that borrowers form special purpose entities ("SPEs") to mitigate against those risks. In this publication, we explore how recent case law has viewed the formation and use of SPEs and which structures have been more effective than others.
Current State of the Law Regarding Bankruptcy Remote Entities
Bankruptcy remote SPEs are typically used in real estate transactions and structured finance to isolate the assets that are the subject of the loan or financing from the financial condition-and any bankruptcy filing-of the equity sponsor or parent entity. In theory, this arrangement allows lenders to assess transactions solely based on the specific assets securing the loan, rather than the financial condition of the sponsor's entire enterprise.
As the term "bankruptcy remote" suggests, there is no way to make a company completely "bankruptcy proof." "[A] pre-petition waiver of the benefits of bankruptcy is contrary to federal law and therefore void."1 Accordingly, the aim is to make the likelihood of a bankruptcy filing by the SPE as remote as possible. That essentially involves a three-pronged approach:
- First, set up the SPE so that it is required to keep its assets, liabilities, books, records, and operations separate from that of its equity sponsor and affiliates to limit the possibility that a third-party creditor of the sponsor will be able to reach the assets of the SPE.
- Second, structure the operating documents of the SPE to limit as much as possible the SPE's managers' discretion to elect to file bankruptcy.
- And third, ensure that the SPE has a trustworthy manager or member in place who is independent from the sponsor and with veto rights over a bankruptcy filing who can also ensure the SPE's corporate separateness obligations are observed.
A. Recent Caselaw
Most of the recent case law regarding bankruptcy remote strategies has focused on the third prong, specifically, the extent to which a lender may prevent a special purpose entity from filing for bankruptcy by appointing an ostensibly independent manager beholden to the lender or by becoming a nominal member of the entity. The theory behind the former strategy is to install a manager who the lender believes will not commence bankruptcy proceedings. The theory behind the latter is to obtain a blocking or "golden share" of the company to vote down any effort to file bankruptcy. While both strategies may be pursued, neither is bulletproof.
1. Independent Manager Approach
The seminal case is In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009) (applying Delaware law). That case highlights the pitfalls in not ensuring the lender's control in the appointment and retention of a SPE's independent managers. In 2009, General Growth Properties, Inc., one of the country's then largest operators of shopping malls, filed for bankruptcy with 359 of its affiliates and subsidiaries, including numerous SPEs that were obligors under certain commercial mortgage backed securities and that the marketplace had presumed were bankruptcy remote. Several lenders filed motions to dismiss the cases of certain of the SPE debtors as having been filed in bad faith because, among other things: (1) the SPEs were solvent, (2) the managers of the SPEs impermissibly put the interests of the parent group above that of the individual SPEs, and (3) the debtors had terminated the independent managers of the SPEs (without notifying the existing managers prior to the bankruptcy filing) and installed new managers to approve the bankruptcy filings in bad faith. The bankruptcy court denied the lenders' motions. The court held that nothing in the bankruptcy code requires a debtor be insolvent, and under Delaware law (and the specific SPE operating agreements), the managers of an LLC have a fiduciary obligation to consider the interests of the equity owners of the company. The court further held that the sponsor had not acted improperly when it terminated the independent managers of the SPEs because nothing in the SPE operating agreements prohibited them from doing so. Accordingly, lenders should be mindful about the discretion the sponsor has to terminate independent managers and should ensure the SPE's organizational documents clearly provide that the independent managers cannot be terminated without the lender's consent.
2. Golden Share" Approach
Several recent cases make clear that lenders should not rely on obtaining a nominal "golden share" membership unit to block a bankruptcy filing. For example, in In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016), a creditor moved to dismiss a SPE-debtor's bankruptcy case based on lack of appropriate authorization. In connection with executing a forbearance agreement, the creditor had negotiated for and obtained a single membership unit in the SPE and an amendment to the SPE operating agreement requiring a unanimous vote of members to commence a bankruptcy proceeding. The court denied the motion, holding that "[a] provision in a limited liability company governance document obtained by contract, the sole purpose and effect of which is to place into the hands of a single, minority equity holder the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor-not equity holder-and which owes no duty to anyone but itself in connection with an LLC's decision to seek federal bankruptcy relief, is tantamount to an absolute waiver of that right, and, even if arguably permitted by state law, is void as contrary to federal public policy." Similarly, in In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016) (applying Michigan law), a lender moved to dismiss a SPE-debtor's bankruptcy case as having been filed without authorization because the lender, as a "special member" of the debtor, had not consented to the bankruptcy filing, as required under the debtor's organizational documents. The bankruptcy court denied the motion holding that the consent provision was void as against public policy under Federal law because it was essentially a bankruptcy waiver. The court noted specifically that the lender's "special" membership interest did not entitle lender to any interest in the profits or losses of the debtor, did not allocate any tax consequences or distributional rights to the lender, and did not require any capital contributions. The court further noted and ultimately found determinative the fact that the operating agreement specifically stated that the special member had "no duty or obligation to give any consideration to any interest of or factors affecting the Company or the Members." The court ultimately held that a blocking member/director provision will be invalid unless the blocking member/director retains normal fiduciary obligations such that it may vote in favor of a bankruptcy filing even if such filing is not in the best interests of the creditor by which they were chosen. On the other hand, a lender can obtain blocking rights if it obtains a material equity position in the SPE. In In re Franchise Services of North America, Inc., 891 F.3d 198 (5th Cir. 2018) (applying Delaware law), a creditor/shareholder who owned $15 million of convertible preferred stock in the debtor moved to dismiss the debtor's bankruptcy case as having been filed without authorization. The bankruptcy court granted the motion to dismiss. Affirming, the Fifth Circuit distinguished In re Intervention Energy Holdings, LLC, noting the creditor here had taken a real equity interest in the company, not just a nominal interest, and "there is no compelling federal law rationale for depriving a bona fide equity holder of its voting rights just because it is also a creditor of the corporation." These cases make clear that lenders cannot simply rely on magic words in operating documents to prevent an SPE from filing for bankruptcy. They must, instead, ensure that they either take a real equity interest in the SPE to block a bankruptcy filing or that they have control over the selection and replacement of one or more independent managers of the SPE.
B. Criteria for Considering a Limited Liability Company Bankruptcy Remote
Given the primacy of bankruptcy remote entities in structured finance, ratings agencies have developed criteria by which they assess whether a special purpose entity is sufficiently bankruptcy remote to warrant a high credit rating. Ratings agencies generally consider entities that exhibit the following criteria as bankruptcy remote.
1. SPE Purpose and Operations
- The SPE is only authorized to engage in a limited scope of business consistent with the purpose of the loan or security offering and may only conduct business activities necessary for or incidental to achieving that purpose.
- The SPE is strictly prohibited from incurring additional debt outside of the ordinary course of the SPE's business.
- The SPE's business is kept separate from that of its sponsor and the SPE is required to:
- Maintain an arm's length relationship with its sponsor, parent, and affiliates;
- Conduct its business in its own name, hold itself out as a separate entity, including by proactively correcting any confusion regarding its name, and observe all corporate formalities;
- Maintain separate books and records;
- Maintain separate accounts and not commingle assets with any other entity;
- Maintain separate financial records;
- Maintain adequate capital in light of its contemplated business operations.
- Pay its own liabilities from its own funds, including retaining and paying sufficient employees in its own name;
- Not guarantee any debts or liabilities of any other entity; and
- Allocate expenses shared with affiliates in a fair and reasonable manner.
2. Amendments to SPE Organization Documents
- The SPE's organizational documents prohibit the sponsor or parent from amending the organizational documents while the indebtedness is outstanding without the lender's consent.
3. SPE Management and Control
- The SPE has a at least one manager that is independent from the sponsor and that has consent rights with respect to the following decisions:
- Filing a bankruptcy or insolvency proceeding;
- Dissolving, liquidating, merging, or selling material or all assets of the SPE;
- Engaging in any new business activities; and
- Amending the SPE's organizational documents.
As established in the case law discussed above, courts are reluctant to enforce independent member or manager consent provisions that allow the independent manager essentially to ignore the best interests of the SPE in favor of the interests of a creditor. Accordingly, the organizational documents should either retain normal fiduciary obligations for the independent manager or simply be silent on the issue. Given that, the selection of the independent manager is critical. The SPE's organizational documents should prohibit the SPE's parent or sponsor from firing or replacing the independent manager selected by the lender. Importantly, the organizational documents should also prohibit the SPE from taking any restricted actions while the independent manager position is vacant, until lender has had the opportunity to select a replacement independent manager. While the presence of these characteristics should provide comfort to lenders that the likelihood of the SPE filing bankruptcy without lender's consent will be remote, lender should engage in ongoing due diligence over the life of the loan to ensure that the SPE's parent is abiding by these provisions in practice.
In connection with preparing for an increase in borrower bankruptcies, lenders have several tools at their disposal. Knowing how to use these tools and how courts have viewed various approaches to control will be critical to how lenders will survive the challenges to their financing structures.
1 See In re Franchise Services of North America, Inc., 891 F.3d 198 (5th Cir. 2018).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.