1.1 Insolvency Laws
If a debtor becomes subject to bankruptcy proceedings, creditors will, with some exceptions, be automatically stayed from collecting and enforcing against the debtor and any posted collateral. Lifting the stay may be time consuming and costly, and subject to the broad statutory and equitable powers of the bankruptcy court. The court also has the power to:

  • release the creditors' rights to excess collateral;
  • allow additional debt to be secured by the collateral;
  • substitute collateral; and
  • reject executory contracts.

Creditors may also be restricted from exercising rights that trigger off a debtor's bankruptcy or financial condition (so-called ipso facto clauses). Unlike many other jurisdictions where bankruptcy effectively amounts to liquidation proceedings, bankruptcy proceedings in the USA also encompass a workout regime (Chapter 11 bankruptcy). Workouts are highly variable and facts and circumstance specific, which makes it difficult to predict the duration of the stay and the impact on a particular creditor.

Consequently, a key aspect of securitisations is to isolate the issuer and its assets from such bankruptcy risks by:

  • transferring the securitised assets to the issuer in a perfected true sale;
  • reducing the risk of the issuer becoming subject to involuntary or voluntary bankruptcy proceedings; and
  • reducing the risk of the issuer becoming substantively consolidated with any affiliates should they become subject to bankruptcy proceedings. 

As an alternative to a true sale structure, it is also possible to transfer exposure to the securitised assets using contracts that are protected against the most troublesome bankruptcy powers.

1.2 Special-Purpose Entities (SPEs)
Establishing a bankruptcy-remote special-purpose entity (SPE) is a key aspect of a typical securitisation transaction.

The transaction documents typically include non-petition clauses that restrict involuntary bankruptcy filings against the issuer.

However, an outright prohibition against the SPE itself voluntarily filing for bankruptcy is unenforceable as against public policy and such risk must therefore be mitigated by more indirect means. Limiting the SPE's unrelated activities and restricting the SPE from having employees and unrelated property reduces the risk of unrelated liabilities. Appointing an independent director whose fiduciary duty runs to the SPE and not to its shareholders, and employing an entity type that allows for such redirection of fiduciary duties reduces the risk of a filing for the benefit of its shareholders.

The independent director(s) also provide(s) important protection against dissolution of the SPE, in part by requiring such director's participation in a dissolution decision and in part by providing that such independent director becomes a "springing member" or "springing partner" if the absence of a member or partner would cause dissolution. The number of independent directors should be at least equal to the minimum number of members or partners required to continue the SPE's existence.

Substantive consolidation is an equitable doctrine that permits a bankruptcy court to disregard the separateness of an entity that itself is not otherwise in bankruptcy and that provides an alternative pathway for an SPE to become entangled in its affiliate's bankruptcy proceedings. Although the analysis differs somewhat between various US circuits, in general a bankruptcy court may order substantive consolidation where the separateness of the entities has not been sufficiently respected or where the affairs of the debtor entities are so entangled that unscrambling will be prohibitive and hurt all creditors.

Multi-factor Analysis
Under older practice, which still applies in some circuits, the courts may rely on a multi-factor analysis. Consequently, the risk of substantive consolidation is generally addressed by requiring the SPE and its credit to be separate from its affiliates based on factors that speak for substantive consolidation identified in the case law. One list of such factors is collected in the Tenth Circuit opinion of Fish v East, 114 F2d 117 (10th Cir 1940):

  • the parent corporation owns all or a majority of the capital stock of the subsidiary;
  • the parent and subsidiary corporations have common directors or officers;
  • the parent corporation finances the subsidiary;
  • the parent corporation subscribes to all the capital stock of the subsidiary or otherwise causes its incorporation;
  • the subsidiary had grossly inadequate capital;
  • the parent corporation pays the salaries or expenses or losses of the subsidiary;
  • the subsidiary has substantially no business except with the parent corporation or no assets except those conveyed to it by the parent corporation;
  • in the papers of the parent corporation and in the statements of its officers, the subsidiary is referred to as such or as a department or division;
  • the directors or executives of the subsidiary do not act independently in the interest of the subsidiary but take direction from the parent corporation; and
  • formal legal requirements of the subsidiary as a separate and independent corporation are not observed.

A second commonly cited list of such factors appears in the case of in re Vecco Constr Indus 4 BR 407, 410 (Bankr ED Va 1980):

  • degree of difficulty in segregating and ascertaining individual assets and liabilities;
  • presence or absence of consolidated financial statements;
  • profitability of consolidation at a single physical location;
  • commingling of assets and business functions;
  • unity of interests and ownership between the various corporate entities;
  • existence of parent or intercorporate guarantees or loans; and
  • transfer of assets without formal observance of corporate formalities.

An additional factor, articulated by the Fourth Circuit Court of Appeals in Stone v Eacho, 127 F2d 284, 288 (4th Cir 1942), has also been cited by a number of cases, namely whether "by... ignoring the separate corporate entity of the [subsidiaries] and consolidating the proceeding... with those of the parent corporation... all the creditors receive that equality of treatment which is the purpose of the bankruptcy act to afford."

The presence or absence of some or all of these factors does not necessarily result in substantive consolidation. In fact, many of these elements are present in most bankruptcy cases involving holding company structures or affiliated companies without thereby leading to substantive consolidation. Various courts have noted that some factors may be more important than others; in particular, the "consolidation of financial statements", "difficulty of separating assets", "commingling of assets" and "profitability to all creditors".

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Originally published by Chambers Global Practice Guides.

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.