special purpose entities in real estate transactions...
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Presenting a live 90-minute webinar with interactive Q&A
Special Purpose Entities in Real Estate
Transactions: Structuring and Documentation Mastering Separateness Provisions, Single Member LLCs, Recycled Entities,
Independent Directors and Non-Consolidation Opinions
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
WEDNESDAY, JANUARY 4, 2017
Samuel R. Arden, Partner, Hartman Simons & Wood, Atlanta
Whalen Kuller, Senior Counsel, Hartman Simons & Wood, Atlanta
John H. Lewis, Senior Counsel, Hartman Simons & Wood, Atlanta
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SPECIAL PURPOSE ENTITIES IN
REAL ESTATE TRANSACTIONS:
STRUCTURING AND
DOCUMENTATION
January 4, 2017
Sam Arden
Whalen Kuller
John Lewis
Introduction:
What is an SPE
• “Single purpose,” “special purpose” and “bankruptcy
remote” are interchangeable in the context of a structured
or securitized commercial real estate loan transaction
• Important differences between a single-purpose entity and
a bankruptcy-remote entity
6
Introduction:
What is an SPE
• Single-purpose entity refers to a corporation, limited
partnership or limited liability company formed under laws
of a particular state
• Organized for a narrow, specific or temporary purpose
• Vast majority are used in connection with real estate
financing transactions
7
Introduction:
What is an SPE
• Not all single-purpose entities are bankruptcy-remote
entities
• Bankruptcy-remote entity is always a single-purpose
entity
• Has additional characteristics that a single-purpose entity
does not have
8
Introduction:
What is an SPE
• SPEs feature some measure of “bankruptcy remoteness”
• Nationally recognized rating agencies require a single-
purpose entity also be bankruptcy-remote
• Will have features that reduce the availability of assets to
satisfy creditors
9
Introduction:
What is an SPE
• Typical SPE is bankruptcy-remote in two primary ways
o SPE is structured and formed to render it less likely that the SPE’s
assets will be made available to creditors of the originating entity
o SPE is structured to render it less likely that the SPE itself will become a
debtor in a bankruptcy proceeding
10
Introduction:
What is an SPE
• A bankruptcy-remote entity is not a bankruptcy-proof
entity
• A bankruptcy-remote entity cannot be prohibited from
seeking Bankruptcy Code protection
11
Introduction:
What is an SPE
• When structuring a bankruptcy-remote entity, the goal is
to reduce the likelihood that the entity will
o File a voluntary bankruptcy action
o Become insolvent
o Have an involuntary bankruptcy action filed against it
• All major rating agencies require a single-purpose entity
be bankruptcy-remote
12
Introduction:
When is an SPE Required
• Used in a variety of commercial loans issuances and
mezzanine financings
• If destined for pooling with other commercial real estate
loans for a CMBS issuance, certain rating agency criteria
may apply
13
Introduction:
When is an SPE Required
• Loans not subject to rating agency criteria, lenders still
require the borrower to meet rating agency criteria
• Smaller loans, some lenders may not require an SPE at
all, or may require an SPE meets only some SPE
requirements
• Commercial real estate loans over a certain monetary
threshold amount are subject to SPE lending strictures
14
SPE Formation and Structure:
• The type of entities most frequently used in rated
commercial mortgage transactions are:
o Limited liability companies (“LLCs”)
o Corporations and limited partnerships
15
SPE Formation and Structure:
• Depending on the size of the loan transaction, one or
more members of an SPE will need to be an SPE
• Also must comply with most or all of the single-purpose
and bankruptcy-remote requirements
• An SPE that is organized as a Delaware, single-member
LLC will not be required to have its sole member be an
SPE
16
SPE Formation and Structure:
• At least one member of the SPE holding a meaningful
economic interest will be required be an SPE
• Chief concern is that the bankruptcy or insolvency of non-
SPE members may precipitate the bankruptcy or
insolvency of the SPE
• At least one member of the SPE that is itself an SPE
reduces such risk
17
SPE Formation and Structure:
Delaware
• Delaware is the preferred state of choice for formation of
the SPE
• Rating agencies have a favorable view of Delaware law
18
SPE Formation and Structure:
Delaware
• Reputation as a preeminent jurisdiction for entity
formation is well-deserved
• Delaware LLCs are popular for structured finance and
securitization transactions
19
SPE Formation and Structure:
Delaware
• Advanced state of its law
• Statutory laws governing business entities are continually
updated and market concerns are addressed
• Also has a wealth of judicial decisions
20
SPE Formation and Structure:
Delaware
• Appealing because it does not aggressively tax non-
Delaware source income
• Delaware LLC statutes piggyback on federal tax rules
• Most LLCs can issue interests without requiring a capital
contribution
21
SPE Formation and Structure:
Delaware
• Business-friendly state government is attractive to
businesses
• Legislature and Governor have demonstrated a
willingness to understand and be responsive to the needs
of business
22
SPE Formation and Structure:
Single-member LLCs
• If the SPE is organized as a single-member Delaware
LLC, its sole member will not be required to be an SPE
• The SPE will be “disregarded” for federal and state
income tax purposes
• An LLC provides flexibility
23
Specific SPE Provisions
• SPE’s organizational documents required to include
certain provisions, such as:
o Restrictions intended to limit or eliminate the ability of an SPE from
incurring liabilities to be included as part of the loan transaction
o Restrictions intended to insulate the SPE from liabilities
o Restrictions intended to protect the SPE from dissolution risk
o Restrictions intended to limit a solvent SPE from filing a bankruptcy
petition
24
Specific SPE Provisions:
Single-Purpose Provisions
• SPE’s objects and powers are restricted as closely as
possible
• Purpose is to reduce the SPE’s risk of insolvency due to
claims created by activities unrelated to the securitized
assets
25
Specific SPE Provisions:
Single-Purpose Provisions
• SPE should not engage in unrelated business activities
• By requiring a limited purpose, lenders limit the potential
pool of creditors and other operational risks
• Purpose of the SPE should be limited in: o The transaction documents
o The organizational documentation of the SPE
• Nature of the limitation will depend on the SPE’s role in
the transaction
26
Specific SPE Provisions:
Single-Purpose Provisions
• SPE’s organizational documents are the preferred locus
because:
o Documents are publicly available and provide public notice of the
restriction
o An organic restriction is less likely to become lost in the organizational
files
27
Specific SPE Provisions:
Debt Limitations
• SPE will be prohibited from o Incurring any other debt, except a limited amount of trade payables
o Granting any liens on its assets
• The lender will consider any fees, expenses, indemnities,
and other payment obligations required to be made by the
entity in question
28
Specific SPE Provisions:
Debt Limitations
• Lenders will allow additional debt if o The additional debt is fully subordinated to the lender’s debt and is
nonrecourse to the SPE or any of its assets
o Does not constitute a claim against the SPE
• Purpose is to minimize the likelihood that the SPE will be
put into bankruptcy by its creditors
29
Specific SPE Provisions:
Merger, Reorganization, Etc.
• The SPE’s organizational documents and the loan
documents include provisions prohibiting the SPE from:
o Consolidating or combining with another entity
o Liquidating or winding-up
o Merging or selling all or substantially all of its assets
o Amending the provisions of the SPE’s organizational documents
30
Specific SPE Provisions:
Merger, Reorganization, Etc.
• The lender will have certain rights under the SPE’s
organizational documents relating to:
o Amendments to the SPE’s organizational documents as they relate to its
bankruptcy remoteness
o Equity transfers in the SPE
o Third-party beneficiary rights to enforce the bankruptcy-remote
provisions
31
Specific SPE Provisions:
Merger, Reorganization, Etc.
• Lender should not be given rights to vote for a voluntary
bankruptcy proceeding
• Not unusual for the lender to have substantial input
regarding removal and appointment of SPE’s independent
directors and criteria
• Changes to the criteria are often subject to lender consent
or approval
32
Specific SPE Provisions:
Pledge of all Assets
• Loan documents require that all of the SPE’s assets be
pledged to secure the SPE’s debt
• None of the SPE’s assets should remain unpledged
33
Specific SPE Provisions:
Separateness Provisions
• Organizational documents contain certain provisions,
called separateness provisions or separateness
covenants
• Intended to ensure its managers, members, directors and
other controlling persons operate the SPE as a separate
legal entity
• Loan documents will have representations from the SPE
34
Specific SPE Provisions:
Separateness Provisions
• Separateness provisions to protect against a substantive
consolidation
• Bankruptcy Code - the equitable principle of substantive
consolidation provides if the activities of two entities are
so entwined, the court may combine assets and liabilities
of two or more entities
• Creditors of the consolidated entities would share in the
pooled assets
35
Specific SPE Provisions:
Separateness Provisions
• Language of the separateness provisions varies from
lender to lender but generally includes requirements that
the SPE:
o Maintain books and records separate from any other person or entity
o Maintain its accounts separate from those of any other person or entity
o Not commingle assets with those of any other entity
o Conduct its own business in its own name
o Maintain separate financial statements
36
Specific SPE Provisions:
Separateness Provisions
• Language of the separateness provisions varies from
lender to lender but generally includes requirements that
the SPE:
o Pay its own liabilities out of its own funds
o Observe all corporate, partnership, or LLC formalities
o Maintain an arm’s-length relationship with its affiliates
o Pay the salaries of its own employees and maintain a sufficient number
of employees
37
Specific SPE Provisions:
Separateness Provisions
• Language of the separateness provisions varies from
lender to lender but generally includes requirements that
the SPE:
o Not guarantee or become obligated for the debts of any other entity or
hold out its credit as being available to satisfy the obligations of others
o Not acquire obligations or securities of its partners, members, or
shareholders
o Allocate fairly and reasonably any overhead for shared office space
o Use separate stationery, invoices, and checks
38
Specific SPE Provisions:
Separateness Provisions
• Language of the separateness provisions varies from
lender to lender but generally includes requirements that
the SPE:
o Not pledge its assets for the benefit of any other entity or make any
loans or advances to any entity
o Hold itself out as a separate entity
o Correct any known misunderstanding regarding its separate identity
o Maintain adequate capital in light of its contemplated business
operations
39
Springing and Special Members
• An SPE should be formed in a state such as Delaware
whose law that provides that bankruptcy of a member or
owner does not cause the SPE to terminate or dissolve
• Done in part by creating the role of the springing member
under the operating agreement
40
Springing and Special Members
• Springing member is a person who has agreed to become
a special member automatically upon the happening of
the event specified in the operating agreement
• Before becoming a special member, is not a member of
the LLC and has no LLC interest
41
Springing and Special Members
• Special member is a member solely for the purpose of
preventing the SPE from terminating for lack of any
members
• Has no interest in the profits, losses and capital of the
SPE
• Has no right to receive any distributions of the SPE's
assets
42
Springing and Special Members
• Is not required to make any capital contributions to the
SPE
• Does not receive an LLC interest in the SPE
• Has no power or authority to act for or bind the SPE
• No right to vote on, approve or otherwise consent to any
action by the SPE
43
Independent Directors
• Primary purpose is to approve or disapprove a borrower’s
bankruptcy filing
• Borrower must have the approval of one or more
independent directors to have sufficient authority to file for
bankruptcy
• Lenders require borrowers to use independent directors to
ensure an SPE borrower is bankruptcy-remote
44
Independent Directors
• Appointing an independent director limits a borrower’s
ability to take certain actions
• An independent director helps insulate against the risk
that the shareholders, members, partners, directors or
managers will control the borrower
45
Independent Directors
• Provisions require the independent director or manager to
affirmatively vote before a voluntary bankruptcy petition is
authorized
• Consent may also be required in other circumstances
• Provisions are enforceable if properly structured under the
laws of the State of Delaware
46
Independent Directors
• Lenders require SPEs to have two independent directors
• Requiring the consent of two separate, independent
individuals exercising their fiduciary or contractual duties
47
Independent Directors
• Independent directors may consider the economic
interests of the lender before consenting to a voluntary
bankruptcy proceeding
• The LLC’s organizational documents cannot eliminate the
implied contractual covenant of good faith and fair dealing
implicit in contracts
48
Independent Directors
• Typical qualifications for an independent director are one
who has not been:
o A direct or indirect legal or beneficial owner in the SPE
o A creditor, supplier, employee, officer, director, family member, manager,
or contractor of the SPE
o A person who controls the SPE
49
Independent Directors
• Must be employed by and engaged by the SPE to qualify
• Engaged by the SPE by entering into an “Independent
Director Agreement”
• Agreement provides for the annual compensation to be
paid to the independent director
• Cost of an independent director ranges from under $1,000
to $2,500+ per entity per year
50
Recycled Entities
• Lender requires its SPE borrower to be a new entity
formed before the transaction
• Limits the risk that any prior activity undertaken by the
borrower could be a basis for consolidating the borrower
with any other entity
51
Recycled Entities
• An advantage of a newly created vehicle for each new
transaction is the assurance that the entity has no prior
history of dealings or disguised liabilities
• Unlikely there would be claims if SPE is created prior to
its use in the loan transaction
• If not newly created, a pre-existing liability of the entity
may result in a lawsuit
52
Recycled Entities
• If a pre-existing entity is used, and not an SPE, it is known
as a “recycled entity”
• If the lender allows the borrower to be a recycled entity,
the lender typically o Reviews all past iterations of the borrower’s organizational documents
o Requires backward-looking representations and warranties
o A certification by an appropriate officer of the entity
o An accounting audit
o Proof of compliance with environmental standards
o Applicable legal comfort
53
Recycled Entities
• Officer’s certificate includes the following regarding the
entity: o Duly formed, validly existing, and in good standing in the state of its
formation
o No judgments or liens of any nature against it
o In compliance with all laws, regulations, and orders applicable to it and
has received all permits necessary for it to operate
o Not aware of any pending or threatened litigation
o Not involved in any dispute with any taxing authority
o Has paid all taxes
54
Recycled Entities
• Officer’s certificate includes the following regarding the
entity: o Never owned any property other than the property that is the subject of
the current transaction and has never engaged in any business except
the ownership and operation of such property
o Never been party to any lawsuit, arbitration, summons, or legal
proceeding
o Provided the lender with complete financial statements
o Has conducted a Phase I environmental audit
o Has materially complied with the separateness covenants referred to in
such opinion since its formation
o Has no material contingent or actual obligations not related to the
mortgaged property
55
Recycled Entities
• An accounting audit should confirm the substance of the
representations and warranties in the officer’s certificate
• Legal opinions will be required
o Legal opinion confirming the relevant representations and warranties
o Non-consolidation opinion containing no assumptions with respect to
the entity’s prior conduct
• If the entity holds real property, lender may request a copy
of the Phase I environmental audit
56
Substantive Consolidation:
General Background
• Substantive consolidation involves combining assets of
multiple entities for purposes of addressing creditor claims
in bankruptcy
• This doctrine must be distinguished from procedural
consolidation
• The doctrine arises under general equitable powers of the
bankruptcy court-Section 105 of the Bankruptcy Code
57
Substantive Consolidation:
General Background
• There is no specific statutory authority
• The doctrine involves a fact-intensive inquiry on a case-
by-case basis
• The general rule is that the application of the doctrine
should be limited but a more modern approach has
expanded the application
58
Substantive Consolidation:
Case Law analysis
• In re Vecco Constr. Indus., 4. B.R. 407 (Bankr. E.D. Va
1980)- This court set out an “elements test” that provided
seven factors to analyze regarding borrower and related
entities such as commingling of assets and consolidated
financial statements.
• In re Augie/Restivo Baking Co., Ltd., 860 F.2d 515 (2d Cir.
1988)-Found the two critical considerations are whether
creditors dealt with the entities at issue as one entity and
if the affairs of the debtor are so entangled that
consolidation will have a broad benefit.
59
Substantive Consolidation:
Case Law analysis
• In re Eastmont Properties v. Southern Motel Assoc., Ltd.,
935 F.2d 945 (11th Cir. 1991)- Found that the essential
inquiry is whether the economic prejudice of allowing the
entities to continue to receive separate treatment
outweighs the prejudice arising from consolidation.
• In re Owens Corning, 419 F.3d 195 (3d Cir 2006)-
Criticizing the rigid application of an elements test and
finding that a proponent of consolidation must show that
the borrower and related entities disregarded
separateness to such an extent that creditors viewed and
treated them as one entity. 60
Substantive Consolidation:
Specific Factors and Considerations
• Commingling of assets
• Inadequate record keeping
• Difficulty in separating assets of the entities
• Overlapping operations
61
Substantive Consolidation:
Specific Factors and Considerations
• Failure to observe corporate formalities
• The benefits of consolidation
• The prejudice to the creditor opposing consolidation
• Impact upon a successful Chapter 11 plan
62
Questions? Sam Arden
sam.arden@hartmansimons.com
770.951.6590
Whalen Kuller
whalen.kuller@hartmansimons.com
770.951.6586
John Lewis
john.lewis@hartmansimons.com
770.951.6571
63
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