non-recourse carve outs, bad-boy guaranties, and personal...
TRANSCRIPT
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Presenting a live 90-minute webinar with interactive Q&A
Non-Recourse Carve Outs, Bad-Boy
Guaranties, and Personal Liability:
Latest Developments Strategies to Avoid or Resolve Lender and Guarantor Disputes in and Outside of Bankruptcy
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
WEDNESDAY, DECEMBER 3, 2015
Thomas W. Coffey, Senior Counsel, Tucker Ellis, Cleveland
Paul S. Magy, Member, Clark Hill, Birmingham, Mich.
James H. Schwarz, Partner, Benesch Friedlander Coplan & Arnoff, Indianapolis
Daniel K. Wright, II, Member, Tucker Ellis, Cleveland
NON-RECOURSE CARVE-OUTS, "BAD BOY"GUARANTIES, AND PERSONAL LIABILITY AFTER
CHERRYLAND
Strafford live webinarsThursday, December 3, 20151:00 p.m. to 2:30 p.m. EST
By
Daniel K. Wright, II, Esq.Member, Real Estate Group
Tucker Ellis LLP950 Main Avenue, Suite 1100Cleveland, OH 44113-7213
and
Thomas W. Coffey, Esq.Chair, Bankruptcy Group
Tucker Ellis LLP950 Main Avenue, Suite 1100Cleveland, OH 44113-7213
and
Paul S. Magy, Esq.Member
Clark Hill, PLC151 S. Old Woodward, Suite 200
Birmingham, MI 48009248-642-9692
and
James H. Schwarz, Esq.Partner
Benesch Friedlander Coplan & Arnoff LLPOne American Square, #2300
Indianapolis, IN 46282317- 685-6127
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TABLE OF CONTENTS
I. General Outline 1
II. Case StudyA. Fact Pattern 4
B. Table of Authorities 12
C. Diagram of Typical CMBS Transaction 13
D. Structure Chart — New Market Center, LLC 14
E. Site Plan — New Market Center 15
F. Pro Forma — Before and After 16
III. Non-Recourse Carve-Outs and How to Deal with Them by James H. Schwarz, Esq. 17
IV. Michigan's Legislature Declares Post-Closing Solvency Covenants Unenforceable asNon-Recourse Carve-Outs by Paul S. Magy, Esq 25
A. Michigan Non-Recourse Mortgage Loan Act, Enrolled Senate Bill No. 992effective March 29, 2012 27
B. Excerpt from Standard & Poor's Structured Finance Ratings Real Estate FinancePublished in 1994 28
C. Excerpt from Standard & Poor's U.S. CMBS Legal and Structured FinanceCriteria, Publication Date: May 1, 2003. 35
V. Substantive Consolidation in Bankruptcy: A Primer for Real Estate Lawyers by ThomasW. Coffey, Esq. and Daniel K. Wright, II, Esq. 41
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General Outline
I. Introductions and overview of presentation
II. "Springing Recourse" and "Bad-Boy" Guaranties — Wells Fargo Bank, N.A. v.Cherryland Mall Limited Partnership, et al. — Paul S. Magy, Esq.
A. Basic Facts and Procedural History1. Separateness covenants2. Limited Recourse Provisions
B. Analysis1. Suit on the Mortgage2. Suit for Deficiency under the Promissory Note3. Guaranty
C. Single-Purpose Entity/Separateness — Requirements and Violations1. Limitations on the purpose of the SPE2. Restrictions on additional indebtedness3. Prohibitions on consolidation and liquidation; restrictions on mergers and
asset sales4. Prohibitions on amendments to organizational documentation5. Separateness covenants6. Impediments to filing a bankruptcy petition (independent director)
D. Definition of "Single Purpose Entity"1. Integration Clause2. Headings/Captions to be Given No Effect3. No definition of "SPE"/Need for Extrinsic Evidence4. Standard and Poor's U.S. CMBS Legal and Structured Finance Criteria —
October, 2002E. Substantive Consolidation in BankruptcyF. Cases Relied Upon
1. LaSalle Bank, N.A. v. Mobile Hotel Props, LLC2. Blue Hills Office Park LLC v. J.P. Morgan Chase Bank3. Wells Fargo Bank Minnesota, N.A. v. Leisure Village Assoc.
G. Michigan and Ohio LegislationH. Conclusion
1. Issues Raised by this Decision(a) Interpretation(b) Why would a borrower or guarantor agree to full recourse upon
insolvency? Isn't that a recourse loan?(c) Chilling effect of the Lenders, CMSA's and MBA's course of
action(d) Alternatives to CMBS?
I. Borman LLC v. 18718 Borman, LLC
III. Non-Recourse Carve-Outs — James H. Schwarz, Esq.
A. Laundry List of Carveouts from A to Z
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1. Erosion of Collateral2. Destruction of Collateral3. Allocation of External Risks4. Preventing Additional Investment by the Lender5. Behavior Control
B. Environmental Indemnities1. Violations of Environmental Laws2. Who Gets the Benefit of the Indemnity3. Indemnification4. Carveout from Indemnity5. Termination of Indemnity
C. Recent Case Law Concerning Non-Recourse Loans1. Heller Financial2. Penn Mutual3. Travelers Insurance4. Blue Hills
D. Other Protective Devices1. Bankruptcy Remote. Entity2. Cash Management Agreement
E. Tax Implications and Non-Recourse DebtF. ConclusionG. Sample Provisions
1. Borrowers Broad Exculpation2. Lenders Narrow Exculpation
IV. Case Study
V. Bankruptcy Perspective — Thomas W. Coffey, Esq.
A. Best Case — Conclude a successful plan of reorganization whereby the remainingfirst mortgage debt is amortized over an extended period, but at a (lower) marketinterest rate
B. Worst Case — Provide for an orderly liquidation in bankruptcy, thus avoiding adistress sale at foreclosure. A liquidation in bankruptcy will (in theory) providefor better market exposure and a disposition under better conditions, yielding ahigher sales price (and a lower deficiency claim against the guarantors)
C. Immediate Benefits1. Stops a foreclosure sale — the borrower gains time to re-tenant and
refinance the property2. Gives the borrower more control over the future of the property3. Postpones the establishment of a deficiency against the guarantors
D. Impediments to Reorganization1. The "bankruptcy remote" provisions in the borrower's organizational
documents2. Relatively few creditors/lack of an "impaired accepting class" of creditors
who are not insiders
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E. Possible Actions1. Standing: Determine if the REMIC Trustee "holds" the original
promissory note and guaranty. The borrower does not want to pay twice!2. Amend organizational documents3. Obtain a loan to:
(a) Create a small but independent "impaired accepting class"(b) Fund shortfall in cash flow to pay interest due the mortgagee
during the Chapter 11 proceedingF. Future Benefits
1. Obtain control of escrows held by the servicer2. Court intervention in leasing process to obtain approval of leases and/or
improve procedure for leasing and funding of tenant work3. "Term our existing indebtedness (at least three years)4. Reduce the interest rate to a (lower) market rate
(a) Resulting reduction in debt service/increase in cash flow.5. Right to prepay at any time without penalty or premium6. Negotiated resolution of guaranty issues7. Negotiated resolution of default interest, late fees, attorneys' fees, and
other amounts8. Reinstatement of the loan9. Mutual covenant not to sue — a fresh start10. No adverse tax consequences11. Preservation of the borrower's ability to file a second bankruptcy
G. Bring the Mortgagee to the Table1. "Cram down" will be objectionable to the mortgagee
VI. Conclusion — What have we learned?
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CASE STUDY
Borrower
New Market Center, LLC, a Delaware limited liability company (the "Borrower"),developed a strip center known as New Market Center in Hometown, Ohio in 2001 (the"Center"). Borrower is structured as a single purpose "bankruptcy remote" entity. Its solemanaging member is New Market Center, Inc., a Delaware corporation ("Manager"), the soleshareholders of which are John Doe (50%) and Richard Roe (50%). Doe and Roe are also thesole directors; the lender did not require a third independent director. The other members are asdepicted on the attached structure chart.
Governing Documents
The governing documents of Borrower and Manager permit Borrower to commence acase under Chapter 11 of the U.S. Bankruptcy Code with the unanimous consent of all membersof Borrower and all directors of Manager, respectively.1
Material amendments to these governing documents are prohibited without (a) theapproval of the first mortgage holder, and (b) a "no downgrade letter" from the applicable ratingagencies.2
The governing documents also prohibit the Borrower from incurring any indebtednessexcept for (a) the first mortgage, and (b) trade payables incurred in the ordinary course ofbusiness of operating the Center in amounts that are "normal and reasonable under thecircumstances".3
Shopping Center
New Market Center consists of approximately 62,821 square feet of gross leasable areaand includes the tenants indicated on the attached site/leasing plan.
Financing.
Borrower obtained a commitment for a permanent loan from BundesBank MortgageCapital, LLC dated October 11, 2001, amended November 3, 2001, and extended November 27and December 15, 2001. The loan was in the original principal amount of $5.5 million withinterest at the rate of 7.0% per annum for a period of 10 years and matured on December 31,2011. The amortization period is 30 years, and the current principal balance is approximately$4.8 million. The loan is non-recourse except for certain "bad boy carve-outs".
Borrower's principals, John Doe and Richard Roe, ("Guarantors") executed a joint andseveral personal guaranty relative to the loan. The guaranty was intended to be limited to the
1 How would things be different if there was an outright prohibition on filing a petition in bankruptcy?
2 How would things be different if the loan documents prohibited "any amendments" to the governing documents?
3 How would things be different if the loan documents prohibited "any and all debt other than the first mortgageloan"?
41868182.3
"bad boy carve-outs" in the non-recourse provisions contained in the loan documents (seebelow).
The loan was sold to a REMIC trust (i.e. "securitized") in early 2002. The trustee of thetrust ("Mortgagee") is J.P. Moneybags Bank, N.A. ("Trustee"). The servicer of this loan isBuffadia ("Servicer") and the special servicer is ABC Capital Asset Management LLC ("SpecialServicer").
Tenants
Short Circuit was an anchor tenant of the Center, occupying approximately 17,209 squarefeet of the 62,821 gross leasable square feet of the Center (or 27.3% thereof) until December,2009, when they ceased paying rent, filed for protection under the Bankruptcy Code, ceasedoperating, and vacated their store premises. This allowed the other anchor tenant of the Center,Old Army, to pay vastly reduced rent, all of which created a serious financial hardship forBorrower.
Guarantors have contributed substantial amounts of cash to Borrower throughout 2010and into 2011 to enable Borrower to pay all debt service payments to Servicer during thisdifficult period.
In October, 2010 the Borrower concluded a lease extension with an existing tenant of theCenter, Shoe Circus, LLC ("Shoe Circus"), for 12,150 square feet of GLA (19.27% of theCenter). This document included a co-tenancy provision requiring Old Army to occupy at least16,500 square feet in the Center. The existing Old Army lease expires in early 2012. Servicerapproved this document on behalf of Mortgagee. This is a key fact, as we shall see below.
In late 2011, Borrower negotiated a new 5-year business deal with Old Army forapproximately 17,000 square feet (or 27% of the total leaseable area) in the Center and presentedthe documentation to Mortgagee (in care of the Servicer) for approval, but Servicer has neverapproved or disapproved the new Old Army lease deal, despite repeated requests from Borrower,and despite the co-tenancy provision in the Shoe Circus, LLC lease, which Servicer approvedjust months before, thus causing a failure under the co-tenancy provision in the Shoe Circuslease.
In early 2011, Borrower also negotiated a letter of intent for a new 10-year lease withBetty Ann's Fabric Warehouse for the entire 17,209 square feet of space that was previouslyoccupied by Short Circuit and presented said documentation to Mortgagee (in care of Servicer)for approval, but Servicer has never approved or disapproved the Betty Ann Fabrics transactiondespite repeated requests from Borrower.
The Old Army and Betty Ann lease deals would provide a positive cash flow from theCenter for the foreseeable future, and would allow the Center to be refinanced by a life insurancecompany.
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Mortgage Provisions/Lease Approvals
The mortgage contains the following provision regarding approval of leases byMortgagee:
62. Leases.
(a) Mortgagor shall not enter into any Lease ("Major Lease") (i) greater than tenpercent (10%) of the gross leaseable area of the Improvements or 10,000 square feet of theMortgaged Property or (ii) with a term of ten (10) years or more without the prior writtenapproval of Mortgagee[, not to be unreasonably withheld, conditioned or delayed.]iMortgagor shall specifically request approval in writing and furnish such information asMortgagee shall reasonably require. Mortgagee shall approve or disapprove any such MajorLease within fifteen (15) business days after receipt of such written request and all requestedinformation.
Consequently, Mortgagee and/or Servicer has effectively brought the leasing ofapproximately 73.27% of the Center's GLA to a halt, destroying the cash flow and value of theCenter, and increasing the likelihood of a deficiency judgment in foreclosure and a claim underthe guaranty for damages.
Re-tenanting Costs
Borrower expects to have substantial re-tenanting costs on this project that could beupwards of $500,000. Servicer currently holds a "Leasing Reserve Escrow" of $480,000, but hasno obligation to (and will not) release any portion of the reserve to Borrower, even if the currentdefault is cured.
Trade Area Activity
Nippon Motor Company has recently broken ground on a major production facility inMarket Center's trade area. This will likely increase the value of New Market Centerdramatically, so there is substantial "upside" at the end of the rainbow . . . if Borrower can hangon to the Center. Otherwise, Mortgagee (or the purchaser at a foreclosure sale) may reap awindfall.
Sale of Adjacent Parcel
Borrower owned an adjacent 2 acre parcel of undeveloped land that is not included in thelegal description that is attached to the Market Center mortgage. Borrower sold this parcel to anunrelated third party in May, 2011 for $500,000 and immediately distributed all proceeds to itsmembers. On the date of sale, Borrower was not in default under the Market Center mortgage.
Special Servicer has asserted that although the adjacent 2 acre parcel was not included inthe legal description attached to the mortgage, the granting clause of the mortgage includes"appurtenances" and "proceeds" in the definition of "Mortgaged Property", and argued that the 2
4 What if the bracketed language was not present? What if this provision contained a "deemed approval" clause?
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acre parcel was an "appurtenance', the $500,000.00 received by Borrower upon sale constituted"proceeds", and that same constitute "Mortgaged Property" that are subject to the lien andsecurity interest created under the loan documents.
Special Servicer has further asserted that since the loan documents prohibit a transfer of"the Mortgaged Property or any part thereof or interest therein", the distribution of the proceedsof sale to the members of Borrower was a violation of the loan documents, that such distributionconstitutes "waste", and that the $500,000.00 must be returned to Borrower.
Finally, Special Servicer has claimed that Guarantors are liable for the amount of saiddistribution under paragraph l(f) of their Guaranty (see below).5
Promissory Note
The promissory note contains the following rider (part (b) applies after maturity onDecember 31, 2011):
"HYPER AMORTIZATION RIDER
Notwithstanding any other provision to the contrary contained in this Note:
(a) Maker shall have the right to prepay the entire principal balanceand all other amounts due ("Payoff without premium, on any Payment Datewithin three months prior to the Maturity Date.
(b) From and after the Maturity Date, interest shall accrue on theunpaid principal balance at a rate per annum equal to the Interest Rate plus two(2%) percentage points ("Revised Interest Rate"). Interest accrued at the RevisedInterest Rate and not paid pursuant to Section 4(a)(ii) of that certain CashManagement and Security Agreement, dated the date hereof, between Borrowerand Lender (the "Lockbox Agreement), shall be deferred and added to theprincipal balance of this Note and, if permitted by applicable law, shall earninterest at the Revised Interest Rate (such accrued interest is hereinafter referredto as "Accrued Interest). All of the unpaid principal balance of the Note,including any Account Interest, shall be due and payable on the date (the"Extended Maturity Date") which is the earlier to occur of (x) the twentieth(20th) anniversary of the Maturity Date or (y) the date on which theindebtedness including all interest and Accrued Interest is repaid to Payee fromfunds available in the Deposit Account pursuant to the Lockbox Agreement."(emphasis added)6
5 Compare this situation with the facts of Travelers Ins. Co. and Blue Hills.
6 How would things be different if the loan documents did not include this additional 20 year period following thematurity date?
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Loan Default
In light of the substantial and unsustainable financial burden imposed upon Borrower inthis situation (which was voluntarily absorbed by Borrower's principals during 2010 and intoearly 2011), and because of the failure and/or refusal by Mortgagee and Servicer to approve thenew Old Army and Betty Ann lease transactions, Borrower's principals were forced to re-evaluate the situation, and in late 2011 determined that it no longer made sense to continue theircontributions of capital to Borrower. Consequently, Borrower is unable to continue to pay thefull debt service to Mortgagee, but has remitted all net cash from the operation of the property toServicer in a timely manner.
Borrower has in good faith continued to manage the Center (without fee or charge), hasdirected the tenants to pay all rent and other charges directly to Special Servicer (which thetenants have done), and has otherwise fully cooperated with Mortgagee and Special Servicer.Borrower has asked whether its members must return the $500,000 distributed to them in May,2011.7
Because the full debt service due for the final months of 2011 has not been paid, theSpecial Servicer has become involved. Special Servicer is a "B Piece buyer" and owns some ofthe lower-rated tranches of debt in the subject REMIC trust (see the attached diagram illustratinga typical CMBS transaction).
In February, 2012, Special Servicer instructed its counsel to send a "Notice of Defaultand Acceleration" to Borrower and the Guarantors. Thereafter, Special Servicer's counselthreatened to file a Verified Complaint Requesting Appointment of Receiver, Injunctive Relief,and Other Equitable and Legal Relief in state court. However, because of the relatively smallsize of the loan, the cost of the receiver, the fact that all tenants had been instructed by Borrowerto pay their rent directly to the Special Servicer and are doing so, and that there are no realexpenses to be paid other than real estate taxes, insurance and electricity for the parking lotlights, this complaint has not yet been filed.8
Special Servicer has recently obtained an appraisal of Market Center that sets the value at$2.8 Million. Special Servicer has indicated that this will be Mortgagee's bid in foreclosure,and that Mortgagee will pursue a claim for a deficiency in the amount of $2.0 Million againstGuarantors.9
Deficiency Claim
The original loan commitment dated October 12, 2001 was for a "market rate,non-recourse" mortgage loan, and provides in pertinent part:
7 What factors affect how this question is answered? See Travelers Ins. Co.
8 How would things be different if Borrower had not cooperated (to a point) with Servicer and Mortgagee? SeeTravelers Ins. Co.
9 What bearing does the mortgagee's bid in foreclosure have on this situation? See Whitestone and Penn Mutual.Does it make a difference whether state law permits judicial or non-judicial foreclosure sales?
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14. Non-recourse: The loan shall be non-recourse except thatthe Borrower and its Key Principals shall berequired to provide guarantees against(a) misapplication of funds, (b) Borrower'sobligations for environmentalrepresentations, indemnities and covenants,(c) fraud and misrepresentation, and (d) thefiling of a bankruptcy proceeding withinnine (9) months after closing the Loan.
The loan commitment was revised (and extended) three times, but this provision wasnever changed.
The Guaranty provides in pertinent part as follows:
1. Indemnity and Guaranty. Guarantor (i) assumes liability for,(ii) guarantees payment to Lender of, (iii) agrees to pay, protect, defend, saveharmless and indemnity Lender from and against any and all liens, damages(including, without limitation, punitive or exemplary damages), losses, liabilities(including, without limitation, strict liability), obligations, settlement payments,penalties, fines, assessments, citations, claims, litigation, demands, defenses,judgments, suits, proceedings, costs and expenses of any kind whatsoever(including reasonable attorneys', consultants' and experts' fees and disbursementsactually incurred in investigating, defending, settling or prosecuting any claim orproceedings or enforcing any term of this Guaranty) (collectively "Costs") whichmay at any time be imposed upon, incurred by or asserted against Lender as aresult of the following "Indemnified Matters":
(a) Rent or other payments received from Tenants paid more than one(1) month in advance;
(b) Proceeds of insurance policies, condemnation or other taking notapplied in accordance with the Loan Documents;
(c) Rents, issues, profits, revenues of the Center and tenant securitydeposits relating to the Center received and applicable to a period after theoccurrence of an Event of Default or Default, which are not applied to theordinary and necessary expenses of owning and operating the Center or paid toLender;
(d) All obligations, requirements and indemnities of Borrower underthe Loan Documents relating to Hazardous Substances or compliance withEnvironmental Laws;
(e) Physical wastel°;
10 See Travelers Ins. Co.
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(f) Transfer of the Mortgaged Property or any part thereof or interesttherein in violation of the Loan Documents; and
(g) Fraud, material misrepresentation or failure to disclose a materialfact by Borrower or any of its principals, officers, general partners or members,any guarantor, any indemnitor. In addition, Guarantor hereby unconditionally andirrevocably guarantees payment of the entire Debt if any of the following occurs[within nine (9) months of the date hereof] :11 (i) a voluntary bankruptcy filing by,or an involuntary bankruptcy filing against, Borrower or any general partner ormanaging member or majority shareholder of Borrower; or (ii) the Centerbecomes an asset in any bankruptcy proceeding.
(h) This is a guaranty of payment and performance and not ofcollection. The liability of Guarantor under this Guaranty shall be direct andimmediate and not conditional or contingent upon the pursuit of any remediesagainst Borrower or any other person (including, without limitation, otherguarantors, if any), nor against the collateral for the Loan. In the event of aDefault, Lender shall have the right to enforce any and all rights, powers andremedies available to Lender which shall be non-exclusive and cumulative. If theindebtedness and obligations guaranteed hereby are partially paid or dischargedby reason of the exercise of any of the remedies available to Lender, thisGuaranty shall nevertheless remain in full force and effect, and Guarantor shallremain liable for all remaining indebtedness and obligations guaranteed hereby.Guarantor shall be liable for any deficiencies in the event the full amount ofthe Indebtedness owing under the Loan Documents is not received by Lenderafter the receipt of any payments or after foreclosure of the Mortgage.
Special Servicer now claims that the text set forth in bold above obligates the Guarantorsto pay any deficiency judgment that the Mortgagee may obtain.
Borrower and Guarantors initially thought that a mutual mistake occurred as to the termsof the Guaranty that are set forth in bold above, as these provisions of the Guaranty are atvariance with the provisions of the Loan Commitment.
Borrower and Guarantors now recall that (a) Guarantors demanded that the languagehighlighted in bold above be deleted from the Guaranty prior to their execution to make theGuaranty consistent with the loan commitment provision quoted above, and (b) BundesBankagreed, but they suspect that in the closing process, BundesBank or its counsel may havemistakenly attached the Guarantor's signature pages to the prior draft (containing the text setforth in bold above) of the Guaranty at the closing.
Borrower's Reaction
After an evening of drinking with his old friend from Tennessee, Jack Daniels, one of theGuarantors fired off a hasty e-mail to Special Servicer stating in part "any attempt to enforce any
11 What if the bracketed language was not present?
101868182.3
claims against me beyond those discreet obligations set forth in paragraphs 1(a) through (g) ofmy Guaranty will be met with a counterclaim for fraud!"12
Borrower and Guarantors are also livid that Special Servicer has blocked their ability to re-tenantand refinance the Center through its inaction on the requests for consent to the Old Army andBetty Ann lease transactions (both of whom are AAA credits), particularly since Old Army is anexisting tenant of the Center, and is required as a tenant under the co-tenancy provisions of theShoe Circus lease, which Servicer expressly approved in October, 2010. Borrower and theGuarantors (a) claim that Special Servicer, as a "B Piece Buyer", has a conflict of interest,and (b) propose to sue Mortgagee, Servicer, and Special Servicer for bad faith anddamages based on various tort theories.
Issues
1. What should Borrower do?
2. What should Guarantors do?
3. Is a single asset bankruptcy helpful to Borrower or the Guarantors?
4. How would the results change if certain key provisions in the loan documents weredifferent?
Attached: Table of AuthoritiesCMBS Structure ChartOwnership Structure ChartSite/Lease PlanPro-Forma
12 What if the loan documents contained a contractual limitation on damage claims against the lender? Is such aprovision unconscionable?
111868182.3
Table of Authorities
1. Wells Fargo Bank, NA v. Cherryland Mall Limited Partnership et al.,(a) 295 Mich. App. 99, 812 N.W.2d 799 (2011)(b) 493 Mich. 859, 820 N.W.2d 901 (2012)(c) (On Remand) 300 Mich. App. 361, 835 N.W.2d 593 (2013)
2. 51382 Gratiot Avenue Holdings, LLC v. Chesterfield Development Co., LLC,(a) 2011 WL 4695820 (E.D.Mich.) (Oct. 5, 2011)(b) 835 F.Supp.2d 384 (E.D.Mich 2011)(c) 2012 WL 205843 (E.D.Mich Jan. 24, 2012)
3. Heller Financial, Inc. v. Lee, 2002 WL 1888591 (N.D.I11.)
4. Penn Mutual Life Insurance Company v. Cleveland Mall Associates, 916 F.Supp.715 (E.D.Tenn., 1996)
5. Whitestone Savings and Loan Association v. Allstate Insurance Company, 28 N.Y.2d 332,270 N.E.2d 694, 321 N.Y.S2d 862 (1971)
6. Travelers Ins. Co. v. 633 Third Assocs., 14 F.3d 114 (2nd Cir. 1994)
7. Blue Hills Office Park LLC v. J.P. Morgan Chase Bank, et al., 477 F.Supp.2d 366 (USDC,D. Mass., 2007)
8 LaSalle Bank N.A. v. Mobile Hotel Properties, LLC, et al, 367 F.Supp.2d 1022 (E.D.Louisiana, 2004)
9. In re: General Growth Properties, Inc. et al., Debtors, 409 B.R. 43, 62 Collier Bankr.Cas.2d279, 51 Bankr.Ct.Dec. 280 (Aug. 11, 2009)
10. Michigan Non-Recourse Mortgage Loan Act, Mich. Comp. Laws §§445.1591-95, effectiveMarch 29, 2012
11. Ohio Non-Recourse Mortgage Loan Act, Ohio Revised Code Section 1319.07-09, effectiveMarch 27, 2013
12. Borman LLC v. 18718 Borman, LLC, 777 F.3d 816
121868182.3
The diagram below provides a summary of the events in a typical CMBS transaction.
Pooling & ServicingAgreement
Trustee
. BorrowerA • Bori owerB
Proceeds I Loans Proceeds .Co 1.1 tro 'Hug. Loans .
ClassLender/ Originator
Proceeds I Loans
Depositor
Proceeds 1 Loans
Trust (RE1VII.C)
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/ Master Servicer
A.:-Trattche•
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R
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Special Servicer
John Doe
50%
Shareholder
STRUCTURE CHART
OF
NEW MARKET CENTER, LLC
Richard Roe
50%
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New Market Center, I
nc.,
a Delaware corporation
• John Doe
40%
Sally Doe
9.5%
Richard Roe
30%
Susa
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19.5%
1%
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Member
Member
Member
Managing Member
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New Market Center,
LLC,
a Del
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liability company
New Market Center
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ter)
Hometown, OH
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SITE/LEASE PLANyermatlim"Iff_xcamairomagi
Market Centel'23, 29
1
Pro-FormaMarket Center
Pre-Bankruptcy Post-Bankruptcy Difference
Income $ 280,476.00 1 $ 580,000.00 2 $ 299,524.00
Expenses $ (161,644.00) (161,644.00) -0-
NOI $ 118,832.00 418,356.00 $ 299,524.00
Interest $ (350,000.00) (@7%) (294,788.00)(@5.9%) $ (55,212.00)
Principal $ (121,965.00) (61,784.00) $ (60,181.00)
Repair and TI Escrows $ (51,180.00) (61,784.00) $ 10,604.00
Net $ (404,313.00) -0- $ 404,313.00
1 Includes Shoe Circus at reduced rent due to failure of co-tenency. Excludes Old Army (expired).
2 Includes Shoe Circus at full rent, new Old Army lease, and new Betty Ann lease.
1403598.097000.000003.1
NON-RECOURSE CARVE-OUTS
AND HOW TO DEAL WITH THEM
Presented by
:
James H. Schwarz
Benesch, Fri
edla
nder
, Coplan & Aro
noff
, LLP
One American Squ
are,
Suite 2300
Indianapolis, IN 46282
Tel: (317) 6
32-3
232
Fax: (317) 6
32-2
962
Email: jsc
hwar
z@be
nesc
hlaw
.com
NONRECOURSE CARVEOUTS AND HOW TO DEAL WITH THEM
James H. Sch
warz*
* At
torn
ey, Benesch, Fri
edla
nder
, Coplan & Aro
noff
, LLP, Indiana University, B.S., 1977, wit
h
highest distinction; Indiana University School of Law, ID., 198
0, S1
11111720 cuin kt
ude.
1.
INTRODUCTION
A non
-recourse loan i
s a "secured
loan that al
lows
the len
der to attach on
ly the
coll
ater
al, not the borrower's per
sona
l assets, if
the loan is not repaid." Bla
ck's
Law Dic
tion
ary
947 (71
h ed. 199). Once upon a time nonrecourse loa
ns mig
ht have be
en nonrecourse in a "real"
sense. i
f a borrower was una
ble or unwilling to pay the debt on a pro
pert
y, the bor
rowe
r ha
d
the option to wallc away from the deal wi
thou
t having to put up any more money to exercise
this
exi
t strategy. The borrower ha
d al
l of th
e upside if market values went up and none of the
down side. The len
der toolc
all of the mar
ket
rislcs if property values plummeted be
low the
amount outstanding under the loan. Lenders and their counsel realized th
at thi
s left borrowers
in the env
iabl
e position of bei
ng able to malce a
ll the decisions wit
h re
spec
t to the property
without having to worry ab
out the le
nder
and
its interests. In res
pons
e to the
se experiences, the
list of "carve-outs" to the bas
ic exc
ulpa
tion
section in the loan document has grown by leaps
and bo
unds
. Borrowers have always taken the broad view that in nonrecourse financing they
always have the
right to "wa
lk from
the
deal"
at any time when i
t no longer
malc
es any
economic sense without having to come up with additional ca
sh. On the other han
d, lenders
have had a har
d time coming to terms with the concept that borrowers should not be required to
pay back funds advanced an
d which they promised to rep
ay. As a res
ult,
at the en
d of th
e day,
a borrower is le
ft wit
h an eco
nomi
c choice either to (a)
pay off the loan
in full an
d lc
eep the
prop
erty
or (b
) give up the property to the le
nder
, in goo
d condition, quickly and
peacefully.
In a typical single-as
set real estate transaction with a lim
ited
liability company wit
h
no oth
er assets as the borrower, nonrecourse pro
visi
ons really malce no sen
se at
all.
The way
the transaction is
set up ma
lces
the loan "n
onre
cour
se" to the principals of th
e owning ent
ity.
In
that situation, the entity cannot be pierced,
it has no other assets and the lender's sole pra
ctic
al
remedy is to foreclose aga
inst
the property. The lender generally will see
k to protect its
elf i
n
such ins
tanc
e by obtaining a guaranty from a par
ty with substantial as
sets
, an
d the same iss
ues
as to ex
culp
atio
n will ari
se in the ne
goti
atio
n of such
guar
anty
. There may be re
duct
ions
in
such guaranteed amounts
based
upon sa
tisf
acti
on of debt
service coverage t
ests, lease-up
provisions or completion of co
nstruction.
This
art
icle
attempts to describe how the documentation in commercial real estate
financing
deals
with t
he c
ompeting i
nter
ests
of borrowers and
lenders
over
nonrecourse
provisions.
In a perfeCt world, a borrower would always pay off t
he loan at
the end
of th
e day
'and
nev
er eng
age in any "ba
d" act
s that wou
ld end
ange
r the lender's collateral prior to a default
situation. However, on
ce a loan goes bad
, the borrower and t
he len
der
will have
different
interpretations as to what actions should be p
ermitted. Be
caus
e of these dyn
amic
s, parties
shou
ld take gr
eat ca
re in reviewing the nonrecourse se
ctio
ns in the loan doc
umen
tati
on.
LAUNDRY LIST OF CARVE OUTS FROM A To Z
of an
yone
who has neg
otia
ted a nonrecourse loan can a
ttest, the l
ist of pos
sibl
e
nonrecourse
carve
outs is
se
emin
gly
endless.
In the
draconian
nonrecourse
carve
out
provision, the only thing the bo
rrow
er may have nonrecourse
against
is for
the pay
ment
of
principal an
d in
tere
st on the loan i
tself
It is interesting to note that nothing forces a lender to
foreclose on a property an
d "talce back the
keys," so
that a borrower
in a nonrecourse deal
could
still be s
tuck
with pa
ying
ope
rati
ng e
xpenses even after an event of default i
n a
CAN RPo
rtbl
\linanage\SLB\1479923_1.DOC - 6/23/2012/2:50 PM/a
nonrecourse
deal. Joshua S
tein in h
is a
rticle, No
nrec
ours
e Ca
rve
outs: How Far i
s Far
Enough?,' breaks down nonrecourse carve outs into liv
e (5)
categories:
Erosion of co
llateral;
Dest
ruct
ion of co
llateral;
Allocation of ex
ternal ris
ks;
Prev
enti
ng additional investment by the len
der;
and
Behavior con
trol
.
Each
cat
egor
y may be th
ough
t of as
a policy underlying various carve out
s, and
any
one carve out may fur
ther
one
or more of these policies. These policies sho
uld be kept in min
d.
when nonrecourse carve outs ar
e being negotiated a
s they w
ill he
lp the att
orne
y un
ders
tand
both h
is c
lient's an
d the
other sides
posi
tion
s. The lender un
ders
tand
s in any nonrecourse
tran
sact
ion that the len
der has ag
reed
to bear the ris
k of any market decline in the pro
pert
y.
What the lender has not bargained for is tha
t the borrower will st
rip ca
sh out of the deal or
make any deals which will negatively impact the income stream of the pro
pert
y, or th
at the
borrower will no longer be
int
eres
ted in pru
dent
ly managing the property after the bor
rowe
r
realizes that th
is property ca
nnot
be "turned ar
ound
."
A.
Envi
ronm
enta
l Obligations. Thi
s carveout is in
tend
ed•t
o allocate the ris
k
of al
l environmental pr
oble
ms to the borrower.
It attempts to protect the len
der from any loss
incurred as a
resu
lt of any environmental obligation un
dert
aken
by the bo
rrow
er in the loan
documents. The amount of such loss
is not subject to any cap wh
atso
ever
. These obligations
are discussed
below in the section dea
ling
wit
h environmental indemnity provisions.
B.
.Misapplication of Casualty and
Cond
emna
tion
Proceeds. A b
ehav
ior
central
devi
ce,
this
carveout covers the s
ituation where
the
borrower r
ecei
ves
casu
alty
or
insurance proceeds and f
ails to apply such funds i
n accordance with the terms of the loan
docu
ment
s. The liability under thi
s carve-out sh
ould
be li
mite
d to the amount of th
e misapplied
funds.
C.
Misapplication of Sec
urit
y Deposits.
This
carveout covers se
curi
ty
deposits put
up by lessees und
er the
ir lea
ses.
There sho
uld not be recourse ag
ains
t the borrower
for any se
curi
ty deposits properly applied in substantial co
mpli
ance
wit
h the le
ases
or which
are promptly delivered to the le
nder
within a pr
edet
ermi
ned time limit after a request by the
lender.
D.
Misa
ppli
cati
on of Property Income.
The lender's concern
here i
s that
property income is not used for the ben
efit
of the collateral property, but ra
ther
distributed to
the pr
inci
pals
of the borrower.
Again, the borrower wa
nts to make sure that onl
y ca
sh rec
eive
d
is included in the det
ermi
nati
on of property in
come
. Also, the borrower will want to limit this
provision to apply onl
y after receipt of notice from the lender of an event of default. In such a
situation, it
will be extremely difficult to determine
if prior to such distribution there were not
enough funds to pa
y for property expenses an
d debt ser
vice
that was due
in the near future. In
addition, a li
mite
d pa
rtne
r or member who has no obligation to repay such loan surely will not
Joshua Stein, Nonrecourse Carve outs: How Far is Far Enough? A Tool To Reduce Lenders'
' Risk Can Reduce Their Competitiveness, R
eal Estate Rev. (Summer 1997).
be w
illing to
give back such fun
ds. The lender
will want to make sure that any ope
rati
ng
payment co
vena
nts ar
e fi
rst satisfied from such
property income
prior to any dis
trib
utio
ns to
the principals.
E.
Failure
to Pay I
mpositions. Im
posi
tion
s will i
nclu
de r
eal
estate an
d
pers
onal
property taxes and insurance premiums. The len
der
will want
all impositions to be
paid whe
ther
or not an event of default has occ
urre
d so that
it knows it will not have to go out
of poc
ket to cov
er reqUired property exp
ense
s. The borrower
will want a limitation pr
ovid
ing
that this obligation only
aris
es to the extent that there
is sufficient property income to satisfy
such impositions and that property income must fir
st be
applied to impositions before
it i
s
applied
to any o
ther p
roperty ex
pens
es. The len
der ca
n co
ver
this s
ituation by r
equiring
imposition escrows or by usi
ng a lockbox account wit
h ca
sh management provisions.
F.
Removal of Improvements. Th
is pro
visi
on is me
ant to protect the lender
from the removal or disposal by borrower in violation of the loan documents, of any fixtures,
personal pro
pert
y, or im
prov
emen
ts at the pr
oper
ty. The borrower will want to limit th
is to any
intentional and wr
ongf
ul removal. Many lenders try to in
clud
e a dim
inut
ion of val
ue concept.
The bor
rowe
r sh
ould
attempt to limit such value loss to situations where a foreclosure sal
e has
occu
rred
, and as a res
ult of such di
minu
tion
of val
ue, the lender has failed to recover the full
amount of the loan
obligations from the sal
e as determined by
a court of law of com
pete
nt
juri
sdic
tion
beyond the right of fu
rther ap
peal
.
G.
Coll
ecti
on Costs. These provisions are
normally picked up as advances
which ar
e tr
eate
d as pri
ncip
al under the loan. The borrower sh
ould
always require the le
nder
to
go out of pocket before these are
car
ved out from the exculpation provisions.
H.
Cash o
n Hand.
This
pro
visi
on i
s intended t
o pick up
cash
or
cash
equi
vale
nts held by the borrower when an event of de
fault has oc
curr
ed or ca
sh payments made
to principals of the borrower
within a cer
tain
time period p
rior to an eve
nt of def
ault
. As a
general
rule, the lender w
ill not have a sec
urit
y interest in the ca
sh of the borrower. The
borr
ower
sho
uld
try to l
imit thi
s carveout to cash payments made at a time when ope
rati
ng
expenses or debt service pay
ment
s were due
at such time bu
t not paid.
I.
Cash Distributions. If
there i
s a
viol
atio
n of a loan
prov
isio
n which
limited the amount of cas
h which could be distributed to pr
inci
pals
, the lender will want to be
able t
o reach
such f
unds i
mpro
perl
y paid. Th
ese
are normally t
ied
to some debt s
ervi
ce
coverage ratio test.
J.
Frau
dulent Transfers. To the ext
ent that a payment made is tr
eate
d as a
frau
dule
nt transfer
in a bankruptcy proceeding, the le
nder
wil
l want to be made who
le. Th
is
prov
isio
n should be li
mite
d only to the actual loss su
ftbr
ed by the len
der.
X..
Lease Impairments. The pur
pose
of thi
s provision
is to make sure
that
the cash stream of the property
is not impaired by
the borrower. The len
der is
concerned about
any amendment, m
odificatiOn, c
ance
llat
ion,
termination, or
wa
iver
of any le
ase,
or
the
obligations of any lessee agreed to by borrower or any default by bo
rrow
er und
er a lease which
allows the lessee to either terminate the lease or set off aga
inst
lease pay
ment
s. The borrower
0001
00:6
0584
28-1
would like to li
mit any such acts to material acts on the part of borrower that materially impair
the lender's security an
d any in
tent
iona
l an
d substantial de
faul
ts caused by the borrower.
L.
Prohibited L
eases. Many pen
sion
fund
lenders must make sure that
certain le
ases
are
not entered into or
such
acts may imp
act their tax exempt sta
tus.
In order to
control the borrower, the lender may wish to establish a for
mula
or procedure to calculate such
loss, or perhaps to convert the whole loan into a full recourse deal.
M.
Transaction Costs of any Lien Enforcement Action. The len
der do
es not
want the property to bear the costs of any transfer taxes and re
cord
ing ch
arge
s required to be
paid
in order to record any de
ed or ot
her conveyance document that has to be recorded in a lien
enforcement action. This may include costs ass
ocia
ted with the appointment of a receiver, an
action to prevent waste, for
eclo
sure
cos
ts, bankruptcy action costs an
d specific performance
actions.
N.
Violations of Law.
This
provision
attempts to make t
he borrower
personally liable for the failure to com
ply
with
legal requirements so that the le
nder
does not
have to cu
re such problems with
its funds. Such provision attempts to pick up violations of th
e
American wit
h Disabilities Act
and ERISA violations. The bor
rowe
r wa
nts to lim
it th
is onl
y to
violations that oc
curr
ed while the borrower owned the property and
for wh
ich the borrower
received prior written notice from a governmental entity.
O.
Oper
atin
g Costs. Th
is provision attempts to recover from the borrower
utility charges, insurance premiums
and
other
oper
atin
g costs
required t
o be p
aid by the
borrower under the loan documents. Again, the borrower w
ill want to limit this car
veou
t to
property income that was availabk to pay such costs and ch
arge
s.
P.
-Uninsured Casualty. Th
is pr
ovis
ion
protects t
he l
ende
r ag
ains
t any
casu
alty
not covered by insurance, including de
duct
ible
amounts. The borrower may arg
ue that
it sho
uld on
ly be re
spon
sibl
e fo
r such amounts to the ex
tent
it f
ailed to mai
ntai
n the insurance
required und
er the loan documents,
Q.
Crim
inal
Acts. The lender do
es not want t
o bear t
he costs of any
criminal pen
alti
es incurred as a result of th
e acts of th
e borrower. The borrower should att
empt
to l
imit such
carveout t
o any
pena
lty
actually imposed
by a c
ourt of law of competent
juri
sdic
tion
beyond
right of fu
rthe
r appeal.
R.
Closing
Costs. These
prov
isio
ns ca
rveo
ut from the
excu
lpat
ion
provisions any commitment fee, loan fee, mortgage rec
ordi
ng tax, brokerage commission, title
insurance premium o
r, ot
her cl
osin
g costs that the bor
rowe
r was req
uire
d, but
, failed, to pay,
with respect to the loan. Most of these costs ar
e paid from
loan proceeds
at the time of the
clos
ing,
so th
ese should not be big items of con
cern
.
S.
Yield
Main
tena
nce Premiums. Th
is p
rovision imposes liability on
the
borrower if any yield maintenance premium is payable as a result of a prepayment of th
e loan.
T.
Inte
rfer
ence
with Lien Enforcement Actions. Lenders want to get back
the property as
quickly as pos
sibl
e in the event they have to
bring an enforcement action.
Lenders will want to enf
orce
full liability ag
ains
t the borrower if t
he borrower takes any action
to contest, delay, oppose, impede or otherwise interfere with a
lien enforcement act
ion.
The
borrower should have the right to contest wh
ethe
r an eve
nt of de
faul
t occurred that gave rise to
the enforcement action, and if bor
rowe
r prevails, the le
nder
sho
uld pay borrower's costs and
attorney fees in defending such ac
tion
.
U.
Bankruptcy.
Lenders do not want to be subject to the provisions of the
Bankruptcy Code and i
ts automatic stay. Acc
ordi
ngly
, lenders
draft fu
ll recourse clauses to
prevent the borrower from
ever filing by imposing
full
recourse
liability if
such an a
ction
occurs. These provisions should on
ly relate to vol
unta
ry actions commenced by the borrower.
V.
Prohibited Transfers. In approving a nonrecourse dea
l, lenders take into .
account
in t
heir underwriting that the principals of the borrower know how to manage and
operate the
property. Accordingly, lenders i
nser
t springing
full recourse
clauses to p
revent
transfers of th
e ownership interest in the borrower to other parties. The bor
rowe
r should try to
limit th
is provision to intentiona
l an
d voluntary transfers of in
terests which take management
out of th
e control of th
e original principals.
W.
Fraud. A n
ormal
carv
e- out pro
visi
on i
s for fraud committed by the
borrower in co
nnec
tion
wit
h the loan. The better-question is what con
stit
utes
"fr
aud"
because
the term i
s rarely d
efined i
n the loan d
ocumentation. The amount of the recourse
liability
should be
limited
to any a
ctual damage suffered by the len
der;
the e
ntir
e loan s
hould
not
become recourse. Fraud should be defined as the actual, ma
teri
al, intentional and proven fraud
or i
nten
tion
al misrepresentation (a
nd not
include any
constructive or negligent fraud
or
misrepresentation), up
on whi
ch the len
der actually and
reasonably relied upo
n in making such
loan, which fraud or intentional misrepresentation is not cured within a set period of time after
receipt of wr
itten notice from the lender.
X.
Non-D
eliv
ery of Fi
nanc
ial Information or
Documents. Not onl
y do
es the
lender want to get its
collateral back qui
ckly
, bu
t it also needs to obtain the financial an
d other
property documents i
n order to eff
ecti
vely
manage the pro
pert
y. The lender may imp
ose a
requirement fo
r the delivery of documents and information from the borrower or the loan will
become fully recourse. if such a provision i
s agreed to by the borrower, any such do
cume
nt
must be a material document, an
d the lender must be required to give detailed notice to the
borrower of such do
cume
nts allowing a rea
sona
ble time period for the bo
rrow
er to provide the
same.
Y.
'Additional Fi
nanc
ing. In order to get the property quickly, the lender
does not want to deal wi
th any subordinate lenders who may have a security int
eres
t in the
property. Most loan do
cume
nts include a prohibition aga
inst
any additional financing placed
against the property, and many include a car
veou
t that makes the loan en
tire
ly recourse for a
violation of such co
vena
nt. The borrower sh
ould
have the right to pay routine trade payables
and to obtain unsecured loans for improvements, replacements or repairs to the property.
Z.
. SPE Covenants. In s
ecuritized r
eal
estate tra
nsac
tion
s, lenders require
that the borrower co
mply
wit
h special pu
rpos
e en
tity
provisions which make them ba
nkru
ptcy
remote. The failure to meet such provisions normally requires the loan
to become recourse in
hill
. Thi
s protective device
is discussed in Article V bel
ow.
000100:6058428-1
ENVIRONMENTAL INDEMNITIES
A nonrecourse car
veou
t that appears in almost eve
ry com
merc
ial real est
ate loan is
an environmental indemnity.
In fact, an environmental indemnity generally go
es further than a
loan w
ith
full rec
ours
e, as the indemnifying parties generally inc
lude
not onl
y the borrower,
but also the gua
rant
ors an
d/or
any
oth
er parties affiliated wi
th the borrower.
A.
Viol
atio
ns of Env
iron
ment
al Laws.
Environmental indemnities protect
the le
nder
aga
inst
any losses incurred as a result of any vio
lati
ons of ap
plicable environmental
laws. The bor
rowe
r sh
ould
be required to remedy a violation of en
vironmental laws onl
y to
the
extent that a go
vern
ment
al agency pr
ovid
es written
noti
ce to th
e borrower th
at an
environmental problem
exis
ts. The mer
e fact tha
t the lender may want, th
e borrower to deal
with
a p
roblem sh
ould
not
be t
he c
atal
yst for
environmental
rern
edia
tion
. The f
act
that
hazardous materials ar
e pr
esen
t on the pro
pert
y sh
ould
not cau
se any act
ion to
be un
dert
aken
.
It is on
ly when there is a vi
olat
ion of environmental law
s that the borrower must take action. I
f
any action i
s required by a no
tice
from a goYt6rnmental agency, the bor
rowe
r ne
eds the right to
contest any such a
lleged v
iola
tion
prior to the time that the lender can
und
erta
ke any such
acti
ons an
d look to the bo
rrow
er for repayment under an in
demn
ity.
B.
Who Gets Be
nefi
t of th
e Indemnity. Most lenders want th
e• in
demnity to
run not only to them but also to
any thi
rd par
ty who acq
uire
s the loan by for
eclo
sure
or deed in
lieu of fo
reclosure. A bor
rowe
r does not have a problem wit
h the indemnity ru
nnin
g in fav
or of
the lender, or any purchaser or assignee of al
l or any part of th
e lo
an, including participants or
affi
liat
es of th
e le
nder
, such purchaser, assignee or pa
rtic
ipan
t. However, a bor
rowe
r does not
want its
indemnity to survive on
ce the par
ty with wh
ich
it has negotiated the loan is no longer
in the picture. Accordingly, a bor
rowe
r does not want the ind
emni
ty to run in fa
vor of a par
ty
who acq
uire
s the pr
oper
ty by fo
recl
osur
e, power of sa
le, or by deed in lieu of fo
reclosure.
C.
Indemnification. Lenders want to be indemnified for any environmental
risks, whe
ther
the problem occ
urre
d as a res
ult of the mor
tgag
ed pro
pert
y or from any ot
her
prop
erty
, wi
th no limitations wha
tsoe
ver.
The borrower do
es not want to be on the ho
ok for
any
consequential .d
amag
es as a
result of such
inde
mnif
icat
ion.
The borrower wants to be
responsible for re
leas
es of hazardous sub
stan
ces on or from its pro
pert
y and not from adjoining
properties where
it has
no co
ntro
l of such
situation. The le
nder
will argue
that any
environmental ri
sk is to
be allocated solely to th
e borrower.
D.
Carve Out from Indemnity. The borrower sh
ould
not have any
liability
unde
r such indemnity for the acts attributable to the lender or
its ag
ents
or employees du
ring
the period of time that the bor
rowe
r owns the pro
pert
y. The len
der will want to red
uce such
limitation to
its gross ne
glig
ence
or
willful mi
scon
duct
. In addition, the bor
rowe
r sh
ould
not
have any
liability t
o the
lender to
the
extent that
it can
establish t
hat any
environmental
viol
atio
n oc
curr
ed a
fter
the property is con
veye
d to
a thi
rd par
ty as a result of a for
eclo
sure
,
power of sa
le or deed in lieu of fo
reclosure.
E.
Term
inat
ion of Ind
emni
ty.
The l
ende
r wi
ll want the in
demn
ity
to
surv
ive the re
paym
ent of th
e loan. The bor
rowe
r will want the indemnity to ter
mina
te when the
loan is repaid in full. Most len
ders
wil
l agree to a ter
mina
tion
of th
e indenmity within a cer
tain
period of time either af
ter the loan l
ias been repaid or the date that the lender, or
its af
fili
ate,
acquires the property. If t
he loan has been rep
aid,
there is
litt
le chance that the len
der will ever
be con
side
red an "operator" of the pro
pert
y. Some lenders will require that an en
viro
nmen
tal
assessment be un
dert
aken
at the time of the indemnity te
rmin
atio
n in ord
er to have evi
denc
e
that the property was "cl
ean"
at t
he time of th
e loan pay
off.
,
IV.
RECENT CASE LAW CONCERNING NONRECOURSE LOANS
In Hel
ler Fi
nanc
ial, Inc
. v. Lee
,' the bor
rowe
r was fou
nd lia
ble for the nonrecourse
debt
for a hot
el in Or
land
o, Flo
rida
. The note co
ntai
ned a nonrecourse clause pro
vide
d th
at
"[s]ubject to the pr
ovis
ions
set for
th below, no Maker shall be personally lia
ble to
pay the Loan
....
" However, th
e note also included a carveout.which stated:
[Notwithstanding the
fore
goin
g, ea
ch Ma
lcer
(excluding Robert
Alpe
rt),
jointly and s
everally, shall be p
ersonally
liab
le for . . . (b)
repayment of the Loan and
all other obl
igat
ion[
s] of Mal
cer under the
Loan Documents in the ev
ent of (i) an
y br
each
of any
of th
e covenants
in S
ecti
on 6.3
or 6.
4 of the
Loan Agreement pertaining. to
transfers,
assignments an
d pl
edge
s of interests and a
ddit
iona
l en
cumb
ranc
es in
the Property and the Corporation ... .3
Sect
ion 6.
4 of th
e loan agr
eeme
nt prohibited the bo
rrow
er from pe
rmit
ting
the fil
ing
of any lien or other encumbrance on the Pr
oper
ty.
Ultimately though, six lie
ns wer
e filed on
the property, to
whi
ch the len
der did not co
nsen
t. Ba
sed on
the terms of th
e no
te, the co
urt,
applying Ill
inoi
s law, fou
nd that there was a default and
the ent
ire in
debt
edne
ss was due
and
paya
ble.4
The bor
rowe
r at
temp
ted
to avoid this re
sult
by arg
uing
that the carve outs were
actually l
iquidated da
mage
s pr
ovis
ions
that we
re unenforceable
as pe
nalt
ies.
The c
ourt
however, concluded that that the carve out
was not a liquidated damages provision bec
ause
it
only
provided
for
actual damages; the amount outstanding under
the
loan.' However,
assuming that the outstanding de
bt exc
eede
d the ag
greg
ate amount of th
e impermissible liens,
the carve out pr
ovid
ed for
a remedy greater tha
n the actual damages from th
e de
faul
t. From
the opinion, it
doe
s not ap
pear
that t
his argument was rai
sed,
as the co
urt did not ad
dres
s it
.
In Penn Mutual Life Insurance Company v. Cleveland Mall Associates,` the le
nder
bid On a inall ren
ovat
ion project at
the for
eclo
sure
sale, but
pai
d le
ss for it t
han the amount of
the debt. The len
der th
en wanted to recover the
dif
fere
nce.
The court granted the def
enda
nts'
moti
on i
n li
mine
and
held
that the value of the mall
is the amount at which the le
nder
had
succ
essf
ully
bid
for
it a
t the for
eclo
sure
sal
e.
In rea
chin
g it
s co
nclu
sion
, the court relied on the rule i
n Whitestone Sav
ings
and
Loan Ass
ocia
tion
. v. Allstate In
sura
nce Company: whi
ch deems the pri
ce bid at a .foreclosure
sale
to be the value of the pro
pert
y. Al
lowi
ng the mor
tgag
ee to sue
later on
gro
unds
tha
t the
property is actually worth less th
an the bid price wou
ld und
ermi
ne the
int
egri
ty of a foreclosure
2 No. 01 C 6798, 2002 WL 1888591 (N.D. 11
1. Aug. 16,
2002
).
Id. at*l.
4 Se
e Id
. at
*5.
5 Se
e /d
.6 916 F. Supp. 715 (E.D. Tenn., 19
96).
270 N.E
.2d 694 (1971)
000100:6058428-1
sale
and cre
ate the po
ssib
ilit
y of fraud or of a double recovery when the mortgagee seeks the
proc
eeds
of any insurance on the property. The lender in Penn arg
ued that there sho
uld be a
tort
/fra
ud ex
cept
ion
to the Whitestone r
ule under the circumstances of a nonrecourse loan
beca
use when the loan
is nonrecourse, t
he lender has no mot
ivat
ion to bid
les
s th
an the amount
of th
e de
bt, as a def
icie
ncy will not be av
aila
ble.
The court rejected this arg
umen
t, st
atin
g that
there is
no reason for the lender to bid any le
ss tha
n the value of th
e property.
The lesson from Penn is to always pu
rsue
a def
icie
ncy if po
ssible. Th
is cas
e did not
discuss any ne
goti
ated
carveout for fraud. Pre
suma
bly,
that
is be
caus
e either no such carveout
appeared in the documentation or more likely, bec
ause
the que
stio
n ne
ver became ripe: in the
court's ey
es, the lender recovered the entire debt when it bid the full amount at the foreclosure
sale. In fact, the court even stated that on
e re
ason
to bid le
ss tha
n the fu
ll amount of th
e debt in
the
nonrecourse
context
coul
d be t
hat the
lend
er may h
ave
other
reasons
to pu
rsue
the
borrower.' These reasons cou
ld include a remedy based on a nonrecourse carve out
.
The cas
e of Travelers Ins
. Co.
v. 633 Thi
rd Assocs.9 shows how the acts of the
borrower can
cause a
court to "ov
erri
de a nonrecourse p
rovi
sion
. The len
der loaned t
he
borrower $145 mil
lion
on a nonrecourse bas
is. The borrower learned that it would be los
ing
some important tenants. Faced wi
th a dep
ress
ed real estate market an
d mounting vacancies, the
borr
ower
distributed $4 m
illi
on t
o it
s pa
rtne
rs, and was prepared
to d
istr
ibut
e another $17
mill
ion.
The lender brought suit to set aside the
firs
t distribution and
to enjoin the proposed
distribution as a fraudulent co
nvey
ance
. The dis
tric
t co
urt di
smis
sed the co
mpla
int be
caus
e it
determined t
hat the le
nder
had
no
property i
nter
est in t
he accumulated c
ash
assets of the
borrower due to the non-
reco
urse
provisions. Bec
ause
it ha
d no interest it cou
ld not cla
im to be
inju
red by actual or
thr
eate
ned
distributions. Later, the borrower failed to pay i
ts real estate
taxes and
its loan pay
ment
s. Aft
er such default, the bor
rowe
r distributed the $17 mil
lion
to
its
part
ners
. The next day the lender filed for foreclosure and
had a receiver appointed. The lender
amended i
ts c
ompl
aint
all
egin
g that the distributions rendered the
borrower i
ncapable of
performing its
obligations under the loa
n, including the payment of property ta
xes.
The lender
clai
med that the failure to pay pr
oper
ty taxes would con
stit
ute waste remediable in equity, as
would
failure
to maintain t
he pr
oper
ty i
n good condition
and
repair. The district c
ourt
dismissed the lender's equitable action for waste be
caus
e it would lie onl
y ag
ains
t a mortgagor
in possession and be
caus
e at
the time of th
e co
mpla
int a receiver was in place.
The court rec
ogni
zed th
at the intentional failure to pay property taxes where there is
an obligation to do so or where the failure i
s fraudulent con
stit
utes
waste. The cou
rt further
held
that the mere failure to pay
principal an
d in
tere
st will not
constitute waste.
The court
allo
wed the claim of waste rel
atin
g solely to the period of time before the appointment of a
receiver. The court also found
that the d
istribution injured the lender bec
ause
the borrower
migh
t have been
enjoined from
distributing cas
h reserves to
its partners on
the grounds that
such a d
istribution wo
uld
have prevented i
t from pa
ying
pro
pert
y taxes. Accordingly, the
lender had s
tanding
to c
hallenge the d
istributions u
nder
the fraudulent co
nvey
ance
sta
tute
insofar as t
he l
ende
r's claims r
elat
ed to the p
orti
on of the d
istr
ibut
ions
against w
hich
an
equitable action for waste cou
ld be brought.
Penn, 916 F.S
upp.
at 718.
14 F.3d 11
4 (2d Cir. 199
4), reversing 816 F.Supp. 197 (S.D.N.Y. 1993).
The most re
cent
case is
Blue Hi
lls Office Park LLC v. J.
P. Mor
tgag
e Chase Bank.°
This
cas
e demonstrates t
hat sometimes
it i
s best to
deliver back t
he p
roperty
as soon
as
possible and that prior ac
tion
s ca
n come back to haunt a bor
rowe
r if the non
-recourse carve-
outs are
not drafted wel
l. In Blue Hills, the bo
rrow
er brought an
action against the lender for
breach of the cov
enan
t of goo
d faith an
d fa
ir dealing. The bas
is for the claim was that the
lend
er failed to make available to the borrower cer
tain
sums held
in a leasing reserve to pay
real e
state taxes and
debt service on
the
loan
. Th
is reserve acc
ount
was established for the
payment of lo
an pri
ncip
al and int
eres
t if th
e primary te
nant
vacated the pro
pert
y.
The biggest problem for the borrower and the gu
aran
tors
of the loan was that the
borrower had
entered int
o a set
tlem
ent agreement with the owner of the adjacent property and
waived i
ts right to ob
ject
to the issuance of a special per
mit to construct a parking garage.
Without
notifying
or s
eelcing the
consent of the l
ende
r, the borrower entered
into s
uch
sett
leme
nt agr
eeme
nt w
ith.
the
adjacent p
roperty owner and
an af
fili
ate of the pr
oper
ty's
primary te
nant
. The borrower received $2,000,000 in settlement pr
ocee
ds and
nev
er notified
the le
nder
of such settlement. The primary tenant gave notification to the bor
rowe
r that it was
not renewing i
ts lease. As a res
ult the borrower did
not have
sufficient funds to pay the real
estate taxes that were due
. The borrower requested the lender to make funds ava
ilab
le from the
leasing reserve to pay deb
t service and the real estate tax pa
ymen
t. The lender di
d not respond
to such request but did pay the real estate ta
xes.
However, the le
nder
told the borrower that the
loan was accelerated as of Aug
ust 2,
2004, the date the real est
ate taxes were due. Thereafter,
the le
nder
notified the
guar
anto
rs of its i
nten
tion
to fo
recl
ose. on
the
property and of the
ir.
potential liability un
der the guaranty in ca
se of a def
icie
ncy in the pro
ceed
s of th
e foreclosure
'sal
e. The foreclosure sal
e occurred and
the property was sold for less than the outstanding debt.
The len
der th
en requested the gua
rant
ors to pay the deficiency.
The lender contended th
at the borrower transferred part of the mortgaged property
with
out the
prior
written consent of the l
ender
as a r
esul
t of entering
into t
he set
tlem
ent
agre
emen
t an
d not providing such funds to the le
nder
. As a res
ult,
such ev
ent triggered
full
recourse liability under the loa
n. The court agreed with such an
alys
is and the failure
-to pa
y the
$2,000,000.00 to the len
der caused the gua
rant
ors
to become lia
ble for the
full d
efic
ienc
y,
which was greater tha
n the $2,000,000 not paid ov
er to the lender.
It sho
uld also be noted that
the court found that the bor
rowe
r failed to maintain it status as a single pur
pose
entity. Such a
violation also caused full recourse liability under the loan.
V.
OTHER PROTECTIVE DEVICES
In a
ddition to nonrecourse carve outs, len
ders
oft
en emp
loy
other me
chan
isms
to
protect against the risk pre
sent
ed by nonrecourse loans. The two most common that appear in
almost all such loans ar
e the requirement that the borrower be
"bankruptcy remote" and
that
some sor
t of cas
h management arrangement be put in place.
A.
Bankruptcy Remote Ent
ity. Un
der a bankruptcy remote
structure, the
borrower is formed as a special purpose entity whose single pur
pose
is own and ope
rate
the
properly sec
ured
by
the
loan.
While
it i
s be
comi
ng mor
e common f
or these e
ntities
to be
organized as lim
ited
liability com
pani
es, the corporate an
d partnership forms of organization
1)̀ 477 F. Supp. 366 (Mass. 2007)
000100:6058428-1
can also be used. Pu
rsua
nt to the special purpose en
titi
es' organizational doc
umen
ts, the en
tity
is pro
hibi
ted from filing fo
r bankruptcy without the unanimous consent of it
s governing bo
dy.
This
governing bod
y ca
n be a board of directors, its general partners, or a board of managers.
One or more of these parties is typically an independent party designated by the lender or by
some third p
arty. The loan documents
will lik
ely also inc
lude
cov
enan
ts that in
sure
that the
borr
ower
is tr
eate
d as a separate an
d distinct e
ntity from it
s parent.
Borrower's c
ounsel
frequently w
ill be required
to issue an
opinion
that consolidation of the bor
rowe
r wi
th i
ts
affi
liat
es is not likely.
B.
Cash Management Agreement.
Cash management agreements
are also
often used to protect against the ri
sk of mi
sapplication of funds in nonrecourse loans. The cas
h
management arr
ange
ment
is in
tend
ed to insure that either on an ong
oing
basis or up
on a loan
default, all income produced by the property will automatically flow into a separate account to
whic
h the bo
rrow
er does not have fre
e access. If su
fficient income
is generated by the pro
ject
,
the use of a cas
h management agreement shall insure that ope
rati
ng expenses, taxes and other
impositions
will be
paid a
nd a
lso make i
t unlikely that the borrower w
ill be able to d
rain
money out of th
e'project. I
n addition to the ca
sh management arr
ange
ment
, lenders may also
require that cer
tain
reserve accounts be mai
ntai
ned or other cre
dit enhancements such as letters
of cr
edit
be used to de
crea
se some of th
e risk.
VI.
TAX IMPLICATIONS OF NONRECOURSE DEBT
A b
orro
wer under a nonrecourse loan who chooses to give up the
collateral and
walk away from a
project essentially sells the property to
its lender.
This
ana
logy
becomes
even more apropos when the tax aspects of the tr
ansa
ctio
n ar
e considered.
Generally, nonrecourse purchase money mor
tgag
es are
included
in the borrower's
basis
for
the
property.
This general
rule i
s li
mite
d in three
situations:
(1) when the
nonrecourse debt exceeds the fair ma
rket
value of the pro
pert
y; (2)
when the s
eller retains
sign
ific
ant control ov
er the property transferred; and (3)
when the term of th
e nonrecourse debt
exce
eds the useful economic
life of th
e encumbered property."
When contemplating exiting a project with nonrecourse
debt, co
ncer
ns regarding
tax im
plic
atio
ns will move higher on the pri
orit
y list. The leading cas
e re
gard
ing mortgage
rules for
tax
implications i
s Crane
v. Com
miss
ione
r of Internal Revenuel2
in wh
ich
the
Supreme Court h
eld
that the amount r
ealized on t
he d
isposition of encumbered
property
includes the amount of any liability in which the taxpayer-debtor is relieved.
However, the Court in Crane
indicated that if nonrecourse
liability exceeded the
value of the pro
pert
y, the amount realized would be lim
ited
to the
property's value.' The
concept behind thi
s economic benefit theory was that when nonrecourse debt ex
ceed
s the value
of the property, the debtor cannotbe hel
d personally lia
ble for the debt and
will treat the debt
as bei
ng lim
ited
to the value of the property. However, in a
latet case, the Supreme Cou
rt
rejected t
his reasoning an
d he
ld that the amount rea
lize
d for tax purposes included the en
tire
GUERIN, SANFORD M., TAXATION OF REAL ESTATE TRANSACTIONS 17 (2001).
12 33
1 U.S. 1 (1947).
13 Id. at 14 n. 37
.
nonrecourse liability even if it exceeded the fa
ir mar
ket value of th
e encumbered property."
IiiCommissioner of In
terna! Revenue v
. Tufts, the taxpayer had a
basis
in t
he pro
pert
y, after
depr
ecia
tion
, de
duct
ions
and
other capital con
trib
utio
ns of $1,
455,
740.
00, and the fair mar
ket
valu
e of th
e pr
oper
ty was $1,400,000.00. The nonrecourse debt on the property exceeded both
of the
se amounts and the taxpayer, following the reasoning from Crane, claimed a los
s of
$55,
740.
00. Wh
ile acknowledging the validity of Crane rat
iona
le, the Court departed from
its
logic and found that there was a gain of app
roxi
mate
ly $40
0,00
0.00
after including the ent
ire
nonrecourse mortgage that was assumed.
VII.
CONCLUSION
When one thi
nks of an ex
culp
ated
real es
tate
loa
n, one nor
mall
y assumes that the
lend
er has agreed to waive its right to seek recovery from any asset of th
e borrower other tha
n
the
collateral securing such loa
n in the event of either a payment or a per
form
ance
default
under the loan doc
umen
ts. The lender has agreed to look solely to such security for repayment
and waives its right to obtain a deficiency ju
dgme
nt against the borrower. The borrower has a
viable exi
t st
rate
gy if the deal goes "s
outh
" with a financial exposure li
mite
d to its equity in
such real estate.
The lender has concerns in any
exculpated d
eal that the borrower may do "b
ad
thin
gs" such as misapplication of funds or the commission of fr
aud or misrepresentation at the
time of the loan application or loan closing, inducing the lender to make a nonrecourse loan
based on such underwtiting considerations. The lender also i
s co
ncer
ned with economic ri
sks
dealing wi
th the operation of the pr
oper
ty, such as payment of impositions, the maintenance of
the pr
oper
ty, t
he filing of mec
hanics' liens and environmental contamination. The len
der is
also
concerned ab
out the time and expense involved in foreclosing on a property when it i
s the only
source of recovery for the loan a
rud the borrower i
s no longer
inte
rest
ed i
n managing and
oper
atin
g the sa
me.
The les
son to be learned in arriving at
a balance of these concerns is that the car
ve
outs should be addressed at the loan commitment stage and
not negotiated du
ring
the clo
sing
proc
ess.
Both parties ar
e entitled to get the be
nefi
t of th
eir intended bargain, but "nonrecourse"
certainly ca
n mean different things t
o di
ffer
ent
people depending
on which
side of the
borrower/lender ta
ble yo
u are si
ttin
g on. It sho
uld be noted that a violation of a non
-recourse
carve-ou
t ca
n cause a non
-recou
rse carve-ou
t guarantor to be
liab
le for the entire loan amount
even i
f the
violation causes a
ctual damages
less tha
n the amount of the outstanding loan.
Notw
iths
tand
ing the parties' in
tent
ions
at the cl
osin
g of the loa
n, thatnonrecourse loan may not
be as nonrecourse as the borrower and the gu
aran
tors
originally thought.
VIII
. SAMPLE PROVISIONS
A.
Borrower's Bro
ad Exc
ulpa
tion
.
B.
Lender's Nar
row Exculpation.
14 Com
miss
ione
r of Inte
rnal
Revenue v. Tufts, 461 U.S. 300, 307 (19
83)
000100:6058428.-1
ATTACHMENT A
Notwithstanding an
ythi
ng to th
e contrary contained h
erein
or i
n any
other Loan
Documents, exc
ept as expressly provided for in the
Gua
rant
y of Completion or the
Guaranty of
Payment, no pas
t, pre
sent
of fu
ture
par
tner
of th
e Borrower sha
ll have any pe
rson
al liability for
the re
paym
ent of pr
inci
pal of or in
tere
st on th
e Loan or fo
r th
e payment or per
form
ance
of any
of th
e ag
reem
ents
or obligations whatsoever, monetary or otherwise, of th
e Bo
rrow
er pursuant
to the
Loan Doc
umen
ts,
all such lia
bili
ty being expressly waived by the
Banks and
the
Age
nt,
and th
e Agent an
d th
e Banks sha
ll look so
lely
to th
e assets of th
e Bo
rrow
er for the
repayment
of such
prin
cipa
l and
interest and for the
per
form
ance
of such ag
reem
ents
or obligations an
d
shal
l not se
ek any def
icie
ncy or
personal jud
gmen
t ag
ains
t any pa
st, pr
esen
t or future pa
rtne
r of
the Bo
rrow
er; provided, however that the
for
egoi
ng provisions of th
is paragraph sha
ll not limit
the li
abil
ity of ei
ther
the
Guarantor or th
e Ge
nera
l Pa
rtne
r fo
r fr
aud.
ATTACHMENT B
Sect
ion X. Ex
culp
atio
n,
(a)
Exce
pt as otherwise pr
ovid
ed i
n th
is Sec
tion
X, nei
ther
Borrower no
r
any constituent pa
rtne
r of Bor
rowe
r sh
all be per
sona
lly li
able
for the
payment of any principal,
inte
rest
or other sum evidenced by the
Note or for any def
icie
ncy judgment that Lender may
obtain fol
lowi
ng the
foreclosure
-of t
he Mor
tgag
e; and Lender's sole recourse ag
ains
t Bo
rrow
er
for an
y default un
der th
e No
te, th
e Mortgage or an
y other Loan Document sha
ll be limited to
the property encumbered by the
Mor
tgag
e and any other
collateral given to se
cure
the
Loan •
(col
lect
ivel
y, the
"Pr
oper
ty")
.
(b)
The foregoing lim
itat
ion of lia
bili
ty set for
th i
n subsection (a)
above
shal
l not ap
ply,
aff
ect,
imp
air or
prejudice Lender's ri
ghts
to:
(1)
name Borrower or any
constituent par
tner
of Borrower as
a pa
rtne
r de
fend
ant in any act
ion,
proceeding, re
ference or arb
itra
tion
, sub
ject
to th
e limitations
of th
is Sec
tion
X;
(2)
asse
rt any
unpaid amount due
under the
Loan as a de
fens
e
or o
ffse
t ag
ains
t an
y cl
aim
or ca
use of act
ion
against Lender by Borrower, any of i
ts
constituent pa
rtne
rs, or any
guarantor or in
demn
itor
in co
nnec
tion
with th
e Loan;
(3)
exercise s
elf-help r
emedies (such
as s
etoff) aga
inst
any
real or pe
rson
al property of Bor
rowe
r or
any other per
son or entity;
(4)
enfo
rce ag
ains
t any pe
rson
or entity whatsoever, including
Borrower and i
ts con
stit
uent
par
tner
s, and
recover under any lea
ses,
master leases, guarantees
of pay
ment
, gu
aran
tees
of co
mple
tion
, environmental or
other indemnities, s
urety bonds, le
tter
s
of cre
dit,
ins
uran
ce policies and ot
her similar rights to pa
ymen
t or
per
tbrm
ance
whi
ch may be
executed in co
nnec
tion
wit
h th
e Loan or th
e Pr
oper
ty;
(5)
recover
agai
nst
Borrower co
mpen
sato
ry,
cons
eque
ntia
l
and
punitive damages as we
ll as any other co
sts an
d ex
pens
es incurred by Len
der (i
nclu
ding
,
with
out (i
mita
tion
, at
torn
eys'
, ex
pert
s' and
consultants' fee
s and
expenses)
as a r
esul
t of
Borr
ower
's fraud, br
each
of tru
st, br
each
of warranty, m
isre
pres
enta
tion
, wa
ste,
failure t
o
main
tain
the
insurance req
uire
d un
der th
e Loan Documents, failure to pay
taxes or as
sess
ment
s
which ar
e a lien aga
inst
the
Pro
pert
y, bre
ach of th
e due-on:sale cl
ause
of th
e Mortgage, br
each
of the
restriction
agai
nst
furt
her encumbrance
cont
aine
d in
th
e Mortgage,
entr
y into or
modi
fica
tion
of leases
in v
iolation of the
pro
visi
ons of the
Loan Do
cume
nts,
or receipt of
rentals for periods of more than
month(s) in
advance und
er leases of th
e Pr
oper
ty;
'(6)
recover any
insurance
proceeds, co
ndem
nati
on, aw
ards
,
tena
nt security
deposits,
utility
deposits, pr
epai
d re
nts or o
ther s
imilar funds o
r payments
attr
ibut
able
to th
e Pr
oper
ty which wer
e not
paid to Lender or were not otherwise app
lied
as
required in th
e Loan Documents;
000100:6058428-1
(7)
recover any rents, income, revenues, issues and
profits of
the Property that were received
at any time
after the occurrence of an Event of Default or at
any time w
ithin the 12 mon
th p
eriod
prec
edin
g such o
ccurrence
that were not
applied
as
required under the Loan Documents, or if t
he Loan Documents contain no such requirements,
that were not
applied
to pay
amounts
due
under
the
Loan Documents, o
perating and
maintenance expenses (including taxes and
insurance pr
emiu
ms) of the
. Pr
oper
ty, and any
deposits to a reserve or escrow account as required Linder the Loan Documents;
(8)
the Loan Documents;
recover any Loan proceeds not applied as req
uire
d un
der
(9)
enfo
rce ag
ains
t Borrower a
ll of Borrower's obligations to
complete construction on
the Pro
pert
y as contemplated by the Loan Documents;
(10)
enfo
rce any
indemnity
or o
ther
obligation of Borrower
whic
h may ari
se from or in co
nnec
tion
with Lender's issuance of or performance under any set
aside letter, or the enforcement of any set aside letter against Lender;
(11)
recover from Borrower a
nd its
constituent
part
ners
the
entire ind
ebte
dnes
s evidenced or secured by the Loan Documents in the .event of the exe
rcis
e
of any right or remedy under any federal, s
tate
or local forfeiture law resulting in the loss of th
e
lien of the Mortgage (or the
prio
rity
thereot) against the Pr
oper
ty, less any proceeds Lender
may receive und
er its
tit
le insurance policy therefor;
(12)
recover from Borrower and
its constituent partners (A) any
fees, ex
pens
es, costs an
d charges (including a
ttor
neys
', e
xperts' .
and
consultants' fees and
expenses) wh
ich Lender incurs
as a party (by i
ntervention
or otherwise) to any a
ction or
proceeding dir
ectl
y or
ind
irec
tly affecting Borrower, the Property or Lender's interests, ri
ghts
or remedies under an
y of the Loan Documents or (B) any payments
or funds exp
ende
d or
advanced by Lender pursuant to the pr
ovis
ions
of any Loan Document to pe
rfec
t, protect or
maintain the priority of any Loan Document or to pro
tect
, repair or maintain the Pth-p
erty;
(13)
recover from B
orrower an
d its constituent
partners any
loss,
liability or exp
ense
(including
atto
rney
s', experts' and c
onsultants' fe
es and
expenses)
incurred by Lender in con
nect
ion with any claim or allegation made by Borrower or any of it
s
constituent partners, or any successor, as
sign
or creditor of Borrower or any of it
s constituent
partners, that the Loan i
s, or any Loan Document establishes, a joint ven
ture
or partnership
arra
ngem
ent be
twee
n Lender and Borrower;
(14)
recover from Borrower and its
constituent
partners any
amount wit
hdra
wn from
any
account
in wh
ich
Lender h
as a s
ecurity
inte
rest
unless such
withdrawal was made in accordance with the document cre
atin
g such security interest or was
otherwise au
thor
ized
by Lender in writing; or
(15)
recover
any
costs, expenses of li
abil
itie
s (i
nclu
ding
atto
rney
s', ex
perts'
and con
sult
ants
' fe
es and
expenses) incurred by
Lender and
arising from a
breach of any
judgment, ver
dict
, order, consent decree or set
tlem
ent relating to the
deposit,
storage, disposal, burial, dumping, spilling, le
akin
g, cle
anup
, ch
arac
teri
zati
on, remediation or
abatement of toxic or hazardous waste, hazardous m
aterials, hazardous su
bsta
nces
or waste
products (as defined in any applicable federal or state law) or arising from any environmental
prov
isio
n in any Loan Document relating to the Pro
pert
y or
any portion thereof (i
ncluding,
with
out
limitation, any such e
nvironmental p
rovision c
ontained i
n the Mortgage or
in any
environmental indemnity given to Lender in con
nect
ion with the Loa
n).
(c)
Borrower and i
ts constituent partners shall be
personally
liab
le for
the
payment of a
ll amounts
and
perf
orma
nce of a
ll obligations
described
in the
fore
goin
g
subsection (b)
, clauses (1) th
rough (1
5).
(d)
Notwithstanding
the
limi
tati
on of l
iabi
lity
in su
bsec
tion
(a)
above,
Borrower shall be
fully personally l
iabl
e for
all of Borrower's
obligations under the Loan
Documents, and L
ende
r's recourse to the
personal a
ssets of Borrower an
d its
constituent
partners shall not be limited in any way by
this Sec
tion
X, if
Borrower (A) at
tempts to prevent
or delay the foreclosure of th
e Mortgage or any other co
llat
eral
for the Loan or the ex
erci
se of
any of Lender's
other remedies u
nder any Loan Document, or (B) claims
that any Loan
Document is in
vali
d or unenfor
ceable and such a claims will have the effect of preventing or
delaying such foreclosure or any other exercise of remedies. Without limitation, Borrower
shall be deemed
to have attemp
ted
to prevent or de
lay such for
eclo
sure
or other exercise of
remedies if CO
borrower files a
petition under the Bankruptcy Reform Act
of 1978, II U.S.C.
§101 et seq. (t
he "Ba
nkru
ptcy
Cod
e"),
as amended, (i
i) Borrower opposes a mot
ion by Lender
to l
ift an aut
omat
ic stay imposed
pursuant to 11 U.S.C. §362 and
for leave to foreclose the
Mort
gage
and
any other c
ollateral fo
r the Loan, or (iii) Borrower
files a proposed p
lan of
reor
gani
zati
on und
er the Bankruptcy Code und
er which Lender wo
uld receive (x
) less tha
n al
l
of the Pro
pert
y or (y)
a lien en
cumb
erin
g less tha
n all of the Property or (z)
a lien having a
lower
priority or terms
less fav
orab
le to Lender tha
n the Mortgage as
it existed immediately
prior to the filing of a pet
itio
n under the Ba
nlcr
uptc
y Code. Nothing in thi
s Section X shall be .
deemed to be a wai
ver of any right which Lender may have under Sections 506(a), 506(b),
1111(b) or any other provision of the Bankruptcy Code to fi
le a claim that
all of the Property
shall continue to secure all
of th
e indebtedness owed to Lender under the Loan Documents.
(e)
Nothing
in t
his Section X shall rel
ease
, impair or otherwise
affe
ct the
validity or
enforceability of the No
te, the Mortgage and the other Loan Documents or the
perf
ecti
on or
prio
rity
of the lie
n of the Mortgage upon the Property. Nothing herein shall be
cons
true
d to prohibit Lender from
exer
cisi
ng any remedies available to Lender provided that,
except as provided in subsections (b)
and
(d)
above, Lender shall not attempt to execute against
or recover out of any
property of Borrower
other th
an the Property. Nothing
herein s
hall
modi
fy, di
mini
sh or discharge the personal obligations under the Loan Documents as set fo
rth
in a separate written guaranty the
reof
, or the personal liability of Borrower or any other person
or entity un
der any indemnification pr
ovis
ions
of th
e Loan Documents.
000100:6058428-1
Michigan's Leg
isla
ture
Declares Post Closing Solvency
Covenants Unenforceable as Nonrecourse Carveouts
Paul S. Magy, Esq.
Kupe
lian
Ormond & Magy, P.C
.Southfield, Michigan
Michigan b
orrowers i
n general and nonrecourse carve out guarantors
in p
arti
cula
r, have had
great cause for
concem in th
e aftermath of two court decisions that pa
rsed
the int
rica
cies
of th
e
specific contract language while ignoring the ba
sic purpose of CMBS len
ding
and the rationale
behind SPE ("single
or special purpose e
ntity") st
atus
. Wells Fargo Bank, NA v
. Ch
erry
land
Mall
, N.W. 2d
, 2011 WL678593 (Mich. App. 2011) and 51382 Gra
tiot
Avenue Hol
ding
s
Inc. v
. Chesterfield
Development Company, 2011 U.S. D
ist. LEXIS (E.D. Mich. 2011) have
turn
ed the CMBS industry on i
ts ear by tr
ansf
ormi
ng nonrecourse gua
rant
ees into full recourse
guar
ante
es merely on the basis of insolvencies caused by the economic downturn. The mere
insolvency of a borrower in a CMBS loan had never before been understood to
trigger rec
ours
e
to the
car
veou
t gu
aran
tor unless, perhaps, if
the ins
olve
ncy was caused by other bad act
s of the
borrower. Otherwise, since virtually eve
ry def
ault
ing bo
rrow
er ent
ity is arg
uabl
y in
solv
ent,
every
so-c
alle
d nonrecourse loan would, actually be the
opp
osit
e. Thi
s would lead to the absurd result
that a carveout gu
aran
tor'
s li
abil
ity would be l
imited t
o actual damages caused by "bad boy"
acts, bu
t have full li
abil
ity
if the
value of th
e property fal
ls below the
amount of th
e de
bt mer
ely
because of market conditions.
In t
he past sev
eral
years, numerous CMBS properties have be
en f
orec
lose
d up
on,
while
numerous others have been given back to
the
lender by
deed in lieu of foreclosure. Where there
have been def
icie
ncie
s in foreclosure sales or there have not bee
n re
leas
es obt
aine
d fo
r th
e
benefit of the
gua
rant
or, th
ese two cases have sent a chill up the spi
ne of many who had tried to
put th
e past .b
ehin
d th
em. Sp
ecia
l servicers, on the other hand, may feel th
at they have been
handed a recoupment too
l on a silver
platter. Special Servicers are
asking attorneys wh
ethe
r
they can, should
or have a fiduciary
duty to examine al
l past de
fici
enci
es to
make a
dete
rmin
atio
n re
gard
ing probable l
iabi
lity
and p
otential collectability from carve out gua
rant
ors.
In M
ichigan there
is a s
ix year statute of
limitations to
bring th
ese "new" claims th
at had no
t
previously been on any
one'
s ra
dar sc
reen
. Each state has its own statute covering enforcement
of guarantees. Obv
ious
ly tens, i
f not hu
ndre
ds of
bill
ions
of dollars of gua
rant
or exposure
is
implicated
if sud
denl
y nonrecourse carve out guarantors are
liable for deficiency jud
gmen
ts
base
d solely on t
he bo
rrow
er's
insolvenOy. How about the
question
of whe
ther
a c
arve
out
guar
anto
r needs to include
this p
otential l
iabi
lity
on their fin
anci
al statement as a contingent
liab
ilit
y th
at is no lon
ger as remote as it
previously seemed?
Numerous CRE trade associations and others submitted arnicus br
iefs
in the Michigan Court of
Appe
als supporting rev
ersa
l of the lower court rul
ing
in the Cherryland ca
se. The CMBS world
held i
ts bre
ath
waiting and watching. Dis
appo
inti
ngly
, th
e co
urt exalted form over su
bsta
nce.
gave sho
rt shrift to the fundamental purpose of the particular cov
enan
ts inv
olve
d, ign
ored
direct
evidence of-the actual int
ent of the parties tha
t in
solv
ency
was not a recourse tr
igge
ring
eve
nt,
but wr
ote
that
if its decision appeared "i
ncon
grue
nt with th
e na
ture
of nonrecourse deb
t" and
could
result "in economic disaster for the bu
sine
ss community in Michigan"
it was a m
atter of
public policy best addressed by th
e le
gisl
atur
e. C
herryland at 16.
Michigan's Leg
isla
ture
Acts Sw
iftl
y to Enforce
the Original In
tent
of Nonrecourse CMBS Loans
Page 2
In l
ight
of th
e court's
invitation on December .27, 2011, the
actual existence of two deficiency
judgments
totaling ov
er twe
lve
million
dollars, more lawsuits being
filed
by th
e la
w fi
rm
representing the dif
fere
nt special servicers hoping to
sei
ze the
se new opportunities, Michigan's
commercial r
eal
esta
te interests took ac
tion
. Led
by th
e Bu
ildi
ng Owners and Managers
Asso
ciat
ion
of Met
ro D
etroit (BOMA) and with th
e support and backing
of the
entire CRE
comm
unit
y, legislation was proposed and quickly passed
to end the
threat of
these cases for
guarantors in Mi
chig
an.
On Ma
rch
29, 2012, M
ichigan's .Governor si
gned
the
Michigan
Nonrecourse
Mort
gage
Loan Ac
t into law. htto://www.leoislature.mi.00vidocuments/2011-
2012/publicact/pdf/2012-PA-0067.odf.
The Act pas
sed wi
th ove
rwhe
lmin
g, bi-
part
isan
support in
the Michigan Senate 37-5 and the
Michigan House 97-12.
It expressly declares a bor
rowe
rs
"ins
olve
ncy"
unavailable as a t
rigg
erin
g ev
ent
for a no
n-re
cour
se c
arve
out
in a
comm
erci
al
mortgage loan on Michigan p
roperty, characterizing such springing rec
ours
e as a deceptive
trade pr
acti
ce and, as such, une
nfor
ceab
le.
The enabling language of th
e new law states:
The leg
isla
ture
rec
ogni
zes that it
is in
here
nt in a nonrecourse loan tha
t th
e lender
takes th
e ri
sk of a b
orrower's insolvency,
inab
ilit
y to
pay
or lack of ad
equa
te
capi
tal after th
e loan is made and tha
t th
e pa
rtie
s do not
intend th
at the borrower
is per
sona
lly liable for payment of a nonrecourse loan
if the
borrower is insolvent,
unab
le to pay, or la
cks adequate capital aft
er the loan
is made. The legislature
recognizes tha
t th
e us
e of a post closing so
lven
cy cov
enan
t as a nonrecourse
carveout, or
an interpretation of
any provision in a loan document that re
sult
s in a
dete
rmin
atio
n th
at a post closing so
lven
cy cov
enan
t is a nonrecourse carveout, is
inco
nsis
tent
with this act and the
nat
ure of a nonrecourse loan; is an unf
air and
deceptive
busi
ness practice and against
public po
licy
; and should not
be
enforced.
It sta
tes
in §3(
1) th
at: "A post closing solvency cov
enan
t shall not be use
d, directly or ind
irec
tly,
as
nonrecourse carveout or as the basis for
any cla
im or action a
gain
st a borrower or any
guar
anto
r or
oth
er sur
ety on a non
reco
urse
loan." The Act was given immediate and ret
roac
tive
effe
ct and e
xpre
ssly
applies t
o the "enforcement and i
nterpretation
of a
ll nonrecourse
loan
documents in existence on
, or ent
ered
into on or
after the
effe
ctiv
e date of this a
ct. §5. The
enab
ling
lan
guag
e of the
new law
goes on to state:
It is th
e in
tent
of the legislature that this act ap
plie
s to any cla
im made or action
taken to
enforce a post closing solvency covenant on or after the effective date of
this act, to
any cla
im made to enforce a pos
t closing solvency cov
enan
t that is
pending on the e
ffec
tive
date of this act; and t
o any
action to enforce a
post
closing solvency cov
enan
t that is pending on the
eff
ecti
ve date of
the act, un
less
a judgment or fi
nal order has been ent
ered
in th
at action and a
ll rights to appeal
that
judgment or fi
nal order have been exh
aust
ed or have expired.
While
Michigan's Nonrecourse
Mortgage Loan Ac
t ostensibly so
lves
the
problem
of t
he
Cherryland and Chesterfield cas
es for
CMBS loans on Michigan properties or go
vern
ed by
Michigan law,
it remains to be seen what the
imp
act of tho
se cas
es as "persuasive aut
hori
ty" will
be in ot
her st
ates
if l
ende
rs att
empt
to pu
rsue
carve out guarantors on this ba
sis.
It c
an cer
tain
ly
be said that Michigan's legislature acted
with such speed and v
irtual unanimity tha
t th
ere
is no
doub
t regarding
its views about th
ose cases Ye
t, the
fin
al cha
pter
on the
cases and the
new
Michigan's Legislature Acts Swiftly to Enforce
the Original Intent of Nonrecourse CMBS Loans
Page 3
• •
law
is still in the drafting stage. The Cherryland case is pending on application for review by the
Michigan Supreme Court. The C
hesterfield case i
s on appeal
to the U
nited States 6
ih Circuit.
While each case could be decided on the merits, either court may dispose of the appeal before
it as moot. This would be a m
istake, especially since the lender has announced i
ts p
lan
to
challenge the legislation—at least it
s retroactivity—on constitutional grounds. It
would be ironic
if
the guarantors were first victimized by springing recourse and then victimized a second time by
a springing judgment if the
legislation
is later invalidated i
n whole or in
part.
It would a
lso be
unfortunate' if
the C
herryland and
Chesterfield cases actually remained u
ncriticized by higher
courts when they have been criticized
in virtually every other corner and by every other scholar
that has written on the subject.
•
The constitutional challenge should be interesting and may not be an all or nothing proposition.
The Michigan legislature identified three classes of claims for immediate and retroactive effect:
1) those that may be brought in the future based upon p
rovisions
in e
xisting loan documents
and 2) those that are currently pending or being litigated through the courts, including 3) those
that may have already r
esulted
in a judgment, so long as the cases are under appeal. Not
surprisingly, the lender's attorney wants to protect the judgments he has fought.hard to secure.
He will argue that his client's contract rights have been impaired and constitutional rights have
been violated. The obvious counter argument is that the legislation did not take away any right
that the c
ontracts p
rovided. Those r
ights never
existed. The l
egislation only t
ook .away an
interpretation by the courts that was incorrect under every fundamental understanding of CMBS
and
the
original intent o
f the
parties. The Contract Clause prohibition (both
federal and
Michigan) on impairment of contract is not absolute and is subject to the inherent police power
of the State to safeguard the interests of its people. Thus, lit
igat
ion over the constitutionality of
the
statute
will involve an examination of whether 1) there actually
is an impairment (is there
such a thing as a carveout for insolvency in a CMBS loan); 2) th
e law
is necessary to the public
good i
n that State (such as avoiding the freeze of CMBS investment in a state and the draining
of its resources); and 3) the manner i
n which the
Legislature
to addressed the problem was
reasonable. A court may d
ifferentiate between the classes of claims b
eing g
iven r
etroactive
effect as part of that constitutionality analysis or sustain the broad
retroactivity as reasonable
under
all of the circumstances.
The question
of whether a post closing s
olvency covenant should ever trigger nonrecourse
carve out guarantor
liability is one with
bill
ions
of dollars of implications around the country. How
the Michigan courts have dealt with this, how the CRE community has responded to
it, how the
Michigan l
egislature resolved
it and the attendant l
itig
atio
n will be
instructive for
practitioners,
judges, investors, lenders and legislators.
o Paul S. Magy, Esq.
Kupe
lian
Ormond & Magy, P.C.
Act No. 67
Publ
ic Acts of 2012
Approved by the Governor
March 29,.2012
Filed with the Secretary of State
March 29, 2012
EFFECTIVE DATE: March 29, 2012
STATE OF MICHIGAN
96TH LEGISLATURE
REGULAR SESSION OF 2012
Introduced by Senators Meekhof and Ric.bardville
ENROLLED SENATE BILL No. 992
• AN ACT to regulate the use and enforceability of ce
rtain loan covenants in no
nrec
ours
e co
mmer
cial
loan transactions
in thi
s st
ate.
The People of th
e State of Michigan ena
ct:
Sec. 1. This act
shall be known and may be cit
ed as th
e "nonrecourse mortgage loan act
".
Sec. 2. As used in thi
s ac
t:
(a) "Nonrecourse car
veou
t" means a specific exception, if
any, to the
nonrecourse provisions se
t fo
rth in the loa
n
documents for a nonrecourse lo
an tha
t has the
effect of cr
eati
ng, if specified events oc
cur,
per
sona
l li
abil
ity of the
borrower or a guarantor or ot
her su
rety
of the loan for all
or some amounts owed to the lender.
(b) "Nonrecourse loan" means a commercial lo
an secured by a mortgage on real pr
oper
ty located in th
is state and
evid
ence
d by loan documents th
at meet any
of the following:
(f) Provide that the len
der
will not enf
orce
the lia
bili
ty or obligation of the borrower by an action or proceeding in
which. a money judgment is sought aga
inst
the bor
rowe
r.
(ii)
Provide tha
t an
y judgment in an
y action or pr
ocee
ding
on the loa
n is enforceable aga
inst
the
bor
rowe
r only to
the extent of the borrower's interest in the mortgaged property and other col
late
ral se
curi
ty giv
en for the loa
n.
(iii
) Provide th
at the len
der will not see
k a deficiency judgment against the borrower
(iv) Provide tha
t th
ere
is no recourse aga
inst
the bor
rowe
r personally for the loa
n.
(v) Include any combination of s
ubpa
ragr
aphs
(i) to (iv) or any
other provisions to the effect th
at the loa
n is
wit
hout
personal l
iabi
lity
to the bo
rrow
er beyond
the
borr
ower
's int
eres
t in the mortgaged p
roperty and
other
coll
ater
al
secu
rity
giv
en for the loa
n.
(c) "Nonrecourse provisions" means 1 or more of the provisions described in subdivision (b)(i) to (v), whe
ther
or not
the loan is su
bjec
t to a nom
•eco
urse
carveout or car
veou
ts.
(d) "P
ost cl
osin
g so
lven
cy cov
enan
t" means any pro
visi
on of th
e loan documents for
a nonrecourse loan, whe
ther
•
expr
esse
d as a covenant. rep
rese
ntat
ion,
war
rant
y, or
default, that relates so
lely
to th
e so
lven
cy of the
borrower•,
including, wit
hout
limitation, a provision req
uiri
ng tha
t the borrower maintain adequate capital or ha
ve the ability to
pay it
s debts, wit
h respect to any
period of tim
e after the da
te the loa
n is ini
tial
ly funded. The term do
es not include a
covenant not to file a voluntary bankruptcy o• other vol
unta
ry insolvency proceeding or• not to collude in an in
volu
ntar
y
proc
eedi
ng.
Sec.
3. (1)
A post closing solvency covenant shall not be used, di
rectly; or indirectly, as a non
reco
urse
carveout or as
the basis fo
r an
y cl
aim or action ag
ains
t a borrows• or any guarantor or ot
her sure
ty on a non
reco
urse
loan.
(2) A pro
visi
on in the documents fo
r a non
reco
urse
loan that doe
s not comply wit
h subsection (1)
is invalid and
unenforceable.
(14)
Sec. 4.
This ac
t do
es not pro
hibi
ts loarrsecured by a mortgage on real property located in th
is state Fro
m being fully
recourse to the bo
rrow
er or the guarantor, in
cluding, but not limited to,
as a result of a post closing so
lven
cy covenant,
if the loa
n documents for th
at loan do not contain nonrecourse loa
n provisions.
Sec. 5. This act
app
lies
to the enforcement and interpretation of all no
nrec
ours
e loan documents in existence on, or
entered in
to on or aft
er, t
he effective date of th
is act
.
Enacting section 1. The legislature recognizes th
at it
is inherent in a non
reco
urse
loa
n that the len
der takes the risk
of a borrower's insolvency, i
nabi
lity
to pa
y, or lack of adequate capital aft
er the loan is
made and that the parties do not
inte
nd tha
t the bo
rrow
er is personally liable fo
r payment of a nonrecourse loan if
the borrower
is insolvent, unable to
pay,
or lacks adequate capital aft
er the
loan is made. The legislature rec
ogni
zes th
at the use of a post cl
osin
g so
lven
cy
covenant as a nonrecourse carveout, or an int
erpr
etat
ion
of any provision in a loan document that
results in a
determination that a post closing so
lven
cy covenant is a nonrecourse carveout, is inconsistent with this act
and the
natu
re of a nonrecourse loa
n; is an unfair and de
cept
ive business pra
ctic
e and. agai
nst public pol
icy;
and sho
uld not be
enforced. It
is the intent of the legislature th
at this ac
t ap
plie
s to any
claim made or action tak
en to en
forc
e a post
dosi
ng sol
venc
y covenant on or aft
er the effective date of thi
s act; to any claim made to en
forc
e a post closing solvency
covenant that is pen
ding
on the
eff
ecti
ve dat
e of this ac
t; and to any action to enforce a post cl
osin
g so
lven
cy covenant
that
is pending on the effective dat
e of this act, unless a judgment or fi
nal or
der has been entered in that action and
all
rights to appeal that judgment o1• fi
nal order ha
ve been ex
haus
ted or hav
e expired.
This act
is ordered to
tak
e immediate effect.
Approved
Governor
C,,P
Secr
etar
y of the Sen
ate
Clerk of the House of Representatives
CHAPTER FOUR
SPECIAL-PURPOSE BANKRUPTCY -REMOTE
ENTITIES
OVERVIEW
The terms "s
ingle purpose," "
special p
urpose: and "bankruptcy remote" are us
edin
a variery of c
ontexts throughour sr
rucrured fin
ance
and se
curitizacion. A
lthough
the terms have gen
eral
ly recognized meanings, t
hose
meanings may va
ry gr
eatly
depending on the role of th
e entity and the
type of tr
ansaction. Sp
ecial-purpose
bankruptcy-remote enciries ("
SPEs") ar
e used in a wide variety of c
ommercial
mortgage se
curirizacions. Furthermore, t
he role of the SPE may be ch
ar of
'
borr
ower
, depositor, g
eneral partner, member, l
essor, is
suer or some oc
her role.
As th
e commercial mortgage se
curi
riza
tion
markerhas ev
olved, so has rhe
special-purpose bankruptcy-r
emot
e real e
stare v
ehicle..In ea
rly p
ool tr
ansa
ctio
ns only
the depositor w
as re
quired CO bean SPE (r
ee Cha
pter
Two, P
ool T
ransactions). The
deposicor w
ould perform only o
ne fu
nction in i
s "c
orpo
rate
" life, i.
e., de
posi
ting
commercial mortgage l
oans
into the tr
ust which would is
sue t
he ra
ted s
ecur
itie
s.Crearing th
e de
posi
tor a
s an SPE was re
larively st
raightforward—once the depositor'
deposired the l
oans, i
t was pr
ohibited from en
gagi
ng in
any ot
her a
ctivities w
hich would
expose it
co li
abilities. The pr
ohibition rarely pr
esented any business problems because
once ate de
posit w
as co
mplete, t
here was li
ttle
need f
or the continued ex
istence of t
hede
posi
tor i
n the f
irst pl
ace. Th
is is
still g
enerally nue with re
spec
t to po
ol de
als.
However, in the la
sr few ye
ars, St
andard & Poor
's ha
s seen an in
creasing number of
property-specific c
ransac-dons wh
ere the underlying borrower, who owns and operates
real
esrace as
a bu
siness, m
ust also be an SPE. Because the bo
rrow
er is
very much an
operating e
ntity, cr
iter
ia had to be developed co m
eld the historical SPE de
posi
tor
criteria with the r
eali
ties
of owning and operating r
eal e
stare.
In January 1993, Standard & Poor's published
its R
eal Estate Finance SPE
crit
eria
ro address the increasing changes in the commercial mortgage marker.
Since that rime, Standard & Po
or's has seen a number of c
ommercial mortgage
"conduic" tr
ansa
ctio
ns where pools of newly originated loans are bei
ngsecurirized. Standard & Po
or's
has received dozens of reqUests with respect co rhe
need for
SPEs in
chose con
duit
tra
nsac
tion
s. In addition co, the newly formed
commercial mortgage conduits, Standard & Po
or's has begtin ro
see real es
tare
developers who want to use limited li
ability c
ompanies as bo
rrow
ers in
conduit,
credit le
ase and oc
her pr
oper
ty-specific transactions.
As a result o
f the continuing changes in the real estate marker and as rh
e types of
deal
s and
vehicles change, Sr
andard & Po
or's has decided to publish below is
crit
eria
refacing to SPE
s in
the context of commercial mortgage securicizarion
transa
ctions.
STANDARD sr POOR'S REAL ESTATE FINANCE
105
RATIONALE FOR THE SPE IN A COMMERCIAL MORTGAGE TRANSACTION
To understand the rationale for S
tandard & Po
or's cr
iteria, i
t is n
ecessary to first
define an SPE in the most basic terms:
An SPE is
an
entity which is u
nlikely to become insolvent a
s a re
sult of its
own ac
tivities and which is
adequately insulatedicons the consequences of
any related pany's i
nsolvency.
The SPE is
generally urilized i
n one of th
ree different types of tr
ansactions;
1. The property -specific transaction;
2. The pool transaction; and
3. The credit l
ease transaction.
The most basic f
orms of these transactions, which are s
ubjecr ro a variety of
structural permurartons. ar
e discussed in detail i
n Chapters One, Two and Three
of th
is publication and are briefly summarized below.
Property
-Specific Transactions
The property -specific transaction is d
riven by owners and operators of re
al esrate
who are looking co borrow funds at a lower overall cost than what might be
available f
rom
cradirional l
ending so
urces. -
In the property -specific transaction, S
tandard & Po
or's credit analysis focuses on
the property mortgaged by the borrower as collateral for the loan. It
is critical t
oStandard & Po
or's analysis chat the borrower not be subject. C
O economic
problems unrelarcd to The borrower's real esrace collateral. h is
for this reason
that the borrower in the property -specific transaction must be an SPE.
As noted above, many property -specific transactions include, as
pars of th
eir
structure, a deposit of one or more mortgage loans into a crust. As a re
sult, a
property
-specific transaction may require multiple SPEs. In addition ID the
borrower being an SPE, th
e deposicor may be required co be an SPE if t
hetransfer of the loan by the depositor ro a trust could nor be characterized
. properly as a rrue sa
le.
106
STANDARD & POOR'S REAL E
STATE FINANCE
RATIONALE FOR THE SP
E IN A COMMERCIAL. MORTGAGE TRANSACTION (connnurd)
Pool Transactions
As discussed in Chapter Two, in
a traditional pool transaction, an owner of
mortgage loans (t
he "Depositor") will transfer a portfolio of mortgage loans
(ogether with any reserve f
unds, s
ecurity deposits, i
nsurance policies, LOCs,
guarantees or other forms of credit enhancement fo
r the mortgage lo
ans) to a
trust which will i
ssue the rated securities i
n exchange for the proceeds from the
sale of t
he se
curities which are issued by the trust and secured by the mortgage
loans. Generally sp
eaking, S
tandard & Poor's credit an
alysis in a pool rransaccion
focuses on a combination of a
sset-specific a
nd actuarial analysis of th
e economic
characceristics of th
e mortgage pool, wi
th limited analysis of th
e underlying pool
bOrrowers.
One of the concerns that Standard & Poor's has in connection with the transfer
of die loans from the Depositor co the crust is w
hether the transfer c
onstitutes a
"true sale" under applicable law. E
ven though the transfer may be accomplished
by means of a "
purchase and sale" agreement, c
ircumstances surrounding the
transfer could lead a court to conclude that the transfer of lo
ans was nor a sale
bur a financing transaction whereby the trust made a secured loan co the
Depositor. If such a recharaererization were to occur, the transfer of the loans
would be viewed as a pledge of co
llateral by the Depositor, an
d, if th
e Depositor
were CO become subject- to
a bankrupEcy proceeding, the loans would be deemed
CO be parr of the Depositor's estate under Section 541 of the U.S. Bankruptcy
Code (the "Bankruptcy Code). Consequently, the automatic st
ay and ocher
Bankruptcy Code provisions could apply to the mortgage loans and their
proceeds, creating the li
kely interference with payments on the rated securities.
In order to ameliorare the ri
sk that the transfer is
not a "T
rue sale," the Depositor
is fr
equently established as an SPE. The purpose of creating an SPE Depositor is
ro create an entity which should nothecomesubject to a bankruptcy proceeding,
thus alleviating the risk that the Depositor will become in
solvent, fi
le a
bankruptcy petition and then (i
t or its c
reditors) c
laim that the transfer was not a
true sa
le. If t
he Depositor does nor become su
bject to a bankruptcy proceeding,
there is a lower likelihood that the Depositor or
its c
reditors will have any
incentive to recharacterize the transaction as a secured financing.
STANDARD & POOR'S REAL ESTATE FINANCE
107
108
RATIONALE FOR THE SPE IN A COMMERCIAL MORTGAGE TRANSACTION (continued)
Credit Lease Transactions
As discussed in Chapter Three, in
a credit l
ease transaction the borrower obtains
a loan which is s
ecured by a "triple net" le
ase co a rated tenant. The borrowei
executes a note and mortgage in favor of th
e lender and assigns it
s right co collect
the rents co the lender. Th
is lender will then deposit the note, mortgage and
assignment of r
ents into a
crust which will issue rated securities. (A
gain, as in
property-specifIC transactions, che trust s
tructure is
nor always utilized and the
borrower may is
sue its notes directly).
•The key difference between the structured credit l
ease transaction and traditional
real estate f
inancing is
that i
n the s
tructured credit lease transaction, i
f the tenant
carries a credit rating (
or it
s lease payments are guaranteed by a creditworthy
entity), the borrower will be able to obtain a raring o
n its debt ob
ligation, even
though the borrower
is nitrated. Generally speaking, th
is racing will change
only if t
he raring o
n the tenant improves or de
clines.
Because the rating on the transaction
is tied to the tenant's rating (a
nd not that
of th
e landlord/borrower), i
s is c
ritical that the landlord/borrower be an SPE. If
the landlord/borrower were not bankruptcy remote, its insolvency could interfere
with the flow of income paying the rated securities.
As with the property-specific transaction, a credit l
ease transaction may re
quire
multiple SPEs. If
a depositor deposits the loan into a trust, in addition to the
landlord/borrower being an SPE, the depositor may be required co be an SPE if
the transfer of the loan by the depositor co the crust could not be characterized
properly as a true sa
le.
STANDARD 8c POOR'S REAL ESTATE FINANCE
OVERVIEW OF SPE CRITERIA
Standard & Poor's SPE' criteria can be divided up into four fundamental
categories:
1. Items intended to prohibit the SPE from incurring liabilities:
• L
imitaticin on Purpose
• Limitation on Indebtedness
• P
rohibition on liquidation, consolidation, merger, etc.
2. Items intended co insulate the SPE from
liabilities of th
ird parties:
• Separateness c
ovenants
.• N
onconsolidation opinions
3. Items intended to protect the SPE from dissolution risk:
• Prohibition on dissolution
• S
pecial-purpose bankruptcy-remote equity owner (e.g., SPE general
• partners and SPE members)
4. Items intended to protect the'solvent SPE from filing a bankruptcy petition:
• Independent director
The three most frequently misunderstood aspects'of t
he SPE are the independent
director, t
he special-purpose equity owner and the nonconsolidation opinion.
Independent Directors
Generally s
peaking, St
andard & Po
or's requires chat an SPE have an
independent director among it
s board of di
rectors. The independent director's
vore is
required to undertake certain actions, most importantly, to fi
le a
bankruptc-y petition with respect co the SPE. The independent director is
•intended co protect against t
he si
tuation where an otherwise solvent SPE might
be voluntarily fi
led by directors who are also directors of ch
e SPE's parent. F
or '
example, if
there were no independent director, t
he board of directors of th
e SPE
may be the exact same directors f
or the SPE's parent. If
parent were co
become insolvent and deem
it advantageous for the SPE to file a bankruptcy
petition (irrespective of the effect on che SPE's creditors), the board of di
rectors
may si
mply vote co file a
bankruptcy petition with respect' to the solvent SPE.
The independent di
rector is
intended in part co help insulate against the risk that
the parent's board of d
irectors will be able co 'control the SPE and voce to file the
otherwise solvent S
PE.
STANDARD & POOR'S REAL ESTATE FINANCE
109
OVERVIEW OF SPE CRITERIA
(continued)
Spec
ial -Purpose Eq
uity
Owner
The mos
t fr
eque
ndy used SPEs in commercial mortgage transactions are
corporations and lim
ited
par
tner
ship
s. Alt
houg
h this is
not the cas
e with
corp
orat
ions
, with limited partnerships there ar
e ci
rcum
stan
ces under which the
insolvency of an equity owner co
uld cause a dissolution of
the limited
partnership.
Limi
ted partnership SPEs are most frequently use
d as borrowers in credit lea
se
.anerproperry-specific transactions. Generally s
peaking, the
y co
nsis
t of
one
general partner and mu
ltip
le limited partners. Und
er the Revised Uniform
• Limited. P
artn
ersh
ip Ace
, ifa general partner of a li
mite
d partnership were to
beco
me su
bject 00 a ban
krup
tcy proceeding, th
e partnership wo
uld
dissolve
unle
ss it
was otherwise con
tinu
ed or re
cons
titu
ted by the
remaining partners.
Because Standard & Po
or's can
not predict wh
ethe
r or
not
the rem
aini
ngpa
rtne
rs wou
ld continue or
reconstitute, S
tandard & Po
or's att
empt
s to pro
tect
against the dissolution risk by re
quir
ing th
at the
gen
eral
partner of t
he lim
ited
partnership be an SPE. If
the general partner is
an SPE, th
is sho
uld gr
eatl
yreduce the cha
nces
chat th
e general partner will bec
ome insolvent an
d th
epartnership will dissolve.
The SPE general partner al
so pro
tect
s ag
ains
t th
e possibility char the
partnership
woul
d be involuntarily fi
led or
that a bankruptcy court's app
rova
l might be
requ
ired
for
the limited partnership co un
dert
ake ce
rtai
n ac
ts whi
ch cou
ld be
critical to th
e limited partnership's ab
ilit
y ro
repay the rac
ed indebtedness. For
example, if
the sole general partner of a
n SPE limited partnership were to
become insolvent and the
partnership wanted co refinance the rated securities, it
is pos
sibl
e that bankruptcy court ap
prov
al might be required in or
der to
refinance th
e raced securities. I
f, however, th
e ge
nera
l pa
rtne
r we
re an SPE, th
egeneral partner s
houl
d nor be
come
the
subject of
a bankruptcy proceeding an
dno cou
rt approval wo
uld be required.
110
STANDARD & PO
OR'S
REAL E
STAT
E FINANCE
OVERVIEW OF SPE
CRITERIA
(continued)
Nonconsolidation Opi
nion
s
One of the fu
ndam
enta
l co
mpon
ents
of a
n SPE is
tha
t th
e insolvency ofan
affi
liat
e of a
n SPE sho
uld not impact the SPE. Under th
e equitable provisions of
Section 105 of
the Bankruptcy Cod
e, a court has the power to
"substantively
cons
olid
ate"
ostensibly s
eparate bu
t re
late
d entities. S
ubst
anti
ve con
soli
dati
ontreats the ass
ets a
nd liabilities of th
e entities as if they be
long
ed co one, en
abli
ngthe creditors of
each formerly separate estate to reach the ass
ets of
the
'con
soli
date
d es
tate
.
In a commercial mortgage tra
nsac
tion
, if an
affiliate o
f th
e SPE were to become
inso
lven
t, ir
is possible th
at the affiliate or th
e affiliate's cr
edit
ors wo
uld attempt
co sub
stan
tive
ly consolidate the insolvent af
filiate with the SPE
, effectively
placing the SPE und
er bankruptcy court protection and sub
ject
ing its as
sets
to
the cl
aims
of th
e affiliate's c
reditors.
When cou
rts decide whe
ther
to substantively consolidate tw
o en
titi
es, a
great
deal
of their f
ocus is
on
the degree ro which the affairs oldie entities are
intertwined. The separateness requirements (t
ee Cha
pter
Four, SPE Li
mited
Part
ners
hips
) are int
ende
d co separate th
e affairs of
the affiliate wi
th chose of th
eSP
E, an
d help protect aga
inst
the
consolidation risk. How
ever
, substantive
cons
olid
atio
n is
a complex subject and
the
sep
arat
enes
s covenants alone wi
ll not
adequately protect aga
inst
the risk. For this re
ason
, cou
nsel
co the SPE MUSE
properly st
ruct
ure therransaction and the
relationship between th
e af
fili
ate a
ndth
e SPE to avoid th
e substantive consolidation
risk. I
n or
der to
con
firm
thi
sst
ruct
ure,
Standard & Po
or's req
uire
s the co
unse
l fo
r th
e SPE CO deliver an
opin
ion to tha
t ef
fect
.
SPEC
IFIC
SPE CRITERIA
Although a wid
e range of
entities such as
general partnerships, li
mited
part
ners
hips
, corporations, municipalities, not
-for-profit in
stit
utio
ns,
eleemosynary in
stit
utio
ns, p
ublic purpose co
rpor
atio
ns and
business crusts are
util
ized
in commercial mor
tgag
e transactions, t
he type of
enti
ties
most frequently
utilized in recendy ra
ted commercial mor
tgag
e tr
ansa
ctio
ns are
cor
pora
tion
s,limited partnerships and limited lia
bili
ty companies. Where possible, the
foll
owin
g criteria should be incorporated in
to bot
h th
e en
tity
's organizational
documents and, as
app
lica
ble,
the
tra
nsac
tion
doc
umen
ts (s
ee Cha
pter
One,
Representations a
nd Warranties in
Property-
Specific Transactions).
STANDARD & PO
OR'S
REAL E
STAT
E FI
NANC
E111
112
SPECIFIC SPE CRITERIA (continued)
SPE Limited Partnerships
In Standard & Po
or's analysis of a limiced partnership, Standard 8c Poor's will
evaluate whether the limiced partnership conforms to the following:
. The limited partnership's purpose should be limited. The nature of th
elimitation will depend on the limited partnership's role in che transaction..
For example, a borrower's purpose generally s
hould be li
mited to owning
and operating che mortgaged property. A depositor's purpose generally
.should be limited co depositing the morcgage loans.
•2. The limited partnership's ability to incur indebtedness sh
ould be limired.
Again, the nacure of th
is li
mitation will depend on the l
imired partnership's
role in the transaction. For example, a
borrower generally will be limiced to
incurring (1) the indebtedness which secures the rated securities and (2)
liabilities i
n the ordinary course of bu
siness relating to the ownership and
operation of th
e mortgaged property.
3. The li
mited partnership (and, as
applicable, it
s parcners and affiliares) should
be prohibited from engaging in any dissolution, l
iquidation, consolidation,
merger or asset s
ale, or amendment of i
ts limited partnership agreement as
long as
the raced securities a
re outstanding.
4. Ac le
ast one general partner of the limired partnership should be an SPE (f
eeChapter F
aun SPE Corporate GeneralParmers and SPE Co
rporations). Among
.ocher things, this requirementis intended co protect against dissolution of
the limited partnership during che course of th
e raced transaction.
5. The consent of the general parrner of th
e limited partnership (including the
vote of the independent director of th
e SPE general partner) should be
required in order to: •-
.• F
ile, or consent to the fi
ling of, a bankruptcy or insolvency perition or
otherwise instirute insolvency proceedings;
• Dissolve, li
quidate, co
nsolidate, merge, or se
ll al
l or substantially a
ll of che
assets' f th
e partnership;
• Engage in any ocher business acrivity; a
nd• Amend the limited partnership agreemenr.
STANDARD & POOR'S REAL ESTATE FINANCE
F c c c
111
SPECIFIC SPE CRITERIA (continued)
6. The limited partnership (and, as
applicable, it
s partners and affiliates) should
agree to abide by certain '
'Separateness Covenants" whereby the li
mired
partnership covenants:
• To maintain books and records separate from any ocher person or entity;
• To maintain its a
ccounts separate from any ocher person or encity; -
• Noc to commingle assets with chose of any ocher entity;
• To conduct it
s own• business in
its own name;
• To maintain separate fi
nancial statements;
• To pay it
s own li
abilities our °Pits own funds;
• To observe al
l pannership formalities;
• To maintain an arm's-length relationship with is af
filiates;
• To pay the sa
laries of i
ts own employees and maintain a sufficient number
of em
ployees in light of i
ts contemplated business operations;
• Noc co guaranree or become obligated for che debts of an
y other entity or
hold our it
s credit as being available to satisfy t
he obligations of others;
• Nor to acquire obligations or se
curities of i
ts partners, members or
• shareholders;
• To allocate fairly and reasonably any overhead for shared office space;
• To use se
parate stationery, in
voices, and checks;
• Nor to pledge it
s assets fo
r the benefit of any ocher entity or make any
loans or advances to any entity;
• To hold itself out as
a separate enciry;
• To correct any known mistinderstanding re
garding its s
eparate identity;
and
• To maintain adequate ca
pital i
n light of i
ts contemplated business operations.
If th
ere is more than one general parrner, the limited partnership agreement
should provide chat the partnership shall c
ontinue (
and not dissolve) f
or so
long as another solvent general pawner ex
ists.
8. If th
e limired partnership
is an
out-of-state or foreign entity, the limiced
partnership muse be qualified under applicable law in the gate in which the
collateral is
located.
9. Standard & Po
or's requests an opinion of c
ounsel char upon the in
solvency
of (1) a limited partner having greater than a 49% interest in the limired
partnership or (2) any general partner char is nor an SPE, th
e limiced
partnership or it
s assers'and liabilities would nor be substantively
consolidated with chat insolvent partner. D
epending on
the circumsrances,
additional nonconsolidation opinions may be required.
STANDARD & POOR'S 'REAL ESTATE FINANCE
113
SPECIFIC SPE CRITERIA (c
onti
nued
)
SPE Cor
pora
te Gen
eral
Partners
Typi
call
y, the SPE General Par
tner
is a corporation. I
n Standard & Poor's
anal
ysis
of a
corporation, S
tandard & Poo
r's will eva
luat
e whether the certificate
or ar
ticl
es of in
corp
orat
ion conforms to th
e fo
llow
ing;
1. The cor
pora
tion
's pur
pose
sho
uld be lir
nice
d to acting as gen
eral
par
tner
of
the limited pa
rtne
rshi
p.
2. The corporation's abi
lity
to incur indebtedness should be limited.
3. The cor
pora
tion
sho
uld be pro
hibi
ted fr
om eng
agin
g in
any dis
solu
tion
,liquidation, co
nsol
idat
ion,
merger or
ass
et sa
le, o
r amendment of
its a
rtic
les
of inco
rpor
atio
n as
lon
g as the
rated sec
urit
ies are ou
tsta
ndin
g-.
4. The cor
pora
tion
should ha
ve ac least o
ne ind
epen
dent
director.
5. The unanimous con
sent
of the di
rect
ors s
hould be required co:
• F
ile, or consent co the fli
ng of, a bankruptcy or
ins
olve
ncy petition or
othe
rwis
e institute i
nsol
venc
y proceedings or
cause the partnership CO do so;
• To dissolve, li
quidate, co
nsolidate, mer
ge, or
sell all
or su
bsta
ntia
lly all of
the as
sets
of the corporacion;
• Engage in any och
er bus
ines
s ac
civi
ry; a
nd• Amend the art
icle
s of
incorporation of th
e corporation or
voc
e CO amend
the li
mite
d partnership's limited partnership ag
reem
ent.
6. The dir
ecto
rs of th
e corporacion sh
ould
be re
quir
ed to consider rhe
interests
of th
e creditors of
the corporation in
con
nect
ion with all
cor
pora
re actions.
7. The cor
pora
tion
sho
uld agree to
observe the "Se
para
tene
ss Cov
enan
ts"
referred to ab
ove.
8. Standard &Po
or's
requests an opinion of co
unse
l th
at upon the in
solv
ency
of an
y sh
areh
olde
r ho
ldin
g more tha
n a 49% of th
e stock of t
he corporation,
the co
rpor
atio
n or
its as
sets
and liabilities would not
be substantively
cons
olid
ated
wit
h th
at in
solvent s
hareholder. Depending on
cir
cums
tanc
es,
additional nonconsolidation op
inio
ns may be required.
114
STANDARD & PoOr5 REAL ESTATE FINANCE
SPECIFIC SPE CRITERIA (c
onti
nued
)
SPE Cor
pora
tion
s
In Standard & Poo
r's analysis of a corporarion, St
anda
rd & Poor's will eva
luat
ewh
ethe
r the eel-rifle= or ar
ticl
es of i
ncorporation conforms co E
fie f
ollo
wing
: •1. The cor
pora
tion
's pur
pose
sho
uld be li
mite
d. The nat
ure of
the limitation
will dep
end on the
cor
pora
tion
's role i
n th
e transaction. For example, a
borr
ower
's purpose generally should be lim
ited
to Owning and
ope
rari
ng the
mort
gage
d property. A depositor's pur
pose
gen
eral
ly should be limited to
depositing the mortgage loans.
2. The corporation's ability to in
cur in
debt
edne
ss sho
uld be
limited. A
gain
, th
enature of t
his l
imit
atio
n will depend on the
cor
pora
tion
's rol
e in
the
transaction. For example, a bo
rrow
er gen
eral
ly wi
ll be limited to
inc
urri
ng(1) th
e indebtedness whi
ch sec
ures
the rat
ed se
curities and
(2) li
abilities i
nthe ordinary course of
business relaring co the
own
ersh
ip and
operation of
the mo
rtga
ged property. '
3. The corporation should be pro
hibi
ted from eng
agin
g in
any
dis
solu
tion
, •
liquidation, consolidation, merger or asset s
ale, or amendment of
its a
rticles
of in
corporation as
lon
g as the
rac
ed securities are outstanding.
4. The corporacion sh
ould
hav
e ac
16st one independent director.
5. The unanimous con
sent
of th
e directors s
houl
d be required to:
• F
ile, or
con
sent
to th
e filing of
, a ban
krup
tcy or
ins
olve
ncy petition or
othe
rwis
e insrirure i
nsolvency pr
ocee
ding
s;• To dissolve, li
quidate, co
nsolidate, mer
ge, o
r se
ll al
l or substantially al
l of
the as
sets
of the corporation;
• Eng
age in any oth
er business ac
civi
ry; and
• Amend the
arricles o
f inc
orpo
rari
on of th
e corporation.
6. The directors of the corporation sh
ould
be required to co
nsid
er rhe
interests
of th
e creditors of
the corporacion in
connection with all cor
pora
te actions.
7. The corporation should agree ro observe th
e "S
epar
aten
ess Co
vena
nts"
refe
rred
to ab
ove.
8
If th
e co
rpor
atio
n is
an
out-of-state or fo
reig
n enrity, the corporation should
be qualified und
er app
lica
ble law in the
stare in wh
ich th
e co
llat
eral
is located.
9. St
anda
rd & Poo
r's requests an opinion of
coun
sel th
at upon th
e insolvency
of an
y sh
areh
olde
r holding mo
re than a 49% of the stock of
the corporation,
the corporation or
its a
sset
s wo
uld nor be
consoliLred with that insolvent
shareholder. Dep
endi
ng on circumstances, ad
diti
onal
non
cons
olid
atio
nop
inio
ns may be required.
STANDARD & POOR'S REAL ESTATE FINANCE
115
SPECIFIC SPE CRITERIA (courinued)
SPE Limited Liability Companies
In Standard & Po
or's analysis ofa limited liability company, St
andard & Po
or's
will evaluate whether the articles of organization of the company conforms co the
following:
1. The limited liability company's purpose should be limited. For example, a
borrower's purpose generally should be limited to owning and operating the
mortgaged property. A depositor's purpose generally should be limited co
depositing the mortgage loans.
2. Thelimited liability company's ability to incur indebtedness should be
limited. The nature of th
e limitation will depend on the limited liability
.company's role in the transaction. For example, a
borrower generally will be
limited co (1) in
curring the indebtedness which secures the raced securities
and (2) liabilities i
n the ordinary course of bu
siness relating to the ownership
and operation of th
e mortgaged property.
3. The limited liability company sh
ould be prohibited from engaging in any
dissolution, li
quidation, consolidation, merger or asset s
ale and amendment
of is ar
ticles of organization as long as the raced securities are outstanding.
4. The limited li
ability company must have at le
ast one member which is
an
SPE, su
ch as an SPE corporation, described above. Generally, o
nly the
bankruptcy-remote special-purpose member should be designated as the
"manage? under the law under which the limited liability company is
. organized, and the li
mited liability company's ar
ticles of organization should
provide that it
will dissolve only on the bankruptcy of a managing member.
5. The unanimous consent of the members (including the vote ache
independenr director of die SPE member) sh
ould be required CO:
• F
ile, or consent to the fi
ling of, a bankruptcy or in
solvency petition or
otherwise institute i
nsolvency proceedings;
• D
issolve, li
quidate, co
nsolidate, merge, or Se
ll all or s
ubstantially al
l of th
eassets of the limited liability company;
• Engage in any ocher business activity; a
nd• Amend che limited liability company's organizational documents.
110
STANDARD & POOR'S REAL ESTATE FINANCE
N L
SPECIFIC SPE CRITERIA (continued)
6. The limited liability company should agree to observe the "Separateness
Covenants" referred to above.
7. To the extent permitted by tax la
w, the ar
ticles of organization should
•provide that che.vote ofa majority of the remaining members
is su
fficient co
continue the li
fe of the limited liability company, in
che event of a
termination event. If
the required consent of the remaining members co
continue the limited li
ability company is
not obtained, th
e articles of
organization must provide that the limited li
ability company not liquidate
collateral (e
xcept as permitted under the transaction documents) without the
consent of ho
lders of ch
e raced securities. Such holders °Effie rated securities
may continue co exercise all o
f their rights under the existing security
agreements or mortgages, and must be able to retain the collateral until the
debt has been paid in full or otherwise completely discharged.
8. If th
e limited liability company
is an out-of
-'scale o
r foreign entity, the
limited liability company should be qualified under applicable law in the
state in which the collateral is located.
9. Standard & Po
or's requests an opinion of counsel that upon the insolvency
of any member holding more than 49% of the membership interests in che
limited liability c
ompany, the limited liability company or
-its assets and.
liabilities w
ould not be substantively consolidated with that in
solvent
member. Depending on the circumstances, additional nonconsolidarion
opinions may be required. A
lso, Standard & Poor's requires an opinion of
counsel chat the limited liability company will be taxed as a partnership and
nor as a corporation.
STANDARD & POOR'S REAL ESTATE FINANCE
117
STANDARD'
=
&POOR'S
Publ
icat
ion Dale: May 1. 2003
U.S. CMBS Legal and Str
uctu
red Finance
Criteria
Intr
oduc
tion
The commercial mortgage sec
uril
izat
ion market has steadily ev
olve
d since the pu
blic
atio
n in 1994 of
Standard & Poor's criteria gov
erni
ng com
merc
ial mo
rtga
ge sec
urit
izat
ion tr
ansa
ctio
ns. One result has been
that Standard & Poor's has received numerous req
uest
s for an upd
ate of Str
uctu
red Fi
nanc
e Ra
ting
s, Real
Estate Flnance—Legal and Str
uctu
red Fi
nanc
e Issues in Commercial Mortgage Securities, As the
commercial mor
tgag
e se
curi
tiza
tion
mar
ket has seasoned and grown sig
nifi
cant
ly over the la
st sev
eral
year
s, Sta
ndar
d & Poor's fe
lt it
was app
ropr
iate
to re-evaluate the ex
isti
ng criteria and to add fu
rthe
r to
pics
that are
per
tine
nt to th
ese is
sues
, the ev
olut
ion of whi
ch, in
each ca
se, is
due to Standard & Poo
r's
addr
essi
ng nov
el features or changes tha
t have arisen over the las
t several ye
ars.
This gu
ide compiles and
upda
tes Standard & Poo
r's legal cr
iter
ia for
commercial mortgage sec
urif
izaf
iion
.
It sho
uld be not
ed that, as the
marketplace evo
lves
, the
crit
eria
dis
cuss
ed in th
is pub
lica
tion
are subject to
revi
sion
. Standard & Poo
r's re
gula
rly re
view
s it
s criteria to keep current wit
h both changes in the la
w and
mark
et developments in
the
area of structured finance. As a res
ult,
the
se criteria are not stagnant, but
evol
ve over time. Standard & Poor's welcomes con
tact
and communication wit
h potential as
wel
l as current
mark
et par
tici
pant
s to
con
sult
wit
h it for cl
arification re
gard
ing an
y of the
criteria de
scri
bed in thi
spu
blic
atio
n, or wi
th any questions reg
ardi
ng fut
ure structured transactions and developments as the
y arise.
The goal is
to enable eas
y ac
cess
and to provide the re
ason
ing behind the
rat
ing cr
iter
ia'.
To thi
s en
d.Standard & Poor's
will
con
tinu
e to
pub
lish
its
criteria to keep ma
rket
participants in
form
ed of any new
approaches to ra
ting
structured tr
ansa
ctio
ns. As a practical necessity, this pub
lica
tion
can
not and doe
s not
purport to
address eve
ry issue that comes up in a loa
n or
igin
atio
n or commercial mo
rtga
ge securilizalion
tran
sact
ion.
In the absence of clear gu
idel
ines
, ma
rket
participants are urged to use a pru
dent
lender
standard.
This
publication Is di
vide
d Into liv
esec
tion
s and 16 app
endi
xes.
The first thr
ee sec
tion
s de
al wit
h th
e th
ree
basic types of commercial mortgage securitization tr
ansa
ctio
ns:
• The property-specific or "stand-alone tra
nsac
tion
(i.e., a loa
n tr
ansa
ctio
n involving a single property
with
one borrower, mu
ltiple properties wi
th one bor
rowe
r, cross
-collateralized multiple properties wi
thmu
ltip
le borrowers, a small number of non-
cross-
collateralized properties wi
th unrelated bor
rowe
rsthat does not con
stit
ute a pool) and the large loa
n tr
ansa
ctio
n (i.e., a lar
ge loa
n included wit
hin a
cond
uit or poo
l tr
ansa
ctio
n or a gro
up of large lo
ans to unrelated borrowers tha
t ar
e pooled tog
ethe
r)(s
ee section one
);• The poo
l tr
ansa
ctio
n (i.e., poo
ls of pe
rfor
ming
loans, po
ols of non
performing loa
ns and conduits)
(see section two); and
• The credit lease tr
ansa
ctio
n (see section three).
Each of th
ese types of transactions has a number of variations and may involve any
one of se
vera
l property
type
s, in
clud
ing retail, multifamily, of
fice
, in
dust
rial
, mobile home parks, he
alth
care, war
ehou
se and mix
edus
e.
The las
t two se
ctio
ns address issues th
at are
applicable to
eac
h of the
thr
ee types of co
mmer
cial
mortgage
transactions. Sp
ecif
ical
ly, s
ecti
on four deals wi
th Sta
ndar
d & Poor's criter
ia rel
atin
g to special-purpose
bank
ruil
itiy
-rem
ote en
titi
es (SP
Es),
Section five describes St
anda
rd & Poor's cr
iter
ia relating to legal
opinion
he appendixes de
al wit
h certain specific topics in
greater det
ail,
as well as providing some of th
e
standard forms for
CMBS transactions.
We would lik
e to express our
appreciation to the aut
hors
of some of the attached app
endi
ces,
InclUding
Tom G
illi
s, Tom Murray, Din
a Moskowitz, Roy Chun, Shawn Har
ring
ton,
Nancy Ols
on, and James Penrose.
Last, a special tha
nks to Maureen Coleman, Jo
an Biro and tO
rn Diamond for the
ir efforts in making
contributions and revisons to !his publication.
Gale C. Scott, Managing Director, Glo
bal Re
al Estate Finance, (1) 21
2-43
8-26
01. .
2
Section 'F
our
Spec
ial-Purpose Bankruptcy-Remote Entities
Overview
The terms "single purpose," "spe
cial
purpose." and "bankruptcy rem
ote"
are
use
d in
a variety of co
ntex
tsthroughout the
structured finance and sec
urit
izat
ion ma
rket
s. Alt
houg
h the terms have gen
eral
ly rec
ogni
zed
mean
ings
, th
ese me
anin
gs may vary gr
eatl
y de
pend
ing on the
role of the ent
ity and the typ
e of transaction.
Special-purpose, bankruptcy-re
mote
ent
itie
s "SPEs" are
use
d in a wid
e variety of commercial mo
rtga
gese
curi
tiza
tion
s. Roles that may ca
ll for
an SPE entity in
a sec
ueit
izat
ion in
clud
e those of borrower, de
positor,
trust,-general partner, member, le
ssor
, and issuer.
Sinc
e th
e original pub
lica
tion
of St
anda
rd & Poor's Legal arid Str
uctu
red Fi
nanc
e Is
sues
in Comthercial
Mort
gage
Securities, Sta
ndar
d 8 Poor's has received on
goin
g inquiries re
gard
ing
criteria rel
atin
g to SPEs.
These inquiries grow out of various market fac
tors
, in
clud
ing th
e in
crea
sed de
sire
by-i
ssue
rs to use li
mite
dli
abil
ity companies and the inc
lusi
on of large lo
ans in
poo
l transactions. This sec
tion
updates the criteria
rega
rdin
g SPEs In li
ght of the
se mar
ket factors and inquiries.
Rationale for the SPE in a Commercial Mortgage-Backed Transaction
. To und
erst
and the rationale for Standard & Poorts criteria, i
t is necessary
to describe an SPE in the most
basic terms. An SPE is an entity,
for
med co
ncur
rent
ly wit
h or imm
edia
tely
pri
or to th
e su
bjec
t transaction,
that
is unlikely to become ins
olve
nt as a result of it
s own act
ivit
ies and that is
adequately in
sula
ted from the
consequences of an
y related
part
y's in
solv
ency
. 1 he SI b is ge
nera
lly
utilized in one of three different types
of tra
nsac
tion
s:
• The properly-
spec
ific
or large loan transaction:
• The poo
l transaction; and
• The credit lease transaction.
The most basic forms of th
ese transactions, wh
ich ar
e su
bjec
t to a variety of structural per
muta
tion
s, are
discussed in
det
ail in
sec
tion
s on
e, two
, and thr
ee of th
is publication and are
briefly summarized below.
Prop
erty
-Spe
cifi
c and Large Loan Transactions
In the properly-sp
ecif
ic or large lo
an transaction, St
anda
rd 8 Poo
r's credit analysis focuses on the property
mort
gage
d by the borrower as
collateral for the lo
an.
It is cr
itic
al to St
anda
rd 8 Poor's analysis tha
t th
ebo
rrow
er be insulated from economic iss
ues that are unr
elat
ed to th
e bo
rrow
er's
'real estate collateral. It
is
for th
is rea
son
that
the
borrower in
the
property-
spec
ific
or la
rge loan tra
nsac
tion
must be an SPE.
As discussed in se
ctio
n dne, many property-
specific transactions include, as part of the
ir structure, a
•deposit of one or more mor
tgag
e lo
ans into a trust. As a res
ult,
in a property-specific transaction, multiple
SPEs may be appropriate. In
add
itio
n to
each bor
rowe
r being an SPE, th
e de
posi
tor an
d/or
the
holder of
any securities or
interests in mo
rtga
ge loan received or retained in connection wit
h a transfer of a loan or
loan
s should be an SPE if
the
tra
nsfe
r of the loan or loa
ns by th
e or
igin
ator
to the depositor, or by the
depositor to a trust, c
ould
not oth
erwi
se be characterized properly es
a "tr
ue sal
e..
' Pool Tra
nsac
tion
sAs discussed i
n se
ctio
n tw
o, in
a traditional poo
l transaction, one or more mor
tgag
e loan sellers will tr
ansf
era portfolio of mo
rtga
ge loa
ns (to
geth
er wit
h any loan do
cume
ntat
ion,
reserve funds. security dep
osit
s,insurance policies, l
etters of cr
edit
, gu
aran
tees
, or oth
er forms of credit enhanCement for
the mor
tgag
eloans) to the de
posi
tor which, in
turn, will tr
ansf
er a Suc
h mo
rtga
ge loa
ns to a t
rust. The tru
st wil
l issue th
era
ted se
curi
ties
, which ar
e backed by th
e mo
rtga
ge loans, to
inv
esto
rs in exchange for
the pro
ceed
s from
the sa
le of the securities.
One of th
e concerns that St
anda
rd 8 Poor's has in co
nnec
tion
wit
h th
e transfer of th
e loans from the
originators to the
depositor. or from th
e de
posi
tor to the
trust, is
whe
ther
the
tra
nsfe
r co
nsti
tute
s a Tru
e sa
leunder applicable law
. Even tho
ugh th
e transfer may be acc
ompl
ishe
d by
means of an agr
eeme
nt between
the tr
ansf
eror
and the
tra
nsfe
ree fo
r th
e pu
rcha
se and sal
e of the
mortgage lo
ans,
circumstances
89
surr
ound
ing th
e transfer cou
ld lea
d a cou
rt to conclude tha
t the transfer of lo
ans was not a sal
e, but
rat
her a
fina
ncin
g transaction wh
ereb
y the tr
ansf
eree
has made a loan to the transferor secured by the transferor's
interest in th
e mo
rtga
ge loa
ns.
If such a rec
hara
cter
izat
ion we
re to oc
cur,
the putative tr
ansf
er of the mo
rtga
ge loans would ins
tead
be
cons
true
d as
a pledge of mor
tgag
e loans by the tra
nsfe
ror as col
late
ral for the financing an
d, if
the
tran
sfer
or wer
e to become sub
ject
to a bankruptcy proceeding, a bankruptcy co
urt co
uld Include th
e loans
M the transferor's estate pursuant to Section 541 of the "Bankruptcy Code. Con
sequ
entl
y, the
automatic
stay and oth
er Bankruptcy Code pro
visi
ons co
uld ap
ply to
the mor
tgag
e loans, any
related collateral, and
pthc
eeds
of the foregoing, which would lik
ely in
terf
ere wi
th tim
ely payments of in
tere
st or the ultimate
payment of pr
inci
pal on the rated sec
urit
ies.
In situations wh
ere a tra
nsfe
r ca
nnot
be characterized properly as a true sa
le, the tr
ansf
eror
generally
should be an SPE. In
addition, any
sec
urit
ies or interests in th
e transferred mo
rtga
ge loa
ns received or
retained by a loan or
igin
ator
in connection wit
h such tra
nsfe
r ge
nera
lly sh
ould
be hel
d in
an SPE.
The purpose of cr
eating
an SPE in th
ese si
tuel
ions
is to
create an entity that sho
uld not become sub
ject
to
a bankruptcy pr
ocee
ding
. The use of an SPE ent
ity is
designed to red
uce the risk of the -
transferor
beco
ming
insolvent (or
being substantively con
soli
date
d wi
th an ins
olve
nt af
filiate), f
iling a bankruptcy
peti
tion
, and cla
imin
g (o
r having oth
er cre
ditg
rs of the tr
ansf
eror
cla
lrr)
tha
t the transfer of the mortgage
loan
s and oth
er collate
ral to
the dep
osit
or or the securilization tru
st was not a true sale. If
the
depositor or
holder of se
curi
ties
or re
tain
ed Interests do not become sub
ject
le a bankruptcy pr
ocee
ding
(or
substantively consolidated wit
h an Insolvent affiliate), the
lik
elih
ood th
at the
depositor or holder of se
curi
ties
or retained interests or the
ir cre
dito
rs will have any
inc
enti
ve to recharactedze the tr
ansa
ctio
n as a secured
fina
ncin
g is
con
sequ
entl
y reduced. (See Section Five, Legal Opinions, for
a more det
aile
d di
scus
sion
of
true sal
e issues).
Credit Lease Tra
nsac
tion
sAs discussed in Section Th
ree,
in a credit lease transaction, the borrower, as lan
dlor
d and owner of th
e fee
inte
rest
in an income -
producing re
al property, obtains a loan th
at is se
cure
d by a "tr
iple
net" bo
ndab
le lease
to a rated ten
ant.
Typ
ical
ly, th
e landlord/borrower
will
execute a not
e and mo
rtga
ge in fa
vor of the len
der
and wil
l as
sign
its
right to co
llec
t the rents un
der the lease to the len
der.
the len
der wi
ll the
n de
posi
t, ei
ther
dire
ctly
or indirectly thr
ough
a dep
osit
or, th
e no
te, mortgage, assignrrient of re
nts,
and related col
late
ral into
a tru
st tha
t will issue rated sec
urit
ies.
As in property
-spe
cifi
c transactions, th
e tr
ust st
ruct
ure (i.e., whe
re the
trust iss
ues th
e rated securities) i
snot al
ways
employed. The len
der or its
affiliate may instead dir
ectl
y is
sue the rated se
curi
ties
(th
roug
h en
indenture or oth
erwi
se) and deposit the not
es, t
he mor
tgag
es, the as
sign
ment
s of lea
ses and rents, and the
rela
ted collateral wit
h a collateral ad
mini
stra
tor to
hold in
tru
st and as col
late
ral for th
e ra
ted se
curi
ties
.
A key dif
fere
nce between th
e structured credit lease tr
ansa
ctio
n and traditional rea
l estate financing is that
in the for
mer case,
if the
tenant has been ass
igne
d a
-cre
dit ra
ting
by Standard and Poor's (o
r the tenant's
lease payments are
guaranteed by en entity who has been ass
igne
d a credit ra
ting
), it
wil
l be possible,
•un
der most circumstances, to ass
ign a rat
ing to the
credit lease de
bt obl
igat
ion of the lan
dlor
d/bo
rrow
erbased on the credit ra
ting
of the tenant (or its
guarantor). Generally, the ra
ting
ascribed to
the cre
dit lease
debt
obligation of a lan
dlor
d/bo
rrow
er wil
l be
adj
uste
d only if t
he rat
ing on the tenant (
or the
guarantor of th
etenant's lease obl
igat
ions
) improves or dec
line
s.
Because the
rat
ing on the tra
nsac
tion
is li
ed to th
e ra
ting
of th
e tenant (o
r it
s creditworthy guarantor), it
is
crit
ical
tha
t th
e landlord
/bor
rowe
r be an SPE. If
the
lan
dlor
d/bo
rrow
er wer
e not an SPE, a lan
dlor
d/bo
rrow
erinsolvency cou
ld int
erfe
re wit
h timely payments of in
tere
st or the ul
tima
te payment of principal on the
rat
edse
curi
ties
.
As wit
h property-specific transactions and poo
l transactions, in
a cre
dit lease tr
ansa
ctio
n, multiple SPEs
may be app
ropr
iate
. For example, if
a depositor conveys the cre
dit tenant loans int
o a
trust, in addition to
the landlord/borrower being an SPE, th
e depositor also sho
uld be an SPE if t
he tra
nsfe
r of the
cre
dit tenant
loan by the depositor to the
tru
st cou
ld not be characterized pro
perl
y as a tru
e sa
le.
90
Overview of SPE Criteria
The following gen
eral
categories are th
e fr
amew
ork for St
anda
rd & Poor's SPE cri
teri
a:
• R
estr
icti
ons intended to limit o
r el
imin
ate th
e ab
ilit
y of an SPE from incurring
liab
ilit
ies ot
her than the
debt
to be inc
lude
d as part of the rated tra
nsac
tion
, in
clud
ing (i
) res
tric
tion
s an
d/or
limitations on
indebtedness, and (i
i) li
mitations on pur
pose
of the SPE and the
act
ivit
ies in
whi
ch i
t may eng
age.
• Re
stri
ctio
ns intended to ins
ulat
e the SPE from
liab
ilit
ies of af
fili
ates
and thi
rd par
ties
, Including (i
) the
requ
irem
ent that the
organizational documentation of the SPE and the
tra
nsac
tion
documents
cont
ain separateness covenants described in th
is sec
tion
and (I
I) the req
uire
ment
that a
nonc
onso
lida
tion
opinion be delivered wit
h respect to the SPE meeting the guidelines described in
Section'Five of th
is pub
lica
tion
.• R
estr
icti
ons Intended to pr
otec
t the SPE from di
ssol
utio
n risk, i
nclu
ding
(i)
abs
olut
e prohibitions on
liquidation and con
soli
dati
on for so long as
the rat
ed sec
urit
ies ar
e outstanding, (I
I) re
stri
ctio
ns on
merg
er of the SPE, and sal
e of al
l or substantially all of the as
sets
of the SPE, in
each Cas
e, wit
hout
the pr
ior written consent of the
len
der an
d, fo
llowing th
e se
curi
tiza
tion
of th
e indebtedness, re
ceip
t of
a ratings confirmation, and (i
ii) t
he req
uire
ment
that, except for a properly structured si
ngle
member
limi
ted
liab
ilit
y company as dis
cuss
ed below, (
a Si
ngle
MemberLLC*), th
e SPE hav
e ap
prop
riat
esingle-purpose, bankruptcy-r
emot
e eq
uity
owners (e.g., SPE gen
eral
par
tner
s -wi
th respect to an SPE
limi
ted pa
rtne
rshi
p, or an SPE member hol
ding
a mea
niri
gful
ebo
nomi
c.in
tere
st wit
h respect to
an
SPE lim
ited
liability company that is
not a Sin
gle Member LLC).
-• R
estr
icti
ons intended lo limit a sol
vent
SPE fro
m filing a ban
krup
tcy petition (or
taking any oth
erinsolvency act
ion)
, including the requirement that the SPE (and/or any SPE con
stit
uent
ent
ity)
hav
ean ind
epen
dent
director or independent manager whose vot
e is
required pr
ior to the fi
ling of any
bank
rupt
cy (or
taking an
y ot
her insolvency act
ions
) in ac
cord
ance
wit
h th
e gu
idel
ines
of th
is.se
ctio
n.
'Alt
houg
h a sin
gle -member LLC typically con
tain
s on
ly one member, it
may contain•multiple Members. The
term
"single-member LLC" is
use
d in thi
s se
ctio
n fo
r ease of di
scus
sion
. (See Appendix
XIII for
a dis
cuss
ion
of Sta
ndar
d & Poor's SPE criteria fo
r single-member LLC
s).
The for
egoi
ng categories of restrictions fo
r SPEs are
dis
cuss
ed in de
tail
in th
is Sec
tion
.
Specific SPE Criteria
Alth
ough
a wid
e range of en
titi
es such as gen
eral
partnerships, li
mited partnerships, limited
liab
ilit
yco
mpan
ies,
cor
pora
tion
s, municipalities. not
-for-profit i
nstitutions, ch
aritable Ins
titu
tion
s, pub
lic pu
rpos
ecorporations, and bus
ines
s trusts are
utilized in
com
merc
ial mortgage transactions, the
typ
e of ent
itie
s most
freq
uent
ly use
d in
rec
entl
y ra
ted commercial mor
tgag
e transactions are corporations, li
mited partnerships,
and li
mite
d li
abil
ity co
mpan
ies.
The following cri
teri
a sh
ould
be Inc
orpo
rate
d into bot
h the tr
ansa
ctio
ndocuments in addition to the following:
• If the SPE is a co
rpor
atio
n, the
filed articles of inc
orpo
rati
on;
• i
f the SPE is a li
mite
d liability company, th
e li
mite
d liability company operating agr
eeme
nt;
• I
f the SPE is a li
mite
d partnership, the limited partnership agreement; and
• If the SPE is another ty
pe of entity. it
s co
rres
pond
ing or
gani
zati
onal
doc
umen
ts.
Restrictions on Add
itio
nal Indebtedness
The abi
lity
of an SPE to incur in
debt
edne
ss, ot
her th
an the
indebtedness th
at is supporting the rat
edse
curi
ties
, sho
uld be limited. "rh
e na
ture
of th
is limitation wi
ll depend on the SPE
's role in
the tra
nsac
tion
.
For example, the
SPE mortgage bo
rroW
ers or
gani
zati
onal
doc
umen
tati
on and the tra
nsad
tion
documentation that evidences the
indebtedness ba
ckin
g the rated se
curi
ties
sho
uld generally re
stri
ct the
SPE mor
tgag
e borrower fro
m incurringindebtedness ot
her th
an (i)
the ind
ebte
dnes
s th
at backs the
rat
edse
curi
ties
and (ii
) uns
ecur
ed trade pay
able
s th
at are as follows:
• S
ubject to a can on the
agg
rega
te amount of trade indebtedness tha
t may be incurred (w
hich
maximum amo
unt,
in the
cas
e of an SPE mortgage 'b
orro
wer in
property speCific or la
rge lo
an
9)
tran
sact
ions
, is gen
eral
ly less than 2% of the principal amount ind
ebte
dnes
s su
ppor
ting
the rated '
secu
riti
es, and is generally le
ss tha
n a de minimis amount in
the case of an SPE equ
ity owner of an
SPE mor
tgag
e borrower);
• i
ncur
red in
the
ordinary co
urse
of bu
sine
ss, .
• R
elated to th
e ownership and ope
rati
on of the mortgaged property;
• R
equi
red to be pai
d wi
thin
60 day
s from the dale such trade pay
able
s are
first i
ncurred by the SPE
mort
gage
bor
rowe
r (and not me
rely
60'
days
from the date on wh
ich th
e tr
ade pa
yabl
es are due
); and
▪ Not ev
iden
ced by a pro
miss
ory no
te (se
e Section One, Pe
rmit
ted indebtedness, f
or a fur
ther
discussion of ad
diti
onal
deb
t).
Stan
dard
& Poor's
will gen
eral
ly rev
iew,
on a case-by-case basiC. the
documentation and inf
orma
tion
wit
hre
spec
t to
any
add
itio
nal de
bt that an SPE is permitted to incur.
Limitations on the
Purpose of an SPE
The purpose for which the SPE is fo
rmed
and the act
ivit
ies th
at the SPE may be engaged in should be
expr
essl
y li
mite
d in
both the transaction documents and the org
aniz
atio
nal documentation of the SPE. The
natu
re of the limitation will depend on the
SPE's rol
e in
the tra
nsac
tion
. Fo
r example, an SPE mortgage
borr
ower
's pur
pose
should be lim
ited
to owning and ope
rati
ng the mortgaged properly th
at is collateral for
the de
bt sup
port
ing the rated securities and act
ivit
ies necessary and inc
iden
tal to such purpose. The
purp
ose of any
equ
ity owner of an SPE mor
tgag
e bo
rrow
er that itself is
a SPE constituent entity should be
limi
ted to own
ing the eq
uity
interests in th
e SPE mor
tgag
e bo
rrow
er, while an SPE dep
osit
ors purpose
should be lim
ited
to de
posi
ting
the mor
tgag
e lo
ans Into the tru
st tha
t wi
ll issue the
rated sec
urit
ies.
Prohibition on Con
soli
dati
on and Liquidation; Restrictions on Mergers and Asset Sal
esBo
th the
org
aniz
atio
nal documentation of an SPE and the
tra
nsac
tion
documentation related to the
inde
bted
ness
tha
t supports ihe
rated sec
urit
ies should, f
or so lon
g as the rated sec
urit
ies ar
e ou
tsta
ndin
g,prohibit the SPE from doing the fo
llow
ing:
• Consolidating or com
bini
ng wit
h another en
tity
;• L
iquidating or winding-up
; and
• Merging or selling all or substantially all of it
s as
sets
, in
eac
h case, wi
thou
t the pr
ior written consent
of the len
dera
nd, in the case of pro
pert
y-sp
ecif
ic or large lo
an transactions, rec
eipt
of a rat
ings
conf
irma
tion
.
Prohibition on Amendments to Documentation
Both
the
org
aniz
atio
nal documentation of an SPE and the tra
nsac
tion
documentation related to the
inde
bted
ness
tha
t supports the
rated sec
urit
ies should prohibit th
e SPE from amending the
provisions of th
eor
gani
tati
onal
documentation of the SPE tha
t pertain to SPE cri
teri
a (including any defined ter
ms per
tain
ing
to such
criteria) as long as the
rat
ed sec
urit
ies are ou
tsta
ndin
g.
SPE Equity Owners of SPE Limited Partnerships, SPE Limited Lia
bili
ty Companies,
and Multitiered SPE Structures
The discussion th
at follows addresses the
pro
per st
ruct
urin
g for SPE equity ow
ners
in limited pa
rtne
rshi
psand
limited
liability companies, whi
ch are
two of th
e most common types of en
titi
es use
d in
com
merc
ial
mort
gage
transactions. SPE equity ow
ners
for
oth
er types of entities, such as
gen
eral
par
tner
ship
s and
trus
ts. ar
e examined by Standard & Poor's on a cas
e-by-case basis.
SPE Equ
ity Owners in SPE Lim
ited
Partnerships
SPE limited partnerships ar
e frequently use
d as borrowers in mortgage loa
n tr
ansa
ctio
ns. Ty
pica
lly,
SPE
limited partnerships consist of one gen
eral
partner and one or more lim
ited
partners. Und
er the
Rev
ised
Unif
orm Limited Pa
rtne
rshi
p Act, if
a gen
eral
par
tner
of a lim
ited
partnership wer
e to become sub
ject
to a'
bank
rupt
cy proceeding, the
par
tner
ship
would dis
solv
e unless it
was oth
erwi
se con
tinu
ed or reconstituted
by the
remaining partners. Because Standard & Poo
r's ca
nnot
predict whe
ther
or not th
e re
main
ing pa
rtne
rswould co
ntin
ue or reconstitute an SPE limited par
tner
ship
, St
anda
rd & Poor's seeks to pro
tect
aga
inst
this
diss
olut
ion
risk
by requiring th
at all gen
eral
par
tner
s of the SPE limited partnership be structured as SPEs
themselves. Re
quir
ing the SPE lim
ited
partnership to ha
ve each of it
s ge
nera
l partners be an SPE should
redu
ce the
ris
k of a gen
eral
par
tner
becoming in
solv
ent,
whi
ch might oth
erwi
se cau
se the
SPE lim
ited
partnership to
dis
solve.
.
92
Prov
idin
g th
at all gen
eral
partners of an SPE limited par
iner
shit
i will be SPEs sho
uld al
so protect aga
inst
the po
ssib
ilit
y th
at, in
the
cas
e wh
ere a ge
nera
l pa
rtne
r becomes insolvent but
the lim
ited
partnership is not,
a ban
krup
tcy courts approval in con
nect
ion wi
th the gen
eral
partner's insolvency mi
ght be required for the
SPE lim
ited
par
tner
ship
to un
dert
ake ce
rtai
n ac
ts. Fo
r example; if
the sol
e ge
nera
l pa
rtne
r of an SPE limited
part
ners
hip were to become insolvent and the SPE limited par
tner
ship
des
ired
to refinance the related
mort
gage
loan; it is po
ssib
le tha
t th
e approval of the ba
nkru
ptcy
cou
rt would be required wi
th res
pect
to
such proposed financing.
•
Where an SPE gen
eral
par
tner
of the SPE limited partnership is not en SPE cor
pora
tion
or a properly
structured sin
gle-member LLC, but instead is en SPE limited par
tner
ship
or SPE lim
ited
lia
bili
ty company
that is not a pro
perl
y structured Sin
gle Member LLC, the SPE gen
eral
par
tner
should
itself hav
e SPE
gene
ral pa
rtne
rs that are SPE corporations o
r pr
oper
ly structured single-member LLCS in the manner
described in
thi
s Se
ctio
n. Thi
s gu
idel
ine ap
plie
s wi
th equal force to each SPE limited par
tner
ship
or limited
liability company included in
the chain of ge
nera
l partnership ownership in
the bor
rowe
r st
ruct
ure.
SPE Equ
ity Owner In SPE Lim
ited
Liability Company
In gen
eral
(except in
the case of a.pro
perl
y structured single-member LLC
), wi
th respect to transactions
involving an SPE lim
ited
lia
bili
ty company, at
lea
st one member of
the SPE lim
ited
lia
bili
ty company hol
ding
a meaningful economic int
eres
t in
such SPE (ge
nera
lly at
lea
st 0.5%) sh
ould
Itself be an SPE. Sta
ndar
d &
Poor
's chi
ef concern is that the
bankruptcy or insolvency of non-SPE members may pre
cipi
tate
the
bank
rupt
cy or in
solv
ency
of th
e SPE lim
ited
liability company or a dissolution of th
e SPE lim
ited
lia
bili
tycompany. Hav
ing at
lea
st one member of th
e SPE lim
ited
lia
bili
ty company that is
itself an SPE mit
igat
essuch ris
k. How
ever
, as des
crib
ed in Appendix XIII, Sta
ndar
d & Poo
r's
will
rat
e a transaction involving a
prop
erly
structured single-member LLC (wh
ich has no SPE economic members).
.
.Where the
SPE equ
ity owner of th
e SPE limited lia
bili
ty company is not an SPE cor
pora
tion
or a properly
structured single -member LLC, but instead is structured as an SPE lim
ited
lia
bili
ty company tha
t is
not a
sing
le-member LLC, such SPE equ
ity owner must it
self hav
e an SPE equity owner that is
an SPE
corp
orat
ion or a properly structured sin
gle-member LLC in the manner des
crib
ed in th
is Sec
tion
. This
guid
elin
e ap
plie
s wi
th equal force to ea
ch SPE lim
ited
liability company or SPE lim
ited
par
tner
ship
Inc
lude
din
the
borrower structure.
The "Independent Director"
The 'fol
lowi
ng discussion concerns Sta
ndar
d & Poor's recommendations fo
r "in
depe
nden
t directors" fo
r SPE
orga
niza
tion
al structures. These recommendations are commonly fol
lowe
d in transactions reviewed by
Stan
dard
& Ppor's and are cur
rent
ly viewed by Sta
ndar
d & Poor's as prevalent In
the
market. The
discussion that follows do
es not
, however, attempt to address ea
ch possible permutation and com
bina
tion
of ent
itie
s th
at may comprise th
e SPE's org
aniz
atio
nal structure. Ind
epen
dent
director pr
ovis
ions
for.ge
nera
lpartnership borrowers, tru
st borrowers, and oth
er borrowing structures that dif
fer f
rom the structures
described below ar
e ex
amin
ed by St
anda
rd & Poors on a case-by-c
ase basis.
As noted abo
ve, th
e vo
te of th
e independent director is required to un
dert
ake ce
rtai
n ac
tion
s, most
impo
rtan
tly,
to
file a bankruptcy petition or ta
ke oth
er ins
olve
ncy action wit
h re
spec
t to the SPE. The
provisions reg
ardi
ng the
ind
epen
dent
dir
ecto
r are in
tend
ed to protect ag
ains
t a vol
unta
ry bankruptcy
petition being fil
ed by th
e sh
areh
olde
rs, members, partners, dir
ecto
rs, or managers (as app
lica
ble)
of an
othe
rwis
e so
lven
t SPE. Th
is situation cou
ld ari
se, fo
r example, where all of the di
rect
ors on the boa
rd of an
SPE corporation wer
e al
so members of th
e bo
ard of dir
ecto
rs of the operating company parent of that SPE
corporation.
If there wer
e no ind
epen
dent
dir
ecto
r on the board of th
e SPE corporation, and the
parent of the SPE
corp
orat
ion were to become insolvent and
, as
a con
sequ
ence
, deem it advantageous fo
r the SPE
corp
orat
ion to file a bankruptcy. p
etition (
without re
gard
to th
e im
pact
on the
SPE corporation's cre
dito
rs),
the di
rect
ors of the
SPE cor
pora
tion
cou
ld simply vo
le to
file a ban
krup
tcy pe
titi
on wit
h respect to
the
othe
rwis
e so
lven
t SPE corporation. The ind
epen
dent
dir
ecto
r is
, therefore, int
ende
d (i
n part) to help In
sula
teag
ains
t the risk that th
e sh
areh
olde
rs, members, partners, dir
ecto
rs, or managers (as
app
lica
ble)
of the
pare
nt of th
e SPE will be abl
e to control the SPE and vot
e to file a ban
krup
tcy pefition wit
h re
spec
t to
an th
eotherwise so
lven
t SPE.
The following is a generally acceptable definition of "
independent di
rect
or".
93
A duly ap
poin
ted member of the bo
ard of dir
ecto
rs of the re
leva
nt entity who shall not hav
e be
en, at the
time
of such appointment or at
any lime while se
rvin
g as a dir
ecto
r or manager of the re
leva
nt ent
ity and
may not hav
e been at an
y time in the preceding five years, an
y of the
fol
lowi
ng:
• A direct or indirect legal or beneficial owner in such ent
ity or any
of it
s af
fili
ates
:• A creditor, supplier, emp
loye
e, of
ficer, di
rect
or. f
amily member, manager, or co
ntra
ctor
of such entity
or any of it
s af
fili
ates
; or
• A per
son who con
trol
s (wh
ethe
r di
rect
ly, i
ndir
ectl
y. or ot
herw
ise)
such ent
ity or any of it
s af
fili
ates
, or
any creditor, supplier, emp
loye
e, of
fice
r, dir
ecto
r, man
ager
, or con
trac
tor of such
enti
ty or
its
affi
liat
es.
Independent Directors for SPE Cor
pora
tion
s-A
n SPE cor
pora
tion
sho
uld ha
ve, at al
l limes while th
e in
debt
edne
ss sup
port
ing the rated se
curi
ties
Is
outstanding, at Meat one ind
epen
dent
director du
ly app
oint
ed to, and ser
ving
on, it
s bo
ard of directors. in
addition, the un
anim
ous co
nsen
t of the boa
rd of di
rect
ors of the
SPE (Including th
e in
depe
nden
t di
rect
or(s
))sh
ould
be required to file, or consent to the filing of, a ban
krup
tcy or insolvency petition or ot
herw
ise
institute insolvency pro
ceed
ings
wit
h re
spec
t to the SPE corporation. The board of di
rect
ors of the SPE
corp
orat
ion (i
nclu
ding
the independent director(s)) sho
uld he required to con
side
r the In
tere
sts of the
cred
itor
s of the SPE cor
pora
tion
in connection wit
h all such ba
nkru
ptcy
and ins
olve
ncy ac
tion
s.
•Independent Directors for
SPE Lim
ited
Liability Companies
An SPE lim
ited
lia
bili
ty company sho
uld ha
ve, at al
l limes while the in
debt
edne
ss supporting the ra
ted
secu
riti
es is outstanding:
• An ind
epen
dent
manager or in
depe
nden
t director who is a duly ap
poin
ted member of.
and serving
on, the board of managers or bo
ard of dir
ecto
rs of the SPE lim
ited
fia
blli
ty company bor
rowe
r, if
the
SPE lim
ited
liability company bor
rowe
r is
structured such tha
t it inc
lude
s a boa
rd of managers or
boar
d of dir
ecto
rs whose vot
e is
required wi
th res
pect
to taking any bankruptcy or ins
olve
ncy ac
tion
;or
• An SPE ind
epen
dent
member that is
a member of the SPE limited lia
bili
ty company bor
rowe
r having
(x)
if such ind
epen
dent
member of th
e SPE lim
ited
liability company borrower is
a corporation, an
inde
pend
ent director, (y)
If such in
depe
nden
t member of the SPE lim
ited
liability company bor
rowe
ris
a lim
ited
lia
bili
ty company, an ind
epen
dent
member or in
depe
nden
t ma
nage
r, or (
z) if
such
inde
pend
ent member Of th
e'SP
E li
mite
d li
abil
ity company bor
rowe
r is
a.limited par
tner
ship
, an SPE
gene
ral pa
rtne
r th
at it
self has an ind
epen
dent
dir
ecto
r if
such ge
nera
l pa
rtne
r is
a corporation, or an
inde
pend
ent manager or in
depe
nden
t member if
such SPE gen
eral
par
tner
is a limited
liab
ilit
ycompany; or
• As to an
y si
ngle-member LLC, an ind
epen
dent
member that is
a "no
n-economic member, whi
chmay be a corporation having an Ind
epen
dent
director, a limited l
iability company having an
inde
pend
ent member, or in
depe
nden
t manager or a limited partnership having a gen
eral
par
tner
that
has an ind
epen
dent
director,.independent manager, or independentmember, as applicable. For any
properly structured si
ngle-member LLC, the independence fe
atur
e provided by an ind
epen
dent
director may also be provided by an ind
ivid
ual who ser
ves as the "no
n-economic member" of the
limi
ted
liability company borrower, provided the in
divi
dual
would oth
erwi
se qua
lify
as an independent
director if
the SPE lim
ited
lia
bili
ty company bor
rowe
r were structured wi
th a boa
rd of ma
nage
rs.
Independent Dir
ecto
rs for
SPE
Lim
ited
Partnerships
Each gen
eral
par
tner
of an SPE lim
ited
partnership borrower sh
ould
have, at all times while th
ein
debt
edne
ss sup
port
ing the ra
ted se
curi
ties
is ou
tsta
ndin
g, the fol
lowi
ng:
• An ind
epen
dent
dir
ecto
r among its
boa
rd of directors, if
such ge
nera
l partner is
a cor
pora
tion
, in the
manner described und
er the Section ent
itle
d "I
ndep
ende
nt Directors for
SPE Corporations," ab
ove;
Or• An independent manager or independent-member (as applicable) if
such ge
nera
l partner is
aproperly structured single-member LLC, in
the Manner described under the
Sec
tion
ent
itle
d"I
ndep
ende
nt Directors foi SPE Lim
ited
Liability Companies" abo
ve.
94
Separateness Covenants
As discussed abo
ve, in
ord
er to in
crea
se the lik
elih
ood th
at an SPE wil
l be ins
ulat
ed from the
liab
ilit
ies and
obligations ()fits aff
ilia
tes and third parties, the SPE sho
uld agree to abide and, as app
lica
ble,
Its
shareholders, members, pa
rtne
rs, and
affi
liat
es should ag
ree to cause the SPE to ab
ide by the following
separateness covenants .w
ith respect to the SPE (the "S
epar
aten
ess Covenants") whereby the
SPE
cove
nant
s, among oth
er thi
ngs:
• To mai
ntai
n bo
oks and rec
ords
sep
arat
e from
othe
r person or entity;
• To mai
ntai
n it
s ac
coun
ts sep
arat
e from shy oth
er person or ent
ity;
• Not to co
mmin
gle as
sets
wit
h th
ose of any
oth
er ent
ity;
• To conduct it
s own bus
ines
s in
its
own name;
• To maintain se
para
te financial statements;
• To-pay its
own lia
bili
ties
out of Its own funds;
• To obs
erve
all partnership for
mali
ties
;
• To mai
ntai
n an arm's
-len
gth relationship wit
h it
s af
fili
ates
; •
• To pay the
salaries of it
s own emp
loye
es and mai
ntai
n a suf
fici
ent number of em
ploy
ees in
lig
ht of Its
contemplated bus
ines
s op
erat
ions
;• Not to guarantee or become obligated for the debts of any oth
er ent
ity or hold out
Its credit as being
avai
labl
e to satisfy the obligations of others;
-
• No
t to acquire obligations or se
curi
ties
Oils partners, members, or shareholders;
• To allocate fairly and reasonably an
y overhead for
shared
office space;
• To use sep
arat
e stationery. in
voic
es, and che
cks;
• Not to pledge
its as
sets
for the
benefit of any oth
er ent
ity or make any loans or advances to an
y
entity;
• 'To
hold itself out as a sep
arat
e en
tity
;
• To cor
rect
any known mis
unde
rsta
ndin
g re
gard
ing
its s
epar
ate Identity; and
• To rnaintaln adequate capital in
lig
ht of it
s contemplated business op
erat
ions
.
Nonconsolidation Opi
nion
sIn
ord
er for an ent
ity to be con
side
red an SPE, th
e in
solv
ency
of an affiliate of th
at SPE should not im
pact
the SPE. Und
er the equ
itab
le provisions of Sec
tion
105 of th
e Ba
nkru
ptcy
Code, a cou
rt has the
power to
"substantively consolidate" ostensibly sep
arat
e but. related entities. Sub
stan
tive
con
soli
dati
on tre
ats th
e
asse
ts and lia
bili
ties
of th
e en
titl
es as if
the
y belonged to on
e, enabling the cr
edit
ors of eac
h fo
rmer
ly
sepa
rate
estate to rea
ch the ass
ets of the consolidated es
tate
.
In a com
merc
ial mortgage tra
nsac
tion
, if
an affiliate of th
e SPE were to become ins
olve
nt,
it is po
ssib
le that
the
affiliate or the
aff
ilia
te's
cre
dito
rs wou
ld attempt to substantively co
nsol
idat
e the in
solv
ent af
iili
ate wi
ththe SPE, ef
fectively pl
acin
g the SPE under ban
krup
tcy co
urt protection and sub
ject
ing
its as
sets
to th
e
claims of the affiliate's c
reditors.
In det
ermi
ning
whe
ther
to substantively co
nsol
idat
e two entities, c
ourt
s ge
nera
lly focus on the
deg
ree to
whic
h th
e affairs of the
ent
itie
s ar
e in
tert
wine
d. The separateness covenants (and the
oth
er SPE criteria)
described in
thi
s Se
ctio
n are intended to se
para
te the affairs of the
affi
liat
e wi
th those of the SPE, and to
mitigate con
soli
dati
on ris
k. The law
pertaining to sub
stan
tive
consolidation is,
however, a com
plex
sub
ject
and th
e separateness covenants alo
ne wil
l not adequately protect aga
inst
the
ris
k. For thi
s reason; c
ouns
el
to the
SPE must pro
perl
y st
ruct
ure th
e tr
ansa
ctio
n and the rel
atio
nshi
p between the SPE and its
affiliates
(Including affiliated property man
ager
s) to
-avoid the
ris
k of sub
stan
tive
con
soli
dati
on. In
ord
er to co
nfir
mwh
ethe
r a given SPE str
uctu
re is ap
prop
riat
ely In
sula
ted from consolidation ris
k, Sta
ndar
d & Poor's relies
on an opinion of co
unse
l fo
r the SPE to that effect. Sta
ndar
d & Poor's specific guidelines wi
th respect to
nonconsolidation opinions are di
scus
sed in
det
ail in Sec
tion
Fiv
e of this publication.
-
Pre-
Existing Entities as SPEs
Generally, an SPE ent
ity sh
ould
be formed immediately pri
or to th
e subject tr
ansa
ctio
n in
ord
er to limit th
erisk that an
y pr
ior ac
tivi
ty inv
olvi
ng the
ent
ity (i.e., act
ivit
y oc
curr
ing before the
incurring of th
e indebtedness
secu
ring
the rat
ed sec
urit
ies)
cou
ld be a ba
sis fo
r co
nsol
idat
ing such the proposed SPE with an
y ot
her
95
entity. St
anda
rd & Poo
r's has fre
quen
tly been asked whe
ther
a pre-existing entity may qualify for tre
atme
ntas an SPE, add has, on a case-
by-c
ase ba
sis,
reviewed transactions Involving mor
tgag
e loan borrowers
that are
pre
-exi
stin
g entities. (See Appendix XIV fora fu
rthe
r di
scus
sion
of "pre-existing" or "r
ecyc
led"
SPEs.)
Entity-Specific SPE Criteria
As not
ed abo
ve, the types of en
titi
es most fr
equently use
d in rec
entl
y ra
ted co
mmer
cial
mor
tgag
etr
ansa
ctio
ns are cor
pora
tion
s, limited partnerships, and limited liability com
pani
es. Set forth below are
. specific criteria that should be inc
orpo
rate
d in
to bot
h th
e tr
ansa
ctio
n documents:
• I
f the SPE is a cor
pora
tion
, the filed articles of in
corp
orat
ion;
• If the SPE is a limited lia
bili
ty company, th
e limited
liability company operating agreement; .
• I
f the
SPE is a lim
ited
par
tner
ship
, th
e li
mite
d partnership agreement; and
• The SPE cri
teri
a ap
ply wi
th equ
al for
ce to an SPE that is
itself s
ervi
ng as a SPE equ
ity owner of
another SPE. St
andard & Poo
r's gu
idel
ines
for eac
h of these types of entity are
set forth des
crib
edhe
re.
SPE Cor
pora
tion
sIn
Standard & Poor's analysis of an SPE corporation (in
clud
ing where-the SPE cor
pora
tion
is ac
ting
as an
SPE equity owner of an SPE lim
ited
partnership or SPE lim
ited
lia
bili
ty.c
ompa
ny as described abo
ve),
Stan
dard
& Poor's
will
eva
luat
e wh
ethe
r both the certificate or articles of incorporation of the SPE
corporation and the tra
nsac
tion
documents relating to the
indebtedness th
at support the rated sec
urit
ies
gene
rall
y -conform to the fol
lowi
ng:
• Limited purpose. The SPE corporation's purpose sho
uld be limited as described un
der the he
adin
g"L
imit
atio
n on the Purpose of an SPE" abo
ve.
• Res
tric
tion
on add
itio
nal de
bt. The SPE corporation's ab
ilit
y to inc
ur ind
ebte
dnes
s sh
ould
be
limi
ted as described under the heading "Re
stri
ctio
ns on Add
itio
nal Indebtedness" ab
ove.
• P
rohibition on other ac
tivi
ties
, merger, consolidation, and asset sales. The SPE cor
pora
tion
'(and its
equ
ity ow
ners
and affiliates) should, so long as
the rat
ed sec
urit
ies are outstanding, be (i
)pr
ohib
ited
from engaging in an
y business act
ivit
y ot
her th
an owning th
e mortgaged pr
oper
ty that
secu
res th
e re
late
d in
debt
edne
ss if
such SPE corporation is th
e borrower. or, if such SPE
•co
rpor
atio
n is
an SPE equity owner, from engaging in an
y business act
ivit
y ot
her th
an owning eq
uity
inte
rest
s in
the
SPE borrower; (1
1) prohibited from con
soli
dati
ng or co
mbin
ing wi
th another ent
ity;
(iii
)pr
ohib
ited
from
liqu
idat
ing or win
ding-up; and (iv
) prohibited from merging or selling
all or
substantially
all of it
s as
sets
, in
each case, Wit
hout
the
pri
or written consent of the le
nder
, an
d, in
the
case of a prope
rty-specific or large loan tra
nsac
tion
, re
ceip
t of a ratings con
firm
atio
n.• Prohibition on amendments to do
cume
ntat
ion.
The SPE corporation should be pro
hibi
ted from
amending the SPE provisions of it
s organizational documentation as described under the
heading
"Prohibition on Amendments to Do
cume
ntat
ion"
abo
ve.
• independent dir
ecto
r. The SPE corporation sho
uld ha
ve at le
ast one ind
epen
dent
director, and the
unanimous consent of the bo
ard of di
rect
ors (
incl
udin
g th
e in
depe
nden
t director) should be required
toli
le, or consent to th
e filing of,
a ban
krup
tcy or ins
olve
ncy pe
titi
on, or oth
erwi
se institute ins
olve
ncy
proc
eedi
ngs as described und
er the heading "The 'In
depe
nden
t Director"' abov
e.• Separateness cov
enan
ts. The SPE corporation sho
uld agree to obs
erve
the
separateness
covenants described un
der th
e heading "S
epar
aten
ess Covenants" abo
ve, and the separateness
covenants sh
ould
be con
tain
ed in the
file
d articles or certificate of incorporation of such SPE
corporation (as wel
l as in the tr
ansa
ctio
n do
cume
nts)
.• Foreign qua
lifi
cati
on.
If the
SPE cor
pora
tion
is fo
rmed
in a jurisdiction di
ffer
ent from whe
re the
mortgaged property is located, the
SPE corporation sho
uld be
qua
lifi
ed und
er applicable la
w in
the
stat
e in
which the mortgaged property is
located.
• Nonconsolidation opi
nion
. St
anda
rd & Poor's
will typically expect a non-
consolidation opinion to be
delivered
in the
circumstances described in Section Fi
ve of th
is pub
lica
tion
.
SPE Limited Partnerships
In Standard & Poor's analysis of an SPE limited partnership (including wh
ere th
e SPE lim
iled
partnership is
acti
ng as an SPE equ
ity owner of another SPE limited partnership or SPE lim
ited
lia
bili
ty company as
96.
described ab
ove)
, St
anda
rd & Poor's
will
eva
luat
e wh
ethe
r both the limited par
tner
ship
agr
eeme
nt of th
eSPE lim
ited
partnership and the tra
nsac
tion
documents relating to the
ind
ebte
dnes
s that supports the rated
secu
riti
es conform•to the fo
llow
ing:
• Limited purpose. The SPE limited partnership's purpose sho
uld be lim
ited
as des
crib
ed und
er the
heading "L
imit
atio
n on Purpose of an SPE' abov
e.• R
estr
icti
on on additional de
bt, The SPE limited partnership's abi
lity
to in
cur in
debt
edne
ss should
be limited as described und
er the heading "Re
stri
ctio
ns on Additional Ind
ebte
dnes
s" abo
ve.
• P
rohibition on other activities, merger, consolidation, and asset saf
es. The SPE lim
ited
partnership (
and
its equity own
ers and afliliates) should, so lon
g as the rat
ed sec
urit
ies are
outstanding, be (i
) prohibited from eng
agin
g in any bus
ines
s activity oth
er than ow
ning
the
mortgaged property tha
t se
cure
s the related indebtedness if
such SPE limited par
tner
ship
is th
eborrower, or
, if such SPE limited partnership Is an SPE equ
ity owner, from en
gagi
ng in any business
acti
vity
oth
er than owning equ
ity interests in
the SPE borrower: (i
i) pro
hibi
ted fr
om con
soli
dati
ng or
combining wi
th another entity; (i
ii) p
rohibited from liquidating or wi
ndin
g-up
; and (iv
) pr
ohib
ited
from
merging or se
lling all or substantially all of Its as
sets
, in
each cas
e, wit
hout
the pri
or written consent
of the len
der an
d, In
the
cas
e of a property-sp
ecif
ic or la
rge loan transaction, receipt of a ratings
confirmation.
•• Prohibition on amendments to do
cume
ntat
ion.
The SPE lim
ited
par
tner
ship
should be prohibited
from amending the
SPE provisions of It
s or
gani
zati
onal
documentation as described und
er the
heading "Prohibition on Amendments to Documentation" abo
ve.
• SPE general par
tner
, All of the gen
eral
par
tner
s of the
SPE lim
ited
partnership sho
uld be SPEs as
described un
der the heading "SPE Equity Owner of Li
mite
d Partnerships and Limited Liability
Companies" abo
ve.
• Independent dir
ecto
r. The consent of the SPE gen
eral
partner of .th
e SPE lim
ited
partnership
(inc
ludi
ng the
vot
e of the Ind
epen
dent
Dir
ecto
r of the SPE gen
eral
par
tner
) sho
uld be required in
orde
r to fil
e, or co
nsen
t to the filing of,
a bankruptcy or ins
olve
ncy petition or ot
herw
ise institute
inso
lven
cy pro
ceed
ings
as described und
er the hea
ding
"The 'In
depe
nden
t Di
rect
or"'
abov
e.• Sep
arat
enes
s co
vena
nts.
The SPE limited partnership should ag
ree to obs
erve
the separateness
covenants wi
th res
pect
to th
e SPE described under the
heading "Separateness Covenants" ab
ove,
and the separateness covenants sh
ould
be co
ntai
ned
in bot
h th
e tr
ansa
ctio
n documents and the
limi
ted partnership ag
reem
ent of such SPE limited partnership. Ad
diti
onal
ly, the li
mite
d partnership
agre
emen
t of the SPE limited partnership should specifically req
uire
that fo
r so long as the
Inde
bted
ness
sup
port
ing the rated se
curi
ties
is ou
tsta
ndin
g, eac
h of the equ
ity owners of the SPE
limi
ted partnership
will .c
ause the SPE lim
ited
partnership to observe th
e Separateness Covenants.
• Continuity pro
visi
ons.
If there is more than one gen
eral
partner, th
e limited partnership ag
reem
ent
of the SPE lim
ited
partnership sho
uld provide that the SPE limited partnership shall con
tinu
e (and
not dissolve) f
or so long as another sol
venr
gene
ral partner of the
SPE limited partnership exists,
. For
eign
qualification. If
the
SPE limited partnership is for
med
in a ju
risdiction dif
fere
nt from wh
ere
the mortgaged property is located, the SPE limited partnership sho
uld be qua
lifi
ed tinder applicable
law
in the sta
te In which th
e collateral sec
urin
g th
e indebtedness tha
t secures th
e rated se
curi
ties
is
located.
. Nonconsolidation opinion. Sta
ndar
d & Poor's
will typ
ical
ly exp
ect a non -
cons
olid
atio
n opinion
to be
delivered
in the
circumstances described und
er the
.hea
ding
"No
nCon
soli
deti
on Opinions'. ab
ove.
SPE Lim
ited
Liabllity Companies
In April of 2002, St
anda
rd & Poor's published
its th
ird edition of "Le
gal Criteria for
Stnrctured Fi
nanc
eTr
ansa
ctio
ns,"
whi
ch is St
anda
rd & Poods legal criteria for residential mo
rtga
ge-b
acke
d and asset-b
acke
dstructured fin
ance
tra
nsac
tion
s. The publication inc
lude
d "Appendix IV
: Legal Cr
iter
ia for LLCs," which
significantly re
vise
d th
e criteria for SPE lim
ited
lia
bili
ty com
pani
es and inc
orpo
rate
d St
anda
rd & Poor's
criteria on sin
gle-member LLCs. Thal appendix is at
tach
ed to th
is pub
lica
tion
as Appendix XIII, Rev
ised
Legal Criteria for Mul
ti-and Sin
gle-Member LLCs.
Stan
dard
& Poo
r's has now adopted these cri
teri
a fo
r use in
commercial mo
rtga
ge-b
acke
d se
curi
liza
tion
s..Therefore, in
Standard-&. Poor's analysis of an SPE limited liability company (including where the
SPE
limi
ted
liab
ilit
y company is acting as an SPE equity owner of an SPE limited partnership or an
othe
r SPE
limited
liability company as des
crib
ed abo
ve),
Sta
ndar
d & Poods wil
l evaluate whe
ther
the
SPE limited
liab
ilit
y company's.limited
liability company ope
rati
ng agreement, th
e tr
ansa
ctio
n documents relating to th
e
97
Inde
bted
ness
sup
port
ing th
e ra
ted securities and the opi
nion
s de
live
red
in connection th
erew
ith co
nfor
m to
Appendix XII
I.
Conduit SPE Criteria
In typical con
duit
transactiOns,'Ienders make mortgage loa
ns (us
uall
y under $20 million in original principal
balance) to
bat
-rowers wi
th the
specific intent to convey the mortgage lo
ans into a sec
urit
izat
ion wi
thin
arelatively sho
rt tim
e following the cl
osin
g of the loa
n. Gen
eral
ly, all of the conduit mortgage loa
ns conveyed
into
the sec
urit
izat
ion trust are ex
pect
ed to meet sta
ndar
d Underwriting criteria es
tabl
ishe
d by the
orig
inat
ing co
ndui
t le
nder
.
Standard & Poo
r's is
frequently as
ked wh
ethe
r borrowers in
conduit tra
nsac
tion
s Must comply with
Stan
dard
& Poo
r's SPE cri
teri
a described in
thi
s section. If
the poo
l of conduit mortgage loans inc
lude
d in
the securitization is large enough and diverse enough to be treated as a poo
l-wide or ag
greg
ate ba
sis by
Standard & Poo
r's
Strict compliance wi
th Standard & Poor's SP
E_cr
iter
ia wou
ld not be necessary.
11, however, mortgage loa
ns to an
y borrower or gr
oup of aff
ilia
ted bo
rrow
ers co
mpri
se in th
e ag
greg
ate
more than 5% of th
e Mo
rtga
ge loan po
ol, or if
any mortgage loa
n is
$20 million or more
the SPE criteria
should be complied with. Standard & Poor's general gu
idel
ines
are set
for
th bel
ow, These assume that the
loan
documents contain a pro
hibi
tion
on sub
ordi
nate
indebtedness se
cure
d by the mortgaged pro
pert
y th
at. serv
es as collateral fo
r the loans.
Loans wit
h Less than 5% Borrower Con
cent
rati
on or Less than $20 Million
With
respect to mortgage loa
ns made to a borrower or affiliated gr
oups
of borrowers, where (i)
the
principal
bala
nces
of such mor
tgag
e lo
ans (as of
line
closing dale of the sec
urit
izat
ion)
com
pris
e (in the aggregate).
less than 5% of th
e aggregate ou
tsta
ndin
g principal ba
lanc
e of all of the mortgage loa
ns comprising the
securitized po
ol of mo
rtga
ge loans, and (ii) t
he out
stan
ding
pri
ncip
al bal
ance
of any sin
gle mortgage loa
n is
less than $20 million bo
rrow
ers sh
ould
comply wit
h St
anda
rd & Poods SPE criteria, except that such
borr
ower
s need not comply wit
h the•followine:
Recornmendations for an Ind
epen
dent
Director as dis
cuss
ed und
er the
hea
ding
"The Independent
Dire
ctor
" above;
Delivery of a nonconsblidation op
inio
n regarding the borrower as discussed under the
hea
ding
"Non
cons
olid
atio
n Opinions" ab
ove;
and;
If the bor
rowe
r is
a lim
ited
partnership'or a limited lia
bili
ty company, the recommendation tha
t an
equi
ty owner be an SPE as discussed un
der th
e he
adin
g "SPE Equ
ity Owner of SPE Lim
ited
Partnerships and SPE Limited Liability Companies and Mul
titi
ered
SPE Str
uctu
res,
" above.
However, loa
ns that on
ly meet the
se standards wil
l not be viewed by Sta
ndar
d & Poo
r's as ful
l ba
nkru
ptcy
-remote SPEs,
Loans wit
h 5% or Greater Borrower Con
cent
rati
on or $20 Million or Gr
eate
r Pr
inci
pal Balance
For mortgage loa
ns made to a borrower or aff
ilia
ted groups of bo
rrow
ers,
where (i)
the pri
ncip
al bal
ance
s of
such mortgage loa
ns (as of the cl
osin
g da
te of the securitization) comprise (in
the agg
rega
te) 5% or more of
the ag
greg
ate .o
utst
andi
ng pri
ncip
al balance of
all of the mortgage lo
ans comprising the
securitized poo
l of
mortgage loansgi (i
i) the out
stan
ding
principal balance of any sin
gle mortgage loan
is $20 million or More,
the bo
rrow
er should be str
uctu
red in
compliance wi
th a
ll of St
anda
rd & Poo
r's SPE criteria.
In any eve
nt, St
anda
rd & Pao
r's may request that additional bor
rowe
rs be SPEs or wa
ive
Its SPE gui
deli
nes
depending upon Standard & Poor's evaluation of economic and other inc
enti
ves fo
r filing a ban
krup
tcy
peti
tion
.
For ease of re
fere
nce,
we refer to the independent di
rect
ors,
independent managers, and ind
epen
dent
members in this discussion as "Independent Di
rect
ors.
"
98
Substantive Consolidation in Bankruptcy: A Primer for Real Estate Lawyers
by
Thomas W. Co
ffey
, Esq.
Chai
r, Bankruptcy Group
Tucker Ellis & West LLP
Cleveland, Ohi
o
and
Dani
el K. Wri
ght,
II, Esq.
Member, Real Es
tate
Group
Tucker Ellis & West LLP
Clev
elan
d, Ohio
Over
the l
ast two d
ecades, the is
sue of substantive c
onso
lida
tion
in bankruptcy h
as
become a major concern in re
al est
ate mo
rtga
ge financing, such that this con
cept
has assumed a
pree
mine
nt pla
ce in the structuring an
d do
cume
ntat
ion of
mortgage loans. This has resulted in
all sorts of
lega
l gy
mnas
tics
aim
ed at avoiding not only substantive consolidation in
bankruptcy,
but the
very f
iling of
bankruptcy by
a b
orro
wer
alto
geth
er, as well as some un
inte
nded
cons
eque
nces
for lenders and
bor
rowe
rs alike. Yet few lawyers out
side
the bankruptcy bar fu
lly
unde
rsta
nd thi
s mysterious con
cept
.
Related co
ncep
ts inv
olvi
ng "single p
urpose e
ntit
ies"
and
"se
para
tene
ss cov
enan
ts" in
loan doc
umen
tati
on hav
e received much attention in the la
st year with the
adv
ent of Wells Far
go
Bank
, NA v
. Ch
errv
land
Mall Li
mite
d Partnership et a
l. --
- N.W.2d -
--, 20
11 WL 6785393
(Mich.App.) an
d 51382 Gra
tiot
Avenue Holdings, LLC v. Ch
este
rfie
ld Dev
elop
ment
Co., LLC,
2011
WL 4695820 (E.D.Mich.) (Oct
. 5, 2011); --
-F.S
upp.
2d--
-, 201
1 WL 6153023 (E.
D.Mi
ch.)
(Dec. 12, 2
011); an
d 2012 WL 205843 (E.
D.Mi
ch.)
(Jan. 24
, 2012
), wherein ins
olve
ncy was
found an a matter of law to be a vi
olat
ion of
the "s
epar
aten
ess covenants" contained in the lo
an
documents at
iss
ue, in
eac
h ca
se triggering a "s
prin
ging
rec
ours
e" gua
rant
y, a res
ult th
at mig
ht
have
been
avoi
ded
with a b
ette
r understanding of
the c
once
pts an
d principles surrounding
substantive consolidation.
The purpose of this art
icle
is to review, explain, an
d hopefully de
myst
ify the co
ncep
t of
substantive consolidation in.bankruptcy, and to pr
omot
e a better understanding of wha
t it is, and
is not, so
that l
ende
r's an
d borrower's f
uture
negotiations (and
loan
documentation) may
accurately ref
lect
the exi
stin
g le
gal j
urisprudence on this sub
ject
.
1.
Background
"Substantive consolidation i
s the me
rger
of separate entities into one act
ion so tha
t the
assets and
liabilities of both p
arties may be
aggr
egat
ed i
n order to e
ffect a more equ
itab
le
dist
ribu
tion
of pr
operty among creditors." Ma
tter
of Bak
er & Get
ty Financial Ser
vice
s Inc., 78
B.R.
139, 14
1 (B
ankr
. N.D. Ohio 1987); See also, In re
Owens Cor
ning
, 419 F.3
d 195, 205 (3r
d
Cir. 2005).
0970
00.0
0000
3 14
8038
5.2
The ap
plic
atio
n of sub
stan
tive
consolidation
is no
t expressly
authorized under
the
Bankruptcy Co
de.
Rule 1015 of
the Rules of Ban
krup
tcy
Procedure
prov
ides
for joi
nt
administration of
ca
ses;
ho
weve
r, t
he Ad
viso
ry Committee
Note
s thereunder st
ate
that
"con
soli
dati
on, as
distinguished fro
m jo
int administration, is neither aut
hori
zed no
r prohibited by
this
rule si
nce the pr
opri
ety of con
soli
dati
on dep
ends
on substantive considerations and
affects
the su
bsta
ntiv
e ri
ghts
of cr
edit
ors of
the different est
ates
?" Ad
viso
ry Com
mitt
ee Not
e, Bankr.
Rule 101
5. A
ccor
ding
ly, the power to substantively consolidate derives fr
om the gen
eral
equity
juri
sdic
tion
of a court of ba
nlcruptcy un
der Se
ctio
n 10
5(a)
of the Ba
nkru
ptcy
Cod
e. In re Richton
International, 12 B.R. 55
5, 557 (Ba
nkr.
S.D.N.Y. 1981). Non
ethe
less
, co
urts
recognize tha
t as
a
general rule "the po
wer to consolidate sho
uld be use
d sp
arin
gly because of
the possibility of
unfa
ir tre
atme
nt of cr
edit
ors of a corporate deb
tor who hav
e dealt solely wit
h that debtor wi
thou
t
know
ledg
e of
its in
terr
elat
ions
hip with oth
ers.
" Chemical Bank New York Trust Company v.
Khee
l, 369 F.2
d 845, 847 (2d
Cir
. 1966). See als
o, In re Owens Coming, 419 F.3
d 195 (3
rd Cir.
2005)(reversing substant
ive co
nsol
idat
ion in
view of pr
ejudice to cre
dito
rs).
Cert
aint
y is elu
sive
wit
h respect to substantive con
soli
dati
on in ba
nkru
ptcy
because of the
appl
icat
ion of
the general equity pow
ers of
the ba
nkru
ptcy
courts to the
se issues an
d the evolving
nature of the substantiv
e co
nsol
idat
ion do
ctri
ne. The app
lica
tion
of th
e doctrine is ex
trem
ely fact
inte
nsiv
e and
relates to the business an
d cr
edit
or rel
atio
nshi
ps lea
ding
up to ban
krup
tcy as well
as other factors.
One court stated th
e matter more
blun
tly:
"as to substantive consolidation,
precedents are
of little val
ue, t
here
by making ea
ch analysis on
a cas
e-by
-case basis." In re Crown
Mach
ine & Welding, 100 B.R
. 25 (Ba
nkr.
D. Mont. 1989). Fu
rthe
rmor
e, the case law has not
evol
ved in an
entirely consistent ma
nner
. Ac
cord
ingl
y, cas
e law i
s only a general gui
de in
attempting to an
tici
pate
wha
t circumstances me
rit its ap
plic
atio
n.
Early ca
ses involving substantive consolidation ap
plie
d a test that -re
semb
led the test for
pier
cing
the corporate veil or det
ermi
ning
whe
ther
one cor
pora
tion
was the
alt
er ego
of an
other.
A lea
ding
cas
e in
this regard is Fish v. East, 114 F.2
d 177 (1
0th Ci
r. 194
0), i
n wh
ich the court se
tforth the "i
nstr
umen
tali
ty" rule. The court held th
at the assets of
a sub
sidi
ary organized by
its
parent .c
orpo
rati
on to ra
ise money fro
m the public for the par
ent should be consolidated wit
h th
e
pare
nt because, based on a
n analysis of the
facts, the two c
orpo
rati
ons were a
ctually one
enterprise wit
h the su
bsid
iary
ope
rati
ng as a mere ins
trum
enta
lity
of th
e parent. I
n so
hol
ding
, the
court identified ten factors as su
ppor
ting
a dec
isio
n to con
soli
date
:
(1)
The par
ent co
rpor
atio
n owns all
or a maj
orit
y of th
e ca
pita
l st
ock of the
subs
idia
ry.
(2)
The par
ent an
d su
bsid
iary
cor
pora
tion
hav
e common dir
ecto
rs or of
fice
rs.
(3)
The par
ent co
rpor
atio
n fi
nanc
es the sub
sidi
ary.
(4)
The parent co
rpor
atio
n subscribes to al
l the ca
pita
l st
ock of the su
bsid
iary
or oth
erwi
se causes it
s incorporation.
(5)
The subsidiary ha
s grossly inadequate capital.
(6)
The par
ent co
rpor
atio
n pays the sal
arie
s or
expenses or
los
ses of
the
subsidiary.
097000M00003.14
8038
5.2
2
(7)
The subsidiary has substantially no bus
ines
s except wit
h the pa
rent
corp
orat
ion or no assets except those con
veye
d to it
by the parent corporation.
(8)
In the papers of th
e parent cor
pora
tion
and in the statements of it
s officers
"the
sub
sidi
ary"
is referred to as
such or as a de
part
ment
or division.
(9)
The directors or executives of the subsidiary do not act independently in
the interest of the su
bsid
iary
but take direction fr
om the par
ent corporation.
(10)
The fon
nal le
gal requirements of the subsidiary as a separate and
independent co
rpor
atio
n are not observed.
Courts fre
quen
tly
cited and
reli
ed on the Fish c
ase in
analyzing facts and determining
whet
her a subsidiary and i
ts parent should be co
nsol
idat
ed. See, e.g.
In re Gulfco Investment
Corp
., 593 F.2d 921, 92
8-29
(10th Cir. 1979); Anaconda Building Materials Co. v.
Newland, 336
F.2d 625, 629 (9th
Cir. 1964); Fi
sser
v. International Ba
nk, 282 F.2d 231, 238 (2d Cir. 1960);
Maule Ind
ustr
ies v. Gerstel 232 F.2d 294, 297 (5
th Cir. 1956).
Under th
is approach, co
urts
did
not
gen
eral
ly per
mit consolidation without a showing th
at
organization of the subsidiary resulted in
some blatant abuse, even in cases where one or more of
the above factors was present As not
ed by one co
urt:
Few que
stio
ns of law
are better settled than th
at a -c
orpo
rati
on is
ordinarily
a wholly se
para
te entity from i
ts stockholders, whether
they be one or mor
e. . . . But notwithstanding such
situation and
such intimacy of relation, the cor
pora
tion
will be regarded
as a
legal entity, as a general rule, and the cou
rts will ignore the fiction
of corporate entity only wit
h caution, and when the circumstances
just
ify
it, as
when i
t is used as
a s
ubterfuge
to d
efeat
public
convenience, justify wrong, or pe
rpet
uate
a fraud.
Commerce Trust Co. v. Woodbury 77 F.2d 478, 487 (8
th Cir. 1935). Thus, it
was observed th
at
"The rep
orte
d cases have gen
eral
ly been ea
sily
decided bec
ause
the courts could point to blatant
abuses of the s
epar
ate
corporate
entities i
n the
ente
rpri
se s
truc
ture
." Landers, A Unified
Approach to Parent. Subs
idiary, and
Affiliate Questions in
Bankruptcy. 42 U. Chi. L. Rev. 58
9,
635 (1975). I
t has
been noted
that "
[i]n
the
olde
r cases, t
he ap
plic
atio
n of substantive
consolidation was limited to extreme cases involving fraud or neglect of cor
pora
te formalities
and accounting procedures." In re Standard Bra
nds Paint Co., 154 B.R. 563, 568 (Bankr. C.D.
Cal. 1993).
Whil
e ea
rlie
r decisions fr
eque
ntly
cited the
ten factors enunciated by
the Fish v.
Eas
t and
Gulfco courts, subsequent decisions have produced a
list of sev
en elements relevant to
determining the appropriateness of co
nsolidation:
1.
The presence or absence of co
nsolidated financial statements;
2.
The un
ity of i
nter
ests
and
ownership
between
the
various, corporate
entities;
309
7000
.000
003 1480385.2
3.
The existence of parent and inter-c
orpo
rate
guarantees on loans;
4.
The deg
ree of dif
ficu
lty in segregating and ascertaining individual assets
and
liabilities;
5.
The transfer of as
sets without fonnill observance of co
rporate formalities;
6.
The commingling of assets and business functions; and
7.
The profitability of consolidation at a single ph
ysic
al loc
atio
n.
See
Matt
er of Baker & Getty Financial Services, Inc
., 78 B.R. 13
9, 142 (Bankr. N.D.
Ohio 198
7), In re Ve
cco Co
nstr
ucti
on Industries
Inc.
, 4 B.R. 407, 410 (Bankr. E.D
. Va. 1980),
In re Ri
chto
n, 12 B.R. at
558 (Ba
nkr.
S.D.N.Y. 1981) and In re St
op & Go of Ame
rica
, Inc., 49
B.R. 743, 747 (B
antu. D. Mass. 1985).
There are a few reported opinions involving substantive consolidation in which
at least
one of th
e le
gal entities was a sta
tuto
ry lim
ited
liability company. S
ee In re Edw
ards
Theatres
Circuit, Inc
. 281 B.R. 675, 677 & n.1
, 678 (Bankr. C.D. Cal. 2002) (n
oting that bankruptcy
estates of five California corporations and two Delaware li
mite
d li
abil
ity co
mpan
ies,
and the
ir
affiliates, were s
ubstantively c
onso
lida
ted
in confirmed Chapter
11 pl
an).
"Based on t
he
development of the case law
with respect to both cor
pora
tion
s and
partnerships, however, th
ere
does not app
ear to be any reason why materially different st
anda
rds or pri
ncip
les should apply to
an analysis of th
ese
[substantive c
onso
lida
tion
] is
sues
as
they
relate t
o a
limited
liab
ilit
y
company." 2 Collier on Bankruptcy
¶ 105.09[1][c], at 105-87 (15th ed. rev., 1998) (f
ootnote
omitted). See
also, In re Owens Cor
ning
, 419 F.3d 195 (3rd Cir. 2005) and In re Brentwood
Golf
Clu
b 329 B.R. 802 (B
ankr. E.
D. Michigan 2005).
Although the presence of some or
all of the foregoing ele
ment
s may be instrumental in
determining whether the pa
rent
and subsidiary should be treated as a sin
gle entity, t
heir existence
alon
e does not
necessarily mandate sub
stan
tive
consolidation. The cou
rts re
cogn
ize that the
se
factors should not
be mechanically applied and are not dispositive, but they must be ev
alua
ted in
the overall "balancing of equities" favoring consolidation versus those fa
vori
ng separation. See
In re DRW Property Co. 82, 54 B.R. 489, 495 (Bankr. N.D. Tex. 1985); In re Dou
ghnu
t Queen
Ltd.
, 41 B.R. 706, 709 (Ba
nkr.
E.D.N.Y. 1984). The Third Circuit Cou
rt of Appeals
in In re
Owens Coming 419 F.3d 195 (3rd
Cir, 2005) warned
agai
nst the dangers of merely
using a
checklist of factors, saying t
hat "too often
the
factors
in a
checklist
fail to
sepa
rate
the
unimportant from the important, or even to set out a sta
ndar
d to make the att
empt
.... Running
down f
actors as a c
heck list c
an lead a
court to
lose s
ight of why we ha
ve s
ubst
anti
ve
consolidation
in the fir
st instance .. : ." In re Owens Corning 419 F.3
d 19
5, 210-11 (3rd Cir.
2005) The par
ty proposing consolidation b
ears
the burden of demonstrating that a
prejudice
resulting therefrom
is outweighed by the benefit to be obt
aine
d. I
d. Moreover, this burden
is a
"sub
stan
tial
one. In re N.S. Garrott & Son
s, 48 B.R. 13, 18 (Bankr. E.D
. Ark. 1984).
The
balancing test als
o has been stated:
1.
There must be a
necessity for substantive consolidation or a harm to be
avoided by
the use of su
bstantive co
nsol
idat
ion;
and
0970
00.0
0000
3 148(1385.2
2.
The benefits of
substantive consolidation must outweigh the harm
to be
caused to ob
ject
ing cr
edit
ors.
In re F.A. Po
tts & Co., Inc., 23 B.R
. 569, 572 (Bankr. E.D. Pa.
1982).
This approach
is c
larified by the court in
In
re S
nider Bros., Inc., 18 B.R
. 230, 234
(Bailiff. D. Mas
s. 1982):
While
seve
ral
courts hav
e recently attempted to
delineate what, might be c
alle
d the
`elements of
cons
olid
atio
n,' [citations omi
tted
] we fin
d th
at the only re
al cri
teri
on is th
at which
we hav
e re
ferr
ed to, nam
ely the ec
onom
ic prejudice of co
ntin
ued de
btor
separateness versus the
econ
omic
pre
judi
ce of consolidation. Th
ere is no one set of el
emen
ts which, if
esta
blis
hed,
will
mandate consolidation in
eve
ry ins
tanc
e. Mor
eove
r, th
e fact tha
t corporate fon-na
liti
es may hav
e
been ignored, or that di
ffer
ent debtors are as
soci
ated
in business in some way
, does not by
itse
lf
lead
ine
vita
bly to the con
clus
ion th
at it
would be equitable to merge oth
erwi
se separate estates.
Therefore, eve
n in
cases wh
ere a s
ignificant number of the foregoing f
actors and
elements were pr
esen
t, the cou
rts co
nsid
ered
them
in the context of sp
ecific cir
cums
tanc
es tha
t
weig
h in
favor of co
nsolidation. Even in cases where substantive consolidation is ordered, some
courts l
imit the scope of i
ts e
ffec
t an
d ex
pres
sly
find t
hat substantive
consolidation
is n
ot
retroactive and does not
ope
rate
to
destroy
cert
ain
defe
nses
and r
ight
s th
at existed p
rior to
subs
tant
ive consolidation. See, In re Garden Rid
ge Corporation, et al.
, 338 B.R. 627 (Ba
nkr.
D.
Del. 2006).
II.
Analysis
Curr
ent ca
se law indicates that the ci
rcum
stan
ces in
whi
ch substantive consolidation has
been held ap
prop
riat
e are as
fol
lows
:
A.
Fraud Upon, or Injustice to, Creditors
Where affiliates of
the de
btor
were organized to hinder an
d de
lay jud
gmen
t creditors and
prop
erty
tra
nsfe
rs were for the so
le pur
pose
of pl
acin
g property beyond the reach of creditors,
consolidation is app
ropr
iate
. In re Tureaud,
45 B.R. 658 (Ba
nkr.
N.D. Okl
a. 1985).
Accord, In
re Sto
p & Go of Am
eric
a, In
c., 49 B.R
. at
743 (s
hell cor
pora
tion
formed to hol
d franchise was a
"del
iber
ate scheme" to protect franchise seller's in
tere
st in a manner lik
ely to res
ult in
fra
ud on
cred
itor
s; cor
pora
tion
had
no tel
epho
ne, office, ba
nk account, expenses or income).
The court in Gulfco, supra, stated:
It is, of cou
rse,
proper to disregard a sep
arat
e le
gal
entity when such action is necessary to avoid fra
ud or injustice." 593 F.2
d at
928
. Although the
ten
factors
in Fish v. E
ast were pr
esen
t to a
"considerable
degree," the c
ourt h
eld
that
consolidation was not
app
ropr
iate
bec
ause
of th
e absence of
a pur
pose
to or
gani
ze the corporate
subs
idia
ries
to hinder and delay creditors fraudulently. Id.
Thus
, th
e mere i
dentity of
corporate names, stockholders and o
ffic
ers or the fact of
ownership of cap
ital
sto
ck i
n one
corp
orat
ion by ano
ther
alone a
re not
sufficient to jus
tify
disregarding the corporate
fiction. The cor
pora
tion
must ha
ve been "organized or us
ed to hinder,
delay or defraud the creditors of the bankrupt, and co
nsti
tute
s mere leg
al paraphernalia observing
5097000.000003 1480385.2
form only an
d no
t existing in su
bsta
nce or
reality as a separate entity." Malik In
dust
ries
, Inc
. v.
Gers
tel,
232 F.2
d 294, 297 (5
th Cir. 1956).
Additionally, co
urts
will re
view
the cir
cums
tanc
es to determine whether the
effect of
substantive co
nsol
idat
ion will work an
inju
stic
e on one cre
dito
r to the benefit of ano
ther
. For
exam
ple,
consolidation has
been
deni
ed where i
t would
unjustly ben
efit
cre
dito
rs of a parent
corp
orat
ion ov
er creditors of the su
bsid
iary
pro
pose
d to be consolidated. In re Fl
ora Mir Candy
Corp
orat
ion, 432 F.2
d 10
60 (2d
Cir
. 1970) (s
ubsi
diar
y's de
bent
ure holders would be u
nfai
rly
d is ad
vant
aged
).
B.
Creditor Reliance on Enterprise as a Group
Cour
ts als
o ha
ve all
owed
sub
stan
tive
consolidation i
n cases where the
cred
itor
s ha
ve
relied justifiably on th
e assets and cre
dit of a gro
up of en
titi
es, or the cre
dit of a parent when
dealing wi
th its
subsidiary. See Stone v. Eacho
127 F.2
d 284 (4
th Cir. 1942). In
In Soviero v.
Franklin National Bank of Long Isl
and,
328 F.2d 446 (2d
Cir. 19
64),
ther
e we
re clear findings of
commingling of
assets and fu
ncti
ons of
the af
fili
ated
ent
itie
s and flagrant disregard of corporate
form
s. Moreover, creditors were advised that the bankrupt was a "co
nsol
idat
ed enterprise and
were d
elivered c
onso
lida
ted
fina
ncia
l statements l
isting assets of
the
affiliated co
mpan
ies
as
those of the bankrupt without separation.
Id. at
447
. See
also
In
re Richton I
nternational
Corporation, 12 B.R
. 555 (Ba
nkr.
S.D.N.Y. 1981); In re Food Fai
r, Inc., 10 B.A. 123 (Ba
nkr.
S.D.N.Y. 1981); an
d In r
e Murray Ind
ustr
ies,
Inc., 119 B.R. 820 (Ba
nkr.
MD. Fla. 1990).
Like
wise
, the U.S. Court of Appeals for the Thi
rd Cir
cuit
has uph
eld consolidation of
the es
tate
s
of three deb
tors
, all ha
ving
the same officers, dir
ecto
rs, and shareholders, operating
iden
tica
l
businesses und
er ver
y similar names, tha
t did no
t heed corporate formalities in the course of
borrowing funds and us
ing cr
edit
. In re Lisanti Foods In
c. 2
41 Fed
. Appx. 1, 2-3 (3d Cir
. 2007).
In g
ranting
consolidation where
creditors
relied o
n the
consolidated e
nterprise, the Second
Circ
uit in
the Soviero
cas
e al
so made it clear that consolidation sho
uld no
t be lim
ited
to cases
wher
e the
subs
idia
ry was o
rganized f
or the purpose of
hindering o
r de
frau
ding
cre
dito
rs.
Soviero v.
Franklin Na
tion
al Bank,
328 F.2d at
448.
On the o
ther han
d, where c
reditors r
ely solely on
the
representations and
credit of a
pare
nt co
rpor
atio
n an
d additional se
curi
ty from su
bsid
iary
corporations is not
requ
ired
,
substantive consolidation of
a sub
sidi
ary in
to its
par
ent will not
be im
pose
d. Ana
cond
a Bu
ildi
ng
Materials Co
. v.
Newland
336 F.2
d 625 (9t
h Ci
r. 196
4) (so holding, notwithstanding that the
pare
nt held
all the ou
tsta
ndin
g st
ock of
eac
h subsidiary, there we
re some common officers an
d
directors, and some evidence th
at the
sub
sidi
arie
s we
re minimally cap
ital
ized
). Se
e al
so In re
Flora Mir Candy Cor
pora
tion
, 432 F.2
d 1060, 10
62-6
3 (2d
Cir. 1970).
Similarly, where a creditor ex
tend
ed credit to a deb
tor based on tha
t debtor's fin
ance
s
alone, without knowledge of the debtor's negotiations to merge wit
h another entity, the Se
cond
Circuit in
In
re Aug
ie/R
esti
vo Baking Company Ltd., 860 F.2
d 515 (2d
Cir
. 19
88) held that
cons
olid
atio
n would im
pair
the rights of tha
t cr
edit
or and
unfairly be
nefi
t la
ter creditors of
the
merg
ed entities. The court wen
t on to ho
ld that the various considerations enu
mera
ted
in prior
decisions "are merely va
rian
ts on two cri
tica
l factors: (i) whe
ther
cre
dito
rs dea
lt with the en
titi
es
as a sin
gle ec
onom
ic uni
t and 'd
id not
rely on the
ir sep
arat
e id
enti
ty in extending credit' .. . or
097000.000003 1489385.2
6
(ii)
whether the a
ffairs of th
e, debtors a
re so
entangled
that c
onso
lida
tion
wi
ll be
nefi
t al
l
creditors." Id
. at
518 (c
itations omitted).
C.
Inte
rrel
atio
nshi
ps of En
titi
es and Acc
ount
s
"Where the i
nterrelationships of
the
group a
re hopelessly ob
scur
ed and
the time an
d
expense
nece
ssar
y ev
en to at
temp
t to unscramble them
so substantial .
as
to t
hreaten
the
real
izat
ion of
any n
et a
ssets for
all the
cred
itor
s, equity
is not h
elpless to r
each a
roug
h
approximation of
justice to some rat
her t
han de
ny any to all." Chemical Bank v. Kheel,
369 F.2
d
at 847 (2n
d Ci
r. 1966). The sit
uati
on must be extremely egr
egio
us, however, and
amount to an
impo
ssib
ilit
y of rec
onst
ruct
ing fi
nanc
ial re
cord
s to determine intercorporate cl
aims
, liabilities
and ow
ners
hip of ass
ets.
See
also
In re Reserve Cap
ital
Cor
p., 2007 WL 880600, *5 (Bankr.
N.D.
N.Y.
2007) (re
fusi
ng to order
substantive
consolidation upon req
uest
of a
trustee who
"acknowledge[d] ..
. that unt
angl
ing th
e affairs of the Debtors, wh
ile
it may req
uire
extensive
lega
l an
d fo
rens
ic accounting work, is not imp
ossi
ble"
); In re
143
8 Meridian Place, N.W. Inc.,
15 B.R. 89 (Ba
nkr.
D.D
.C. 19
81) (
neither the court no
r the cr
edit
ors could intelligently sort out
or separate the fi
nanc
ial af
fair
s of the corporations).
Alth
ough
inequities may be involved i
n the co
nsol
idat
ion,
the
y may be ou
twei
ghed
by
prac
tica
l considerations such
as accounting
difficulties and
expense, which may occ
ur where
inte
rrel
atio
nshi
ps of corporate gr
oups
are hig
hly complex or untraceable. See
In re Co
ntin
enta
l
Vending Ma
chin
e Co
rp.,
517 F.2
d 99
7, 100
1 (2
d Cir. 197
5), ce
rt. de
nied
sub
nom. James Tal
cott
Inc.
v Wha
rton
, 424 U.S
. 913 (1
976)
.
D.
Impact on Est
ates
and Pla
ns of Re
orga
niza
tion
Though a provision for
mer
ger or con
soli
dati
on of the deb
tor with one or more persons
may be a pe
rmis
sibl
e means for the ma
ndat
ory adequate imp
leme
ntat
ion of a Cha
pter
11 plan, 11
U.S.C. § 1123(a)(5)(C), t
he mer
e in
clus
ion of
a substantive con
soli
dati
on provision in a Ch
apte
r
11 p
lan do
es not mean tha
t su
ch a pro
visi
on w
ill be or can be aut
omat
ical
ly confirmed over
prop
er obj
ecti
on. See,
In re Sto
ne & Webster, Inc., 286 B.R
. 53
2, 542, 545 n.8
, 546 (Ba
nkr.
D.
Del.
2002) (reserving
examination
of f
acts
of
Cha
pter
11 ca
se bearing
upon nu
mero
us
substantive
consolidation
fact
ors
and
conc
omit
ant
dete
rmin
atio
n wh
ethe
r substantive
cons
olid
atio
n warranted). Where co
nsol
idat
ion
will facilitate or expedite reorganizational
proc
eedi
ngs for a number of re
late
d de
btor
s, consolidation may be imposed, particularly
if
separate plans of reorganization would not
be
feasible.
In Int
erst
ate St
ores
, Inc., 15 Col
lier
Bankr. Cas
e 63
4, 640-41 (B
ankr
. S.D.N.Y. 1978); In re F.
A. Pot
ts & Co., Inc., 23 B.R
. 569
(Ban
kr. E.D. Pa.
1982).
The ability to consummate a pla
n quickly alone, however, may not
just
ify co
nsol
idat
ion,
par
ticu
larl
y if
the rig
hts of creditors of th
e proposed consolidated
entity
would th
ereb
y be diminished. In re Flora Mir Candy Cor
p., 432 F.2
d 1060, 1063 (2d
Cir
. 1970).
Trad
itio
nall
y, substantive con
soli
dati
on has bee
n gr
ante
d by
the courts "sparingly" due to
the extreme impact on substantive rights of cr
edit
ors.
However, the Ele
vent
h Circuit Court of
Appe
als,
in adopting for the fir
st time a st
anda
rd by which to eva
luat
e motions for substantive
cons
olid
atio
n, h
as no
ted
what
it te
rmed
"a 'modern'
or '
liberal' trend
toward allowing
substantive
consolidation, which has
its
genesis i
n the
incr
ease
d ju
dici
al recognition of the
wide
spre
ad use of interrelated cor
pora
te structures by sub
sidi
ary corporations ope
rati
ng under a
097000.000N3 148
0385
.2
pare
nt e
ntit
y's
corporate umbrella for tax
and
bu
sine
ss p
urpo
ses.
" Eastgroup
Prop
erti
es v
.
Sout
hern
Mot
el Ass
ocia
tion
, Ltd., 935 F.2d 245 (11
th C
ir. 1991). Se
e al
so, In r
e Af
fili
ated
Food
s, Inc., 249 B.R
. 770 .(Ba
nkr.
W. D. Mo. 2000) and
In re
Brentwood Golf Club, 329 B.R
.
802, 811 (Bankr.E.D. Michigan 20
05);
con
tra Owens Coming, 419 F.3d
at 209 n
.15 ("we
disa
gree
with the
asse
rtio
n of
a
'lib
eral
tr
end'
toward increased
use
of substantive
cons
olid
atio
n").
The Ele
vent
h Circuit requires tha
t the proponent of
substantive con
soli
dati
on show tha
t
(i) there is substantial ide
ntit
y be
twee
n the
entities to be con
soli
date
d; and
(ii) consolidation
is
necessary to avo
id soine har
m or to re
aliz
e some ben
efit
. Upon making th
ese two sho
wing
s, th
e
court he
ld that a presumption ar
ises
tha
t creditors ha
ve not relied so
lely
upon the cr
edit
of one of
the
enti
ties
inv
olve
d in
the con
soli
dati
on. The burden then s
hifts to the obj
ecti
ng creditor to
show tha
t it (a) has
rel
ied on the sep
arat
e credit of one of
the entities being con
soli
date
d, and
(b)
will be prejudiced by su
bsta
ntiv
e consolidation. Fi
nall
y, if the ob
ject
ing creditor successfully
demo
nstr
ates
the foregoing, th
en the court non
ethe
less
may order con
soli
dati
on, but only if it
dete
rmin
es that the benefits of co
nsol
idat
ion "h
eavi
ly' ou
twei
gh the har
in. Ea
stgr
oup Pr
oper
ties
v. Southern Mo
tel As
sn., supra, citing In re
Auto-
Train Co
rp., 810 F.2
d 270 (D.
C. Cir
. 1987).
The dec
isio
n falls wi
thin
the "cr
edit
or rel
ianc
e" fact si
tuat
ions
discussed abo
ve, ex
cept
tha
t it
crea
tes a presumption of cr
editor nonreliance merely upon a showing of su
bsta
ntia
l id
enti
ty and
the av
oida
nce of
han
n or
rea
liza
tion
of be
nefit fr
om consolidation.
While such a presumption
may not
nec
essa
rily
follow fr
om the required sh
owin
g, creditors of a limited pu
rpos
e entity
form
ed i
n connection wit
h a str
uctu
red finance tr
ansa
ctio
n co
uld,
in many cas
es, show both
reliance on a si
ngle
ent
ity an
d su
bsta
ntia
l ha
rm fro
m consolidation.
The Eleventh
Circ
uit'
s de
cisi
on in the Eastgroup Properties cas
e al
so dem
onst
rate
s that
cons
olid
atio
n may be gr
ante
d not only with respect to a par
ent an
d its su
bsid
iary
, but al
so to
members of a consolidated gro
up, an
d en
titi
es tha
t merely hav
e "common ownership." In the
Eastgroup Pr
oper
ties cas
e, one deb
tor was a limited par
tner
ship
tha
t ha
d th
ree corporate equity
owners, wh
ich were als
o th
e ultimate own
ers of
the other deb
tor,
a cor
pora
tion
. None of the
owne
rs was
inv
olve
d in
the
bankruptcy pr
ocee
ding
as debtor.
See
also F.
D.I.
C. v. Co
loni
al
Realty Co., 966 F.2
d 57 (2d
Cir
. 19
92) (
bank
rupt
cy court has
authority to pe
rmit
sub
stan
tive
consolidation of
gene
ral partnership with two of its in
divi
dual
general partners).
The Eighth
Circuit follows a similar but not
ide
ntic
al app
roac
h. "F
acto
rs to co
nsid
er
when d
ecid
ing wh
ethe
r su
bsta
ntiv
e consolidation
is a
ppro
pria
te include (i)
the n
eces
sity
of
cons
olid
atio
n due
to the
inte
rrel
atio
nshi
p among de
btor
s; (
ii)
whet
her
the
bene
fits
of
consolidation outweigh the har
m to cre
dito
rs; an
d (iii) p
rejudice resulting from no
t co
nsol
idat
ing
the de
btor
s."
In re Giller, 962 F.2
d 796, 799 (8
th Cir
. 19
92) (
granting con
soli
dati
on by fi
ndin
g
that
the ben
efit
s ou
twei
gh the hann).
The Sec
ond an
d Th
ird
Circuits (encompassing New York and
Del
awar
e, among oth
er
jurisdictions) follow the
trad
itio
nal
set of factors b
ut hav
e reduced them t
o• two a
lter
nati
ve
standards. "[A] pro
pone
nt of substantive consolidation must demonstrate one of two rat
iona
les
for
its ap
plic
atio
n: that (
i) prepetition the entities for whom sub
stan
tive
con
soli
dati
on is so
ught
disr
egar
ded separateness so significantly their cr
edit
ors re
lied
on the br
eakd
own of
entity borders
and
treated them as
one l
egal
entity, or
(ii)
postpetition
thei
r assets a
nd l
iabilities a
re so
scrambled that sep
arat
ing them i
s pr
ohib
itiv
e an
d hurts
all creditors."
In re -Lisanti Foo
ds, 24
1
097000 000003 148
0385
.2
Fed.
Appx. at 2 (marks and
citations omitted); See I
n re
Aug
ie/R
esti
vo Baking Co. 860 F.2
d at
518 (s
ame).
Limited
case
law
specifically ad
dres
ses the legality of substantive
consolidation of
aba
nkru
pt deb
tor an
d a solvent no
n-de
btor
affiliate.
Although a split of au
thor
ity exists,
it has
been
hel
d that creditors (who did
not hav
e a
clai
m against the non-
debtor aff
ilia
tes di
rect
ly)
coul
d bring be
fore
the court par
ties
alleged to be the "alter ego" of the debtor. In re 19
48Meridian Place, 15 B.R. at
95-
96. See In re Crabtree, 39 B.R
. 7.18, 722-26 (Ba
nkr.
E.D. Te
nn.
1984
) (the right to bri
ng.a
ddit
iona
l pa
rtie
s be
fore
the court who are
the alt
er ego
of th
e de
btor
is
inde
pend
ent of
the ri
ght of
creditors to for
ce a person into ban
krup
tcy un
der Se
ctio
n 303 of th
eBankruptcy Cod
e); Ma
tter
of Munford, 115
B.R. 390 {Ban
kr. N.D. Ga. 1990).
On the other hand,
the co
urt in
In re Alp
ha & Omega Realty Inc., 36 B.R
. 416 (B
ankr
. D.
Idah
o 19
84),
held
that a sol
vent
affiliate of the d
ebto
r would
not be consolidated
with the
debt
or's
est
ate be
caus
e the
affiliate was not
its
elf a
debtor.
In support of the pos
itio
n against
consolidation Of non
-deb
tor pa
rtie
s, th
e court in
In re DRW Property Co., 82,
supra, st
ated that it
was "unaware of
any
sta
tuto
ry or common law authority to substantively consolidate debtor and
non-
debtor
par
tner
ship
s. The non
-deb
tor partnerships are
cer
tain
ly well outside of
the sc
ope of
this Court's jur
isdi
ctio
n." 54 B.A
. at
497 (emphasis in
orig
inal
). See
also
In
re The Julien
Company, 120 B.R. 930 (Ba
nkr.
W.D. Tenn. 199
0) (n
notion to consolidate de
btor
cor
pora
tion
with
non
debt
or shareholder violates due pr
oces
s ri
ghts
of non-
debt
or and
its separate cr
edit
ors)
;In re Lease-A-
Flee
t In
c. 14
1 B.
R. 869, 872 (B
ankr
. E.D. Pa. 199
2) ("caution must be multiplied
exponentially
in a s
itua
tion
where
a co
nsol
idat
ion of a d
ebto
r's ca
se w
ith
a non-
debt
or i
sat
temp
ted,
by a si
ngle
par
ty whi
ch ... is
a creditor of th
e de
btor
only and wh
ose
efforts ar
e no
tjoined by any other in
tere
sted
parties").
In a prominent decision by
the United
States Supreme Cou
rt considering sub
stan
tive
consolidation, the court hel
d in
Sampsel v. Imperial Pap
er & Col
or Cor
pora
tion 313 U.S. 215
(1941), that substantive con
soli
dati
on of a non-
debt
or cor
pora
tion
int
o an
individual bankrupt's
,es
tate
was pro
per where the tr
ansf
er of pro
pert
y by the individual to the cor
pora
tion
was not in
good
faith, was made for the
pur
pose
of pl
acin
g it beyond the reach of th
e individual's cre
dito
rs,
and where the ef
fect
of the tr
ansf
ers was to hi
nder
, de
lay or def
raud
the individual's creditors.
Id. at
217
-18 (so holding despite the Court of Appeals fin
ding
tha
t the non-
debtor cor
pora
tion
coul
d no
t be deemed the alt
er ego
of th
e individual bankrupt un
der applicable sta
te laws). Thus,
the decisions,,in fa
vor of consolidation of a de
btor
's sol
vent
affiliate usu
ally
req
uire
some sort of
harm o
r fraud on c
reditors and
typ
ical
ly include a d
eten
nina
tion
tha
t the so
lven
t entity was
mere
ly the "a
lter
ego" of
the de
btor
.
E.
Gene
ral Growth Pro
pert
ies and the Eff
ect of
Bankruptcy Filings for Special
Purpose Entities.
•
The b
ankr
uptc
y ca
se o
f Ge
nera
l Gr
owth
Pr
oper
ties
, In
c. and
its
affiliates in
2009
provided some unique in
sigh
ts into t
he ef
fect
of bankruptcy f
ilin
gs f
or a
ffiliated
entities
including special purpose
entities. The Gen
eral
Gro
wth Properties cas
e in
volv
ed 388 separate
enti
ties
, in
clud
ing a larg
e number of sp
ecia
l purpose
entities. A number of motions to dis
miss
thes
e ca
ses were filed by secured cre
dito
rs. The motions were de
nied
in a co
nsol
idat
ed opinion
909
7000
.000
003 14
8(13
85.2
by the
ban
krup
tcy
cour
t. See, In
re Gen
eral
Gro
wth
Properties, Inc., 409 B.R. 43 (Ba
nkr.
S.D.N.Y. 2009) (the "GGP Dec
isio
n").
'
In t
he GGP D
ecis
ion,
the b
ankr
uptc
y co
urt fo
und
that
ind
epen
dent
man
ager
s ac
ted
corr
ectl
y when the
y vo
ted to commence bankruptcy pr
ocee
ding
s for th
e special purpose
entities,
noting that un
der applicable Del
awar
e la
w, the managers were obl
igat
ed to protect th
e interests
of owners, not
with
stan
ding
the imp
endi
ng insolvency of
the entities. The ban
krup
tcy co
urt al
sorejected contentions tha
t the fi
ling
s for th
e special purpose entities were made in ba
d faith. The
cour
t fo
und
that
the cre
dito
rs knew when they ex
tend
ed cre
dit to the deb
tor
entities tha
t th
ey
were
acc
epti
ng security from special pur
pose
ent
itie
s that were pa
rt of a la
rge group of
affiliated
companies an
d th
at it was therefore pro
per to evaluate the go
od fai
th and
reasonableness of
the
bank
rupt
cy filings from the pe
rspe
ctiv
e of
the co
nsol
idat
ed gro
up, an
d no
t fr
om the per
spec
tive
of the individual spe
cial
purpose entities.
However, th
e most significant aspect of th
e GGP Decision may be relative to su
bsta
ntiv
econsolidation. The ban
krup
tcy court noted that the
sec
ured
-len
ders
, who were in
conv
enie
nced
by the fil
ings
, still enjoyed the fundamental
protections of
the spe
cial
purpose entity st
ruct
ure,
including "protection ag
ains
t the su
bsta
ntiv
e co
nsol
idat
ion of th
e project-level Debtors with any
othe
r en
titi
es."
In re Ge
nera
l Gr
owth
Pro
pert
ies,
Inc
. 409 B.R. at 69 (Ba
nkr.
S.D
.N.Y
. 2009).
As if t
o em
phas
ize
its point, the ban
krup
tcy court ad
ded th
at "No
thin
g in
thi
s Op
inio
n implies
that the a
ssets an
d liabilities of any of -t
he Sub
ject
Debtors cou
ld p
rope
rly be substantively
cons
olid
ated
with those of
any
oth
er ent
ity.
Id.
As the holding of the GGP Dec
isio
n makes cl
ear,
eve
n if
a spe
cial
pur
pose
ent
ity does
become a
debt
or i
n a
bankruptcy ca
se, an
d ev
en i
f the
case
involves affiliated entities,
substantive consolidation is not nec
essa
rily
in the of
fing
. In
fac
t, the GGP Dec
isio
n re
cogn
ized
protection against substantive consolidation as a fundamental protection provided by
the special
purp
ose entity str
uctu
re, f
or which the cre
dito
rs neg
otia
ted.
The GGP Dec
isio
n's re
cogn
itio
n of
a cr
edit
or's
right not to ha
ve a special purpose entity de
btor
sub
stan
tive
ly con
soli
date
d in
jointly
admi
nist
ered
af
fili
ate
bank
rupt
cy ca
ses
bols
ters
th
e tr
adit
iona
l no
tion
th
at su
bsta
ntiv
eco
nsol
idat
ion,
far
fro
m being au
toma
tic
in b
ankr
uptc
y, is me
rite
d only r
arely an
d when the
circ
umst
ance
s warrant
it.
III.
Co
nclu
sion
As the cas
e law
demo
nstr
ates
, wh
ile
skil
lful
efforts to avoid a -bo
rrow
er's
filing for
prot
ecti
on in
ba
nkru
ptcy
ha
ve no
t be
en en
tire
ly fr
uitf
ul,
efforts
to avoid
subs
tant
ive
consolidation
in ba
nkru
ptcy
ha
ve ge
nera
lly
been
effective
abse
nt e
gregious circumstances
warranting the app
lica
tion
of this
doctrine.
Under the
cur
rent
sta
te of th
e law
in this area, in
cases inv
olvi
ng a typical single pu
rpos
eentity structure and
separateness co
vena
nts such a
s those incorporated i
nto th
e major
rati
ngagencies' st
ruct
ured
finance criteria fr
om the app
lica
ble ca
se law referred to abo
ve, it would be
diff
icul
t for a cr
edit
or, the SPE deb
tor,
or
its tr
uste
e in
ban
krup
tcy to claim tha
t re
cogn
itio
n of
the de
btor
as se
para
te from an
y ot
her pe
rson
would be inequitable, or re
sult
in a fr
aud or
injustice
on cre
dito
rs.
Similarly, it
would be
diff
icul
t for such an SPE debtor or its
tru
stee
in bankruptcy
to argue tha
t such a str
uctu
re mis
lead
creditors by creating the appearance that the
debtor an
d its
0970
00.0
0000
3 14
8038
5.2
10
affiliates were one
unit
, or that the affairs of
the deb
tor an
d any ot
her pe
rson
were so
entangled
that it would be too costly or tim
e consuming to dea
l with or co
nsid
er them
sepa
rate
ly, that it
appe
ared
tha
t th
e assets of th
e de
btor
were av
aila
ble to meet claims of an
y other person, or tha
t
assets wer
e tr
ansf
erre
d to the deb
tor without fair consideration or wi
th intent to hinder, delay, or
defraud
cred
itor
s. Finally, cre
dito
rs of such an SPE debtor sh
ould be able to show reliance on
the se
para
te cre
dit an
d assets of su
ch an SPE deb
tor (i.e., that th
ey were "r
ing fe
ncer
), and
tha
t
creditors of
such de
btor
would be Unable to show tha
t any of them
did in
fact re
ly on th
e credit
and assets of an
y ot
her person, ab
sent
perhaps a "springing re
cour
se gua
rant
y or sim
ilar
device,
whic
h could actually militate ag
ains
t the len
der'
s go
al of av
oidi
ng substantive con
soli
dati
on.
In t
his regard, it i
s im
port
ant to note that one may not
be
able to ha
ve i
t bo
th w
ays,
particularly bef
ore a court of eq
uity
such as a U.S. Bankruptcy Cou
rt, an
d argue th
at (a) an SPE
debtor's a
ssets sh
ould
be "ring fencer for one c
redi
tor such tha
t substantive
cons
olid
atio
n
should not
apply, but (b) tha
t the ri
ng fencing, ev
en tho
ugh ob
serv
ed by the deb
tor,
doe
s no
t
apply to the
creditor, and
tha
t that same cre
dito
r may look to other persons for sat
isfa
ctio
n of
the
debt
but st
ill avoid substantive consolidation. U
ntil
this di
scre
te iss
ue is au
thor
itat
ivel
y de
cide
d,
this will ve
ry much rem
ain
a- work in
pro
gres
s.
11097000.000003 1480385.2