special purpose entities in real estate transactions...

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Presenting a live 90-minute webinar with interactive Q&A

Special Purpose Entities in Real Estate

Transactions: Structuring and Documentation Mastering Separateness Provisions, Single Member LLCs, Recycled Entities,

Independent Directors and Non-Consolidation Opinions

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, JANUARY 4, 2017

Samuel R. Arden, Partner, Hartman Simons & Wood, Atlanta

Whalen Kuller, Senior Counsel, Hartman Simons & Wood, Atlanta

John H. Lewis, Senior Counsel, Hartman Simons & Wood, Atlanta

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SPECIAL PURPOSE ENTITIES IN

REAL ESTATE TRANSACTIONS:

STRUCTURING AND

DOCUMENTATION

January 4, 2017

Sam Arden

Whalen Kuller

John Lewis

Introduction:

What is an SPE

• “Single purpose,” “special purpose” and “bankruptcy

remote” are interchangeable in the context of a structured

or securitized commercial real estate loan transaction

• Important differences between a single-purpose entity and

a bankruptcy-remote entity

6

Introduction:

What is an SPE

• Single-purpose entity refers to a corporation, limited

partnership or limited liability company formed under laws

of a particular state

• Organized for a narrow, specific or temporary purpose

• Vast majority are used in connection with real estate

financing transactions

7

Introduction:

What is an SPE

• Not all single-purpose entities are bankruptcy-remote

entities

• Bankruptcy-remote entity is always a single-purpose

entity

• Has additional characteristics that a single-purpose entity

does not have

8

Introduction:

What is an SPE

• SPEs feature some measure of “bankruptcy remoteness”

• Nationally recognized rating agencies require a single-

purpose entity also be bankruptcy-remote

• Will have features that reduce the availability of assets to

satisfy creditors

9

Introduction:

What is an SPE

• Typical SPE is bankruptcy-remote in two primary ways

o SPE is structured and formed to render it less likely that the SPE’s

assets will be made available to creditors of the originating entity

o SPE is structured to render it less likely that the SPE itself will become a

debtor in a bankruptcy proceeding

10

Introduction:

What is an SPE

• A bankruptcy-remote entity is not a bankruptcy-proof

entity

• A bankruptcy-remote entity cannot be prohibited from

seeking Bankruptcy Code protection

11

Introduction:

What is an SPE

• When structuring a bankruptcy-remote entity, the goal is

to reduce the likelihood that the entity will

o File a voluntary bankruptcy action

o Become insolvent

o Have an involuntary bankruptcy action filed against it

• All major rating agencies require a single-purpose entity

be bankruptcy-remote

12

Introduction:

When is an SPE Required

• Used in a variety of commercial loans issuances and

mezzanine financings

• If destined for pooling with other commercial real estate

loans for a CMBS issuance, certain rating agency criteria

may apply

13

Introduction:

When is an SPE Required

• Loans not subject to rating agency criteria, lenders still

require the borrower to meet rating agency criteria

• Smaller loans, some lenders may not require an SPE at

all, or may require an SPE meets only some SPE

requirements

• Commercial real estate loans over a certain monetary

threshold amount are subject to SPE lending strictures

14

SPE Formation and Structure:

• The type of entities most frequently used in rated

commercial mortgage transactions are:

o Limited liability companies (“LLCs”)

o Corporations and limited partnerships

15


• Depending on the size of the loan transaction, one or

more members of an SPE will need to be an SPE

• Also must comply with most or all of the single-purpose

and bankruptcy-remote requirements

• An SPE that is organized as a Delaware, single-member

LLC will not be required to have its sole member be an

SPE

16


• At least one member of the SPE holding a meaningful

economic interest will be required be an SPE

• Chief concern is that the bankruptcy or insolvency of non-

SPE members may precipitate the bankruptcy or

insolvency of the SPE

• At least one member of the SPE that is itself an SPE

reduces such risk

17


Delaware

• Delaware is the preferred state of choice for formation of

the SPE

• Rating agencies have a favorable view of Delaware law

18


Delaware

• Reputation as a preeminent jurisdiction for entity

formation is well-deserved

• Delaware LLCs are popular for structured finance and

securitization transactions

19


Delaware

• Advanced state of its law

• Statutory laws governing business entities are continually

updated and market concerns are addressed

• Also has a wealth of judicial decisions

20


Delaware

• Appealing because it does not aggressively tax non-

Delaware source income

• Delaware LLC statutes piggyback on federal tax rules

• Most LLCs can issue interests without requiring a capital

contribution

21


Delaware

• Business-friendly state government is attractive to

businesses

• Legislature and Governor have demonstrated a

willingness to understand and be responsive to the needs

of business

22


Single-member LLCs

• If the SPE is organized as a single-member Delaware

LLC, its sole member will not be required to be an SPE

• The SPE will be “disregarded” for federal and state

income tax purposes

• An LLC provides flexibility

23

Specific SPE Provisions

• SPE’s organizational documents required to include

certain provisions, such as:

o Restrictions intended to limit or eliminate the ability of an SPE from

incurring liabilities to be included as part of the loan transaction

o Restrictions intended to insulate the SPE from liabilities

o Restrictions intended to protect the SPE from dissolution risk

o Restrictions intended to limit a solvent SPE from filing a bankruptcy

petition

24

Specific SPE Provisions:

Single-Purpose Provisions

• SPE’s objects and powers are restricted as closely as

possible

• Purpose is to reduce the SPE’s risk of insolvency due to

claims created by activities unrelated to the securitized

assets

25



• SPE should not engage in unrelated business activities

• By requiring a limited purpose, lenders limit the potential

pool of creditors and other operational risks

• Purpose of the SPE should be limited in: o The transaction documents

o The organizational documentation of the SPE

• Nature of the limitation will depend on the SPE’s role in

the transaction

26



• SPE’s organizational documents are the preferred locus

because:

o Documents are publicly available and provide public notice of the

restriction

o An organic restriction is less likely to become lost in the organizational

files

27


Debt Limitations

• SPE will be prohibited from o Incurring any other debt, except a limited amount of trade payables

o Granting any liens on its assets

• The lender will consider any fees, expenses, indemnities,

and other payment obligations required to be made by the

entity in question

28


Debt Limitations

• Lenders will allow additional debt if o The additional debt is fully subordinated to the lender’s debt and is

nonrecourse to the SPE or any of its assets

o Does not constitute a claim against the SPE

• Purpose is to minimize the likelihood that the SPE will be

put into bankruptcy by its creditors

29


Merger, Reorganization, Etc.

• The SPE’s organizational documents and the loan

documents include provisions prohibiting the SPE from:

o Consolidating or combining with another entity

o Liquidating or winding-up

o Merging or selling all or substantially all of its assets

o Amending the provisions of the SPE’s organizational documents

30



• The lender will have certain rights under the SPE’s

organizational documents relating to:

o Amendments to the SPE’s organizational documents as they relate to its

bankruptcy remoteness

o Equity transfers in the SPE

o Third-party beneficiary rights to enforce the bankruptcy-remote

provisions

31



• Lender should not be given rights to vote for a voluntary

bankruptcy proceeding

• Not unusual for the lender to have substantial input

regarding removal and appointment of SPE’s independent

directors and criteria

• Changes to the criteria are often subject to lender consent

or approval

32


Pledge of all Assets

• Loan documents require that all of the SPE’s assets be

pledged to secure the SPE’s debt

• None of the SPE’s assets should remain unpledged

33


Separateness Provisions

• Organizational documents contain certain provisions,

called separateness provisions or separateness

covenants

• Intended to ensure its managers, members, directors and

other controlling persons operate the SPE as a separate

legal entity

• Loan documents will have representations from the SPE

34



• Separateness provisions to protect against a substantive

consolidation

• Bankruptcy Code - the equitable principle of substantive

consolidation provides if the activities of two entities are

so entwined, the court may combine assets and liabilities

of two or more entities

• Creditors of the consolidated entities would share in the

pooled assets

35



• Language of the separateness provisions varies from

lender to lender but generally includes requirements that

the SPE:

o Maintain books and records separate from any other person or entity

o Maintain its accounts separate from those of any other person or entity

o Not commingle assets with those of any other entity

o Conduct its own business in its own name

o Maintain separate financial statements

36





the SPE:

o Pay its own liabilities out of its own funds

o Observe all corporate, partnership, or LLC formalities

o Maintain an arm’s-length relationship with its affiliates

o Pay the salaries of its own employees and maintain a sufficient number

of employees

37





the SPE:

o Not guarantee or become obligated for the debts of any other entity or

hold out its credit as being available to satisfy the obligations of others

o Not acquire obligations or securities of its partners, members, or

shareholders

o Allocate fairly and reasonably any overhead for shared office space

o Use separate stationery, invoices, and checks

38





the SPE:

o Not pledge its assets for the benefit of any other entity or make any

loans or advances to any entity

o Hold itself out as a separate entity

o Correct any known misunderstanding regarding its separate identity

o Maintain adequate capital in light of its contemplated business

operations

39

Springing and Special Members

• An SPE should be formed in a state such as Delaware

whose law that provides that bankruptcy of a member or

owner does not cause the SPE to terminate or dissolve

• Done in part by creating the role of the springing member

under the operating agreement

40


• Springing member is a person who has agreed to become

a special member automatically upon the happening of

the event specified in the operating agreement

• Before becoming a special member, is not a member of

the LLC and has no LLC interest

41


• Special member is a member solely for the purpose of

preventing the SPE from terminating for lack of any

members

• Has no interest in the profits, losses and capital of the

SPE

• Has no right to receive any distributions of the SPE's

assets

42


• Is not required to make any capital contributions to the

SPE

• Does not receive an LLC interest in the SPE

• Has no power or authority to act for or bind the SPE

• No right to vote on, approve or otherwise consent to any

action by the SPE

43

Independent Directors

• Primary purpose is to approve or disapprove a borrower’s

bankruptcy filing

• Borrower must have the approval of one or more

independent directors to have sufficient authority to file for

bankruptcy

• Lenders require borrowers to use independent directors to

ensure an SPE borrower is bankruptcy-remote

44


• Appointing an independent director limits a borrower’s

ability to take certain actions

• An independent director helps insulate against the risk

that the shareholders, members, partners, directors or

managers will control the borrower

45


• Provisions require the independent director or manager to

affirmatively vote before a voluntary bankruptcy petition is

authorized

• Consent may also be required in other circumstances

• Provisions are enforceable if properly structured under the

laws of the State of Delaware

46


• Lenders require SPEs to have two independent directors

• Requiring the consent of two separate, independent

individuals exercising their fiduciary or contractual duties

47


• Independent directors may consider the economic

interests of the lender before consenting to a voluntary

bankruptcy proceeding

• The LLC’s organizational documents cannot eliminate the

implied contractual covenant of good faith and fair dealing

implicit in contracts

48


• Typical qualifications for an independent director are one

who has not been:

o A direct or indirect legal or beneficial owner in the SPE

o A creditor, supplier, employee, officer, director, family member, manager,

or contractor of the SPE

o A person who controls the SPE

49


• Must be employed by and engaged by the SPE to qualify

• Engaged by the SPE by entering into an “Independent

Director Agreement”

• Agreement provides for the annual compensation to be

paid to the independent director

• Cost of an independent director ranges from under $1,000

to $2,500+ per entity per year

50

Recycled Entities

• Lender requires its SPE borrower to be a new entity

formed before the transaction

• Limits the risk that any prior activity undertaken by the

borrower could be a basis for consolidating the borrower

with any other entity

51

Recycled Entities

• An advantage of a newly created vehicle for each new

transaction is the assurance that the entity has no prior

history of dealings or disguised liabilities

• Unlikely there would be claims if SPE is created prior to

its use in the loan transaction

• If not newly created, a pre-existing liability of the entity

may result in a lawsuit

52

Recycled Entities

• If a pre-existing entity is used, and not an SPE, it is known

as a “recycled entity”

• If the lender allows the borrower to be a recycled entity,

the lender typically o Reviews all past iterations of the borrower’s organizational documents

o Requires backward-looking representations and warranties

o A certification by an appropriate officer of the entity

o An accounting audit

o Proof of compliance with environmental standards

o Applicable legal comfort

53

Recycled Entities

• Officer’s certificate includes the following regarding the

entity: o Duly formed, validly existing, and in good standing in the state of its

formation

o No judgments or liens of any nature against it

o In compliance with all laws, regulations, and orders applicable to it and

has received all permits necessary for it to operate

o Not aware of any pending or threatened litigation

o Not involved in any dispute with any taxing authority

o Has paid all taxes

54

Recycled Entities

• Officer’s certificate includes the following regarding the

entity: o Never owned any property other than the property that is the subject of

the current transaction and has never engaged in any business except

the ownership and operation of such property

o Never been party to any lawsuit, arbitration, summons, or legal

proceeding

o Provided the lender with complete financial statements

o Has conducted a Phase I environmental audit

o Has materially complied with the separateness covenants referred to in

such opinion since its formation

o Has no material contingent or actual obligations not related to the

mortgaged property

55

Recycled Entities

• An accounting audit should confirm the substance of the

representations and warranties in the officer’s certificate

• Legal opinions will be required

o Legal opinion confirming the relevant representations and warranties

o Non-consolidation opinion containing no assumptions with respect to

the entity’s prior conduct

• If the entity holds real property, lender may request a copy

of the Phase I environmental audit

56

Substantive Consolidation:

General Background

• Substantive consolidation involves combining assets of

multiple entities for purposes of addressing creditor claims

in bankruptcy

• This doctrine must be distinguished from procedural

consolidation

• The doctrine arises under general equitable powers of the

bankruptcy court-Section 105 of the Bankruptcy Code

57


General Background

• There is no specific statutory authority

• The doctrine involves a fact-intensive inquiry on a case-

by-case basis

• The general rule is that the application of the doctrine

should be limited but a more modern approach has

expanded the application

58


Case Law analysis

• In re Vecco Constr. Indus., 4. B.R. 407 (Bankr. E.D. Va

1980)- This court set out an “elements test” that provided

seven factors to analyze regarding borrower and related

entities such as commingling of assets and consolidated

financial statements.

• In re Augie/Restivo Baking Co., Ltd., 860 F.2d 515 (2d Cir.

1988)-Found the two critical considerations are whether

creditors dealt with the entities at issue as one entity and

if the affairs of the debtor are so entangled that

consolidation will have a broad benefit.

59


Case Law analysis

• In re Eastmont Properties v. Southern Motel Assoc., Ltd.,

935 F.2d 945 (11th Cir. 1991)- Found that the essential

inquiry is whether the economic prejudice of allowing the

entities to continue to receive separate treatment

outweighs the prejudice arising from consolidation.

• In re Owens Corning, 419 F.3d 195 (3d Cir 2006)-

Criticizing the rigid application of an elements test and

finding that a proponent of consolidation must show that

the borrower and related entities disregarded

separateness to such an extent that creditors viewed and

treated them as one entity. 60


Specific Factors and Considerations

• Commingling of assets

• Inadequate record keeping

• Difficulty in separating assets of the entities

• Overlapping operations

61


Specific Factors and Considerations

• Failure to observe corporate formalities

• The benefits of consolidation

• The prejudice to the creditor opposing consolidation

• Impact upon a successful Chapter 11 plan

62

Questions? Sam Arden

[email protected]

770.951.6590

Whalen Kuller

[email protected]

770.951.6586

John Lewis

[email protected]

770.951.6571

63

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