structuring special purpose entities: separateness...

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

Structuring Special Purpose Entities:

Separateness, Bankruptcy Remoteness

and True Sales

Today’s faculty features:

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

TUESDAY, SEPTEMBER 12, 2017

Samuel A. Newman, Esq., Gibson Dunn & Crutcher, Los Angeles

Daniel B. Denny, Esq., Gibson Dunn & Crutcher, Los Angeles

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Structuring Special Purpose Entities: Separateness, Bankruptcy Remoteness and True Sales Samuel A. Newman and Daniel B. Denny September 12, 2017

• The sine qua non of structured financing is the effort to separate the credit quality of the assets being securitized from the credit risk of any entity involved in the financing.

• The requisite legal separation is achieved by two structuring techniques:

• True Sales/Contributions: This transfer is structured so that it is “absolute” in the sense that the original owner retains no legal/equitable interest in the assets following the transfer. The objective is to remove the assets from the bankruptcy estate of the transferor and isolate them in a Special Purpose Vehicle (SPV), also referred to as a Special Purpose Entity (SPE).

• Bankruptcy Remote Vehicle: The SPV is structured so that (i) it is unlikely to become the subject of a bankruptcy case and (ii) its assets are unlikely to be considered part of the transferor’s bankruptcy estate.

Separation of Asset Risk From Entity Risk

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• The principal method of transferring assets to an SPV is a “true sale.” The transfer is intended to have the effect of removing the assets transferred from the transferor’s estate under Bankruptcy Code section 541. The law governing the transfer is applicable non-bankruptcy law. In structuring true sales, the following issues must be considered: • Intent of the Parties • Economic Consequences of the Transaction • Recourse and Risk of Loss • Fixed Purchase Price • Right to Redemption • Right to Surplus • Administration and Collection of Payments • Accounting Treatment • Reduction in Interest in Loans and Participations • Physical Possession of Documents: Reflection of Sale on Books and Records • The Buyer as a Subsidiary of the Seller

Separation of Asset Risk From Entity Risk – The True Sale

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• The threshold issue in a true sale analysis is whether the parties intended that the transaction constitute a sale rather than a financing. “Where the parties intention is clearly and unambiguously set forth in the agreement, effect must be given to the expressed intent.” Granite Partners, L.P. v. Bear, Stearns & Co., 17 F. Supp. 2d 275, 300 (S.D.N.Y. 1998).

• None of the transactional documentation pertaining or referring to the transfer from the originator should be inconsistent with an absolute transfer.

• Transfer should be evidenced by a formal instrument of transfer (bill of sale).

• Intent generally given effect without regard to extrinsic evidence, but where rights of third parties or equities may require, courts have looked beyond the form of agreement to the conduct of the parties.

True Sale – Intent of the Parties

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• Recourse and Risk of Loss

• One of the most important factors.

• Both the nature and extent of recourse must be evaluated.

• complete recourse will likely be characterized as a secured loan

• limited recourse will not preclude a transfer from being classified as a true sale

• Examples of direct and indirect recourse include:

• warranties as to collectability

• adjustments to the purchase price

• guarantees by the transferor

• collateral security from the transferor

• obligations to repurchase, or substitute for, under-performing receivables.

The True Sale – Economic Consequences of the Transaction

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• Fixed Purchase Price

• Primary feature of a purchase transaction.

• Right to Redemption

• Right of the transferor to redeem or repurchase the transferred property.

• Right to Surplus

• Does the seller retain the right to retain excess collections?

• A transaction will be determined to be a secured loan where the transferee is obligated to account to the transferor for any surplus received from the assignment over the amount of the debt or investment, plus an agreed return to the lender.

• Administration and Collection of Payments

• Factors that would favor characterizing a transaction as a sale include notification by the transferee of account debtors and control by the transferee over the collection of the accounts.


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• Accounting Treatment

• The assets transferred should not be reflected on the books and records of the transferor as being owned by it.

• The transferred assets should be treated as having been sold under GAAP.

• If the SPV’s financial statements are consolidated with the transferor’s financial statements, the SPV’s ownership of the assets should be specifically stated in notes to the statements so that its ownership is not concealed by the consolidated presentation.

• Reduction in Interest in Loans and Participations

• Courts will consider whether the transferee acknowledges that his rights in the transferred property would be extinguished if the money owed were paid through another source.

• Physical Possession of Documents; Reflection of Sale on Books and Records


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• The Buyer as a Subsidiary of the Seller

• Corporate law does not prevent a seller from selling an asset to a subsidiary.

• Absent application of a doctrine such as fraudulent conveyance, substantive consolidation, alter ego, instrumentality or a similar doctrine or of a specific federal or state statute, a court normally will:

• not disregard transactions between a seller and its subsidiary, and

• will recognize and uphold the separate existence of the subsidiary so long as the transactions between them are at arm’s length and on commercially reasonable terms.


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• If the purchase price or other consideration received by the transferor is less than the reasonably equivalent value of the assets transferred to the SPV, the transaction may be subject to attack as a fraudulent conveyance.

• In some receivables securitization financings, cash or additional receivables are transferred to the SPV as a capital contribution by the transferor – a form of internal credit enhancement.

• In these financings, the benefits to and/or the financial condition of the transferor must be considered.

Fraudulent Conveyance

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• Structured financing is premised on the ability to separate the assets to be financed from any entity credit risk and the related bankruptcy risk. This has two facets:

• Structuring the SPV to be “bankruptcy remote” so that it is unlikely to commence, or have commenced against it, a bankruptcy case.

• Structuring the SPV so that it is unlikely to be affected by the bankruptcy of the transferor or any of its affiliates.

Structuring a Bankruptcy Remote SPV – Introduction

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• Structuring a “VALID” bankruptcy remote SPV generally involves attention to at least five areas:

• Voluntary

• Activities

• Liens

• Involuntary bankruptcy

• Debts

Structuring a Bankruptcy Remote SPV – Introduction

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• Advance restrictions against filing a voluntary bankruptcy case pursuant to an agreement between a debtor and a creditor have been held to be void as against public policy.

• No conclusive way to deprive an SPV of the legal right to commence bankruptcy.

• Structuring is directed towards the corporate governance of the SPV.

• Applicable non-bankruptcy law governs who has the authority to make an entity’s decision to commence bankruptcy proceedings.

• Where the SPV is owned by the originator, the SPV may be structured so that:

• one or more directors are independent, and

• a super-majority vote, including all or at least one of the independent directors, is required in order for the BOD to approve a voluntary bankruptcy.

Structuring a Bankruptcy Remote SPV – Voluntary Bankruptcy

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• BUT . . . See General Growth Properties, Inc., 409 B.R. 43, 64-65 (Bankr. S.D.N.Y. 2009):

• “If Movants believed that an ‘independent’ manager can serve on a board solely for the purpose of voting ‘no’ to a bankruptcy filing because of the desires of a secured creditors, they were mistaken. As the Delaware cases stress, directors and managers owe their duties to the corporation and, ordinarily, to the shareholders.”


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• Del. Code tit. 6 § 18-1101:

• (c) To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is party to or is otherwise bound by a limited liability company agreement, the member’s or manager’s or other person’s duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.


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• An SPV is a newly created entity with no prior business activities that could have given rise to preexisting creditors, or other claims (tort, environmental, etc.…)

• An SPV activities are restricted to those necessary or incidental to the financing which is accomplished by:

• restrictions being placed in the charter and by-laws of the corporate SPV

• restrictions placed in the trust instrument establishing trust SPVs

• restrictions placed in the transactional documents

• drafting protection against amendments into the foregoing documents

• Type of assets that can be acquired by the SPV in the future must be clearly defined.

• An SPV can acquire assets of more than one originator and issue separate series of ABS relating to the assets acquired from each originator.

Structuring a Bankruptcy Remote SPV – Activities

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• Financed assets should be free of liens in favor of parties external to the structured financing.

• Constituent documents typically provide that the assets cannot be subjected to a voluntary lien or security interest in favor of anyone other than the holders of the structured debt.

• Involuntary liens can be an issue.

• They include potential secured claims that arise directly and indirectly against the SPV (liens in favor of governmental authorities that encompass the assets of all members of a corporate family).

• May be necessary to have all or part of the SPV owned by an independent entity (a charity or an investment banking firm).

Structuring a Bankruptcy Remote SPV – Liens

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• In order to substantially reduce the risk of an involuntary filing, all or most of the consensual creditors of the SPV may be required to sign an agreement not to file an involuntary case against the SPV until at least 366 days after the structured debt has been paid.

• These creditors are typically financial institutions that provide funding or services and professionals.

• The 366 day period is tacked on to when the structured debt is paid in order to avoid a preference attack.

Structuring a Bankruptcy Remote SPV – Involuntary Bankruptcy

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• Debt of the SPV generally limited to those related to the structured financing in question.

• Non-recourse debt payable only from cash flow in excess of that necessary to pay the ABS may also be permitted.

• Sometimes additional debt, either subordinated or non-recourse, may be incurable and payable from cash flow in excess of that necessary to pay the ABS.

Structuring a Bankruptcy Remote SPV – Debts

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• Goal of legally separating the assets from entity credit risk would not be realized if the SPV were to be substantively consolidated with the transferor in a subsequent transferor bankruptcy.

• In a substantive consolidation, the assets of two or more entities are pooled, intercompany claims are eliminated and claims of outside creditors are generally treated as claims against the common fund.

Structuring An SPV That Will Not Be Substantively Consolidated

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• Courts have historically considered two broad issues:

• The relationships of the potentially substantively consolidated entities both among themselves and with creditors; and

• The impact of the effect of substantive consolidation on the creditors of the consolidated entities.


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• Questions to ask:

• Whether an entity proposed to be consolidated with another entity is a “mere instrumentality” or “alter ego” of the other entity?

• Whether their affairs are hopelessly obscured?

• Whether the benefits of substantive consolidation – usually, facilitating a reorganization – outweigh the prejudice to any third party that justifiably relied on the separateness of the entity with which it dealt?


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• There are a number of recurring issues to consider when structuring an SPV and its relationship with the originator and their relationships with creditors:

• Compliance with SPV formalities.

• Separateness of SPV decision-making and operations.

• SPV’s possession of its assets and management of its liabilities.

• Separateness of SPV’s offices and financial statements.

• Arms-length nature of SPV’s transactions with originator.

• Disclosure of the separateness of the SPV and its assets

• Separateness of the relationship between SPV & third-parties.

• No list of factors can be all-inclusive.


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• A specified % of the directors will be independent.

• Board of Directors (BOD) and SPV stockholders will hold all regular meetings (at least quarterly) appropriate to authorize corporate action. A quorum of the BOD will be present in person at least one meeting each year. Complete minutes of all such meetings will be kept by the SPV.

• SPV will have sufficient officers and personnel to run its business and operations. At least one senior officer of the SPV will be, or have the same qualifications as, an independent director.

Substantive Consolidation Issues List Developed From Existing Case Law

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• Decisions with respect to the SPV’s business and daily operations will be independently made by the SPV and will not be dictated by its parent or any affiliates thereof.

• All business transactions entered into by the SPV with any of its affiliates that are permitted will be on terms that are not more or less favorable to the SPV than terms and conditions available at the time to the SPV for comparable transactions with unaffiliated persons and will be approved by a majority of the BOD, including each independent director.

• The declaration of dividends by the SPV will be approved by a majority of the BOD, including each director who is an independent director.


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• SPV will act solely in its own corporate name and through its own authorized officers and agents. No affiliate(s) of the SPV will be appointed agent of the SPV.

• SPV will directly manage its own liabilities, including paying its own payroll and operating expenses. In the event employees of the SPV participate in pension, insurance and other benefit plans of the parent or any affiliates thereof, the SPV will on a current basis reimburse the parent or such affiliate for the SPV’s pro rata share of the costs thereof.

• SPV will maintain a separate office (a) which if leased from its parent will be on terms no more or less favorable to the SPV than could be obtained elsewhere and (b) which will be conspicuously identified as the SPV’s office so it can be easily located by outsiders.


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• SPV will prepare and maintain its own separate, full and complete books, records and financial statements.

• Financial statements will comply with GAAP.

• Audited annual and unaudited quarterly financial statements will be distributed to the debt security holders of the SPV.

• Neither the parent nor any affiliates thereof will guarantee debts of the SPV and the SPV will not guarantee debts of the parent or any affiliates thereof.

• SPV will not acquire obligations or securities of, or make loans or advances to, the parent or any affiliates thereof.

• SPV will not commingle any of its money or other assets with the money or assets of the parent or any affiliate thereof.


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• SPV will maintain separate bank accounts in its own name.

• Investment guidelines and criteria will be established by a majority of the BOD including at least one director who is an independent director. Investments will be made by the SPV directly or by brokers engaged and paid by the SPV, and will be carried by the SPV in its own name.

• If the SPV is included within the parent’s (or any other affiliate's) consolidated financial statements, the existence of the SPV and the ownership of its assets will be disclosed in a footnote.


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• GGP was a publicly traded REIT, among the largest operators of regional shopping centers in the US.

• Owned or managed over 200 shopping centers in 44 states.

• At the end of 2008, the GGP Group had $29.6 billion in assets and $27.3 billion in liabilities.

• GGP held the bulk of its operating assets through SPE subsidiaries, with each SPE holding one asset.

• GGP filed a voluntary chapter 11 case on April 16, 2009 and caused 388 SPEs to file voluntary chapter 11 petitions and through motions to use cash collateral and to continue cash management practices sought authority to use the cash generated by the SPEs to fund the reorganization.

The General Growth Chapter 11 Bankruptcy Cases

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• SPE filings and efforts to use SPEs’ cash conflicted with two key premises of the SPE structure:

• That an SPE would not be subject to bankruptcy case at the instance of its parent.

• That an SPE’s assets (and its cash flow in particular) would not be affected or interrupted by the parent’s financial condition/bankruptcy.

• The first day declaration emphasized that GGP ran its business as an integrated enterprise with management centralized at GGP’s Chicago headquarters.

• Managed its cash through a centralized cash management system

General Growth

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• The Bankruptcy Court issued an interim order permitting GGP to collect and use the cash generated by its SPEs pending a final hearing on the cash management system and DIP financing package.

• GGP’s centralized cash management system was inconsistent with a typical parent/SPE structure where an SPE would collect its income in its own separate account and pay expenses from that account with excess cash upstreamed to the parent.

• GGP swept income from its SPE subs into a common operating account, and then paid the SPE’s obligations from that account.

• Certain SPE lenders did have deposit account control agreements under which they would assume control of the SPE’s deposit account upon default, preventing that SPE from upstreaming cash to GGP.

General Growth

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• Under the initial DIP package, the DIP lender was to have a first-priority administrative expense claim on the central account and the SPEs were to guarantee GGP’s obligations under the DIP loan and secure those guarantees with second-priority liens on substantially all of their assets.

• GGP also proposed to replace the SPEs secured creditors’ liens on cash with administrative expense claims on the intercompany claims held by the SPEs (to be junior to GGP’s DIP lender’s claim).

• SPEs’ lenders filed numerous objections arguing that:

• such guarantees and liens were prohibited by the SPE documents.

• proposed adequate protection was inadequate.

General Growth

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• The final orders entered by the court allowed GGP to continue using its centralized cash management system, but granted SPE secured creditors a first-priority administrative expense claim on GGP’s centralized cash account.

• In addition, several would-be DIP lenders emerged while the motions were pending and offered more favorable terms. SPEs did not have to guarantee GGP’s obligations or grant liens on their assets, and the DIP lenders’ administrative expense claim on GGP’s central cash account was junior to SPEs’ secured creditors’ claims.

• Importantly, the court’s ruling largely respected the separateness of the SPEs.

• Numerous motions to dismiss the SPE bankruptcy filings were filed on the grounds the petitions were filed in bad faith because the SPEs were solvent, not otherwise in sufficient financial distress.

General Growth

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• In an August 11, 2009 decision, Judge Gropper denied the MTD under the standard that dismissal was only required if both objective futility of the reorganization process and subjective bad faith in filing the petition are found.

• Subjective bad faith -- creditors argued (i) that GGP filed and replaced the independent managers of several of the SPEs on the eve of the bankruptcy filings, without notifying the creditors or the independent managers under post-filing and (ii) GGP failed to negotiate with SPEs lenders before causing the SPEs to file for bankruptcy.

• Court rejected first argument holding that GGP was within its rights to appoint them pursuant to the SPE’s organizational documents and that no notice was required and rejected the second argument holding that the Bankruptcy Code does not require debtors to negotiate with their creditors before filing for bankruptcy.

• Objective Futility

• The SPEs were solvent, so the filing wasn’t done to delay inevitable foreclosure.

• SPE’s liabilities were neither contingent nor speculative.

General Growth

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• Moving creditors also argued that the purpose of the SPE structure was to insulate secured creditors of individual SPEs from credit risk related to the financial health of the larger corporate group.

• Court agreed with GGP finding that the moving creditors actually benefitted from GGP’s integrated structure.

• Court also noted that directors of a solvent Delaware corporation have a fiduciary duty to manage the corporation in the best interests of its shareholders, not its creditors. Therefore, the SPE’s independent managers had a fiduciary duty to consider parent GGP’s interests when deciding whether to file a chapter 11 petition.

• In the court’s view, the key purpose of the SPE structure was to protect creditors from substantive consolidation and the Court emphasized that it was not substantively consolidating the SPEs with GGP.

General Growth

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• Strengthen the independent manager provisions of SPE governing documents (eliminate the requirement that managers have fiduciary duties equivalent to those owed by directors of a Delaware corporation).

• Strengthen the provisions governing replacement of independent managers to prevent a parent from replacing an SPE independent manager with managers likely to favor a bankruptcy filing.

• Lenders should consider springing/bad boy guarantees – the SPE’s parent should guarantee the loan if the SPE files a bankruptcy petition.

• Lenders can impose stricter separateness covenants on SPEs – GGP’s centralized cash management system was a glaring exception to separateness.

• SPE organizational documents could waive the automatic stay if the SPE files for bankruptcy.

General Growth – Lessons Learned

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• In re Bashas' Inc., 437 B.R. 874 (Bankr. D. Az. 2010), the bankruptcy court noted, "The Banks have presented no affirmative evidence to show that they would be prejudiced by a substantive consolidation, or that they would be practically impaired by combining the Debtor entities' assets and liabilities in these cases." The court went on, "The court thus perceives no practical nor [sic] legal prejudice to the Banks or any other creditor." 437 B.R. at 928.

• DB Capital Holdings, LLC v. Aspen HH Ventures, LLC (In re DB Capital Holdings, LLC), 463 B.R. 142 (B.A.P. 10th Cir. 2010). Chapter 11 case was commenced without due authorization, per Colorado law. LLC agreed to waive right to commence chapter 11 case. Decision is not "precedential.“

• In re Lake Michigan Beach Pottawattamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016). The required consent of the special member was held void as against public policy.

• In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. Del. 2016). A “golden share” void as contrary to federal public policy.

Cases

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• In re Bay Club Partners-472, LLC, 2014 WL 1796688 (Bankr. D. Ore. May 6, 2014). Creditor's conduct is "cleverly insidious."

• Green Bridge Capital S.A. v Shapiro (In re FKF Madison Park Group Owner, LLC), 2011 WL 350306 (Bankr. D. Del. Jan. 31, 2011). Authority to commence a case is a function of state law.

• Greenhunter Energy, Inc. v Western Ecosystems Technology, Inc., 337 P.3d 454 (Wyo. 2014). Disregard of single-purpose entity, in part because it is a disregarded entity for tax purposes. The tax filing can be "one of many relevant pieces of information demonstrating that Appellant directed benefits from the LLC to itself."

Cases

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• Duke Energy Royal, LLC v. Pillowtex Corporation (In re Pillowtex, Inc.), 349 F.3d 711 (3d Cir. 2003). As the result of changes to UCC, "intent of the parties" no longer an important factor. 349 F.3d at 721–722.

• Law v. Siegel¸ 134 S. Ct. 1188, 1194 (2014) (section 105 does not allow bankruptcy court to "contradict" the Code.).

• United Airlines, Inc. v. HSBC Bank USA, N.A., 416 F.3d 609 (7th Cir. 2005). Characterization of lease v. secured transaction a matter of "functional analysis under federal common law" "informed" by state law.

Cases

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Samuel A. Newman

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Sam Newman is a partner in the Los Angeles office of Gibson, Dunn & Crutcher and a member of both the Business Restructuring and Reorganization Group and the Corporate Department. His practice involves representing creditors, debtors and other parties-in-interest in Chapter 11 cases. He also advises buyers, sellers, lenders and borrowers in transactions involving distressed assets. Mr. Newman has been named as one of California's leading lawyers in business and restructuring by Chambers USA – America's Leading Business Lawyers and recognized by his peers as one of The Best Lawyers in America® in the area of Bankruptcy and Creditor-Debtor Rights Law. Mr. Newman has also been named as a Southern California Super Lawyer in the area of Bankruptcy & Creditor/Debtor Rights. Mr. Newman's speaking engagements include Debtor In Possession Financings: Current Developments, Los Angeles County Bar Association, When Lenders Fail: The Ultimate Indignity, The Financial Lawyers Conference; The Subprime Meltdown From an Insolvency Litigation Perspective, 11th Annual Southwest Bankruptcy Conference of the American Bankruptcy Institute; The Subprime Lending Industry: A Look at the Restructuring of a Market in Turmoil, the American Bar Association Annual Meeting, Section of Business Law; When Good Loans Go Bad: An In-Depth Discussion of the Subprime Lending Industry, Turnaround Management Association. Mr. Newman is admitted to practice law in California. He earned his law degree magna cum laude from Georgetown University Law Center where he was elected to the Order of the Coif. He received a Bachelor of Science degree in Foreign Service from Georgetown University's School of Foreign Service in 1992. Prior to joining Gibson, Dunn & Crutcher LLP, Mr. Newman held political and fundraising positions with the Democratic National Committee (DNC) in Washington, DC and served in legislative and policy positions for Senator John Glenn (OH) and Representatives Gary Ackerman (NY) and Rob Andrews (NJ). He lives in Manhattan Beach, California with his wife, Katja, and their children Jakob and Max.

Partner, Gibson, Dunn & Crutcher LLP 333 South Grand Avenue, Los Angeles, CA 90071-3197 Tel: +1 213.229.7644 [email protected]

Daniel B. Denny

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Daniel Denny is a senior corporate associate in the Los Angeles office of Gibson, Dunn & Crutcher and is a member of Gibson Dunn’s Business Restructuring & Reorganization Practice Group. Mr. Denny has a wide range of experience representing debtors, creditor groups and potential acquirers in distressed settings. Mr. Denny also has significant commercial real estate finance experience.

As Debtor counsel, Mr. Denny has advised clients on a broad range of matters, including pre-bankruptcy planning, corporate governance, executory contracts and leases, financial restructuring and asset disposition, claims adjudication and other matters pertaining to the reorganization of the debtor. His creditor representations have concerned out-of-court restructurings, voluntary and involuntary chapter 7 and 11 bankruptcy cases, and cross-border insolvency proceedings. Mr. Denny has significant experience litigating fraudulent transfer claims in state and federal court.

Mr. Denny, moreover, has worked from start to finish on various real estate work-outs, including the drafting of pre-negotiation agreements, forbearance agreements and loan modification agreements. Mr. Denny has represented major institutional lenders in connection with the origination and sale of construction and permanent mortgage loans and mezzanine loans, including the structuring and negotiation of intercreditor agreements, co-lender agreements and non-consolidation opinions.

Mr. Denny is currently a member of the Board of Directors for the Los Angeles Bankruptcy Forum, and a member of the Financial Lawyers Conference, American Bankruptcy Institute and the Los Angeles County Bar Association.

Mr. Denny received his Juris Doctor magna cum laude in 2005 from the University of Notre Dame, where he served as Executive Managing Editor of the Notre Dame Law Review. He received his Bachelor of Arts degree magna cum laude in 1998 from Wheaton College and Master of Arts degree cum laude in 2002 from Gordon-Conwell Theological Seminary. Mr. Denny is also active in the community through his pro bono representation of the Benjamin Franklin Elementary Foundation in Glendale, California.

Mr. Denny is admitted to practice in the State of California.

Associate, Gibson, Dunn & Crutcher LLP 333 South Grand Avenue, Los Angeles, CA 90071-3197 Tel: +1 213.229.7646 [email protected]

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