structuring special purpose securitization vehicles to attain...

Structuring Special Purpose Securitization Vehicles to Attain Bankruptcy Remoteness Avoiding Substantive Consolidation and Achieving True Sale With SPVs

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TUESDAY, NOVEMBER 12, 2013

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

John C. Keith, Attorney, Valensi Rose, Los Angeles

Michael V. Blumenthal, Partner, Thompson & Knight, New York

Demetra L. Liggins, Partner, Thompson & Knight, Houston

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Structuring Special Purpose

Securitization Vehicles to Obtain

Bankruptcy Remoteness

Michael Blumenthal John C. Keith

Demetra Liggins

999999.999999 ACTIVE 6105481.4

● Pretty self-explanatory: the status of being

remote – or insulated – from the prospect of a

bankruptcy or the effects of a bankruptcy.

● Probably for as long as there has been a

bankruptcy law, creditors have attempted to

insulate themselves from the impact of that

law.

What is bankruptcy remoteness?

6

● Bankruptcy affects the balance of power between

debtors and creditors, by providing debtors with

substantial protections.

● Bankruptcy affects the balance of power between

different creditors, who must compete for the limited

resources of the debtor within the confines of the

bankruptcy law.

● Examples:

● Automatic stay

● Discharge of prepetition debts

Why does bankruptcy remoteness matter?

7

● The terms “special purpose entity” (“SPE”) and “special purpose

vehicle” (“SPV”) are used interchangeably.

● "A SPE is an independent legal entity that can be used to mitigate

the disruption caused by a bankruptcy filing by all or some of the

members of a corporate group.”

● "Ideally, the SPE will be a newly created” business entity, and,

"most commonly, SPEs are either limited partnerships or limited

liability companies.”

● Samantha J. Rothman, Lessons from General Growth Properties: The

Future of the Special Purpose Entity, 17 Fordham J. Corp. & Fin. L.

227, 229-30 (2012).

What is a bankruptcy remote special purpose

entity/vehicle?

8

● SPEs are a securitization tool for lenders.

● “[T]he new entity will take title to the property that

serves as collateral for the loan. Transferring the

property collateral to the [SPE] accomplishes the goal

of separating the property collateral from the

bankruptcy risks of its prior owner.”

● Adam B. Weissburg & John Matthew Trott, Special Purpose

Bankruptcy Remote Entities, Los Angeles Lawyer (January 2004).


entity/vehicle?

9

● "The SPE's corporate documents will generally contain restrictive

provisions requiring that the SPE be limited to its stated purpose

of holding the collateral assets,” thereby "reducing the risk of the

SPE becoming insolvent.”

● "In addition, a SPE's bankruptcy remote provisions will also

generally require that in order to file for bankruptcy voluntarily,

there must be unanimous consent of the SPE's directors or

partners with an 'independent' director, partner, or managing

member of the SPE," who is generally "designated by the lender

and can presumably veto any suggestion of the SPE filing a

voluntary bankruptcy petition.”

● Samantha J. Rothman, Lessons from General Growth Properties: The

Future of the Special Purpose Entity, 17 Fordham J. Corp. & Fin. L.

227, 230-32 (2012).


entity/vehicle?

10

● Ratings agencies, large loan originators and other

major market players (collectively, the “rated market”)

view the SPE structure as important for ensuring that

an SPE’s creditors will not potentially compete with

creditors of another entity.

Why do lenders care?

11

● The means by which lenders have endeavored to

achieve bankruptcy remoteness have developed over

the years.

● Although by now an established securitization tool for

lenders, bankruptcy remote SPVs are, in the long view,

a recent permutation of these endeavors.

● Earlier efforts focused on advance contractual waivers

of the protections of bankruptcy law, which were met

with judicial hostility.

Why did SPEs/SPVs emerge as a tool to

achieve bankruptcy remoteness?

12

● Advance waivers of the right to file bankruptcy are

unenforceable.

● “To sustain a contractual obligation of this character

would frustrate the object of the Bankruptcy Act.”

● The “Bankruptcy Act would in the natural course of

business be nullified in the vast majority of debts

arising out of contracts, if this were permissible.”

● In re Weitzen, 3 F. Supp. 698-99 (S.D.N.Y. 1933) (citing Fed. Nat.

Bank v. Koppel, 253 Mass. 157 (1925).

Judicial Hostility to Waivers of Bankruptcy Law

Protections

13

● "It is a well settled principal that an advance

agreement to waive the benefits conferred by the

bankruptcy laws is wholly void as against public

policy.”

● In re Tru Block Concrete Prods., Inc., 27 B.R. 486, 492 (Bankr.

S.D. Cal. 1983).


Protections

14

● Waivers of specific bankruptcy protections are also unenforceable.

● Automatic stay (11 U.S.C. § 362)

● In re Shady Grove Tech Ctr. Assocs. Ltd. Partnership, 216 B.R. 386, 390 (Bankr. D. Md. 1998) (“self-executing clauses in pre-petition agreements purporting to provide that no automatic stay arises in a bankruptcy case are contrary to law and hence unenforceable, and ... self-executing clauses in prepetition agreements ... to vacate the automatic stay are likewise unenforceable.").

● In re Pease, 195 B.R. 431, 435 (Bankr. D. Neb. 1996) ("The Bankruptcy Code pre-empts the private right to contract around its essential provisions, such [as] those found in 11 U.S.C. § 362.")


Protections

15

● Waivers of specific bankruptcy protections are also unenforceable.

● Right to a discharge or to discharge particular debts.

● Johnson v. Kriger (In re Kriger), 2 B.R. 19, 23 (Bankr. D. Or. 1979) ("It is a well settled principle that an advance agreement to waive the benefit of a discharge in bankruptcy is wholly void, as against public policy.").

● Giaimo v. Detrano (In re Detrano), 222 B.R. 685, 688 (Bankr. E.D.N.Y. 1998) ("As a matter of superseding federal bankruptcy policy ... , a prepetition waiver of a discharge of a particular debt or of all debts is against public policy and unenforceable.")


Protections

16

● Ipso facto clauses are also unenforceable.

● “An ipso facto clause is a provision in an executory

contract or unexpired lease that results in a breach

solely due to the financial condition or the bankruptcy

filing of a party.”

● “Such clauses are generally unenforceable in

bankruptcy."

● In re Cole, 226 B.R. 647, 652 (B.A.P. 9th Cir. 1998)


Protections

17

● Why an SPE?

● Preserve separateness and avoid substantive consolidation

● Limit other potential liabilities

● Limit ability to file bankruptcy

● Sole purpose is to own the property or assets being financed

● In purpose section

● May do all other things necessary in connection with owning and operation

SPE’s AND NECESSARY PROVISIONS

18

● Limitations and Affirmative Obligations while loan outstanding

● Maintain separate books and records

● File own tax returns, if applicable

● Will not commingle assets with any other Person

● Maintain separate financial statements

● Pay its own liabilities

● Will not guarantee or pledge its assets for benefit or obligations of any other Person

Limitations & Affirmative Obligations

19

● Cannot file Bankruptcy (sometimes called Material Action)

without unanimous consent of Members and Independent

Manager(s)

− Includes state law receiverships or other similar proceedings

● May not dissolve

● Cannot make distribution in violation of loan documents


20

● Cannot modify or repeal SPE provisions of

LLC/Operating Agreement without lender consent,

including the following provisions

● Waiver of right to partition

● SPE provisions are for benefit of creditors

● Any amendments shall be subject to required SPE provisions


21

Limitations on the Company's Activities.

(i) This Section is being adopted in order to comply with certain provisions required in

order to qualify the Company as a "special purpose" entity.

(ii) The Member shall not, so long as any Obligation is outstanding, amend, alter, change or

repeal the definition of "Independent Manager" or [the special member, purpose, powers,

management, independent manager, distributions, exculpation and indemnification, assignments,

resignation, admission of additional members, dissolution, waiver of partition/nature of interest,

benefits of agreement/no third party rights, amendments, and definitions sections of the LLC

agreement] without the unanimous written consent of the Independent Managers. [Any

amendment, alteration, change or repeal of provisions in this agreement shall be subject to this

Section.]

(iii) Notwithstanding any other provision of this Agreement and any provision of law that

otherwise so empowers the Company, the Member or any Officer or any other Person, so long as

any Obligation is outstanding, neither the Member nor any Officer nor any other Person shall be

authorized or empowered, nor shall they permit the Company, without the prior unanimous written

consent of the Member and all Independent Managers, to take any Material Action, provided,

however, that, so long as any Obligation is outstanding, the Member may not authorize the taking

of any Material Action, unless there are at least two Independent Managers then serving in such

capacity.

Limitations and Affirmative Obligations:

Sample Provision

22

(iv) The Member shall cause the Company to do or cause to be done all things necessary to

preserve and keep in full force and effect its existence, rights (charter and statutory) and franchises.

The Member also shall cause the Company to:

(A) maintain its own separate books and records and bank accounts;

(B) at all times hold itself out to the public as a legal entity separate from the Member and any

other Person;

(C) file its own tax returns, if any, as may be required under applicable law, to the extent (1)

not part of a consolidated group filing a consolidated return or returns or (2) not treated as a division

for tax purposes of another taxpayer, and pay any taxes so required to be paid under applicable law;

(D) except as contemplated by the Transaction Documents, not commingle its assets with

assets of any other Person;

(E) conduct its business in its own name and strictly comply with all organizational

formalities to maintain its separate existence;

(F) maintain separate financial statements;

(G) pay its own liabilities only out of its own funds, provided, however, the foregoing shall not

require the Member to make any additional capital contributions to the Company;


Sample Provision

23

(H) maintain an arm's length relationship with its Affiliates and the Member;

(I) pay the salaries of its own employees, if any, provided, however, the foregoing shall not

require the Member to make any additional capital contributions to the Company;

(J) not hold out its credit or assets as being available to satisfy the obligations of others;

(K) allocate fairly and reasonably any overhead for shared office space;

(L) use separate stationery, invoices and checks;

(M) except as contemplated by the Transaction Documents, not pledge its assets for the

benefit of any other Person;

(N) correct any known misunderstanding regarding its separate identity; and

(O) maintain adequate capital in light of its contemplated business purpose, transactions and

liabilities, provided, however, the foregoing shall not require the Member to make any additional

capital contributions to the Company.

Failure of the Company, or the Member on behalf of the Company, to comply with any of the

foregoing covenants or any other covenants contained in this Agreement shall not affect the status

of the Company as a separate legal entity or the limited liability of the Member.


Sample Provision

24

(v) So long as any Obligation is outstanding, the Member shall not cause or permit the

Company to:

(A) except as contemplated by the Transaction Documents, guarantee any obligation of

any Person, including any Affiliate;

(B) engage, directly or indirectly, in any business other than the actions required or

permitted to be performed under Section [the single-purpose provision], the Transaction

Documents or this Section;

(C) incur, create or assume any indebtedness other than as expressly permitted under

the Transaction Documents;

(D) make or permit to remain outstanding any loan or advance to, or own or acquire any

stock or securities of, any Person, except that the Company may invest in those investments

permitted under the Transaction Documents and may make any advance required or expressly

permitted to be made pursuant to any provisions of the Transaction Documents and permit the

same to remain outstanding in accordance with such provisions;

(E) to the fullest extent permitted by law, engage in any dissolution, liquidation,

consolidation, merger, asset sale or transfer of ownership interests other than such activities

as are expressly permitted pursuant to any provision of the Transaction Documents and

subject to obtaining any approvals required under this Agreement; or

(F) except as contemplated or permitted by the Transaction Documents, form, acquire

or hold any subsidiary (whether corporate, partnership, limited liability company or other).


Sample Provision

25

● Independent manager – sometimes two, depending upon size

of deal

● Must consider only interests of company, including its

creditors

● Excludes consideration of Member(s) and Affiliate interests

● But consider duty of good faith

● Exculpation except for bad faith or willful misconduct

● Resignation ineffective until successor

● Cannot remove unless notice which names successor

Independent Managers

26

Independent Manager.

As long as any Obligation is outstanding, the Member shall cause the Company at all

times to have at least two Independent Managers who will be appointed by the Member.

To the fullest extent permitted by law, including Section 18-1101(c) of the Act, and

notwithstanding any duty otherwise existing at law or in equity, the Independent

Managers shall consider only the interests of the Company, including its creditors, in

acting or otherwise voting on the matters referred to in Section 9(d)(iii). Except for

duties to the Company as set forth in the immediately preceding sentence (including

duties to the Member and the Company’s creditors solely to the extent of their

respective economic interests in the Company but excluding (i) all other interests of the

Member, (ii) the interests of other Affiliates of the Company, and (iii) the interests of any

group of Affiliates of which the Company is a part), the Independent Managers shall not

have any fiduciary duties to the Member or any other Person bound by this Agreement;

provided, however, the foregoing shall not eliminate the implied contractual covenant of

good faith and fair dealing. To the fullest extent permitted by law, including Section 18-

1101(e) of the Act, an Independent Manager shall not be liable to the Company, the

Member or any other Person bound by this Agreement for breach of contract or breach

of duties (including fiduciary duties), unless the Independent Manager acted in bad faith

or engaged in willful misconduct.

Independent Managers: Sample Provision

27

No resignation or removal of an Independent Manager, and no appointment of a

successor Independent Manager, shall be effective until such successor shall have

accepted his or her appointment as an Independent Manager by executing a counterpart

to this Agreement. In the event of a vacancy in the position of Independent Manager, the

Member shall, as soon as practicable, appoint a successor Independent Manager.

Notwithstanding anything to the contrary contained in this Agreement, no Independent

Manager shall be removed or replaced unless the Company provides the Lender with no

less than two (2) business days' prior written notice of (a) any proposed removal of such

Independent Manager, and (b) the identity of the proposed replacement Independent

Manager, together with a certification that such replacement satisfies the requirements

for a Independent Manager set forth in this Agreement. All right, power and authority of

the Independent Managers shall be limited to the extent necessary to exercise those

rights and perform those duties specifically set forth in this Agreement. Except as

provided in the second sentence of this Section 10, in exercising their rights and

performing their duties under this Agreement, any Independent Manager shall have a

fiduciary duty of loyalty and care similar to that of a director of a business corporation

organized under the General Corporation Law of the State of Delaware. No Independent

Manager shall at any time serve as trustee in bankruptcy for any Affiliate of the Company.

An Independent Manager is hereby designated as a "manager" within the meaning of

Section 18-101(10) of the Act.

Independent Managers: Sample Provision

28

● Special Member

● If borrower is a sole member entity then a special member needs

to spring into existence – Independent Manager becomes

special member

● Avoids liquidation or dissolution

Special Members

29

Members.

Upon the occurrence of any event that causes the Member to cease to be a member of the

Company (other than upon continuation of the Company without dissolution upon (i) an

assignment by the Member of all of its limited liability company interest in the Company and

the admission of the transferee pursuant to [the assignments and admission of additional

members sections of the LLC agreement], or (ii) the resignation of the Member and the

admission of an additional member of the Company pursuant to the resignation and

admission of additional members sections of the LLC agreement]), each Person acting as an

Independent Manager pursuant to [the independent manager section of the LLC agreement]

shall, without any action of any Person and simultaneously with the Member ceasing to be a

member of the Company, automatically be admitted to the Company as a Special Member and

shall continue the Company without dissolution. No Special Member may resign from the

Company or transfer its rights as Special Member unless (i) a successor Special Member has

been admitted to the Company as Special Member by executing a counterpart to this

Agreement, and (ii) such successor has also accepted its appointment as Independent

Manager pursuant to [the independent manager section of the LLC agreement]; provided,

however, the Special Members shall automatically cease to be members of the Company upon

the admission to the Company of a substitute Member.

Special Members: Sample Provision

30

Each Special Member shall be a member of the Company that has no interest in the

Company’s profits, losses and capital and has no right to receive any distributions of

Company assets. Pursuant to Section 18-301 of the Act, a Special Member shall not be

required to make any capital contributions to the Company and shall not receive a limited

liability company interest in the Company. A Special Member, in its capacity as Special

Member, may not bind the Company. Except as required by any mandatory provision of the

Act, each Special Member, in its capacity as Special Member, shall have no right to vote on,

approve or otherwise consent to any action by, or matter relating to, the Company, including,

without limitation, the merger, consolidation or conversion of the Company. In order to

implement the admission to the Company of each Special Member, each Person acting as an

Independent Manager pursuant to Section 10 shall execute a counterpart to this Agreement.

Prior to its admission to the Company as Special Member, each Person acting as an

Independent Manager pursuant to Section 10 shall not be a member of the Company.

Special Members: Sample Provision

31

● Substantive Consolidation

● True Sale vs. Fraudulent Transfer

Issues Arising From Bankruptcy of Transferor

What is substantive consolidation?

● Substantive consolidation is a judicially created

doctrine that results in consolidating the assets and

liabilities of different entities by merging such

entities’ assets and liabilities and treating the related

entities as a consolidated entity for purposes of

distribution in a bankruptcy case.

33

● The assets of the debtor and its consolidated affiliates

will be treated as common assets.

● Creditors of each entity all hold claims against the

common assets of the consolidated entity.

● Inter-entity claims against each entity that has been

consolidated will be eliminated.

Effects on the parties and the transaction

34

Borrower SPE

LLC

99% LLC Member

1% SPE Member

Corporation A (operating company)

35

Borrower SPE

LLC

99% LLC Member

1% SPE Member

Corporation A (operating company)

36

THREE TESTS (and variations) COURTS HAVE USED

IN SUBSTANTIVE CONSOLIDATION ANALYSIS

1. The Owens Corning standard in the Third Circuit;

2. The Augie/Restivo standard in the Second Circuit;

3. The Auto-Train standard in the DC Circuit.

37

● Under the Owens Corning standard, a proponent of

substantive consolidation must establish:

● the entities pre-petition disregarded their separateness so

significantly that their creditors relied on the breakdown of entity

borders and treated them as one legal entity, or

● post-petition that the assets and liabilities of the entities are so

scrambled that separating them is prohibitive and hurts all

creditors.

In re Owens Corning, 419 F.3d 195 (3d Cir. 2005).

The Owens Corning Standard (Third Circuit)

38

● The Third Circuit emphasized five principles:

● First, the general expectation of state law and the

Bankruptcy Code is that courts respect entity separateness

absent compelling circumstances.

● Second, the harms that substantive consolidation

addresses are nearly always those caused by debtors (and

the entities they control) that disregard separateness.

Harms caused by creditors typically are remedied by

fraudulent transfer actions or equitable subordination.


39

● Third, mere benefit to the administration of the case is

hardly a harm calling substantive consolidation into

play.

● Fourth, because substantive consolidation is extreme,

it should be rare and a remedy of last resort.

● Fifth, although substantive consolidation may be used

defensively to remedy identifiable harms, it may not be

used offensively (e.g., to disadvantage tactically a

group of creditors in the plan process or to alter

creditors’ rights).


40

● The Augie/Restivo standard, established by the Second

Circuit and adopted by the Ninth Circuit, looks at two

factors:

● whether creditors dealt with the entities as a single economic

unit and did not rely on their separate identity in extending

credit and

● whether the affairs of the two entities are so entangled that

consolidation will benefit all creditors.

Union Savings Bank v. Augie/Restivo Baking Co. (In re

Augie/Restivo Baking Co.), 860 F.2d 515 (2d Cir. 1988).

Augie/Restivo Standard (Second Circuit,

adopted by Ninth Circuit)

41

● Under the Auto-Train standard, the proponent of

consolidation must first make a prima facie case

demonstrating that:

● there is substantial identity between the entities to be

consolidated, and

● that consolidation is necessary to avoid some harm or to realize

some benefit.

Auto-Train Standard (DC Circuit)

42

● Once the proponent for consolidation has made this

showing, “the burden shifts to an objecting creditor to

show that

● it has relied on the separate credit of one of the entities to be

consolidated; and

● it will be prejudiced by substantive consolidation.”

Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.,

Inc.), 810 F.2d 270 (D.C. Cir. 1987).

Auto-Train Standard (DC Circuit)

43

● In its recent opinion in Paloian v. LaSalle Bank, N.A. (In

re Doctors Hospital of Hyde Park, Inc.), 2013 WL

3779657 (Bankr. N.D. Ill. July 17, 2013), the Seventh

Circuit held that a court should go beyond evaluation of

a documented list of separateness “factors” and should

examine whether the behaviors of the related entities

are consistent with separateness over the life of the

transaction, not just at the time the SPE is established.

● The bankruptcy court, on remand, nevertheless held

that the entities were separate, focusing on the parties’

intentions.

Behaviors Consistent with Separateness

44

● The courts, in reaching their conclusions under the

various tests, consider the following factors:

● Is it possible to segregate and ascertain individual assets and

liabilities? Or are the assets of the parent and the SPE

commingled?

● Does the SPE observe the legal formalities of separateness?

● Do the entities have common directors or officers, or, if the SPE

has separate directors and officers, do they take direction from

the parent corporation?

CONCLUSION

45

● Are the business affairs of the parent and the SPE intertwined?

In the papers of the parent and in its officers’ statements, is the

SPE referred to as a subsidiary, department or division? Are

the entities more profitably consolidated at a single physical

location?

● Could the SPE exist independently of the parent? Or does the

SPE have substantially no business except with the parent and

no assets except those conveyed from the parent? Does the

parent finance the subsidiary, pay salaries or cover losses and

costs for the SPE? Is the SPE grossly undercapitalized?

CONCLUSION

46

● Does the parent own all or a majority of the capital stock of the

SPE? Did the parent subscribe to all the capital stock of the

SPE or otherwise cause its incorporation?

● Are there parent or intercompany guaranties and loans?

CONCLUSION

47

● “A ‘true sale’ is a crucial step in the formation of a valid

BRE [bankruptcy remote entity] because . . . the new

entity will take title to the property that serves as

collateral for the loan. Transferring the property

collateral to the [BRE] accomplishes the goal of

separating the property collateral from the bankruptcy

risks of its prior owner.”

● “If the transfer is a true sale the assets transferred

should not be considered assets of the estate of the

transferor under 11 U.S.C. § 541, and the transfer should

not be subject to revocation as a fraudulent

conveyance.”

True Sale vs. Fraudulent Transfer

48

● “The Bankruptcy Code does not define ‘true sale’ and

so presently, the matter of sale characterization is

largely governed by state law.”

● "Under the common law of most states, transfers of

property . . . even though characterized as sales and

made in exchange for reasonably equivalent value, may

. . . where the economic risks and rewards of the

transferred asset are retained by the transferor, be re-

characterized as secured loans.”

● Adam B. Weissburg & John Matthew Trott, Special Purpose Bankruptcy

Remote Entities, Los Angeles Lawyer (January 2004).

True Sale vs. Fraudulent Transfer

49

● On remand from Paloian v. LaSalle Bank, N.A. (In re

Doctors Hosp. of Hyde Park, Inc.), 619 F.3d 688 (7th

Cir. 2010).

● Debtor sells accounts receivable (A/R) to SPV.

● A/R used to secure loan to SPV.

● SPV makes rent payments to lessor at above fair

market value, which debtor seeks to recover as

fraudulent transfers.

● Issue: Was sale of A/R to SPV a “true sale”?

Paloian v. LaSalle Bank, N.A., 2013 Bankr. LEXIS

3074 (Bankr. N.D. Ill. Jul. 17, 2013)

50

● A “court will look to the substance of the

transaction, rather than the form. Therefore, it is

important to focus on whether the transaction is

arms length and commercially reasonable as well as

in proper form and subsequent acts actually treat the

sale as real.”


3074 (Bankr. N.D. Ill. Jul. 17, 2013)

51

● In addition, court will look to factors including the following:

● “Recourse: Whether, considering the nature and extent of the recourse, direct and indirect against the transferor, the risk of loss is transferred to the SPE. The originator must retain little if any of the benefits and burdens of owning the receivables. If the originator retains too much risk or benefit from the receivables and later becomes a debtor in bankruptcy, there is a risk that the receivables will be included in the bankruptcy estate.”

● “Post-transfer control over the assets and administrative activities: Whether the transferor is permitted to service or collect the assets but must be removed if it defaults on those duties.”


3074 (Bankr. N.D. Ill. Jul. 17, 2013)

52

● “Accounting Treatment: Whether the transfer must be treated as a sale on the transferor's books.”

● “Adequacy of Consideration: Whether the transaction is at arms'-length for adequate consideration (full market value) received by the transferor.”

● “Parties intent: Whether the documents reflect statements that the parties intend a sale.”

● 2013 Bankr. LEXIS 3074, at *407-413.

● Analyzing these factors, court finds sale of A/R to SPV was a true sale.


3074 (Bankr. N.D. Ill. Jul. 17, 2013)

53

● Authority to File Bankruptcy, Dismissal for Bad Faith

Filing, and Involuntary Bankruptcies

● Fiduciary Duties

● Conflicts of Interest

● Springing or “Bad Boy” Guaranties

Issues Arising from an SPV’s Bankruptcy Filing

● 11 SPV debtors with same current or past principal.

● Governing documents require that secured lender's

designee on board consent to any bankruptcy filing.

● SPVs' properties in foreclosure.

● Board concludes following intended procedures to file

bankruptcy would be futile.

● Principal pays law firm to solicit creditors to file

involuntary petitions.

In re Kingston Square Associates, 214 B.R. 713

(Bankr. S.D.N.Y. 1997)

55

● Trade creditors and professionals file involuntary petitions.

● Secured lenders seek to dismiss, argue that collusion between debtors and petitioning creditors constitutes bad faith under 11 U.S.C. § 1112(b).

● Court holds:

● "a bankruptcy petition will be dismissed if both objective futility of the reorganization process and subjective bad faith in filing the petition are found.”

● "although the debtors plainly orchestrated the filing of the involuntary petitions, they had reason to believe that reorganization was possible and did not circumvent any court-ordered or statutory restrictions on bankruptcy filings such that, absent any evidence of objective futility of the reorganization process, the cases ought not be dismissed now.”

− 214 B.R. at 714-15, 734.



56

● Court dismisses argument that it’s wrong to let debtors circumvent bankruptcy remote provisions in their governing documents:

● "The Movants may feel bruised because the Respondents outmaneuvered what the Movants thought was an iron-clad provision in the corporate by-laws preventing a bankruptcy filing, but this does not mean that, without more, the petitions must be dismissed.”

● Court has harsh words for lenders' designee on board:

● “he completely ignored the limited partners' plight in the face of foreclosure actions instituted by the group which placed him on the boards of directors”

● "If he was the 'independent' director, it was in name only."

− 214 B.R. at 736.



57

● Court expressly refuses to opine whether it should

nullify bankruptcy remote provisions in debtors' bylaws

as against public policy.

● But, case is an early illustration of limitations, as a

bankruptcy proofing device, of an SPV with governing

documents requiring secured lender's board designee

to consent to any bankruptcy filing.



58

● Relying on Kingston Square Associates, court denies

secured lenders' motions to dismiss Chapter 11 cases of

debtors owned by General Growth Properties, Inc. ("GGP").

● GGP is a real estate investment trust and ultimate parent of

750 subsidiaries, joint venture subsidiaries and affiliates.

● Bankruptcy cases commenced in April 2009, in wake of

credit market crisis, which prevented GGP and affiliated

entities from refinancing debt.

● At the time, the largest real estate bankruptcy in history.

In re General Growth Properties, Inc., 409 B.R. 43


59

● Many debtors are project-level SPVs holding single real estate assets (e.g., shopping centers).

● Governing documents require consent of nominally "independent" directors or managers – really lender designees – to file bankruptcy.

● Debtors remove lender designees and replace them with directors who approve bankruptcy filings.

● Court rejects lenders' argument that it is bad faith for SPVs to make this end-run around bankruptcy remote provisions in their own governing documents.



60

● “[I]t cannot be said that the admittedly surreptitious firing of the two 'Independent Managers' constituted subjective bad faith on the part of the Debtors sufficient to require dismissal of these cases.”

● “The corporate documents did not prohibit this action or purport to interfere with the rights of a shareholder to appoint independent directors to the Board.”

● “[T]he Independent Managers did not have a duty to keep any of the Debtors from filing a bankruptcy case.”

● “[T]hey had a prima facie fiduciary duty to act in the interests of 'the corporation and its shareholders.'"



61

● Court says Kingston Square Associates involves a "far more egregious action [] 'suggestive of bad faith,'" – debtors' collusion with petitioning creditors – which still did not warrant dismissal, since "the collusion was not rooted in a 'fraudulent or deceitful purpose' but designed 'to preserve value for the Debtors' estates and creditors.’”

● Court finds similar design here, which outweighs delay and inconvenience to secured lenders:

● "It is clear . . . that Movants have been inconvenienced by the Chapter 11 filings . . . However, inconvenience to a secured creditor is not a reason to dismiss a Chapter 11 case.”

− 409 B.R. at 67-69.



62

● Court does not address whether bankruptcy remote

provisions in SPVs' governing documents are

unenforceable as against public policy.

● Case is like the flip side of Kingston Square Associates

– debtors maneuver into voluntary, instead of

involuntary, bankruptcy.

● But, same result: SPVs allowed to proceed with

bankruptcy cases.



63

● Unlike Kingston Square Associates and General Growth Properties, court addresses – and rejects – public policy challenge to anti-bankruptcy provision in SPV’s governing documents (LLC agreement prohibits filing bankruptcy).

● After defaulting on secured loans, and facing receivership, LLC files Chapter 11 case through its Manager.

● Court dismisses on ground that Manager filed without authorization and in bad faith.

● Court reasons: "all of the case law upon which Manager relies” for public policy argument “involves a debtor's agreement with third parties to waive the benefits of bankruptcy."

In re DB Capital Holdings, LLC, 463 B.R. 142 (10th Cir.

BAP Dec. 6, 2010)

64

● "Debtor has not cited any cases standing for the proposition

that members of an LLC cannot agree among themselves

not to file bankruptcy, and that if they do, such agreement is

void as against public policy, nor has the court located any.”

● Also, operating agreement limits Manager's authority to

operating business "as presently conducted," and prohibits

"any act that would make it impossible to carry on the

ordinary business of the Company.”

● DB Capital Holdings indicates courts might accept a waiver

of the benefits of bankruptcy, so long as it is purely internal

to the debtor, and not part of a third-party agreement.


BAP Dec. 6, 2010)

65

● But, lenders ought not rely too heavily on DB Capital

Holdings.

● Opinion technically unpublished.

● Holding narrow – court expressly declines to say if

anti-bankruptcy provision enforceable if evidence

shows it was coerced by lender.

● Other creditors file involuntary case, during which

court rejects as against public policy debtor’s waiver of

right to oppose relief from stay.


BAP Dec. 6, 2010)

66

● Lenders inserting themselves or designees as "independent" directors or managers, with veto power over a borrower’s bankruptcy filing, should be careful.

● Refusing to authorize a bankruptcy otherwise in the borrower’s interest may be a breach of fiduciary duty.

● “[A]n independent director's or manager's fiduciary duties are to the company and its shareholders . . . not to the secured lender.”

● Sheldon L. Solow & Uday Gorrepati, Can Lenders Prevent LLC Bankruptcy Filings? A Recent Decision Highlights the Debate, 128 Banking L.J. 220, 224 (2011).

Fiduciary Duty Issues

67

● SPE financings are typically non-recourse loans with

certain non-recourse carve outs based upon specific

acts and events which will trigger recourse liability.

● Lenders usually require a guaranty from the sponsor or

principal of the borrower which is triggered only upon

the occurrence of non-recourse carve outs.

Springing or “Bad Boy” Guaranties

68

● Recourse against the guarantor is typically comprised

of two subsets:

● The first is limited to specific acts and events for which there will

be liability for lender’s actual loss, including actions such as:

waste, misappropriation or conversion of funds, environmental

issues, fraud or misrepresentation, gross negligence or willful

misconduct, breach of representations, warranties or covenants

of the loan documents and removal or disposal of assets after

an event of default.


69

● A second subset of acts and events triggering liability for the

entire debt (as opposed to just damage caused by the act or

event) usually include: the borrower filing a voluntary

bankruptcy petition or colluding with others to have petitions

filed or having an involuntary petition filed against the borrower;

appointment of a receiver, trustee or examiner; failure to provide

financial information; failure to maintain a Single Purpose Entity;

failure to obtain lender’s prior written consent to any voluntary

financing or lien encumbering the financed assets.


70

● Another trigger for the entire debt typically in CMBS

loans and approved by rating agencies is that the

borrower becomes insolvent and fails to pay its debts

as they become due. Typically these clauses do not

provide or say that the failure to remain solvent must

be caused by some act or mission of the borrower or

guarantor or any one associated with them (more

about this later).


71

● Courts have generally sided with lenders in litigation

challenging the enforceability of these guaranties:

● Rejecting equitable arguments that the non-recourse carve out

guaranties result in “unenforceable penalties” or should

otherwise be voided on public policy grounds

● The majority of courts favor a plain reading of unambiguous

provisions negotiated by sophisticated parties

Court Decisions Interpreting Springing

Guaranties

72

● ESH acquired the Extended Stay hotel chain, which

thereafter filed a chapter 11.

● Lightstone Holdings and Mr. Lichtenstein, which

owned the membership interests of ESH, also delivered

bad boy guaranties to the mezzanine lenders which

would be triggered if ESH filed bankruptcy.

● The recourse liability was capped at $100,000,000.

In re Extended Stay: Bank of America v. Lightstone

Holdings, 32 Misc.3d 1244A (N.Y. Sup. Ct. 2011)

73

● Defenses raised by Lichtenstein:

● He had a fiduciary duty to preserve company assets which

would be accomplished by filing bankruptcy.

● Absent a bankruptcy filing, he would be committing waste.

● He had attempted to tender the collateral, offering the lenders a

deed or assignment in lieu of foreclosure, but lenders were

unable to agree and refused to accept the tender.

● The trigger based upon the bankruptcy filing was void as

against public policy.



74

● The court held that the guaranties were executed and

negotiated by sophisticated parties, and all of the

arguments and defenses raised were rejected. The

court also ruled that lenders had no obligation to

accept tender as a remedy.



75

● Bad boy guaranty provided for liability of the entire

loan if subordinate financing was placed on the

collateral without lender’s prior consent

● A second mortgage was placed on the property

without lender’s consent; however, was paid prior to

any default under the senior mortgage.

● Upon default of senior loan the lender sued guarantors

for the deficiency alleging it was triggered when the

subordinate financing was obtained without their

consent.

4 Princeton Park Corporate Center v. SB Rental,

410 N.J. Super. 114 (N.J. App. Div. 2009)

76

● Court strictly construed and enforced the bad boy

guaranty even though there was no negative impact to

the lender.

● The court ruled that the language of the guaranty was

unambiguous, negotiated by sophisticated parties at

arms length and triggered upon a subordinate financing

without lender’s consent.

4 Princeton Park Corporate Center v. SB Rental,

410 N.J. Super. 114 (N.J. App. Div. 2009)

77

● Borrowers and guarantors were alleged to have

breached the non-recourse carve out provisions in both

the loan agreement and guaranty by failing to maintain

the property and permitting it to become encumbered

by taxes in the amount of $90,000, Environmental

Control Board Liens aggregating $650 and a

Mechanic’s Lien of $148,000.

● The lender accelerated the indebtedness originally in

the amount of $13 million and sought $20 million

constituting principal, contract and default interest, exit

fees and its costs and expenses, including legal fees.

G3-Purves Street v. Thomas Purves, 101 A.D.3d

37 (N.Y. App. Div. 2012)

78

● Guarantors asserted defenses that the guaranty was a

liquidated damage provision imposing an

unenforceable penalty based upon the fact that it

provided for full recourse liability against the

guarantors if any of the carve out acts occurred

irrespective of how minor the default was.

● The trial court rejected each of the defendants’

arguments and held that the bad boy guaranty was

enforceable.


37 (N.Y. App. Div. 2012)

79

● On appeal, the appellate division affirmed, holding that the

triggering of the guaranty based upon the non-recourse carve out

was not a liquidated damage provision and therefore was

enforceable. The court also held that the non-recourse carve outs

were previously enforced against the borrower.

● The appellate court further pointed out that the guaranty

provisions did not provide for liquidated damages and only the

recovery of actual damages incurred by lender. The guaranty

simply provided and established who was responsible for

repaying the outstanding loan—guarantors in addition to the

borrower, and the damages were to be calculated pursuant to the

terms of the loan documents and therefore not speculative or

incalculable.


37 (N.Y. App. Div. 2012)

80

● There have been a few court cases which held that de

minimis defaults, like failure to pay real estate taxes

which were cured within the applicable grace period,

did not trigger recourse liability. See, e.g., ING Real

Estate Financial (USA) v. Park Avenue Hotel

Acquisition, 4010 slip op. 50276 (U) (Sup. Ct. N.Y. Co.

Feb. 24, 2010).

Minority View

81

● See also, the California case of GECCMC 2005 – C1 Plummer Street

Office v. NRFC NNN Holdings, 2012 Cal. App. LEXIS 366 (Cal. App.

2d Dist. Mar. 29, 2012), holding that a guaranty providing for liability

upon termination of the lease of the sole tenant was not triggered

where the tenant simply stopped paying rent and abandoned the

property, because the guarantor and the borrower had not engaged

in any misconduct. The court varied from the language of the

guaranty and opined that the “intent” of the guaranty was to

protect lender from specific bad acts of borrower or guarantor

rather than acts outside of their control, holding that the sole

security for loans was the property.

● The foregoing decisions are an extreme minority and courts

throughout the country have generally enforced springing/bad boy

guaranties.

Minority View

82

● The standard definition of an SPE used in CMBS loans

provides, inter alia, that the borrower must remain

solvent and pay its debts as they become due from its

own assets.

● The cases of Wells Fargo Bank v. Cherryland Mall

(“Cherryland”), 812 N.W.2d 799 (Mich. Ct. App. 2011)

and 51382 Gratiot Avenue Holdings v. Chesterfield Dev.

Co., 835 F.Supp.2d 384 (E.D. Mich. 2011) (“Chesterfield)

ruled that the bad boy guaranties were triggered based

upon the failure to remain an SPE based upon the fact

that the borrower failed to remain solvent and pay its

debts as they became due.

Solvency of Borrower

83

● In both cases, the guarantors argued that to interpret

the guaranties to spring into effect based upon

borrower’s insolvency would, in essence, make all non-

recourse loans recourse as to guarantors upon a

default of the loan and lead to absurd and draconian

results.

● The legislative bodies of both Michigan and Nevada

have enacted statutes which make the Cherryland and

Chesterfield carve outs unenforceable.

Solvency of Borrower

84

● Guarantors should carefully look at their bad boy guaranties

prior to execution and also review them throughout the term

of the loan so as not to inadvertently trigger liability.

● Triggers may have occurred prior to maturity or default, even

though the lender has not called the default, and courts have

typically enforced strictly the terms of the guaranties.

● Although bad boy guaranties typically have non-interference

clauses, guarantor should negotiate a release with the

lenders and condition their cooperation in an uncontested

foreclosure to obtain a release.

Drafting Pointers

85

● Another pitfall is when a mezzanine lender forecloses on a

membership interest in the borrower, it can subsequently file a

bankruptcy and trigger liability under the bad boy guaranty. A

guarantor has no control over this type of involuntary bankruptcy.

One solution is to obtain an indemnification from the mezzanine

lender upon tender of the membership interest.

● At inception of the loan, a guarantor may seek to require language

that it is no longer liable if the mezzanine lender ultimately

becomes the owner of the property, or a guarantor will not be liable

to the mezzanine lender under its bad boy guaranty unless the

mezzanine lender indemnifies the guarantor prior to its filing of its

involuntary bankruptcy.

Drafting Pointers

86

● The inter-creditor agreement between the senior and

mezzanine lender should provide that the mezzanine

lender cannot foreclose on the membership interest

unless it tenders a replacement bad boy guaranty.

● Sometimes a majority of the lenders actually request or

consent to a borrower’s bankruptcy filing, in which

event the guarantor should seek an exculpation from

liability under the guaranty agreement.

Drafting Pointers

87

● Cap the guaranty.

● Provide that the guaranty expires or decreases after a

certain period of time or under certain conditions, i.e.

borrower not being in control of the underlying asset.

● Carefully analyze any required net worth or liquidity

covenants of a guarantor which are becoming more

common: which assets or liabilities to include/exclude;

GAAP or other standards; clauses requiring net worth

maintenance.

Drafting Pointers

88

Michael Blumenthal

[email protected]

John C. Keith

[email protected]

Demetra Liggins

[email protected]

89