Bankruptcy Remote Entities In Hotel Financings: Lender Salvation or Borrower Nightmare?
 
October 1, 1999
 

The concept started in the 1980s with mortgage and asset-backed securitizations: transfer assets to a special purpose entity (SPE) with the expectation that the assets will be shielded from the creditors in bankruptcy of the transferor (e.g., bankruptcy remote), thus ensuring that the assets will be available to retire securities (usually relatively short-term notes) issued by the SPE. This resulted in several advantages, including permitting the transferor to obtain a significantly better credit rating for the notes than the general rating of the transferor.

Recently, SPEs have been used in traditional financing for essentially the same purposes, although the primary impetus has come from lenders rather than borrowers. While this is beginning to affect virtually all forms of secured financing, it is likely to have a more profound impact on real estate financing, including financing for hotel and resort properties. The concept is similar to that applied in securitizations: transfer the property to an SPE borrower whose only debt is the mortgage and security interests of the lender, so that the problems of affiliated entities, including bankruptcy, will not unduly interfere with the continued operation of the property or the ability of the lender to foreclose on its mortgage and realize the full value of the property. The perceived benefit of this structure is that the assets of the SPE entity will not be consolidated with the related entity that transferred the property to the SPE in the event that the transferor entity is the subject of a voluntary or involuntary bankruptcy.

In some cases, such a structure will enable borrowers to obtain financing that might not otherwise be available, at least on favorable terms. The other side of that coin is the cost of creating and maintaining the structure, operating the property in an SPE environment and, if a refinancing is involved, transferring the property.

The most common SPEs are corporations, limited liability companies (LLCs) and business trusts, although the latter are normally used only in securitizations. Each has similar, basic characteristics: (a) a permitted purpose limited to owning and operating the property and entering into the loan, (b) a prohibition against incurring other debt except in the ordinary course of business, or entering into transactions with or for the benefit of affiliated entities other than for fair value and on arms-length terms, (c) a requirement that the SPE operate completely independently from all other entities, (d) a requirement that the SPE have an independent director, member or trustee at all times, and (e) a prohibition against merger, sale of substantial assets, voluntary bankruptcy, cessation of business, liquidation or dissolution, or the amendment or violation of the terms of any of its operative documents, without the consent of the independent director, member or trustee.

While corporations work well in many cases, the pass-through attributes of LLCs for tax purposes frequently make them the preferred entity. This is particularly true of Delaware LLCs. Recent amendments to the Delaware Limited Liability Company Act permit an LLC to have a single-purpose member that has no economic interest in the LLC, is not required to make capital contributions, and whose vote need only be required for specified, limited purposes. Recent IRS private rulings permit an LLC with only one economic member (the transferor of the property in the typical structure) and a single-purpose member to be treated as a single-member LLC for federal tax purposes. This results not only in a complete pass through to the economic member of all profits and losses, but avoids the need for a separate set of books, FIN and the like. It can be virtually transparent to third parties.

If a corporate SPE is used, only an individual independent director is needed. A person having no relationship to the SPE or its affiliates is necessary, and a lender may impose additional requirements. Independent directors that will satisfy lenders can be "rented" from service companies such as CT Corporation. CT's fees are currently $1,200 a year and an indemnity agreement is required, although an indemnity from the SPE is accepted.

The usual LLC SPE structure is to form a corporate SPE to act as the single-purpose member, with the member having an individual independent director. The single-purpose member fulfills the function of the corporate SPE independent director and that member can only act to file bankruptcy or take similar antilender actions with the consent of the member's independent director. While this is more complex, the advantages of the LLC will usually outweigh the nominal cost of the single-purpose member and if there are multiple properties, the same corporate SPE can usually function as the single-purpose member for each LLC.

Of course, an independent director of a corporate SPE or single-purpose member of an LLC will not completely block bankruptcy and other antilender actions, as that independent director has a fiduciary duty to act in the best interests of the entity. An appropriate vote by the independent director to file bankruptcy may not necessarily be in the best interests of the lender. The independent director structure does, however, create a higher threshold of persuasion, reduce the probability of the owner entity becoming involved in unrelated or financially risky activities, or being put into bankruptcy to benefit an insolvent transferor parent. It also limits the ability of a borrower to use bankruptcy and other acts as weapons against a lender.

In addition to the costs involved in creating and maintaining this structure, which are really not that burdensome in the context of most hotel and resort financings (the exception being multiproperty portfolio transactions), are those relating to the transfer of the property to the SPE and operational costs. As indicated, if a Delaware LLC is used for the SPE, some operational costs can be avoided. Others, such as the transfer of alcoholic beverage and other operating licenses, and obtaining consents from third parties, cannot.

If an SPE structure is used for acquisition financing, the only transfer costs are those that would be incurred in any event. They can become significant, however, in connection with the refinancing of existing property, especially in high transfer tax states such as Florida. In a recent transaction where Holland & Knight represented a borrower that refinanced multiple properties, transfer costs exceeded $1,000,000.

Counsel needs to be creative to minimize such costs. For example, in the transaction just referred to, borrower's counsel was able to avoid approximately $350,000 in Florida transfer costs by demonstrating to the lender that the entity that had owned the property since it was acquired had functioned, in effect, as a special purpose entity, and the lender permitted that entity to act as the borrower, although it had to be restructured as a true SPE. In addition, counsel had to conduct rather extensive due diligence and provide an opinion as to how the entity had been operated. This was a bit of a gamble as the due-diligence review was costly and if the results had not been satisfactory the opinion would not have been given or accepted. A borrower cannot count on lender willingness to accept this approach.

One approach to avoid transfer costs in anticipation of possible refinancing, would be to put in place, at the time of acquisition, an operational structure similar to an SPE, even though an independent director or member is not used until the refinancing. If the owner entity is truly operated independently from its affiliates and careful records are kept, it may be possible to achieve the result described in the preceding paragraph.

Another matter that has to be considered is how the SPE will function as the owner of the property after the loan is repaid, as the borrower will not wish to incur another round of transfer costs. This should not be difficult if counsel is careful to draft the SPE organizational documents so that the SPE-specific elements drop off or can be easily amended out upon repayment of the loan.

Of course, all of this begs the question: "Does this structure really work?" Although SPEs have been used in securitizations for years, there has been little litigation and, therefore, few reported cases. This is because securitizations, with few exceptions, have not resulted in losses to investors. With the use of SPEs in traditional forms of financing, however, this may change. Unlike securitizations, where there is normally a pool of hundreds of millions of dollars of relatively small receivables and various forms of credit enhancement, in a typical commercial real estate financing only one business operation has to go bad for the creditors to circle. When our economy reaches a low point in the market cycle and this starts to occur, bankruptcy attorneys expect the SPE structures to be attacked. Some lawyers are reluctant to provide lender-required closing opinions because of the unsettled state of the law in this area. Early discussion of the nonconsolidation opinion among borrower, borrower's counsel and lender and its counsel is essential.

It is clear that lenders believe the structure has a good enough chance of standing up to judicial scrutiny to require it in major financings. In addition, there is the possibility that Congress may act to protect the SPE structure in bankruptcy proceedings, as was proposed (to protect securitization SPE structures) in bankruptcy reform legislation earlier this year. That legislation did not make it to the floor because of other issues, but it can be expected that lenders' lobbyists will continue to push for it and borrowers will continue to pay for it.

________

Mr. Leixner practices in the Fort Lauderdale office. He can be reached at 954-468-7883 and at tleixner@hklaw.com