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Editorial 7 MIN READ

The single-purpose entity in October 2017: what lenders actually buy

One asset, one borrower, one bankruptcy ring-fence, and a stack of covenants written by rating agencies

The Editors
Staff, Incorporator.org
7 min read Updated
Contents 6 sections
  1. When a lender asks for an SPE
  2. Why Delaware, usually
  3. The separateness covenants
  4. Failure modes
  5. The shape of a good SPE, in one paragraph
  6. Sources

single-purpose entity is a vehicle that owns one thing, borrows against that one thing, and is legally restrained from doing anything else. In commercial real estate it is usually a Delaware LLC holding a single building. In project finance it is usually a Delaware LLC or statutory trust holding a single power plant, toll road, or pipeline. The point is not tax efficiency. The point is to convince a lender that if the sponsor above goes broke, the lender can still reach the asset underneath.

Sponsors form these vehicles because they have to. The loan documents require it.

When a lender asks for an SPE

The phrase to listen for in a term sheet is "bankruptcy-remote." A bankruptcy-remote borrower is one the lender believes will not be dragged into the bankruptcy of its parent, and whose own bankruptcy is unlikely to be filed collusively. Those two risks — substantive consolidation with the parent, and a voluntary Chapter 11 filed to stall foreclosure — are what the SPE structure exists to defeat.

On a conduit CMBS loan of meaningful size, the borrower will be a newly formed Delaware LLC whose sole asset is the mortgaged property. The rating agencies — S&P, Moody's, Fitch, DBRS, Kroll — publish criteria that tell originators what language they want to see in the organizational documents before they will rate the resulting securities investment grade. S&P's U.S. CMBS rating methodology distinguishes a "special-purpose, bankruptcy-remote entity" from an "SPE with independent director," and requires the latter for loans above stated thresholds; Moody's and Fitch have similar tiers. A $60 million loan will typically sit in a borrower with a non-consolidation opinion and at least one independent manager. A $200 million loan will sit in a borrower with two independents, a springing member, and a substantive-consolidation opinion addressed to the trustee.

Project finance works the same way. A wind farm financed on a non-recourse basis is built inside a ProjectCo LLC whose sole purpose is to own that wind farm, enter the PPA, and service the debt. Sponsors in energy and infrastructure use the SPE to quarantine the project's liabilities from the sponsor's balance sheet and to quarantine the sponsor's liabilities from the project's lenders. When the deal works, the SPE lets a mid-cap developer finance a billion-dollar asset without putting the whole company at risk.

Why Delaware, usually

The default jurisdiction for SPEs is Delaware, and the default form is either the limited liability company under the Delaware LLC Act (6 Del. C. § 18-101 et seq.) or the statutory trust under 12 Del. C. § 3801 et seq. Lenders prefer Delaware for the same reasons corporate lawyers prefer it — mature case law, a court that moves quickly, a bar that writes opinion letters the rest of the country accepts — plus two provisions that matter specifically to SPE practice.

The first is 6 Del. C. § 18-1101(c), which allows an LLC operating agreement to expand, restrict, or eliminate fiduciary duties, subject to the implied covenant of good faith and fair dealing. That lets the drafters pin a member-manager or independent manager to a narrowly defined role without fear that a fiduciary claim will sweep the definition aside.

The second is 6 Del. C. § 18-304, which says an LLC is not dissolved by the bankruptcy of a member unless the operating agreement or a separate agreement says so. The springing-member structure — where an independent person becomes the sole member if the ordinary member goes bankrupt, so the LLC does not collapse with its parent — depends on provisions like these working the way they read.

The Delaware statutory trust is used in the same neighborhood of transactions, most often to hold aircraft, railcars, and pass-through real-estate interests (including 1031-compatible "DST" offerings under IRS Rev. Rul. 2004-86, 2004-2 C.B. 191). The trust form has its own separateness virtues: the trustee holds title, the beneficial owners are passive, and the governing instrument can be written to mirror the LLC separateness covenants.

The separateness covenants

Open any CMBS loan agreement and find the SPE covenants. They are formulaic, because the rating agencies made them formulaic. In a representative loan the borrower represents and covenants that it:

  • was formed solely to acquire, own, and operate the Property and will conduct no other business;
  • will not own any asset other than the Property and incidental personal property;
  • will not incur any debt other than the loan and trade payables paid in the ordinary course within sixty days;
  • will maintain its own books, records, bank accounts, and financial statements separate from any affiliate;
  • will file its own tax returns (except to the extent consolidated as a disregarded entity is required);
  • will hold itself out as a separate entity, including on stationery, invoices, and contracts;
  • will pay its own liabilities out of its own funds and will not commingle assets with any affiliate;
  • will observe corporate and LLC formalities;
  • will transact with affiliates only on arm's-length terms;
  • will maintain at least one (for smaller loans) or two (for larger loans) independent managers whose consent is required for any bankruptcy filing, dissolution, or amendment of the separateness provisions.

The independent-manager provision is the hinge. The independent is not there to run the business; they are there to refuse to sign a bankruptcy petition when the sponsor wants one. Loan documents specify who qualifies — typically a natural person who has not served as an officer, director, employee, or significant creditor of the borrower or any affiliate within the preceding five years, and who is provided by a recognized corporate-services firm. The independent also owes, under the operating agreement, a duty to consider the interests of the lender alongside those of the member. That duty is written in because standard LLC fiduciary duty runs to the members; Delaware's § 18-1101(c) flexibility is what makes the lender-regarding duty enforceable.

Non-consolidation opinions live or die on these covenants. Counsel giving the opinion is asserting that, based on the organizational documents and a set of factual certificates, a bankruptcy court applying the multi-factor consolidation test would not consolidate the SPE with its parent. The test, drawn from cases like In re Augie/Restivo Baking Co., 860 F.2d 515 (2d Cir. 1988) and In re Owens Corning, 419 F.3d 195 (3d Cir. 2005), asks whether creditors dealt with the entities as a single unit and whether the affairs are so entangled that consolidation benefits all creditors. The covenants are drafted to answer both questions in the negative, on the page.

Failure modes

The risk in an SPE is that the separateness collapses in practice. When it does, two bad things happen: a bankruptcy court substantively consolidates the SPE with its parent, and a state court pierces the veil to reach the members. The doctrines are different but the facts that trigger them overlap.

Delaware veil-piercing requires a showing that the LLC was a sham or that respecting the entity would work a fraud or injustice; the leading modern treatment is NetJets Aviation, Inc. v. LHC Communications, LLC, 537 F.3d 168 (2d Cir. 2008) (applying Delaware law). Courts look for commingling of funds, undercapitalization at formation, failure to observe formalities, and use of the entity to perpetrate a wrong. An SPE whose member sweeps cash nightly into a parent concentration account without documentation, or whose books are kept on the parent's general ledger, is giving a future plaintiff the affirmative case.

The cautionary tale cited most in CMBS circles is General Growth Properties, the 2009 bankruptcy in which the parent REIT filed Chapter 11 and pulled several hundred of its SPE subsidiaries into the filing with it — notwithstanding that the subsidiaries were current on their mortgages and had independent managers. The bankruptcy court declined to dismiss the SPE cases (see In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009)), reasoning that the independents could properly consider the interests of the enterprise in authorizing the filings. Lenders responded by tightening the independent-manager covenants: requiring independents from larger, more reputable providers, specifying that the duty to the lender is explicit, and requiring unanimous consent rather than majority consent for a bankruptcy filing.

The shape of a good SPE, in one paragraph

A good SPE in October 2017 is a Delaware LLC formed shortly before closing; owns exactly the collateral and nothing else; has an operating agreement with the rating-agency separateness covenants incorporated verbatim; has at least one independent manager from a recognized corporate-services firm and, for larger loans, two; has a springing-member provision that keeps the entity alive if its sole member files; keeps its own books, its own bank account, and its own stationery; pays for shared services by invoice at arm's length; and receives a clean non-consolidation opinion at closing. If any of those pieces is missing, either the loan does not rate or the pricing reflects the gap.

The SPE is a strange kind of legal object. It is designed to be powerless. It exists so that when the sponsor above it gets into trouble, nothing happens to the asset below. Sponsors sometimes resent the covenants; lenders and ratings committees count on the resentment going unacted on.

Sources

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