Incorporator The Journal of U.S. Formation
Start Free Quiz
Editorial 7 MIN READ

The single-purpose entity, reviewed: thin by design

A Delaware LLC with one asset, one loan, one independent director, and a separateness covenant that reads like a sermon

The Editors
Staff, Incorporator.org
7 min read Updated
Contents 9 sections
  1. When you actually need one
  2. Why Delaware, almost always
  3. What a separateness covenant actually says
  4. The independent director and the golden share
  5. The non-consolidation opinion
  6. Tax treatment, usually disregarded
  7. The Corporate Transparency Act adds a wrinkle
  8. The loose end
  9. Sources

single-purpose entity is a company designed to hold one asset, borrow one loan, and go bankrupt in isolation. The lender requires it, the rating agency scores it, and the bankruptcy bar writes opinions about whether it will actually stay isolated when the parent fails.

The form has been standard in commercial real estate, asset-backed securities, and project finance for three decades. In 2022 it is still drafted around the same four moving parts: a newly formed Delaware LLC, a set of separateness covenants baked into the operating agreement, at least one independent director with a veto on bankruptcy filings, and a non-consolidation opinion from counsel that the securitization trustee will read once and file forever.

When you actually need one

Lenders require an SPE when the collateral has to be legally quarantined from a sponsor's other problems. A CMBS lender funding a $120 million office tower does not want that tower dragged into the sponsor's operating-company bankruptcy. An ABS sponsor securitizing receivables does not want those receivables clawed back into the servicer's estate. A project-finance lender funding a pipeline wants recourse to the pipeline and nothing else.

The asset sits inside a freshly incorporated LLC with no operating history, no employees, no other creditors, and nothing on the balance sheet except the collateral and the loan. The LLC is often called an SPE (single-purpose entity) or an SPBRE (single-purpose bankruptcy-remote entity); the second label adds the half of the job the lender is actually buying, which is remoteness from a sponsor filing. The thinness is the feature, and the covenants in the operating agreement look almost copy-pasted across deals because the form has converged.

Why Delaware, almost always

You can form an SPE in any state, and some deals use New York or the project's home state for idiosyncratic reasons. The default is Delaware. The reason is not Chancery (the SPE is not supposed to litigate anything) and not privacy (the SPE's ownership is disclosed to the lender). The reason is 6 Del. C. § 18-1101(c), which permits an LLC operating agreement to expand, restrict, or eliminate fiduciary duties by contract, subject only to the implied covenant of good faith and fair dealing.

That matters because the separateness covenants and the independent director's veto are contractual constructs. They work best in a state whose statute explicitly allows the operating agreement to be the last word on what the manager and members owe each other and the entity. A Delaware SPE can say, in plain terms, that the independent director owes no duty to the equity at all when deciding whether to authorize a bankruptcy filing. That sentence is load-bearing, and § 18-1101(c) is what makes it enforceable.

Formation mechanics are ordinary. A Certificate of Formation is filed with the Division of Corporations for a $90 fee; the operating agreement then does the real work. If you need a refresher on the state's formation pipeline, the Delaware formation guide walks through it.

What a separateness covenant actually says

The heart of any SPE operating agreement is a schedule of covenants the entity makes about how it will conduct itself. A typical list runs fifteen to twenty items: the entity will maintain its own books, not commingle funds with any affiliate, file its own tax returns (or be included on consolidated ones consistent with its documents), hold itself out as separate, pay its own liabilities from its own funds, maintain adequate capital, not guarantee affiliate debt, not pledge assets for an affiliate's benefit, observe formalities, and not amend its organizational documents without the independent director's consent.

Each item is a factor a court would consider in a veil-piercing or substantive-consolidation analysis; the covenants pre-emptively stack the record. They are also covenants in the loan agreement, so a breach gives the lender an event of default independent of any court's view.

The independent director and the golden share

The single most-discussed feature of an SPE is the independent director (or independent manager, in the LLC context). The role is narrow. The independent director is typically a professional from a service firm that provides directors for hundreds of SPEs, sits on the board or manager slate of the entity, and does essentially nothing until a bankruptcy filing is proposed. At that point the director's vote is required to authorize the filing. No unanimous written consent, no voluntary petition under Chapter 11.

The structure is sometimes called a golden-share or blocking-director arrangement. It has been tested, and it is not bulletproof. In In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), Judge Gropper denied motions to dismiss Chapter 11 petitions filed by numerous SPE subsidiaries of General Growth, including petitions that had been approved with the participation of independent managers. The court held that the independent managers owed fiduciary duties to the SPEs as going concerns, not solely to the secured lenders, and that on the facts of the case (a sponsor-level liquidity crisis that threatened the subsidiaries' ability to refinance) the managers had not breached their duties by consenting to the filings.

The holding cut against lenders in the moment and has shaped drafting since. Post-GGP SPE operating agreements typically say, explicitly, that the independent director or manager owes no fiduciary duty to the equity, and owes duties (if any) solely to the entity's creditors. They sometimes try to go further and waive all fiduciary duties. The § 18-1101(c) statutory permission is what makes those waivers defensible. Whether a bankruptcy court presented with the next GGP fact pattern would honor them is a live question; the case law since 2009 has not resolved it cleanly.

Practitioners have learned not to sell the independent director as a bar to filing. It is a speed bump, a document-production event, and a factor in a non-consolidation analysis. It is not a lock.

The non-consolidation opinion

Every securitization with an SPE comes with a non-consolidation opinion: a reasoned letter from counsel concluding that, in a bankruptcy of the sponsor, a court would not substantively consolidate the SPE's assets and liabilities with the sponsor's estate. The opinion walks through the factors under In re Auto-Train Corp., 810 F.2d 270 (D.C. Cir. 1987), and its progeny, and concludes that the separateness covenants, the independent director, the arm's-length intercompany dealings, and the absence of commingling all point to the SPE being respected as a separate entity.

These opinions are reasoned and heavily qualified. They are not guarantees. The issuing firm takes reputational risk and charges accordingly; the fees are a real line in the deal budget.

Tax treatment, usually disregarded

The SPE is almost always a single-member LLC wholly owned by a holding entity in the sponsor's structure. Under the check-the-box regulations at Treas. Reg. § 301.7701-3, a domestic LLC with a single member that does not elect otherwise is a disregarded entity for federal tax purposes, meaning its income, deductions, and credits flow up to its owner and it files no separate federal return.

That is the right answer for most SPE deals. A disregarded entity avoids a second level of tax, keeps the loan interest deductible at the ultimate taxpayer, and does not complicate the sponsor's consolidated return. A partnership SPE (with two or more members) is sometimes used where the sponsor wants to admit a preferred equity investor at the SPE level; in that case the SPE files Form 1065 and issues K-1s. A C-corporation SPE is rare and usually driven by a specific regulatory or REIT-blocker reason.

The single-member default also simplifies the non-consolidation analysis: there is one equity owner, one set of books, and one clear ownership chain to describe in the opinion. The single-member LLC primer covers the baseline tax mechanics in more depth.

The Corporate Transparency Act adds a wrinkle

The Corporate Transparency Act, codified at 31 U.S.C. § 5336, took effect for reporting purposes on a phased schedule after FinCEN's final rule published in September 2022. The statute requires most domestic LLCs and corporations to report beneficial ownership information to FinCEN unless they fit one of twenty-three enumerated exemptions.

SPEs are not categorically exempt. Each SPE will have to run the exemption checklist. The most commonly relevant path for an SPE sitting under an exempt parent is § 5336(a)(11)(B)(xxii), the subsidiary-of-an-exempt-entity exemption, which covers entities whose ownership interests are controlled or wholly owned, directly or indirectly, by one or more entities described in certain of the other exemptions (large operating companies, public companies, regulated banks and insurers, certain investment vehicles, and so on). The scope of that sub-of-exempt path depends on which parent exemption applies and how the SPE is owned; a sponsor whose parent is a registered issuer under § 5336(a)(11)(B)(ii) will typically sweep its SPEs into the (xxii) carve-out, while a sponsor whose parent is a private real-estate fund may not.

The practical effect is another diligence item for any new SPE: confirm whether a FinCEN filing is needed, and if so, who collects and reports the beneficial-owner information. For securitization sponsors with hundreds of SPEs on the servicer's books, the administrative load is real.

The loose end

The SPE form rests on two bets. The first is that courts will continue to honor contractual separateness among entities under common control when it is documented carefully and observed in practice. The second is that the independent-director veto, backed by § 18-1101(c) fiduciary waivers, will hold up when a sponsor in distress genuinely wants its subsidiaries to file. GGP tested the second bet in one direction and drafting has since pushed back. The next test will come in the next downturn, and every securitization trustee in the market has a file of opinions hoping it does not.

Sources

Keep reading

More from the journal.