“Bankruptcy Remote” Special Purpose Entities in Commercial Mortgage Lending: Characteristics, Enforcement and Limitations

“Bankruptcy Remote” Special Purpose Entities in Commercial Mortgage Lending: Characteristics, Enforcement and Limitations Authored by David W. Forti, Esq. and Allison Whip, Esq1 October 2020 1 David W. Forti, Esq. is a partner at Dechert LLP and co-chair of Dechert’s global finance and real estate practice groups. Allison M. Whip, Esq. is an associate at Dechert LLP in the global finance and real estate practice groups. This publication should not be considered as legal opinions on specific facts or as a substitute for legal counsel. It is provided by the authors as a general informational service and may be considered attorney advertising in some jurisdictions. Prior results do not guarantee a similar outcome. The views expressed in this publication are the views of the authors except as otherwise noted. Dechert LLP October 2020 Page 2 Part I — Introduction It has become common practice in commercial mortgage lending for the borrower to be structured as a “single purpose” or “special purpose” entity. In its simplest form, a special purpose entity is simply an entity formed solely to own a specific property and any personal property ancillary thereto. Regardless of lender requirements, many property owners regularly use special purpose entities to own properties as a method to ring-fence particular assets and their associated liabilities into independent silos. At the other end of the spectrum is a full-fledged “bankruptcy remote” special purpose entity. The organizational documents for such an entity will contain a long laundry list of separateness covenants, independent director/manager requirements and various other provisions relating to bankruptcy remoteness. At this end of the spectrum it is also common in many larger commercial loan transactions for lenders to require a non-consolidation opinion and a recourse guaranty of the sponsor for a voluntary or collusive involuntary bankruptcy filing of the borrower. Although common in many types of lending transactions, full-fledged bankruptcy remote structures are routinely utilized in loans that will be included in commercial mortgage-backed securitizations (“CMBS”). This requirement has been a part of CMBS since its inception, is expected by bond buyers, and impacts the ratings of the CMBS by the rating agencies (i.e. not utilizing special purpose entities will have a negative impact on the ratings of the bonds).2 Although not quite as ubiquitous as in CMBS lending, and often with fewer bells and whistles, bankruptcy remote special purpose entities are often required in non-CMBS mortgage loans and many lenders have the same requirements for their balance sheet and CMBS loans. This article will address some of the background and rationale for the use of special purpose entity structures in commercial real estate loan transactions and is intended as a training piece on the subject. Bankruptcy Remoteness “Bankruptcy remote” is often misunderstood. Many people mistakenly interpret it to mean “bankruptcy proof.” These entities are not (and ultimately cannot be) bankruptcy proof; many have legitimately gone insolvent and/or voluntarily or involuntarily filed for bankruptcy. What a lender, bondholder or rating agency relies on when making, investing in, or rating a mortgage loan is that the collateral property and its financial and legal structure can essentially be boxed and then evaluated, so that things outside of that box (like the insolvency of an affiliate) will not have an adverse effect. In other words, a lender, investor or rating agency wants to know that the collateral and cash flow securing the loan will be available to satisfy the loan and that the individual property’s operating performance and value can be isolated from other properties and entities. This enables these parties to evaluate the risk of the loan, i.e., its probability of full repayment, by considering the attributes of the collateral alone. If the collateral property could be available to satisfy the debts of others, or if credit events of affiliates or owners could impact the property, that would change the analysis. In fact, this desire for separateness is so acute that these loans are often non-recourse to the sponsor (except for specified bad acts) to ensure that the bankruptcy of the parent would not lead to a consolidation of the borrower with its bankrupt parent. A primary goal of bankruptcy remoteness is to prevent a borrower from filing a “strategic” bankruptcy. A “strategic” bankruptcy filing is “when an otherwise solvent and financially sound borrower entity nevertheless files for bankruptcy 2 CMBS trusts issue “certificates,” not “bonds,” but such certificates are often referred to as bonds in the industry. When we refer to bonds herein we are referring to the certificates issued by CMBS trusts Dechert LLP October 2020 Page 3 as part of its (likely less stable) corporate parent’s legitimate insolvency proceeding.”3 The view that the bankruptcy of General Growth Properties, Inc. (“GGP”) meant bankruptcy remoteness was broken is why In Re General Growth Properties, Inc.,4 was fascinating to many people. Many of the individual debtors in General Growth were special purpose entities whose malls were performing. In other words, the cash flow and value from a performing mall were sufficient to satisfy the debt on that individual mall, and yet the special purpose entity owner (with the consent of the independent directors/manager5) was able to voluntarily file for bankruptcy. Thousands of pages have been written on General Growth. The purpose of this paper is not to get into the detail, but we note that the case (i) was a hard lesson for some that bankruptcy remote does not mean “bankruptcy proof” and (ii) led to many changes in the way borrowers and loans are now structured to be considered “bankruptcy remote,” including the use of recourse for voluntary bankruptcy filings, “professional” independent directors and certain fiduciary duty waivers. In addition to the desire to keep the assets “in a box” as described above, lenders have other reasons to avoid bankruptcy to the maximum extent possible. The uncertainty of cram-down risk (simply put: changing the terms of the loan to potentially reduce the interest rate, lengthen the amortization schedule, extend the term, etc.) is an unsettling thought to the lending community, especially when the loan in question will be backstopping rated bonds. Anything that could make that event less likely is highly valued. In addition to cram-down and other risks, costs and delays, a borrower’s bankruptcy filing has several other potential negative effects on the noteholder(s), including, but not limited to, the suspension of payments to creditors and the limitation of enforcement actions that a creditor may take in response to such nonpayment (the “automatic stay”).6 Bankruptcy remoteness highlights the tension between the United States Bankruptcy Code7 (the “Bankruptcy Code”) and the freedom of contract afforded by state law, and particularly, Delaware law. Special purpose entities are usually organized under Delaware law to satisfy lender and/or rating agency requirements, since Delaware law provides great flexibility in structuring entity governance, including the reduction or elimination of certain fiduciary duties owed by directors or managers. Federal public policy advanced by the Bankruptcy Code dictates that persons and entities must have access to federal bankruptcy protection. As a result, limitations placed on the governance of special purpose entities that amount to a complete prohibition on bankruptcy filings have generally been rejected by bankruptcy courts. Pre-petition waivers of the right to file for bankruptcy protection are unenforceable, as are pre-petition waivers of the automatic stay, except under limited circumstances. Therefore, although state law may permit the elimination of fiduciary duties, an argument could possibly be made that a federal bankruptcy court may hold that such provision is invalid as a matter of federal public policy if it totally restricts an entity’s right to file bankruptcy. Bankruptcy remoteness has its limits. It significantly reduces the risk of a bankruptcy filing by a special purpose entity, but it does not eliminate the risk. As such, lenders utilize other features to “encourage” the borrower to comply with special purpose entity provisions to increase the likelihood of the timely repayment of its debt obligations. For example, “bad boy” guaranties 3 Moody’s Investors Service, Inc., CMBS – US: Sector update – Q3 2019: Slight Improvements in credit metrics amid falling interest rates, Dec. 5, 2019, p. 4. 4 In Re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009). 5 The terms “independent director” and “independent manager” are used interchangeably throughout this paper and a reference to either includes both. 6 Moody’s Investors Service, Inc., Cross Sector Rating Methodology: Bankruptcy Remoteness Criteria for Special Purpose Entities in Global Structured Finance Transactions, Oct. 7, 2014, p. 1-2. 7 11 U.S.C. §101, et seq. Dechert LLP October 2020 Page 4 from a controlling party, typically the transaction sponsor, provide an alternate source of repayment of the loan if a borrower commits certain bad acts specified in the loan documents, specifically including violations of special purpose entity provisions. Special Purpose Entities Special purpose entities are designed to insulate an entity from the risks of bankruptcy and also decrease the risk that the entity’s assets will be consolidated into the bankruptcy estate of an affiliated entity. A special purpose entity is typically bound by requirements in its organizational documents and/or loan documents which: (i) restrict its purpose and powers; (ii) limit its ability to incur additional indebtedness, other than ordinary course debt related to its ownership and operation of the mortgaged property or other encumbered assets...