Practical Advice on the Preparation of the. Substantive Non-consolidation Opinion in Real Estate Transactions

Transcription

1 Practical Advice on the Preparation of the Substantive Non-consolidation Opinion in Real Estate Transactions By: Richard D. Jones Richard A. Bendit 1 I. INTRODUCTION Substantive non-consolidation opinion practice has become a necessary part of advising lenders and borrowers in capital markets transactions. This article will focus on the market requirements which have evolved regarding the use, format and content of substantive nonconsolidation opinions and commonly encountered issues relating to the commercial mortgage backed securities ( CMBS ) market. II. MORTGAGE LOAN SECURITIZATION AND THE SINGLE PURPOSE ENTITY REQUIREMENT One of the most important and central underwriting requirements for commercial real estate loans originated for sale into rated securitization transactions 2 is that the mortgaged property, the performance of which will be rated, must be isolated from: (A) the bankruptcy of affiliates of the borrower, (B) the poor performance of other properties which may be owned by the proposed borrower s sponsor or its affiliates, and (C) any debts and obligations, other than the loan and the ordinary trade debt of the borrower related to the ownership and operation of the real property. The first step in making this so, is to require that the property in question be owned by a single purpose entity (an SPE ). Fundamentally, an SPE is an entity which conducts no business other than the ownership of the property securing the loan and has, among other things, no debts other than the loan and reasonable trade debt. An SPE borrower can be a corporation, partnership, limited liability company or business trust. Ownership of the mortgaged property by the SPE borrower is intended to ensure that the performance of the loan will be impacted solely by the quality and operation of the mortgaged property. 1. Richard Jones is a partner and Chairman of the Real Estate Group at Dechert Price & Rhoads in Philadelphia. Richard Bendit is an attorney in the Real Estate and Securitization Groups at Dechert Price & Rhoads. The authors gratefully acknowledge the contributions made in the preparation of this article by Timothy Boyce, a partner at Dechert Price & Rhoads and William C. Stefko, an associate at Dechert Price & Rhoads. All Rights Reserved Securitization transactions are transactions in which commercial mortgage loans are accumulated into pools and securities are issued, backed by such loans. The four rating agencies (Standard & Poor s Ratings Services, a Division of the McGraw-Hill Companies, Inc., Fitch IBCA, Inc., Moody s Investors Service, and Duff & Phelps Credit Rating Co.) rate the issued securities. C:\DOCS.NONCON.DOC 3/14/ :03 AM

2 Why is SPE-ness so important? Didn t lenders go about their business perfectly comfortably for years without worrying about such matters? In fact, wasn t a borrower with other assets at one time a good thing? It was, before the invention (and that s really the right word) of the modern commercial mortgage backed securitization industry. Now it s not. When the CMBS industry was in its infancy, the rating agencies 3, large loan originators and other major market players (collectively, the rated market ) concluded that the SPE structure was important. Moreover, upon considering the application of the United States Bankruptcy Code (the Bankruptcy Code ) to the SPE structure, the rated market also concluded that mere ownership of the mortgaged property by an SPE borrower wasn t enough to ensure that the performance of the mortgaged property would not be impacted by exogenous events because of the risk of the application of the legal doctrine of substantive consolidation. Under this doctrine, a bankruptcy court may treat two or more legally distinct entities or individuals as a single debtor with a common pool of assets and liabilities. Consequently, the bankruptcy of an affiliate of a borrower, for example, could result in the extension of the jurisdiction of the bankruptcy court to the borrower and the combination of the borrower s assets and liabilities with those of its bankrupt affiliate. III. WHAT IS SUBSTANTIVE CONSOLIDATION Substantive consolidation is a judicially created doctrine derived from the general equitable powers granted to bankruptcy courts by Section 105(a) of the Bankruptcy Code. 4 Although several tests have been developed to determine whether substantive consolidation is warranted, the basic rule is that two or more entities which look and act like a single entity prior to bankruptcy (particularly in the eyes of the creditors) should be treated in bankruptcy as a single debtor. Although the Bankruptcy Code does not expressly provide for the substantive consolidation of different entities or individuals, courts have exercised their equitable jurisdiction to order substantive consolidation in appropriate circumstances. Courts determine whether circumstances are appropriate on a case-by-case basis. Under the existing case law, a court s inquiry into the substantive consolidation of related entities may include an examination of, among other things: (A) the structures of the entities which may be subject to consolidation, (B) the relationships between the entities, (C) the relationships of the entities to their respective 3 4 Note that each rating agency has its own set of criteria (which may or may not be published) regarding the structure and rating of commercial mortgage loans to be included in a mortgage loan securitization transaction. As such, references in this article to rating agency requirements reflect the authors general experiences representing borrowers and lenders in the CMBS market and are not intended to reflect the policies of any particular rating agency. Substantive consolidation should not be confused with procedural consolidation. Unlike substantive consolidation, procedural consolidation is specifically authorized by the Federal Rules of Bankruptcy Procedure and provides for the joint administration of related estates in bankruptcy. Additionally, procedural consolidation does not alter the rights of the parties by consolidating the estates of the bankruptcy debtors. 2

3 creditors and other third parties, (D) the impact upon the creditors of each entity if consolidation were to be ordered, and (E) whether such parties would be unfairly prejudiced or treated more equitably by substantive consolidation. Given that resolution of the question of substantive consolidation has turned on a detailed factual analysis on a case-by-case basis, the law of substantive consolidation is difficult to synthesize. Every court which has considered the issue has struggled. What has emerged, however, are a series of related tests, one or more of which have been embraced by most of the courts which have subsequently considered the issue. The following is a brief summary of the most commonly cited tests: 1. The Alter Ego/Corporate Veil Checklist Test: Under this test, the courts will use a checklist approach to determine whether a corporation is a mere instrumentality or alter ego of the bankrupt corporation, with no independent existence of its own. FDIC v. Hogan (Matter of Gulfco Inv. Corp.), 593 F.2d 921, 928 (10 th Cir. 1979). However, the absence of one or more factors identified in this test will not necessarily defeat a request for consolidation. As such, the test is far from mechanical. The factors considered in this analysis are separateness factors and alter ego factors. a. The separateness factors are: (i) the degree of difficulty in segregating and ascertaining individual assets and liabilities; (ii) the presence or absence of consolidated financial statements; (iii) the profitability of consolidation at a single physical location; (iv) the commingling of assets and business functions; (v) the unity of interests and ownership between the various corporate entities; (vi) the existence of parent and intercorporate guarantees on loans; and (vii) the transfer of assets without formal observance of corporate formalities. See, In re Vecco Const. Indus., Inc., 4 B.R. 407, 410 (Bankr. E.D. Va. 1980). b. The alter ego factors are: (i) the parent corporation owns all or a majority of the capital stock of the subsidiary; (ii) the parent and the subsidiary have common officers and directors; (iii) the parent finances the subsidiary; (iv) the parent is responsible for incorporation of the subsidiary; (v) the subsidiary has grossly inadequate capital; (vi) the parent pays salaries, expenses or losses of the subsidiary; (vii) the subsidiary has substantially no business except with the parent; (viii) the subsidiary has essentially no assets except for those conveyed by the parent; (ix) the parent refers to the subsidiary as such or as department or division of the parent; (x) the directors or officers of the subsidiary do not act in the interest of the subsidiary, but take directions from the parent; and (xi) the formal legal requirements of the subsidiary as a separate and independent corporation are not observed. See, In re Tureaud, 45 B.R. 658, 662 (Bankr. N.D. Okla. 1985), aff'd, 59 3

4 B.R. 973 (N.D. Okla. 1986) (citing Fish v. East, 114 F.2d 117, 191 (10th Cir. 1940) and Gulfco, 593 F.2d at 928). 2. The Balancing Test: Several versions of this test have been articulated at the circuit court level. The basic goal of each version of the test is to balance the benefits that substantive consolidation would achieve against the harm substantive consolidation would cause. The most often cited balancing tests are: a. The Auto-Train Test: Under this standard articulated by the D.C. Circuit, the proponents of substantive consolidation must demonstrate that: (i) a substantial identity exists between the entities, and (ii) substantive consolidation is necessary to avoid some harm or realize some benefit. If these factors are shown to be present in the matter under consideration, then those objecting to substantive consolidation must show that they relied on the separate credit of the entities and that they would be prejudiced from substantive consolidation. If this showing is made, then the court may order substantive consolidation only if the benefits heavily outweigh the harms. See, Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270, 276 (D.C. Cir. 1987) (quoting Chemical Bank New York Trust Co. v. Kheel, 369 F.2d 845, (2d Cir. 1966) (Friendly, J., concurring); In Re Continental Vending Machines Corp.., 517 F.2d 997, 1001 (2d Cir. 1975), cert. denied, 424 U.S. 913). b. The Augie/Restivo Test: Under this test, the Second Circuit reasoned that the separateness factors were merely variants of two critical themes: (i) whether creditors dealt with the entities as a single economic unit and did not rely on their separate credit in extending credit, and (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors. To meet the first prong of this test, proponents of substantive consolidation must show the lack of reliance on the separateness of the debtors by providing evidence about the course of dealing between the creditors and the debtors and the creditors expectations of the separateness of the debtors when making decisions to extend credit. To meet the second prong, proponents of consolidation must show that the benefits of substantive consolidation inure to all creditors by demonstrating either that the cost of disentangling the entities will exhaust the remaining assets of the pool, or that it remains impossible to identify and allocate the assets accurately. See, Union Savings Bank v. Augie/Restivo Banking Co., Ltd. (In re Augie/Restivo Baking Co., Ltd, 860 F.2d 515 (2d Cir. 1988). c. The Eastgroup Test: The Eleventh Circuit essentially adopted the Auto-Train test by requiring proponents of substantive consolidation to demonstrate: (i) a substantial identity between the 4

5 entities to be consolidated; and (ii) that consolidation is necessary to avoid some harm or realize some benefit. The Eastgroup court noted that the Auto-Train standard was part of a modern trend toward allowing substantive consolidation. See, Eastgroup Properties v. Southern Motel Assoc. Ltd., 935 F.2d 245, (11th Cir. 1991). Presumably, in a case proceeding under the jurisdiction of the D.C. Circuit the court would favor the Auto-Train test, while in a case proceeding in the Second Circuit, the Augie Restivo Test, and in the Eleventh Circuit the Eastgroup Test. However, it s far from that clear. Even a casual reading of the cases in these and other circuits suggests that there is enough fuzziness and uncertainty in the language of all these tests to allow a court to literally pick and choose amongst the factors in each of the tests that have been articulated and synthesize its own view of the jurisprudential guidance. As each case is so fact-intensive, a prudent observer will conclude that absolutely all the tests and all the factors articulated and all the major decisions are relevant, and must be closely examined in the light of the facts of any specific transaction to assess the risk of substantive consolidation. IV. RESPONSE TO THE THREAT OF SUBSTANTIVE CONSOLIDATION To mitigate the threat of substantive consolidation, the rated market may require that: (i) the mortgaged property be held by an SPE, and (ii) the relevant borrower take steps to ensure that the separateness of such borrower s ownership will be recognized by the courts in the event that an affiliate bankruptcy occurs. Such steps include the incorporation of separateness covenants in the loan documents and in the organizational documents of the borrower. Separateness covenants are agreements and legal commitments of the borrower which have been identified in the cases described above as consistent with the borrower s legally separate identity. A representative list would be as follows: borrower has not and shall not: (A) fail to do all things necessary to preserve its existence as an SPE and will not, nor will any member thereof, amend, modify or otherwise change its articles of organization or operating agreement in a manner which adversely affects borrower's existence as an SPE; (B) enter into any contract or agreement with any member or affiliate of borrower or any affiliate of a member of borrower except upon terms and conditions that are intrinsically fair and substantially similar to those that would be available on an arm's-length basis with third parties other than an affiliate; (C) make any loans or advances to any related [or unrelated] third party; (D) fail to conduct and operate its business in all material respects as presently conducted and operated; (E) fail to maintain books and records and bank accounts separate from those of its affiliates, including its members or general partners, as applicable; (F) fail to at all times hold itself out to the public as a legal entity separate and distinct from any other entity (including any affiliate thereof, including any member of borrower or any affiliate of any member 5