WHAT’S SO SPECIAL?

Mastering Special Purpose Entities

A special purpose entity (SPE), sometimes called a special purpose vehicle (SPV), is a legal entity formed for a specific, limited purpose. The limited purpose of the SPE will depend upon the underlying transaction, but the purpose often relates to the acquisition, maintenance, operation, and financing of specific assets. In the United States, SPEs are often limited liability companies formed as subsidiaries of larger parent companies. SPEs can be used in several types of transactions including real estate and related asset financing and securitization transactions.

Why use an SPE?

SPEs are used to isolate assets within a corporate structure. By doing so, the parties to a financial transaction are able to isolate and reallocate the risk of a transaction in a number of ways. First, since SPEs generally have only one asset or group of assets and only one creditor, the creditor is able to more easily predict whether an SPE will remain solvent for the duration of the transaction. Second, if the SPE is a bankruptcy remote entity, the SPE will need to obtain the consent of an independent director before the SPE will be able to declare bankruptcy. This mechanism makes gaining bankruptcy protection more difficult, therefore reducing the risk to a creditor that an otherwise solvent SPE will be able to discharge its debt. Third, restrictive covenants requiring the SPE to operate as an independent entity reduce the risk that the assets of the SPE will be substantively consolidated with the assets of affiliated entities in a bankruptcy proceeding.

Substantive consolidation is a legal tool through which a bankruptcy court may treat the assets and liabilities of affiliated entities as though they were held by a single entity. For creditors of the SPE, substantive consolidation is undesirable because the process delays resolution of the bankruptcy case and often results in a much smaller recovery.

The rise of the SPE and its common uses

The rise in the number of SPEs over the past few decades has been largely driven by investor demand for structured finance products. As various global factors drove the growth of consumer, residential, and corporate credit, investors sought to trade in securities backed by the loans. Although securitization transactions have been used by mortgage lenders since the 1980s to sell residential mortgage backed securities to investors, the market had expanded exponentially since the mid-1990s. Furthermore, in the mid-2000s, demand for more highly-structured products—for instance, those that re-securitized the lower-rated groups of securities (called tranches) from previous securitizations—increased rapidly as risk and valuation tools became more widely available. Unfortunately, these tools frequently suggested that such investments carried minimal credit risk, and the recent financial crisis exposed the shortcomings of these products. Managed effectively, however, structured finance products and the SPEs used to create them continue to play an important role in the efficient operation of global financial markets.

What is an SPE, and how is it different from a subsidiary company?

SPEs are commonly used to securitize various types of loans and other receivables. Securitization refers to the practice of pooling various types of debt such as residential and commercial mortgages, auto loans, and credit card receivables, and selling that debt to investors in the form of bonds or other structured finance products. In the typical case, a bank or other financial institution will make a loan to various companies and individuals, and each borrower will deliver a note to the financial institution promising to repay the loan with interest over the course of several years. While the financial institution could continue to hold these notes and collect payments from the borrowers slowly over time, it may instead prefer to receive a smaller payment immediately by selling the right to receive the stream of payments to investors. The financial institution will transfer the notes evidencing the underlying loans to an SPE. The notes are then sorted into different tranches based on credit risk. The SPE will

issue bonds backed by the notes in each tranche and sell the bonds to investors. The diagram to the right (figure 1) illustrates the process.

Interestingly, while the assets underlying securitization transactions are usually receivables backed by real or tangible property, more unusual assets may also be securitized. This was the case with the famous Bowie Bonds which were first issued in 1997 and backed by the future royalty revenues of 25 albums recorded by the late David Bowie before 1990. In exchange for giving up the right to 10 years of royalties for these albums, David Bowie received an up-front payment of $55 million. By March 2004, due to lower-than-expected sales revenue, Moody’s Investors Service downgraded the credit rating of the Bowie Bonds. Despite the downgrade, Bowie Bonds were revolutionary in their time, and they have since been followed by numerous other artists and institutions to securitize intellectual property rights.

SecuritizationTransactions

ASSET(LOAN)

ASSET(LOAN)

ASSET(LOAN)

INVESTORS

ORIGINATOR

SENIORTRANCHE

MIDDLETRANCHE

SUBORDINATED

TRANCHE

ASSETS

NOTES

CASH

CASH

SPE

FIGURE

SPEs are also commonly used in financing transactions to isolate the risk associated with a particular venture. In a typical example illustrated in the diagram on the left (figure 2), a large operating company would like to obtain a loan to purchase a parcel of real estate. Instead of purchasing the property and obtaining the loan directly, the operating company instead forms a bankruptcy remote SPE to obtain the loan and purchase the property. The lender then makes the loan to the SPE rather than the operating company.

The arrangement is favorable for the lender who can rely on the value of the underlying property to secure the loan. In the event that the operating company falls into financial trouble and declares

bankruptcy, the lender remains secured by the underlying property, and if the SPE is complying with corporate operating formalities, the assets of the SPE will not be substantively consolidated into the bankruptcy estate of the operating company.

The arrangement is also favorable to the operating company because its assets and credit are insulated from claims from the lender in the event that the revenue generated from the investment in the property is insufficient to repay the loan. Furthermore, if the operating company has poor credit, the lender may be willing to lend to the SPE, having only one asset and one creditor, at a more favorable interest rate.

Financing transactions and risk management

2OPERATINGCOMPANY

LENDER

REAL ESTATE

SPENOTES

CASH

FIGURE 2

To maintain the separate legal existence of an SPE, it should:Maintain its books, records and accounts separate from any other person or entity

Maintain a sufficient number of employees in light of its contemplated business operations

Conduct its business in its own name Allocate fairly and reasonably any overhead for shared office space

Maintain separate financial statementsUse separate stationery, invoices, and checks bearing its own name

Pay its liabilities out of its own funds

Hold itself out as a separate legal entityObserve all corporate formalities

Correct any known misunderstandings regarding its separate identityMaintain an arm’s-length relationship

with its affiliates

Maintain adequate capital in light of its contemplated business operations

Pay the salaries of its employees out of its own funds

Additionally, the SPE should not:Commingle assets with those of any other entity

Guarantee or become obligated for the debts of any other entity or hold out its credit as being available to satisfy the obligations of any other entity

Acquire obligations or securities of its partners, members, or shareholders

Pledge its assets for the benefit of any other entity or make any loans or advances to any entity

SPEs may also be used to simplify the transfer of assets from one party to another. When assets are held in an SPE, the equity interests in the SPE may be transferred to another party without the burden and expense of attempting to transfer each asset individually. Additionally, SPEs may be used to attract investment into a new venture without increasing the debt of the sponsoring company and without diluting its existing investors. The sponsoring entity can form an SPE to invest in a specific project with equity investments into the SPE provided by outside investors. These investors are able to participate in the venture without investing directly into the sponsoring company.

What does it mean for an SPE to be “bankruptcy remote?”

Many SPEs are formed to be bankruptcy remote. A bankruptcy remote SPE refers to an SPE whose assets are intended to be isolated from any creditors of affiliated entities within its corporate structure. In the event that entities affiliated with the SPE would enter into bankruptcy, the assets of the SPE would not be included in the bankruptcy estate and would not be available to satisfy the obligations of creditors of affiliated entities. SPEs maintain their bankruptcy remote status through restrictive covenants in their governing documents.

Typically, the governing documents will contain provisions restricting the SPE from conducting any activity outside its stated purpose of acquiring,

maintaining, operating, and financing a specific asset or group of assets. Additional restrictive covenants include provisions preventing the SPE from owning property other than the assets it was established to hold, merging, or consolidating with another entity, incurring any debt other than a specific loan (other than minor amounts of trade payables necessary for operating the property), commingling its assets with affiliated entities, guaranteeing the debts of another entity, or pledging its assets to secure the debts of another entity.

It is important to note, however, that bankruptcy remote does not mean bankruptcy proof. A bankruptcy remote SPE may seek bankruptcy protection subject to satisfaction of the conditions set forth in its governing documents. Such conditions often state that decisions relating to bankruptcy must be made by considering the interests of the SPE itself and not merely the interests of its corporate parent or other affiliated entities. Filing a voluntary bankruptcy petition or taking any other bankruptcy-related action also typically requires the prior unanimous written consent of professional independent directors or independent managers. Often, lenders will require that an independent director be provided by a nationally recognized professional services company such as Corporation Service Company® (CSC®).

While the requirements for who can serve as an independent director vary slightly among lenders, there are several common requirements. Typically, an independent director must not have a legal or beneficial ownership interest in the SPE or its affiliated entities; must not be a member, manager, creditor, customer, supplier, or other person who derives substantial income from the SPE or its affiliated entities; must not be a member of the immediate family of any of the foregoing; and must not be a person or entity controlling or under common control with any of the foregoing.

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Common requirements for independent directors

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Copyright ©2016 Corporation Service Company. All Rights Reserved.CSC is a service company and does not provide legal or financial advice. The information presented here is for

informational purposes only. Consult with your legal or financial advisor to determine how this information applies to you.

CSC is an industry leader in providing comprehensive solutions for special purpose entities to corporations, law firms, financial institutions, and private equity firms. Solutions include corporate office and governance services, international special purpose vehicles, and passive investment company services. CSC is also able to provide experienced independent directors who are knowledgeable about the intricacies of distressed situations and the fiduciary duties of corporate directors.

CSC and its wholly owned subsidiary, Delaware Trust®, provide a full suite of trust and agency, independent director, private equity networking, and special purpose entity services to corporations, law firms, financial institutions, and private equity firms. Think of us as a boutique provider of customizable services, with an expert team ready to assist you from pre-closing through completion of your deal.

Alli Gerhart is associate general counsel for Corporation Service Company. Prior to joining CSC, Alli was an associate at Richards, Layton & Finger where her practice included advising and rendering legal opinions on the formation and operation of Delaware special purpose entities.

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