Independent Director Tacitly OKs Bankruptcy by Silent Ratification

Over the years, the real estate ­industry relied heavily on securitization vehicles to finance commercial real estate projects. The loans are ­packaged and then sold in pools to investors. Various mechanisms have been developed to ­facilitate collection of the loans without the uncertainty of a borrower bankruptcy filing that could delay and increase the costs of collection. Lenders in these secured transactions often use special purpose entities, or SPEs, to attempt to limit the risk of a borrower bankruptcy filing. While these structures can vary, the concept is to create a separate corporate entity whose only ­purpose and asset is the one real estate project, and the only significant obligation is the mortgage loan. The SPE is isolated from the financial affairs of the corporate parent or affiliates. The lender requires the borrower to appoint an independent director to the board from a mutually acceptable source, and unanimous board approval for certain key decisions, such as the decision to file for bankruptcy. Consequently, a lender is able to reduce the risk of delay after default and high costs of collection, and the ­borrower benefits from lower interest rates and fees from the lower cost loan.

A number of companies now provide independent directors to serve on these SPE borrower boards. These individuals are often professionals with experience in secured transactions. The idea is that they will use that experience in a crisis and, presumably, head off ill-advised or ­impulsive decisions by the developer/owner. The ability of such an independent director not to approve a borrower decision to file a bankruptcy case was addressed recently in a decision by the U.S. Bankruptcy Court for the Northern District of West Virginia in In re Tara Retail Group, Case No. 17-bk-57 (May 4). In that case, an independent director who never affirmatively voted in favor of authorizing the filing of a bankruptcy case was found to have tacitly ratified the borrower’s ­decision to file when the independent director remained silent and did not object after the case was filed.

The Debtor Sinks After the Flood