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In the aftermath of the Enron collapse, single purpose entities (SPEs) have been portrayed as tools of corporate villains, used to conceal financial information from investors. Despite these images, however, using SPEs is not intrinsically wrong or misleading. Lenders customarily require that the real estate projects they finance be owned by SPEs. In this context, use of the SPE structure is designed to confine the lender’s risk to the particular real estate asset being financed and to avoid the problems encountered when a borrower with multiple assets files a bankruptcy petition. Generally, the borrower will establish an SPE for the sole purpose of owning, constructing and operating the project. Most often, it will take the form of a limited partnership or limited liability company, due to the liability and tax benefits associated with such entities. PREMISE OF THE NONRECOURSE BARGAIN The loan to an SPE is typically on a nonrecourse basis: The lender has recourse to the real estate but, absent certain “bad boy” exceptions, cannot collect any deficiency from the borrower. The premise of the nonrecourse bargain with the borrower is that in the event of the borrower’s default, the lender will be able to foreclose on and realize the value of its collateral. That result is, in turn, premised on the assumption that an SPE is “bankruptcy remote.” However, that assumption could prove to be a misconception. To a certain extent, the use of an SPE does provide bankruptcy protection. The SPE structure will, in fact, isolate the property from other assets and focus the bankruptcy risk on the specific property. However, SPEs can and do seek refuge in Chapter 11, triggering the automatic stay provision that protects the property from foreclosure and placing the amount of the secured lender’s claim at risk. SPEs employ a number of strategies in Chapter 11 proceedings. However, there are techniques lenders employ to protect their interests, both in structuring an SPE transaction to vitiate the Chapter 11 risks and in response to a Chapter 11 filing. COMMON TACTICS USED BY DEBTORS � Vote Gerrymandering. One tactic, vote gerrymandering, enables a debtor to “cram down” a reorganization plan against the will of the secured lenders — i.e., to bind the secured lenders to a plan that they vote against. To determine the amount of a lender’s secured claim, the bankruptcy court first determines the fair market value of the real property based on expert testimony and affidavits. Typically, the fair market value will be considerably less than the total amount owing to the secured lender — otherwise a bankruptcy filing probably would not have taken place. As a result, the secured portion of the lender’s claim is established to equal the fair market value of the property as determined by the court. In addition, the secured lender holds an unsecured deficiency claim representing the difference between the outstanding principal amount of the loan and the fair market value of the property. Substantially all the SPE’s unsecured debt will consist of this unsecured portion of the secured lender’s claim. SPEs generally have only a few trade creditors as other unsecured creditors. In order to achieve a cram down of a reorganization plan, the debtor must gain the affirmative vote of at least one class of impaired unsecured creditors. Accordingly, the creation of an impaired class of creditors, separate from the lender’s deficiency claim, is imperative to the SPE. The Bankruptcy Code provides that a plan may place a claim or interest in a particular class only if that claim or interest is “substantially similar” to the other claims or interests in the class. Invariably, therefore, a debtor’s plan of reorganization will classify the lender’s unsecured deficiency claim as “substantially dissimilar” from any trade creditors’ claims, thereby establishing two classes of unsecured creditors. Each class also will be impaired. The approval of the reorganization plan by only one of those classes is necessary. The debtor will structure the reorganization plan in a way that is sufficiently advantageous to the unsecured trade creditors so that they will vote for and approve the plan. If the court confirms the plan, the strategy allows the debtor to limit the post-reorganization secured debt to the fair market value of the property as determined by the court, and to pay the secured lender only a small portion of the value of its unsecured deficiency claim. The Bankruptcy Code provides little guidance with respect to claims classification, and different courts have taken different approaches to the issue. Efforts to provide a legislative solution have so far proved unsuccessful. � The New Value Exception. Using the new value exception to the absolute priority rule is another strategy often employed by SPEs. The new value exception allows the owners of an SPE to reduce or eliminate the lender’s unsecured deficiency claim while retaining their interest in the debtor by infusing “new value” in the form of new capital. The absolute priority rule, codified in the Bankruptcy Code at 11 U.S.C. � 1129, requires a reorganization plan to provide for full payment of all other claims before the equity holders can receive any interest in the reorganized debtor. The new value exception, however, provides a way around the absolute priority rule, enabling equity holders to retain an interest in the debtor and to cram down a reorganization plan without paying all other claims in full. A judicially created doctrine, the new value exception enables equity owners to retain their ownership interests if they contribute capital that is “new,” “substantial” and “necessary” for the reorganization of the debtor, and that is “reasonably equivalent” to the value they retain under the reorganization plan. The value contributed must be in the form of money or “money’s worth.” Courts recognizing the new value exception reason that the former equity holders do not receive an interest “on account” of their equity claim, which would violate the absolute priority rule, but rather because they have infused the debtor with new capital to ensure its survival. The existence of the new value exception is one of the primary reasons for an SPE to seek Chapter 11 protection. Were it not for the ability of the equity owners to effectively retain their ownership interests in the borrower, Chapter 11 would have little value to the owners other than delaying the inevitable lender foreclosure. Lenders, on the other hand, argue that there is significant unfairness in allowing the equity owners of a single-purpose borrower to infuse funds that could have been used to pay down the debt. Compounding the confusion is the fact that the case law generally does not provide clear definitions of terms such as “new,” “substantial” and “necessary.” In an effort to reduce litigation by eliminating court battles over these ambiguous terms, the National Bankruptcy Review Commission proposed an objective standard whereby equity holders could retain their owners hip interest only if they make a cash contribution that pays the principal amount of the secured claim down to 80 percent of the value of the property. Congress has not yet promulgated legislation incorporating the proposal. LENDER STRATEGIES IN SPE BANKRUPTCY FILINGS � The Bad Faith Filing. Once the Chapter 11 petition has been filed by an SPE, there is a variety of strategies lenders can employ to attack the filing. The existence of bad faith in commencing or prosecuting a bankruptcy case constitutes cause for either dismissing the case or granting relief from the automatic stay. Bankruptcy courts employ no particular test to determine bad faith; rather, they use their equitable discretion to apply several tests and to examine several key factors. A finding of bad faith is based on the facts. The court inquires into the “totality of circumstances” to determine whether the purposes of the Bankruptcy Code would be furthered by permitting the Chapter 11 petitioner to avail itself of the protections of Chapter 11, or whether the petition was filed with an intent to abuse the judicial process and the purposes of reorganization. Most courts use a two-pronged test — combining an “objective futility” test with a “subjective bad faith” test — and require the presence of both elements for a finding of bad faith. The objective futility test is designed to ensure that there is some relation between the bankruptcy filing and Chapter 11′s statutory objective of resuscitating a financially troubled debtor. Under this test, a plan is deemed to have been proposed in bad faith if there is no realistic possibility of reorganization. The key factors in assessing objective futility include whether there is a going concern to preserve pursuant to the plan, whether there are employees to protect (other than the principals) and whether there is true hope of rehabilitation on a financial basis. With respect to subjective bad faith, the courts have identified several recurring but nonexclusive fact patterns from which bad faith may be inferred. The aim of the subjective bad-faith inquiry is to determine whether the petitioner’s real motivation is to abuse the reorganization process and to cause hardship or delay to creditors by resorting to the Chapter 11 process. A lender could argue, based on a review of both tests, that any filing by an SPE would be in bad faith. However, because the inquiries are factual and based on the totality of the circumstances, and because the courts and judges vary in their degree of pro-debtor leaning, it is often difficult to predict the outcome of bad faith decisions. PURCHASING TRADE CREDITOR CLAIMS Purchasing the claims of trade creditors is perhaps the most effective means secured lenders use to combat Chapter 11 filings by SPEs. In a recent case, a fully secured creditor employed this strategy successfully after a debtor proposed to repay a loan at a disputed interest rate by purchasing 21 of the 34 unsecured trade claims and voting to reject the debtor’s plan. In ruling that the creditor did not act in bad faith, the court stated that “creditors are not expected to approach reorganization plan votes with a high degree of altruism and with a desire to help the debtor and their fellow creditors.” This strategy can be employed by any secured creditor in a bankruptcy proceeding in which a cram down may be a likely outcome, and it is the most effective action a creditor can take in response to the cram down strategy of the debtor. STRUCTURING TRANSACTIONS TO REDUCE BANKRUPTCY RISK A lender’s strategies with regard to an SPE’s Chapter 11 filing are not limited to action taken after the bankruptcy filing occurs. Some of the most effective techniques are those put in place at the time the loan is structured. One method of reducing bankruptcy risk is to structure the loan so that in the event of a bankruptcy filing, it becomes recourse to the borrower. This recourse obligation is then guaranteed by a party who directly or indirectly controls the borrower’s decisions, thus providing a significant incentive on the part of that guarantor to prevent a bankruptcy filing. Generally, a guarantor will accept this type of arrangement because the basic bargain with the lender of making the loan nonrecourse is that the lender has recourse to its collateral; a bankruptcy filing, designed to prevent the lender from having such recourse, violates and undermines the basic bargain. Another way a lender can protect itself is to impose a “bankruptcy remote” provision in the borrower’s corporate governance documents. Such provisions are commonplace in securitization transactions, since the existence of such a provision has a direct impact on how the transaction is rated by the rating agencies. In securitization transactions, the borrower is required to add to its corporate governance documents a provision requiring a unanimous vote of the board of directors in order for the borrower to file for relief under the Bankruptcy Code. Another provision requires the election of an “inde-pendent director.” While “bankruptcy remote” provisions would appear to provide absolute protection against the filing of voluntary petitions, such provisions are not “bankruptcy proof.” One bankruptcy court found that a debtor’s orchestration with its creditors of an involuntary bankruptcy filing, designed to circumvent the independent director’s ability to veto a voluntary petition, was not improper and did not serve as a basis for dismissal of the involuntary petition. In so ruling, the court stated that the independent director’s allegiance to the lender and failure to ratify an involuntary filing demonstrated an abdication of his fiduciary role, including to the creditors of the company, once the company approached insolvency. As a result of this case, borrowers generally designate an “independent director” who is approved by the lender based on objective criteria and who has no affiliation with either the borrower or the lender. LEGISLATIVE RESPONSE NEEDED The Enron controversy suggests that SPEs may be used by the unscrupulous in unconscionable ways to the detriment of investors and employees. But SPEs need not stray from the bounds of the law to deprive lenders of the benefit of their bargain. By seeking the protection of a Chapter 11 filing, an SPE can expose its lenders to significant, unanticipated risk and undermine the purposes for which Chapter 11 was enacted. On the more controversial issues, the Bankruptcy Code provides little guidance. Congress has considered taking action to restrict or eliminate the right of SPEs to seek Chapter 11 protection. Until such measures are enacted, however, lenders should try to lessen their bankruptcy risk by using strategies as discussed previously as they structure their transactions. David L. Dubrow is a partner and Daniel P. Conneen an associate in the business law department in the New York office of Arent Fox Kintner Plotkin & Kahn. They can be reached at [email protected]and [email protected].

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