Single Purpose Entity (SPE), explained

SPEs: Protecting parent companies and lenders thorough the use of single purpose entities

A “single purpose entity” (“SPE”) is an entity, usually a limited liability company in the context of a real estate transaction, created by a parent company to isolate financial risk and provide increased security to any legal entity. The SPE’s legal status as a separate company makes its obligations separate from the parent company, even if the parent company goes bankrupt, and therefore insulates the lenders collateral from potential troubles of the parent company.

A simple “SPE” structure looks like the following:

The Parent Company creates an SPE for the sole purpose of owning the real property

(Most transactions would be more complicated above the SPE level, with several investors and/or a joint venture in place of a single “parent company.”)

The SPE owns the real property, but has no other assets or material liabilities (the SPE may sign service contracts and loan documents). If the property is financed, the mortgage lender will have a security interest in the real property. (In a financing with multiple layers, such as mezzanine financing, the mezzanine lender would have a security interest in the SPE, and not the real property.)  Often the SPE will contract with various parties, such as a property manager, construction manager, development manager, or other service providers, depending on the nature of the deal. The SPE will also directly enter into any leases or other occupancy agreements affecting the real property. The parent company enters into no direct agreements as they relate to the management or operation of the real property, thereby making both the SPE and the parent company “immune” from the liabilities and obligations of one another.

This SPE structure is often preferred by the parent company and required by lenders because (1) it protects the lender’s collateral (the real property) from claims by any other creditors, and (2) it isolates the business activities of the SPE, which protects the parent company (and thereby, any lender of the parent company) from claims by third parties (and limits them to the assets of the SPE, which is just the real property).

Example

The following is an example of how the parent company’s liability is limited. Parent company (PC) owns three properties, each of which is owned through a separate SPE. Property A is valued at $3,000,000, Property B is valued at $10,000,000, and Property C is valued at $100,000,000.  A third-party claim is made with respect to an event that occurred at Property A, and the claimant secures a judgment for $10,000,000.

Because Property A is in an SPE, the liability is limited to the value of the property: $3,000,000. However, if the PC owned all of the properties directly, without an SPE structure, the claimant could pursue payment of its judgment by liening Property B and Property C, thereby subjecting these unrelated properties to the liability of Property A. If you are a lender of the PC who made a loan for Properties B or C, that is obviously a terrible result.

Therefore, in order to isolate the liability of each of the PC’s properties, the PC should use an SPE structure, as illustrated below:

The parent company inoculates itself and each property by using an SPE for each property

Bankruptcy Remote

As stated above, there is also a bankruptcy benefit to lenders – and lenders often require that an SPE be “bankruptcy remote”. If the SPE files for bankruptcy, it is much easier for the lender to lift the automatic stay and proceed with foreclosure, because it is the SPE’s only creditor and therefore  has the only vote for bankruptcy issues such as approving the SPE’s plan of reorganization under Chapter 11. Additionally, if the parent company declares bankruptcy, the lenders lien against the real property may also be isolated from creditors, as the SPE can claim independence from the parent company and avoid being consolidated into the bankruptcy of its parent.

A bankruptcy remote entity is always an SPE, but not all SPEs are bankruptcy remote.  In order to be bankruptcy remote, an SPE must satisfy certain requirements, such as (1) inserting at least one director, general partner, managing member or controlling person who is not otherwise affiliated or associated with the borrower (often called “independent managers” or “independent directors”, whose primary purpose is to approve or disapprove a borrower’s bankruptcy filing); (2) being formed for the limited purpose of owning and operating specific real property; (3) holding itself out to the public as a separate legal entity distinct from any other person or entity; (4) maintaining its assets in a way that segregates and identifies them separately and apart from the assets of any other person or entity; (5) conducting business solely in its own name; and (6) holding no indebtedness other than a loan that is secured by a particular parcel of property and indebtedness for trade payables incurred in the ordinary course of business (in accordance with the loan documents). It’s important to remember that a “bankruptcy remote” entity is not bankruptcy proof; however, the inclusion of these provisions does help prevent the consolidation of the SPE into a bankruptcy of the parent company.

SPE Provisions

In order to ensure that an entity will be an SPE (and, if applicable, bankruptcy remote), a lender will often require that the owning entity covenant to adhere to certain “SPE provisions,” which provisions need to be integrated into the operating agreement of the owning entity. An example of “SPE provisions” is:

“Single Purpose Entity” shall mean a corporation, limited partnership or limited liability company which at all times on and after the date hereof:

(a)        is and will be organized solely for the purpose of acquiring, developing, owning, holding, selling, leasing, transferring, exchanging, managing and operating the Property (and no other property other than personal property that is necessary or incidental to the ownership, operation, and management of the Property), entering into financings regarding the Property such as the Loan Agreement with Lender and performing its obligations under the loan documents), refinancing the Property in connection with a permitted repayment of the Loan, and transacting lawful business that is incident, necessary and appropriate to accomplish the foregoing;

(b)       is not, and will not be engaged, in any business unrelated to the acquisition, development, ownership, management or operation of the Property;

(c)        does not have, and will not have, any assets other than those related to the Property;

(d)       will not engage in, seek or consent to, any dissolution, winding up, liquidation, consolidation, merger, sale of all or substantially all of its assets (unless such sale will result in the repayment in full of the Loan), transfer of limited liability company interests or amendment of certificate of formation or operating agreement (as applicable) with respect to the matters set forth in this definition;

(e)        [now is, and will be a limited liability company organized in the State of [Delaware] [Note – most commercial real estate loans require a Delaware SPE] that (i) has at least two (2) Independent Managers, (ii) will not cause or allow the members or managers of such entity to take any bankruptcy action or any other material action, either with respect to itself unless the two (2) Independent Managers then serving as managers of the company shall have consented in writing to such action, and (iii) has and shall have either (x) a member which owns no economic interest in the company, has signed the company’s limited liability company agreement and has no obligation to make capital contributions to the company, or (y) two (2) natural persons or one (1) entity that is not a member of the company, that has signed its limited liability company agreement and that, under the terms of such limited liability company agreement becomes a member of the company immediately prior to the withdrawal or dissolution of the last remaining member of the company;] [only applicable if Independent Managers are required]

(f)        is and intends to remain solvent and shall pay its debts and liabilities from its then available assets (including a fairly allocated portion of any personnel and overhead expenses that it shares with any affiliate) from its assets as the same shall become due, and shall maintain adequate capital for the normal obligations reasonably foreseeable in a business of its size and character and in light of its contemplated business operations; [Parent Company should push to clarify that this requirement will not require the parent company to make any capital contributions to the SPE]

(g)       will not fail, to correct any known misunderstanding regarding the separate identity of such entity and shall not identify itself as a division of any other person;

(h)       will maintain its accounts, books and records separate from any other person and will file its own tax returns, except to the extent required by reason of the fact that it is required to file consolidated tax returns by law or is treated as a disregarded entity and is not required to file a particular tax return;

(i)        will maintain its own records, books, resolutions and agreements;

(j)        (i) will not commingle, its funds or assets with those of any other person and (ii) will not participate in any cash management system with any other person;

(k)       will hold its assets in its own name;

(l)        shall conduct its business in its name or in a name franchised or licensed to it by an entity other than an affiliate of itself, except for business conducted on behalf of itself by another person under a business management services agreement that is on commercially reasonable terms, so long as the manager, or equivalent thereof, under such business management services agreement holds itself out as an agent of the owner;

(m)      will maintain its books, bank accounts, balance sheets, financial statements, accounting records and other entity documents separate from any other person and will not permit its assets to be listed as assets on the financial statement of any other entity except as required by general acceptable accounting principles or tax basis accounting using the accrual method as determined by owner or on another accounting basis reasonably acceptable to Lender;

(n)       will pay its own liabilities and expenses, including the salaries of its own employees, out of its own funds and assets, and will maintain a sufficient number of employees in light of its contemplated business operations; [Parent Company should push to clarify that this requirement will not require the parent company to make any capital contributions to the SPE]

(o)       will observe all limited liability company formalities;

(p)       will have no indebtedness (including loans, whether or not such loans are evidenced by a written agreement) other than (i) the Loan and (ii) unsecured trade and operational debt incurred in the ordinary course of business relating to the ownership and operation of the Property and the routine administration of owner, and which amounts are normal and reasonable under the circumstances;

(q)       will not assume or guarantee or become obligated for, the debts of any other person and will not hold out its credit as being available to satisfy the obligations of any other person;

(r)        will not acquire obligations or securities of its members or any other affiliate;

(s)        will allocate, fairly and reasonably, any overhead expenses that are shared with any person, including, but not limited to, paying for shared office space and services performed by any employee of any person;

(t)        now maintains and uses, and will maintain and use, separate stationery, invoices and checks bearing its name, which stationery, invoices and checks utilized by owner or utilized to collect its funds or pay its expenses shall bear its own name and shall not bear the name of any other entity unless such entity is clearly designated as being the owner’s agent;

(u)       except pursuant to the loan documents or any permitted encumbrances, will not pledge its assets for the benefit of any other person;

(v)       will hold itself out and identify itself, as a separate and distinct entity under its own name or in a name franchised or licensed to it by an entity other than an affiliate of owner and not as a division or part of any other person, except for services rendered under a business management services agreement with an affiliate that complies with the terms of this Agreement, so long as the manager, or equivalent thereof, under such business management services agreement holds itself out as an agent of owner;

 (w)     will not identify its members or any affiliate of any of them, as a division or part of it, and shall not identify itself, as a division of any other person;

(x)       will not enter into or be a party to, any transaction with its members or Affiliates except in the ordinary course of its business and on terms which are intrinsically fair, commercially reasonable and are no less favorable to it than would be obtained in a comparable arm’s-length transaction with an unrelated third party;

(y)       shall not enter into or be a party to, any transaction contract, or agreement with any of its members or affiliates except in the ordinary course of its business and on terms which are commercially reasonable terms comparable to those of an arm’s-length transaction with an unrelated third party;

(z)        shall not have any obligation to, and shall not indemnify its officers, directors or members, as the case may be, in each case unless such an obligation or indemnification is fully subordinated to the Loan and shall not constitute a claim against it in the event that its cash flow is insufficient to pay the Loan;

[(aa)     such entity’s organizational documents shall provide that no Independent Manager of such entity may be removed or replaced without cause and unless such person provides Lender with not less than three (3) business days’ prior written notice of (a) any proposed removal of an Independent Manager, together with a statement as to the reasons for such removal, and (b) the identity of the proposed replacement Independent Manager, together with a certification that such replacement satisfies the requirements set forth in the organizational documents for an Independent Manager;] [only applicable if Independent Managers are required]

If the SPE is not being formed at acquisition, the lender will often require a “recycled entity certificate,” which states that the SPE has and will continue to obey the SPE provisions.

Ultimately, the structure of the SPE in a typical commercial real estate financing secured by a mortgage will look like the following:

If using an SPE structure, only the SPE should contract with any entity with regard to the management or operation of the property

SPEs are just one method of limiting a party’s liability. A party may want to include an exculpation provision, “anti-sandbagging provision,” survival period, and basket and cap provisions to limit its potential liability.