A bankruptcy remote entity is a special-purpose vehicle (or special purpose entity) (“SPV”) that is formed to hold a defined group of assets and to protect them from being administered as property of a bankruptcy estate. See Paloian v. LaSalle Bank Nat’l Assn (In re Doctors Hospital of Hyde Park, Inc.), 507 B.R. 558, 701, 702 (N.D. Ill. 2013). Bankruptcy remote entities are intended to separate the credit quality of assets upon which financing is based from the credit and bankruptcy risks of the entities involved in the financing. See id. However, “bankruptcy remote “does not necessarily mean “bankruptcy proof.” Lenders should recognize the bankruptcy risks that cannot be eliminated, even if the borrower is bankruptcy remote entities.

Bankruptcy Remote Entities

To achieve bankruptcy remote status, the borrower must be legally separate from all affiliated entities. Id. Amongst other things, the borrower should have its own organizational documents, maintain all corporate formalities, maintain separate books and records, maintain separate accounts, prepare separate financial statements, avoid commingling of its assets with those of any other person, act solely in its own corporate name and through its own officers and agents, and conduct only arm-length transactions with affiliated entities. Id. The SPV should also be prohibited from incurring debt or other obligations, and limited in its purpose and the activities in which it may engage. The SPV’s sole asset is frequently the property securing a loan or debt obligation and its sole purpose should be to own and manage that property. The corporate documents may also attempt to create impediments to a bankruptcy filing. For example, they may impose limitations on the directors ability to authorize a bankruptcy filing. These restrictions reduce (but do not eliminate) the risk that the SPV will file for bankruptcy, be forced into bankruptcy, or otherwise be adversely affected by a bankruptcy of its affiliates.

Bankruptcy Remote Entities May File for Bankruptcy

Despite restrictions on the ability to file for bankruptcy, bankruptcy courts have permitted remote entities to file for bankruptcy over their lenders’ objections. For example, in General Growth Properties Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), the debtors comprised a large commercial real estate enterprise. The debtors’ affiliated entities included numerous bankruptcy-remote SPVs. The lenders believed that the SPVs were bankruptcy-proof because their independent directors were picked by the lenders could not authorize a bankruptcy filing without the lenders’ consent. The bankruptcy court, however, found that this belief was misplaced. Id. at 65 (“if Movants believed that an ‘independent’ manager can serve on a board solely for the purpose of voting ‘no’ to a bankruptcy filing because of the desires of a secured creditor, they were mistaken.”). Directors and managers owe their duties to the SPV and, ordinarily, to the shareholders. Prior to the General Growth bankruptcy filing, the debtors replaced the independent directors of the SPVs with new directors who then authorized the bankruptcy filings without the lenders’ consent. After the filing, the secured lenders asked the bankruptcy court to dismiss the cases on the grounds that they had been filed without authorization and in bad faith. Although many of the SPVs did not need bankruptcy relief, the bankruptcy court denied the motion to dismiss, holding that the interests of the enterprise as a whole could be considered in determining whether to file individual SPVs.

Bankruptcy Remote Entities May be Forced into Bankruptcy Through Substantive Consolidation

Bankruptcy courts have also forced bankruptcy remote entities into bankruptcy through substantive consolidation with the bankruptcy estates of affiliated entities. See Westlb AG v. Kelley, 514 B.R. 287, 291 (D. Minn. 2014); see also Bank of N.Y. Trust Co. v. Official Unsecured Creditors Comm. (In re Pac. Lumber Co.), 584 F.3d 229 (5th Cir. 2009). Although regarded as an extreme and unusual remedy, bankruptcy courts have the equitable power to substantively consolidate the assets and liabilities of numerous distinct legal entities and treat them as if they belong to one single entity. The goal of substantive consolidation is to effect a more equitable distribution of property among creditors. Although there is no clear standard, in deciding whether entities should be consolidated in bankruptcy, courts have applied a highly fact specific analysis which consider compliance with corporate formalities, separateness of decision-making, separateness of operations (including offices and financial statements), possession of assets, and whether the entities acted at arms-length in their dealings. This may leave SPVs, particularly those that have not scrupulously adhered to the organizational and operational requirements, susceptible to consolidation with affiliated debtors.

Assets of a Bankruptcy Remote Entity May be Sold

Once the assets of a bankruptcy remote entity are within the jurisdiction of the bankruptcy court, the bankruptcy court can authorize the sale of the lender’s collateral under section 363 of the Bankruptcy Code, free and clear of the lender’s liens. The requirements for selling assets free and clear of a lender’s security interests are easily satisfied and a bankruptcy court has broad discretion to conduct a sale in the manner it deems most appropriate. Because the goal of a bankruptcy sale is to realize the highest value for assets, a bundled offer to purchase assets of the SPV together with assets of affiliated debtors could be held to be higher and better than a credit bid of the SPV lender under section 363(k) of the Bankruptcy Code, which would leave the lender with a lien on the proceeds of sale.

Conclusion

As the court observed in General Growth, the lender’s expectations about the efficacy of protections designed into a loan structure may be unreasonable. Or, a borrower may simply ignore loan covenants or corporate requirements. In either case, the result could be a bankruptcy filing by an entity that was thought to be bankruptcy remote. When that occurs, bankruptcy courts, as courts of equity, have the ability to fashion remedies that are at odds with the reasonable expectations of lenders when they structure and document a loan.