The Not-So-Remote Possibility of the Bankruptcy of a Bankruptcy Remote Entity

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. Continue Reading

Revised Pennsylvania Statute Creates Power of Attorney Chaos

The Pennsylvania Legislature enacted extensive changes to Title 56 of the Decedents, Estates and Fiduciaries Code affecting powers of attorney, effective as of January 1, 2015. The amendments create a number of issues for creditors in commercial transactions and individuals and businesses engaging in the transfer of equity interests, bonds or other assets of a business.

The general rules applicable to execution of a power of attorney require, in part, that the power of attorney be acknowledged before a notary and witnessed by two individuals older than eighteen years of age. Prior to the recent amendments, Title 56 exempted from the notary acknowledgement and witness requirements certain transactions including:

  • powers granted to or for the benefit of creditors in commercial transactions,
  • a power granted for the sole purpose of facilitating the transfer of stock, bonds or other assets,
  • a power contained in a governing document for a corporation, partnership, limited liability company or other legal entity by which a director, partner or member authorizes another to do things on behalf of the entity; and
  • a warrant of attorney to confess judgment.

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Dead Hand Provisions: A Lesson for Lenders from the Delaware Chancery Court

In Pontiac General Employees Retirement System v. Ballantine, et al., the Delaware Chancery Court refused to dismiss a claim against a lender for aiding and abetting a breach of fiduciary duty by the borrower’s directors. The claim was based on a “dead hand proxy put” provision in the credit agreement, which defined “continuing directors” – for purposes of determining whether there had been “change in control” – to exclude any director nominated in connection with, or as a result of, a dissident-proxy challenge (actual or threatened), even if the then-current directors ultimately approved their appointment.

The court rejected the Lender’s argument that it did not “knowingly participate” in the alleged breach because the credit agreement was negotiated at “arm’s-length”. The court stated that:

[W]hen you are an arm’s-length contractual counterparty, you are permitted, and the law allows you, to negotiate for the best deal that you can get. What it doesn’t allow you to do is to propose terms, insist on terms, demand terms, contemplate terms, incorporate terms that take advantage of a conflict of interest that the fiduciary counterparts on the other side of the negotiating table face.

The court also stated its prior opinions were sufficient to put the lender “on notice” that such provisions were “highly suspect and could potentially lead to a breach of duty on the part of” a borrower’s directors.

In light of this recent development, administrative agents and lenders need to reconsider the legal risk in incorporating these types of change of control provisions in new facilities and when amending, modifying or joining any existing facility.

Alternative Investment Vehicles & Subscription Facilities: A look at Protecting Lenders’ Collateral

Private funds often seek subscription facilities for short term bridging of capital calls in order to, among other things, avoid the need to call capital in advance of closing an investment and backstop late capital call proceeds from the fund’s limited partners.  As collateral, lenders providing such facilities receive a security interest in investors’ capital commitments, capital contributions and the general partner’s right to make capital calls on the investors and enforce payment thereof. 

A common issue for lenders arises when a fund creates Alternative Investment Vehicles (“AIVs”).  In this instance, capital can be called from investors by a general partner of the AIV to finance investments, regardless of whether the AIV is a borrower or whether the investment is financed with proceeds of the subscription facility or not.  Two primary market approaches have developed to protect the lender’s security interest in this instance:

  1. Incurrence and Maintenance Covenants.  The first approach is to require that a borrowing base test be satisfied at the time of making a loan (“incurrence”) as well as at all times the loan is outstanding (“maintenance”).  The ratio for the financial test is set at an amount derived from the lender’s internal financial models to ensure sufficient collateral coverage; the level of risk associated with this ratio may also affect pricing for the transaction.  The ratio should be set at the level at which the lender is no longer comfortable that the commitments will be sufficient to repay the loans in full.
  2. Require all existing and future AIVs to become Borrowers.  Under the second approach, all AIVs are joined as borrowers (and any future AIVs are required to become borrowers).  Each AIV-borrower is severally liable for the amounts it borrows, and each AIV pledges to the lender the account into which the proceeds of the capital calls will be remitted and the general partner pledges its rights and remedies with respect of such call capital.

Although the second approach is often appealing to lenders, it will include additional time and financial expenses for later AIVs formed.  Moreover, this option still allows an AIV-borrower to call capital, diminishing the total unfunded capital commitments, for investments not financed with loan proceeds (but funded with the cash from the capital call itself).  Because of the several nature of the loans, having an AIV as a borrower does not allow the lender to call capital of that AIV to pay loans of other borrowers – rather, only to repay loans made to the particular AIV.  If the AIV borrows no funds, no capital call of its investors would be made to repay the loans. 

For these reasons, the general protections for a lender making a subscription facility available to a private fund are the incurrence and maintenance covenants described above.  As a business matter, the lender should ensure the ratios of those covenants provide sufficient collateralization of loans to be made under the facility, such that even if unpaid capital were called for non-loan purposes, there is still sufficient collateral remaining to proceed against.  Although joining all AIVs as borrowers is an approach taken in the market, lenders and their counsel should examine whether the benefits provided to the lender offset the additional cost of joining such entities.

What now for banks in the physical commodities sector?

Banks play an important business role in the physical commodities sector by providing the much needed access to capital and related risk management, including through:

• extension of credit;
• project finance;
• market making and liquidity;
• risk management and hedging; and
• fostering competition.

These services are especially important to small and medium-sized companies that do not have the in-house cash flows, expertise or risk management capabilities of their larger competitors.
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Make Whole Provisions in Bankruptcy

Loan agreements and bond indentures often contain “make-whole” provisions, which provide yield protection to lenders and investors in the event of a repayment prior to maturity. They accomplish this by requiring the borrower to pay a premium for pre-payment of a loan. This allows lenders to lock-in a guaranteed rate of return when they agree to provide financing. Borrowers also benefit since the yield protection allows lenders to offer lower interest rates or fees than they would absent such protection.

As contractual provisions, lenders and investors expect make-whole provisions to be enforceable according to their terms. But, what happens if the borrower files a bankruptcy petition?

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What’s in a Name? Amendments to the Uniform Fraudulent Transfer Act

On July 16, 2014, the Uniform Law Commission (the “Commission”) approved a series of discrete amendments to the Uniform Fraudulent Transfer Act (the “UFTA”) and renamed it the Uniform Voidable Transactions Act (the “UVTA”). The UVTA is intended to address inconsistency in the courts, better harmonize with the Bankruptcy Code and the Uniform Commercial Code (the “UCC”), and provide litigants with greater certainty in its application to a fraudulent transfer action. While the amendments are not intended to completely overhaul the UFTA, there are three categories of noteworthy updates, each highlighted below.

Background

Under the UFTA, a “fraudulent transfer” exists when a debtor transfers property to a third party with the intent to hinder, delay or defraud its creditors, or, if the debtor was insolvent at the time of the transfer, the debtor received less than reasonably equivalent value for such property. The UFTA, as adopted by the individual states, provides a remedy for creditors against such third-party transferees by allowing a fraudulent transfer to be “voided” and treated as if it never happened. Consequently, the value of the property is returned to the debtor or its estate. Continue Reading

What Happens to Your Collateral During a Bankruptcy?

This post was written by Michael J. Venditto and Sarah K. Kam.

Lenders and their attorneys are conditioned to believe that being over-secured is as good as life gets for a creditor.  Lenders want to secure repayment with collateral that is valuable and liquid, while their attorneys ensure that the security interest is properly perfected.  But, post-closing confidence in a job well done can quickly evaporate if the borrower files a bankruptcy case intending to sell the collateral.

Is it true that a debtor can sell collateral without the lender’s consent?   Yes, under the Bankruptcy Code it can be done ‒ even if the collateral is sold for less than the amount of outstanding debt.  So, a secured creditor must be proactive if a distressed borrower tries to sell the collateral in a bankruptcy.  Continue Reading

Distressed Over Eligible Assignees: Who’s In, Who’s Out in Meridian Sunrise Village

 This post was written by Jonathan Korman and Bart Cicuto.

A recent decision out of the U.S. District Court for the Western District of Washington will be of interest to both lenders and borrowers of loans that are expected to be traded. In Meridian Sunrise Village, LLC v. NB Distressed Debt Investment Fund Limited, hedge funds found themselves excluded from the definition of “Eligible Assignee” under a loan agreement when the Court narrowly interpreted the meaning of “financial institutions” to exclude a distress debt fund. The Court equated “financial institutions” with “entities that make loans” rather than any entity that manages money, such as a hedge fund, ultimately resulting in the fund’s inability to vote for a Reorganization Plan.

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A $1.8 million Drafting Lesson

In a typical case of distressed borrower where the lender was left holding the unpaid debt bag,  the Fifth Circuit Court of Appeals chimed in on the hotly debated and litigated prepayment premiums litigation. In re Denver Merchandise Mart, 740 F.3d 1052 (5th Cir. 2014).  The lender was secured, with the accelerated $24 million note and the alleged prepayment penalty of $1.8 million. Not outrageous considering it was 7.5% of the outstanding principal whereas other courts enforced a 37% prepayment premium in In re School Specialty, 2013 WL 183851, at *2 (Bankr. D. Del. April 22, 2013) So why did the court send the lender home without a prepayment penalty? and 25% in In re Financial Center Associates of East Meadow, L.P., 140 B.R. 829, 839 (Bankr. E.D.N.Y. 1992).

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