Steve Whelan 2016-11-15 05:53:10
SECURITIZATION OF EQUIPMENT LEASES AND LOANS continues to provide a robust form of capital for many ELFA members. One critical element of a successful transaction is the establishment of a bankruptcy-remote, special purpose entity (SPE, typically a limited liability company, or “LLC”) to own the assets and issue the asset-backed securities (ABS). Two recent court decisions have overturned creditor efforts to interpose a special or independent member for the express purpose of blocking a Bankruptcy Code filing.
Voluntary Petition. In re Lake Michigan Beach Pottawattamie Resort LLC, decided in April 2016 by a Bankruptcy Court in Chicago, upheld the filing of a bankruptcy petition despite the refusal of the Special Member to authorize any such “Material Action,” as required by the operating agreement of the LLC. The Special Member had been imposed by the lender to the LLC (whose loan was collateralized by a mortgage on the resort property of the LLC) as a condition to its forbearance from pursuing remedies following the LLC’s default on the loan. The lender was appointed as the Special Member but had “no duty or obligation to give any consideration to any interest of or factors affecting the Company or the Members.”
When the LLC again defaulted on the loan, the lender commenced foreclosure on the collateral. On the day before the foreclosure sale was to have occurred, the LLC petitioned for relief under the Bankruptcy Code, thereby blocking the sale and any other remedies that the lender might take. The lender sued to dismiss the bankruptcy case on the grounds that the LLC had not complied with its operating agreement requirement for the lender to approve such a Material Action.
The court construed the Special Member section of the operating agreement as lacking the “essential playbook for a successful blocking director structure…the director must be subject to normal director fiduciary duties” and able to “vote in favor of a bankruptcy filing, even if it is not in the best interests of the creditor that they were chosen by.” The court ruled that the Special Member provision was void. The bankruptcy petition hence was duly authorized and the lender’s motion to dismiss was denied.
More OverReaching. Similarly, in June 2016 In re Intervention Energy Holdings, LLC ruled that “a limited liability company governance document obtained by contract, the sole purpose and effect of which is to place into the hands of a single, minority equity holder the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor—not equity holder—and which owed no duty to anyone but itself in connection with an LLC’s decision to seek federal bankruptcy relief, is tantamount to an absolute waiver of that right, and…is void as contrary to federal public policy.”
In that controversy, the LLC operating agreement issued one common unit in the LLC to the lender and the approval of all common unit holders would be required “prior to any vol- untary filing for bankruptcy protection.” Th e Bankruptcy Judge in Delaware concluded that the blocking arrangement constituted nothing less than “an absolute waiver by the LLC of its right to seek federal bankruptcy relief” and ruled that the bankruptcy proceedings were validly authorized by the LLC, notwithstanding the refusal of the lender to vote its common unit in favor of that action.
ABS sponsors and investors must beware of overreaching.
Takeaways. A properly structured Equipment ABS transaction should
have the independent director or member not waive its statutory duties;
call for unanimous votes for a broader range of major decisions and not just a bankruptcy petition (as was the case with Intervention Energy); and
have unanimous vote requirements not expire until all ABS have been repaid.
Involuntary Petition. A well-structured ABS deal also will try to limit the possibility of an involuntary petition against the SPE. Typically, the sponsor will construct the transaction so that the SPE only deals with a limited universe of counterparties, consisting of the seller and servicer of the assets, plus the indenture trustee and purchasers of the ABS. Each of those entities will be required, in the transaction documents that it signs, to agree not to join in the filing of an involuntary petition against the SPE, for at least one year aft er all ABS have been repaid. Investors and rating agencies insist upon these “non-petition” clauses.
Late in 2015, an SPE issuer, Zohar CDO 2003-1, Ltd., defaulted on principal and interest payments due to its ABS noteholders. Th e bond insurer paid principal and interest to senior noteholders at the November 20, 2015, maturity of the notes, and hence became the controlling creditor, entitled to sell the assets of the SPE by reason of Zohar’s default in payment of the notes. Two days later the largest holder of the remaining, subordinated notes filed an involuntary petition against Zohar, to prevent what it perceived to be a disadvantageous foreclosure on Zohar’s collateral.
At a January 2016 hearing on Zohar’s motion to dismiss the involuntary petition, the bankruptcy court concluded that a further hearing was needed to determine whether the noteholder’s nonpetition covenant could be enforced specifically or whether its breach simply would subject it to an action for damages. Ultimately, the Subordinated noteholder withdrew its petition against Zohar before the court could issue a definitive ruling on enforceability of the covenant, thereby leaving the question unanswered, but ABS practitioners are confident that nonpetition clauses can be written to survive a more vigorous challenge.
It is inevitable that frustrated subordinated borrowers or creditors will attack measures intended to guard against the possibility of an SPE bankruptcy. Th e lesson from recent cases is that sponsors and investors need to avoid overreaching in their efforts to minimize the possibility that an SPE issuer of ABS debt could become subject to Bankruptcy Code proceedings.
Stephen T. Whelan is a partner in the New York office of law firm Blank Rome LLP and a member of the ELFA Board of Directors.
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