If you are business person looking to obtain a loan to purchase commercial real estate, the lender may require you to hold the property in a single purpose entity (typically a limited liability company (“LLC”) or corporation). If you are a lender in a position to finance your borrower’s commercial acquisition, it is often an advisable move to have the borrower establish a single purpose entity which owns the property. But what exactly is a single purpose entity, why are they often an important part of the real estate transaction, and how are they legally established?
A single-purpose entity, not to be confused with its more expansive relative, the special-purpose entity (both commonly abbreviated as “SPE”), in the context of a commercial real estate transaction, is a limited liability company or corporation that holds title to particular real estate in which the financing lender holds a mortgage but which has no other assets or liabilities. Often the SPE will contract with a second company with the same owners that will manage the property, handle the tenant leases, take care of business operations, and incur all liabilities associated with managing the commercial real estate, or it will hire a third party management company to fulfill this role. This SPE structure is often required by lenders because it insulates the lender’s collateral (the property on which they have the mortgage) from claims by any other creditors and restricts the business activities of the owning entity, thereby protecting the lender, and the SPE owners alike, from unrelated claims by third parties looking to target the subject property as a source of recovery.
For example, let’s say the borrowing company that will own the subject property is a general purpose LLC, called ABC, LLC. The lender provides the purchase money loan to ABC, LLC which is secured by a first position mortgage on the property. ABC, LLC was formed by its owners shortly before the loan transaction and at the time the entity was not engaged in other activities. But since there are no formal business activity restrictions on ABC, LLC, the owners later decide to also use the entity to start a trucking company. One of the trucking company’s drivers negligently causes a horrible accident and ABC, LLC gets sued by several injured parties, and the damages exceed the trucking company’s liability policy limits. Suddenly, there are numerous judgment creditors filing liens against ABC, LLC’s real estate on which Lender has its mortgage. The lender’s mortgage is still in paramount position on title, but there are still myriad ways this scenario and numerous other scenarios can cause headaches for the lender with respect to its collateral, especially if the fallout from the accident causes financial catastrophe for ABC, LLC, which then ends up filing for Chapter 11 bankruptcy reorganization.
This is another key feature to an SPE: special bankruptcy circumstances. Since the SPE will only have one creditor – the lender – if the SPE files for bankruptcy, it is much easier for the lender to lift the automatic stay and proceed with foreclosure, because it has the one and only vote for bankruptcy issues such as approving the SPE’s plan of reorganization under Chapter 11. If there are numerous other creditors, they could potentially force the lender into a “cram-down” situation where, despite having a first-position mortgage on the property, the lender may have to submit to a plan of reorganization that is not in its best interests due to the dynamics at play with the other creditors in the bankruptcy proceeding.
Lenders can even take it to the next level and require the SPE to be “bankruptcy remote”. A bankruptcy remote LLC is one in which it is required that the LLC have the affirmative approval of an “independent” manager or director of the entity in order for it to have authority to file bankruptcy in the first place. Typically for a manager or director to be deemed “independent”, they must not have any direct or indirect ownership interest in the entity, either at the time or at any time within several years prior to their involvement in the entity. For many SPEs that are commonly managed by only one or two individual owners, the requirement to maintain a separate “independent” manager can become an overwhelming burden.
So what features must exist for an entity to be legally recognized as a “Single Purpose Entity”? Since the essence of an SPE is that it is an entity that exists for only one purpose, e.g., for the ownership and operation of a particular piece of commercial property, the most fundamental of elements of an SPE is a good “purpose clause”. There are variations of the common provisions of a purpose clause, but essentially it must achieve the desired effect of explicitly noticing the existence of restrictions on the rights of the SPE to undertake activities that would otherwise be allowed by a general-purpose legal entity. The purpose clause should be included in a public document, such as in the entity formation documents filed with the secretary of state’s office. This may not always be practical for lenders to insist upon, but at the very least, it should be drafted into the set of loan documents, usually in the loan agreement. In addition to the purpose clause, lenders should also require a set of covenants designed to sharpen the separation between the SPE and any other entity or affiliates, such as anti-comingling of assets and prohibition on guaranteeing obligations of other entities, or a requirement for the SPE to maintain its own tax identification number and have its own bank accounts. Lenders may also require restrictions on other actions that general purpose entities may usually undertake, such as the ability to incur additional debt or the right to voluntarily seek bankruptcy protection. There are a common range of elements associated with SPEs, but there is no exact set of uniform criteria for qualification as an SPE.
As one might expect, depending on the nature of the covenants, restrictions, and other hoops the SPE entity and its owners are expected to jump through, the costs for compliance with SPE requirements can become increasingly burdensome, especially when the SPE is expected to secure an independent manager to maintain bankruptcy remoteness. As with most things, there is a tradeoff between what the lender needs to require to ensure adequate SPE protection, and the tolerance the borrowing entity will exercise in the spirit of securing the financing it desires, which will largely depend on the nature of the particular circumstances and size of the transaction. In general, it is advisable for a lender to ask that the entity owning the property become an SPE, and by the same token, SPE structuring by the entity owners is often advisable, and is commonly utilized by sophisticated business people as a valuable form of asset and liability protection.