When Assets Are 'Sold' to Special Purpose Entities

By Aaron R. Cahn, James Gadsden and Bryan J. Hall
May 27, 2011

The Seventh Circuit's decision in Paloian v. LaSalle Bank, N.A. (In re Doctors Hospital of Hyde Park Inc.) (“Paloian“), 619 F.3d 688 (7th Cir. 2010) sheds some new and perhaps disturbing light on the use of special purpose entity (“SPE”) structures in corporate finance and also has implications for attorneys who deliver opinions to support transactions involving SPEs.

SPE structures have long been useful to companies seeking to alter the composition of their balance sheet. When properly used, SPE structures are a valuable tool of modern corporate finance, permitting companies to obtain needed liquidity by monetizing otherwise illiquid assets on their balance sheet, particularly receivables. Unfortunately, SPE structures can also facilitate “aggressive” accounting by companies that use them to conceal debts by shifting them to off-balance-sheet SPEs. SPE structures played a key role in the financial maneuvering by Enron and others that ultimately unraveled in their highly publicized collapses.

While a company can, of course, always finance its own receivables, using the SPE device is often attractive to lenders and may result in a faster transaction on better terms. By lending to an entity whose only purpose is to purchase and then realize on the assets it obtains from the operating company, the lender won't need to concern itself with the overall financial condition of the operating company and run the risk that it might get caught up in a restructuring or even a bankruptcy of the company.

In that situation, the lender's ultimate recovery is likely to be delayed and possibly even diminished, since the delay may serve to dilute the value of the collateral, and the bankruptcy court may authorize the debtor to utilize the cash proceeds of the collateral to fund the expenses the debtor incurs in its bankruptcy case. See Bankruptcy Code, 11 U.S.C. ' 363(c)(2).

Typical SPE Structure

In a typical SPE financing structure, the beneficiary of the financing establishes an SPE subsidiary that will exist for the sole purpose of facilitating the financing.

The beneficiary, or seller, then sells the assets that it would otherwise use as collateral for a traditional secured loan to the SPE in exchange for cash. The SPE funds its purchase of the collateral by borrowing money from the lender in exchange for a promise of repayment and a security interest in the collateral. If all goes as planned, the SPE repays the loan from the proceeds of the collateral.

While the SPE, and not the seller, is the nominal borrower under the loan, the borrowed funds (recharacterized as sale proceeds) essentially flow through the SPE to the seller. However, because the SPE is a separate legal entity from the seller, it provides a layer of insulation between the lender and the seller's general financial situation. If the seller enters bankruptcy, the lender expects to be able to continue its dealings with the SPE without interference. Even if the SPE can no longer service the loan as planned, the lender typically can expeditiously enforce its security interest.

Therefore, while the lender in an SPE financing must consider and underwrite the risk that the collateral will decline in value, the lender has relatively little exposure to risks related to the seller's general financial condition.

In addition to allowing for better loan terms than could perhaps be offered in a traditional secured financing, SPE structures also facilitate securitized financing transactions, in which an institution (commonly known as the “originator”) makes a loan and sells securities (commonly known as “asset-backed securities” or “ABS”) representing fractional interests in the repayment proceeds of the loan to potentially numerous and widely distributed purchasers. The SPE structure's potential to control the scope of risks that a lender must consider and underwrite is particularly valuable to ABS purchasers, who typically cannot perform the comprehensive due diligence that is common among traditional secured lenders.

Yes, But Was It a Sale or Really a Loan?

However, in order to accomplish these goals, it is important that other parties, including a bankruptcy trustee, not have the ability to challenge the bona fides of the transaction between the seller and the SPE.

Historically, the concern has been to distinguish between a “true sale” of the assets to the SPE on the one hand, and a secured loan transaction on the other. If there has been a true sale, creditors of the seller will have no recourse against the assets sold to the SPE, while if the transaction is determined to be only a secured loan, courts will deem the seller to have retained interests in the assets and a trustee or other creditors may be able to undo the transaction.

To determine whether a transfer of assets to an SPE is a true sale, courts have traditionally focused on the economic substance of the transfer, particularly whether sufficient indicia of ownership of the assets shifted from the seller to the SPE, disregarding in the process the label that the parties attached to it. For a detailed discussion of the issues relevant to true sale determinations, see Comm. on Bankr. & Corporate Reorganization of the Ass'n of the Bar of the City of N.Y., “Structured Financing Techniques,” 50 Bus. Law. 527, 533, 542-47 (1995).

Some courts have structured their analysis as a totality of the circumstances test, while others have balanced enumerated factors, but in either case, their primary concern has been whether the SPE has gained a sufficient portion of the benefits of ownership of the transferred assets and assumed a sufficient portion of the related risks. The following are one court's concept of the principal factors that weigh in favor of recharacterizing a purported sale as a secured loan:

language of the documents and conduct of the parties;
recourse to the seller;
seller's retention of servicing and commingling of proceeds;
purchaser's failure to investigate the credit of the account debtor;
seller's right to excess collections;
purchaser's right to alter pricing terms;
seller's retention of right to alter or compromise unilaterally the terms of the transferred assets;
seller's retention of right to repurchase assets.

In re Jersey Tractor Trailer Training Inc., 2007 WL 2892956, at *7 (Bkrtcy. D. N.J. Sept. 28, 2007), aff'd, 2008 WL 2783342 (D. N.J. July 15, 2008).

In Major's Furniture Mart Inc. v. Castle Credit Corporation Inc., 602 F.2d 538 (3d Cir. 1979), the Third Circuit found that an alleged sale of receivables from a debtor-furniture-company (Major's) to one of its creditors (Castle) was actually a secured loan because Major's retained all of the risks of ownership of the receivables. Major's represented that its account debtors met certain credit quality standards, and if they failed to pay Castle as promised, Major's had to make up the shortfall.

While the court acknowledged that guarantees of credit quality, and even of collection, could alone potentially be consistent with a true sale of receivables, it held that there cannot be a true sale if the “purchaser” does not take on any of the economic benefits and risks of ownership of the receivables.

In a similar vein, the court in In re Carolina Utilities Supply Company Inc., 118 B.R. 412 (Bkrtcy. D.S.C. 1990), noted that if the transferor retains the right to recover the receivables from the transferee by repaying the purchase price, this suggests that no true sale has occurred.

The transferee SPE's compensation is also relevant: In In re Woodson Co., 813 F.2d 266 (9th Cir. 1987), the Ninth Circuit noted that if the transferee's financial reward for entering into a series of purported sale transactions fluctuates over time with changes in prevailing borrowing rates, this suggests that the transactions are disguised loans rather than true sales. In a true sale, fees should typically represent fixed compensation for servicing the transferred assets.

It should also be noted that as in most financial dealings, lenders generally require legal opinions to support SPE transactions. However, while standard corporate and enforceability opinions are relatively uncontroversial in most secured loans, attorneys who specialize in opinion practice almost universally regard “true sale” opinions as among the most difficult and contentious opinions that can be requested.

The Challenges of 'True Sale' Opinions

That task is made no less difficult by the Seventh Circuit's Paloian decision, the basic facts underlying which are as follows:

Doctors Hospital of Hyde Park Inc. (“Doctors Hospital”) obtained a revolving credit facility (the Daiwa Loan) from Daiwa Healthco-2 LLC (“Daiwa”), pursuant to which:
Doctors Hospital contributed all of its health care receivables on an ongoing basis to MMA Funding, L.L.C. (“MMA”), a special purpose entity organized by the individual owner of Doctors Hospital,
MMA granted a security interest in those health care receivables to Daiwa,
Daiwa loaned funds to MMA, and MMA disbursed those funds either to Doctors Hospital or directly to Doctors Hospital's creditors as the purchase price of the receivables.

Paloian, 2010 WL 3363596, at *1-2; In re Doctors Hospital of Hyde Park Inc., 360 B.R. 787, 798-804 (Bankr. N.D. Ill. 2007).

Doctors Hospital conducted its operations in facilities that it leased from HPCH LLC. Nomura Asset Capital Corporation made a $50 million loan (“the Nomura Loan”) secured by those facilities, and assigned the loan to LaSalle Bank, N.A. (“LaSalle”) as trustee of a mortgage securitization pool. Paloian, 2010 WL 3363596, at *1-2; In re Doctors Hospital of Hyde Park Inc., 360 B.R. at 804-819. MMA at times made payments due under the Nomura Loan.

Doctors Hospital filed for Chapter 11 and a Chapter 11 trustee was appointed. In subsequent litigation, the trustee asserted that Doctors Hospital's bankruptcy estate could recover MMA's payments to LaSalle as fraudulent transfers of property of the debtor (Doctors Hospital), because the purported transfers of Doctors Hospital's health care receivables to MMA pursuant to the Daiwa Loan were not “true sales” to a separate special purpose entity. Paloian, 2010 WL 3363596, at *1-2.

In considering the trustee's claim that Doctors Hospital's purported transfers of its health care receivables to MMA were not true sales, the bankruptcy court, and the district court on appeal each applied a multi-factor balancing test aimed at assessing the extent to which Doctors Hospital transferred the benefits and burdens of ownership of the health care receivables to MMA. See In re Doctors Hospital of Hyde Park Inc., 360 B.R. at 847-53 and LaSalle National Bank Association v. Paloian, 406 B.R. at 336-44.

Each court based its decision principally on the contribution agreement under which Doctors Hospital transferred the receivables to MMA, which provided that Doctors Hospital “relinquished 'all right, title, and interest in and to [the receivables]'” and expressly stated the parties' intent that the transfer of receivables be a true sale. Id. at 339 (quoting In re Doctors Hospital of Hyde Park Inc., 360 B.R. at 800).

Relying on a law review article by Thomas Plank, a professor at the University of Tennessee College of Law, “The Security of Securitization and the Future of Security,” 25 Cardozo L. Rev. 1655-1741 (2004), the lower courts analyzed the question as whether MMA was effectively organized as a special purpose entity and whether MMA should be considered an alter ego of Doctors Hospital. In affirming the bankruptcy court's decision, the district court also emphasized Daiwa's reliance on MMA's separateness, and the officer's certificate and legal opinion delivered in connection with the Daiwa Loan.

Seventh Circuit's Paloian Decision

On further appeal, the Seventh Circuit, in an opinion by Chief Judge Frank Easterbrook, focused primarily on the parties' actual conduct, as opposed to their intent as expressed in their agreement, and reversed. See Paloian, 290 WL 3363596, at *7-*9.

Judge Easterbrook noted that in a typical true sale the purchaser makes an upfront payment to purchase assets from the seller, assumes management of the assets, and makes a profit or loss, as the case may be, depending on how much value it can extract from the assets.

The record in Paloian did not indicate that MMA ever actually purchased Doctors Hospital's receivables for any particular price. Instead, MMA merely received a small portion of the proceeds of the receivables to cover its operating expenses. Moreover, Doctors Hospital continued to carry the receivables on its books and informed its other creditors that Daiwa had a security interest in the receivables, even though MMA was owned by the principal of Doctors Hospital and not by Doctors Hospital itself.

The Seventh Circuit also examined the extent to which MMA was operationally separate from Doctors Hospital, and observed that in actual practice MMA operated as if it were a department of Doctors Hospital. MMA did not have an office, a phone number, a checking account, or even stationery; in fact, all of its letters were written on Doctors Hospital's stationery. It did not prepare separate financial statements or file tax returns.

The Seventh Circuit's examination of MMA's operational separateness as part of its true sale analysis is notable because courts have traditionally considered this issue under a separate and extensive body of case law addressing substantive consolidation of SPEs with their parent company in the parent's bankruptcy case. If a bankruptcy court substantively consolidates an SPE with its parent, the SPE's assets become part of the parent's bankruptcy estate because the parent and the SPE are deemed to be substantially the same entity.

To determine whether an SPE is separate and independent, and therefore not subject to substantive consolidation with its parent (the asset seller) in a bankruptcy case, courts have looked to whether the entities disregarded separateness so significantly that their creditors relied on the breakdown of entity borders and treated them as one legal entity, and whether the entities' assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors. In re Owens Corning, 419 F.3d 195, 216 (3d Cir. 2005).

Substantive consolidation in its traditional form was not at issue in Paloian, and the Seventh Circuit neither explicitly discussed substantive consolidation nor cited any authorities that do. However, the Seventh Circuit's opinion makes the obvious point that a sale requires a transfer to an entity that is and remains legally distinct from the seller.

Considering both Doctors Hospital's failure to transfer substantial benefits and burdens of ownership to MMA and MMA's apparent lack of operational separateness from Doctors Hospital, the Seventh Circuit held that under its conduct-based analysis there was insufficient evidence in the record to support a finding of a true sale of receivables from Doctors Hospital to MMA.

Accordingly, the Seventh Circuit vacated and remanded the case with instructions for the bankruptcy court to determine whether there was a bona fide sale of receivables and whether “MMA Funding was more than a name without a business entity to go with it.” Id. at *8.

Practice Tips

This result is supportable under existing case law because it appears that MMA did not take on many of the benefits and burdens of ownership of the receivables. However, transaction planners would do well to take note of the Seventh Circuit's emphasis on MMA's lack of operational separateness. This emphasis could lead a future court to find that there was no true sale in a transaction in which an SPE took on many of the benefits and burdens of ownership of the assets but lacked sufficient operational separateness from its parent.

The Paloian decision suggests that parties who wish to take advantage of the legal benefits of a true sale must configure their transaction to resemble a bona fide arms-length sale to a third party, and accept whatever disadvantages and inconveniences that may entail. Paloian also reiterates the importance of ensuring that the parties to a structured financing comply in practice with the separateness and other terms of the transaction documents.

In the wake of Paloian, lawyers delivering true sale opinions in SPE transactions should carefully assess the extent to which the transaction documents require the parties to keep the SPE operationally separate from the seller, and consider incorporating appropriate assumptions to the effect that the parties will, as a practical matter, comply with those separateness requirements. This may involve addressing matters that have traditionally been considered more relevant to non-consolidation opinions than to true sale opinions.

This article first appeared in the New York Law Journal, a sister publication of this newsletter.

Aaron R. Cahn is counsel, James Gadsden is a partner, and Bryan J. Hall is an associate with Carter Ledyard & Milburn LLP. Gadsden is head of, and Cahn and Hall are members of, the firm's bankruptcy and creditors rights practice group.

The Seventh Circuit's decision in Paloian v. LaSalle Bank, N.A. (In re Doctors Hospital of Hyde Park Inc.) (“Paloian“), 619 F.3d 688 (7th Cir. 2010) sheds some new and perhaps disturbing light on the use of special purpose entity (“SPE”) structures in corporate finance and also has implications for attorneys who deliver opinions to support transactions involving SPEs.

SPE structures have long been useful to companies seeking to alter the composition of their balance sheet. When properly used, SPE structures are a valuable tool of modern corporate finance, permitting companies to obtain needed liquidity by monetizing otherwise illiquid assets on their balance sheet, particularly receivables. Unfortunately, SPE structures can also facilitate “aggressive” accounting by companies that use them to conceal debts by shifting them to off-balance-sheet SPEs. SPE structures played a key role in the financial maneuvering by Enron and others that ultimately unraveled in their highly publicized collapses.

While a company can, of course, always finance its own receivables, using the SPE device is often attractive to lenders and may result in a faster transaction on better terms. By lending to an entity whose only purpose is to purchase and then realize on the assets it obtains from the operating company, the lender won't need to concern itself with the overall financial condition of the operating company and run the risk that it might get caught up in a restructuring or even a bankruptcy of the company.

In that situation, the lender's ultimate recovery is likely to be delayed and possibly even diminished, since the delay may serve to dilute the value of the collateral, and the bankruptcy court may authorize the debtor to utilize the cash proceeds of the collateral to fund the expenses the debtor incurs in its bankruptcy case. See Bankruptcy Code, 11 U.S.C. ' 363(c)(2).

Typical SPE Structure

In a typical SPE financing structure, the beneficiary of the financing establishes an SPE subsidiary that will exist for the sole purpose of facilitating the financing.

The beneficiary, or seller, then sells the assets that it would otherwise use as collateral for a traditional secured loan to the SPE in exchange for cash. The SPE funds its purchase of the collateral by borrowing money from the lender in exchange for a promise of repayment and a security interest in the collateral. If all goes as planned, the SPE repays the loan from the proceeds of the collateral.

While the SPE, and not the seller, is the nominal borrower under the loan, the borrowed funds (recharacterized as sale proceeds) essentially flow through the SPE to the seller. However, because the SPE is a separate legal entity from the seller, it provides a layer of insulation between the lender and the seller's general financial situation. If the seller enters bankruptcy, the lender expects to be able to continue its dealings with the SPE without interference. Even if the SPE can no longer service the loan as planned, the lender typically can expeditiously enforce its security interest.

Therefore, while the lender in an SPE financing must consider and underwrite the risk that the collateral will decline in value, the lender has relatively little exposure to risks related to the seller's general financial condition.

In addition to allowing for better loan terms than could perhaps be offered in a traditional secured financing, SPE structures also facilitate securitized financing transactions, in which an institution (commonly known as the “originator”) makes a loan and sells securities (commonly known as “asset-backed securities” or “ABS”) representing fractional interests in the repayment proceeds of the loan to potentially numerous and widely distributed purchasers. The SPE structure's potential to control the scope of risks that a lender must consider and underwrite is particularly valuable to ABS purchasers, who typically cannot perform the comprehensive due diligence that is common among traditional secured lenders.

Yes, But Was It a Sale or Really a Loan?

However, in order to accomplish these goals, it is important that other parties, including a bankruptcy trustee, not have the ability to challenge the bona fides of the transaction between the seller and the SPE.

Historically, the concern has been to distinguish between a “true sale” of the assets to the SPE on the one hand, and a secured loan transaction on the other. If there has been a true sale, creditors of the seller will have no recourse against the assets sold to the SPE, while if the transaction is determined to be only a secured loan, courts will deem the seller to have retained interests in the assets and a trustee or other creditors may be able to undo the transaction.

To determine whether a transfer of assets to an SPE is a true sale, courts have traditionally focused on the economic substance of the transfer, particularly whether sufficient indicia of ownership of the assets shifted from the seller to the SPE, disregarding in the process the label that the parties attached to it. For a detailed discussion of the issues relevant to true sale determinations, see Comm. on Bankr. & Corporate Reorganization of the Ass'n of the Bar of the City of N.Y., “Structured Financing Techniques,” 50 Bus. Law. 527, 533, 542-47 (1995).

Some courts have structured their analysis as a totality of the circumstances test, while others have balanced enumerated factors, but in either case, their primary concern has been whether the SPE has gained a sufficient portion of the benefits of ownership of the transferred assets and assumed a sufficient portion of the related risks. The following are one court's concept of the principal factors that weigh in favor of recharacterizing a purported sale as a secured loan:

language of the documents and conduct of the parties;
recourse to the seller;
seller's retention of servicing and commingling of proceeds;
purchaser's failure to investigate the credit of the account debtor;
seller's right to excess collections;
purchaser's right to alter pricing terms;
seller's retention of right to alter or compromise unilaterally the terms of the transferred assets;
seller's retention of right to repurchase assets.

In re Jersey Tractor Trailer Training Inc., 2007 WL 2892956, at *7 (Bkrtcy. D. N.J. Sept. 28, 2007), aff'd, 2008 WL 2783342 (D. N.J. July 15, 2008).

In Major's Furniture Mart Inc. v. Castle Credit Corporation Inc. , 602 F.2d 538 (3d Cir. 1979), the Third Circuit found that an alleged sale of receivables from a debtor-furniture-company (Major's) to one of its creditors (Castle) was actually a secured loan because Major's retained all of the risks of ownership of the receivables. Major's represented that its account debtors met certain credit quality standards, and if they failed to pay Castle as promised, Major's had to make up the shortfall.

While the court acknowledged that guarantees of credit quality, and even of collection, could alone potentially be consistent with a true sale of receivables, it held that there cannot be a true sale if the “purchaser” does not take on any of the economic benefits and risks of ownership of the receivables.

In a similar vein, the court in In re Carolina Utilities Supply Company Inc., 118 B.R. 412 (Bkrtcy. D.S.C. 1990), noted that if the transferor retains the right to recover the receivables from the transferee by repaying the purchase price, this suggests that no true sale has occurred.

The transferee SPE's compensation is also relevant: In In re Woodson Co., 813 F.2d 266 (9th Cir. 1987), the Ninth Circuit noted that if the transferee's financial reward for entering into a series of purported sale transactions fluctuates over time with changes in prevailing borrowing rates, this suggests that the transactions are disguised loans rather than true sales. In a true sale, fees should typically represent fixed compensation for servicing the transferred assets.

It should also be noted that as in most financial dealings, lenders generally require legal opinions to support SPE transactions. However, while standard corporate and enforceability opinions are relatively uncontroversial in most secured loans, attorneys who specialize in opinion practice almost universally regard “true sale” opinions as among the most difficult and contentious opinions that can be requested.

The Challenges of 'True Sale' Opinions

That task is made no less difficult by the Seventh Circuit's Paloian decision, the basic facts underlying which are as follows:

Doctors Hospital of Hyde Park Inc. (“Doctors Hospital”) obtained a revolving credit facility (the Daiwa Loan) from Daiwa Healthco-2 LLC (“Daiwa”), pursuant to which:
Doctors Hospital contributed all of its health care receivables on an ongoing basis to MMA Funding, L.L.C. (“MMA”), a special purpose entity organized by the individual owner of Doctors Hospital,
MMA granted a security interest in those health care receivables to Daiwa,
Daiwa loaned funds to MMA, and MMA disbursed those funds either to Doctors Hospital or directly to Doctors Hospital's creditors as the purchase price of the receivables.

Paloian, 2010 WL 3363596, at *1-2; In re Doctors Hospital of Hyde Park Inc., 360 B.R. 787, 798-804 (Bankr. N.D. Ill. 2007).

Doctors Hospital conducted its operations in facilities that it leased from HPCH LLC. Nomura Asset Capital Corporation made a $50 million loan (“the Nomura Loan”) secured by those facilities, and assigned the loan to LaSalle Bank, N.A. (“LaSalle”) as trustee of a mortgage securitization pool. Paloian, 2010 WL 3363596, at *1-2; In re Doctors Hospital of Hyde Park Inc., 360 B.R. at 804-819. MMA at times made payments due under the Nomura Loan.

Doctors Hospital filed for Chapter 11 and a Chapter 11 trustee was appointed. In subsequent litigation, the trustee asserted that Doctors Hospital's bankruptcy estate could recover MMA's payments to LaSalle as fraudulent transfers of property of the debtor (Doctors Hospital), because the purported transfers of Doctors Hospital's health care receivables to MMA pursuant to the Daiwa Loan were not “true sales” to a separate special purpose entity. Paloian, 2010 WL 3363596, at *1-2.

In considering the trustee's claim that Doctors Hospital's purported transfers of its health care receivables to MMA were not true sales, the bankruptcy court, and the district court on appeal each applied a multi-factor balancing test aimed at assessing the extent to which Doctors Hospital transferred the benefits and burdens of ownership of the health care receivables to MMA. See In re Doctors Hospital of Hyde Park Inc. , 360 B.R. at 847-53 and LaSalle National Bank Association v. Paloian , 406 B.R. at 336-44.