Because Waiting and Consolidating Don’t Rate:A Tour of

Selected Techniques Used to Minimize the Impact of Project Distress[1]

By

Cheryl Kelly[2]

Thompson Coburn LLP

One U.S. Bank Plaza

Suite 3300

St. Louis, MO 63101

Ph: 314-552-6167

Fx: 314-552-7167

Email:

A.The Quest to Eliminate, Minimize or Deter the Dreaded Possibility of Bankruptcy and Competing Creditor Claims

Bankruptcy permits an obligor to delay collection efforts for some period of time and in certain instances to restructure, re-characterize or otherwise avoid claims or liens on terms and conditions that are not always palatable to creditors. Court administration of a debtor’s affairs and the debtor’s implementation of the remedies available to it in bankruptcy may result in added expense and frustrated expectations. Further, certain modes of conducting business may increase the risk of competing creditor claims against assets and altered priorities. In the latter part of the 1980s, creative thinkers began devising various techniques aimed at eliminating or minimizing the risks to a creditor of the financial distress of an obligor. These techniques as developed over the years are sometimes generically referred to (particularly in the context of certain types of asset based or accounts receivable financing) as “structured finance”. Eliminating, rendering more remote, or deterring the possibility of a bankruptcy and other potentially adverse occurrences associated with an obligor’s financial distress is the desired end of all of these machinations.

Endeavoring to cover all aspects of the theory and practice of “remoteness” techniques in the brief time allotted would be overly ambitious. Consequently, this presentation will assume a working knowledge of the topic and will touch only upon certain current developments relating to three devices sometimes utilized to minimize the risk of a bankruptcy: a) waivers of bankruptcy rights (particularly waivers of the right to the protection of the automatic stay), b) certain specialized third-party guaranties, and c) bankruptcy remote entity structuring. However, those eager to study this area in greater detail need not despair. No topic in the last 25 years appears to have been given greater treatment, and a vast array of resources authored by scholars and practitioners alike is available for consultation. A selected (but fairly comprehensive) bibliography of materials covering both the theoretical and the practical aspects of various techniques employed to minimize bankruptcy risk is set forth at Exhibit A to assist anyone interested in “drilling down” further into the depths of this area.

B.Waivers of Rightsand Remedies Afforded Under the Bankruptcy Code

1.Waiver of the Right to File Bankruptcy or to Purse an Involuntary Bankruptcy

A pre-default waiver by an obligor of the right to file bankruptcy is generally not enforceable. Whether a waiver of the right to file a voluntary or involuntary proceeding in other scenarios (such as waiver of the right to file a subsequent voluntary bankruptcy by a debtor in connection with confirming a plan of reorganization, or a waiver of the right to commence an involuntary proceeding by a junior creditor in favor of a senior creditor as part of an intercreditor arrangement) will pass muster with a bankruptcy court remains to be seen.

2.Waiver by Debtor of the Right to Protection Afforded by the Automatic Stay

Efforts to enforce pre-bankruptcy waivers of the automatic stay and waivers included in plans of reorganization have met with limited success. The status of the waiver of the automatic stay was recently chronicled in depth by John C. Murray and Judith Greenstone Miller, in Waivers of Automatic Stay: Are They Enforceable (And Does the New Bankruptcy Act Make a Difference)?,41 Real Prop. Prob. & Tr. J. 357 (Copyright © 2006 American Bar Association). A copy of this Article will be distributedat the presentationwith the permission of the American Bar Association solely for purposes of supplementing these materials.

3.Other Waivers

Given the explosion of second lien financing, senior creditors are becoming more creative in seeking and endeavoring to enforce pre-bankruptcy transfers of the right to vote and similar limitations on other bankruptcy rights, such as the right to seek relief from the automatic stay, and the right to receive adequate protection payments (which the senior lender may seek to have paid over to it). See, e.g., Jo Ann J. Brighton & Mark N. Berman, Second-Lien Financings: Enforcement of Intercreditor Agreements in Bankruptcy, Part I: More Questions than Answers, 25-Feb Am. Bankr. Inst. J. 38 (2006); Jo Ann J. Brighton & Mark N. Berman, Second-Lien Financings, Part II: Anecdotes and Speculation--the Good, the Bad and the Ugly, 25-Mar Am. Bankr. Inst. J. 24 (2006); Jo Ann J. Brighton & Mark N. Berman, Second-Lien Financings, Part III: Anecdotes--the Good, the Bad and the Ugly: Atkins--the Good, 25-May Am. Bankr. Inst. J. 14 (2006); Jo Ann J. Brighton & Mark N. Berman, Second-Lien Financings: Good, Bad, and Ugly (Part IV), 25-Jun Am. Bankr. Inst. J. 1 (2006); Jo Ann J. Brighton & Mark N. Berman, Second Lien Financing: Part V: Who Gets What?, 25-Aug Am. Bankr. Inst. J. 38 (2006); John E. Moose & Patrick M. Jones, Is it Debt, or Is it Equity? How the Classification of Hybrid Securities Can Turn a Good Company Bad, 26-Mar Am. Bankr. Inst. J. 32 (2007); James D. Prendergast, Secured Real Estate Mezzanine Lending (With Form), 23 No. 2 Prac. Real Est. Law. 35 (2007); Paul Baisier, Second-Lien Financings--More Good, Bad and Ugly: A Decision at Last, 26-Apr Am. Bankr. Inst. J. 50 (2007); Grant Puleo & Michael Lyon, Mezzanine Loans to Developers and Owners of Real Estate Projects: 10 Ways to Improve the Quality of the Equity Pledge, 22 No. 4 Real Est. Fin. J. 46 (2007); Mark S. Fawer & Michael J. Waters, Mezzanine Loans and the Intercreditor Agreement: Not Etched in Stone, 22 No. 4 Real Est. Fin. J. 79 (2007),and other of the materials cited in the bibliography respecting the validity and enforceability of various “bankruptcy-proofing” and “bankruptcy-remoteness” techniques as utilized in the context of intercreditor agreements.

C.Springing, Exploding and Non-Recourse Carve-Out (“Bad Boy”) Guaranties

Each of these types of guaranties may be used at the outset of the loan or as part of a workout as a means of deterring or minimizing risks of bankruptcy or other occurrences that may impact recovery on the credit.

1.Springing Guaranty

The obligations of the guarantor under this type of guaranty become effective (or “spring” into existence) only upon the happening of certain specified events in the future, such as:

  • The filing of a bankruptcy petition by or against the borrower or pledgor (guarantor’s counsel will typically seek to limit the effect of an involuntary filing to those in which the guarantor was actively involved in instigating).
  • The violation of single asset/bankruptcy remote covenants in the loan documents by a borrower or pledgor.
  • Particularly where the guaranty is taken as part of a work out, efforts to hinder, delay or contest (whether by seeking injunctive relief, the filing of a redemption notice or otherwise) by a borrower, pledgor or guarantor of enforcement by the lender.

Guarantor’s counsel may seek to negotiate for liability under the guaranty to terminate (notwithstanding its springing into being) upon the occurrence of indefeasible payment in full of the indebtedness.

2.Exploding Guaranty

Under this form of guaranty, the entire (or some limited) amount of the indebtedness is guarantied on certain terms and conditions from outset of the execution and delivery of the document. The liability under the guaranty will evaporate or “explode” upon the occurrence of certain specified events such as successful completion of a foreclosure or recordation of a deed (or transfer) in lieu of foreclosure (and, if the lender can negotiate for same, the passage of applicable avoidance periods).

3.Non-Recourse Carve-Out (“Bad-Boy”) Guaranty

a.Sample “non-recourse carve out” provisions (covenants imposing recourse liability as an exception to the generally non-recourse nature of the obligation at hand) are provided at Exhibit Battached hereto. “Carve-outs” from non-recourse liability are also typically known as “bad boy” covenants because they generally impose liability for fraud, misappropriation of rents, the filing of a bankruptcy and other potentially detrimental conduct within the control of the obligor.

b.Blue Hills Office Park, LLC. v. J.P. Morgan Chase Bank, 477 F. Supp. 366 (D. Mass 2007). (In what may be the first reported decision enforcing a “bad-boy” carve out from non-recourse liability, a borrower and guarantors are held liable for the entire amount of the secured indebtedness (not just the amount of the damages resulting from the prohibited conduct) as a result of a breach of a covenant not to settle litigation without the consent of the lender and utilizing the proceeds of the award for purposes other than payment of the secured indebtedness).

4.Generally

a.Forms and Additional Details

Samples of each of the foregoing types of guaranties may be found in some of the materials cited in the bibliography. See, e.g., Brian E. Greer & Joel S. Moss, Guaranties in Bankruptcy: A Primer, 16 J. Bankr. L. & Prac. 3 Art. 2 (2007); Joshua Stein, Lender’s Model State-of-the-Art Nonrecourse Clause (with Carveouts), 43 No. 7 Prac. Law. 31 (1997); and Sidney A. Keyles, Counseling the Client on Springing and Exploding Guaranties (with Forms), 12 Prac. Real Est. Law. 29 (1996).

b.Bases to Contest or Support Springing and Exploding Guaranties

A guarantor may seek to challenge the validity or enforceability of a springing or exploding guaranty in bankruptcy claiming that:

  • The “springing” or “exploding” feature of the guaranty (as the case may be) is unenforceable ipso facto clauses under Sections 363(l), 365(e) and 541(c) of the Bankruptcy Code(Title 11, U.S. Code) (the “Bankruptcy Code”).
  • The guaranty is inequitable and the bankruptcy courts, as courts of equity and through the general equity powersafforded those courts under Section 105 of the Bankruptcy Code is entitled to set aside or limit same.
  • The guaranty is an impermissible penalty under Section 506(b) of the Bankruptcy Code.
  • The enforcement of the guaranty is subject to the automatic stay arising under Section 362 of the Bankruptcy Code.

Section 524(e) of the Bankruptcy Code, which generally precludes a bankruptcy of an obligor from discharging a third-party guarantor or other non-debtor obligated on the indebtedness, is available to the creditor to counter the foregoing arguments by an obligor.

D.A Brief Overview of Structured Finance

1.Aims

  • Separate credit risks of a borrowing entity from its assets—underwriting focuses on the value of the collateral and the ease of recourse thereto, as opposed to the credit worthiness of the borrowing entity and lender endeavors to isolate the security from unrelated credit risk.
  • Provide means for entities to raise capital (e.g., via securitization and true sale transactions).
  • Increase and maintain investor confidence in securitization markets.

2.Substantive Consolidation-One Particularly Unpopular Bankruptcy Risk

The risk of substantive consolidation drives rating agency and other creditor requirements to include “single asset” covenants in borrower organizational documents and in certain instances, where the size and risk of the transaction merit same, to require delivery of a “non-consolidation” opinion.

Substantive consolidation is an equitable remedy which may be ordered by a bankruptcy court in order to consolidate the assets and liabilities of ostensibly separate but related entities. Substantive consolidation treats the assets and liabilities of separate entities as if they belonged to one, enabling the creditors of each formerly separate entity to claim an interest in the assets of the consolidated estate. As observed in Morse Operations, Inc. v. Robins Le-Cocq, Inc. (In re Lease-a-Fleet, Inc.), 141B.R.869, 872 (Bankr. E.D. Pa. 1992), “[s]ubstantive consolidation is a powerful vehicle in bankruptcy by which the assets and liabilities of one or more entities are combined and treated for bankruptcy purposes as belonging to a single enterprise” (quoting Comment, Substantive Consolidation in Bankruptcy: A Primer, 43 Vand. L. Rev. 207, 208 (1990)). Because substantive consolidation can dramatically affect the rights and interests of creditors and other parties in interest, it is generally regarded as a power “that should be used sparingly.” Bracaglia v. Manzo (In re United Stairs Corporation), 176 B.R. 359, 368 (Bankr. D. N.J. 1995); In re Bonham, 226 B.R. 56, 59 (Bankr. D. Alaska 1998)(“The cases uniformly hold that substantive consolidation should be used sparingly, with an eye to possible negative effects on creditors.”).

With the possible exception of Bankruptcy Code Section 302(b), which some courts have interpreted as authorizing the substantive consolidation of the bankruptcy estates of a husband and wife[3], and Bankruptcy Code Section 1123(a)(5)(C), which provides that a Chapter 11 plan may provide for the consolidation or merger of a debtor with one or more persons, the Bankruptcy Code, does not expressly provide for or sanction the doctrine of substantive consolidation. Instead, the authority to order substantive consolidation is recognized as arising from the general equitable powers conferred upon bankruptcy courts under Bankruptcy Code Section 105(a). See, e.g., Woburn Associates v. Kahn (In re Hemingway Transport, Inc.), 954 F.2d 1, 11 n. 14 (1st Cir. 1992).

The doctrine of substantive consolidation first developed under the bankruptcy laws existing prior to the enactment of the modern Bankruptcy Code in 1978. Early decisions essentially applied an alter ego or pierce the corporate veil test in assessing the propriety of substantive consolidation. See, e.g., Stone v. Eacho (In re Tip Top Tailors, Inc.), 127 F.2d 284 (4th Cir. 1942), cert. denied, 317 U.S. 635, 63 S.Ct. 54, 87 L.Ed. 512 (1942)(cited inReider v. F.D.I.C. (In re Reider), 31 F.3d 1102, 1105 (11th Cir. 1994)).

Modern courts have distinguished substantive consolidation from the doctrine of alter ego or piercing the corporate veil. See, e.g., F.D.I.C. v. Colonial Realty Company, 966 F.2d 57, 60-1 (2nd Cir. 1992)(the comparison between substantive consolidation and the doctrine of piercing the corporate veil “is not entirely apt.”); see also, Comment, Substantive Consolidation in Bankruptcy: A Primer, 43 Vand. L. Rev. 207, 218 (1990) (same). Specifically, substantive consolidation is recognized as providing “more extensive relief than piercing the corporate veil, because substantive consolidation is a complete merger of legal entities, while piercing the corporate veil is essentially a limited merger for the benefit of only one creditor or group of creditors.” In re Cooper, 147 B.R. 678, 683 (Bankr. D.N.J. 1992). Thus, modern courts recognize that the issue of substantive consolidation requires consideration of factors beyond those implicated by the doctrine of piercing the corporate veil. Id. at 683-4; Reider v. F.D.I.C. (In re Reider), 31 F.3d 1102, 1105-8 (11th Cir. 1994).

Modern courts have developed a number of different tests or approaches for analyzing the applicability of substantive consolidation. Thus, for instance, in Eastgroup Properties v. Southern Motel Assoc., Ltd., 935 F.2d 245 (11th Cir. 1991), the Eleventh Circuit followed a three-part approach previously developed by the D.C. Circuit in Drabkin v Midland-Ross Corporation (In re Auto-Train Corporation, Inc.), 810 F.2d 270, 276 (D.C. Cir. 1987). Under this approach, “the proponent of substantive consolidation must show that (1)there is substantial identity between the entities to be consolidated; and (2)consolidation is necessary to avoid some harm or to realize some benefit.” Eastgroup, 935 F.2d at 249. If the proponent makes such a showing, “the burden shifts to an objecting creditor to show that (1)it has relied on the separate credit of one of the entities to be consolidated; and (2)it will be prejudiced by substantive consolidation.” Id. In the event that the latter showing is made, “the court may order consolidation only if it determines that the demonstrated benefits of consolidation ‘heavily’ outweigh the harm.” Id. (citations omitted).

Courts utilizing the foregoing approach often consider the following factors when evaluating whether a party has made a prima facie case for substantive consolidation:

  • the presence or absence of consolidated financial statements;
  • the unity of interests and ownership between the various corporate entities;
  • the existence of parent and inter-corporate guarantees on loans;
  • the degree of difficulty in segregating and ascertaining individual assets and liabilities;
  • the existence of transfers of assets without formal observance of corporate formalities;
  • the commingling of assets and business functions; and
  • the profitability of consolidation at a single physical location.

Eastgroup, 935 F.2d at 249 (citing In re Vecco Construction Industries, Inc., 4 B.R. 407, 410 (Bankr. E.D. Va. 1980)); In re Optical Technologies, Inc., 221 B.R. 909, 913 (Bankr. M.D. Fla. 1998).

An alternative approach was advanced by the Second Circuit in Union Savings Bank v.Augie/Restivo Baking Company, Ltd. (In re Augie/Restivo Baking Company, Ltd.), 860 F.2d 515 (2nd Cir. 1988). Specifically, in the Augie/Restivo case, the Court indicated that substantive consolidation would be appropriate if either of the following circumstances were determined to exist: “(i) creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit; or (ii) the affairs of the debtors are so entangled that consolidation will benefit all creditors.” Id. at 518 (citations omitted).

Ultimately, determinations regarding the applicability of substantive consolidation are extremely fact-sensitive and involve the weighing of various equitable considerations. Consequently, courts do not always strictly adhere to or rigidly apply the various approaches and/or factors identified above. See, e.g., Central Claims Services, Inc. v. Eagle-Picher Industries, Inc. (In re Eagle-Picher Industries, Inc.), 192 B.R. 903, 905 (Bankr. S.D. Ohio 1996)(“Because the cases so much turn on their individual facts, we find that the lists presented by the several courts in their decisions, of factors of which must be present in order to determine the issue of substantive consolidation, are of limited use.”); Bracaglia v. Manzo (In re United Stairs Corporation), 176B.R. 359, 369 (Bankr. D. N.J. 1995)(“while such tests may be helpful in some analyses this court adopts the ultimate test of balancing of the equities”). While this makes it extremely difficult to generalize about the applicability of substantive consolidation, current case law does suggest certain factual circumstances in which the doctrine is likely to be applied. These circumstances include the following:

a.Fraud or Injustice on Creditors

Substantive consolidation is frequently applied when it appears that a debtor has utilized an affiliate to defraud or hinder creditors. Thus, for instance, in Shubert v. Jeter (In re Jeter), 171 B.R. 1015 (Bankr. W.D.Mo. 1994), aff’d 178 B.R. 787 (W.D. Mo. 1995) aff’d 73 F.3d 205 (8th Cir. 1996), a husband and wife engaged in the home construction business placed essentially all of the liquid assets of the business in their son’s name so as to avoid the claim of a creditor from whom they had borrowed over $100,000. These funds were eventually utilized to set up a separate corporation through which the husband and wife continued to conduct their home construction business. When both the corporation and the husband and wife were subsequently forced into bankruptcy, the bankruptcy trustee requested that the individual and corporate estates be substantively consolidated. Finding that the corporation had been established to delay and defraud creditors, the court determined that such relief was appropriate. Specifically, the court stated “[b]ecause [the corporation] was created in furtherance of efforts to conceal assets from creditors, even though the corporation then legitimately engaged in a construction business, the court finds sufficient evidence of commingling of the [individuals’] and the [corporation’s] finances and affairs to support substantive consolidation . . . .” Id. at 1020; see also Simon v. New Center Hospital (In re New Center Hospital), 187 B.R. 560 (E.D. Mich. 1995)(substantive consolidation appropriate in light of evidence that assets and operations of debtor and non-debtor affiliates had been extensively commingled and that debtor had transferred funds to the non-debtor affiliates prepetition to avoid the claims of various creditors); Bracaglia v. Manzo (In re United Stairs Corporation), 176 B.R. 359 (Bankr. D. N.J. 1995) (court substantively consolidates Chapter 7 corporate debtor with non-debtor affiliates to whom the debtor had transferred its equipment prepetition after debtor’s lender brought state court action to foreclose its lien on the debtor’s property).