“Bankruptcy Remote” Special Purpose Entities in Commercial Mortgage Lending: Characteristics, Enforcement and Limitations

Part I — Introduction

It has become common practice in commercial mortgage lending for the borrower to be structured as a “single purpose” or “special purpose” entity. In its simplest form, a special purpose entity is simply an entity formed solely to own a specific property and any personal property ancillary thereto. Regardless of lender requirements, many property owners regularly use special purpose entities to own properties as a method to ring-fence particular assets and their associated liabilities into independent silos. At the other end of the spectrum is a full-fledged “bankruptcy remote” special purpose entity. The organizational documents for such an entity will contain a long laundry list of separateness covenants, independent director/manager requirements and various other provisions relating to bankruptcy remoteness. At this end of the spectrum it is also common in many larger commercial loan transactions for lenders to require a non-consolidation opinion and a recourse guaranty of the sponsor for a voluntary or collusive involuntary bankruptcy filing of the borrower.

Although common in many types of lending transactions, full-fledged bankruptcy remote structures are routinely utilized in loans that will be included in commercial mortgage-backed securitizations (“CMBS”). This requirement has been a part of CMBS since its inception, is expected by bond buyers, and impacts the ratings of the CMBS by the rating agencies (i.e. not utilizing special purpose entities will have a negative impact on the ratings of the bonds).  Although not quite as ubiquitous as in CMBS lending, and often with fewer bells and whistles, bankruptcy remote special purpose entities are often required in non-CMBS mortgage loans and many lenders have the same requirements for their balance sheet and CMBS loans.

This article will address some of the background and rationale for the use of special purpose entity structures in commercial real estate loan transactions and is intended as a training piece on the subject.

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