What is a Single Purpose Entity and Why is it Important in Commercial Real Estate Financing Transactions?
If you are a business person looking to obtain a loan to purchase commercial real estate your lender may require you to hold the property in a single purpose entity (typically a limited liability company (“LLC”) or corporation). Likewise, if you are a lender planning to finance a borrower’s commercial acquisition it is often advisable to first have your borrower establish a single purpose entity that will own the property. But what exactly is a single purpose entity, why are they often an important part of the commercial real estate transaction, and how are they legally established?
In the context of a commercial real estate transaction a single purpose entity, not to be confused with its more expansive cousin, the special purpose entity, is usually a limited liability company or s-corporation that is established for the single purpose of holding real estate that is the subject of the underlying loan. This real estate is collateral for the financing lender who holds a mortgage on the property; the single purpose entity usually owns no other assets and is subject to no other liabilities. The single purpose entity may contract with a second company which is typically organized and owned by the same individuals. This second company serves as the manager of the property held by the single purpose entity, performing functions such as handling tenant leases and taking care of business operations related to the property. The second company also typically incurs all liabilities associated with management of the commercial real estate. Another common practice is to hire a professional management company to fulfill this role. The single purpose entity structure may be required by lenders because it insulates the real estate collateral from claims by other creditors and restricts the business activities of the entity, thereby protecting the lender and the single purpose entity owners alike from claims against the real estate by third parties looking to target the property as a source for recovery of monetary damages.
For example, let’s say the borrowing company that will own the subject real estate is a general purpose limited liability company called ABC, LLC. Lender Bank provides the purchase money loan to ABC, LLC which is secured by a first position mortgage on the property in favor of Lender Bank. ABC, LLC was formed by its owners shortly before the loan transaction with Lender Bank and, at the time, ABC, LLC was not engaged in other activities. However, since no business activity restrictions were placed on ABC, LLC, the owners of the company subsequently decide to start using ABC, LLC as a commercial trucking company in addition to holding the lender’s collateral real estate. One of ABC, LLC’s truck drivers negligently causes a terrible accident and ABC, LLC gets sued by several injured parties. The monetary damages turn out to greatly exceed ABC, LLC’s liability insurance policy limits. Suddenly there are numerous judgment creditors attaching liens against the subject real estate held by ABC, LLC. Lender Bank’s mortgage is still in first position on title, but there are still myriad ways this scenario, and numerous other scenarios, can cause headaches for Lender Bank with respect to its collateral, especially if the financial fallout from the accident drives ABC, LLC into seeking bankruptcy protection.
This illustrates another key feature of single purpose entities – special treatment in bankruptcy proceedings. Since the single purpose entity will have only one creditor – the lender – if the single purpose entity files for bankruptcy protection it is much less cumbersome for the lender to lift the “automatic stay” imposed on creditors under 11 U.S. Code § 362 and proceed with foreclosure of the mortgage. Likewise, the lender has the one and only vote in the bankruptcy proceedings on issues such as approving the single purpose entity’s plan of debt reorganization. On the other hand, if there are other creditors involved in the bankruptcy proceedings a “cramdown” situation (in which less than the full amount of indebtedness is repaid) may be forced upon the lender if it gets outvoted by the other creditors. As such, despite having a first position mortgage on the property, the lender may have to submit to a debt reorganization plan that is not in the lender’s best interests.1
Lenders can even take the foregoing situation to another level and require the single purpose entity to be “bankruptcy remote”. A bankruptcy remote entity is one in which the entity is required to have the affirmative approval of an “independent” manager or director in order for it to file bankruptcy in the first place. Typically an entity manager or director is deemed “independent” only if that individual has not had any direct or indirect ownership interest in the entity at the time of their above-referenced involvement in the entity or at any time within several years prior to their involvement in the entity. For many smaller single purpose entities which may be managed by only one or two individuals, the requirement to maintain a separate “independent” manager in the wings is an overwhelming and prohibitive burden, making the bankruptcy remote single purpose entity a rare breed.
So what features must exist for an entity to be legally recognized as a “Single Purpose Entity?” Since the essence of a single purpose entity is to exist for only one purpose, the ownership and operation of a piece of commercial property, the most fundamental component of a single purpose entity is having a good “purpose clause.” There are variations to 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 single purpose entity 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 single purpose entity and any other form of entity or affiliate. Such covenants may include a prohibition on the co-mingling of assets and prohibition on the guaranteeing of obligations of other entities. The covenants may also include an explicit requirement for the single purpose entity to have its own tax identification number and maintain its own bank accounts. Likewise, lenders may require restrictions on other actions that general purpose entities usually can undertake, such as the ability to incur additional debt or the right to voluntarily seek bankruptcy protection. There is a common range of elements associated with single purpose entities but there is no exact set of uniform legal criteria for qualification as one.
As one might expect, depending on the nature of the covenants, restrictions and other hoops the single purpose entity and its owners are required to jump through the costs for compliance with such requirements can become increasingly burdensome, especially when the single purpose entity is expected to secure an independent manager to maintain bankruptcy remoteness. There is a trade-off between the manner of impositions the lender requires in the single purpose entity to ensure adequate loan protection and the tolerance threshold of the borrowing entity in subjecting itself to such impositions in the spirit of securing the financing it desires. The nature of this trade-off will largely depend upon the circumstances and size of the particular transaction. In general, it is advisable for a lender to ask the borrower that the entity owning the property become a single purpose entity. By the same token, single purpose entity structuring by the borrower is often advisable, and is commonly utilized by sophisticated business people as a valuable form of asset and liability protection.
1 The foregoing “cramdown” example involving a real estate mortgage has been oversimplified for illustration purposes.
About the Author
Jack Atnip III is an experienced litigator and creditors’ rights attorney who practices in the areas of Commercial Litigation, Financial Services, Collections/Creditors’ Rights, and Bankruptcy. Contact Jack by email or at (612) 305-1501.
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