Structured finance refers to the use of transaction and entity structure to facilitate outcomes not feasible for operating companies themselves, and includes legally isolating assets in a given transaction from the consequences of a future insolvency. It permits lenders to the entity, and purchasers of notes and other obligations issued by the entity, to rely on the creditworthiness of the isolated assets, disregarding the creditworthiness of the transferor, and figures prominently in an increasing number of finance transactions, from asset-backed securitization to the financing of real estate assets and mobile goods. This article considers how a special purpose entity ("SPE") achieves its purposes, and discusses essential formation and operational considerations of Delaware limited liability companies and Delaware statutory trusts, the preferred SPE vehicles.
How And Why SPEs Work
SPEs typically feature some measure of "bankruptcy remoteness." That is, they have features that reduce the availability of their assets to satisfy creditors in a bankruptcy proceeding. The typical SPE is bankruptcy-remote in two primary ways, each of which is made possible by its governing law. First, the SPE is structured and formed so as to render it less likely that the SPE's assets will be made available to creditors of the originating entity in the case of the originating entity's future bankruptcy. The SPE is structured as a separate legal entity under state law, distinct from its member(s) or owner(s), manager(s), and the originator or transferor of its assets, and as permitted by such law its members or owners (including their trustees in bankruptcy) and their creditors are denied rights in any specific SPE assets and any right to exercise legal or equitable remedies with respect to any specific SPE assets. Second, the SPE is structured so as to render it less likely that the SPE itself will become a debtor in a bankruptcy proceeding. Being a limited purpose entity, the SPE has no assets or liabilities except those specifically transferred to it or assumed by it in connection with the transaction at hand. Under its governing agreement, it has neither power nor authority to hold assets or incur liabilities unrelated to the transaction at hand.
As a further safeguard against SPE bankruptcy, the governing agreement often creates the role of an independent director or other independent decision-maker whose affirmative vote or other action is necessary (in addition to whatever other action is generally required for the entity to take action) in order for the SPE to file a voluntary petition for bankruptcy relief. The decision-maker must be independent from the originating entity and the member or owner of the SPE (for example, it cannot serve on the board of directors or in another decision-making capacity for the originating entity or the member or owner of the SPE). Foreseeable circumstances can present decision-makers with conflicting duties to entities and their members or owners, and lenders and other third parties with whom those entities have dealings. An SPE should be formed under law that permits, and its governing agreement should provide for, the modification or elimination of potentially conflicting duties (including fiduciary duties) such that the independent decision-maker can serve the desired purpose without facing such conflicts.
An SPE should be formed under law that provides, or permits its governing agreement to provide, that the bankruptcy of a member or owner does not cause the SPE to terminate or dissolve. In the context of a single-member limited liability company SPE, this is done in part by creating the role of the springing member under the governing agreement. Essentially, the springing member is a person who has agreed to become a special member automatically upon the happening of the event specified in the governing agreement (e.g., the last person otherwise a member ceases to be a member). The springing member, while a springing member and before becoming a special member, is not a member of the LLC and has no LLC interest. The special member is a member solely for the purpose of preventing the SPE from terminating for lack of any members, and typically (i) has no interest in the profits, losses and capital of the SPE, (ii) has no right to receive any distributions of the SPE's assets, (iii) is not required to make any capital contributions to the SPE, and (iv) does not receive an LLC interest in the SPE. The special member, in its capacity as such, generally has (v) no power or authority to act for or bind the SPE, and (vi) no right to vote on, approve or otherwise consent to any action by, or matter relating to, the SPE.
The Preferred SPEs: Delaware LLCs And Delaware Statutory Trusts.
Typically, SPEs are formed as limited liability companies under the Delaware Limited Liability Company Act, 6 Del. C. 18-101 et seq. (the "DLLC Act"), or as statutory trusts under the Delaware Statutory Trust Act, 12 Del. C. 3801 et seq. (the "DST Act").
Delaware LLCs.
Generally, a Delaware LLC is formed at the time of the filing of a certificate of formation in the office of the Secretary of State of the State of Delaware (the "Secretary of State"), or at any later time specified in such certificate. The certificate of formation must set forth (i) the name of the Delaware LLC, and (ii) the address of the registered office, and the name and address of the registered agent for service of process on the Delaware LLC, and may include (iii) a future effective time for such certificate, and (iv) such other matters as the members determine. The certificate must be executed by one or more authorized persons - authorization is typically memorialized in the LLC agreement. An LLC agreement may be entered into by the member (the DLLC Act explicitly permits single-member LLCs) or members of the Delaware LLC before, after, or at the time of the filing of a certificate of formation and, regardless of when it is entered into, may be made effective as of the formation of the Delaware LLC or at such other time as is provided therein. While an LLC agreement can be written or oral, Delaware LLCs used in structured finance transactions, and Delaware LLCs with respect to which legal opinions will be delivered, consistently have written agreements.
Where a Delaware LLC is formed as an SPE, its LLC agreement explicitly limits its powers and authorities to those necessary to its special purpose. Unless otherwise provided in its LLC agreement, a Delaware LLC is managed by its members in proportion to their interests in its profits, with a simple majority of such interests controlling. Thus, alternative allocations of managerial authority among members can be achieved, but must be set out in the LLC agreement. Similarly, a Delaware LLC may be managed, in whole or in part, by a manager (who need not be a member). Managers can be further designated as officers, directors, or otherwise. Unlike corporate law statutes, the DLLC Act provides little in the way of operational requirements or procedures for managers, officers and directors - any such matters should be comprehensively addressed in the LLC agreement. Delaware Statutory Trusts.
Generally, a Delaware statutory trust or DST is formed at the time of the filing of a certificate of trust in the office of the Secretary of State, or at any later time specified in such certificate. The certificate of trust must set forth (i) the name of the Delaware statutory trust, and (ii) the name and business address of at least one of the trustees meeting the residency requirements set forth in Section 3807 of the DST Act (for example, having its principal place of business in Delaware), and may include (iii) a future effective time for such certificate, and (iv) such other matters as the trustees determine. The certificate must be executed by all of the trustees, whose appointment as such, rights and duties are set forth in a governing instrument. Every DST must have a governing instrument.
Where a DST is formed as an SPE, its governing instrument explicitly limits its powers and authorities to those necessary to its special purpose. Unless otherwise provided in its governing instrument, a DST is managed by or under the direction of its trustees. As noted above, each DST must have at least one trustee meeting certain Delaware residency requirements. The DST Act provides complete flexibility as to how many additional trustees, if any, a DST may have, and as to the allocation of responsibilities among them. For example, a DST might have one trustee who both satisfies the residency requirements of Section 3807 of the DST Act and manages the business and affairs of the statutory trust. Alternatively, a DST might have multiple trustees, one participating in the statutory trust solely to satisfy the residency requirements of Section 3807 of the DST Act, and the other(s) responsible for all other matters, including day-to-day administration of the trust and its affairs. The governing instrument can entitle any person, including a beneficial owner, to direct the trustees or other persons in the management of the statutory trust, and unless the governing instrument so provides, neither such power nor its exercise causes such person to be a trustee or to have duties (including fiduciary duties) or liabilities relating thereto to the statutory trust or to a beneficial owner thereof.
Conclusion
Delaware LLCs and DSTs figure prominently in a great many structured finance transactions. They provide the bankruptcy-remoteness and other attributes required by the marketplace, and are easy and efficient to form and maintain.
Published May 1, 2007.
