With structured finance transactions on the rise, it is critical for borrowers to understand what a nonconsolidation opinion is and how it fits into the deal. This article will address the law of substantive consolidation, the role of nonconsolidation opinions in transactions and when they may be required and offer practical advice for avoiding common pitfalls.
The doctrine of substantive consolidation refers to the equitable power of a Bankruptcy Court to consolidate the assets and liabilities of separate, but related, entities. When debtors are substantively consolidated, the assets and liabilities of such debtors are pooled and essentially treated as the assets and liabilities of a single debtor. The substantive consolidation of two or more entities may impact on the rights and obligations of creditors and other parties in interest in a case under the Bankruptcy Code.
A court’s determination of whether substantive consolidation is appropriate in any given case is fact sensitive. Courts generally focus on two critical inquiries: whether (1) pre-petition, creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit; or (2) post-petition, the assets and liabilities of the debtors are so entangled that consolidation will benefit all creditors.
Subject to a narrow exception not applicable here, the Bankruptcy Code does not expressly authorize substantive consolidation, but it recognizes that a Chapter 11 plan may provide for the “consolidation of the debtor with one or more persons” as a means of implementation.
A nonconsolidation opinion is an opinion letter issued by counsel to the borrower pursuant to which counsel opines that the assets of the borrower – and the collateral offered to secure the deal – will not be subject to substantive consolidation with, and made available to creditors of, certain affiliated parties in the event of a bankruptcy filing. The opinion is fact intensive and generally much longer than other opinions at closing.
In order to issue a nonconsolidation opinion, the borrower must be a single purpose entity (SPE) and conduct no business other than holding the asset being offered as collateral. While it is more common that the borrower SPE is a new entity formed for the purpose of holding the specific asset offered as collateral in the finance transaction; for example, real property, accounts receivable. In certain cases, recycled entities may also be used.
According to guidance from S&P Global Ratings, a nonconsolidation opinion is appropriately requested by a lender or rating agency to analyze the risk of substantive consolidation between the borrower SPE and affiliated parties that, as a result of the applicable corporate structure, have control of decision-making authority over the SPEs or a majority economic interest in the SPEs. Depending on the circumstances, a lender may also seek an opinion regarding risk of consolidation between SPEs and certain indirect affiliates – such as an affiliate that provides services for the borrower SPE; for example, pursuant to a property management agreement where the SPE’s asset is real property.
Because the ultimate goal of the opinion is to examine whether the borrower and the affiliated parties are at risk of consolidation – and ideally conclude that they are not – the nonconsolidation opinion requires its authors to analyze in detail the organizational documents of the SPE and affiliated parties, all transaction documents and apply relevant state and federal case law to reach a conclusion. Restrictions in the conduct of the SPE borrower in its formation documents and relevant transaction documents, the manner in which the SPE and affiliated parties have in fact operated their businesses, and the existence of other external mechanisms, such as the presence of an independent director, are all critical to this inquiry.
Does the transaction involve an SPE? In order for counsel to give a nonconsolidation opinion, the borrower must be an SPE.
Understand the need for a fact-intensive review. As set forth above, the analysis is fact-sensitive and wide-ranging in scope. It will take bankruptcy counsel drafting the opinion some time to work through all of the documents, understand the transaction and draft what at times can be a 30+ page opinion. Allow appropriate time and budget for this process to meaningfully occur.
Be mindful of the scope of guarantees and indemnities. It is common for lenders to request that certain affiliated parties guaranty certain obligations and offer environmental and other indemnity agreements. If you need a nonconsolidation opinion, proceed with caution. The existence of such documents is not fatal to the consolidation analysis; however, the devil is in the details. The existence of intercorporate guaranties and a related entity obligating itself for the debts of borrower are among the facts a court will consider when deciding whether substantive consolidation is appropriate. Where the guaranty or indemnity is limited to certain bad acts, like contamination of the property, counsel can usually work around the issue. The broader the scope of guaranty or indemnity, the more likely it is that the intent is to make the guarantor/indemnitor generally liable for the loan and the harder it will be to reach the necessary conclusion.
Consider the prior conduct of recycled entities. While less common, a recycled entity may be a borrower in a structured finance transaction. In connection with the opinion, the recycled entity must amend its organizational documents to include SPE language for the conduct of its business going forward and certify that since its formation, it has operated in a manner consistent with those restrictions.
Enlist bankruptcy counsel early. Bankruptcy counsel will need to identify appropriate pairings, understand the transaction, and comment on the documents to align them with requirements for the opinion. It may be necessary to revise certain provisions of the transaction and to amend organizational documents, including modification of SPE language and guaranty/indemnification provisions. Accordingly, obtaining input on these issues is often critical to success of the deal.
Expect that clients will have to provide supporting certifications. The SPE borrower and paired entities will be expected to provide certifications regarding the conduct of its business and organizational structure in support of the nonconsolidation opinion. In the case of a recycled borrower, an additional certification will be necessary to affirm the conduct of the entity since its formation. While not often controversial documents, set client expectations regarding their necessity.
Refer to rating agency guidance. A rating agency involved in the transaction will often be a driving force behind negotiation of language in the nonconsolidation opinion; therefore, reference to rating agency guidance is critical in navigating the scope of the nonconsolidation opinion and assumptions and conclusions contained therein.
Marita S. Erbeck is a partner at Faegre Drinker Biddle & Reath LLP in Florham Park.