Restructuring

A previous blog entry discussed the Seventh Circuit’s opinion in Paloian v. LaSalle Bank, N.A., 619 F.3d 688 (7^th Cir. 2010) and whether the trustee of a securitization trust could be held liable as the “initial transferee” of the transferred funds.  Today’s entry focuses on the court’s discussion of whether MMA, a non-debtor subsidiary of the Hospital, was truly “separate” from the Hospital.
Of course, if the securitization trustee, LaSalle Bank, had been paid with the assets of MMA, a non-debtor “bankruptcy-remote entity,” and not the assets of the Hospital, then LaSalle also would have had the defense to the fraudulent transfer action that the transfers that the chapter 11 trustee was seeking to recover were not transfers of property of Hospital’s estate.  Because the Hospital had purported to transfer all its accounts receivable – essentially its sole source of cashflow – to MMA years before the bankruptcy, Judge Easterbrook also had to consider the effectiveness of such a transfer to shield LaSalle from fraudulent transfer claims. 
Unfortunately for LaSalle, the Seventh Circuit suggested that MMA appeared to be a separate entity in name only.  As Judge Easterbrook commented on the use of a bankruptcy remote, special purpose entity in structuring transactions, “To make the idea work, the separate entity must be, well, separate.”
Although the Seventh Circuit remanded the issue for further evidence on MMA’s separateness, it pointed to a number of the “usual attributes” of a bankruptcy remote vehicle that it found lacking:

• 99% of the equity in MMA was owned by the Hospital, and 1% was owned through trusts controlled by Desnick.
• MMA had no office, phone number, or stationery of its own. 
• MMA did not have its own checking account.
• MMA did not prepare financial statements or file tax returns. 
• There was also no record of a purchase price for the Hospital’s receivables.  Instead, it appeared that MMA simply took a cut of the proceeds of the receivables every month to cover its own operating costs, and the Hospital kept the remainder. 
• In addition, the Hospital carried the accounts receivable on its books as a corporate asset. 

It is unclear whether Judge Easterbrook’s comments on separateness in Paloian should raise any red flags for parties structuring bankruptcy remote, special purpose entities.  While some of the facts noted by Judge Easterbrook may be common in special purpose entities (for example, lack of independent ownership, lack of a physical office or a phone number, or even not filing separate tax returns), some of facts on which Judge Easterbrook focused suggests that the separateness analysis in Paloian follows existing case law on the topic:

• Special purpose entities do not often send out correspondence, so they may not need their own stationery.  MMA, however, did send out letters, but it used the Hospital’s letterhead when it did so. 
• Special purpose entities typically would segregate their funds into their own bank accounts.  Although Judge Easterbrook states that MMA did not have its own checking account, it is not clear whether this meant that all MMA’s funds were deposited into an account in the name of the Hospital or otherwise commingled with those of the Hospital.  Such activities would be inconsistent with the typical separateness requirements for bankruptcy remote entities.
• Special purpose entities sometimes are part of a consolidated group for purposes of financial reporting and filing tax returns.  It is not clear from Paolian whether this is the reason why MMA did not prepare its own financial statements or file its tax returns.
• When the transferor of a financial asset holds the equity in the special purpose entity receiving the transfer, it may not receive the entire purchase price in cash, but a portion may be paid in the form of a subordinated note or contribution to the capital of the special purpose entity.  Although the decision notes that 99% of the equity of MMA was owned by the Hospital, it is not clear from the decision whether the Hospital and MMA simply failed to adhere to corporate formalities in transferring the receivables and distributing cash to the Hospital (activities contrary to separateness), or whether the absence of a cash purchase price or the fact of transfer of funds from MMA to the Hospital rendered the two entities not separate. 

It is important to remember that Paloian does not involve substantive consolidation, and courts have cautioned that substantive consolidation is difficult to achieve and should be used only sparingly.  In potentially ignoring the corporate form to allow the fraudulent transfer claims to proceed against LaSalle, the Seventh Circuit did not address substantive consolidation, but instead relied upon the well-established maxim applied in other bankruptcy contexts that courts will look beyond the parties’ labels for a particular transaction to discern the true nature of a transaction from the facts and circumstances, including the parties’ practices, business activities, and relationships.  While it remains to be seen how broadly Paloian will be applied, it serves as a valuable reminder to borrowers and lenders, particularly in the securitization industry, that corporate formalities should be observed when relying on the bankruptcy remoteness of an entity that has generated the securitized assets.