No More Separation Anxiety – Court Confirms Operational Separateness of Bankruptcy Remote Entity
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In an exhaustive 200+ page opinion, the United States Bankruptcy Court for the Northern District of Illinois resolved in favor of LaSalle Bank the fraudulent transfer suit brought by the chapter 11 trustee against LaSalle in Paloian v. LaSalle Bank Nat’l Assn. (In re Doctor’s Hospital of Hyde Park, Inc.), 2013 WL 3779657 (Bankr. N.D. Ill. July 17, 2013).  The decision includes a detailed and in-depth examination of case law, scholarly articles and commentary on the characteristics and function of bankruptcy remote entities (SPEs).  The decision is valuable precedent for determining whether, at least in the Seventh Circuit, such entities meet the requisite threshold of separateness to be considered SPEs.
Previous posts here, here, and here set forth the factual background and trace the complex series of decisions issued by the bankruptcy court and the Seventh Circuit on the various issues central to the bankruptcy trustee’s fraudulent transfer suit.  This post focuses on the bankruptcy court’s findings of fact and conclusions of law on the issue of bankruptcy remoteness.
As a brief recap, if LaSalle had been paid with the assets of MMA, a non-debtor SPE, and not the assets of Doctor’s Hospital, then LaSalle would have had the defense to the fraudulent transfer action that the transfers that the trustee was seeking to recover were not transfers of property of Doctors Hospital’s estate.  The status of MMA was, therefore, an issue.  The Seventh Circuit, skeptical about whether MMA was a legitimate bankruptcy remote vehicle, remanded to the bankruptcy court the issue of whether MMA “was more than a name without a business entity to go with it.”  In doing so, the remand opinion implied a standard broader than legal separateness for analyzing the legitimacy of bankruptcy remote entities:  such entities must be operationally distinct from related entities (in this case, Doctor’s Hospital, which was the originator, parent, and debtor).
The bankruptcy court’s opinion issued in connection with the trustee’s motion for summary judgment after remand reserved for trial several issues, including whether there was sufficient evidence to determine if MMA was a legitimate bankruptcy remote entity under the Seventh Circuit’s “operational separateness” test. 
At trial, the court heard evidence as to whether, during the time period relevant to the underlying transactions, MMA was truly separate from Doctor’s Hospital.  All evidence from the first trial was re-offered at the remand trial and admitted without objection; additional evidence and stipulations were also approved and admitted.
The court found that the following evidence indicated MMA was indeed an SPE separate and distinct from Doctor’s Hospital:

  • At all relevant times, MMA existed as an LLC under Illinois law.
  • MMA’s Articles of Organization and Operating Agreement each provided that its single purpose was “[t]o accept accounts receivable of Members, to administer the servicing, financing, collection and distribution of proceeds of such receivables, and to do such other acts and things incidental to the foregoing single purpose.”  During the relevant time period, there was no evidence that showed MMA engaged in activity it was not authorized to conduct.
  • Provisions in its Articles of Organization made it more difficult for MMA to file for voluntary bankruptcy, which is a characteristic common to SPEs.
  • MMA’s Operating Agreement specified that it would have no employees and, instead, would be managed by its member.
  • MMA observed corporate formalities, such as adopting annual resolutions through the board of directors of its manager and making corporate filings required by the Illinois Secretary of State.
  • Although MMA shared space with other entities in the corporate group, MMA received its own mail at the corporate group address.  An expert on healthcare securitization testified that SPEs typically share office space with a parent company because of their limited purpose.
  • MMA had its own bank account that reflected account activity during the relevant time period, including cash originating from the receivables.
  • MMA’s representatives issued the vast majority of borrowing base certificates to the lender in connection with requests to draw on the facility.  Even though MMA submitted certain loan advance requests using Hospital’s stationary and Hospital officers executed a few of the borrowing base certificates issued in connection with the advance requests, the lender did not find it unusual for an SPE to use the stationary of the originator, and did not object, because it was clear the correspondence came from MMA.
  • Although the receivables that were purportedly sold to MMA appeared as an asset of Doctor’s Hospital on its audited financial statements, UCC-1 financing statements were filed describing the transfer of the receivables to MMA and granting the lender a security interest in the receivables, indicating to the “outside world” the true control of the interests in those receivables.
  • In addition, although the loan appeared as a liability of Hospital on Hospital’s audited financial statements, Doctor’s Hospital’s auditors were made aware that MMA, and not Doctor’s Hospital, was the actual borrower.  It appeared that the auditors believed there was some sort of parent subsidiary relationship at work that necessitated listing the loan as a liability of Doctor’s Hospital.  Moreover, the borrowing base certificates evidenced MMA’s receipt and control of receivables from Doctor’s Hospital.
  • The lender’s employees testified that they would not have made a loan directly to Doctor’s Hospital and, instead, relied on the separateness of MMA to provide Doctor’s Hospital with indirect access to the loan at a lower interest rate.

The court held that the weight of the evidence was heavily in favor of concluding that MMA was a valid bankruptcy remote entity at all times.  The court concluded that whether an entity is “operationally distinct” must be considered in light of all evidence regarding the entity’s purpose and function.  Here, MMA’s sole purpose was to purchase and hold Hospital’s receivables; the parties to the transaction bargained for this limited purpose for their own economic reasons (e.g., a lower cost loan), and the trustee had not met his burden of showing that MMA did not function as it was supposed to.
The court was cognizant of the repercussions for the distressed lending industry that would result from rejecting “even a carefully prepared entity”:  “[An SPE’s] status as an independent economic unit is the entire basis on which the lender chooses to extend credit.  There is good reason to avoid judicial disruption of commercial transactions based on a balancing of factors susceptible to subjective interpretation.  As noted by one securitization expert, ‘[d]iscretion would undermine the securitization market.  Some degree of certainty is essential for the market’s functioning….’”
The bankruptcy court entered judgment dismissing the fraudulent transfer claims, on the basis that the trustee had been unable to establish Doctor’s Hospital’s insolvency during the relevant time period, or that the payments the trustee sought to recover were made with Doctor’s Hospital’s property.
Should the decision remain unmodified on appeal, the securitization industry should take some comfort in the court’s validation of MMA as a legitimate SPE.  Although, as a general proposition, corporate formalities should be observed when relying on the bankruptcy remoteness of an entity that has generated securitized assets, here, the court concluded that MMA was “operationally distinct” from Doctor’s Hospital, despite not complying with some corporate formalities.  In addition, the bankruptcy court’s analysis did not focus solely on whether MMA was operationally distinct from Doctor’s Hospital, but looked at whether MMA strayed from the purpose for which it was formed (i.e., to purchase receivables and be a borrower), and the reliance of transaction parties on MMA’s separateness.  The court also noted the economic benefits of SPEs in facilitating commercial loan transactions, in contrast to the remand opinion, which it viewed as “question[ing] any use of a bankruptcy remote structure.”