Special Purpose Entities

Welcome to the 84th Pari Passu newsletter.

Last week, we had a true deep dive with a detailed overview of Snowflake and the Cloud Computing market. Today, we are learning more about Special Purpose Entities (also known as SPEs).

Corporate structures are incredibly complex. Companies often create subsidiaries within subsidiaries for a variety of reasons, including tax optimization, risk management, and intellectual property protection. However, when a parent company files for bankruptcy, most of these ‘operating entities’ within the parent company file for bankruptcy and are considered a debtor.

On the other hand, some entities do not file with the parent company, and these are referred to as ‘non-debtor’ entities. There are many components that can create non-debtor entities, and today’s focus in on Special Purpose Entities (SPEs).

Before we start, I have just published on LinkedIn an exciting post on the Coatue EMW event that happened yesterday. Highly recommend. You can read key highlights and get the entire deck shared during the event.

But first, a message from 10 East

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Let’s get to it, what are Special Purpose Entities?

An SPE is an entity that is 'bankruptcy-remote'. It is essential to note right away that 'bankruptcy-remote' does not mean an entity is bankruptcy-proof. In an SPE structure, an entity is only formed immediately before a financing transaction occurs between lenders and a parent company; upon creating the SPE, the relevant financial assets (the assets the lenders secure against) are relocated to the SPE. As previously stated, if the parent company (the original borrower) were to file, the lenders now have additional protection because the SPE is a non-debtor and is 'remote' from the parent company's bankruptcy filing. The SPE acts like any other entity, as it contains key assets / operations. If the SPE assets become worth less than the SPE liabilities, the SPE is insolvent and can still file for bankruptcy [1]. 

To qualify as an SPE, a few requirements must be met. Most of these criteria come in the form of restrictions. One of the significant restrictions is the SPEs ability to incur additional debt other than the debt associated with creating the SPE itself. Additionally, there may be restrictions on any mergers or liquidations. As long as the SPE-related debt is outstanding, the entity is likely restricted from merging or selling its assets with/to another entity without the lender's consent. Upon the creation of the SPE, the transaction must explicitly outline the purpose of the SPE and limit the SPE activities to actions only necessary to achieve its purpose. To do this, SPEs are required to hire an independent manager [1]. This is because of an inherent conflict of interest within the SPE structure. When the SPE is created, it acts through its board of directions. These directors are also managers of the parent entity, creating the potential conflict of interest if a bankruptcy situation arises [6].

For example, suppose the parent company is insolvent while the SPE (which may contain critical assets) is solvent. In that case, the board may be inclined to disregard the purpose for which the SPE is created and thus act against their creditors [2],[3].

Over the past decade, as the use of SPEs has increased, so has the number of legal disputes questioning the validity of SPE structures when a debtor files for bankruptcy. These disputes revolve around two key arguments: substantive consolidation and good faith filings. We will delve into how these two components have been used to challenge an SPE structure in the case of General Growth Properties. But first, let's establish a clear understanding of these arguments [6].

Substantive Consolidation and Good Faith

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