See you in September August 2021 – Consolidation and substantive non-consolidation notice | Cadwalader, Wickersham & Taft LLP

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Substantial consolidation is a fair remedy whereby a bankruptcy court disregards the separate legal existence of a debtor and pools the assets and liabilities of the debtor with one or more of its affiliates, in order to make distributions to creditors as part of a reorganization plan. or liquidation.

The Bankruptcy Code does not contain specific authorization for substantial consolidation. Instead, the power of a bankruptcy court to substantially consolidate affiliated entities flows from its general powers in equity.

When the affiliated entities are substantially consolidated, the intercompany claims between these entities are eliminated, the assets of the consolidated entities are grouped together and the creditors’ claims on each entity are treated against the common pool of assets. Substantial consolidation generally benefits the creditors of one entity to the detriment of the creditors of another entity, because each of the consolidated entities has a different debt ratio.

Lenders in structured finance transactions often require their borrowers to be special purpose entities (“SPEs”) in order to isolate the assets financed and the cash flows of those assets from external factors, such as the performance of other assets. or the conditions of the subsidiaries of the SPE. The substantial consolidation of an SPE with one or more of its subsidiaries goes against the isolation of the assets of the SPE, drawing them into a common distribution pool.

How it works

To provide reassurance about the lender’s interest in the financed assets and the cash flows from those assets, the lender in a structured finance transaction often requires that a non-consolidation notice be issued by the SPE’s legal advisor to fence.

A non-consolidation notice states that if one or more parent entities of the SPE file for bankruptcy, the bankruptcy court would respect the separate legal existence of the SPE and would not order the substantial consolidation of the assets and liabilities of the SPE with those of the SPE. one or more of its parent entities, guarantors or affiliated managers (such as an affiliated trustee).

The notice confirms that the SPE structure required by the Lender will be respected in the event of bankruptcy, and that the assets of the SPE will remain isolated and will not be grouped together in a common distribution pool with those of the subsidiaries of the SPE.

Because the Bankruptcy Code does not contain prescribed standards for substantial consolidation, control standards developed by the courts. Bankruptcy courts have developed multiple, complicated and sometimes contradictory tests to determine whether an SPE should be substantially consolidated with one or more of its parent entities. However, four important categories of factors emerged:

(1) Record keeping: the SPE should have separately identifiable assets and liabilities, as well as separate accounting records and financial statements.

(2) Operational issues: the SPE must be sufficiently capitalized and economically independent of its shareholders.

(3) Intercompany transactions: the transactions of the SPE with the affiliates should be at arm’s length and on commercially reasonable terms, and the guarantees of the obligations of the SPE by the affiliates and other credit supports by affiliates should be limited.

(4) Advantages and disadvantages: Do the advantages of a substantial consolidation outweigh the damage to creditors resulting from a substantial consolidation.

Essentially, the courts seek to determine whether the assets and liabilities of the SPE can be separated from those of its subsidiaries, and whether the SPE can operate as a stand-alone entity. Courts also consider whether a substantial consolidation would cause injustice to creditors who relied on the separate credit and existence of the SPE. Substantial consolidation can occur when the assets and liabilities of an SPE are “hopelessly entangled” with those of its subsidiaries or when an SPE has to rely on its subsidiaries to conduct its business.

Practical advice

The affiliates of the SPE that are included in the non-consolidation opinion are referred to as the “pairings” non-consolidation opinion.

  • The basic rule, and the requirement in rated transactions, is to associate the SPE with any shareholder (or group of affiliated shareholders) who owns 49% or more of the stakes in the SPE, plus any guarantor and any affiliated manager. (collectively, the “Related Entities”).
  • The non-consolidation opinion will have the SPE on one “side” of the opinion, and the Related Entities on the other. Other special purpose entities required for the transaction, such as operational tenants or general partners of a special purpose limited partnership, must be included in the SPE part of the non-consolidation notice, associated with related entities. No non-consolidation notice is required between the SPEs required by the transaction.
  • In real estate transactions with both a mortgage loan and a mezzanine loan, the mezzanine borrower is not an SPE required by the transaction for the purposes of the mortgage loan, as it has a separate debt that must be isolated from the debt of the mortgage borrower. Instead, the mezzanine borrower, as the owner of the mortgage borrower’s equity, should be included as a related entity in the mortgage non-consolidation notice.


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