During the past decade, there has been a dramatic increase in the use of special-purpose entities (SPEs) in a variety of contexts throughout structured finance and securitization markets, as companies and their lenders have found that using SPEs can provide more credit security to the lender and lower interest rates to the borrower. By using an SPE, a company attempts to isolate cash-producing portions of its business from other, riskier portions of the larger business by transferring the financial assets to an SPE. The primary purpose of the isolation and transfer of financial assets to an SPE is to insulate the lender or investors from the insolvency and bankruptcy risks of the original borrower or originator that formed the SPE. This lower risk of insolvency lowers the credit risk and the overall cost of borrowing for the originator.

An SPE is an entity, formed concurrently with, or immediately prior to, the closing of a financing transaction, one purpose of which is to isolate the financial assets from the potential bankruptcy estate of the original entity, the borrower or originator. Often, the originator owns or is affiliated with the SPE, and the parties to the transaction develop elaborate procedural safeguards to ensure that the SPE is unlikely to become insolvent as a result of its own activities and that it is adequately insulated from the consequences of any related party's insolvency, thus reducing the likelihood of the SPE's being involved in a bankruptcy proceeding. SPEs are also sometimes referred to as "single-purpose entities" or "bankruptcy remote entities."

Structure of SPEs

1. Restrictions in charter documents. There is a wide range of entities used to create SPEs, but the type of entities most frequently used are corporations, limited partnerships and limited liability companies. In order to be deemed bankruptcy remote, certain criteria should be incorporated into the transaction documents and the charter documents of the SPE.² One of the limitations included is restrictions on the ability of an SPE to incur additional indebtedness, other than the indebtedness associated with the current transaction. Also, both the transaction documents and charter documents should expressly describe the purpose for which the SPE is formed and limit the activities of the SPE to those necessary to accomplish the purpose for which it was formed. Additional criteria normally included in the organizational and transactional documents of the SPE are prohibitions on the consolidation and liquidation of the SPE, restrictions on mergers and asset sales by the SPE, prohibitions on amendments to the charter and transaction documents and separateness covenants. In addition, there is usually the requirement that the SPE have at least one independent director or its equivalent.

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In the bankruptcy context, preemption will only void a state law, or organizing document under state law, where such law or document conflicts with provisions of the Bankruptcy Code, particularly those sections prohibiting ipso facto clauses.

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2. Requirement of independent director. In many structured transactions, the SPE is established by a non-SPE operating entity parent or affiliate, and the parent originator often has a credit rating below the credit rating of the SPE. The SPE, depending on its business entity structure, acts through its board of directors, general partner, management committee or managing member. The directors or managers of the parent originator may serve as directors or managers of the subsidiary SPE. Interlocking directorates, however, may present potential conflicts of interest since among the major decisions that may be taken by the directors or managers of an SPE would be the decision for the entity to file for bankruptcy. If the parent originator becomes insolvent even though the subsidiary SPE is financially viable and is meeting its debts as they become due, there may be an incentive for the originator parent to cause the subsidiary SPE to "voluntarily" file a bankruptcy proceeding in order to consolidate the SPE's assets with those of the originator parent. This concern has prompted rating agencies and lenders to require the SPE to appoint an "independent director" in the case of corporate SPEs or the equivalent in the case of other forms of SPEs. The charter documents of the SPE typically require that it have at least one director or manager that is independent from the parent originator, and in addition, that the vote of the independent director or manager is required with respect to any action seeking bankruptcy protection for the SPE or the amendment of its charter documents. Further, rating agencies generally require that the charter documents of an entity seeking to be considered an SPE recite that in voting on bankruptcy matters, an independent director has to take into account the interests of the investors or the lender.³

Bankruptcy Courts Will Recognize and Uphold Contractual and State Law Provisions Governing Who May File Bankruptcy Petitions on Behalf of SPEs

SPEs are creatures created under state law, and state law governs the recognition and enforcement of an SPE's charter documents, including the requirements that an SPE have an independent director or manager, and that the approval of the independent director or manager be obtained prior to filing a bankruptcy petition. In order to help ensure bankruptcy remoteness of an SPE, it is necessary that parties to the transaction have some comfort that state law, and not federal law, will govern the determination of what persons or entities have authority to file a voluntary bankruptcy petition, irrespective of the form of the business entity that is the SPE. If the state law requirements are not recognized and upheld by a federal bankruptcy court, then they would be ineffective in ensuring bankruptcy remoteness between the subsidiary SPE and its parent originator.

1. Form of SPE business entity. A review of case law with respect to corporations and partnerships reveals that the validity of a bankruptcy filing on behalf of a business entity is a determination to be made under state law and not under federal law. This principle is most firmly established in the corporate context, where it is well settled that state law governs who may file a bankruptcy petition on behalf of a corporation. A significant body of case law also exists with respect to partnerships, and, as with corporations, the courts have traditionally looked to state law to determine who may file for bankruptcy relief on behalf of a partnership. Although there are no cases directly on point, through analogy to corporate and partnership cases, it is expected that state law filing requirements in a limited partnership or limited liability company SPE's charter document would also be respected under federal law.

2. Corporations. It is a well-established principle that bankruptcy courts will look to the law of the state in which a corporation is chartered to determine who possesses the requisite authority to file a bankruptcy petition on behalf of a corporation. The seminal case on this point is the Supreme Court opinion in Price v. Gurney, 324 U.S. 100 (1945). In Price, a shareholder of an Ohio corporation, intending to remove the standing board, filed a bankruptcy petition on behalf of the corporation. 324 U.S. at 101. In ruling on whether the shareholder had authority to file, the Court stated, "[t]he district court in passing on petitions filed by corporations under chapter X must of course determine whether they are filed by those who have authority to act. In the absence of federal incorporation, that authority finds its source in local law." Price, 324 U.S. at 106. Because Ohio corporate law vested management authority in the board of directors, the Court ruled, the petition filed by the shareholder was not valid. Id.

Naturally, the lower federal courts, including the bankruptcy courts, have followed the Price ruling with respect to corporate bankruptcy filings. For example, in Keenihan v. Heritage Press Inc., the Eighth Circuit ruled that an Arkansas corporation's chapter 11 petition was an invalid filing because it was filed by the president, who had no state law authority to cause the corporation's filing. 19 F.3d 1255, 1259 (8th Cir. 1994). The court initially noted that the authority to commence bankruptcy proceedings on behalf of a corporation is derived from state law. Id. at 1258 ("[a] person filing a voluntary bankruptcy petition on a corporation's behalf must be authorized to do so, and the authorization must derive from state law"). In this case, the corporation's president had been validly removed pursuant to a state court-issued temporary restraining order. Id. at 1259. Thus, he did not possess the authority to place the corporation into bankruptcy. Id. ("because the authority to file bankruptcy on a corporation's behalf derives from state law, and because the TRO represents state law that limited [the president's] powers...we conclude [the president] lacked the authority to file bankruptcy..."); see, also, In re Phillips, 966 F.2d 926, 934 (5th Cir. 1992) ("[f]or many years, courts have consistently looked to state law to determine whether a person has authority to file a voluntary petition on behalf of a corporation").

Precedent also exists for the proposition that bankruptcy courts will uphold limiting provisions not only of state statutes, but of articles of incorporation and bylaws as well. Bankruptcy courts recognize the validity of charter documents that restrict the authority to file bankruptcy to certain persons or entities, so long as they are endorsed under state law. For example, in Winter v. Bel-Aire Investments Inc. (In re Bel-Aire Investments Inc.), 97 B.R. 88, 89 (Bankr. M.D. Fla. 1989), the court invalidated a bankruptcy filing on behalf of a corporation made by the corporation's president because the president did not possess the requisite authority under the corporation's articles of incorporation. Florida law requires a valid resolution of a corporation's board of directors before a bankruptcy filing is authorized. Id. at 90. In Bel-Aire, the court examined the corporation's articles of incorporation, and because they limited the president's duties to management of the corporation's business, the court determined that filing a bankruptcy petition on behalf of the corporation was beyond the president's discretion. Id. at 89-90 ("[i]t is well established that since the Bankruptcy Code itself does not establish the requisites for the initiation of a voluntary corporate bankruptcy case, the validity ...must be determined with reference to the laws of the state in which the corporation was chartered...[t]here is no question that the authority to manage the affairs of the corporation does not include the right to file a petition for relief under any of the operating chapters of the Bankruptcy Code."); see, also, In re Quarter Moon Livestock Co. Inc., 116 B.R. 775, 778 (Bankr. D. Idaho 1990) ("the authority to file a bankruptcy petition must be found in the instruments of the corporation and applicable state law") (emphasis added).

In light of the principle set forth by the Supreme Court in Price, in evaluating whether a corporation's bankruptcy petition was properly authorized, courts will examine the corporation's articles of incorporation, bylaws and the law of the state in which the corporation is incorporated. See, e.g., In re Giggles Restaurant Inc., 103 B.R. 549, 553 (Bankr. D. N.J. 1989); In re Nyack Autopartstores Holding Co., 98 B.R. 659, 663 (Bankr. S.D.N.Y. 1989); In re Markus Enters. Inc., 91 B.R. 459, 460 (M.D. Tenn. 1988); In re Minor Emergency Ctr. of Tamarac Inc., 45 B.R. 310, 311 (Bankr. S.D. Fla. 1985); In re Hawaii Times Ltd., 53 B.R. 560, 561 (Bankr. D. Haw. 1985); In re Crescent Beach Inn Inc., 22 B.R. 155, 157 (Bankr. D. Me. 1982); In re Autumn Press Inc., 20 B.R. 60, 61 (Bankr. D. Mass. 1982).

3. Partnerships and other entities. A substantial body of law also exists on the filing-authority issue in the partnership context. These cases have traditionally held that state law governs who may file a bankruptcy petition on behalf of a partnership. In Union Planters Nat'l. Bank v. Hunters Horn Associates (In re Hunters Horn Associates), 158 B.R. 729, 730 (Bankr. M.D. Tenn. 1993), the court held that because "nothing in the Bankruptcy Code defines who may act to file a petition for a partnership...[t]he general rule has emerged that authority to bind an entity to a voluntary petition in bankruptcy is determined by state law." In Hunters Horn, the debtor was a partnership with two general partners, one of whom had recently died. Id. at 729. The remaining partner filed for bankruptcy relief on his own behalf, and subsequently, with the consent of the deceased partner's estate, commenced a chapter 11 proceeding on the partnership's behalf. Id. at 730. The court was presented with the opportunity to determine what effect the death of one partner, and the individual bankruptcy of the other partner, had on the authority to place the partnership into bankruptcy. Id. The court referenced Tennessee state law, as well as the operative partnership agreement, to conclude that upon the death of the deceased partner, filing authority for the partnership passed to the surviving partner. However, upon his individual bankruptcy filing, these "contractual rights of management were property interests which became property of [the partner's] chapter 7 estate." Id. at 731. The court ultimately determined that the individual bankruptcy filing caused management of the partnership to become the prerogative of the trustee. Id. However, in doing so, the court looked to state law and the operative provisions of the partnership agreement. Id.

The Fifth Circuit addressed filing authority in the partnership context in Phillips, 966 F.2d 926. As in Hunters Horn, a general partner's authority to place the partnership into bankruptcy was called into question because the general partner had filed his own individual bankruptcy petition prior to seeking bankruptcy relief on behalf of the partnership. Phillips, 966 F.2d at 928. The court held that, under the Texas Uniform Partnership Act, the partner was not permitted to place the partnership into bankruptcy after he had secured chapter 11 protection for himself. Id. at 929. In support of their decision to rely on Texas law to determine the question of the partner's authority to file, the court stated "[t]hroughout the many revisions to federal bankruptcy law, courts continue to resolve authority-to-file disputes according to state law." Id. "Without further direction from Congress, we will continue to look to state law to determine which people have authority to seek federal bankruptcy protection on behalf of state-created business entities." Id.; see, also, Goldberg v. Rose (In re Cloverleaf Properties), 78 B.R. 242, 243 (9th Cir. B.A.P. 1987) ("[a]lthough a general partner may ordinarily bind a partnership without the consent of the other general partners, in bankruptcy this rule is reversed"); Jolly v. Pittore, 170 B.R. 793, 797 (S.D.N.Y. 1994) (citing Price, 324 U.S. at 106) ("[a] person filing a voluntary bankruptcy petition on a partnership's behalf must be authorized to do so, and authorization must derive from state law.").

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In the bankruptcy context, preemption will only void a state law...where such law or document conflicts with provisions of the Bankruptcy Code....

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The principle that state law governs who may initiate bankruptcy proceedings on behalf of a partnership is also supported by the advisory committee notes to the Federal Rules of Bankruptcy Procedure. Prior to Dec. 1, 2002, Bankruptcy Rule 1004(a) provided that a "voluntary petition may be filed on behalf of the partnership by one or more general partners if all general partners consent to [the filing of] the petition." Bankruptcy Rule 1004 was amended in recognition of the profusion of caselaw regarding this issue, so that it no longer addresses filing authority on behalf of partnerships. The advisory committee note attendant to amended Bankruptcy Rule 1004 states: "[s]ince this [the authority to file issue] is a matter of substantive law beyond the scope of these rules, Rule 1004(a) is deleted, as is the designation of subdivision (b)."

There is a nascent but clear trend in federal bankruptcy jurisprudence to lend this "authority-to-file" principle, already firmly entrenched in the corporation and partnership contexts, to other business entities such as limited partnerships and limited liability companies. Courts deciding who may file for bankruptcy protection on behalf of a limited partnership have held that state law governs. See, e.g., Phillips, 966 F.2d at 928. The U.S. Bankruptcy Court for the Eastern District of Virginia likewise held, albeit in dicta, that state law governs the authority-to-file question in the context of limited liability companies. See In re DeLuca, 194 B.R. 79, 87 n. 12 (Bankr. E.D. Va. 1996) (stating that the manager of the LLC had no authority to file a bankruptcy petition on the LLC's behalf because the LLC's operating agreement, valid under Virginia law, required a vote of all members to make the decision to place the LLC into bankruptcy). Thus, bankruptcy courts will look to state law to determine who is authorized to request bankruptcy relief on behalf of a corporation, partnership, limited partnership or limited liability company.

4. Preemption. The first issue to consider is whether the Bankruptcy Code, as federal law, would preempt state law rules regarding who may file a bankruptcy petition on behalf of an SPE. Because the authority-to-file question has generally been regarded as an issue of substantive law that is not addressed in the Bankruptcy Code, the courts have not held that federal preemption would vitiate the effect of state statutes or charter documents that place restrictions on which persons or entities may act to request bankruptcy relief on behalf of an SPE. For example, in the Phillips case, the general partner who had filed a bankruptcy petition on behalf of the partnership was faced with the fact that Texas law did not authorize this filing. 966 F.2d 926 at 928. As a result, he argued that the provision of Texas law that restricted his authority was preempted by former Bankruptcy Rule 1004(a). Id. In rejecting this argument, the court reasoned that "when Congress accorded the Supreme Court authority to promulgate the Bankruptcy Rules, it stated, '[s]uch rules shall not abridge, enlarge, or modify any substantive right.'" Id. (quoting 28 U.S.C. §2075). The court thus held that former Bankruptcy Rule 1004(a) could not augment the substantive management authority of general partners in a partnership formed under state law. Id. at 934.

In the bankruptcy context, preemption will only void a state law, or organizing document under state law, where such law or document conflicts with provisions of the Bankruptcy Code, particularly those sections prohibiting ipso facto clauses. See, e.g., Summit Inv. and Dev. Corp. v. LeRoux, 1995 WL 447800, at *12 (D. Mass. Oct. 20, 1994), aff'd., 69 F.3d 608 (1st Cir. 1995) ("ipso facto" provisions within state partnership law and partnership agreement that removed management authority from general partner who filed individual bankruptcy petition were preempted by the Bankruptcy Code, because the partnership agreement was an executory contract that could not be terminated by an ipso facto clause, pursuant to Bankruptcy Code §365(e)); In re Map 1978 Drilling Partnership, 95 B.R. 432 (Bankr. N.D. Tex. 1989) (holding that partnership agreement that required an absolute majority vote by limited partners for a sale of assets outside the ordinary course was preempted by Bankruptcy Code §1126(d), even though the partnership agreement was valid under state law).

Conclusion

In the absence of a contractual or state statutory provision that conflicts with federal law, the bankruptcy courts will approve limitations on bankruptcy filings that comply with state law. This is because bankruptcy courts consider the authority-to-file issue a question of substantive rights. These filing authority rights, to the extent that they are not addressed by the Bankruptcy Code, are determined by the laws of the state in which the SPE is chartered. The courts have already reached a consensus regarding the issue of which persons or entities have authority to file petitions on behalf of corporations and partnerships. The increase in the use of other business entities, such as limited partnerships and limited liability companies, has given the courts additional occasion to address this issue in the context of these special entities. In so doing, the courts have borrowed rules and reasoning from the corporate and partnership-law arena. Because the authority-to-file question is not addressed in the Bankruptcy Code, the Code will not preempt contractual and state law provisions dealing with filing authority. Thus, restrictions on the decision to file a bankruptcy proceeding for an SPE that are enforceable under state law should be upheld by the bankruptcy courts, helping to ensure that SPEs remain a viable alternative in insulating financial assets from the risks of bankruptcy of affiliated organizations.

Footnotes

¹ The author gratefully acknowledges the assistance of Sheilah Gibson, James Carignan and William Firth III in the preparation of this article. Return to article

² "Legal Criteria for Structured Finance Transactions," Standard and Poor's, April 2002. Return to article

³ Id. Return to article