The Bottom Line:
The United States Bankruptcy Court for the Northern District of Illinois recently issued a decision in an adversary proceeding related to Doctors Hospital of Hyde Park’s bankruptcy filing. See Paloian v. LaSalle Bank, N.A. (In re Doctors Hospital of Hyde Park, Inc.), Case No. 02-363, 2011 Bankr. LEXIS 4745 (Bankr. N.D. Ill. Dec. 2, 2011). That decision addressed issues that had been appealed to the Seventh Circuit Court of Appeals, but following the Seventh Circuit’s written decision in Paloian v. LaSalle Bank, N.A., 619 F.3d 688 (7th Cir. 2010), were remanded to the Bankruptcy Court for further findings. The two decisions find that in order to determine whether a special purpose entity (an “SPE”) constitutes a bankruptcy remote entity (and is thus, presumably, free from the claims of its parent company’s creditors), a court must review the entire context of the financing relationship between the SPE and its parent. The courts determined that one must look beyond the question of whether the SPE is a formally distinct legal entity from its parent and in addition, conduct a factual balancing test to determine whether the SPE is sufficiently separate from its parent and whether any transfer of financial assets from a parent to its SPE constitute a true sale. While the Seventh Circuit’s decision has been criticized by industry commentators as confusing the concepts of bankruptcy remoteness and legal separateness, the Seventh Circuit’s newly articulated standard for determining bankruptcy remoteness now stands as the law of that circuit.
What Happened:
Doctors Hospital of Hyde Park, Inc. (“Doctors Hospital” or “Debtor”) was owned by Dr. James Desnick (“Desnick”). To maintain stable cash flow, Doctors Hospital obtained a revolving credit facility (the “Daiwa Loan”) from Daiwa Healthco-2 LLC (“Daiwa”). Under the terms of the credit facility Doctors Hospital contributed all of its healthcare receivables on an ongoing basis to MMA Funding, L.L.C. (“MMA”), a special purpose entity, 99% of the equity of which Desnick owned. MMA granted a security interest in all contributed healthcare receivables to Daiwa. Daiwa then loaned funds to MMA and MMA disbursed those funds either to Doctors Hospital or directly to Doctors Hospital’s creditors as the purchase price of the contributed receivables.
In addition, Doctors Hospital conducted its operations in facilities that it leased from HPCH LLC (“HPCH”)—another Desnick owned entity. Nomura Asset Capital Corporation (“Nomura”) loaned $50 million to HPCH (the “Nomura Loan”). In exchange, HPCH granted Nomura security interests in the leased facilities and the rent payments it received from Doctors Hospital. Doctors Hospital guaranteed HPCH’s obligations to Nomura and secured that guaranty by granting Nomura security interests in certain of its personal property. Initially, Doctors Hospital paid HPCH’s obligations under the Nomura Loan from cash that Doctors Hospital received from various third parties. Later, MMA paid HPCH’s obligations from the proceeds of the Daiwa Loan. Nomura later sold the Nomura Loan (together with the related security and credit enhancements) to Asset Securitization Corporation, which in turn sold it as part of an Asset Securitization Corporation Commercial Mortgage Pass-Through securitization pool maintained by LaSalle Bank, N.A. (“LaSalle”) as trustee.
Doctors Hospital filed for Chapter 11 protection in April of 2000. LaSalle, as trustee, filed a proof of claim in the bankruptcy for over $60 million based on the Debtor’s obligations arising from its guarantee of a loan. The bankruptcy trustee then filed an adversary proceeding against LaSalle. The complaint, which sought to (i) void the guaranty and security interest as fraudulent transfers and (ii) void the lease held by LaSalle or to recover as fraudulent transfers payments of rent that the Debtor made to LaSalle in excess of the property’s fair market rental value, served as a counterclaim to the LaSalle proof of claim. Ultimately, the Bankruptcy Court for the Northern District of Illinois concluded that some repayments were avoidable and others were not. Both parties appealed to the District Court, which affirmed the Bankruptcy Court’s decision. The parties then appealed the decision to the Seventh Circuit Court of Appeals. In December 2010, the Seventh Circuit vacated the District Court’s judgment and remanded the case to the Bankruptcy Court with instructions. Paloian v. LaSalle Bank, 619 F.3d 688 (7th Cir. 2010).
On appeal, the Seventh Circuit stated that the Bankruptcy Court would have to determine whether (i) the Debtor was insolvent at the time payments were made, which would involve determining whether MMA was in fact a separate business entity and not a “part, department or function of the Debtor”, and (ii) whether the transfer of the accounts receivable to MMA constituted a true sale. The Seventh Circuit reasoned that if such transfers were determined not to constitute a true sale, then MMA did not serve as the bankruptcy-remote intermediary LaSalle relied upon to make payments under the Nomura Loan. The Seventh Circuit also stated that:
As far as we can tell from this record. . .MMA Funding lacked the usual attributes of a bankruptcy-remote vehicle. It was not independent of Desnick or the Hospital; Desnick owned MMA Funding (99% of which was owned by the Hospital, and 1% of which was owned by a firm that Desnick owned directly or through some trusts), and MMA Funding operated as if it were a department of the Hospital. It did not have an office, a phone number, a checking account, or stationery; all of its letters were written on the Hospital's stationery. It did not prepare financial statements or file tax returns. It did not purchase the receivables for any price (at least, if it did, the record does not show what that price was). Instead of buying the receivables at the outset, MMA Funding took a small cut of the proceeds every month to cover its (tiny) costs of operation. The Hospital continued to carry the accounts receivable on its own books, as a corporate asset; it told other creditors that Daiwa had a security interest in the receivables, which is of course the sort of structure that makes the payments amenable to a preference-recovery action whether or not the receivables are remitted to a lockbox at a bank. There is scarcely any evidence in this record that MMA Funding even existed, except as a name that Daiwa's and Desnick's lawyers put in some documents.
619 F.3d at 696. The Seventh Circuit concluded that “the Code allows the trustee to look out for the interests of these other creditors, who may not appreciate that they should have charged extra [in interest] to offset the effects of a bankruptcy-remote vehicle that was hidden in the weeds. Perhaps LaSalle can offer on remand evidence to show that there was a bona fide sale of accounts receivable from the Hospital to MMA Funding and that MMF was more than a name without a business entity to go with it.” Id.
After the Seventh Circuit remanded the case back to the Bankruptcy Court, the Chapter 11 Trustee filed a motion for summary judgment seeking a determination as to whether MMA was actually a bankruptcy remote entity vis-à-vis Doctors Hospital, and if so whether there was a true sale of receivables thereto.
In addressing the bankruptcy remote issue, the Bankruptcy Court discussed how the test articulated by the Seventh Circuit addressed whether MMA was operationally separate and independent from Doctors Hospital, and not simply whether MMA was a distinct legal entity. See Paloian v. LaSalle Bank, N.A. (In re Doctors Hospital of Hyde Park, Inc.), Case No. 02-363, (Bankr. N.D. Ill. Dec. 2, 2011). In articulating that test, the Bankruptcy Court noted that the Seventh Circuit had expanded the legal criterion for entities seeking bankruptcy remote status. Despite disapproval from various industry commentators in response to the Seventh Circuit’s decision, the Bankruptcy Court was constrained to adopt the Seventh Circuit’s standard for determining bankruptcy remoteness. Based on the test articulated, the Bankruptcy Court found that on the evidence presented, it could not determine whether MMA operated as a distinct business entity and ordered a trial.
In addressing whether there was indeed a true sale, the Bankruptcy Court addressed the factors typically assessed when determining whether a transaction constitutes a true sale. Those factors include (i) whether the entity had recourse for uncollected receivables, (ii) whether the debtor had post-transfer control over the assets and administrative activities, (iii) how accounting was treated between the entities, (iv) whether the transfer included adequate consideration for the receivables and (v) whether the parties intended the transfers to be true sales. The Bankruptcy Court also stated that while the Seventh Circuit’s decision questioned whether a true sale had occurred, it did not specify particular failings with respect to the transaction. The Seventh Circuit simply highlighted that there was no evidence in the record that MMA paid Doctors Hospital any sort of purchase price for the assets. It did not address whether the grant of an equity interest, the loan satisfaction and the cash made available to Doctors Hospital constituted adequate consideration. The Seventh Circuit’s decision also did not discuss the fact that the loan documents (including the legal opinion) suggest that the parties to the loan contemplated and intended a true sale. Accordingly, the Bankruptcy Court found that while some elements of a true sale are present, others may be lacking. Again, the Bankruptcy Court determined that the issue must be decided at trial and not on a motion for summary judgment.
Why the Case is Interesting:
While the issues discussed above remain sub judice, the decisions issued by the Bankruptcy Court and the Seventh Circuit thus far demonstrate that when analyzing whether an entity constitutes a valid bankruptcy remote special purpose entity, courts may look at separateness factors typically assessed in conjunction with a substantive consolidation analysis, and not just whether the entity was intended by the parties to be bankruptcy remote through appropriate documentary formalities. Moreover, when analyzing whether a transaction constitutes a true sale, courts will look closely at all factors discussed in relevant case law to determine whether a true sale has in fact been achieved. Both of these analyses are fact intensive and require a hard look at the entire transaction between the debtor and the financing entity. In addition, these decisions suggest that while parties can create an entity with the intention that it be a valid bankruptcy remote special purpose entity, subsequent operational activities between the special purpose entity and its parent can alter the entity’s status. Accordingly, this case is a good reminder that in the documentation process and during the life of the transaction, parties should be diligent in ensuring that their transaction documents, and the entities involved in their transactions, achieve and sustain as many factors as possible that weigh in favor of a special purpose entity’s separateness and a true sale.