Pub. 5 2015 Issue 1

Taking Legal Opinions One Step Further - Non-Consolidation Opinions By JOHN HAY & CHRISTINA NOYES COUNSELOR’S CORNER L E NDERS ROUTINELY RELY UPON OPINIONS FROM BORROWER’S COUNSEL TO VERIFY THAT ALL NECESSARY DUE DILIGENCE BEEN done, and that all necessary actions have been taken to ensure that the transaction is valid and enforceable. A non-consolidation opinion, which is bankruptcy focused and requires ad- ditional assurances over and above the customary opinion of borrower’s coun- sel, can be an important component of the transaction in certain situations such as when the loan is more than $20,000,000. With any commercial loan in which the primary or sole collateral is real estate, a lender needs to be concerned a bankruptcy could prevent (or at least greatly delay) the lender’s ability to foreclose on its collateral upon a default. If the reason for the default is related to the borrower’s other business activities, those activities are more likely to cause bankruptcy proceedings that could impair the ability of the lender to handle and foreclose on the collateral, even if that collateral is itself not impaired. To prevent this, lenders frequently require borrowers to place the collateral in a business entity – a corporation or limited liability company – that has no other business activities, and cause that entity (known as a single purpose entity or SPE) to be the borrower on the loan. The other owners or affiliates of the SPE are then usually required to guarantee the loan. Although the SPE may be the bor- rower, there is a danger that if a major affiliate of the SPE borrower goes into bankruptcy, the bankruptcy court will consolidate all affiliates of the bankrupt entity into the bankruptcy proceedings, even if they would otherwise not qualify for bankruptcy protection. This has happened in numerous cases, the most prominent recent one is the General Growth Corporation, in which the bankruptcy court consolidated some of the separate entities owned by Gen- eral Growth into a single bankruptcy proceeding, including entities owning shopping centers that were profitable. This caused the profitable centers, each of which was collateral for a loan from a different lender, to become collateral for the unprofitable centers, thereby benefiting the lenders of unprofitable centers at the expense of lenders to the profitable centers. There are steps that can be taken to prevent that result, which is called “substantive consolidation” by the bankruptcy courts. The purpose of a non-consolidation opinion letter is to be sure that borrower’s counsel has verified that the borrower has in fact taken all of those steps that can reasonably be taken. A non-consolidation opinion essentially states that if an affiliate of the borrower is involved in bankruptcy or insolvency proceedings, the borrower will not be consolidated into those proceedings, unless the borrower has taken specific action that would warrant bankruptcy protection. The purpose is to ensure that the lender is in the best position at loan closing to exercise its future remedies against the collateral if the loan goes into default without having to deal with a bankruptcy of the affiliate. The opinion will not guar- antee that substantive consolidation cannot happen. It can only state that, based on the then current law, all steps have been taken that can reasonably be taken to prevent it from happening. Currently, a non-consolidation opinion can be issued by a law firm that deals with both lending and bankruptcy law under the following circumstances: the borrower must be an SPE that owns the property and does not own any other property; the borrower must have no other business than owning and managing the property; the borrower must not be liable for, or pay, any debts or obligations of any affiliate or owner; the borrower must be held out to the public and to all persons dealing with it as separate from any of its affiliates or owners; the borrower must have separate books and records and must keep separate financial records and tax returns (although it can be part of a consolidated group of companies for tax purposes with separate records); and the borrower must have no obligations other than the ownership and management of the property. In short, it must be totally separate from any other affiliate, it can- not be the alter ego of any affiliate and no affiliate can be its alter ego. Before preparing a non-consolidation opinion, the firm issuing the opinion may require its client to separate its operations from other entities. The formation documents must typically include certain representations and affirmative covenants on separate opera- tions after the loan is finalized. The opinions tend to contain many pages of legal analysis, and are very time con- suming for the borrower clients. Many law firms lack the expertise to issue non-consolidation opinions and other law firms refuse to do so because of the potential liability that may accrue. Ensuring that the lender is in the best position at loan closing and has taken all the steps it can take under current law to minimize or avoid bankruptcy complications, however, is a worthy and necessary step for large loans. w John Hay and Christina Noyes are partners in Gust Rosenfeld’s Commercial section and can be reached at 602-257-7422. 8 www.azbankers.org