Over the past 10-20 years, a large number of secured equipment finance and asset securitization transactions have been structured using either a Delaware Statutory Trust (a “DST”) created pursuant to the Delaware Statutory Trust Act, 12 Del. C. Section 3801 et seq. (the “DST Act”) or a Delaware Limited Liability (a "DLLC") Company created pursuant to the Delaware Limited Liability Company Act, 6 Del. C. Section 18-101 et seq. (the “DLLC Act”). The use of either a DST or a DLLC offers many advantages and protections to the parties involved and flexibility and benefits to those who structure such transactions.
The Preference for Delaware SPEs
Many structured equipment finance and asset securitization transactions involve a special purpose entity (an “SPE”) created specifically to serve as owner/lessor/borrower with respect to an asset being financed or as a sponsor with respect to a pool of assets being securitized. In each case, the parties must select the “home state” of each SPE used in the transaction. Several factors including limiting the liability of the participants, linking and limiting debt obligations to a particular asset or class of asset, tax characterization, bankruptcy remoteness and ability to satisfy Know Your Customer (“KYC”)/Patriot Act information requirements impact this decision. Industry professionals frequently select Delaware as the home state for structured finance SPEs, for numerous reasons.
The industry’s preference for Delaware begins with the State’s general reputation as the foremost jurisdiction for forming a business organization. Delaware entities constitute a substantial percentage of the “Fortune 500” companies and the companies listed on the New York Stock Exchange and quoted on the NASDAQ Stock Market.
One reason for Delaware’s overall stature is the advanced state of its law. Delaware’s statutory laws governing business entities are regularly reviewed and updated. Delaware also has a wealth of judicial decisions, which affords business decision-makers a greater degree of certainty and predictability. Further, Delaware’s Court of Chancery and the Delaware Supreme Court enjoy a worldwide reputation for excellence; their wide-ranging experience with business issues has resulted in unparalleled expertise, which translates into efficient, prompt, fair, and more predictable resolution of disputes. Another component of the “Delaware advantage” is Delaware’s “business friendly” state government. Delaware’s legislature and Governor historically have demonstrated a willingness to understand and be responsive to the needs of business. Finally, business executives, investors, and rating agencies are familiar with, and frequently have a favorable view of, Delaware law as it relates to Delaware business entities. This level of acceptance among decision-makers in the capital and commercial markets is a major factor contributing to Delaware’s status as the forum of choice for the formation of business entities.
A report by one of the major rating agencies highlights Delaware’s preeminence. Focusing on the use of a single-member limited liability company as an SPE in structured financings, Moody’s Investors Service touted Delaware as “the preferred state for the LLC’s formation,” stating that the “provisions of the [Delaware Limited Liability Company Act (the “Delaware Act”)], in conjunction with other protections described in [the] report, provide sufficient grounds for a highly rated transaction using a single member LLC as an [SPE]. To date, virtually all of the single member LLCs involved in transactions that Moody’s has evaluated had been formed pursuant to the Delaware Act” (emphasis added). In addition, the report stated that “the Delaware courts have developed a coherent body of corporate law that is highly predictive in nature. Because most LLCs are formed in Delaware, and given Delaware’s volume of corporate law precedents, Delaware courts are likely to be among the first to develop case law regarding the appropriate treatment of single member LLCs.”
The Preference for DSTs and DLLCs
An SPE used in a structured finance transaction frequently takes the form of a DST or a DLLC.
The DST is widely viewed as the preferred vehicle for structured equipment finance and asset securitization transactions. DSTs offer several advantages over a common law trust in structured finance transactions. One advantage is a comprehensive statutory framework, the DST Act, which authorizes the creation of DSTs and provides express rules governing their internal affairs. By stating that a DST is a separate legal entity, may carry on any lawful business or purpose, has perpetual existence (except as otherwise provided in the DST’s governing instrument i.e. its Trust Agreement), and will not terminate or dissolve as a result of the death, incapacity, dissolution, termination or bankruptcy of a beneficial owner (again, except as otherwise provided in the Trust Agreement), the DST Act provides DSTs with bankruptcy remoteness features not present in a common law trust. In addition, a DST (unlike a common law trust) is a separate legal entity. This aspect allows the DST to be a party to finance documents in its own name, thereby bolstering the argument that liability should be limited to the DST as an entity. This aspect also may make it easier for the DST to satisfy KYC requirements of other parties to the transaction.
The DLLC may be the most popular type of alternative business entity. Created pursuant to the DLLC Act, a DLLC may engage in virtually any lawful activity, including acting as an SPE in a structured financing. In its report, Moody’s Investors Service explained that “[l]imited liability companies provide a number of advantages to sponsors …. Single member LLCs are particularly appealing because of (i) the simplicity of their formation and operation ... and (ii) their attractive tax treatment, where the sponsor avoids taxation at the LLC entity level and need not file tax returns for the LLC.”
General Advantages of DSTs and DLLCs
Following are some general advantages offered by DSTs and DLLCs.
Ease of Formation and Maintenance with Minimal Cost
DSTs and DLLCs are relatively easy and inexpensive to form and maintain. Each is formed by filing a “short form” certificate (a certificate of trust for a DST and a certificate of formation for a DLLC) and by entering into a Trust Agreement or LLC Agreement, as applicable. A modest fee must be paid to the Delaware Secretary of State upon the filing of a certificate of trust or certificate of formation. No annual fees or franchise taxes are required to be paid to the State of Delaware by a DST, and a modest annual fee must be paid by a DLLC. In addition, a DST requires that there be a trustee within the State of Delaware while a DLLC requires the appointment of a registered agent within the State of Delaware.
The basic approach of both the DST Act and the DLLC Act is to let the parties define their business relationship, and to provide rules only in situations where the parties have failed to agree. A stated policy of both statutes is to give maximum effect to the principle of freedom of contract and to the enforceability of a DST’s Trust Agreement or a DLLC’s LLC Agreement. This enables parties to create relationships that best suit their business needs and to determine, by agreement, nearly all aspects of those relationships. For instance, in the DST’s Trust Agreement or DLLC’s LLC Agreement, parties may provide for various classes of beneficial owners (in the case of a DST) or members (in the case of a DLLC), with each class enjoying different rights, powers, and duties, including separate voting rights and economic rights. Also, the DST Act and the DLLC Act provide that, to the extent that a trustee of a DST or a member or manager of a DLLC has duties (including fiduciary duties) to the entity and certain constituents, the DST’s Trust Agreement or the DLLC’s LLC Agreement may expand, restrict or eliminate such duties. (The elimination of such duties is an important tool in addressing the concerns presented by the General Growth bankruptcy matter.)
The business and affairs of a DST are typically managed by a trustee or trustees, but a Trust Agreement may provide for management by other persons, including the DST’s beneficial owners and/or third-parties. The Trust Agreement may address practically any aspect of the DST’s management; for example, it may provide for an amendment of the Trust Agreement, a merger, conversion or consolidation, or a sale of trust property, with or without the vote or approval of any particular trustee, a (particular) beneficial owner or a third-party, as the parties may desire.
A DLLC similarly offers broad management flexibility, allowing parties to select the arrangement that works best for them. Under the DLLC Act, a DLLC typically is “owned” by its members, who can participate in management without jeopardizing their limited liability, but alternatively may elect to have the DLLC managed by someone else (e.g., a “manager”) or adopt a blend of these two approaches. The LLC Agreement may provide for different classes of members and managers, each having whatever rights, powers, and duties are desired.
Generally speaking, beneficial owners and trustees of a DST, and members and managers of a DLLC, have no personal liability for the debts and obligations of the entity. In addition, the DST Act and DLLC Act empower DSTs and DLLCs to “indemnify and hold harmless any … person from and against any and all claims and demands whatsoever.” This limitation on personal liability and broad scope of permissible indemnification are viewed favorably by prospective investors and industry professionals.
As a matter of United States federal income tax law, a DST or DLLC may be structured so that it will not be subject to tax at the business organization level. Therefore, from a tax perspective, DSTs and DLLCs offer a tax efficient alternative to the corporation, which typically is taxed at the organization level. Of course, the contractual freedom afforded by the DST Act and DLLC Act enables parties to select the tax treatment most appropriate to their business needs.
Specific Bankruptcy Remoteness Features of DSTs and DLLCs
Both the DST Act and the DLLC Act contain “default rules” and enabling provisions that facilitate bankruptcy remoteness.
Minimizing the Risk Posed by an Originator’s Bankruptcy
A major concern in every structured financing is whether creditors of the originating company will be able to reach the SPE’s assets to satisfy their claims in a bankruptcy proceeding involving the originator. The DST Act and DLLC Act contain protective provisions that address this risk.
- Less Risk of SPE Consolidation. Under the DST Act and DLLC Act, DSTs and DLLCs are legal entities separate and distinct from those who own or manage them. The rules governing management and internal affairs of the DST and DLLC typically are those chosen by the parties; therefore, compliance with these agreed upon formalities should be relatively easy. These features can help parties maintain separateness between the SPE and the originating company, thereby reducing the likelihood that a bankruptcy court will consolidate the assets and liabilities of the SPE with those of the originator.
- More Protection for SPE Assets. The DST Act provides that no creditor of a beneficial owner of a DST has any right to obtain possession of or exercise any legal or equitable remedies with respect to the DST’s property. Unless otherwise provided in a DST’s Trust Agreement or a DLLC’s LLC Agreement, neither a beneficial owner nor a member of the SPE has any interest in specific SPE property. A beneficial interest in a DST, or a limited liability company interest in a DLLC, is personal property. By reinforcing separateness, these statutory provisions can help shield SPE assets from the originating company’s creditors in cases where the originator retains an interest in the SPE.
- Less Risk of SPE Termination. A DST has perpetual existence and cannot be terminated or revoked by a beneficial owner or other person except in accordance with the terms of its Trust Agreement. A DLLC also has perpetual existence subject to the terms of the LLC Agreement. The DST Act provides that the bankruptcy of a beneficial owner does not terminate or dissolve the DST except to the extent otherwise provided in its Trust Agreement. Similarly, the DLLC Act provides that the bankruptcy of a member does not dissolve the DLLC unless otherwise provided in the LLC Agreement. The DLLC Act also provides that the LLC agreement can limit and/or define the events that will cause dissolution of the DLLC. Furthermore, the LLC Agreement may provide that a person does not cease to be a member upon such person’s bankruptcy. (This is of particular relevance to single-member DLLCs used as SPEs and the rating of securities issued by them.) Finally, a DST’s Trust Agreement and a DLLC’s LLC Agreement can limit the SPE’s activities, and include other provisions to enhance separation of the securitized assets from the originator. A carefully drafted Trust Agreement or LLC Agreement can help significantly reduce the risk that a bankrupt originator or a trustee in bankruptcy will be able to terminate the SPE prematurely and reach its assets.
Minimizing the Risk of the SPE's Bankruptcy
A second major concern in securitizations is that the SPE itself will file for bankruptcy for reasons unrelated to the creditworthiness of the asset pool. Seeking to minimize this risk, parties sometimes implement procedures regarding the SPE’s voluntary commencement of bankruptcy proceedings. The flexibility provided by the DST Act and DLLC Act permit responsibility for making this determination to be vested in an appropriate decision-maker, such as an independent trustee or other manager designated in the Trust Agreement or LLC Agreement. Under the DST Act and the DLLC Act, the “duties (including fiduciary duties)” and related liabilities of such decision-makers to the SPE and certain of its constituents may be restricted by the Trust Agreement or LLC Agreement, and any such decision-maker acting under such instrument or agreement will not be liable to the SPE or such constituents for relying in good faith on the instrument or agreement. Participants therefore may agree to provisions that restrict the fiduciary duties and related liabilities of the designated decision-maker in regard to a bankruptcy filing for the SPE. In this regard, a DST or DLLC can provide a meaningful advantage over a corporate SPE: a corporation generally does not offer as much contractual flexibility regarding the fiduciary duties and liabilities of its directors, which means that a fiduciary of a corporate SPE, faced with decisions regarding bankruptcy of the SPE, may confront increased risk of liability to an originator/stockholder.
Further, in a DST’s Trust Agreement or a DLLC’s LLC Agreement, the parties can limit the SPE’s purposes and powers, and structure its management and decision-making authority, to reduce the risk of having creditors or claims against it that are not related to the transaction. The absence of such claims and creditors can reduce the likelihood that the SPE itself will become bankrupt.
A DST has an additional bankruptcy remoteness feature. Depending on its underlying characteristics and the purposes for which it is established, a DST may not always be eligible to commence a bankruptcy case as a debtor under the federal Bankruptcy Code. This potential advantage is not available where a corporation is the SPE, because corporations are eligible to commence bankruptcy proceedings as debtors.
DSTs are widely regarded as the preferred vehicles for equipment finance and asset securitization transactions, and DLLCs, including single-member DLLCs, are being used more frequently as SPEs in asset securitizations. The general preference for Delaware as the SPE’s “home state;” ease and low cost of formation and maintenance; contractual freedom; management flexibility; limited liability; tax advantages; and particularly, special bankruptcy remoteness features, are all key factors that appeal to securitization professionals, businesses contemplating securitization, potential investors, and rating agencies, and help make DSTs and DLLCs uniquely attractive as SPEs.
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