Certain Transactional Planning in, or in Relation to, Bankruptcy

May 16, 2007

This article is intended to address certain transactional issues that can come up in a bankruptcy proceeding or in relation thereto – specifically family asset protection vehicles, special purpose entities, sale lease-backs, and bankruptcy court ordered sale bidding procedures (including break-up fees). This article is here because it sets forth a number of issues to consider. However, because this area of the law is changing, this article is out of date, particularly with respect to whether any protections are provided by single member limited liability companies or separate, but related, entities that in fact work together, particularly through cross-guaranties and cross-collateralizations.

American Inns of Court
Jeopardy Program – Transactional Issues
Kenneth L. Samuelson

1. Family Planning Vehicles for Asset Protection Purposes.

(a) Authority for Little Protection for Personal Actions. In re Turner, 335 B.R. 140, 2005 Bankr. LEXIS 2379; 55 Collier Bankr. Cas. 2d (MB) 581 (N.D. Cal., 2005) “Asset protection” is not illegal [**15] and is honored by the law if done for a legitimate purpose. For example, an individual may do business through a corporation or limited liability company and will not be held personally liable for the debts of the entity. The assets of the corporation or limited liability company will not be considered the assets of the individual interest holder. However, an entity or series of entities may not be created with no business purpose and personal assets transferred to them with no relationship to any business purpose, simply as a means of shielding them from creditors. Under such circumstances, the law views the entity as the alter ego of the individual debtor and will disregard it to prevent injustice. Under similar facts, a trial court found that the corporation created by a judgment debtor to hold his assets was the judgment debtor’s alter ego. This finding was noted with approval by the Ninth Circuit Court of Appeals. See Fleet Credit Corp. v. TML Bus Sales, Inc., 65 F.3d 119, 120 (9th Cir. 1995). In Fleet, the trial court found that Berthold, the judgment debtor, had operated a corporation: . . . as an extension of himself. He personally directed the [**16] transfer . . . and did so for reasons that had nothing whatsoever to do with the operation of the corporate entity. . . . [I]t is beyond cavil that an inequitable result would follow were the Court to permit Berthold to shield himself with Taylor’s corporate form.

(b) Analysis of Debtor’s Control and LLC Statutes. In re Juan Santaella, 298 B.R. 793, 2002 Bankr. LEXIS 1423, 16 Fla. L. Weekly Fed. B 17 (S.D. Fla., 2002) (individual debtor retained total control); “Domestic Asset Protection Trusts: Pallbearers to Liability?”, ABA Real Property, Probate and Trust Journal, Vol. 34 No. 3 (Fall 2000); “Limited Liability Companies as Trust Substitutes, Part 1″ and “A Charging Order is the Exclusive Remedy Against a Partnership Interest: Fact or Fiction?”, ABA, Probate and Property, Vol. 17, No. 6 (Nov./Dec. 2003); “Basic Track: Asset Protection Planning – From Alaska to Vanuatu”, program presented at the ABA Section of Real Property, Probate and Trust Law Symposia (April 26, 2001).

2. The Use and Validity of Special Purpose Entities.

(a) Isolating Assets and Avoiding Substantive Consolidation. special purpose entity formed solely to isolate specified financial assets, from the operations of its parent operating company, for the benefit of a particular loan being made to that special purpose entity, in order to protect the lender’s interest in those assets as collateral for that loan and to avoid a substantive consolidation under Section 105. Transactions of this type typically require borrower’s counsel to render formal legal opinions that the transfer of the assets, from the operating company to the special purpose subsidiary/borrower, is a “true sale” and that the special purpose entity is not subject to substantive consolidation in the event of a bankruptcy of the operating company. See In re Doctors Hospital v. Desnick, 2007 Bankr. LEXIS 605 (N.D. Ill. E.D., 2007).

(b) Using Substantive Consolidation Nunc Pro Tunc to Revive a Cause of Action. In re Dahon, 2004 Bankr. LEXIS 1470, 52 Collier Bankr. Cas. 2d (MB) 1727, 43 Bankr. Ct. Dec. 187 (Mass., 2004).

(c) A LLC Operating Agreement. A limited liability company operating agreement is not an executory contract where the debtor has no present duties, except remote contingent ones. In re Capital Acquisitions & Management Corp., 341 B.R. 632, 2006 Bankr. LEXIS 807 (N.D. Ill., 2005).

(d) Piercing the Corporate Veil. In re Evergreen Security, 319 B.R. 245, 2003 Bankr. LEXIS 2108, 18 Fla. L. Weekly Fed. B 99 (M.D. Fla. O.D., 2003).

3. True Lease vs. Disguised Sale. Court refused to rule whether a series of related sale/lease-backs (whereby the “Landlords” funded the acquisition of the assets and obtained the tax benefits of the ownership thereof) were really disguised financings. Court felt that deciding recharacterization was premature, but indicated a reluctance to recharacterize, particularly where the main benefit of doing so seemed to be to the debtors’ equity holders, rather than to other creditors. In re Mirant Corporation, 327 B.R. 262, 2005 Bankr. LEXIS 619, 44 Bankr. Ct. Dec. 175 (N.D. Tx F.W. Div., 2005).

4. Bidding Procedures and Break-Up Fees.

(a) Forms. See attached extract of a contract of sale, and 2 related motions, under Section 363. See, also, In re E.Spire Communications, Inc., 2002 Bankr. LEXIS 1934 (Dela., 2002).

(b) The Amount of Break-Up Fees; Judicial Analysis. In re O’Brien Environmental Energy, Inc., 181 F.3d 527, 1999 U.S. App. LEXIS 16652, 34 Bankr. Ct. Dec. 827 (N.J., 1999), the Court held: “We therefore conclude that the determination whether break-up fees or expenses are allowable under § 503(b) must be made in reference to general administrative expense jurisprudence. In other words, the allowability of break-up fees, like that of other administrative expenses, depends upon the requesting party’s ability to show that the fees were actually necessary to preserve the value of the estate. Therefore, we conclude that the business judgment rule should not be applied as such in the bankruptcy context. Nonetheless, the considerations that underlie the debtor’s judgment may be relevant to the Bankruptcy Court’s determination on a request for break-up fees and expenses.”