We are able to obtain more competitive interest rates though Commercial Mortgage Backed Securities (“CMBS”) loans instead of traditional bank financing. CMBS loans meet special requirements allowing them to be bundled and sold in blocks on capital markets. Usually income properties with tenants are the most common types of projects eligible for CMBS loans.
The CMBS lenders have a checklist of requirements that the borrower must satisfy to be eligible for this type of financing. The special purpose entity (“SPE”) which is almost always an LLC is one of them.
An SPE LLC Operating Agreement will prohibit any activity or ownership of assets outside the scope of the particular activity and real estate being financed. For the investors in these CMBS loans to reduce their risk associated with various freedoms inherent in an LLC, the borrower LLC must put on “handcuffs” and give up many freedoms with the LLC to be eligible for the reduced rates that come with CMBS financing. The LLC Operating Agreement must contain certain unusual provisions, such as no amendments to the Operating Agreement without lender’s consent.
Accordingly, the Certificate of Formation and Operating Agreement for this type of LLC will generally have a long list of restrictions on the company that are copied from loan documents. Significantly, CMBS lenders do not rely on having these provisions in the loan documents but require them in the company’s organizational documents, perhaps to emphasize that the prohibited acts exceed the company’s authority in addition to constituting a loan default.
The list of restrictions are intended to assure that the company remains a single purpose entity which is “bankruptcy remote”. This means that should the company’s principals, parent company or affiliates become insolvent, the SPE LLC will not be brought into the bankruptcy or insolvency proceeding affecting related persons. “Bankruptcy remote” does not mean “bankruptcy proof”. Bankruptcy can still occur if the business of the SPE LLC fails, although, as discussed below, lenders seek protections even in this instance.
The biggest risk being reduced by the SPE structure is the risk of interruption in payments from tenants should the member of the LLC declare bankruptcy. For example, in the event a loan is to finance a building used for student housing, multi-family housing, shopping center or commercial office buildings with tenants, then a bankruptcy of the member in a non-SPE LLC may cause the rents to be paid to the bankruptcy trustee or debtor in possession. This is a risk to the bank or investor “holding the paper.” Thus to reduce that risk the LLC may have a “special member” who only becomes a member with a vote in the event the single equity member experiencing a trigger event, such a bankruptcy.
Depending on the lender, often the lender’s checklist requires the SPE LLC to be a Delaware LLC.