For acquisitions or refinancings over $5 Million, the borrower may be 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. These borrowers first need to be a single member, single/special purpose entity (“SPE”) which is almost always an LLC (although sometimes is can also be a limited partnership).
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. These restrictions usually can only be removed when the loan is paid-in-full or otherwise refinanced. 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. The LLC Operating Agreement sets forth this “Special Member” who is a non-equity member who “springs” into action only upon certain circumstances. Alternatively, the SPE’s Operating Agreement may call for an “Independent Director” or “Independent Manager” whose authority is limited to voting on specific matters like bankruptcy and dissolution (and the SPE’s Operating Agreement will typically provide that such decisions cannot be made without the vote of the “Independent Director” or “Independent Manager”. The “Special Member”, “Independent Director” or “Independent Manager” will be independent of the other members, and typically is a designee of a corporate service company which provides these persons as part of its services for a fee. In large transactions, there may be two of such persons in order to assure the lender that a bankruptcy filing will not be made without the involvement of two independent individuals.
Depending on the lender, often the lender’s checklist requires the SPE LLC to be a Delaware LLC. They also usually require opinion letters from lawyers in the state of the SPE LLC’s organization plus a lawyer in the state where the LLC owns real estate. Those opinions give extra comfort to the investors in the SPE LLC that the entity was duly formed, eligible and authorized to enter into the transaction.
Another type of LLC is the series LLC. Unlike traditional LLCs, the series LLC has the ability to segregate assets from each other within the same LLC. In each of the 15 states and territories with series LLC statutes (except Illinois), the members of the LLC may establish series under the LLC without requiring a filing with the Secretary of State. These series are a hybrid between divisions and parent-child subsidiaries with some features of brother-sister entites, although they are all contained within one “entity”. These were first used for mutual funds to allow separate funds within a family of funds to file one SEC filing, to save costs. Sometimes these Series LLCs are used for real estate investments for smaller investment properties which do not justify the costs associated with separate LLCs. The Operating Agreement for the Series LLC established each series within an LLC. These are not as predictable as a traditional LLC, for example the effect of bankruptcy on the LLC and its ability to have separate article-9 UCC filings may be less certain. Nevertheless, the Series LLC has become popular accounting for about one-percent of the new LLCs being filed. Financing through the Series LLC can be challenging and these entities are not candidates for CMBS loans.