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Massachusetts Court Allows Substantive Consolidation of SPE Real Estate Company
Practical Law Legal Update w-005-4729 (Approx. 4 pages)
Massachusetts Court Allows Substantive Consolidation of SPE Real Estate Company
by Practical Law Real Estate
| Published on 09 Feb 2017 • Massachusetts |
A Massachusetts court recently allowed a non-debtor real estate special purpose entity (SPE) to be substantively consolidated into a debtor's bankruptcy estate.
On December 13, 2016, in In re Cameron Construction & Roofing Co., Inc., a Massachusetts bankruptcy court allowed a non-debtor real estate holding company that was formed as a special purpose entity (SPE) to be substantively consolidated into a debtor's bankruptcy estate ().
Substantive consolidation is an equitable remedy that combines the assets and liabilities of an entity that is related or affiliated with the debtor's bankruptcy estate.
Background
The decedent owned two separate businesses involved in a bankruptcy case:
- Debtor: Cameron Construction & Roofing Co., Inc. (Roofing Company).
- Defendant: Cameron Construction LLC (Construction LLC).
Roofing Company filed for bankruptcy in 2014. Construction LLC held a parcel of real property (the "Property") that was surrounded by hazardous waste sites in an industrialized area.
The attorney for the decedent testified that the decedent formed Construction LLC as an SPE limited liability company to take title to the Property to avoid any potential environmental liability being transferred to Roofing Company.
- Common Control. Both Roofing Company and Construction LLC were under the control of the decedent.
- Disproportionate Ownership. The decedent was 99.9% owner of Construction LLC and contributed 90% of the initial capital. Roofing Company was only a .1% owner of Construction LLC but contributed 10% of the initial capital.
- Commingling of Business Assets. Construction LLC's primary asset was the Property. Roofing Company used the Property without a lease agreement.
- Single Source of Income. Roofing Company paid money to Construction LLC labeled as rent on its tax returns. The rent paid by Roofing Company to Construction LLC far exceeded the fair rental value of the Property. Construction LLC had no other significant sources of income other than the rent payments. The funds transferred as rent were used to pay the salaries of Construction LLC's employees.
- Business Purpose and Lack of Corporate Formalities. Construction LLC's stated purpose in its organizational documents was to own, manage, and develop real estate, but it performed the functions of Roofing Company. Neither Roofing Company nor Construction LLC had any corporate records such as meeting minutes, votes, or resolutions.
- Common Work Force. Construction LLC's employees worked exclusively on Roofing Company's jobs without subcontract agreements or invoices. Construction LLC paid significant wages to its employees, particularly to the decedent's spouse even though she only worked part-time.
Construction LLC argued against substantive consolidation because it:
- Filed separate tax returns.
- Had separate articles of incorporation.
- Gave its employees separate W-2s.
- Filed separate annual reports.
Outcome
The court agreed with the trustee, but distinguished between piercing the corporate veil and substantive consolidation:
- Piercing the corporate veil would have made the decedent's assets available for the debts of Roofing Company.
- Substantive consolidation would only make the assets of the Construction LLC available for the debts of Roofing Company.
The court held that trustee sustained its burden of proof by satisfying the test adopted by the court in In re Hemingway Transp., Inc. (954 F.2d 1).
Practical Implications
SPEs are typically formed to hold title to real property to avoid issues in bankruptcy like substantive consolidation, which is why this case provides significant caution for commercial real estate owners.
Even an SPE with sufficient separateness covenants in its organizational documents is not guaranteed protection from substantive consolidation if its owner fails to operate its businesses separately. It is particularly important for business owners to avoid commingling assets of separate entities because it is often seen as a deciding factor by courts in deciding whether entities are, in fact, separate.
For more information on commercial real estate SPEs, see Practice Note, Bankruptcy Remote Entities in Commercial Real Estate Transactions.