Lenders sometimes require individuals who wish to obtain business loans to purchase commercial real estate to hold the property in question in what’s commonly referred to as a single-purpose entity. Typically, it applies primarily to limited liability corporations or corporations. But why do lenders require single-purpose entities in the first place?
What Is a Single Purpose Entity?
A single-purpose entity enables an LLC or corporation to hold the title to a piece of commercial real estate on which a lender has a mortgage but there are no other assets or liabilities. The single-purpose entity can then contract a different company with the same owners to handle the running of the property and also incur liability associated with the property in question. They can also hire a management company to take care of management and business proceedings as a third-party entity. But what are the benefits of having a single-purpose entity?
For lenders, a single-purpose entity protects their asset, the real property, because it separates the real estate from the day to day running of the business. This protects lenders and the single-purpose entity owners from claims made by other creditors who may wish to target the physical property as a source of recovery.
Additionally, a single-purpose entity enacts special bankruptcy circumstances, whereby if the single-purpose entity were to file for bankruptcy, the lender can foreclose on the property significantly more easily than if other lenders or creditors were involved. These special bankruptcy circumstances work in the lender’s favor because the involvement of other creditors could force the lender to agree to an action plan that doesn’t suit their best interests.
Think of it this way: the single-purpose entity owns the real property, but does not own any other assets or material liabilities. This prevents other creditors from attempting to use the subject property as a means to recover a loss or claim a debt. The single-purpose entity is usually the one that contracts with third parties, such as management companies or service providers, as well as enters into leases or occupancy agreements if that is the nature of the property’s purpose. However, the parent company does not enter into any direct management or operation agreements, thus separating the liabilities and obligations of the single-purpose entity and the parent company as they relate to one another.
If a creditor were to make a claim, the single-purpose entity would be better protected. Why? Because the lender’s collateral is exempt from claims by any other creditors regarding business proceedings.
What Should a Single Purpose Entity Clause Include?
There are several common elements associated with single-purpose entities, but there are no exact criteria for qualification. For a single-purpose entity to be legally recognized, the primary element is a good purpose clause, which must explicitly note the restrictions on the rights of the single-purpose entity to undertake activities that would otherwise be allowed by other entities.
This clause generally needs to be included in documentation such as an entity formation document that is legally filed with the Secretary of State. The clause must, at a minimum, be included in loan agreements and loan documents. There should also be additional covenants that emphasize the legal separation of the single-purpose entity and any other entities. Although there are no steadfast rules for what covenants must be included in legal documentation, some common covenants are:
The single-purpose entity must maintain separate bank accounts and finances.
Exclusion of guaranteeing obligations of other entities.
Assets between other entities or individuals may not be mingled
Requiring the single purpose entity to maintain a separate tax identification number
In addition, lenders sometimes impose further restrictions that might otherwise be allowed by a general-purpose entity, such as the right of the parent company to seek bankruptcy protection or incur additional debt.
If you want to learn more about single-purpose entities, how they might benefit your business, or why lenders may require them, Emerald Law can assist you. We have the knowledge and expertise to answer all your questions regarding single purpose entities and other commercial real estate concerns.