Case Commentary: CRM Collateral II, Inc. v . Tricounty Metro. Trans., 2012 WL 164537 (9th Cir. 2012).
Of the many pitfalls to creating a bankruptcy remote entity, failing to make the entity actually bankruptcy remote is the most basic and the greatest. The purpose of a bankruptcy remote entity (“BRE”) is to segregate risk, in the event that the principal entity becomes insolvent. Indeed, the more accurate term is insolvency remote entity; however, that has less of a ring to it and creates the acronym “IRE.” That said, ire is an apt description for BREs, since that seems to be the only guaranteed result of BRE formation.
A classic BRE looks like this: Smith Corp. is a project developer, White Elephant is the project, and Smith Corp. II is the BRE. Smith Corp. has another project under development: Golden Goose. Golden Goose is proving to be very profitable. If Smith Corp. developed both Golden Goose and Smith Corp. within the same corporate structure, White Elephant’s insolvency would wipe out Golden Goose’s profits. Therefore, Smith Corp. creates Smith Corp. II. Smith Corp. II develops White Elephant and in so doing, takes on all the liability. Therefore Smith Corp. II bears the risk if White Elephant becomes insolvent and Smith Corp. is free to reap the profits of the successful Golden Goose. If White Elephant and Smith Corp. II turn out to be profitable, then the profits will flow back to Smith Corp. or the the Smith Corp. II shareholders. Pro-tip: Smith Corp. is the sole shareholder of Smith Corp. II or they have mutual shareholders. This is a simplified structure that does not delve into more sophisticated financing structures or issues of shareholder liability. However, it makes the point – you create a separate entity for a project, because you don’t want to avoid the risk of that project’s insolvency. This case involves a tortured form of this basic structure.
In this case, you had three entities: Collateral II, Tricounty Metro (“TriMet”), and Colorado Railcar. TriMet contracted with Colorado Railcar for the manufacture and delivery of light rail cars. Colorado Railcar was apparently in financial distress before the contract was signed. TriMet, concerned about Colorado Railcar’s financial health and ability to complete the project, requested a bond. Unfortunately, Colorado Railcar was in such ill health that a bond was out of the question.
Ultimately, Colorado Railcar proposed to get a letter of credit for $3 million from Key Bank. Colorado Railcar was in such poor shape it evidently could not offer any suitable collateral, because it had to get outside investors to supply collateral, so Collateral II was formed. Investors supplied collateral to Collateral II, which in turn gave it sufficient assets to secure the LOC. Collateral II was both the applicant on the obligor on the $3 million LOC that protected TriMet’s interest in its contract with Colorado Railcar.
Therein lay the problem. Collateral II’s express intent was to insulate its investors and their collateral from Colorado Railcar’s default. As was feared, Colorado Railcar defaulted and TriMet certified defaults and requested payment on the LOC. Collateral II woke up to the fact that it agreed to a LOC that paid TriMet up to $3 million upon Colorado Railcar’s default, making Collateral II liable to Key Bank. Of course, Collateral II could look to Colorado Railcar for repayment; but if the LOC was paid out, then by fair implication Colorado Railcar was already insolvent.
The district court ruled that Collateral II was a surety and had the defense of discharge, making TriMet liable for the balance received on the LOC. This seemed to vindicate Collateral II’s decision to obtain a LOC, for which it was liable upon the default of Colorado Railcar as it teetered on the brink of insolvency.
Unfortunately for Collateral II, the Ninth Circuit ruled that there was no suretyship: meaning that things were as they seemed: Collateral II applied for and received a $3 million LOC for the benefit of Colorado Railcar, TriMet was entitled to draw upon the LOC, and Collateral II had to pay Key Bank or lose its collateral.
So we are left with the question: was Collateral II a BRE? The short answer is no. The longer answer is that a BRE relationship requires more than just creating a corporate entity legally distinct from the risk bearing entity. A BRE relationship requires that the separate entity be entirely insulated from the default of the risk bearing entity. Collateral II was not properly insulated; indeed, it was quite the opposite. It applied for, pledged collateral, and received a LOC payable upon Colorado Railcar’s default. That was not the hoped for result. The moral is your entity is not bankruptcy remote if it bears the risk of another’s default.