This post is part of an occasional series highlighting a project finance article or news item from the past. It is often interesting and thought provoking to look back on these items with the perspective of months, years or decades of further experience.
With this installment, we turn to an article that first appeared in the February 2003 issue of the Project Finance NewsWire and was written by Chadbourne partner and head of the corporate practice, Allen Miller.
This article is particularly timely as we are seeing more emphasis on project M&A, due in part to the seemingly insatiable appetite of yieldcos for new assets. There is more liquidity in projects than in quite some time. Companies that typically hold and operate assets are thinking about selling due to higher valuations. Companies that typically sell assets are finding the process a little smoother.
READ MORE ABOUT PROJECT M&A ISSUES HERE.
Project Sales: Traps For The Unwary
by Allen Miller, in New York
Merchant power companies seeking to sell or refinance projects to increase liquidity face wary purchasers or lenders who are giving renewed scrutiny to a number of legal issues that extend the due diligence inquiry well beyond examination of the project and the contracts to which the project company is a party. In many respects, the law may not be what one thinks it is. What follows is a discussion of a few traps for the unwary.
1. When Consent May Be Required Even Though It Isn’t.
Every purchaser, lender, seller and borrower knows the importance of ascertaining whether contractual consents are required in order to consummate a transaction.
Typically, a review of contracts to which the project company is a party is made to determine whether any contract counterparty has a consent right, right of first refusal or other contractual right or encumbrance upon the transfer or assignment by the project company of its interest in the plant assets or contract rights. If the purchase of the project is effected through a sale of stock of the project company, then a similar contract review is generally made to determine if a consent or termination right is triggered by a change-of-control or comparable provision. If the contract in question does not contain a change-of-control or comparable provision, then the natural conclusion may be that the contract counterparty has no say in the sale of the stock of the project company and that the transaction may proceed without the seller having to obtain any consent.
The problem with this analysis is that there are troublesome court decisions that might be construed to impose on sellers the obligation to obtain consents to stock transfers in certain circumstances even though the contract by its terms imposes no such requirement.
Federal courts in the 9th circuit (which includes California, Oregon and Washington) appear to have concluded that the sale of 100% of the stock of a “shell” company that owns an equity interest in a lower-tier entity may be deemed the same as the direct sale of the equity interest in the lower-tier entity for purposes of analyzing consent or right of first refusal provisions, even though the relevant contract provisions are silent on the issue of change of control.
In effect, the courts have held that if a seller owns little more than an equity interest in another entity, it may not circumvent contractual obligations restricting the transfer of such equity interest by instead selling control of the seller. On the other hand, if there is a sale of 100% of the stock of a “real” entity —that is, a company that has substantial assets in addition to the equity interest in its subsidiary company — then the sale of stock would not be deemed the same as the direct transfer of the equity interest in the subsidiary for purposes of considering consent and right of first refusal provisions restricting a direct transfer of the equity interest.
The approach adopted by courts in the 9th circuit could have some superficial appeal to other courts concerned with the equitable rights of contracting parties, but it has the ill-advised effect of writing into contracts language that is not there. This makes for great uncertainty in determining whether, for example, the consent of a power offtaker may be required under a power purchase agreement -— a key point of analysis in any project company sale.
The concerns created by the decisions in the 9th circuit extend to all parts of the country, not just jurisdictions within the 9th circuit. This is because the case law has not been sufficiently developed in other parts of the country to make an informed decision as to whether the 9th circuit’s analysis would be adopted or rejected.
2. When Liabilities of a Limited Liability Company Aren’t Limited.
The doctrine of “piercing the corporate veil” is an exception to the general rule that shareholders are not liable for corporate debts.
The veil of a corporation is pierced, and the shareholder is held liable for the debts of the corporation, when a court determines that the debt in question is not really a debt of the corporation and, in fairness, should be viewed as a debt of the shareholder.
The doctrine is most often invoked where the courts perceive that a fraud, or something akin to it, is being perpetuated on creditors by the shareholder of a corporation. However, some courts have held that the doctrine applies where the parent has treated its subsidiary as its instrumentality, where the subsidiary is in fact a mere “alter ego” of the parent, or where the parent has exercised such domination and control that the subsidiary lacks any real independence.
In making a determination whether to pierce the corporate veil, courts generally examine various factors considered to be indicia of control, including whether the parent and subsidiary boards are identical, whether the two entities have common officers, whether the directors and officers of the subsidiary take orders from the parent or act independently, whether corporate formalities have been observed, whether officers and employees are paid by the parent or directly by the subsidiary, whether the flow of funds has been properly recorded between parent and subsidiary as dividends, loans or other distributions, whether the subsidiary was adequately capitalized, whether assets of the parent and subsidiary were commingled without regard to true ownership, and whether the subsidiary is commonly referred to as a department or division of the parent.
Although the doctrine of piercing the corporate veil has long been in effect, people often are unaware that courts in some jurisdictions have applied the doctrine to limited liability companies.
That the courts have done so is a surprising development because the common perception is that most of the factors considered by the courts to determine whether to pierce the corporate veil are simply not relevant to limited liability companies. Limited liability company legislation was developed in many states to create entities with the tax characteristics and corporate governance flexibility of a partnership while preserving the liability limiting features of a corporation. However, the relevant statutes afford so much flexibility to limited liability companies that most state laws do not require that they have directors, officers or managers. There is also no requirement that a limited liability company adopt an operating agreement. In short, it is enough under most state statutes that the limited liability company have filed a one-page certificate of formation with the state secretary of state and that its affairs are governed by the members who own it.
It may be difficult at first blush to reconcile the statutory purpose to minimize and streamline recordkeeping and governance mechanisms of limited liability companies with the application to them of the corporate-veil-piercing doctrines. However, more than one court has found that the doctrine may indeed be applied to limited liability companies, with the result that the owner of a limited liability company may be liable for debts of the limited liability company.
The issue becomes relevant to a buyer who purchases, for example, a holding company with two separate project subsidiaries, one of which is performing well, and one of which is a marginal performer with potential upside but also contingent liabilities. The credit analysis will be one thing if the buyer believes that the assets of the performing project may be vulnerable to creditors of the marginal project and quite another if the buyer believes that the two projects will treated separately as standalone projects. The determination as to which approach is most appropriate will depend in part on a veil-piercing analysis of the relations between the projects and their common parent. The fact that the projects are held in limited liability form does not necessarily insulate them from a veil-piercing analysis.
3. When the IRS May Attach Assets of a Company That Doesn’t Owe Taxes.
A subsidiary that is a member of its parent’s consolidated tax group has joint and several liability for taxes of the consolidated group. This liability continues for pre-departure periods even after a consolidated subsidiary leaves the tax group. The result is that the Internal Revenue Service can file a tax lien against the assets of a former consolidated subsidiary even after it has left the group via sale to an unrelated party. Therefore, it is not uncommon for a parent seller to indemnify a buyer against consolidated tax group liability. However, buyers may view the tax indemnity of a struggling seller skeptically, since the indemnification obligation will be an unsecured claim if the seller files for bankruptcy and the bankrupt seller is unable to satisfy the IRS out of assets of the bankrupt estate.
While a due diligence review of the parent’s financial condition may provide some comfort, it is unlikely that the cope of review will extend to sensitive tax liability issues of the parent’s consolidated group. The seller will not allow it due to legal privilege concerns. A buyer that is uncomfortable with a seller’s overall financial condition may require that the equity purchase be restructured as an asset purchase as a condition to proceeding with the transaction.
While newer projects are typically held in partnership or limited liability company form, occasionally some older projects are held in corporate form due to regulatory or other restrictions. In secured lending transactions, these corporate-form projects present special reason for concern because foreclosure on the stock of a project company borrower (which may otherwise be more desirable for the lender than an asset foreclosure) will not insulate the project company from attempts by the IRS to attach “after-acquired property” of the project company. Under the tax laws, the holder of a perfected security interest in “property in existence” generally has priority over a subsequently filed IRS tax lien. The “property in existence” requirement has been construed by the IRS to mean that “after-acquired property”— that is, property acquired after the notice of tax lien is filed — is not protected by the security interest as against the IRS lien even if it is protected from claims by other creditors. The IRS has taken this position even where the contract rights pursuant to which the receivables are earned are subject to the security interest.
The IRS has had a poor track record in defending this position in the courts. However, despite its lack of success, it has shown no sign of retreating from its position, and lenders may want to consider certain protective mechanisms to mitigate the risk.
4. When a Project Company with No Pension Plan May be Liable for Unfunded Pension Liabilities.
Most project companies do not technically have employees. Typically, employment services are provided under an operations and maintenance agreement or a management services agreement. Therefore, employment related liabilities do not generally rank high on the list of concerns of buyers or lenders to a project company except in the context of reviewing the relevant contracts.
However, there are circumstances under which the project company may be subject to employment-related liabilities even though it does not have, and has never had, employees. Under the Employee Retirement Income Security Act of 1974, or “ERISA,” each entity within a “controlled group” is jointly and severally liable for certain pension plan liabilities of related entities within the controlled group. A controlled group is generally defined as including chains of entities connected by at least 80% ownership (including indirect ownership through trusts and similar devices). Entities within a controlled group are often referred to as “ERISA affiliates.”
Controlled group liability is generally limited to liabilities relating to failure to make required contributions to a defined benefit pension plan, failure to file timely premiums to insure the pension plan with the Pension Benefit Guaranty Corporation and underfunding of a terminated pension plans. ERISA affiliates are jointly and severally liable for such liabilities even if the member has no employees who participate in the controlled group pension plan. In certain cases, a former member of a controlled group may remain jointly and severally liable for pension plan liabilities of its former controlled group members for a period of five years after leaving the controlled group.
The issue of ERISA-controlled group liability can be readily dealt with if the due diligence review confirms that there is no defined benefit pension plan within the controlled group and that there has been none within the past five years. If there has been such a plan, then further due diligence, contractual representations and indemnities may be appropriate to provide comfort to the buyer of, or lender to, a project company that the project company will not incur liability associated with pension plans in which its employees never participated.
5. When a Senior Perfected Lienholder May Not Be Able to Foreclose.
A senior lender to a project may require that a subordinated junior lienholder’s lien be extinguished upon foreclosure by the senior lienholder in order to facilitate enforcement of the senior lienholder’s remedies. Typically, this is a contractual arrangement that would be honored by a reviewing court. However, if the junior lienholder should itself file for bankruptcy, the automatic stay of the bankruptcy court may enjoin the senior lienholder’s foreclosure where the junior lienholder’s lien would be extinguished on the theory that the extinguishment of the lien constitutes a taking of bankruptcy estate assets. There is inconclusive judicial authority going both ways on this issue.
In the typical financing context, lenders generally are more concerned about the effects of a possible project company bankruptcy than the effects of the possible bankruptcy of other lenders to a project. However, where corporate loans have been made by an affiliate to support a project, it may be appropriate for a senior lender to consider analyzing its rights and remedies in case the affiliated junior lender files for bankruptcy.
The five issues covered in this article are traps for the unwary. They show the need for buyers and lenders to do a careful analysis of whatever rights other companies with ties to the project company might have before closing.