Crowdfunding Lawyers

Why “Special Purpose Entities” Are So Special

September 16, 2016
Why “Special Purpose Entities” Are So Special

This article was originally published at

As securities attorneys, we’ve been getting a fair amount of questions lately on special purposes entities (SPEs), also known as special purpose vehicles (SPVs). What are they? What do they do? Should I choose an SPE over an LLC? (That last one is my favorite).

First, to nip that last question in the bud, an SPE and LLC are not mutually exclusive. An SPE is a structured finance tool, or an arrangement used to protect a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if its parent company goes bankrupt. An LLC, or limited liability company, on the other hand, is a type of entity (like a corporation, limited partnership, trust, etc).

What’s So Special?

A special purpose entity is simply a “wholly owned” subsidiary of a larger fund or company for the purposes of holding a separate asset, or exploring and/or conducting separate lines of business. It may also allow for different tax treatments across assets and lines of business. In the end, the SPE’s purpose is to provide liability protection to the SPE owner and its investors.

SPEs have been used extensively for the last 30 years. They facilitate securitization, financing, risk sharing, and capital raising, to name a few. Without SPEs, companies would have to put their entire company at risk to achieve the above objectives. SPEs also allow for modularity to easily transfer assets (see this Investopedia video for a visual analogy).

Let’s take, for example, Jen the entrepreneur. Jen owns a large company that is gearing up to develop and launch a new product. Outside of work, Jen also runs a large real estate fund. Jen might utilize an SPE for her company’s new product and for a new property acquisition:

To protect assets in the SPE from liabilities of the parent company

Perhaps it’s important that the company’s new product operate and survive regardless of the parent company’s existence. Or perhaps Jen just wants to separate out the liabilities of the new product from the liabilities of the company. Jen can use an SPE to do this.

Jen also wants to acquire a new property for her real estate fund. She might consider using an SPE to protect the property from claims against the fund (such as investor lawsuits). Without use of an SPE to “house” the property, the fund as a whole would be liable for those potential claims, exposing the fund’s assets to all such claims. By placing the entity in its own SPE, the fund effectively shields the SPE from such claims so long as the SPE itself follows proper governance so as to prevent any “piercing of the corporate veil.” In other words, the SPE must keep its own books and records, avoid commingling, and be properly capitalized.

To protect the parent company from liabilities of the SPE

The company’s new product might be riskier than the company’s normal line of business, or may be a different type of “asset” from the normal activities and assets of the parent company. Maybe the company is digging a new oil well, in which case possible environmental contamination by the oil well would subject the entire parent company to liability.

On the real estate side, Jen wants to make sure that the investors in her fund are protected from liabilities that might arise from a tenant slipping and falling on the property, or from a neighborhood kid’s trespassing on the property and drowning in the swimming pool. (By the way, I know this is morbid, but half of lawyering is brainstorming everything that could go wrong, and proactively drafting around that).

To enable ease of transfer

Perhaps Jen runs an entertainment company and is producing a new online web series. She could use an SPE to hold the asset. So long as so keep all books and records clean, she will be able to easily sell the asset to a major studio someday by simply transferring ownership of the SPE. It’ll save her the hassle of assigning or resigning all contracts with the asset (i.e. licensing and distribution agreements).

If Jen’s real estate fund has a particular SPE with a property that she she’d like to sell, Jen can simply sell the SPE, instead of having to deed the property over to the new owner.

The bank/financier requires it

The company’s new product is one in which investors want to directly invest. Instead of asking investors to invest at the parent company level (and diluting the parent company’s shareholders), Jen can instead have them invest directly into the product itself.

Meanwhile, while closing on the real estate fund’s most recent property acquisition, Jen finds out that most real estate lenders require that properties that they finance are held in their own separate entity where no other assets may be held. This is in large part because of #2 above and because the bank has a particular interest in protecting the property on which it holds a mortgage.

What’s the Purpose?

An SPE is often created for one very particular purpose. In the case of a real estate fund, the SPE is used for the ownership of an individual property. In the case of angel investment syndicates, it is to hold, acquire, and dispose of securities issued by a particular company.

What’s the Entity?

Most SPEs in the United States are actually formed as LLCs, whereas SPEs often take on the form of a charitable trust in Canada and a limited purpose corporation under UK law or offshore law (i.e. Jersey) with a charitable trust owner.

Why do SPEs matter in crowdfunding?

An important discussion happening at this moment is the viability of Regulation CF (equity crowdfunding) without the use of SPEs (because their use is not allowed under the current regulations).

It’s important to first explain why SPEs simplify the capital-raising process. In the venture capital space, it’s been said that every line on a cap table matters—that every line represents an investor that brings some value to the company, yet also has a negative impact caused by the terms associated with that particular investor. Additionally, venture capital firms are often reluctant to invest in companies with long, complex, or messy cap tables. The AngelList syndicates model purports to solve the issue of many small angel investors crowding a cap table by consolidating them all into one (or technically two) lines of a company’s cap table. This reduces the cost and difficulty of managing a company with numerous investors—or as applied to equity crowdfunding, a crowd of investors.

You might be thinking “how difficult could a long cap table possibly be?” Say, for example, 99 investors invest through one SPE. The next time the company needs a signature from investors, it can go directly to the one entity that has the authority to sign and make decisions for all 99 investors. Without an SPE, the company would instead need to spend time and energy hunting down 99 investors for 99 signatures—some of which are super busy executives, others who are vacationing abroad, some of whom will need time to consult their attorneys (who are also on vacation and then take 2 weeks to review) before signing anything, some who will call with a long list of questions, some who are going through personal issues, and maybe some who changed phone numbers and have all your emails going to their spam folder—so they never get the message. This results in an incredible time lag and resource drain on the company. Instead of growing its business, the company needs to assign several staff members to hunt down all of its investors over the course of a week (or pay really expensive attorneys to do this for them). The same thing goes with processing investors, calculating their distributions, maintaining investor contact information, issuing stock certifications, so on and so forth. Every little thing that needs to be done is multiplied in difficulty by 99 times.

Thankfully, the version of the Fix Crowdfunding Act passed by the House and currently at the Senate addresses these issues by creating an equity-crowdfunding SPE, aptly called a “crowdfunding vehicle.” If passed, Reg CF issuers would be able to consolidate the “crowd” of investors onto one line-item of their cap table, with some strings attached. The Fix Crowdfunding Act defines a crowdfunding vehicle as:

A company:

(A) whose purpose (as set forth in its organizational documents) is limited to acquiring, holding, and disposing securities issued by a single company in one or more transactions and made pursuant to section 4(a)(6) of the Securities Act of 1933;

(B) which issues only one class of securities;

(C) which receives no compensation in connection with such acquisition, holding, or disposition of securities;

(D) no associated person of which receives any compensation in connection with such acquisition, holding or disposition of securities unless such person is acting as or on behalf of an investment adviser registered under the Investment Advisers Act of 1940 or registered as an investment adviser in the State in which the investment adviser maintains its principal office and place of business;

(E) the securities of which have been issued in a transaction made pursuant to section 4(a)(6) of the Securities Act of 1933, where both the crowdfunding vehicle and the company whose securities it holds are co-issuers;

(F) which is current in its ongoing disclosure obligations under Rule 202 of Regulation Crowdfunding (17 CFR 227.202);

(G) the company whose securities it holds is current in its ongoing disclosure obligations under Rule 202 of Regulation Crowdfunding (17 CFR 227.202); and

(H) is advised by an investment adviser registered under the Investment Advisers Act of 1940 or registered as an investment adviser in the State in which the investment adviser maintains its principal office and place of business.”

Subsections (C), (E) and (H) are particularly interesting. Sub-section (E) basically says that both the crowdfunding SPE and company that’s raising capital will be co-issuers, whereas under normal circumstances, there would be two separate issuers. I presume this is intended to prevent issuers from using several crowdfunding SPEs to launch multiple campaigns that exceed the current $1M annual cap, among other things. And secondly, subsection (H) requires that a registered investment advisor (RIA) advise the crowdfunding SPE, which effectively adds a layer of regulatory oversight on those putting together these crowdfunding SPEs. What doesn’t quite make sense is subsection (C), which prohibits compensation for this service. I don’t know who would want to perform acquisition, holding, and disposition services for “no compensation” or for free, and quite frankly, no one works for free. But perhaps this just means that funding portals will need to set up subsidiaries or affiliates that perform these services for no cost as part of their bundle of services.

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