Does the use of SPVs provide effective liability limitation?

By Graeme Gurney.

Key Points:
Project development transaction documents should contain protections for both the SPV and the parent.

It is common in property development projects for a project sponsor to seek to limit its risk by the use of a special purpose project vehicle ("SPV"), which is newly incorporated, enters into all of the project documents and does not have any other business. This paper questions the effectiveness of using SPVs, without more, to limit the risk of sponsors in such transactions.

This technique of using SPVs to limit risk and recourse is often referred to as "structural limited recourse". This expression is intended to convey the concept that, by use of this structural element alone, the sponsor will obtain the benefit of limited recourse.

By limited recourse, I mean that the recourse of the project creditors is limited to the project assets and cash flows (including any sponsor equity and specific support offered by the sponsor) but does not extend to other assets of the sponsor.

In essence, this paper:

• advances the proposition that structural limited recourse is ineffective to limit risk in this fashion unless it is combined with other techniques;
• addresses a number of means by which project creditors might seek to have recourse directly to a sponsor notwithstanding the existence of structural limited recourse; and
• suggests means by which the sponsor might, in the drafting of the project documents, prevent creditors from claiming that recourse.

Agency

In general law, a disclosed agent does not incur any personal liability when it enters into a contract with a third party. Rather, the principal is liable directly to the third party in relation to the contract and, to the extent that the agent in fact meets any liability or incurs any expenditure, the agent is entitled to an indemnity from the disclosed principal.

An SPV might be regarded as an agent for its holding company. In that case, the SPV would incur no liability to third parties with whom it contracts. Rather, the parent company would be personally liable directly to those creditors and, to the extent that the SPV in fact incurred any liability or paid any moneys, it would be entitled to an indemnity from the parent, which indemnity would be exercisable by a security holder from or a liquidator of the SPV.

Whether a SPV is an agent of the parent, or a separate legal entity contracting its own right, will be a matter of fact to be determined in the particular case.

In many cases, a SPV will, to all intents and purposes, simply be an alter ego of the parent. It is commonplace for parents and subsidiaries to have common boards, for all decisions in relation to the business of the subsidiary to, in effect, be made within the confines of board meetings of the parent.

This action is available to all creditors of an SPV irrespective of the financial position of the SPV itself.

Insolvent trading

Holding company liability

Readers will be aware that directors of companies can be personally liable for debts which are incurred while a company is insolvent. It is less well known that this also applies to holding companies of wholly owned subsidiaries.

The relevant provisions are found in sections 588V - 588X of the Corporations Act. Section 588V effectively imposes a statutory duty on a holding company to prevent its wholly owned subsidiaries from trading while insolvent. In the context of SPVs, the necessary preconditions for liability to arise are:

• The parent company exercises control over the SPV.
• The SPV must be insolvent at the time the debt was incurred or must become insolvent by incurring the debt.
• There must be reasonable grounds on the part of the parent for suspecting the SPV is insolvent.

Although section 588V can only be enforced against a holding company at the time an SPV is being wound up and then only by the liquidator, the parent of a failed SPV is open to an action for recovery of a shortfall in a winding up flowing from a breach of section 588V.

Liability as a shadow director

Additionally, liability under section 588G of the Corporations Act, which imposes a duty on directors of companies to prevent insolvent trading, can be sheeted home to a holding company and holding companies may be liable for the debts incurred and losses suffered by an SPV where:

• the holding company is held by a court to be a "shadow director" of the SPV; or
• the holding company is held by a court to be vicariously liable for its employees and agents who act as directors of the SPV.

In Kuwait Asia Bank EC v National Mutual Life Nominees Ltd [1991] AC 187 the Privy Council appears to have accepted that in a proper case a parent company could be a shadow director of a subsidiary. [1]

If a property development utilising an SPV fails, then it is likely that the SPV will become insolvent at some point. At least from that point, which will be a matter of fact, an argument is open to a liquidator on each of the bases set out above that the holding company is personally liable for all debts incurred thereafter.

Recommendations

For these reasons, a sponsor holding company should take steps to mitigate against the risks of project failure. Project development transaction documents should contain protections for both the SPV and the parent.

The SPV should seek contractual protections against liabilities arising from project failure, for example:

• limited recourse provisions in debt documents, so that the relevant financier agrees that its recourse in the circumstances of project failure will be limited to the project assets and cashflows; and
• entitlements to terminate pre-sale contracts without liability if practical completion has not been achieved by a sunset date.

The parent should also seek from financiers an express contractual protection against liabilities (either directly or through contracts entered into by the SPV) other than those liabilities expressly accepted by the parent (such as interest guarantees, cost overrun guarantees etc.).

Steps should also be taken to ensure that:

• as a matter of fact, the relevant project SPVs are not "agents" of the parent; and
• at the time debts are incurred, the SPVs are solvent.

[1] This was in the context of the equivalent New Zealand provisions.

Thanks to Nina Marks for her help in writing this article.

For further information, please contact Graeme Gurney.