Delaware: The Jurisdiction of Choice in Securitisation


Delaware continues to be on the cutting edge in offering the securitization community a comprehensive legal framework through which to conduct transactions. That framework includes recent legislation providing some certainty on the issue of what constitutes a "true sale" as well as the constantly evolving alternative entity statutes.

In an effort to provide a greater understanding of the many benefits of Delaware law for securitization transactions, this article will focus on the recently enacted Asset--Backed Securities Facilitation Act, the general advantages of Delaware alternative entities, certain key aspects and features of Delaware limited partnerships, limited liability companies, statutory trusts and limited liability partnerships.

Asset-Backed Securities Facilitation Act

On January 17, 2002, the State of Delaware enacted the Asset-Backed Securities Facilitation Act, 6 Del. C. § 2703A (the "ABSFA"). The ABSFA effectively creates a safe harbor under Delaware state law for determining what constitutes a true sale in securitization transactions.

The ABSFA first provides that:

"[a]ny property, assets or rights purported to be transferred, in whole or in part, in the securitization transaction shall be deemed to no longer be the property, assets or rights of the transferor." [6 Del. C. § 2703A(a)(1)]

Given the foregoing provision, to the extent Delaware law applies, the traditional legal criteria used in determining what constitutes a true sale in the context of a securitization is intended to be irrelevant.

The ABSFA further states that:

"[a] transferor in the securitization transaction ... to the extent the issue is governed by Delaware law, shall have no rights, legal or equitable, whatsoever to reacquire, reclaim, recover, repudiate, disaffirm, redeem or recharacterize as property of the transferor any property, assets or rights purported to be transferred, in whole or in part, by the transferor." [6 Del. C. § 2703A(a)(2)]

The ABSFA also provides that:

"[i]n the event of a bankruptcy, receivership or other insolvency proceeding with respect to the transferor or the transferor's property, to the extent the issue is governed by Delaware law, such property, assets and rights shall not be deemed part of the transferor's property, assets, rights or estate." [6 Del. C. § 2703A(a)(3)]

The foregoing provisions facilitate reaching the conclusion that a true sale exists in the context of a securitization transaction where Delaware law applies.

A number of issues exist that may preclude the ABSFA's application to a particular securitization transaction, including whether federal law will preempt the ABSFA in making a true sale determination and whether Delaware law generally, and the ABSFA in particular, will apply to a transfer in a securitization transaction.

Although not yet judicially tested, the ABSFA is nevertheless a reason to seriously consider whether the parties to a securitization transaction should choose for Delaware law to apply to their contractual relations.

General Advantages of Delaware Alternative Entities

Freedom of Contract

Delaware's strong history of preserving the freedom of contract is maintained in its alternative entity statutes. The basic approach of each alternative entity statute is to permit the creating parties to have the broadest discretion and the maximum amount of flexibility in drafting the governing agreement of the entity.

The alternative entity statutes generally furnish rules concerning internal governance only in situations where the creating parties have not otherwise provided for such rules in the governing agreement. Unlike Delaware corporations, there are far fewer statutory provisions defining the rights, powers, duties and authority of Delaware alternative entities and their owners and managers.

Thus, Delaware alternative entities are essentially creatures of contract. The rights and obligations underlying Delaware alternative entities flow from the contracts establishing them. The underlying principle of Delaware's alternative entity statutes permitting contractual flexibility is especially important in meeting the particular requirements of a securitization transaction, where, for example, the parties may need to grant rights to third parties, such as lenders and creditors, without having such third parties be owners or managers of the entity.

Fiduciary Duties

A significant advantage of Delaware alternative entities is that Delaware's common law fiduciary duties may be modified in an alternative entity's governing agreement. Similarly stated, fiduciary duties may be defined contractually in the governing agreement of an alternative entity.

Moreover, the alternative entity statutes provide that a party to an alternative entity will not be liable for a breach of fiduciary duty if such party relies in good faith on the provisions of the governing agreement.

Judicial Expertise

One of the most coveted advantages advanced by the Delaware alternative entity statutes is the grant of jurisdiction to the Delaware Court of Chancery over most matters involving such entities. The Delaware Court of Chancery is the United States', and perhaps world's, principal forum for the resolution of internal governance disputes of corporations and alternative entities.

Further, the Delaware Court of Chancery is one of the most respected tribunals in the world with regard to complex business and commercial matters over which it has jurisdiction. The body of decisional case law developed in the Delaware Court of Chancery provides considerable guidance on a multitude of governance and business issues.

Moreover, since the Delaware Court of Chancery is a court of equity, it does not have jurisdiction over criminal cases and tort actions seeking primarily damages, thereby allowing it to expedite business cases. Although other states have passed statutes similar to Delaware's corporation and alternative entity statutes, no state has been able to duplicate the sophistication and efficiency of the Delaware Court of Chancery or the consistency in its decisions.

Key Aspects and Features of Delaware Alternative Entities

Delaware Limited Partnerships

Since the Delaware Revised Uniform Limited Partnership Act , 6 Del. C. §§ 17-101, et seq. (the "LP Act") was enacted in January 1983, Delaware has increasingly become the forum of choice for the organization of limited partnerships. A Delaware limited partnership may be formed by two or more persons or entities, and must have one or more general partners and one or more limited partners. Further, a limited partnership may carry on any lawful business, whether or not for profit, with the exception of banking and insurance.

A limited partnership is formed by the filing of a Certificate of Limited Partnership with the Delaware Secretary of State. The required contents of a Certificate of Limited Partnership are few:

  1. the name of the limited partnership,

  2. the address of the registered office and the name and address of the registered agent for service of process required to be maintained by §17-104 of the LP Act for the limited partnership, and

  3. the name and address of each general partner of the limited partnership. Although the original Certificate of Limited Partnership must be signed by all of the general partners, the limited partners need not be listed and need not sign it.

While the Certificate of Limited Partnership is the formal document filed with the Delaware Secretary of State, the business arrangement between the general and limited partners is detailed in a limited partnership agreement ("LP Agreement"). Although Delaware law permits the LP Agreement to be oral, this is generally not advisable, particularly in securitization transactions.

The LP Agreement typically contains provisions addressing the business to be conducted by the limited partnership, the admission of partners, the rights, powers and duties of partners, the allocation of profits and losses among the partners, and the dissolution and winding up of the limited partnership.

In an LP Agreement, different classes and series of limited partnership interests may be established which may have separate and distinct rights and duties.

Comparison to General Partnership

In a general partnership, all partners are jointly liable for the obligations of the partnership and for the wrongful acts of co--partners committed in the course of the partnership's business. In a limited partnership, the general partners have that same liability, but the limited partners who do not participate in the control of the business of the limited partnership generally have no risk beyond their investment in the limited partnership and are not generally liable for the debts and obligations of the limited partnership. The LP Act does, however, grant limited partners the ability to take numerous actions that will not jeopardize their limited liability protection.

Typically, the general partners of a limited partnership are involved in the management of the limited partnership's business and conduct its day-to-day business and affairs. A limited partner generally does not participate in the control of the limited partnership's business, but invests in the limited partnership in exchange for certain economic rights, including the right to share in the profits of the business venture.

However, it is not uncommon, especially in securitization transactions, for the LP Agreement to provide that the general partner's authority with respect to specific types of actions is limited.

In this regard, it is frequently the case that the general partner must obtain limited partner consent before committing the limited partnership to certain courses of action. Such consent rights permit the limited partners to be actively involved in monitoring their investment in the limited partnership without becoming liable as general partners of the limited partnership.

The LP Act offers a very broad array of matters with respect to which limited partner consent may be required without jeopardizing their limited liability, and the drafters of the LP Act regularly consider whether the list of such matters should be expanded to facilitate securitization and other types of transactions.

Similarly, lenders and other third parties may be granted rights under an LP Agreement to help protect their respective interests relating to activities in which the limited partnership engages.

Dissolution of a Limited Partnership

Dissolution of a limited partnership occurs:

  1. at the time or upon the happening of the events specified in the LP Agreement,

  2. unless otherwise provided in the LP Agreement, upon the consent of a certain number of partners,

  3. upon the withdrawal of the last general partner or limited partner without the timely admission to the limited partnership of a successor thereto, or

  4. upon the order of a court if it is no longer practicable to carry on the limited partnership's business in accordance with its LP Agreement.

The process and mechanics of a prospective liquidation are often very important considerations in structuring a securitization transaction. The LP Act offers parties flexibility in the process of liquidation and in the choice of liquidator. Moreover, the statute mandates that creditors' claims be paid or provided for before any distributions may be made to partners, which is a significant protection to lenders and creditors in securitization transactions.

Delaware Limited Liability Companies

A Delaware limited liability company ("LLC") is a form of business entity designed to provide its owners/members with both the limited liability afforded to corporate shareholders and, if desired, the pass-through income tax advantages of a partnership for U.S. Federal income tax purposes. An LLC may carry on any lawful business, whether or not for profit, except for banking or insurance. The very essence of an LLC is the statutory grant of limited liability to all members and managers.

Like a corporation, liability is generally limited to the amount invested in the LLC. But unlike a corporation, if the LLC chooses to be a partnership for U.S. Federal income tax purposes, the profits and losses pass through to the members. In such a case, income of an LLC that is a partnership for U.S. Federal income tax purposes is generally taxed only once at the member level rather than at the entity level and at the owner (shareholder) level, as with corporations.

An LLC is easily formed by executing a Certificate of Formation and filing such certificate with the Delaware Secretary of State. Under the Delaware Limited Liability Company Act, 6 Del. C. §§ 18-101, et seq. (the "LLC Act"), the Certificate of Formation must set forth:

  1. the name of the LLC, and

  2. the address of the registered office and the name and address of the registered agent for service of process required to be maintained by § 18-104 of the LLC Act for the LLC.

Thus, the members of the LLC need not be disclosed in such Certificate. In addition to filing the Certificate of Formation, the members of an LLC must have either an oral or written limited liability company agreement ("LLC Agreement"). Oral LLC Agreements, particularly in securitization transactions, are generally not advisable.

Flexibility of LLC Management Structure

The LLC Act affords parties great flexibility to create a management structure specifically suited to the particular transaction. As a default, management duties are vested in the members in proportion to their share in the LLC's profits. That default rule may be modified, however, by the LLC Agreement wherein the members may agree to elect managers, directors, or other types of administrators (who may be members or outsiders) to manage the LLC. Unlike with a limited partnership, a member of an LLC may participate fully in the management of an LLC without any statutory consequence of loss of limited liability.

Additionally, unless the LLC Agreement otherwise provides, individual members have the ability to bind the LLC. As with an LP Agreement, an LLC Agreement may establish different classes or series of limited liability interests which may have separate and distinct rights and duties.

Many securitization transactions involving LLCs require that the LLC be deemed a bankruptcy remote entity vis-à-vis the members. The LLC Act facilitates achieving this result in a number of respects.

  • First, unless otherwise provided in its LLC Agreement, an LLC has perpetual existence.

  • Second, unless otherwise provided in its LLC Agreement, an LLC does not dissolve solely as a result of the death, retirement, resignation, expulsion, bankruptcy or dissolution of a member or the occurrence of any other event that terminates the continued membership of a member.

  • Third, a creditor of a member does not have any right to obtain possession of, or otherwise exercise legal remedies with respect to, the property of the LLC.

Dissolution of an LLC

Dissolution of an LLC occurs:

  1. at the time or upon the happening of the events specified in the LLC Agreement,

  2. unless otherwise provided in the LLC Agreement, upon the written consent of a certain number of members,

  3. upon there being no member unless a person is admitted to the LLC as a member effective as of the event that caused the last remaining member to cease to be a member, or

  4. upon the order of a court if it is no longer practicable to carry on the LLC's business.

As noted in the discussion of limited partnerships, the process and mechanics of a prospective liquidation of an LLC are often very important considerations in structuring a securitization transaction. Similar to the LP Act, the LLC Act offers parties flexibility in the process of liquidation and in the choice of liquidator. In addition, the statute mandates that creditors' claims be paid or provided for before any distributions may be made to members, which, as noted above, is a significant protection to lenders and creditors in securitization transactions.

Delaware Statutory Trusts

Business trusts have been recognized by the Delaware common law for many decades. Prior to the passage of the Delaware Business Trust Act in 1988, which is now known as the Delaware Statutory Trust Act, 12 Del. C. §§ 3801, et seq. (the "Trust Act"), however, there was no express statutory recognition of a business trust in Delaware.

The Trust Act was drafted to increase the utility of the business trust in modern financing transactions by overruling those principles of the common law of trusts that were deemed undesirable and by including provisions to authorize a high degree of contractual freedom between the trustor and the trustee in determining their respective liabilities and the manner in which the trust could be administered.

A Delaware statutory trust may be formed by one or more trustees for the benefit of one or more beneficiaries. To form a Delaware statutory trust, a Certificate of Trust must be filed with the Delaware Secretary of State setting forth the name of the statutory trust and certain other information.

At the time of the filing of the Certificate of Trust, a written trust agreement (also called a governing instrument) must exist. Further, a statutory trust must have at least one trustee which, in the case of a natural person, must be a person who is a resident of the State of Delaware or which, in all other cases, has its principal place of business in the State of Delaware, unless the statutory trust is or will become a registered investment company under the Investment Company Act of 1940 within a certain time period, in which case only a registered agent in the State of Delaware is required in lieu of a resident trustee.

Under traditional common law principles, the administration of a trust is vested in a trustee who is charged with broad fiduciary obligations to the trust and its beneficiaries. Such obligations not only generally prevent the trustee from delegating any of its discretion and authority with respect to the management of the trust, but also impose a strict standard of care on, and limit the indemnity available to, the trustee in fulfilling such obligations.

Administration of Modern Statutory Trusts

The administration of many modern statutory trusts, however, requires specialized knowledge often outside the scope of expertise of corporate fiduciaries. Under common law theories, allowing anyone other than the trustee to control the business decisions of a trust could lead to the trust being deemed to constitute an agency instead of (or in addition to) a trust.

Classification as an agency relationship can lead to undesirable results including, without limitation, that a trust beneficiary may become liable for the obligations of the trust and/or that a creditor of a beneficiary may be able to disregard the trust and reach its assets to satisfy related or unrelated obligations of the beneficiary.

In addition, a trustee of a common law trust who improperly delegates its discretion may become personally liable for any resulting losses and may not be able to be held harmless against, or indemnified for, such losses.

Under the Trust Act, however, to the extent provided in the governing instrument, a beneficiary is entitled to direct the trustee of a Delaware statutory trust without the risk of personal liability for the debts of the trust or the risk that the creditors of the beneficiary could reach the assets of the trust itself. Specifically, the Trust Act provides that a beneficiary of a Delaware statutory trust shall be entitled to the same limitation of personal liability extended to a stockholder of a private corporation for profit organized under the General Corporation Law of the State of Delaware.

Further, under the Trust Act, a statutory trust has express authority to indemnify and hold harmless the trustee, beneficiary or any other person from and against any and all claims whatsoever, subject only to such restrictions that are set forth in the trust's governing instrument and by public policy generally.

Statutory Trust and Bankruptcy

As with LLCs, many financing transactions involving a statutory trust require that the statutory trust be deemed a bankruptcy remote entity vis-à-vis the beneficiaries thereof. Apart from the trustee control problems noted above, under the common law, a sole beneficiary of a trust generally has the power to terminate the trust at will, notwithstanding any agreement to the contrary set forth in the trust's governing instrument.

Such a power prevents the creation of a bankruptcy remote entity because under bankruptcy and insolvency principles, a trustee in bankruptcy stands in the shoes of the debtor, and if a debtor has the power to terminate a trust and reach the trust's assets, then a bankruptcy trustee of such debtor also has such power.

Under the Trust Act, however, except to the extent provided in its governing instrument, a statutory trust has perpetual existence and may not be terminated or revoked by a beneficiary or any other person, or otherwise terminated by the death, incapacity, dissolution, termination or bankruptcy of its beneficiary. Furthermore, no creditor of a beneficiary has any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, the property of a statutory trust.

As with an LP Agreement and LLC Agreement, the trust's governing instrument may establish different classes or series of beneficial interests which may have separate and distinct rights and duties.

As a result of the certainty with respect to the limited liability of beneficiaries and trustees and the protection of trust assets from creditors, as well as the inherent flexibility with respect to the manner of administration of a statutory trust formed under the Trust Act, Delaware statutory trusts are often used not only in place of common law trusts but also as alternatives to other business entities in securitization and other transactions.

Delaware Limited Liability Partnerships

On January 1, 2000, the Delaware Revised Uniform Partnership Act, 6 Del. C. § 15-101, et seq. ("DRUPA"), became effective and is the governing statute for Delaware general partnerships. As with the LP Act, LLC Act and the Trust Act, DRUPA offers the parties significant flexibility in structuring their relationship and the organization of a partnership in a manner appropriate for a particular transaction, including a securitization transaction. Importantly, under DRUPA, the partners of a Delaware general partnership can be afforded a certain level of protection against liability by qualifying the partnership as a limited liability partnership ("LLP").

The major advantage of a Delaware general partnership's becoming an LLP is that the partners are protected from the general rule that all of the partners of a Delaware general partnership are, in most cases, liable jointly and severally for all obligations of the partnership.

Under DRUPA, the obligations of the partnership incurred while an LLP, whether arising in contract, tort or otherwise, are solely the obligations of the partnership. Under DRUPA, a partner of an LLP is not personally liable, directly or indirectly, by way of indemnification, contribution, assessment or otherwise, for such an obligation of the LLP, solely by reason of being or so acting as a partner. Of course, a partner may still have liability for its own actions or in accordance with the partnership agreement.

Creating an LLP

It is fairly simple to become an LLP. Under DRUPA, unless otherwise provided in the partnership agreement, the necessary approval to become an LLP is the same vote that is otherwise necessary to amend the partnership agreement. Assuming such approval and authorization to become an LLP has been obtained, the partnership initially needs to file a Statement of Qualification with the Delaware Secretary of State. The Statement of Qualification must contain

  1. the name of the partnership,

  2. the address of the registered office and the name and address of the registered agent of the partnership in the State of Delaware for service of process, and

  3. the number of partners of the partnership (although the specific names of such partners do not need to be listed).

Under DRUPA, an LLP is for all purposes a Delaware general partnership, and like a Delaware general partnership, under the default provisions of DRUPA, the LLP is deemed to be a separate legal entity, property acquired by the partnership is property of the LLP and not of the partners individually and no partner has an interest in specific property of the LLP.

If it is desired, however, that the LLP not have separate legal entity status, or that the partners be able to own property acquired by the LLP individually, have an interest in specific property of the LLP or be deemed co-owners of property of the LLP, such "opt-outs" of the default provisions of DRUPA are permissible as long as expressed in:

  1. a Statement of Partnership Existence, which is an additional simple notice filing made with the Delaware Secretary of State; and

  2. the partnership agreement.

As noted above, DRUPA offers limitations against personal liability to partners of an LLP similar to those that are afforded to managers and members of an LLC, limited partners of a limited partnership and shareholders of a corporation, each as organized under the applicable Delaware statute. In addition, as with the LP Act, LLC Act and the Trust, DRUPA offers the parties significant flexibility in structuring their relationship and the organization of a partnership in a manner appropriate for a particular transaction, including a securitization transaction.

Conclusion

With the recent enactment of the Asset--Backed Securities Facilitation Act, alternative entity statutes grounded in freedom of contract principles and modifiable fiduciary duty standards, and the internationally revered Delaware Court of Chancery, Delaware is unequivocally the leading jurisdiction in which to structure securitization and other transactions.