William, Charles, and Alfred Voller were skilled luthiers and forgers of the early 20th century. They created nearly perfect “copies” of several early Italian violins – which they sold at high prices. Their forgery of the Balfour Stradivari violin was so good it was certified as a real Stradivari by a famous London violin dealer.
Another famous violin fraud occurred in the early 21st century when New Jersey millionaire Herbert Axelrod sold thirty fake string instruments purportedly worth $49 Million to the New Jersey Symphony Orchestra for $17 Million. In reality, the instruments were at most worth about $17 Million. Axelrod may have inflated the value hoping to receive a tax benefit for a below-market-value sale. The symphony, buried under debt from buying the instruments, avoided bankruptcy by later selling the instruments for $20 Million.
Fraudulent violin sales make the news because they are uncommon. And while we read about special purpose entities (SPEs) – also called special purpose vehicles — being used to commit fraud, most SPEs serve legitimate business needs. This article discusses legitimate business reasons people use SPEs in real estate transactions.
Enron – Poster Child for Special Purpose Entity Abuse
Enron Corp. was an energy industry darling of the bull market of the 1990s. Formed in the aftermath of deregulation, Enron became an energy trading company. In July 2020, Enron made a deal with Blockbuster (the video rental store) to develop a high-speed Internet network to deliver video on demand to consumers. Enron’s stock skyrocketed, and the company was touted as one of the world’s most innovative companies.
The burst of the tech bubble in 2001 would show the vulnerabilities in Enron’s armor. By 2002, Enron’s stock became unmarketable. Closer scrutiny revealed a series of related-party transactions where Enron used SPEs to conceal losses. Enron executives went to jail for fraud and insider trading. And Arthur Anderson, the Big Five accounting firm that served as Enron’s accountants, would soon dissolve.
Special Purpose Entities in the News
Although accounting rules have been tightened to make another Enron unlikely, SPEs still sometimes get negative press. SPEs made the news again when then President Trump made his financial disclosures, including information on approximately 500 limited liability companies (LLCs) he owned. No details were given regarding how the SPEs were used, but the odds are that most of those LLCs were associated with specific real estate investments.
News articles also expressed amazement that Jared Kushner resigned from positions with 266 companies when he took a position with the US government. Two hundred twenty (220 of these companies were LLCs formed for individual real estate projects. Ivanka Trump had resigned from even more positions – 292 in all. As with her father and husband, most of those companies were LLCs, and most were associated with real estate investments.
Special purpose acquisition vehicles (SPACs) also have been in the news recently. Also known as “blank check companies,” SPACs are a type of SPE used to raise capital for a merger or acquisition with an existing company. Until a merger or acquisition occurs, SPACs are backed only by the cash raised in the offering. SPACs (and sometimes, by extension, SPEs in general) have received negative press as SPAC mergers were called off. How SPACs work is beyond the scope of this article.
In December 2020, Congress passed the Corporate Transparency Act (CTA), which applies to companies considered “shell companies” without significant operations. The implication is those “shell companies” are at high risk of being fraudulent. But the CTA applies to both legitimate real estate investments and small businesses not involved in illicit activity simply because they have fewer than 20 full-time employees or less than $5 Million in gross receipts or sales in the United States,
Why Mortgage Lenders Require Special Purpose Entities
Although the number of Trump family SPEs may sound shocking and the CTA may imply nefarious intent, it’s common to use SPEs in real estate. Given the family’s vast holdings, it’s no surprise the family has hundreds of SPEs. Using SPEs in real estate doesn’t in and of itself indicate illegal or unethical behavior. And unlike with SPACs, real estate SPEs are backed by an asset (the real estate) rather than just investor cash. SPEs are the norm in commercial real estate transactions for legitimate business reasons.
Nearly all real estate investments are financed with mortgage loans. And mortgage lenders universally require that the real estate securing the loan be owned by an SPE that is “bankruptcy remote.”
Lenders underwrite mortgage loans based upon the real estate and its revenues and risk profile. By requiring that the real estate be held in an SPE, the lender can isolate its risk to the real estate, and other business ventures don’t affect the borrower’s ability to pay the mortgage loan.
Joint venture and private equity investors in real estate transactions also usually require their investments to be through an SPE. Like mortgage lenders, they underwrite their risk based only on the real estate and want their investment returns to be tied solely to the real estate.
Property owners also may want to isolate the risk from their real estate investment. Owners frequently seek mortgage loans that are non-recourse, meaning that the mortgage lender agrees to rely upon the revenue and value of the real estate for repayment of the mortgage loan. Real estate is a risky investment – sometimes, properties’ financial performance doesn’t meet forecasts and revenue doesn’t cover mortgage payments. With a non-recourse loan, the lender can foreclose on the real estate, but it can recover no deficiency from the SPE’s owners.
Businesses Use Special Purpose Entities to Isolate Different Asset Types and Business Activities
SPEs also can help to insulate real estate from business risk. For instance, senior housing investments include both real estate that is rented and a business providing meals, healthcare, and other services to senior residents. A senior apartment rental has a similar risk profile to any apartment. But providing seniors with meals, healthcare, and personal services carries significant additional risk.
The senior housing community owner will purchase property, casualty, and liability insurance for the real estate and errors and omissions insurance for the senior services business. But no matter how careful they are and how much insurance they buy, there’s a more significant risk of catastrophic loss (e.g., loss of several lives) in the senior service business than renting an apartment.
The senior housing owner may establish two SPEs – one to own the real estate and a second to operate the senior housing business. Typically, the real estate SPE will lease the real estate to the senior housing SPE. Properly done, this isolates the risks into two “silos.”
Tax considerations also can drive SPE use. An investor may use a Section 1031 exchange to purchase real estate in the senior housing example. But tax laws don’t allow an investor to use Section 1031 funds to purchase a senior housing business. So, the investor might use one SPE to purchase the real estate and lease the real estate to a senior housing company, which uses its own SPE to operate the senior housing business. In this scenario, the same investor can’t own both the real estate SPE and the senior housing SPE if a Section 1031 exchange is involved. Were that the case, the IRS would be likely to disregard the lease to the senior housing SPE and disallow the Section 1031 exchange
Other types of businesses also may use SPEs to isolate or silo risk by business unit or to facilitate financing. Also, isolating individual business units in their own SPEs can facilitate a spin-off or sale of individual business units. For instance, a company that owns two brands of restaurants (e.g., formal sit-down and fast casual) might use separate SPEs for each brand. By keeping each brand’s revenues, expenses, and assets separate, the company could more easily do an IPO for the fast-casual brand or sell the formal, sit-down restaurant brand.
Due to Enron, SPEs have an undeserved negative image. Like fraudulent violin sales, the percentage of SPEs created for fraudulent purposes likely is small compared to the number of SPEs in use.
The reality is that SPEs have many legitimate business uses. Rather than assuming that an SPE is hiding illicit activity, each SPE should be evaluated individually to determine whether the SPE was formed at the behest of a lender or key investor, what business goals the SPE promotes, and
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.