A key feature of project financings is to “ring fence” a project company from the rest of the businesses of a sponsor.

This ring fencing provides the financing parties with more comfort that the project will not suffer if the sponsor or other affiliated entities begin to falter.

This article explains what ring fencing is, why it is done, how entities have been successfully ring fenced, and what risks and issues should be taken into account when considering whether a subsidiary can or should be ring fenced.

Over the years, ring-fencing structures have successfully protected projects from financial difficulties suffered by their affiliates. For example, when Energy Future Holdings filed for bankruptcy in 2014, its subsidiary Texas transmission company, Oncor Electric Delivery Co., remained outside of bankruptcy, having been ring fenced by EFH years before. When SunEdison filed for bankruptcy two years later, many of the project-company subsidiaries were able to continue operating outside of the bankruptcy case.

What is Ring Fencing?

The phrase “ring fencing” refers to steps taken to make a subsidiary “bankruptcy-proof” or “bankruptcy remote.”

Ring fencing is supposed to shield the assets of the subsidiary from the bankruptcy of its parent or affiliates and allow the subsidiary to obtain or maintain a “standalone” credit rating substantially higher than the lower credit rating of its parent.

Ring fencing is used in a variety of financing situations, including acquisition financing, monetizing a subsidiary’s dividend distributions and corporate spin-offs.  In a project finance context, ring fencing generally refers to implementation of several types of protection. They are limits on the project company’s ability to incur debt or engage in business unrelated to the limited purpose of constructing and operating the project, requirements that the entity observe “separateness covenants” — such as maintenance of separate bank accounts and no commingling of assets — and (although less frequently used) a requirement that an independent director or a separate class of stock be established for an entity to vote on voluntary bankruptcy filings. 

These types of provisions are implemented in order to guard against certain specific risks in the bankruptcy context, including the following.

One risk is the borrower parent will file a voluntary bankruptcy petition.

Another risk is substantive consolidation. Substantive consolidation is an equitable remedy that allows the bankruptcy court to pool the assets and liabilities of two separate but affiliated entities and to treat them as though they are the assets of a single bankrupt debtor.  While the tests for consolidation differ across jurisdictions, courts generally consider three tests. The first test is whether creditors dealt with the entities as a single economic unit and did not rely on their separate identities in extending credit. Another test is whether the entities’ affairs are so entangled and confused that substantive consolidation will benefit all creditors. A third test is whether consolidation is necessary to avoid some harm or realize some benefit.

Another risk that ring fencing guards against is the filing of an involuntary bankruptcy petition against the subsidiary by creditors of the parent or its affiliates, by creditors of the subsidiary or by the parent or its affiliates.

The final risk is piercing the corporate veil. The “corporate veil” may be pierced if the subsidiary has acted as the “alter ego” of its parent, if the parent exerts more control over the subsidiary than would be expected of a normal investor, or if the actions of the parent directly caused the subsidiary to incur a liability.  Piercing the corporate veil is a risk when the parent so disregards the separate identity of the subsidiary that their enterprises are seen as effectively commingled.  Creditors could pursue a form of “reverse” corporate veil piercing when the parent is insolvent and the subsidiary is viewed as a source of funds.

How to Ring Fence

There is no one blueprint that will guarantee that an entity is successfully ring fenced. 

However, there are at least six factors at which courts and rating agencies look in order to determine whether an entity is sufficiently “standalone” to justify shielding its assets from creditors of its affiliates (or, in the case of rating agencies, to justify a “standalone”, investment grade, rating).

First, the new entity must be a single-purpose entity.  Its objects and powers must be restricted as closely as possible to the core activities necessary to effect the structured transaction.  This restriction reduces the entity’s risk of voluntary insolvency due to claims or risks associated with activities unrelated to the structured transaction.  It also reduces the risk of third parties filing involuntary petitions against the entity.  These restrictions should be drafted into the entity’s charter documents for two reasons: the charter documents are publicly available, and therefore serve as public notice of the restrictions, and the entity’s management is more likely to refer to these documents, and therefore be reminded of the restrictions, when conducting its affairs.

Second, the new entity should incur no additional debt beyond what is needed for its routine business purposes.  In order to limit the likelihood of an involuntary filing, the entity should covenant not to incur debt except where such action is consistent with its business purpose.  This will reduce the likelihood of holders of additional indebtedness pursuing involuntary petitions to gain access to the entity’s assets or cash.  The entity’s charter documents may also contain limits on the entity’s ability to incur voluntary liens.

Third, the new entity should covenant not to merge or consolidate with a lower-rated entity.  The bankruptcy-remote status of the subsidiary must not be undermined by any merger or consolidation with an entity not adequately protected from bankruptcy or by any reorganization, dissolution, liquidation or asset sale.  The new entity should also covenant not to dissolve.

Fourth, the new entity should observe various “separateness covenants” in order to avoid being substantively consolidated with its parent.  It should maintain separate financial records and financial statements, its own corporate books and records, and separate bank accounts.  There should be no commingling of assets with its parent or any of the parent’s affiliates.  It should pay its own liabilities and expenses from its own funds.  It should take steps to correct any misunderstanding about its separate legal nature from affiliates. Entities may also want to consider implementing restrictions on asset transfers and dividend declarations.

Fifth, the company should consider obtaining a “non-consolidation opinion” from its counsel. A non-consolidation opinion addresses the likelihood that a court will grant substantive consolidation based on the observance by a parent and its subsidiary of the various “separateness covenants” referenced above. As part of providing the opinion, counsel will review the transaction structure and documents to ensure that the project is set up and run in a manner that limits substantive consolidation risk.

Finally, the new entity may wish to include in its charter documents either an independent director or a special class of stock (or “golden share”).  The independent director or the owner of such class of shares should be an independent entity with no tie or relationship to the parent, its affiliates or any lender to the parent or affiliates.  The charter documents of the subsidiary should require the affirmative vote of the independent director or the holder of the golden share before any voluntary filing into bankruptcy.  It should also require the independent director or the holder of the golden share consider the interest of the subsidiary’s creditors, in addition to the interests of the shareholding parent, when deciding whether to file.  This factor is often viewed as critical by the rating agencies in order to insure that a standalone rating for the subsidiary is justified. 

These factors are not in and of themselves bullet-proof. 

For example, courts will generally not compel compliance with the various covenant requirements. “Non-petition” covenants — under which a parent agrees not to file a bankruptcy petition against the subsidiary — are typically not enforceable, as waivers or prohibitions on bankruptcy petitions are void as a matter of public policy. 

Non-consolidation opinions are fact specific, limited in scope and highly qualified; they also do not address the likelihood of the parent independently filing the subsidiary into bankruptcy. 

The “golden share” or independent director mechanism only addresses a voluntary bankruptcy situation and may be of limited benefit. In some cases bankruptcy courts have invalidated “golden-share” provisions in a company’s organizational documents and allowed the company to file for bankruptcy. 

While the independent director or golden shareholder may reduce the risk of a voluntary bankruptcy petition, the risk that creditors will pursue an involuntary filing still exists.  As a result, an entity should consider incorporating as many of the elements listed in this article as possible when contemplating a restructuring with the intent of ring fencing. (It should probably also opt for the independent director approach rather than the golden-share approach.)

When to Ring Fence

Ring fencing is often perceived by the public as an attempt to hide assets that would otherwise be available to creditors. 

However, the companies doing the ring fencing suggest that they are restructuring their assets to maintain the viability of the company. 

The difference between hiding and restructuring may depend in part on timing — for example, whether the new entity was in place before or after the liabilities were incurred.  Although this element has not yet appeared as a factor in the court’s decision-making process, companies would be wise to begin the restructuring and ring-fencing process as soon as practicable, before financial problems arise that make such a restructuring a necessity as opposed to just good business sense.