Bankruptcy Court Refuses to Dismiss Bankruptcy Filings of "Bankruptcy Remote" Subsidiaries of General Growth
On August 11, 2009, the United States Bankruptcy Court for the Southern District of New York (NY Court) issued a significant opinion (Decision) denying motions to dismiss numerous bankruptcies filed by so-called "bankruptcy remote" subsidiaries of General Growth Properties, Inc. (GGP). The NY Court, one of the leading bankruptcy courts in the country, is perhaps the first court to rule on the question of whether single purpose, "bankruptcy remote" debtors, most of whom are current on paying debt service on mortgage loans that do not mature for many years, can seek bankruptcy protection. This is why the structured finance industry has been so closely monitoring the dismissal proceedings in the GGP bankruptcy.
The Decision will likely have significant ramifications going forward as a large portion of the outstanding securitized commercial mortgage debt will either mature or go into default over the next five years. At the same time, borrowers, like the GGP subsidiaries, that were structured to be "bankruptcy proof" may turn to the bankruptcy courts for relief if they cannot obtain refinancing in the commercial real estate credit markets.
"Bankruptcy Remote" Borrowers in the CMBS Market
The commercial real estate finance world has changed dramatically since the rise of the commercial mortgage-backed security (or CMBS) market in the late 1990s. In a CMBS transaction, numerous mortgages are first assigned to a trust, and then, interests in the trust are sold to investors. The interests are given varying degrees of risk with the riskier pieces of the investment pie holding the highest annual returns.
Typically, the agencies rating the bonds sold by CMBS trusts require that the various borrowers whose loans were placed in the trust be structured in a way that would severely limit, or wholly prevent, a voluntary bankruptcy filing. In order to make them "bankruptcy remote," the borrowers were single purpose entities (SPEs) created solely to own a single piece of real estate. Additional protections were written into the SPEs' organizational documents, including the requirement that they have independent managers or directors whose votes were required on certain actions, most importantly, the decision to file a voluntary bankruptcy petition.
The lenders, and ultimately the investors, believed that these protections would greatly reduce or even eliminate the risk that their borrowers could file voluntary bankruptcy petitions or be dragged into an affiliate's insolvency proceeding through substantive consolidation. The dismissal motions in the GGP bankruptcies tested this fundamental assumption.
The SPE Owners' Mortgage Loans and Bankruptcies
In April 2009, GGP (the parent company) and 166 of its subsidiaries (SPE Owners) filed voluntary petitions under Chapter 11 of the Bankruptcy Code. The SPE Owners were SPEs each created to own one mall managed by GGP, encumbered by an individual mortgage loan, many of which were placed in a CMBS pool. The terms of the loans varied from 3 to 30 years. The organizational and loan documents contained "bankruptcy remote/separateness" provisions that the mortgage lenders relied upon in providing financing for each subsidiary.
GGP and the SPE Owners (GGP Group) planned to refinance the debt both at the parent level and at the property level of the SPE subsidiaries. However, the credit crisis and other factors prevented the GGP Group from refinancing its maturing debt. The SPE Owners continued to pay monthly debt service out of rental cash flows and were not in default of their credit facilities, except for a minority of loans that had matured.
The Decision Denying the Dismissal Motions
The mortgage holders (or their special servicers) for 21 of the SPE Owners filed motions to dismiss their bankruptcy petitions on the ground that they were filed in bad faith. First, the lenders argued that the SPE Owners should not have filed for, and were not in need of, bankruptcy protection until the respective maturity dates of their loans were approaching or the loans were in/going into default. The NY Court held that the filings were not premature and that a debtor does not have to be insolvent or in a "particular degree" of financial distress in order to file for bankruptcy. It found that the SPE Owners were in "varying degrees of financial distress" and that there was a reasonably likelihood that the GGP Group intended to reorganize instead of abusing the bankruptcy process.
Second, the movants maintained that putting the entire GGP Group in bankruptcy violated the "separateness" of the special purpose entity structure of the SPE Owners. The NY Court agreed that the structure of SPEs is designed both to insulate the entity from the problems of its affiliates and to make each entity "bankruptcy remote." However, it found that because the cash flow of the entire GGP Group was based on the earnings of the subsidiaries and the GGP Group was experiencing financial problems at the parent level, the GGP Group would have to reorganize its entire structure in order to refinance the SPE Owners' obligations. Therefore, the NY Court concluded that the joint filings of the GGP parent and its subsidiaries were not in bad faith.
Third, the lenders asserted that the SPE Owners acted in bad faith because the initial, so-called "independent" managers or directors of the subsidiary entities were surreptitiously replaced shortly before the bankruptcy filings. They argued that this action was taken to circumvent the "bankruptcy remote" provisions of the SPE Owners' organizational documents that required the unanimous vote of the directors to file a bankruptcy and the directors to consider only the interests of the individual subsidiary entities.
The NY Court disagreed and reasoned that the original "independent" directors, who did not have significant experience in the real estate business, were replaced by more experienced directors when the GGP Group began to have financial problems. Moreover, it rejected the notion that the "independent" managers were required under the corporate documents to prevent or deter the SPE Owners from filing a bankruptcy petition, stating that if the lenders "believed that an 'independent' manager can serve on a board solely for the purpose of voting 'no' to a bankruptcy filing because of the desires of a secured creditor, they were mistaken."
Rather, the NY Court ruled that the "independent" directors had a fiduciary duty under Delaware law (the jurisdiction in which the SPE Owners were formed) to act in the best interests of the company and its shareholders, which included the GGP parent entity. The successor "independent" directors, therefore, did not act contrary to, but in conformity with, their duties by voting to authorize the SPE Owners' bankruptcy filings in order to reorganize the GGP Group's entire structure to refinance the SPE Owners' debt.
Finally, the NY Court attempted to reassure the lenders that their interests would remain protected, notwithstanding the ability of the SPE Owners to file for bankruptcy. It emphasized that the Decision did not "imply that the assets and liabilities of any of the [SPE Owners] could properly be substantively consolidated with those of any other entity." Although not faced with a request that the GGP Group's estates be substantively consolidated, the NY Court nevertheless reinforced one of the central purposes of the SPE structure in CMBS transactions - to prevent the substantive consolidation of the SPE borrower with another entity.
The Decision may likely change the way that mortgage lenders/servicers and SPE borrowers interact and work out defaulting loans over the coming waive of maturities in the commercial real estate arena.
If you have questions or would like additional information, please contact Steve Ostrow (firstname.lastname@example.org; 212.789.7548), Tom Pinney (email@example.com' 215.864.6371) or another member of the Financial Restructuring and Bankruptcy Group.