September 4, 2009
Gibson, Dunn & Crutcher LLP is closely monitoring developments arising from the recent ruling in the Chapter 11 case of General Growth Properties, Inc. ("GGP"), which suggests, among other things, that single-purpose, bankruptcy-remote entities ("SPEs") may not be as "bankruptcy remote" as lenders thought. In an opinion written by United States Bankruptcy Judge Allan L. Gropper, the United States Bankruptcy Court for the Southern District of New York (the "Court") denied the motions of property-level lenders seeking to dismiss the Chapter 11 cases filed by various debtors, including numerous SPEs, owned directly or indirectly by GGP. The property-level lenders argued that the cases should be dismissed for bad faith because the project-level debtors (i) were not in financial distress as of the petition date, making the bankruptcy petitions premature, and (ii) had engineered the bankruptcy filings by replacing the initial independent directors on the eve of the bankruptcy filings. Ultimately, the Court found that bad faith was not present and denied the motions to dismiss.
The Court’s reasoning as to why bad faith was not present may have implications for the structure of SPEs. What follows is a brief summary of the basis for the Court’s finding that bad faith did not exist, a discussion of the implications that the Court’s decision may have for the use of SPEs and a summary of some of the structural changes now under consideration by the lending community as a result of the decision.
Grounds for Denying Motions to Dismiss
The Court’s rejection of the lenders’ arguments on bad faith has several negative implications for the future of real estate lending. First, the Court applied a broad definition of financial distress in evaluating the financial condition of each debtor as of the petition date to support its conclusion that the bankruptcy filings were not premature. Second, the Court asserted that, despite the fact that SPEs are designed and intended to be separate and distinct from their corporate affiliates, when determining whether a bankruptcy petition has been filed in bad faith, it is appropriate to consider the interests of the corporate group as a whole. Third, the Court confirmed that, despite what may be popular belief among secured creditors, independent directors of SPEs cannot merely serve to protect the interests of creditors; instead, they have a fiduciary duty to protect the interests of the company and its shareholders. Lastly, the Opinion suggests that the Court may have been more receptive to the lenders’ arguments that the SPEs at issue should be excluded from the bankruptcy if the property-level lenders had provided such debtors with the opportunity to renegotiate the terms of their loans prior to the bankruptcy filing. Thus, the Opinion may provide some incentive for lenders to modify or do away with the restructuring obstacles inherent in the typical CMBS structure.
Despite arguments to the contrary, namely, that as of the petition date, most of the debtors at issue did not carry debt that was set to mature in the near future and the properties held by the SPEs were, as a general matter, continuing to perform, the Court found that each of the debtors at issue were in varying degrees of financial distress on the petition date. The Court relied on the fact that a number of the debtors had loans that (i) "had cross-defaulted to the defaults of affiliates or would have been in default as a result of other bankruptcy petitions," (ii) had gone into hyper-amortization, (iii) were set to mature or hyper-amortize in one, two or three years from the petition date, or (iv) had other characteristics, that placed the loan in distress, such as a high loan-to-value ratio. The Opinion suggests that the Court’s willingness to view each of these factors as an indication of financial distress may have been due, at least in part, to the Court’s dire view of the CMBS market and the ability to refinance debt at the SPE level.
Interests of the Corporate Group
Apart from the Court’s willingness to find that the debtors at issue were in financial distress on the petition date, what may be more troubling to secured lenders is that the analysis set forth above may have been unnecessary in light of the Court’s assertion that it was not required to examine the issue of good faith as if each debtor was wholly independent; instead the Court determined that it was appropriate to consider the interests of the corporate group as a whole. Recognizing that there is little case law on point, the Court relies on a few cases, which, according to the Court, suggest that considerations of the corporate group are appropriate where putting the subsidiaries into bankruptcy is crucial to the successful reorganization of the corporate group, including the parent company. Under this standard, the Court found that it was appropriate to consider the interests of the GGP corporate group as a whole since the parent companies were dependent on the cash flow from the subsidiaries and therefore, it was unlikely that the parent companies could be successfully restructured if the property-level entities were excluded from the bankruptcy. The Court also relied on GGP’s "centralized management process," noting that the majority of GGP’s services "are provided or administered centrally for all properties" and "[o]nly the most basic building operational needs are addressed at the individual property level."
The property-level lenders argued that the circumstances surrounding the firing of various independent directors and their replacement with independent directors who ultimately voted in favor of bankruptcy was evidence of bad faith on the part of the debtors. The Court found this argument unpersuasive because the original directors had little if any real estate experience and were replaced with directors with expertise in the real estate business and the firing and replacement of the independent directors did not violate the applicable corporate documents, which did not prohibit such action.
Also, the Opinion suggests that that the firing of the independent directors may have been irrelevant to the Court’s determination that bad faith did not exist because, according to the Court, the initial directors would have had a fiduciary duty to consider the interests of the debtor and its shareholders (or members); not just its creditors. This finding exposes a reality of the typical SPE structure: independent directors are bound to comply with the same fiduciary obligations as any other directors and must act in accordance with applicable law or risk liability for breach of fiduciary duty. In the instant case, the applicable law was deemed to be the corporate law of the state of Delaware. Under Delaware case law, directors of a solvent corporation have a fiduciary duty to consider the interests of the corporation and its shareholders, including the parent entity, when determining whether a bankruptcy filing is appropriate. It is unclear how many debtors organized as Delaware limited liability companies had language in their organizational documents affirmatively waiving fiduciary duties, which is permitted under the Delaware Limited Liability Company Act.
Implications for SPEs
In the Opinion, the Court was very careful to rely on settled, existing case law regarding what constitutes "bad faith" to support its denial of the motion to dismiss rather than try to reject the SPE structure. The Court was mindful not to undermine the CMBS community. The Court specifically stated that the "principal goal of the SPE structure is to guard against substantive consolidation." The Court deliberately did not address substantive consolidation (and in hearings the Court specifically stated that it was not ruling on substantive consolidation).
An important "take-away" from the Opinion for a real estate lender should be the realization that if a lender is relying on strong, centralized sponsorship to support its loan (including a sponsor who provides management, leasing and financial support to bridge shortfalls) then an SPE structure may not protect the lender when the sponsor is in financial distress. In the future, rather than relying solely on SPE protections, lenders will need to develop strategies in their loan documents and underwriting to protect against (or at least provide early warning signs of) financial distress at the sponsor level.
Strengthening the Current SPE Structure
The Opinion focuses substantial attention on the financial distress of GGP, the sponsor of the SPEs. In underwriting loans, lenders will now have to consider carefully the financial condition and prospects of the SPE borrower’s sponsor. One possible measure lenders could implement to address financial distress issues would be to include in the SPE borrower’s organizational documents as well as the loan documents strict financial covenants (e.g., restrictions on the aggregate indebtedness of the SPE borrower and its affiliates/parent and restrictions on the total unsecured indebtedness of affiliates/parent). It would also provide early warning of potential financial distress so that lenders can take early remedial actions in advance of a bankruptcy.
In light of the Court’s decision, lenders may elect to include new provisions in loan and organizational documents that curtail the ability of borrowers to unilaterally replace independent directors. For example, lenders might consider requiring that lenders be provided with advanced written notice before any independent directors are replaced. Doing so would provide lenders with time to prepare for a potential bankruptcy filing and the opportunity to take defensive measures or, at the very least, will prevent them from being surprised by a bankruptcy filing.
In addition, lenders can require provisions in organizational documents giving them reasonable approval rights with respect to the replacement of independent directors (e.g., allowing the lender to reject a potential candidate that does not satisfy the definition of "independent director" and/or lacks the requisite experience) and advance notice of any meetings with independent directors to discuss a possible bankruptcy filing. While these suggestions may appear to be easy fixes, they are not without their drawbacks. Historically, provisions of this nature may not have been used out of fear that their inclusion might open the door for potential lender liability.
In an attempt to circumvent the Court’s finding that independent directors owe a fiduciary duty to shareholders, some have proposed a structure in which the SPE borrower would have two classes of members–an economic member and a non-economic member (appointed or approved by lender). Under the proposed structure, the non-economic member would be required to vote in favor of a bankruptcy filing and the economic member or equity holder would waive the fiduciary duty owed to it by the non-economic member, with the end result being that the non-economic member could protect only creditors. While the effectiveness of this structure will not be known until it is actually implemented in a transaction and tested in litigation, the Court’s rejection of the idea that an independent director "can serve on a board solely for the purpose of voting ‘no’ to a bankruptcy filing because of the desires of a secured creditor" suggests that such a provision would likely be challenged.
Separately, as mentioned above, the Court relied on the fact that GGP was dependent on cash flow generated by properties owned by its SPE subsidiaries to support its finding that it was appropriate to consider the interests of the corporate group when deciding whether or not to file for bankruptcy. This suggests that lenders may be able to counter the impact of such reasoning by requiring "hard" cash management systems with no leakage (other than payment of lender approved operating/extraordinary expenses) day one. This would prevent cash generated by SPE-owned properties from reaching parent entities; therefore, a parent entity that approved such a loan would not later have a valid argument that it relied on the cash flow from property held by an SPE borrower. However, borrowers will obviously not be thrilled by the prospect of having to wait until loan maturity, sale or a refinancing in order to pull their equity/profits out of the applicable property.
Finally, the Court’s centralized management argument can perhaps be further mitigated by lenders prohibiting SPE borrowers from "self-managing" their properties; rather, lenders can insist, as a condition to closing, that such SPE borrowers enter into arms-length property management agreements with third-party or affiliated property managers.
Although it is unclear whether the Court’s decision will be relied upon by other courts in the future or whether it is merely an anomaly, it suggests that SPEs may not be as "bankruptcy remote" as once believed. We are actively working with our clients to structure around the weaknesses exposed by the GGP bankruptcy filing, and will continue to monitor this case as well as other decisions that are relevant to the effectiveness of SPEs as bankruptcy remote vehicles.
 GGP is a publicly traded real estate investment trust that is primarily engaged in the business of owning and managing shopping centers. GGP is the general partner of GGP Limited Partnership, which controls, directly or indirectly, GGPLP, L.L.C., The Rouse Company LP, and General Growth Management, Inc., which in turn directly or indirectly control hundreds of individual project-level subsidiary entities. These project-level subsidiaries directly or indirectly own the individual properties at issue in the bankruptcy case. Opinion at 4–5. As a result of the collapse of the real estate markets and the resulting uncertainty regarding the ability to refinance the debt held by GGP and its affiliates, management decided to reorganize the corporate group’s capital structure by filing for Chapter 11 relief. Opinion at 14, 17. On April 16, 2009, 388 entities in the corporate group filed for Chapter 11 protection with an additional 27 filing on April 22, 2009. Opinion at 4 n.6.
 As noted by the Court, SPEs "are structured . . . to protect the interests of their secured creditors by ensuring that the operations of the borrower [are] isolated from the business affairs of the borrower’s affiliates and the parent so that the financing of each loan stands alone on its own merits, creditworthiness and value." Opinion at 7 (internal quotations and citations omitted). To accomplish this, most SPEs have restrictions in their organizational and loan documents that require them to maintain a separate existence and limit the types of debt they can carry. In addition, their organizational documents usually contain prohibitions on consolidation and liquidation, restrictions on mergers and asset sales, prohibitions on amendments to the organizational and transaction documents, separateness covenants and an obligation to retain one or more independent directors. Opinion at 7.
 However, it is unclear whether the Court would have reached a different conclusion because, before considering the argument that the debtors failed to negotiate prior to filing for bankruptcy, the Court states that "[t]he Bankruptcy Code does not require that a borrower negotiate with its lender before filing a Chapter 11 petition" and while, "[t]here are often good reasons for a commercial borrower and its lender to talk before a bankruptcy case is filed," "that does not mean that a Chapter 11 case should be deemed filed in bad faith if there is no prepetition negotiation." Opinion at 36.
 According to the Court, "[s]ome of the mortgage loans . . . had an anticipated repayment date . . ., at which point the loan became ‘hyper-amortized,’ even if the maturity date itself was as much as thirty years in the future." The consequences associated with the failure to repay the loan on the anticipated repayment date included a steep interest rate increase, a requirement that cash be kept at the project-level, with excess cash flow being applied to principal, and a requirement that certain expenditures be submitted to the lender for its approval. Opinion at 9.
 Opinion at 26. At least one commentator has stated that the Court may have incorrectly asserted that refinancing at the SPE level was unlikely noting that "[t]he court decline[d] to consider the contrary and hardly unreasonable position that a solvent SPE borrower with a moderately leveraged loan on a cash flowing property would have access to refinancing capital."
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