August 25, 2009

GGP Ruling Exposes Weaknesses in Popular Bankruptcy Remote SPE Structures

In a recent ruling declining to dismiss the Chapter 11 cases of several subsidiaries of General Growth Properties (“GGP”), the U.S. Bankruptcy Court for the Southern District of New York demonstrated that special purpose entities (“SPEs”), designed to avoid bankruptcy, can nonetheless be subject to bankruptcy proceedings. Rejecting the requests of mortgage holders of several SPEs, the court ruled that the GGP subsidiaries could remain in bankruptcy despite having strong cash flows, no debt defaults and “bankruptcy remote” structures. The SPEs’ secured creditors, special servicers and lenders argued primarily that the cases should be dismissed as having been filed in bad faith since the properties did not need to be rehabilitated and the independent directors whose consent was needed for a Chapter 11 filing had been replaced on the eve of the bankruptcy.

The Bankruptcy Court looked past the form of the SPE bankruptcy remote structures and instead focused on the way in which the SPEs functioned in GGP’s overall business. This perspective had yielded prior rulings that allowed GGP to continue its consolidated cash management system notwithstanding separateness covenants that ostensibly cabined cash to particular properties in the event of a default, including a bankruptcy filing. In the context of the dismissal motions, the court applied the broad perspective of the GGP group of entities rather than the narrow focus of a particular SPE.

Among the weaknesses of the SPE structure exposed by the ruling in GGP was the requirement under applicable Delaware law that independent directors (or managers, in the case of LLC debtors) must consider not only the interests of creditors, as mandated in the entity governing documents, but also the interests of shareholders. Shareholders include GGP as the ultimate parent entity. Independent directors or managers may be ignoring their fiduciary duties of loyalty and care if they simply vote against any filing for bankruptcy protection as CMBS lenders expected.

The GGP court also ruled that, in spite of the fact that the SPEs did not have loans maturing for up to three years and none were in immediate danger of defaulting, it was not premature and in bad faith for SPEs to file bankruptcy proceedings. The court accepted the argument by GGP that the CMBS market was dead for the foreseeable future and that looming balloon payments, albeit in the future, could be seen as current financial distress. In addition, the court ruled that it was appropriate to consider the interests of the affiliated group of entities to which the particular SPE belonged in determining the propriety of the filing. Therefore it was appropriate to file under Chapter 11 at an early point to preserve the value of the group because GGP and each SPE would not otherwise be able to successfully restructure its debt when it came due.

The court also found that it was not bad faith for GGP to replace most of the SPEs’ independent directors with new independent directors days before the bankruptcy filing because it replaced unknown directors with directors having expertise in real estate, CMBS and bankruptcy matters.

The GGP case belies the efficacy of the bankruptcy remote and separateness assumptions of the CMBS structure, while another SPE-related bankruptcy, Extended Stay Hotels, casts doubt on the effectiveness of springing guarantees as bankruptcy deterrents. With the assurance of indemnity against springing guaranty liability proffered by a senior mezzanine lender, Extended Stay’s principal filed a Chapter 11 for the entity. Whether he will retain the benefit of this Faustian bargain remains to be seen since litigation on the guaranty liability is ongoing.

Given the novelty of large SPE bankruptcies, it is impossible to say how well the balance struck by the GGP court between the expectations of CMBS lenders and the sponsor entity will survive as the GGP case moves forward, or whether cases with different facts will lead of a more favorable result for CMBS lenders. Given the current economic climate, there will likely be additional opportunities for these issues to play out. When the securitization market revives, the lessons of these cases will inform the structure and price of new financings.

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Earlier this year, in an article published in the June issue of BNA’s Real Estate Law & Industry Report, Goodwin attorneys analyzed the bankruptcy remote structure in light of the GGP bankruptcy filing and discussed its implications for CMBS lenders and investors. That article is available here.