On August 11, 2009, the US Bankruptcy Court for the Southern District of New York denied five motions to dismiss bankruptcy cases filed by certain bankruptcy remote, special purpose subsidiaries (SPEs) of General Growth Properties, Inc. (GGP). The motions were filed by or on behalf of secured lenders to the SPEs (Movants) who argued that the bankruptcy filings were inconsistent with the bankruptcy remote structures that they had negotiated with GGP.
The decision holds that the SPEs were eligible to be debtors under the Bankruptcy Code and that, under the facts of this case, the filings were not in bad faith. However, the court’s discussion of the propriety of the filings touches on certain issues regarding bankruptcy remote structures, most notably the appropriateness of management taking into account the interests of the GGP group in determining whether to file a bankruptcy petition for an SPE, and the duties of independent managers.
The court made clear that the mere fact that the lenders did not anticipate a bankruptcy filing by an SPE, or that the lenders would be inconvenienced by a bankruptcy case, was not a basis for dismissal. The court also emphasized that it was not impairing the rights of any of the secured lenders to the SPEs under the Bankruptcy Code, that the fundamental protections for which the lenders negotiated were still in place and that nothing in the court’s opinion implied that the assets and liabilities of the SPEs could be substantively consolidated with those of any other entity.
GGP is a publicly traded real estate investment trust with approximately 750 wholly owned subsidiaries in the business of ownership and management of shopping centers. Hundreds of individual projects are owned in special purpose subsidiaries that are structured to be bankruptcy remote. GGP’s bankruptcy filing on April 16, 2009, thus raised concerns in the commercial mortgage finance market because it included filings by 166 bankruptcy remote special purpose entities. Movants sought dismissal of the SPE bankruptcy petitions as bad faith filings.
Were the Filings Premature?
The Movants argued that the good faith of the filings should be examined solely from the perspective of the individual SPE, not from the perspective of the group, and that because the SPEs were solvent enterprises not in default on their debt or in present need of restructuring, that the petitions were in bad faith. The court started with the legal proposition that a debtor need not be insolvent in order to file for bankruptcy protection and that the provisions of the Bankruptcy Code incentivize a debtor to file sooner rather than later. The court viewed the issue as whether the SPEs were in financial distress and found sufficient evidence to support a bankruptcy filing. The financial distress arose primarily because of cross defaults to loans to other affiliates, some of which had already occurred, and some of which would have occurred upon the bankruptcy filings, and because of the impact of the state of the credit markets on the ability to refinance.
Could the SPEs Consider the Interests of the Group in Deciding Whether to File?
The Movants also argued that considering the financial interests of the GGP group, in judging the good faith of an SPE’s filing, would violate the purpose of the SPE structure. However, the court found that legal authority suggested that it was appropriate to consider the interests of affiliates in determining whether to file a bankruptcy case for a subsidiary. Thus the court analyzed GGP’s overall debt structure. GGP’s business plan was premised on its ability to refinance debt, particularly at the SPE level. Thus, if the ability of the group to obtain refinancing became impaired, the financial situation of the SPEs would inevitably be impaired. In this case, it was also clear that the debt at the parent level could not be restructured where cash flow of the parent was based on earnings of subsidiaries that had debt coming due that could not be refinanced.
In reaching this conclusion, the court made the caveat that this analysis only speaks to the good faith of the very fact-based decision to file a bankruptcy petition. It does not mean that interests of the SPEs and their lenders should be sacrificed to the interests of the parent. Secured lenders have fundamental rights under the Bankruptcy Code, which the court deemed not impacted by this decision.
Independent Managers Were Obligated to Consider Parent’s Interests when Determining Whether to File
The court relied on the language of the operating agreements of the SPEs themselves to buttress its determination that the interests of the group should be taken into account in determining the good faith of the filings. The specific language of the operating agreements of the SPEs provided that the independent managers would consider the interests of the company, including its respective creditors, in acting or otherwise voting on the filing of a bankruptcy petition. Testimony by Movants’ witnesses indicated that the lenders believed the interests of creditors would be the primary consideration. However, the operating agreements further provided that the independent managers had a fiduciary duty of loyalty and care similar to that of a business corporation organized under the Delaware General Corporation Law. A recent Delaware Supreme Court case makes clear that the directors of a solvent corporation are required to consider the interests of shareholders in exercising their fiduciary duties. The same decision indicates that the director of an insolvent corporation has duties to creditors. However, in this case it was undisputed that the relevant SPEs had always been solvent and, thus, that the managers were obliged to take into account the interests of the parent.
One Movant argued that the SPE cases should be dismissed because an SPE could not confirm a plan over the objection of its lender. The lender would be the holder of the secured debt and, if there were a deficiency, the largest holder of unsecured debt, thus precluding the SPE from having an impaired accepting class necessary for confirming a Chapter 11 plan. The court rejected this argument because the Bankruptcy Code does not require a debtor to prove that a plan is confirmable in order to file a petition. Courts have not dismissed on this basis until a plan has been filed. The court also noted that GGP could negotiate an agreed plan or choose to leave the debt unimpaired.
Subjective Bad Faith – Failure to Negotiate and Replacement of Independent Managers
Another element considered by the court was the subjective good faith of the debtors. The court rejected the Movants’ contention that the debtors were in bad faith because they did not negotiate prior to filing for bankruptcy protection. The Bankruptcy Code does not require a debtor to negotiate before filing and there was no evidence in the record that pre-filing talks would have been adequate or that the Movants were even willing to work with the debtors. Evidence indicated that in some cases the SPEs could not negotiate because the master servicers were not authorized to modify the loan. While the special servicer could agree to modifications, the loans would not be turned over to the special servicer until there was an actual default.
Finally, the Movants argued that the filings were in bad faith because the independent managers were replaced on the eve of bankruptcy and were not even notified until after the filing. While the court referred to this change as “admittedly surreptitious,” it refused to hold that it was subjective bad faith because it was allowed by the organizational documents of the SPEs and the new managers were qualified to be independent managers.
The case raises several considerations for future transactions. These will first focus on the definitions of independent manager and the terms for replacement of an independent manager. In addition, the duties of an independent manager may be more flexible under the Delaware Limited Liability Company Act than under the Delaware Corporation Act, which was the applicable law in GGP. Finally, the case provides a list of factors that GGP considered in deciding whether to file an entity for bankruptcy. These considerations may be taken into account in future deals in trying to structure to avoid an SPE filing.