A fundamental component in the commercial mortgage-backed securities ("CMBS") market is the lender's reliance that the loan is made to a "bankruptcy remote" special purpose entity ("SPE"). The loan documents and operating agreements relating to an SPE typically require that the SPE maintain separate existence and contain restrictions that limit the SPE's debt and ensure separateness. This structure protects the lender by keeping the operations and assets of the SPE borrower separate and remote from its affiliates and parent—the goal being to ensure that the SPE's operations and assets are not impacted by a bankruptcy proceeding of its affiliates or parent.
On Aug. 11, the U.S. Bankruptcy Court for the Southern District of New York issued a memorandum opinion in the bankruptcy cases of General Growth Properties, Inc. ("GGP") and its debtor subsidiaries (the "Debtor Subsidiaries") that demonstrates that the SPE structure does not ensure that an SPE borrower will always be able to avoid becoming ensnared in the bankruptcy proceeding of its parent and affiliates. In re Gen. Growth Props., Inc., No. 09-11977, 2009 WL 2448423 (Bankr. S.D.N.Y. Aug. 11, 2009).
Credit Crisis Fallout
GGP is the ultimate parent of approximately 750 of the Debtor Subsidiaries. GGP and its Debtor Subsidiaries ("Debtors") own and manage more than 200 shopping centers throughout the United States. The Debtors had approximately $18.27 billion of debt at the project-level secured by the respective underlying real estate (shopping center properties), each of which is typically owned by an SPE. Some of this debt constituted conventional mortgage debt, but a considerable portion of it represented debt securitized in the CMBS market.
The loans typically were structured with three- to seven-year maturities, low amortization rates, and balloon payments due at maturity. The Debtors' business plan was based on the premise that they would be able to refinance their debt. As the credit crisis spread to commercial real estate finance, the Debtors found themselves unable to refinance. Without the ability to refinance, the Debtors began using operating cash to pay obligations as they became due, and two large project-level loans eventually went into default.
The Debtors ultimately filed voluntary petitions under chapter 11 in April of this year.
Bad Faith Claims Dismissed
In the decision, Judge Gropper denied five motions to dismiss certain of the chapter 11 cases filed by one or more of the Debtor Subsidiaries ("Subject Debtors"). Each of the Subject Debtors was an SPE. Each motion to dismiss was filed by or on behalf of a secured lender ("Movants") with a loan to one or more of the Subject Debtors. The Movants premised the dismissal of the cases on the argument that the Subject Debtors filed their cases in bad faith.
The court began its analysis by explaining that, in the U.S. Court of Appeals for the Second Circuit, to dismiss a bankruptcy petition for bad faith, the court must find both objective futility of the reorganization process and subjective bad faith in filing the petition.
The court rejected the Movants' argument that the Subject Debtors were not in financial distress at the time of the filing and the prospect of liability was too remote to justify their respective chapter 11 filings. Instead, the court ruled that the filings of the Subject Debtors were not premature—the Subject Debtors were in financial distress and needed to be placed into bankruptcy.
The court found no evidence to counter the Debtors' demonstration that the CMBS market was "dead" on the Petition Date and that, while solvent and not facing loan maturity, the Subject Debtors were all in varying degrees of financial distress in April 2009 because the Debtors could not refinance their debt. The court explained that an entity is not required to postpone filing for bankruptcy until it is actually insolvent, and found that the Subject Debtors were justified in iling their respective chapter 11 petitions when they did.
The court also rejected the Movants' argument that consideration of the financial problems of the Debtors as a whole would violate the purpose of the SPE structure, and that financial distress must be determined separately for each individual entity. The court found that, while the purpose of the SPE structure was intended to insulate the Subject Debtors from the financial problems of its affiliates, GGP and the Debtor Subsidiaries functioned as an integrated operation.
"Movants do not contend that they were unaware that they were extending credit to a company that was part of a much larger group, and that there were benefits as well as possible detriments from this structure," the court noted.
The court addressed the fact that the Subject Debtors' corporate governance required the appointment of independent managers who were not employed or affiliated with GGP. Pursuant to the SPE Operating Agreements, approval from such independent managers was required for certain significant SPE corporate actions, including the filing of a voluntary chapter 11 petition. The court found that the powers and duties granted to the independent directors under the SPE Operating Agreements were limited to those permitted under applicable state law.
Under Delaware law, the SPE's independent managers did not have a duty to their creditors to prevent a bankruptcy filing, regardless of contrary language in the Subject Debtors' Operating Agreements. Instead, the independent managers had a duty to the business and its shareholders, and any argument that the independent managers of an SPE can serve on the board to prevent that entity from filing for bankruptcy was rejected by the court.
Interests of the Parent Company
The court ultimately held that, under the circumstances of the Debtors' filings, the interests of the parent companies must be taken into account. The court was careful to note that fundamental rights and interests of the subsidiaries and their creditors were not being sacrificed for the benefit of the parent and its creditors. "The point is that a judgment on an issue as sensitive and fact-specific as whether to file a Chapter 11 petition can be in good faith on consideration of the interests of the group as well as the interests of the individual debtor."
The court then analyzed whether the Subject Debtors exercised subjective good faith. The Movants argued that bad faith was evidenced by the failure of the Subject Debtors to negotiate with their respective lenders prior to the petition date, and the abrupt discharge and replacement of certain independent directors to facilitate a filing.
First, the court noted that the Bankruptcy Code does not require a borrower to negotiate with its lender as a condition to filing a chapter 11 petition. While there may be good reason to negotiate, the court found that failing to negotiate does not mean a chapter 11 case should be deemed to have been filed in bad faith. Because of common restrictions in a CMBS lender's ability to negotiate prior to a default or near default of the loan, the court was skeptical that prepetition discussions would have even been adequate.
Consequently, the court concluded that the failure to negotiate with the Movants was justified and not in bad faith.
The court next found that, while replacement of the independent directors for the purpose of obtaining the necessary authority to file bankruptcy was "admittedly surreptitious," the replacements were not indicative of bad faith. The court supported its finding by noting that the underlying corporate documents of the Subject Debtors permitted a shareholder to appoint new independent directors to the board. Furthermore, as discussed above, the independent managers did not have a duty to keep the Subject Debtors from filing a bankruptcy petition.
Accordingly, the court found that the Subject Debtors exercised subjective good faith in the filing of their chapter 11 petitions.
While this decision clearly indicates that bankruptcy inherently alters some of the rights that lenders negotiate and rely on when lending to an SPE, the court was clear that this decision was not intended to collapse the SPE structure.
The court specifically noted that "[n]othing in this Opinion implies that the assets and liabilities of any of the Subject Debtors could properly be substantively consolidated with those of any other entity."
It therefore remains to be seen whether the historic and accepted use of SPEs and securitizations for property-specific and CMBS financing is in jeopardy.