Opinion Serves to Remind Lenders That “Bankruptcy Remote” Does Not Mean “Bankruptcy Proof”

Judge Allan L. Gropper of the Bankruptcy Court for the Southern District of New York issued a much-anticipated order on August 11, 2009, in the challenge to the bankruptcy filings by certain special-purpose-entity (“SPE”) affiliates of General Growth Properties, Inc. (“GGP”).

GGP, the second-largest mall operator in the United States, filed a bankruptcy petition on April 16, 2009. At the same time and shortly thereafter, 166 special purpose entity borrowers that were affiliates of GGP (the “SPE Debtors”) also filed bankruptcy petitions.1 The SPE Debtors, which actually owned the malls operated by GGP, had collectively borrowed approximately $1.83 billion from lenders, secured by one or more malls. The cases were administratively consolidated into a single case before Judge Gropper.

Soon after the SPE Debtors filed their petitions, Metropolitan Life Insurance Company, Helios AMC, LLC, and ING Clarion Capital asked Judge Gropper to dismiss the bankruptcy petitions of certain SPE Debtors, arguing, among other things, that those debtors had filed in “bad faith” because they were not insolvent at the time of the filings.

Judge Gropper’s order denied the lenders’ motions. Noting that “[i]t is well established that the Bankruptcy Code does not require that a debtor be insolvent prior to filing,” the Court concluded that even if individual debtors did not face imminent loan default or maturity, the SPE Debtors’ board members could properly consider whether filing bankruptcy petitions served the collective interests of GGP. Given the “unprecedented collapse of the real estate markets” and “serious uncertainty” about when and if refinancing would be available, the Court concluded that GGP’s management had little choice other than to reorganize the entirety of GGP’s enterprise capital structure through a bankruptcy filing.

Judge Gropper also dismissed arguments that the SPE Debtors’ bankruptcies violated the bankruptcy remote covenants of their organizational documents, in particular the requirement that one or more “independent” managers or directors approve a bankruptcy filing. Rebuking the commonly held misperception that a “bankruptcy remote” structure is “bankruptcy proof,” the Court chided the lenders that “if [lenders] believe[] that an ‘independent’ manager can serve on a board solely for the purpose of voting ‘no’ to a bankruptcy filing . . . they [are] mistaken.” As the Court explained in extensive discussions, the law required the managers and directors of each SPE Debtor (including the “independent” managers and directors) to act in the best interests of the company and its shareholders, not the company’s creditors.2 Since bankruptcy of the SPE Debtors benefited their shareholders (ultimately, GGP), the independent  managers and directors did not violate their fiduciary duties when they voted in favor of the bankruptcies.

The Court also dismissed the argument that the SPE Debtors acted in bad faith by firing the originally appointed independent managers or directors immediately prior to the bankruptcy. The Court found that the SPE Debtors had removed and replaced their independent managers and directors in accordance with those entities’ organizational documents, and thus those actions did not constitute subjective bad faith on the part of the debtors sufficient to require dismissal of their petitions.

Importantly, Judge Gropper stressed that “the fundamental protections that the [Lenders] negotiated and that the SPE structure represents are still in place and will remain in place . . . . This includes protection against the substantive consolidation of the project-level Debtors with any other entities.” The Court went on to state 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.”

The most recent GGP order serves as a timely reminder to lenders and servicers that “bankruptcy remote” does not mean “bankruptcy proof.” Lenders should continue to remember that while SPE covenants may make an SPE bankruptcy less likely, they cannot prevent a bankruptcy filing. While so-called “springing” or “exploding” carveout guaranties, which are triggered by a bankruptcy filing, can help discourage bankruptcy filing, such guaranties are of little or no use if the guarantor is insolvent or itself in bankruptcy. Bankruptcy remote or special-purpose-entity covenants, nevertheless, will continue to serve one of their fundamental purposes—to increase the likelihood that the debts and assets of related borrowers will be kept separate, rather than substantively consolidated as part of a single bankruptcy estate.