Last month, in a significant ruling in the General Growth Properties, Inc. (“GGP”) bankruptcy case, the United States Bankruptcy Court for the Southern District of New York denied motions to dismiss, as bad faith filings, the bankruptcy cases of 20 purported bankruptcyremote special purpose entity (“SPE”) subsidiary debtors.1
The ruling is significant in two main respects: the Court (1) made clear that the bankruptcyremote nature of SPEs means exactly that – the possibility of bankruptcy, while remote, is possible, and (2) held that when assessing the possibility of a bankruptcy filing, directors of SPEs may consider whether a bankruptcy filing would be in the best interests of the integrated group to which it belongs, rather than considering only the need of the individual SPE.
This holding serves as a stark reminder to lenders that “bankruptcy remote” does not mean “bankruptcy proof” and the steps taken to make SPEs bankruptcy remote do not prevent them from filing for bankruptcy. This could raise the likelihood of significant increases in bankruptcy filings, particularly with respect to real estate companies that hold their assets in project- level special purpose entities.
GGP is a publicly-traded real estate investment trust, and the ultimate parent of approximately 750 subsidiaries and affiliates. On April 16, 2009,2 360 entities in the GGP group, including 166 project-level subsidiaries (collectively, the “Debtors”), voluntarily filed for protection under Chapter 11 of the Bankruptcy Code, citing the need “to restructure its finances and deleverage its balance sheet because the collapse of the credit markets have made it impossible to refinance its maturing debt outside of Chapter 11.”3 The Chapter 11 filing constituted the largest real estate bankruptcy filing in United States history.
The Motions to Dismiss
Shortly after the bankruptcy filing, lenders and special servicers filed five motions to dismiss the bankruptcies of certain project-level or mezzanine- level Debtors. The movants requested the Court dismiss the cases of various projectlevel subsidiaries (the “Project-Level Subsidiaries”) as bad faith failings. The Project- Level Subsidiaries were structured as bankruptcy remote SPEs, which meant their operating agreements required them to maintain corporate separateness, maintain independent directors, and take other steps to avoid the risk of a voluntary or involuntary Chapter 11 filing.
The movants asserted that the bankruptcies of certain of the SPEs were filed in bad faith, without any reorganizational purpose, and merely to gain leverage in litigation. The movants raised four specific arguments that they claimed pointed to a bad faith filing: (1) the Project- Level Subsidiaries were current on their obligations and not experiencing any immediate or imminent financial problems; (2) there were no attempts made by the Project-Level Subsidiaries to renegotiate the terms of their respective loans with the relevant lenders; (3) the Debtors improperly replaced certain independent directors of the Project-Level Subsidiaries on the eve of bankruptcy; and (4) since the Project-Level Subsidiaries were created as bankruptcy-remote SPEs, the financial distress of each Project-Level Subsidiary should have been analyzed separately.
In response, the Debtors argued that their decision to take the Project-Level Subsidiaries into bankruptcy was based on their reasonable business judgment and made on the advice of sophisticated financial, restructuring, and legal experts.4 The Debtors argued that the financial difficulties of GGP as the parent entity, coupled with the fact that nine loans at various other project-level debtors had already matured and could not be refinanced, justified filing the Project-Level Subsidiaries as an integrated group.
According to the Debtors, the Project-Level Subsidiaries stood little to no possibility of refinancing their debt outside of bankruptcy as their respective loans matured and became due. This, in turn, would result in large principal payments due in the next one to four years, which the Project-Level Subsidiaries could not afford to repay.
The Court Rejected the Motions to Dismiss
In denying the motions to dismiss as bad faith filings, the Court held that the movants had failed to establish either objective or subjective bad faith on the part of the Debtors.
Although the overarching issue at the center of the Court’s decision was whether the filings of the solvent Project-Level Subsidiaries were made in bad faith, some of the most interesting dialogue in evaluating the bankruptcy filings came during the Court’s “interests of the group” discussion. Bankruptcy Judge Gropper dismissed the movants’ argument that he should evaluate the financial distress of the Project-Level Subsidiaries separately and individually, and instead found that, because the GGP group acted as an integrated whole, the Project-Level Subsidiaries did not act in bad faith in filing for bankruptcy.
The Court held that GGP’s decision to file the Project-level Subsidiaries was made in good faith because the Project-Level Subsidiaries were crucial to GGP’s reorganization. Indeed, the Court found that the interests of the parent companies must be taken into account, and that “a judgment on an issue as sensitive and fact-specific as whether to file a Chapter 11 petition can be based in good faith on consideration of the interests of the group as well as the interests of the individual debtor.”5
With respect to the removal and replacement of independent directors, the Court concluded that the Project-Level Subsidiaries were justified in doing so because the independent managers did not have any expertise in the real estate business and were replaced by seasoned individuals who could commit significant time to the restructuring challenges facing the Project-Level Subsidiaries. Likewise, the independent directors did not have a duty to keep the Project-Level Subsidiaries from filing for bankruptcy protection.6
The Court stated that the Bankruptcy Code does not require “any particular degree of financial distress as a condition precedent [to a Chapter 11 filing].”7 Therefore, it was not surprising that the Court declined to hold that a debtor is not in financial distress and cannot file a Chapter 11 petition if its principal debt is not due within one, two or three years.8 Further, the Court held that the Debtors had a good-faith belief that the credit markets would not improve enough to allow the Project-Level Subsidiaries to refinance their debt before the large principal payments became due.9 The Court stated that the Bankruptcy Code encourages early bankruptcy filings by debtors, since doing so enables creditors to have an ability to maximize their recoveries.10
Lastly, the Court was unmoved by the movants’ arguments that the Project-Level Subsidiaries failed to negotiate with the relevant lenders before filing for bankruptcy. The Project-Level Subsidiaries had reasonably anticipated the inability and unwillingness of the lenders to refinance or modify the terms of the existing loans.11
The Importance of the Decision
The ruling by the Court virtually eliminates the notion that may have taken hold in recent years that, by creating bankruptcy remote SPEs, lenders could avoid the risk of their borrowers filing for bankruptcy. As a result of this decision, core bankruptcy remoteness protections that have traditionally been built into real estate (and other types of commercial mortgage-backed securitization) documentation may have little or no effect in forestalling the bankruptcy filing of an SPE, if the bankruptcy of that SPE is in the interests of the integrated group. However, the separateness of these entities should provide creditors with some protection.