Not necessarily so, according to the recent rulings of Southern District of New York Bankruptcy Judge Allan Gropper in the US$27 billion General Growth Properties Chapter 11 bankruptcy—at least with respect to the issue of substantive consolidation. Judge Gropper’s denial of motions to dismiss certain solvent special purpose entity (SPE) subsidiaries from the General Growth Properties bankruptcy confirms, however, that creditors of a solvent “bankruptcy remote” SPE should not assume that the SPE’s “independent” director or manager will refrain from putting the SPE into bankruptcy when its parent also files. In denying the motions to dismiss, Judge Gropper ruled that the managers of the SPEs, including the independent managers, were within their rights and breached no law or duty when they decided to cause the SPEs to file for bankruptcy along with their parents, General Growth Properties, Inc. and General Growth Properties LP (General Growth), and nearly 400 of their affiliated companies. He made it clear in his published opinion, however, that permitting the solvent SPEs to remain in bankruptcy does not mean that they will be substantively consolidated with their affiliates.

Judge Gropper’s ruling on the motions to dismiss and his prior approval of debtor-in-possession (DIP) financing allowing General Growth access to cash collateral generated by subsidiary SPE assets and pledged to the SPEs’ lenders has sent shock waves through the debt securitization and structured finance markets. While not necessarily killing off those markets, the General Growth Properties rulings will have a direct effect on the way rating agencies, lenders, underwriters and other creditors view traditional bankruptcy remote structures in equipment, as well as real property financings, particularly with respect to two of the basic tenets of securitizations and structured debt—(1) the owner of the securitized assets or collateral will remain out of reach of the equitable powers of a bankruptcy court and (2) such assets will not be used to support the bankruptcy estate of such owner’s parent.

General Growth Properties, Inc. is a publicly traded real estate investment trust and general partner (with a 96 percent equity stake) of General Growth, a limited partnership that manages more than 200 shopping centers, many of which are owned by separate General Growth SPE subsidiaries and separately financed. Such management was done on a nationwide, integrated basis with General Growth providing centralized leasing, marketing, management, cash management, property maintenance and construction management services as well as the arranging of financing.

As in the case of other structured financings and debt securitizations, many of the General Growth SPEs were structured and capitalized in a manner to protect the interests of their secured lenders by ensuring that the assets and liabilities of each SPE were isolated from the affairs of the SPE’s owner and affiliates. Separateness was sought so that each financing (generally, conventional mortgages and mortgages securitized through commercial mortgage backed securities) stood on its own merits, creditworthiness and value without reference to the financial stability of the SPE’s owner.

In response to the recent collapse of capital markets, certain recent debt defaults and cross-defaults and looming maturities or “hyper” amortizations of secured and unsecured debt, General Growth, General Growth Properties, Inc. and 359 of their approximately 700 wholly owned subsidiaries filed for bankruptcy protection under Chapter 11 in the Southern District of New York on April 16, 2009. Another 28 subsidiaries filed on April 22. At the time of filing, General Growth’s shopping center business had a stable and, generally, positive cash flow and was performing well, in spite of the current financial crisis.

The first big news to come out of this case (other than the bankruptcy filings themselves) was Judge Gropper’s approval of General Growth’s first day motion for the use of cash collateral belonging to certain of the General Growth SPE subsidiaries and pledged to their respective lenders. Notwithstanding the lenders’ interest in the pledged cash, Judge Gropper, exercising his equitable powers, permitted the pledged cash to be upstreamed to General Growth in the form of DIP loans to finance General Growth’s post-petition operations. Judge Gropper later affirmed this DIP financing over the objections of the SPE lenders, ruling that the separateness of the SPEs in bankruptcy did not preclude the court from exercising its equitable powers to permit the upstreaming of pledged cash to General Growth so that it may continue to manage the business and financing of its various SPE subsidiaries. Judge Gropper justified his ruling by granting the SPE lenders what he deemed to be “adequate protection” for the use of their collateral, including the payment of post-petition interest on the SPE debt at the non-default rate (the amortization of principal, however, was suspended), the continued maintenance of the shopping center properties by General Growth, a lien on the cash upstreamed and a second priority lien on other assets. Furthermore, the upstreamed cash would be treated as DIP loans, the repayment of which would be a superpriority administrative claim over which the SPEs’ lenders would have a first priority lien. The DIP financing also included a US$400 million loan by a consortium of lenders led by Farallon Capital Management secured by, among other assets, second priority liens on SPE assets pledged to the SPEs’ lenders and first priority liens on unencumbered SPE assets.

Certain of the SPE lenders later filed motions to dismiss the bankruptcy proceedings of their respective SPE debtors on the grounds that their bankruptcies were initiated in bad faith. One SPE lender also asserted that there was no reasonable likelihood the SPE debtor would emerge from bankruptcy because the lender, which would control approval of any plan of reorganization, would not approve a plan that would modify the terms of its financings. Each of the moving lenders asserted, without any substantial contradiction, that their respective SPE debtors had sufficient cash flow to cover their current debt obligations. In other words, the SPE debtors were not insolvent at the time of filing for bankruptcy.

Most, but not all, of the SPE debtors covered by the motions to dismiss were limited liability companies. Other than one SPE that was a trust, Judge Gropper did not distinguish in his published opinion between the SPEs that were limited liability companies and those that were not.

In a well-reasoned, detailed opinion, Judge Gropper denied all of the motions to dismiss. Under Second Circuit bankruptcy law, a Chapter 11 reorganization case shall be dismissed upon a finding of both objective futility of the reorganization process and subjective bad faith in filing for bankruptcy. A debtor does not have to be insolvent at the time of filing. Financial distress, alone, may be sufficient to overcome a claim that a bankruptcy was initiated in bad faith.

After considering the analyses, deliberations and actions of the SPEs’ management boards, the SPEs’ debt maturing or hyper-amortizing within the next couple of years, the lack of refinancing available in today’s capital markets, as well as the financial problems of the General Growth Properties group as a whole, Judge Gropper found neither of the two requirements necessary for dismissal. In justifying his consideration of the financial problems of the General Growth Properties group as a whole, Judge Gropper acknowledged the separateness of each of the SPE debtors and the intention of the SPEs and their lenders to make each SPE “bankruptcy remote.” On the other hand, he also noted the following:

Nevertheless, the record also establishes that the Movants each extended a loan to the respective Subject Debtor with a balloon payment that would require refinancing in a period of years and that would default if financing could not be obtained by the SPE or by the SPE’s parent coming to its rescue. 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. If the ability of the Group to obtain refinancing became impaired, the financial situation of the subsidiary would inevitably be impaired.

The organizational documents of some of the SPE debtors that the lenders sought to have dismissed from the bankruptcy required the appointment of one or more “independent” managers (i.e., individuals not affiliated with General Growth) whose votes would be necessary to put the SPE into a voluntary bankruptcy. Judge Gropper held that prior to insolvency, all of the managers, including the independent managers, owed duties to their respective SPE debtors and their members, notwithstanding statements in the SPE organizational documents to the effect that the independent managers were to consider only the interest of the SPE “including its creditors.” This holding was based on the fact that the SPE organizational documents also provided that the independent managers would be subject to the same duties and loyalties required of a director of a Delaware corporation, which duties and loyalties require that the directors of a solvent corporation consider the interests of both the corporation and its shareholders in exercising their fiduciary duties (noting that under Delaware law the directors of an insolvent corporation may also owe duties to the corporation’s creditors.)

According to Judge Gropper, if the SPE lenders believed that the independent managers served on the boards solely for the purpose of voting “no” to a bankruptcy filing for the benefit of the lenders “they were mistaken.” The independent managers, burdened with the obligations and loyalties of a Delaware corporate director, owed their duties to the SPEs and, absent insolvency, the SPEs members, i.e., the General Growth group of companies. Accordingly, the independent managers acted within their rights and authority when they elected to put their solvent SPEs into bankruptcy in order to benefit the General Growth Properties group as a whole.

Much was made of the fact that independent directors of many of the SPE debtors were replaced just prior to the bankruptcy filings, with the replacement managers providing the necessary votes. This was done on a confidential basis without informing the individuals (provided by Corporation Service Company (CSC)) being replaced. Judge Gropper found that replacing the CSC independent managers, none of whom had any particular real estate experience, with two “seasoned individuals” did not constitute bad faith sufficient to dismiss the bankruptcies.

Upon denying the motions to dismiss, Judge Gropper concluded:

The salient point for purposes of these Motions is that the fundamental protections that the Movants negotiated and that the SPE structure represents are still in place and will remain in place during the Chapter 11 cases. This includes protection against the substantive consolidation of the project-level Debtors with any other entities. There is no question that a principal goal of the SPE structure is to guard against substantive consolidation, but the question of substantive consolidation is entirely different from the issue whether the Board of a debtor that is part of a corporate group can consider the interests of the group along with the interests of the individual debtor when making a decision to file a bankruptcy case. Nothing 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.

Do the above rulings on the DIP financing and motions to dismiss mean the death of bankruptcy remote SPE securitizations? Probably not. The bankruptcy court’s use of its equitable powers to permit SPE cash collateral to be used to finance the operations of the SPE’s parent may have a chilling effect on future SPE debt securitizations and structured financings and will certainly increase the level of uncertainty in structured transactions. On the other hand, the denials of the motions to dismiss were based on established principles and should not change the perceptions or expectations of the rating agencies and capital markets with respect to the role of independent directors or managers (although Judge Gropper’s opinion may be an uncomfortable reminder of those principles). In any event, the opinion preserves, for the time being, the primary goal of separateness in debt securitizations and structured financings, the avoidance of substantive consolidation.

With regard to the equitable powers issue, the best way to avoid being subject to such would be to keep an SPE debtor out of bankruptcy. Relying solely on an independent director or manager to vote “no” to bankruptcy is not going to work. Instead, rating agencies, arrangers, underwriters and other creditors should consider structures where the power and authority of a limited liability company SPE to file for a voluntary bankruptcy is limited to the SPE being insolvent or obtaining the consent of 100 percent of its members, with a nominal membership interest held by a representative of the SPE’s lenders. Unlike the director of a corporation or the managers of the General Growth SPEs and subject to properly drafted organizational documents, a limited liability company minority member controlled by the SPE’s lenders would owe no fiduciary or other duty to the SPE or the majority member. But even this would not be a fail-safe fix. The Bankruptcy Court should dismiss any Chapter 11 voluntary proceeding if the debtor had not, under the laws of the debtor’s jurisdiction of formation, duly authorized the bankruptcy filing (for example, if the manager of a limited liability causes the company to file for bankruptcy without first obtaining the requisite member consent). Under Section 349 of Chapter 11 of the Bankruptcy Code, any such dismissal would generally unwind any prior Bankruptcy Court orders relating to the company’s assets, but herein lies the rub, “[u]nless the court, for cause, orders otherwise.”

This article was published in a slightly different form in the LJN’s Equipment Leasing Newsletter, Volume 28, Number 9 (October 2009)