The Bankruptcy Court for the Southern District of New York recently issued a decision that, if left to stand unchallenged, effectively eviscerates a key structural component of a massive number of financings – specifically, the so-called “bankruptcy remoteness” of a special (or single) purpose entity. On August 11, 2009, the Honorable Allan L. Gropper issued a memorandum opinion (the “Opinion”) on five motions to dismiss (the “Motions”) that were filed in the General Growth Properties, Inc., et al., (“GGP” or “Debtors”) Chapter 11 bankruptcy cases. The movants, ING Clarion Capital Loan Services, as special servicer to certain secured lenders, Helios AMC, LLC, as special servicer to other secured lenders, and Metropolitan Life Insurance Company and KBC Bank N.V., as secured lenders (collectively, the “Movants”), filed their motions on the grounds that (i) the Debtors’ cases were filed in bad faith and (ii) the Debtors were ineligible to file for bankruptcy.1 For the reasons discussed more fully below, the Court denied the request to dismiss the chapter 11 cases because the debtors were “bankruptcy remote special purpose entities.”While the decision is arguably based upon the facts of the case, the Court nonetheless sets forth various general principles that permit any SPE to file for bankruptcy protection – thereby impairing a key structural component to numerous financings done over the years and still outstanding. If the decision remains as law, it will have an impact upon how future financings are structured and the expectations of the lenders.
In a fairly typical capital structure, the Debtors had secured debt, consisting primarily of mortgage and mezzanine debt, various types of unsecured debt, and equity. The secured debt included three conventional mortgages2 held by Metlife; each mortgage being the obligation of a separate Debtor subsidiary. In addition, the Debtors had certain mortgage loans that were financed in the commercial mortgage-backed securities (“CMBS”) market. The entities that issued the mortgages were intended to function as special purpose entities (“SPE”), where, among other things, the operations of the borrower were to be isolated from the business affairs of the borrower’s affiliates, the borrower agreed to various separateness covenants and the borrower had an obligation to retain independent directors.
Historically, the Debtors’ capital needs were satisfied by bank loans and by the CMBS market. The Court made a finding of fact that the Debtors’ business plan was based on the premise that it would be able to refinance its debt, primarily to avoid hyper-amortization of its loans. Due to the credit crisis at the end of 2008, the various administrative requirements of refinancing a loan that are included in a CMBS securitization, and the inability to negotiate with a special servicer, the Debtors had no alternative but to file for bankruptcy protection.
Standard of Review and Discussion
The principle that a Chapter 11 reorganization case can be dismissed as a bad faith filing is a judge-made doctrine. Under the leading cases in the Second Circuit, grounds for dismissal exist if it is clear on the filing date that “there was no reasonable likelihood that the debtor intended to reorganize and no reasonable probability that it would eventually emerge from bankruptcy proceedings.” In re C-TC 9th Ave. P’ship, 113 F.3d 1304 (2d Cir. 1997). “The standard in this circuit is that a bankruptcy petition will be dismissed if both objective futility of the reorganization process and subjective bad faith in filing the petition are found.” In re Kingston Square Assoc., 214 B.R. 713, 725 (Bankr. S.D.N.Y. 1997). “It is the totality of the circumstances, rather than any single factor, that will determine whether good faith exists.” Id. The Court concluded that most bad faith cases involve “a single-asset real estate debtor where the equity investors in a hopelessly insolvent project were engaged in a last minute effort to fend off foreclosure and the accompanying tax loss.” Opinion at 18-19.
Objective Bad Faith: Prematurity
The Movants contended that the Debtors’ Chapter 11 filings were premature because the Debtors were not in financial distress at the time of filing. The Court disagreed. In doing so, the Court found that it is well established that the Bankruptcy Code does not require that a debtor be insolvent prior to filing for bankruptcy.Moreover, the Court noted that theMovants in these cases did not establish that the Debtors’ procedures for determining whether to file for bankruptcy were unreasonable or that the Debtors were unreasonable in concluding that the disarray in the financial market, coupled with the various crossdefault and hyper-amortization provisions in the loan documents, would preclude them from refinancing their debt in the near future. Opinion at 22.
In addition, theMovants argued that prematurity of the filing could not be examined from the perspective of the debtor group, but rather, could only be examined on an individual-entity basis. Again, the Court disagreed. The Court acknowledged that the SPE structure was designed to make each of the Debtors “bankruptcy-remote.” Opinion at 28. Nevertheless, the Court found that the Movants did 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 that structure. Id.The Court further found that each Movant was aware that if the individual SPE was unable to refinance, then the ability of the Debtors, as a group, to obtain refinancing would be impaired. Id.
In support of its ruling, the Court cited to several cases which support the position that the interests of the group can and should be considered. See Heisley v. U.I.P. Engineered Prods. Corp. (In re U.I.P. Engineered Prods. Corp.), 831 F.2d 54 (4th Cir. 1987). In such cases, courts explain that the nature of a corporate family creates an “identity of interest” that justifies the protection of the subsidiaries as well as the parent corporation. See A.H. Robins v. Piccinin, 788 F.2d 994 (4th Cir. 1986). In the case at bar, the Movants never contend that the parent companies acted in bad faith in filing their own Chapter 11 petitions. Citing to the authority that the interests of the parent company must be taken into account, the Court found 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.” Opinion at 29.
The Movants further alleged that the Independent Managers should have considered only the interests of the secured creditors when they made their decisions to file the Chapter 11 petitions. Further, they contended that the Independent Manager, who considered the interests of the Debtors as a group, when voting to file the Chapter 11 petition, breached his or her fiduciary duty to the individual Debtor. In addressing this contention, the Court relied on the individual Debtor’s Operating Agreements, which state that “to the extent permitted by law ... the IndependentManagers shall consider only the interests of the Company, including its respective creditors, in acting or otherwise voting on the matters referred to in Article XIII(p).” Opinion at 31. The Court held that the directors and managers owe their duty to the corporation and to the shareholders. Accordingly, the Court found that the filings were not premature.
Subjective Bad Faith
TheMovants also alleged that the Debtors acted in subjective bad faith because (i) they failed to negotiate with the secured lenders prior to filing, and (ii) the initial Independent Managers of several of the SPE’s were fired and replaced shortly before the petition date.With respect to these arguments, the Court noted, quite simply, that on this record, there was no evidence that pre-filing talks would have been adequate to deal with the extent of the problem. Since none of the Movants adduced testimony from witnesses with final decision-making authority who said that they would have been willing to refinance or modify the terms of the respective Debtors’ loans, there was no evidence that the Debtors acted in bad faith. Moreover, the Court found that the Debtors did not act in bad faith by failing to delay the Chapter 11 filings until after the CMBS loans defaulted or were foreclosed. Opinion at 37.
With respect to the discharge of the original IndependentManagers, the Court found that those managers did not appear to have any expertise in the real estate business and gave weight to the Declaration of Thomas H. Nolan, Jr., dated June 16, 2009, which provided that “stockholders and members desired independent managers with known experience in restructuring environments and complex business decisions, who understood the capital markets, ... and who could bring critical, independent thinking to the restructuring challenges these project entities were facing.” Opinion at 39. In addition, the Court noted that the corporate documents did not prohibit this termination of the original Independent Managers. The Court reiterated that the Independent Managers did not have a duty to keep any of the Debtors from filing a bankruptcy case. Accordingly, the Court found that the firing of the original Independent Managers did not constitute subjective bad faith sufficient to require dismissal of the Debtors’ cases. Opinion at 40.
In summarizing its Opinion, the Court held that the Movants have been inconvenienced by the Debtors’ Chapter 11 filings. Inconvenience to a secured creditor, however, is not a reason to dismiss a Chapter 11 case. The Court said:
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 Debtors could properly be substantively consolidated with those of any other entity.
Opinion at 40. The Court concluded by pointing out that these Motions are a diversion from the parties’ real task, which is to get each of the Debtors out of bankruptcy as soon as feasible. The Court suggested that these negotiations commence in earnest.
Judge Gropper’s Opinion will have a significant effect on any motion to dismiss filed in other bankruptcy cases by SPEs on the basis that the special purpose entities are not supposed to be in bankruptcy. The decision will clearly be a relevant fact as companies and “independent directors” consider whether to commence a bankruptcy case for an SPE. The financial structure of GGP is similar to that of many other “special purpose” financings, and while the Opinion is fact-specific, there are essential basic rules set forth:
(i) independent managers are not precluded from authorizing a bankruptcy filing as part of their fiduciary duties;
(ii) the managers (independent or otherwise) and the bankruptcy court may look to the entire corporate family in analyzing whether a bankruptcy filing is prudent;
(iii) any debtor, including an SPE, need not be “insolvent” at the time of filing; and
(iv) importantly, the key protection afforded by the SPE structure is not bankruptcy “remoteness” but simply avoidance of substantive consolidation – a goal that is not affected by the bankruptcy filing itself.
The Opinion clearly permits an SPE filing for bankruptcy, as supported by the SPE’s organizational documents and the relevant state and federal law in justifying the facts and circumstances that lead to GGP’s bankruptcy filings. It is highly likely that the general rules enunciated in the GGP case would be argued to likewise apply to other similarly-structured financing arrangements – analyzing the nature of the debtors’ corporate family as a whole, the SPE’s place in the family, and the effect the SPE subsidiary has on its direct or indirect parent(s).
It remains to be seen whether the Opinion will be appealed and, if so, overturned. As of now, the precedent is harmful to the notion that an SPE cannot or does not belong in bankruptcy.