In a ruling issued last week, Bankruptcy Judge Allan L. Gropper of the Southern District of New York denied motions to dismiss the Chapter 11 cases of certain “bankruptcy-remote” special purpose entities that are subsidiaries of General Growth Properties, Inc., which filed the largest real estate Chapter 11 case in U.S. history. In denying the motions, Judge Gropper held that the entities did not file for bankruptcy in bad faith and that they were justified in considering the interests of their corporate parent when deciding whether to file.
General Growth Properties, Inc. (the “Company”), a publicly-held real estate investment trust that owns or manages more than 200 shopping centers in 44 states across the country, filed for bankruptcy on April 16, 2009. About $15 billion of the Company’s approximately $27 billion in outstanding debt is in the form of collateralized mortgaged-backed securities (“CMBS”), making the Company the largest borrower in the CMBS markets.
The Company is the ultimate parent of hundreds of subsidiaries—many of which are organized as “bankruptcy-remote” special purpose entities (“SPEs”)—that were, to the surprise of many market participants, also included in the Company’s Chapter 11 proceedings (the “SPE Debtors”). The governing documents and loan agreements of SPEs typically contain restrictions that require them to limit their debt principally to mortgages and to maintain their separate existence from their parent and other affiliates. Also, in an attempt to create an impediment to a bankruptcy filing, the SPEs’ governing documents often contain a requirement that the SPE retain at least one independent director obligated, to the extent permitted by law, to consider only the interests of the SPE, “including its respective creditors,” in deciding whether to approve the SPE’s filing for bankruptcy protection. The Chapter 11 filings of the SPE subsidiaries of the Company has therefore caused great concern in the structured finance and broader capital markets, which rely heavily on the asset isolation thought to be provided by SPEs.
In a previous decision approving the Company’s debtor-in-possession financing, Judge Gropper allowed the Company to access the excess cash collateral from rents of its SPE subsidiaries over the objection of prepetition-lenders to the SPEs (the “SPE Lenders”). Judge Gropper held that the SPE Lenders’ interests were adequately protected, pursuant to section 361 of the Bankruptcy Code, against the diminution of their interests by the grant of a replacement lien on the cash being upstreamed by the SPEs, and a second-priority lien on certain other assets of the Company, and by continuing to pay interest and maintain the properties. Judge Gropper was careful to clarify, however, that in approving the use of cash collateral by the Company he was not endorsing the substantive consolidation of the debtors’ estates.
Motions to Dismiss the SPEs’ Chapter 11 Cases
Several SPE Lenders and pre-petition agents to SPE Lenders (together, the “Movants”) moved to dismiss the Chapter 11 cases of various SPEs. The Movants primarily argued that the cases were filed in bad faith and should therefore be dismissed under Section 1112(b) of the Bankruptcy Code “for cause.” They argued that the filings were improper in that the SPEs were not insolvent and were not facing the imminent maturity of their facilities. They also argued that the Debtors had showed subjective bad faith in replacing independent directors prior to the filings. Hearings to consider the motions to dismiss stretched over three days.
Judge Gropper’s Opinion
Judge Gropper held that the record did not support a determination of bad faith filings by the SPE Debtors. He distinguished the few cases relied on by the Movants to support their argument that the filings were premature, noting that in those cases the debtors were not in financial distress and instead faced wholly speculative liability due to pending litigation. The court noted that, although the SPE Debtors faced varying degrees of financial difficulty due to maturing mortgage debt over the next several years, the debts were not contingent and would necessarily mature at some not-too-distant time. Judge Gropper refused to create an arbitrary rule barring a debtor from filing an anticipatory Chapter 11 petition based on when its principal debt is due. He also found that the SPE Debtors were not unreasonable in concluding that they would not be able to refinance the billions of dollars of their maturing real estate debt in the coming years as a result of the moribund state of the CMBS market.
Significantly, Judge Gropper held that the SPE Debtors were justified in considering the financial distress of the Company as a whole in deciding whether to file for Chapter 11 protection. He reasoned that, while the SPE structure was intended to insulate the financial position of the SPE Debtors from their affiliates, the Movants should have known that, given the larger and somewhat integrated corporate structure of the Company, the financial situation of the Company would impact its subsidiaries, including the SPE Debtors. He stated that the SPE Debtors were in fact required to consider the interests of the parent companies and that the Movants were therefore mistaken in their view that independent managers can serve on boards solely for the purpose of voting against a bankruptcy filing. Although the operating agreements of many of the SPEs provide that their independent directors must not only consider the interests of the SPE and its creditors in deciding whether to consent to a bankruptcy filing, the directors are also required to follow applicable law, including Delaware corporate law. Judge Gropper observed that Delaware law provides that directors and managers owe their duties to the corporation and, ordinarily, its shareholders. Because there was no contention that the SPEs were insolvent (in fact, the Movants argued to the contrary), Judge Gropper concluded that the SPEs’ directors (including the independent directors) had a duty to the shareholders of the SPEs, rather than their creditors. He further concluded that in light of the financial troubles of the Company as a whole, the filings were “unquestionably not premature.”
Judge Gropper also rejected the Movants’ arguments that the Debtors had demonstrated bad faith by replacing the SPE Debtors’ independent directors in advance of the Chapter 11 filings. He noted that the SPEs’ governing documents did not prohibit the dismissals, and the replacement independent directors had the appropriate experience to determine whether a bankruptcy filing was necessary. Moreover, as noted above, the replacement independent directors had no obligation to prevent the Chapter 11 filings and indeed had a duty to consider the interests of the SPEs’ shareholders.
As he did when issuing the cash collateral order, Judge Gropper was careful to emphasize that his decision to deny the motions to dismiss did not indicate any move toward the substantive consolidation of the Debtors’ estates. He distinguished the issue of substantive consolidation from the issue of whether an SPE may file for bankruptcy and noted that the protections offered by the SPE structure against substantive consolidation are still intact.
Judge Gropper’s ruling further erodes the notion of the bankruptcy-remoteness of SPEs (although it remains to be seen how courts may apply the General Growth precedent in situations involving SPEs holding securities or other more traditional financial assets, as opposed to operating assets). Although Judge Gropper stated that the principal goal of the SPE structure is to guard against substantive consolidation, his ruling that SPE entities must consider the interests of their shareholders when deciding whether to file for bankruptcy will create further challenges to creating an SPE structure that is isolated from the financial difficulties of corporate parents.
In re General Growth Properties, Inc., Case No. 09-11977 (ALG), Memorandum of Opinion [Dkt. No. 1284] (Bankr. S.D.N.Y. Aug. 11, 2009).
In re General Growth Properties, Inc., Case No. 09-11977 (ALG), Final Order Authorizing Debtors to (A) Obtain Postpetition Secured Financing Pursuant to Bankruptcy Code Sections 105(a), 362, and 364, (B) Use of Cash Collateral and Grant Adequate Protection Pursuant to Bankruptcy Code Section 361 and 363 and (C) Repay in Full Amounts Owed Under Certain Prepetition Secured Loan Agreements [Dkt. No. 527] (Bankr. S.D.N.Y. May 14, 2009).
Davis Polk Insolvency and Restructuring Update: In re General Growth Properties, Inc. – Cash Collateral Order, May 20, 2009.
1. See Christopher Scinta, “General Growth Wins $400 Million Bankruptcy Loan, Use of Cash,” Bloomberg (May 14, 2009) (citing Morgan Stanley research).