General Growth Properties and the Boundaries of Bankruptcy Remoteness
On August 11, 2009, Judge Allan L. Gropper of the United States Bankruptcy Court for the Southern District of New York issued a decision denying several motions to dismiss filed in the bankruptcy of General Growth Properties (GGP) and its various subsidiaries.
Each of the motions to dismiss was filed on behalf of lenders to project-level or mezzanine-level debtors that were GGP subsidiaries. (Project-level debtors mortgaged their properties; mezzanine-level debtors pledged their equity in the projects as collateral for the mezzanine loan.) Most of the motions to dismiss were filed by special servicers, which, since the GGP bankruptcy filings, have taken over servicing responsibility for securitized mortgage loans, with other motions to dismiss filed by direct lenders.
Ultimately, the question presented to the Court was whether the bankruptcy filings by the solvent and positive cash-flow debtors were made in bad faith. The Court followed the rule set out in In re Kingston Square Assocs., a Southern District of New York bankruptcy decision, in which Judge Brozman set the standard for the adjudication for this type of motion to dismiss: “...[A] bankruptcy petition will be dismissed if both objective futility of the reorganization process and subjective bad faith in filing the petition are found.”
Bankruptcy Remoteness is Not Bankruptcy Proof
The first point of significance for the real estate lending industry relates to the independent director structure and bankruptcy remoteness. Bankruptcy remote covenants require the affirmative vote of one or more independent directors — directors without any vested interest in the business of the project owner — before the project owner is able to file a voluntary petition for a plan of reorganization, among other things.
The general advice has been that these arrangements create a bankruptcy-remote, not bankruptcy-proof entity. But the GGP decision makes clear that the level to which an entity is bankruptcy remote is not bound by an analysis solely of that entity’s own financial condition; it is appropriate (if not required) for directors to look at the best interests of the entity’s shareholders and the effect of its membership in a group of affiliated companies. Indeed, Judge Gropper faulted the creditors for failing to “explain how the billions of dollars of unsecured debt at the parent levels could be restructured responsibly if the cash flow of the parent companies continued to be based on the earnings of subsidiaries....” Further, Judge Gropper cited a case from the Delaware Supreme Court, which found that directors of solvent companies “must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interest of the corporation for the benefit of its shareholder owners.” In light of this analysis, Judge Gropper did not find that the project-level directors’ consideration of the GGP enterprise, as a whole, was in bad faith requiring the granting of the motions to dismiss.
To the real estate lending industry, this is important. Industry-standard language and requirements regarding bankruptcy remoteness place more emphasis on the fiduciary obligations of the directors to the debtor, itself, and its creditors. As a result, many real estate professionals did not anticipate that the financial troubles of a parent enterprise could result in the bankruptcy filing of one of its solvent “walled-off” subsidiaries.
Some bankruptcy commentators have viewed this decision as an unremarkable recitation of existing law. But the real estate lending industry will likely need to reset its expectations with respect to the limited usefulness of the standard bankruptcy-remote structures.
Protecting the Creditors’ Security Interests
The second point of significance for the real estate lending industry — particularly for the stakeholders in the GGP bankruptcy — relates to the protection of the liens and collateral of each secured creditor. Judge Gropper strongly distinguished between a debtor’s right to file a bankruptcy petition and its lender’s rights under a typical “single-purpose entity” structure, which segregates a debtor’s business and assets from that of the entire enterprise, stating that “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.”
The primary concern among creditors to the project-level GGP entities is that the Court might order the assets to be substantively consolidated — the proceeds of one asset pooled with proceeds of other assets for the general benefit of all creditors of the enterprise — to the detriment of the creditors of solvent properties. Therefore, while the question of substantive consolidation was not applicable to the analysis of whether the bankruptcy filings were made in bad faith, Judge Gropper gave some assurance regarding this concern, and stated that these creditors “have only been inconvenienced by the Chapter 11 filings” and 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.” This issue is expressly reserved for later consideration.
Other Bad Faith Filing Arguments
Other interesting arguments were made by the movants in connection with these motions to dismiss. One argument addressed the most perplexing question of the GGP bankruptcy filings — the solvency of the debtors. Indeed, some debtors were solvent but faced a maturity on a balloon loan in the future (in some cases years in the future), and these debtors predicated their filings on their anticipated inability to refinance at that time. Some creditors claimed that a filing based on events that may or may not take place one or more years in the future was necessarily made in bad faith. Judge Gropper dismissed these concerns first by finding that the “Bankruptcy Act does not require any particular degree of financial distress as a condition precedent” to a filing. He then cited testimony given during the discovery phase — particularly with respect to industry unwillingness to renegotiate loans made to GGP and GGP affiliates (particularly those loans that had been securitized) and with respect to the directors’ collective belief that the credit markets would not recover in time to refinance these loans prior to maturity — to find that the directors did not act in bad faith in filing these debtors.
Another interesting argument concerned the “subjective bad faith” of the debtors’ directors. This argument claimed that subjective bad faith arose in two ways: (i) the debtors failed to negotiate with their lenders prior to filing, and (ii) the original independent directors who had been supplied to GGP subsidiaries by a national corporate service company were removed and replaced with two new individuals selected by GGP who, as workout specialists, were more likely to agree to file a bankruptcy petition than the original independent managers.
With respect to failure to negotiate with the lenders, Judge Gropper found that the directors of the project-level GGP subsidiaries reasonably anticipated an inability to successfully negotiate based on three primary reasons. First, he pointed out evidence in the record that GGP and its subsidiaries were unable to negotiate with the servicers of securitized mortgage loans because of the servicers’ unwillingness to talk to them and the constraints imposed by the REMIC (real estate mortgage investment conduit) rules imposed on the trusts holding these securitized loans. Second, Judge Gropper noted the lack of testimony from the moving parties showing a pre-petition willingness by a “decision-making authority” to “refinance or modify the terms” of the applicable loans. Third, Judge Gropper gave weight to evidence from December 2008 (prior to the bankruptcy filings) consisting of a statement by an officer of one of the moving parties that his company shouldn’t “do a loan with GGP now, given their problems.” The totality of this evidence led Judge Gropper to find no proof of subjective bad faith in the directors’ decision to file the debtors.
Judge Gropper had an easier time dismissing the arguments concerning the removal of the independent directors. GGP produced testimony regarding the lack of restructuring experience of the original directors and the wealth of experience provided by the new directors. In addition, Judge Gropper found that GGP replaced these independent directors within the terms required by the debtors’ governing documents.
Hints of What the Plan Could Look Like
Judge Gropper noted that the motions to dismiss “are a diversion from the parties’ real task, which is to get each of the Subject Debtors out of bankruptcy as soon as feasible. The Movants assert talks with them should have begun earlier. It is time that negotiations commence in earnest.”
The question, therefore, is what the plan of reorganization will look like. On the one hand, Judge Gropper found that the directors are permitted — if not required — to take into account the needs of the enterprise as a whole in filing a debtor bankruptcy proceeding. On the other hand, Judge Gropper disclaimed any notion that his decision is a precursor toward substantive consolidation.
This apparent dichotomy will be resolved in the form of a plan of reorganization. Judge Gropper made crystal clear that “[s]ecured creditors’ access to their collateral may be delayed by a filing, but secured creditors have a panoply of rights, including adequate protection and the right to post-petition interest and fees if they are oversecured.” Based on comments made during a prior hearing (concerning the extension of the debtors’ exclusive period for filing a plan), the plan will be a coordinated effort and may include several GGP debtors at once. But from Judge Gropper’s decision on these motions to dismiss we can be cautiously optimistic that creditors of healthy properties owned by debtors with single-purpose entity structures will not be exposed to the liabilities of GGP and its other affiliates and that oversecured creditors should emerge from these bankruptcy proceedings with minimal loss.