SPE Provisions After GGP - A Wall of Steel or Swiss Cheese?

You may have heard that the Bankruptcy Court in the General Growth Properties case recently held that solvent entities could file bankruptcy. In so holding the Bankruptcy Court refused to view each solvent entity in isolation, but instead chose to view the solvent entities as part of a larger group. This is the exact result that the lenders to the solvent entities were hoping to avoid.

Over the last ten years, lenders have attempted to insulate loans made to REITs and other large enterprises by requiring that the loan be made to a special purpose subsidiary, which owns no other assets and conducts no business other than management of the collateral for the loan. Many of the entities to which these loans were made were also required to be bankruptcy remote. This means that the entity had one or more independent directors. The entity could not file for bankruptcy without the consent of the independent directors. Many of these loans were guaranteed in some fashion by the parent of the subsidiary: either full guarantees, carve out guarantees or bad boy guarantees. If there were guarantees, the bankruptcy of a guarantor was usually a default under the loan. Most of these loans had a balloon payment which required either a sale of the collateral or refinance of the loan. Refinancing generally required the involvement of the parent of the subsidiary. If the ability of the parent to obtain refinancing became impaired, the financial situation of the subsidiary would also be impaired.

General Growth Properties filed a Chapter 11 bankruptcy petition in the Delaware bankruptcy court in April, 2009. Prior to filing, General Growth Properties replaced all the independent directors of its various special purpose bankruptcy remote subsidiaries. General Growth Properties and the new independent directors then caused its 388 subsidiaries to file bankruptcy. Recently, five lenders filed motions to dismiss 24 of the bankruptcy cases arguing that they were filed in bad faith. The lenders argued that the 24 debtors had no reason to file bankruptcy. According to the lenders, their loans were not in default, they were current on all payments and their loans didn’t even mature until 2010, 2011 and or 2012. The lenders took the position that if you looked at each debtor, in isolation, it should not have filed bankruptcy and its doing so was in bad faith.

The debtors argued that they were part of a larger group and that even though they were solvent, their bankruptcies were not filed in bad faith; rather they were filed as part of a larger group in order to maximize the entire group’s chances of reorganization. The bankruptcy court agreed with General Growth Properties and the debtors. It refused to view each debtor in isolation. It viewed each debtor as being part of a larger group and found that the cases were not filed in bad faith.

It will be interesting to see if other courts follow the Bankruptcy Court’s approach or instead choose to view each entity separately. It is clear that the protections the lenders thought they were getting with this loan structure may not be as strong as the lenders hoped. It is also not clear how large an impact this case will have, even if other bankruptcy courts choose to follow it. First, this approach will apply only if there is a larger enterprise. Loans made to individuals or stand alone entities will not be affected by this decision. Second, one would expect a borrower to file bankruptcy only if (a) the filing does not cause full recourse to a principal or (b) the principal is willing to incur full recourse for the loan. Thus, this case may be limited to cases where the entire larger enterprise is filing bankruptcy, such as the General Growth Properties cases, or where, due to precipitous declines in real estate values, the principal has little left to lose in pursuing defensive strategies.