Learn more about the Real Estate Group at Schiff Hardin. Attorneys In This Practice James R. Balich Robert I. Berger Jean L. Bertrand Matthew Brett Nathan A. Engel Todd R. Eskelsen J. Mark Fisher Louis T. DeLucia Eugene J. Geekie Jr. Christine C. Goldstein Brett H. Greenberg David A. Grossberg Russel T. Hamilton Graham R. Hone Jean H. Hurricane Janet M. Johnson James M. Kane Brian D. Kluever Donald J. Kreger Paul G. Mackey Sean T. Maloney David A. Mandel Christine A. McGuinness Ivan W. Moskowitz K. William Neuman Randolph M. Perkins Ann K. Pikus Tracy S. Plott Marina Rabinovich Felice Bressler Rose Suma Sanakkayala David S. Sattelberger Natalie S. Starkman Amy E. Sullivan Alexander W. Suto Patricia S. Ullman Schiff Hardin Offices One Atlantic Center, Suite 2300 1201 West Peachtree Atlanta, GA 30309 225 Franklin Street, Suite 2600  Boston, MA 02110  233 S Wacker Drive Suite 6600 Chicago, IL 60606 One Westminster Place Suite 200 Lake Forest, IL 60045 900 Third Avenue New York, NY 10022 One Market, Spear Tower 32nd Floor San Francisco, CA 94105 1666 K Street, NW Suite 300 Washington, DC 20006 - - - - - - - - - Join our mailing list. Forward this alert to a friend or colleague. - - - - - - - - -

When Bankruptcy Remote is not Bankruptcy Proof

On August 11, 2009, the Bankruptcy Court for the Southern District of New York issued a decision in the case of In re: General Growth Properties, Inc., et al., which allowed solvent single purpose bankruptcy remote ("SPE") subsidiaries of a bankrupt mall operator to stay in Chapter 11.

Background

General Growth Properties, Inc. ("GGP") is a publicly-traded real estate investment trust and the ultimate parent of approximately 750 wholly-owned subsidiaries, joint venture subsidiaries and affiliates (the "GGP Companies").

The principal business of GGP Companies is shopping center ownership and management. GGP Companies conducted their business in a centralized manner with only the most basic property decisions addressed at the individual property level. In the past, GGP Companies met their capital needs through various borrowing arrangements, including mortgage loans made by SPE property owning subsidiaries, mezzanine loans, and other unsecured debt at the upper tiers of the GGP Companies ownership structure, but once GGP Companies were no longer able to do so, including being able to refinance maturing debt, GGP Companies gave serious consideration to seeking bankruptcy protection.

In preparation for the filing, the SPE subsidiaries replaced the initially appointed independent directors that, from their perspective, lacked the necessary skills to analyze the matters at hand with seasoned real estate professionals who were not affiliated with the debtors. Thereafter, in April 2009, after careful consideration, 388 of the GGP Companies, including SPE property-owning subsidiaries that were currently meeting their debt service obligations, filed for bankruptcy protection. In May 2009, in order to continue the overall operations of the GGP Companies, the court permitted GGP to have access to the cash generated by the GGP's subsidiaries, including the upstream surplus cash distributions from the SPE property-owning subsidiaries.

While some of the lenders to the GGP Companies participated in negotiations to provide, and have since provided, debtor-in-possession financing, certain of the lenders to the solvent SPE property-owning subsidiaries filed motions to dismiss the Chapter 11 proceedings of their specific borrowers.

Decision

The court denied the request to dismiss the Chapter 11 filings of the solvent SPE property-owning subsidiaries for various reasons, including the following:

1. In a company that takes an integrated approach to the conduct of its business, the interests of the company as a whole will be considered in determining whether the bankruptcy filings by the SPE subsidiaries of the company were in "good faith," and therefore permissible under the Bankruptcy Code. Thus, solvent SPE subsidiaries may be part of the parent company bankruptcy filing when those subsidiaries are crucial to the company's prospects for an effective reorganization. Furthermore, even though the SPE property-owning subsidiaries were meeting their debt service obligations at the time of filing, because of the distressed circumstances of the credit markets and no evident means of refinancing the debt that was coming due in the next several years, the voluntary bankruptcy petitions filed by the SPE subsidiaries were not filed in "bad faith."
2. Initially appointed independent directors and managers can be replaced if there is a legitimate business purpose in doing so, such as requiring special or particular skills needed for the business of the debtors.
3. Under current Delaware law, directors and managers, including independent directors and managers, owe their duty to the corporation and its shareholders, and regardless of the provisions of the loan documents, there is no support under Delaware law for the premise that the independent managers of the SPE subsidiaries should have considered only the interest of the secured creditors when making the decision to file Chapter 11 petitions.
4. The delay and inconvenience that may have been caused by the partial interruption of cash flows and the appointment of special servicers with respect to the specific borrowers was not reason enough to dismiss their Chapter 11 filings so long as the negotiated structure of SPEs with the independent directors was preserved.

The court, however, went on to expressly state that the question of substantive consolidation is entirely different from the question addressed by the court in this opinion, and that nothing in the opinion should be interpreted to imply that the assets and liabilities of the solvent SPE property-owning subsidiaries could or should be consolidated with those of any other entity.

Conclusion

The use of "bankruptcy remote" or "special purpose" entities such as those that comprise part of the GGP Companies, and the propriety of when and how to file such entities for bankruptcy protection to preserve the value of the entities "as a whole," has been a dilemma restructuring professionals have wrestled with for years. Here, the court has provided guidance on when a solvent subsidiary SPE may, in "good faith," file for bankruptcy protection over the objection of its lenders. Furthermore, although reliant on fundamental current Delaware corporate law, the court's finding that the SPE directors had a fiduciary duty to consider, in addition to the SPE's secured creditors, the interests of the debtor-parent and that parent's reliance on the cash upstreamed to it to preserve the debtors' business "as a whole," will provide some level of comfort to the restructuring professionals seeking to preserve value in the entity and its SPE affiliates, to allow a filing, and to preserve value needed by a non-SPE or bankruptcy remote parent.

It is likely that in future financing transactions, lenders that use "bankruptcy remote" or "special purpose entities" will (i) modify the independent director provisions to implement prior notice requirements for the removal and replacement of independent directors; (ii) require borrower's confirmation and acknowledgement that the initially appointed independent directors possess the necessary qualifications, and understand the business and operational needs of the borrower and its parent entities; and (iii) restrict the upstream distributions of excess cash flow if such funds are likely to be needed for the reduction of leverage at maturity in order to refinance the property.

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