In April, 2009, the nation's second largest shopping center owner, General Growth Properties, Inc. and 166 of its subsidiaries filed for relief under chapter 11 in the Bankruptcy Court of the Southern District of New York. These filings raised the concerns of investors in commercial mortgage-backed securities (CMBS) as certain of the General Growth Properties subsidiaries were intended to be "bankruptcy remote" special purpose entities ("SPEs").On August 11, 2009, Judge Allan L. Gropper issued his opinion in General Growth Properties, Inc., et al.. ___ B.R. ___, 2009 WL 2448423 (Bkrtcy.S.D.N.Y.) on the secured creditors' motions to dismiss the subject chapter 11 cases for alleged bad faith. The secured creditors argued that the subject debtors were not yet in need of bankruptcy relief although others in the corporate group were in financial distress. The Court denied the motions to dismiss and held 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 debtors." The Court further held that the special purpose entity structure of the various debtors was still in place and that the Court's opinion on this issue does not imply that substantive consolidation would be appropriate.
Some of the subject debtors which owed mortgages on their properties were set up to function as SPEs. SPE's are intended to protect the interests of the mortgagee secured lenders by isolating the operations of the borrower from the borrower's affiliates and parent. To advance that purpose, there are typically limitations on the SPE, including certain prohibitions on consolidation and liquidation, merger and assets sales, etc. Often SPE documentation requires the entity to retain one or more independent directors or managers. In this instance, although the mortgage loans were typically secured by a separate property owned by an individual debtor, many of the loans were guaranteed by other affiliate debtors. The involved mortgage loans typically were of a three to seven-year term with low amortization and a large balloon payment due at the end. Many of the involved mortgage loans were financed in the commercial mortgage-backed securities ("CMBS") market. In a typical CMBS transactions, mortgages are sold to a tax qualified REMIC trust which in turn sells certificates to investors. The REMIC is managed by a master servicer or a special servicer in the event of defaults.
The Court explained that the principle that a chapter 11 reorganization case can be dismissed as having been filed in bad faith is a "judge-made doctrine." The court set forth Second Circuit precedent that 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" and further cited Chief Judge Brozman that "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." No one factor is determinative and the Court "must examine the facts and circumstances of each case in light of several established guidelines or indicia..."
Argument of Premature Filing
The secured creditors contended that the subject chapter 11 cases were filed prematurely arguing that the various debtors were not yet in financial distress as none of the involved mortgages had a maturity date earlier than March 2010. The Court stated that in effect, the secured creditors argued that the issue of financial distress should not be examined from the perspective of the group but only on an individual-entity basis.
The Court held that the various debtors were justified in filing the chapter 11 petitions when they did. The Court found that the individual debtors were indeed in varying degrees of financial distress at the time of filing of the chapter 11 cases. Some of the loans had cross-defaulted to the defaults of affiliates or would as the result of the other debtors' bankruptcy filings. Also some of the loans had gone into "hyper-amortization" in 2008. The Court noted that there was no evidence to counter the debtors' showing that the CMBS market on which they relied was "dead" as of the petition date with no prospects for improvement.
The Court noted that although Chapter X of the former Bankruptcy Act required that a petition be filed in good faith, neither Chapter XI nor XII of the former Bankruptcy Act contained such requirement and that Congress did not include the good faith requirement in chapter 11 as enacted by the Bankruptcy Reform Act of 1978. The Court further noted that even the 2005 BAPCPA amendments which strengthened section 1112 relating to dismissal or conversion of an abusive chapter 11 case, did not provide for dismissal for a bad faith filing.
The Court also stated that it is "well established that the Bankruptcy Code does not require that a debtor be insolvent prior to filing." The Court also noted a corollary that there is no particular degree of financial distress required as a condition to filing for bankruptcy relief.
SPE Structure Does Not Restrict Group Analysis
The Court also rejected the secured creditors' argument that the SPE or bankruptcy-remote structure of the project-level debtors' financial distress be analyzed only an individual basis. The Court recognized that there is "no question that this [SPE] structure was designed to make each Subject Debtor 'bankruptcy remote.'" The Court found that the secured lenders did not contend "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 this structure." The Court looked to supporting precedent which held that it was sound business practice for a parent business to seek chapter 11 relief also for its wholly-owned subsidiaries when those subsidiaries were crucial for it own reorganization plan. The Court found that the parent Debtor was faced with the "unprecedented collapse of the real estate markets, and serious uncertainty as to when or if they would be able to refinance the project-level debt, the Debtors' management had to reorganize the Group's capital structure."
Fiduciary Duty of "Independent Managers"
The Court noted that the operating agreements of many of the project-level debtors required the appointment of two "independent managers" who are to consider only the interests of the individual company and its creditors in acting or voting as to filing for bankruptcy relief. But the Court further noted that the operating agreements also provided that the independent managers have the fiduciary duty of loyalty of care similar to that of a director of a Delaware corporation.
The Court held that although the operating agreements "may have attempted to create impediments to a bankruptcy filing" by directing the independent managers to only consider the interests of the individual company and its creditors, it also appropriately provided that the independent managers can only act as permitted by applicable Delaware law which provides or "indeed, required" that the directors of a solvent corporation are to consider the interest of their shareholders in exercising their fiduciary duties. The Court cited North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) where the Delaware Supreme Court held that the directors of an solvent corporation navigating in the zone of insolvency "must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owner." The Court held that Delaware law does not support the secured creditors' contention that the independent managers "should have considered only the interests of the secured creditors when they made their decision to file Chapter 11 petitions, or that there was a breach of fiduciary duty" on their part by voting to file chapter 11 based on the interest of the group. Judge Gropper stated that the secured creditors were mistaken if they believed that an independent manager can serve on a board "solely for the purpose of voting 'no' to a bankruptcy filing" as under the applicable Delaware law they owe their duties to the corporation and ordinarily to the shareholders.
No Finding of Objective or Subjective Bad Faith
The Court also rejected the secured creditors' argument that "objective futility" has been established because the debtors will not be able to confirm a plan over their opposition. The Court held that there "is no requirement in the Bankruptcy Code that a debtor must prove that a plan is confirmable in order to file a petition" and that courts have "consistently refused to dismiss on this ground before a plan has been proposed."
The Court further reject the secured creditors' arguments that the subject debtors lacked subjective good faith in their filings by failing to negotiate prior to filing and that several of the independent managers of the SPE's were fired and replaced shortly prior to the filing. The Court held that the "Bankruptcy Code does not require that a borrower negotiate with its lender before filing a Chapter 11 petition." The Court cited two consumer provisions added by BAPCPA to emphasize that "Congress knows how to impose a filing requirement when it wants to do so." Furthermore, the Court noted that "there is no evidence that pre-filing talks would have been adequate to deal with the extent of the problem." The Court also held that the record did not support the assertion that the firing of the independent managers constituted sufficient bad faith to require dismissal and in any event the fired independent managers did not have a duty to keep any of the debtors from filing from bankruptcy under Delaware fiduciary duty law.
No Implication of Substantive Consolidation
The Court noted that fundamental protections negotiated for with SPE structures "are still in place and will remain in place during the Chapter 11 cases. This includes protection against substantive consolidation of the project level Debtors with any other entities." The Court stated that "the question of substantive consolidation is entirely different from the issue" whether a board of a debtor that is part of a corporate group "can consider the interests of the group along with the interest of the individual debtor when making a decision to file a bankruptcy case." The Court also stated that [n]othing in this Opinion implies that the assets and liabilities of any of the Subject Debtors could properly be substantively consolidate with those of any other entity."
The Court also found that the involved Illinois land trust was eligible to be a debtor as it satisfied the Bankruptcy Code's definition of a "business trust" as it conducted business activities.
