Integration and Securitization: The Pursuit of Orthogonal Goals

Every so often a decision comes along that engenders heated debate but then, it seems, it cools off before being able to develop into something more. Even more quickly is this decision forgotten. In the wake of General Growth Properties (GGP),[1] many law firms and financial consultants analyzed the legal ramifications. The GGP decision was dubbed seminal, even transformative, yet the immediate takeaway that resounded was much of the same timeless rhetoric: bankruptcy-remote is not bankruptcy proof. In the year that has passed since the decision, this article will review the relevant facts and the decision—so as not to be forgotten—and will address the real implications, if any, on bankruptcy law in the time subsequent. The article will then opine that the decision actually stands for a simple proposition, one that is as omnipresent as it is forgettable: Lenders cannot hold securitized assets of an integrated corporate and capital structure while, at the same time, believe the assets are bankruptcy-remote.

This article will explain the inner workings of a special purpose entity, describe the corporate and capital structure of GGP, and depict the financial environment of the months leading up to the bankruptcy filings. The article will then discuss the bankruptcy filings and the subsequent five motions to dismiss brought by secured lenders. A large part of the information contained within this article derived from the Aug. 11, 2009, decision and the objections of the debtors’ and creditors’ committees.

Special-Purpose Entities
A special-purpose entity (SPE) or special-purpose vehicle (SPV) is a structure designed to reduce risk and, as a result, render an investment more attractive to potential buyers. The risk of a bankruptcy filing at the parent level—typically known as the “sponsor,” or the entity which creates the SPE—is the primary risk that a SPE attempts to reduce due to the deleterious effects the costs and uncertainties of a bankruptcy filing can have on investments.

Securitization is the process by which assets are converted into negotiable instruments in order to be sold in the financial market, and which allows the sponsor to remove assets from its books and improve its capital ratio while making new loans with the sale proceeds.[2] One common example of an asset frequently securitized is the traditional home mortgage. The bank makes a loan to a homeowner (a mortgage) and retains an interest in the property. The mortgage itself is an asset to the bank and expects the mortgagor to pay according to the terms of the mortgage. The bank can hold this mortgage for the entire duration and collect the payment stream each month or it can sell the mortgage asset and use the sale proceeds to make another loan. The bank of the assets sought to be securitized will capitalize on economies of scale and reduce the risk of market fluctuation; in doing so, the bank will amass its mortgages into one group that will later be subdivided and securitized.[3] Institutional investors typically are pension funds and insurance portfolios, two significant players in the securities market, which seek large investments with relatively low risk and have the level of funds necessary to participate in the securitization market.

Securitizations require a minimum level of relationship to exist between the sponsor and the lender (the investor) throughout the life of the investment until the assets mature and the cash stream ceases. Investors will pay a large, up-front payment to the sponsor for the assets and, as mortgagors begin making their mortgage payments, a portion of the proceeds may upstream to the sponsor while most of the proceeds will upstream to the lender. The bank extends mortgages on a regular basis, and the new, not-yet-securitized mortgages may be transferred to an existing securitized group. This creates a semi-permanent, indirect relationship between the sponsor and the assets—but also generates a significant risk which a SPE attempts to reduce: Should the sponsor file a bankruptcy petition, the assets and/or the cash stream may be deemed property of the bankruptcy estate and would essentially fund the sponsor’s restructuring rather than upstream to the investors. A relationship between the sponsor and the lender that is anything more than minimal has the potential to decimate the investment’s rate of return and heightens risks to a level few investors are comfortable to undertake.

In the event of the sponsor’s bankruptcy filing, the presence of certain characteristics can render a SPE sufficiently formidable to overcome challenges to the SPE’s isolated structure. Distance between the sponsor and the investor is essential, and there are many ways to create and maintain this distance. Organization documents create a SPE and these documents state that (1) the terms and structure of the SPE; (2) contain separateness covenants and prohibitions on consolidation, liquidation and amendments to the organizational and transaction documents; and (3) include restrictions on mergers and asset sales. To further distance the sponsor from the investor, the SPE documents typically contain an obligation to retain one or more independent directors, detail their role, and require an unanimous vote to file a SPE’s bankruptcy petition.

A sponsor should include—and an investor should require—additional criteria that increases the distance between the two. Language that reduces opportunities for director shopping builds distance. The organizational documents should include a notice provision that requires adequate notice of the sponsor’s anticipated or inevitable replacement of an independent manager, and the replacement should be permitted only for cause. This would prevent a sponsor from appointing a manager aligned with the sponsor’s interests, which, in the situation of a financially distressed sponsor, may collude with the sponsor to file a petition for the SPE and fund the reorganization with the SPE’s assets. A notice provision would not come without costs—third parties would have to expend resources monitoring the situation but would come at less of a cost than the costs of having the SPE assets deemed property of the estate.

The specific duties the independent managers owe and to whom the duties are owed should be clear and specific. The duties should contain the fiduciary duties contained within corporate law but they should run to the SPE and its creditors exclusive of the sponsor. As the GGP decision laid out, it is not sufficient and is, in fact, risky simply to refer to state corporate law. For instance, under Delaware corporate law, corporate directors have fiduciary duties of care and loyalty which run to the corporation (i.e., the sponsor) and its equityowners, or shareholders, but not to creditors (i.e., the investor or lender). Thus, organizational documents that reference Delaware corporate law for the duties owed by independent managers do serve the interests of investors.

The Pre-Bankruptcy Days
GGP was a “publicly-traded real estate investment trust and the ultimate parent of approximately 750 wholly-owned Debtor and non-Debtor subsidiaries, joint venture subsidiaries and affiliates”[4] which owned, developed and managed more than 200 shopping malls across the United States. Revenues were generated from community development projects though the sale of “improved land to homebuilders and commercial developers”[5] and from shopping center operations through “rents, property management services, strategic partnerships, advertising, sponsorship, vending machines, parking services and the sale of gift cards.”[6]

The GGP corporate structure essentially involved the parent, A, which owned B, which owned C, which owned hundreds of individual project-level subsidiary entities, which owned the individual properties. GGP took “a nationwide, integrated approach to the development, operation and management of its properties, offering centralized leasing, marketing, management, cash management, property maintenance and construction management” and, in so doing, was an integrated enterprise.[7]

The GGP capital structure was even more complex. It included both conventional mortgages and commercial mortgage-backed securities (CMBS). Conventional mortgages were secured by mortgages on the actual GGP entities, mezzanine debt[8] and even guaranteed by other GGP entities.[9] The typical mortgage loan had a “three- to seven-year term, with low amortization and a large balloon payment at the end.”[10] The CMBS were financed via substantially the same securitization process described above. Indeed, multiple mortgages were “sold to a trust qualified as a real estate mortgage conduit (REMIC) for tax purposes. The REMIC in turn [sold] certificates entitling the holders to payments from principal and interest on this large pool of mortgages.”[11] Different income streams and interest rates attached to investors willing to undertake varying levels of risk. The “REMIC [was] managed by a master servicer that handle[d] day-to-day loan administration functions.”[12] A special servicer would take over management if: “(i) a borrower’s failure to make a scheduled principal and interest payment, unless cured within 60 days, (ii) a borrower’s bankruptcy or insolvency, (iii) a borrower’s failure to make a balloon payment upon maturity or (iv) a determination by the master servicer that a material and adverse default under the loan is imminent and unlikely to be cured within 60 days.”[13]

GGP had substantial capital requirements in order to keep its doors open and were met with more mortgage loans. As the secured loans reached maturity, GGP would pay the large balloon payment only by obtaining another mortgage, a then-fairly common practice that allowed GGP to expand its operations. However, the economic downturn in 2008 obliterated GGP’s ability to refinance its debt with more debt, and despite hiring professionals—ranging from investment banking firms to restructuring firms—GGP was unable to find financing for the vast majority of its debts.

GGP claimed that the CMBS structure—set into place to create distance between GGP and the lenders—even hampered its efforts to negotiate with the special services. GGP contacted the master servicers of the loans set to mature in an attempt to renegotiate but the master servicers refused to allow GGP to the special servicers until the loans were transferred, presumably due to restrictive covenants set in place to establish distance.[14]

The failure to obtain financing to service its debt obligations caused GGP to default on its loans. A month after Citibank commenced foreclosure proceedings on a default loan, GGP filed voluntary petitions under chapter 11.

The Chapter 11 Filings
On April 16, 2009, GGP and 360 of its domestic subsidiaries—and an additional 28 days later—within the GGP conglomerate (the “GGP debtors”) filed voluntary bankruptcy petitions seeking relief under chapter 11. There were 166 SPEs among the 388 domestic subsidiaries that filed petitions. Typical first-day motions were filed, including the GGP debtors’ request for the use of cash collateral and approval of debtor-in-possession (DIP) financing, to which secured creditors immediately objected due to concerns that the secured creditors’ security would be in jeopardy and claims that it was a violation of the separateness of the SPEs for the GGP debtors to “upstream cash from the individual properties for use at the parent-level entity.”[15] The final cash-collateral order included various adequate protections and was entered, and the DIP financing order did not permit the DIP lender to obtain liens on the entities that may have affected the lien interests of several secured creditors.

The Motions to Dismiss
Five secured lenders to approximately 21 of the 166 SPEs—known to be bankruptcy-remote and, in fact, created specifically to be bankruptcy-remote—each filed a motion seeking the dismissals of the SPE-borrower to which the particular secured lender loaned money (the “motions”). Although two of the secured lenders were special servicers to the SPE, the five motions were based on more or less one ground:[16] The petitions were filed in bad faith.[17] The GGP debtors and the creditors’ committee objected to the motions, and in bankruptcy court, Hon. Allan L. Gropper denied the motions.

The alleged objective bad faith was broken down into subcategories: (1) the filings were premature in that they (a) provided no benefit to the creditor since no payments were being made even though there was “ample cash,” and (b) were unnecessary since the SPEs had positive cash flow and the loans did not mature until later; and (2) improperly considered the interests of the GGP group, including the parent and other SPEs. The alleged subjective bad-faith argument was stemmed from two sub-arguments: the filings (1) lacked good faith since the SPEs did not contact the creditors to refinance or extend maturity dates, and (2) were authorized via improper tactics, namely, the replacement of so-called independent directors on the eve of the filings.

The alleged objective futility was based on the alleged inability to confirm a plan over the borrowers’ objection, which essentially argued that to utilize the cramdown provisions of the Bankruptcy Code, the debtors would have to propose a plan that contains an impaired class of claims other than the movants’ secured claim and would have to “obtain acceptance by at least one class of claims that is impaired under the plan…” The movants foresaw their objections to any plan and argued that the petitions were filed in bad faith since no plan could be confirmed.

The Bankruptcy Court’s Decision
The court discussed whether the petitions were filed in bad faith and examined the “facts and circumstances of each case in light of several established guidelines or indicia,” and essentially “conduct[ed] an ‘on-the-spot evaluation of the Debtor’s financial condition [and] motives.’”[18] In applying a two-prong test, the standard in the Second Circuit, which looked to: (1) objective futility of the reorganization process, and (2) subjective bad faith in filing the petition, the court ruled that the motions were not filed in bad faith.

The movants argued that the filings were premature, an argument that the court immediately rejected. The court noted that the entities carried an “enormous amount of fixed debt that is not continent” and immediately went into a discussion of whether the entities were in actual financial distress on the petition date and whether the prospect of liability was too remote to justify a filing. The court held that each entity was in financial distress, albeit some more than others. GGP held board meetings, hired financial consultants and legal counsel, and engaged in comprehensive restructuring discussions. The court rejected the proposition that the GGP debtors should have waited until things became worse. The court found that the Code favors early filings, basing this on two things: The Code (1) does not expressly list bad faith as one of the mentioned grounds for dismissal, and all the listed grounds only pertain to post-petition, and (2) supports the DIP rather than the appointment a trustee. Thus, the court found that, contrary to the lenders’ assertions, the SPEs were, in fact, in financial distress since there existed cross defaults to other financings, high loan-to-value ratios and uncertain prospects for refinancing. The court also stated that insolvency is not a requirement of the Code.

Then court then turned to the interests of the group and whether the entities were to consider those interests. The movants argued that the entities were designed to be SPEs, specifically structured to be remote and isolated from its parent and should not have considered the interests of other SPEs or the interests of the parent. The court pointed out that if the ability to obtain financing of the entire GGP group were hampered, the individual financial health of any of the SPEs would deteriorate; in some ways, at least, the two were indirectly but inextricably linked. The court held that contradictory language prevented a clear understanding as to whom fiduciary duties ran. On the one hand, several SPE operating agreements required the appointment of two independent managers who “shall consider only the interests of the company, including its respective creditors,”[19] while, on the other hand, stated that the independent managers “shall have a fiduciary duty of loyalty and care similar to that of a director of a business corporation organized under the General Corporation Law of the State of Delaware,”[20] which provides that fiduciary duties run to the corporation’s shareholders, and do run to creditors even when operating in the “zone of insolvency.” Indeed, even the parties were confused. GGP interpreted this language to mean the independent managers would not be affiliated with GGP[21] where as the secured lenders believed it to mean that the fiduciary duties of care and loyalty ran to them.[22] The court, somewhat arbitrarily, reconciled the contradiction and concluded that the SPEs were obligated to consider the interests of GGP in determining whether to authorize its own filing. As the court stated in its decision, “[s]een from the perspective of the Group, the filings were unquestionably not premature.”[23]

The next issue with which the court discussed was objective futility—the first element in analyzing whether a chapter 11 petition was filed in good faith—and whether the alleged inability to confirm a plan confirmed that the GGP debtors did indeed file the petitions in bad faith. Interestingly, the court accused one secured creditor of being the party that is acting prematurely and swiftly stated that there is no requirement in the Bankruptcy Code that a debtor must prove that a plan is confirmable.

In discussing subjective bad faith—the second element in analyzing whether a chapter 11 petition was filed in good faith—the court ruled that the Bankruptcy Code does not require a borrower negotiate with its lender prior to filing a chapter 11 petition. The court also found no evidence of bad faith concerning the sudden replacement of two independent managers. Several SPE operating agreements required that there be two independent directors, and allowed the directors to be supplied by a company that specializes in providing professional independent directors.[24] Two such independent directors were supplied but, as it turned out, they did not have any expertise in the real estate business. The court held that the independent managers did not have a duty to keep any of the SPEs from filing a petition and, since managers of solvent companies are charged with the same obligations and duties as directors of a Delaware corporation, the managers owed fiduciary duties and loyalties to the corporation and its shareholders, i.e., GGP.

The Unsophisticated Sophisticated Investor
Investors tend to be their own worst enemy. GGP dealt with sophisticated financial institutional investors that had the resources to conduct extensive due-diligence and make the correct determination, namely, under the then-present structure, it was not conceivable that the SPEs were bankruptcy-remote. This is not to say that every time a so-called bankruptcy-remote SPE is pulled into the estate that there were legal failures on the part of the secured lenders—but as far as GGP is concerned, the idea that a highly integrated company could, at the same time, act as a sponsor, securitize its assets and label the resulting SPEs as bankruptcy-remote is preposterous.

The movants demanded the entities be classified as SPEs and, in response, GGP employed many devices and ensured several characteristics were present to create the distance necessary to label the entities SPEs. The problem was that the movants neglected to look at the level of integration within the GGP enterprise, and analyze the real interplay between the SPEs and the parent. GGP benefited pre-petition from the SPE capital structure: Secured lenders did not require the parent to guarantee the debt, investments were deemed less risky and terms were more favorable—to GGP. GGP did not stop there. It also wanted to benefit from an integrated corporate structure, dictating policy, overseeing “the development, operation and management of its properties” and offering “centralized leasing, marketing, management, cash management, property maintenance and construction management.”[25] This level of integration permitted the SPEs to consider GGP’s interest in their decision to file their own petitions.

The decision is solid. The motions of the secured lenders were rightly denied, but the decision is not novel nor is it shocking. GGP saw an opportunity and the secured lenders were blind.

Conclusion
It not entirely precise to state that the GGP decision stands for the well-known fact that bankruptcy-remote is not bankruptcy proof. The decision actually does not stand for much and the fact that the secured lenders even had to find themselves in this situation is all too surprising. From day one of the securitization the SPEs were not bankruptcy-remote. Although more language—clearer language—should have been inserted in the organizational documents, one must think twice of whether it is even possible to securitize the assets of an integrated enterprise and have actual bankruptcy-remote protections attach. It is the hope—but not the belief—that, on the one year anniversary of the GGP decision, secured lenders will not again pursue orthogonal goals and fall victim to the real perpetrator: themselves.