Securitized Real Estate Loans: U.S. Bankruptcy Court Favors Substance over Form
Securitized real estate loans were extremely attractive a few years ago for one significant reason. Because they were non-recourse loans, except for certain exceptions known as "carve-outs" for bad acts, they generally left neither the borrower nor the principals liable for the principal or interest on the loan.
The lender in a typical securitized loan transaction required the borrower to be a special purpose entity (SPE) that was both separate and bankruptcy-remote. In this context, an SPE had a single function, which was to own only the property being financed by the securitized loan. This separateness was required in order to isolate the borrower's real estate asset, thus preventing it from being substantively consolidated with the assets (and subject to the liabilities) of related parties that might be in financial distress.
Also in this scenario, the borrower was a newly formed entity (such as a limited liability company) with its own newly formed corporate manager. The board of directors of the corporate manager included a so-called "independent director," who was engaged to act as a director but had no other relationship with the borrower or its principals. The bylaws of the board of directors, as well as the borrower's operating agreement, required unanimous consent of the directors in order to file for bankruptcy protection. As a result, the lender seemingly had a mechanism, contained within the entity's corporate formation documents, to prevent the borrower from filing bankruptcy as a means of stalling or impeding a foreclosure proceeding. However, as evidenced by two recent high-profile bankruptcies in the commercial real estate world, a Chapter 11 case may not be dismissed simply because it hinders foreclosure and creates an inconvenience for the lender.
Case Study: General Growth Properties Bankruptcy
In a much-publicized decision in the case of In re General Growth Properties, Inc., et al., the U.S. Bankruptcy Court for the Southern District of New York recently examined these very issues. General Growth Properties, Inc., a publicly held real estate investment trust based in Chicago, filed for bankruptcy in April 2009 in the wake of the nationwide collapse of the commercial real estate market. Collectively, General Growth's bankruptcy cases included 388 debtors operating 200 shopping malls in 44 states.
After the filing, certain lenders made motions to the court to dismiss the bankruptcy petitions as having been filed in bad faith because at least some of General Growth's SPEs were not actually in financial distress; that is, not all of the debts were in default. Another allegation of bad faith arose because certain SPEs made tactical replacements of their original independent directors prior to the filing of bankruptcy. Their goal, the lenders alleged, was to put leaders in place who would effectuate the bankruptcy filings. In fact, one of the lenders admitted on the witness stand that the original directors may not have been qualified to fully understand the complex issues surrounding the entity's financing situation. In defense of its bankruptcy petitions, General Growth argued that after failing to refinance the debt at the individual project level, it needed to put directors in place who were qualified to deal with the situation and make the best decision for its entire group of SPEs.
Ultimately, the Bankruptcy Court sided with General Growth, explaining that under Delaware corporate law (the state where the entities were formed), when a company becomes insolvent, the directors have a duty to the creditors. In General Growth's case, that duty was primarily to the lenders. But because the lenders had not alleged that the SPEs were insolvent, the directors' duties were, as usual, to act in the best interests of the company and its members. As a result, the SPEs were found to have behaved reasonably (and not to have acted in bad faith) by filing the bankruptcy cases for the good of the entire group after they were unable to refinance their securitized loans. The court ruled that General Growth was not required to evaluate the best interests of the creditors of each SPE or to wait until each entity had defaulted before placing it into bankruptcy. In the end, the court chose not to recognize the individual corporate formation documents that the lenders so highly prized. In essence, the court ruled in favor of the substance of the overall matter instead of the technical formation of the entities.
While the exact implications of the General Growth case cannot yet be known, the outcome is clearly favorable to multiple-entity borrowers. Especially if the current commercial real estate crunch persists, the decision provides this class of borrowers with the freedom to file bankruptcies in the absence of an entity-by-entity evaluation of insolvency.
Case Study: Extended Stay Hotels Bankruptcy
The General Growth case offers just one glimpse at how the rash of failed securitized real estate loans may play out in the bankruptcy arena. In fact, further developments in the law may occur in the pending bankruptcy of Extended Stay Hotels, an operator of mid-priced hotels that filed in June 2009 for Chapter 11 protection in the U.S. Bankruptcy Court for the Southern District of New York. In that case (In re Extended Stay Hotels, LLC), the bankruptcy filing allegedly triggered certain "carve-out" provisions and created personal liability on real estate investor David Lichtenstein, whose company, Lighthouse Group LLC, purchased Extended Stay in 2007 and placed approximately $7 billion of debt on the hotel company. However, Lichtenstein has argued that filing for bankruptcy was a fiduciary duty that he owed to the company's shareholders. Lichtenstein stands to be indemnified over $100 million in payments made by the company that arguably triggered the carve-out liability.
The bankruptcy filing has the support of some of the creditors of the hotel company, including the four that hold the most senior portion of the debt, which is in the form of commercial mortgage-backed securities (or CMBS debt). The senior lenders stand to benefit the most from the bankruptcy filing. Not surprisingly, however, some of the holders of the more junior portions of the debt do not approve of the bankruptcy filing as their debt may be wiped out during the bankruptcy process. The Extended Stay case exemplifies the difficulty in obtaining agreement amongst the layers of debt-holders of securitized loans in connection with any sort of loan workout. So, try as it might for an alternate resolution, a borrower may be forced to file for bankruptcy as the most prudent way to get all of the lenders together in one court-supervised forum.
These high-profile bankruptcy cases raise many questions for companies of every size in today's uncertain world of commercial real estate. For example, will cases involving numerous properties and multiple entities affect the developer who has only one or two securitized loans that very well may mature or approach a default? Unfortunately, the difficulty in executing a workout is the same no matter how many loans are involved. In the past, the servicer of the loan, who acts as an agent of the holders of the debt, would not engage in any discussions until the loan was actually in default. Then, that servicer would tell the debtor that it had no authority to work out a deal until it obtained approval from the holders of the CMBS debt.
Even though the borrower entities in a securitized real estate loan are bankruptcy-remote, there is now precedent that, given the reality of the crisis in the credit markets today, bankruptcy may be a useful method to achieve court-supervised consensus with the lenders. In fact, in response to the General Growth case, the federal government has recently issued new rules that will permit the servicer to discuss loan modifications with a borrower prior to a default actually occurring.