Real Estate Finance & Investment ADVISORY

Transcription

1 Real Estate Finance & Investment ADVISORY The GGP Bankruptcy So Far: Grounds for Concern, Sources for Hope June 8, 2009 As the federal government and private markets make progress to quell economic recession and stimulate the engines of financial growth, recent headlines from the commercial real estate industry have focused on certain developments, such as the proposed changes in rating agency methodologies and the repeated false starts with the government s TALF and PPIP programs. However, the bankruptcy case of General Growth Properties (GGP) will also likely have significant long-term implications for commercial real estate and bears continued close monitoring by all industry participants. Overview from 20,000 Feet On April 16, 2009, GGP filed for bankruptcy protection under chapter 11 of the United States Bankruptcy Code. The case is in the U.S. Bankruptcy Court for the Southern District of New York before Judge Allan Gropper. Given the news of the preceding months, this filing, by itself, did not come as a shock to many in commercial real estate. However, GGP also included in its filing most of its solvent special purpose entity subsidiaries (the SPE Property Owners ) that actually owned the real property and acted as borrowers under property-specific loans (securitized, syndicated and portfolio) that, in most cases, were performing and not in default. The filing by the solvent SPE Property Owners was not broadly expected in the market and has industry participants focused on the results to date, and the anticipated developments in this bankruptcy case. Orders have been issued by the court with regard to the use of cash collateral and debtor-in-possession (DIP) financing, but the case is anticipated to run for 12 to 18 months before a reorganization plan is confirmed. Until then, the orders issued to date may be modified based on changed circumstances going forward. Based on developments to date, there is legitimate cause for concern due to the issues discussed below, but also important to note there are grounds to believe that the basic deal structures used in commercial real estate finance may emerge resilient, albeit with such fine-tuning and refinement as are merited from the final results of this case. 1 In the Mandarin alphabet, the same characters can stand for both crisis and possibility, and at this early point in the GGP bankruptcy, this is an appropriate shorthand way to characterize the case. 1 Several of the rating agencies have issued statements that the decisions to date are not anticipated to result, of themselves, in downgrades to existing securitizations, but also noting the need for monitoring the case going forward. See, e.g., Daniel B. Rubock, Saved by the Bell: GGP Bankruptcy Judge is Able to Duck the DIP Question, But Firmly Tackles Cash Collateral, Moody s Structured Finance, May 15, 2009; Huxley Somerville, Group Managing Director and U.S. CMBS group head of Fitch Ratings, Press Release, Fitch Ratings, Fitch: SPE Structure Holds up in GGP Ch. 11 but Adds Costs to U.S. CMBS Trusts (May 21, 2009). This advisory is published by Alston & Bird LLP to provide a summary of significant developments to our clients and friends. It is intended to be informational and does not constitute legal advice regarding any specific situation. This material may also be considered attorney advertising under court rules of certain jurisdictions.

2 The critical issues raised by the case for commercial and multi-family mortgage lenders are (i) the SPE structure and the risk of consolidation; (ii) the use and treatment of property cash flow; (iii) the debtor-inpossession (DIP) financing; and (iv) possible impacts on the structures used for commercial real estate finance going forward. The SPE Structure and Consolidation Risk Will the SPE Structure Hold Up? The filing by the solvent SPE Property Owners raised a question for all secured lenders would the court respect the single-purpose entity structure, with its detailed covenants on separateness designed to isolate the asset and cash flows from the asset? In issuing his oral ruling with regard to the DIP financing and cash collateral, Judge Gropper expressly stated that there was no substantive consolidation of the filing entities. 2 That is good news, as most commercial and multi-family property lenders today, and all lenders in the commercial mortgage-backed securities (CMBS) market, rely on some form of single-purpose entity (SPE) structure as a cornerstone of asset-specific financing. If this SPE structure could not be relied upon, as realistically intended, then participants in the marketplace would likely need to reassess such fundamental expectations, including pricing and the effectiveness of remedies, to address the added uncertainty. While a lender might wish that bankruptcy-remote would mean bankruptcy-proof, the real test of the structure is how well it measures up to realistic expectations based on the bankruptcy process. Any evaluation of the outcome of this case cannot be limited to a binary analysis of substantive consolidation on one hand, versus complete protection of the SPE structure on the other; rather, it must measure how well the secured lenders will fare, given the unique facts of the GGP case and the tumult of the rough justice doled out in a bankruptcy court. 3 From this perspective, the gravest fears of secured lenders have been alleviated. Nevertheless, real concerns exist as this case progresses from its early hearings. What Happened to the Independent Directors? One such concern is how the SPE Property Owners ended up in bankruptcy in the first place, given that (i) they were solvent entities not otherwise in financial distress and (ii) in almost all cases, the organizational documents of such entities required the affirmative vote of one (or in some cases, two) independent directors to file the bankruptcy petition. On June 17, 2009, the court will hear motions to dismiss by several of the secured lenders challenging the appropriateness of the filings by the SPE Property Owners. Other lenders are in the process of investigating the facts related to their potential motions in this area. It is expected that these motions to dismiss will follow two main arguments: (i) bad faith and (ii) ultra vires. 2 3 In the words of the court,... we are not substantively consolidating any estates. We are only deciding matters before the Court today. May 13 Tr. at 153 [emphasis added]. In various statements from the bench, the court discounted concerns over systemic risk arising from the filings by the SPE Property Owners, instead looking to the cases and facts before it and traditional bankruptcy precepts in attempting to adequately protect the rights of secured creditors. -2-

3 The bad faith argument is based on the assumed facts that the entities in question were solvent, performing under their loan documents and not in default or otherwise in financial distress. In such situations, there is case law to support finding that the filings could be dismissed for cause as a bad faith filing. 4 The analysis of what constitutes bad faith for these purposes is fact-intensive, and there is sufficient room for interpretation that the court may find facts on which to deny the motions to dismiss on these grounds. A seemingly more powerful argument to dismiss is that the filings by the SPE Property Owners were in contravention of the organizational documents governing such entities (or, in legal terms, that the filings were ultra vires). According to one lender s motion to dismiss, the independent directors whose votes were required for any voluntary bankruptcy filing were allegedly dismissed on the eve of the bankruptcy filing. 5 These directors may have been replaced with compliant directors who consented to the filings at the behest of GGP. Under settled principles of bankruptcy law, a bankruptcy court will look to state law to determine whether an entity had the appropriate authority to file a bankruptcy petition. 6 At the upcoming hearing, the secured lenders will presumably request discovery to ascertain the specific facts surrounding the actions by and/or dismissal of the independent directors. While the case law seems to support the position of the secured lenders, at least based on the assumed facts, it is unclear how the court will address these motions and whether the court will allow the discovery process to go forward on this issue. In settling matters dealing with cash collateral and the DIP financing before dealing with the motions to dismiss based on bad faith or ultra vires arguments, the court may have, for all practical purposes, closed the door to arguments for dismissal. Granting one motion to dismiss based on the theories described above would likely give rise to similar motions from many of the other secured lenders, effectively ending many of the bankruptcy cases at the property level. The cash collateral and DIP financing orders, based on an agreement among the secured lenders, GGP, the DIP lender and GGP s unsecured creditors, have struck a balance among the various parties to the case, and it seems unlikely that the court would unsettle this and bring the case back to square one. This timeline and protocol to consider cash collateral and DIP financing issues first, before considering motions to dismiss the cases while seemingly counter-intuitive, is the accepted and established procedure in bankruptcy. In some bankruptcies, this timeline may not have much effect on the larger issues in the case, but in the GGP bankruptcy, it seems that the independent director issue may not be fully pursued because of the practicalities of the situation. In the view of some, even if the motions to dismiss are not granted, it is important that these arguments are made, if only to force a decision that will at least provide a benchmark against which lenders can attempt to structure and price transactions going forward See, e.g., In re SGL Carbon Corp., 200 F.3d 154 (3d Cir. 1999); In re C-TC 9th Avenue P ship, 113 F.3d 1304 (2d Cir. 1997). Motion of FRM Funding Company, Inc. Pursuant to 11 U.S.C. 1112(b), to Dismiss the Chapter 11 Case of Fox River Shopping Center, LLC at 4 5. See, e.g., Price v. Gurney, 324 U.S. 100 (1945); In re Century/ML Cable Venture, 294 B.R. 9 (Bankr. S.D.N.Y. 2003). Also, in many loan originations, lenders obtained opinions to this effect, although these were largely limited to single member limited liability companies, as these entities were then relatively new creatures to the market. -3-

4 Use and Treatment of Property Cash Flow To say that a commercial real estate lender relied on the SPE structure is to say simply that such a lender relied on the concept that (i) all property cash flow would be used for expenses of and limited to the mortgaged property, including debt service, taxes, insurance, operating expenses and capital improvements, and only then could any remaining excess cash flow be upstreamed to its parent; and (ii) that these funds would be segregated and remain subject to their lien in the event of a bankruptcy filing. In their bankruptcy court filings and presentations to the court, GGP and the SPE Property Owners contended that they had always utilized cash management in a centralized manner at the parent company level, rather than at the SPE Property Owner level (as typically required under most loan documents). In its May 14 order, the court effectively ratified this approach, permitting the SPE Property Owners to sweep property cash to a central account that would continue to be controlled by GGP. To provide the secured lenders with adequate protection against the use of cash collateral, the court recognized that each secured lender to an SPE Property Owner would be entitled to (i) interest, but not any amortization, at the pre-petition non-default contract rate (which is a statutory provision applicable to single asset real estate); (ii) a first lien on the centralized cash account in the amount of cash swept from its mortgaged property, but only to the extent of any decline in value of the individual SPE collateral (and thus failure of adequate protection); (iii) payment of all sums (other than amortization) required to be paid pursuant to the applicable loan documents; and (iv) a soft second lien on the Goldman Properties (as defined below). The court also reserved the issue of the scope of the security interest in post-petition rents. Notwithstanding the adequate protection package granted to the secured lenders, at least one secured lender argued at the May 13 hearing that GGP s use of cash from each of the SPE borrowers violated the terms of a hard cash management system that provided for cash to be controlled by that lender. In response, Judge Gropper explained from the bench that bankruptcy often unsettles the expectations of secured lenders. So long as the secured lender received adequate protection for its loss, the terms of that lender s hard cash management system did not affect the court s analysis in bankruptcy, and the court effectively treated such lender s hard cash management system as qualitatively the same as the springing or soft cash management arrangements on most of the other loans to the SPE Property Owners. 7 Such statements by the court effectively denigrating the difference between hard versus soft cash management suggest that any reliance on hard cash management may require enhancements to the structures typically used. 8 Secured lenders can take a quantum of comfort that (i) the court s decision could have provided less to the secured lenders in terms of adequate protection and (ii) the specific facts of the GGP case can likely be distinguished from other more standard conduit-like loan transactions, due to the presence of co mingled net cash flow centralized at the GGP corporate level pre bankruptcy. In the words of the court, It is absolutely standard black letter law that covenants and conditions are inevitably breached in bankruptcy. 7 8 At the hearing, one observer noted that, [r]egardless of whether the particular SPE (a) had a soft lockbox that converts to hard after an event of default, such as filing for bankruptcy, [or] (b) had a hermetically sealed, already locked-in cash management system with no money being upstreamed to the GGP..., the judge s answer was the same: once in bankruptcy, pre-petition SPE-level cash management will be jettisoned and bargained-for cash flow isolation mechanisms overridden. Rubock, supra note 1, at 2. It is also possible that the court viewed it as more imperative to treat the vast number of secured lenders in this case on the same footing than to parse out the particulars of alternative cash management arrangements. -4-

5 May 13 Tr. at 151. The issue for secured lenders is to understand that, in bankruptcy, the protections afforded to a secured lender are viewed through the prism of adequate protection rather than from the pre bankruptcy perspective of covenant compliance, a security interest in rents and the ability to exercise remedies on a material default. 9 Nevertheless, it is reasonable to assume that the adequate protection package in this case is at least in part a result of the court s appreciation of the bargain struck between the SPE Property Owners and their respective, individual secured lenders, namely that non-recourse financing was available because cash flows from the individual properties would be ring-fenced. Unless there is an attempt to modify the terms of the adequate protection package, a secured lender at least has a basis on which to form expectations as to the value of its loan and collateral. DIP Financing GGP had initially proposed a DIP financing package arranged by Pershing Square Capital Management LP, an affiliate of one of the largest shareholders of GGP common stock. As initially proposed, the DIP financing would have been secured by second liens on each of the shopping centers owned by the scores of SPE Property Owners, and a first lien on the centralized cash management account. Prior to the hearing on the DIP financing, alternative bidders for the DIP loan emerged and GGP effectively conducted an auction among the various prospective lenders. The secured creditors of the SPE Property Owners had an opportunity to provide input in this process. After several days of discussions among the parties, Judge Gropper approved an order for DIP financing that had the blessing of GGP, as well as the secured creditors to the SPE Property Owners and the bank group holding the unsecured debt of GGP. The investor group providing the DIP loan is led by Farallon Capital Management, an investment fund that teamed with Simon Property several years ago to purchase The Mills Corporation. 10 Importantly for secured creditors, the obligors on the DIP loan do not include any of the SPEs and, unlike the initial proposal, the approved DIP financing plan provides for no second liens on any of the properties currently subject to a first lien mortgage. The primary security for the DIP loan will be shopping center assets recently valued to be worth in excess of $600 million (the Goldman Properties ). These properties currently serve as collateral for an approximately $210 million loan from Goldman Sachs that reportedly includes a discounted payoff mechanism if the loan was discharged prior to June 1, Using the $400 million DIP loan to retire the Goldman Sachs facility effectively increases the leverage on these assets by almost 100 percent. The approved DIP plan also provides the DIP lenders with a lien on the centralized cash management account, provided that such lien is junior to the lien of the secured creditors to the SPE Property Owners. 9 In a report on the first-day hearings in the GGP case, a major rating agency observed that, although the court had made no formal rulings as of that date, [t]he concept of adequate protection may be the Achilles Heel of commercial real estate SPE structuring. Daniel B. Rubock, GGP Bankruptcy Judge Questions Structured Finance Keystone, Moody s Structured Finance, May The approved DIP financing plan provides for a $400 million loan with a term of 24 months at a rate of LIBOR plus 12 percent, with a LIBOR floor of 1.5 percent. The loan includes an exit fee of 3.75 percent, and an administrative agent fee of $30,000 per month, payable in advance. -5-

6 The outcome with respect to the DIP loan is a material improvement when measured against the initial DIP loan proposal, and the secured lenders were satisfied with the result. However, the unanswered questions are cause for continued attention namely, had the Goldman Properties not been available at low leverage, or instead of a robust auction process if only the initial DIP proposal remained on the table, or had there not been significant excess cash flow from the SPE Property Owners, would the court have approved a DIP order that provided second liens against the SPE Property Owners or balanced the equities in a more prejudicial manner against the secured creditors? Looking Forward Looking forward, many observers expect the case to stretch for 12 to 18 months, until a final plan is confirmed. During this time, the automatic stay will presumably remain in place, prohibiting the exercise of any rights or remedies, and in effect asking the secured lenders to remain patient. The next significant hearing in the case is scheduled for June 17, 2009, at which time the court will hear any motions by the secured lenders discussed above to dismiss several SPE Property Owners bankruptcy filings. The results obtained by the secured creditors to date give comfort to investors and credit rating agencies. The initial fears, based largely on the filing and statements by GGP, of breach of SPE separateness and asset isolation resulting in substantive consolidation have not materialized. 11 In fact, the court invited any secured creditors to return for further relief if they felt that the adequate protection granted was being diluted or impaired. Likewise, if commercial real estate market values continue to fall, if retail tenants default on their leases and seek bankruptcy protection and the termination of their leases in shopping centers, if unemployment continues to rise and impact consumer spending, or if GGP defaults on the DIP financing, GGP may return to the court for further relief in bankruptcy. Such circumstances could lead to results that are more prejudicial to the secured creditors than the case has presented to date. Despite being a Final Order, the existing order remains subject to modification on a case-by-case basis for an individual lender as circumstances may warrant and the law may allow. Despite the court s view that cash collateral and adequate protection do not impact SPE structures or credit availability, it remains to be seen how the debtors use of cash collateral under the terms presented will affect the credit markets, which rely on the isolation of cash and asset collateral through the enforcement of cash management, separateness covenants and limited recourse provisions in default circumstances, as well as in initial loan structuring Some of the briefs filed on behalf of secured lenders at the outset of the case, and one brief filed on behalf of CMSA and the MBA, raised cautionary notes of the larger risks to real estate finance of an untrammeled consolidation, whether actual or de facto. These concerns were based on the apparent inappropriateness of the filings by the solvent SPE Property Owners and by the proposed relief initially sought by GGP. The orders that were subsequently issued by the court indicate a more tempered course, but one that nonetheless requires close monitoring to ensure that subsequent interim orders and any plan eventually confirmed are not more prejudicial to secured lenders. 12 Notably, it remains to be seen how the court s orders in this case might affect the proposed plan of the U.S. Treasury to use TALF funds to purchase AAA rated CMBS. -6-

7 Ultimately, the question is what the precedential impact will be of GGP. Do the rulings on the DIP financing and adequate protection constitute minimum standards that a secured creditor could rely on and expect in future cases? How will the terms of the individual loans to the SPE Property Owners be modified in connection with the confirmation of the plan of reorganization, and how will corporate separateness be handled at that time? What effect will the case have on the relative views of investment-grade holders versus B-piece buyers in CMBS transactions? Do independent directors have any value or are they just window dressing? What about amortization? Are there possible structural modifications available to address the issues raised by the case? Is there any practical life for single asset real estate bankruptcy in cases involving multiple entities? And what impact will the case have on GGP s future financing efforts that will be essential to its emergence from bankruptcy and successful economic future? The market-wide impact of the court s decisions in this case will take time to play out. Given the centrality of the SPE structure, including independent directors, to commercial real estate finance, possible reactions from the market may include (i) additional or enhanced separateness covenants contained in loan documents and borrower organizational documents; (ii) tighter lender consent requirements with respect to the appointment and removal of directors; (iii) stepped up loan surveillance practices that better monitor compliance with the separateness covenants; (iv) provisions to make cash management arrangements more stringent and hence more onerous; and (v) additional recourse provisions relating to cash management and surveillance matters. In the short term, these remedial measures, taken together with any step-up in risk premium from greater uncertainty in underwriting as pertains to enforcement of remedies, could result in an increase in the cost of capital flowing to commercial real estate. The specific impacts of any conservative shift in approach from the rating agencies 13 or any negative impact on title coverages or costs could create additional pressures. It is appropriate to consider these strategies, but as the case is still in its early stages (assuming the court refuses to grant the motions to dismiss), it is too early to design solutions when we are not entirely sure about the true scope of the problem. Longer term, one can hope that the markets for commercial real estate finance, which survived in recent years the 1998 liquidity crisis and 9/11, together with the ensuing terrorism insurance concerns, will again prove resilient, leading market participants toward innovations or refinements, from loan structuring and underwriting to surveillance and servicing to legislative relief, that are needed for capital to flow to commercial real estate. The unique and challenging set of facts presented by the GGP case may not be duplicated again, but they will likely continue to resonate. 13 See Press Release, Fitch Ratings, Fitch: SPE Structure Holds up in GGP Ch. 11 but Adds Costs to U.S. CMBS Trusts (May 21, 2009); Daniel B. Rubock, Saved by the Bell: GGP Bankruptcy Judge is Able to Duck the DIP Question, But Firmly Tackles Cash Collateral, Moody s Structured Finance, May 15,

8 If you would like to receive future Real Estate Finance & Investment Advisories electronically, please forward your contact information including address to Be sure to put subscribe in the subject line. If you have any questions or would like additional information please contact your Alston & Bird attorney or any of the following: Joseph Philip Forte Carson Leonard Simon B. Burce ATLANTA One Atlantic Center 1201 West Peachtree Street Atlanta, GA CHARLOTTE Bank of America Plaza Suite South Tryon Street Charlotte, NC DALLAS Chase Tower Suite Ross Avenue Dallas, TX LOS ANGELES 333 South Hope Street 16th Floor Los Angeles, CA NEW YORK 90 Park Avenue New York, NY RESEARCH TRIANGLE Suite Beechleaf Court Raleigh, NC SILICON VALLEY Two Palo Alto Square Suite El Camino Real Palo Alto, CA VENTURA COUNTY Suite Townsgate Road Westlake Village, CA WASHINGTON, D.C. The Atlantic Building 950 F Street, NW Washington, DC Alston & Bird llp 2009