The United States Bankruptcy Court for the Southern District of New York recently issued a decision that places into doubt the "bankruptcy remoteness" of special purpose entities (SPEs). In General Growth Property Inc.'s (GGP) chapter 11 bankruptcy case, Judge Gropper, on 11 August 2009, rejected five motions to dismiss several special purpose entities (SPE Debtors) from the parent's bankruptcy proceedings. The motions to dismiss were brought by loan servicers ING Capital Loan Services LLC and Helios AMC LLC and lenders Metropolitan Life Insurance Co. (Metlife) and KBC Bank NV (together, the Movants), each of which is a secured lender to one or more of the SPE Debtors.

The primary ground on which dismissal had been sought was that the SPE Debtors' cases were filed in bad faith in that there was no imminent threat to the financial viability of the SPE Debtors.

GGP is a real estate investment trust that owns and manages more than 200 shopping malls in 44 states across the US. A large part of GGP's secured debt consists of mortgage debt, secured by mortgages on over 100 properties, each of which is typically owned by a separate corporate entity, or SPE.

The mortgage debt can in turn be categorised as conventional or as debt further securitised in the commercial mortgage-backed securities (CMBS) market. The bankruptcy court examined three of the mortgages held by Metlife to illustrate the conventional mortgage debt, and found that each of the mortgages was an obligation of a separate SPE Debtor.

These SPE Debtors were intended to operate as SPEs, which are structured in this manner to protect the interests of their secured creditors by measures including separateness covenants and limitations on indebtedness.

The bankruptcy court found that the capital needs of the GGP group had increasingly been met through loans obtained in the CMBS market, and that GGP's business plan had been based on the assumption that it would be able to refinance this debt.

Such refinancing proved impossible with the onset of a crisis in the credit markets, and notably in the CMBS market.

In April 2009, 388 of the GGP group companies (Debtors), including a large number of SPEs, filed voluntary petitions under chapter 11 of the Bankruptcy Code in the Southern District of New York.

Lenders to some of the SPEs had attempted unsuccessfully to prevent GGP from using cash flows to the SPEs as cash collateral and from granting its DIP lenders a lien on accounts that included funds from the SPEs. In this latter case, they sought to have the chapter 11 cases of the SPE Debtors dismissed outright on the grounds that these cases were filed in bad faith.

The principle that a chapter 11 reorganisation case can be dismissed as a bad faith filing is a judge-made doctrine, which is applied "only sparingly and with great caution." (Carolin Corp. v Miller, 886 F.2d 693, 700 (4th Cir. 1989)).

To determine whether a bankruptcy filing was made in good faith, the court must examine the "totality of circumstances, rather than any single factor." (In re Kingston Square Assocs., 214 B.R. 713, 725 (Bankr. S.D.N.Y. 1997)).

The Movants argued that the SPE Debtors' bad faith was evidenced by the fact that the prospect of liability for the SPE Debtors was too remote on the date of their filings. The Movants argued further that the issue of financial distress cannot be examined from the perspective of the group but only on an individual-entity basis.

The bankruptcy court first examined the question of whether the prospect of liability for the SPE Debtors was too remote to justify a chapter 11 filing and found a number of factors, such as the existence of cross-defaults and the existence of hyper-amortisation in the case of one of the loans, that justified the Debtors' determinations that the SPE Debtors were in financial distress. The bankruptcy court noted that these determinations were made in a series of board meetings following substantial financial analysis.

Rejecting the Movants' contention that the Debtors had a good faith obligation to delay a chapter 11 filing until they were temporally closer to an actual default, the bankruptcy court refused to establish an "arbitrary rule … that a debtor is not in financial distress and cannot file a chapter 11 petition if its principal debt is not due within one, two or three years."

The bankruptcy court went on to reject the Movants' contention that the question of financial distress can only be examined on an individual-entity, and not on a group, basis. The bankruptcy court cited a number of cases in support of this decision, including one case that found that it was clearly sound business practice for a parent company to seek chapter 11 protection for its wholly-owned subsidiaries when those subsidiaries were crucial to its own reorganisation plan. (Heisley v U.I.P. Engineered Prods. Corp., 831 F.2d 54 (4th Cir. 1987)). The court accepted that the SPE structure was designed to make each SPE Debtor "bankruptcy remote." The Movants were aware, however, 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. If the ability of the group to obtain refinancing became impaired, the financial situation of its subsidiaries would likely also be impaired.

The bankruptcy court found that the Debtors had established that the filings were designed to preserve value for the Debtors' estates and creditors, including the Movants. While accepting that the Movants had been "inconvenienced" by the chapter 11 filings, Judge Gropper held that inconvenience to a secured creditor is not a reason to dismiss a chapter 11 case, and declined to dismiss the SPE Debtors' cases.

The Commercial Mortgage Securities Association (CMSA) filed a the brief of amicus curiae (Amicus Curiae Brief) in the GGP chapter 11 cases on 1 May 2009, arguing that there are systemic implications to the SPE Debtors filing within the GGP corporate bankruptcy. According to the Amicus Curiae Brief, if GGP were allowed to treat the SPE Debtors and all of the other GGP affiliates as one enterprise with all assets held for the benefit of the collective whole, the consequences could be "disastrous to the world of real estate finance."

Judge Gropper's decision in the GGP case appears to address some of the concerns raised in the Amicus Curiae Brief. Judge Gropper expressly stated that "the fundamental protections that the Movants negotiated and that the SPE structure represents are still in place and will remain in place during the chapter 11 cases." Noting that a principal goal of the SPE structure is to guard against substantive consolidation, Judge Gropper stated that nothing in his opinion implied "that the assets and liabilities of any of the SPE Debtors could properly be substantively consolidated with those of any other entity." Judge Gropper went on to point out that the question of substantive consolidation is entirely different from the issue of whether the board of a debtor that is part of a corporate group can consider the interests of the group along with the interests of the individual debtor when making a decision to file a bankruptcy case.

It is not yet clear how this decision in the GGP case will be treated in any future litigation that raises similar issues. The decision does appear to undermine a key protection that secured lenders to entities structured as "bankruptcy remote" had relied upon in structuring secured transactions, and will likely have an impact on the way that future secured financings are structured.