A recent ruling in the General Growth Properties bankruptcy case has rattled lenders as some fear it might make it easier for real estate owners to bend bankruptcy rules at the expense of their financiers. The ruling, issued by Judge Allan Gropper of U.S. Bankruptcy Court, on Aug. 11, allowed the Chicago-based REIT to include a number of properties held by special purpose entities (SPEs) in its bankruptcy filing, in spite of the fact that the properties in question are not experiencing financial distress.

The ruling is noteworthy because SPEs are supposed to be "bankruptcy remote" vehicles designed to protect individual assets from the consequences of financial distress on a corporate level. As a result, the ruling surprised many in the commercial real estate industry. But while it will likely entail some negative consequences for the lenders in question and for any commercial mortgage-backed securities (CMBS) investors holding bonds backed by the REIT’s SPE-owned assets, real estate lawyers are seeing the case as an anomaly rather than a glimpse of things to come.

“You have to take a step back and realize that there are some unique features in this case you don’t see in a lot of other cases, largely because [the whole company] has filed for bankruptcy protection,” says Adam Weissburg, partner in the finance group of Cox, Castle & Nicholson, LLP, a Los Angeles-based law firm. “If you are not willing to file the entire company, there’s somebody somewhere who may file recourse. So while this case is interesting and may have some implications for certain kinds of transactions, it’s not likely to have earth-shattering implications for most owners.”

The dispute between General Growth and its lenders first came to the fore in early June. Separate lawsuits from creditors including ING Capital Loan Services LLC, Helios AMC, LLC, Metropolitan Life Insurance Company, KBC Bank, N.V. and others asked the court to dismiss bankruptcy filings for several properties held by the REIT through SPEs on the grounds that the filings were made in bad faith because there was no threat to the financial viability of the vehicles. The lenders also argued that since SPEs are supposed to protect performing assets from implications of a corporate bankruptcy filing, their inclusion in the General Growth bankruptcy case would shake the confidence of CMBS investors in SPE vehicles. Furthermore, suits pointed out the debt on the vehicles was not in default and alleged that the SPE's independent directors improperly acted in the interests of General Growth ahead of the interests of the creditors.

General Growth’s lenders are right to be worried, since Judge Gropper’s ruling means any extra cash flow from the assets in question will be used toward restructuring purposes rather than renovations and upgrades that might help preserve the lenders’ investment in those malls, says Henry D. Finkelstein, partner in the real estate practice of Greenberg Glusker, a Los Angeles-based law firm.

What’s more, those properties will now accumulate special servicing fees in spite of having relatively stable cash flows, adds Frank Innaurato, managing director of analytical services with Realpoint LLC, a Horsham, Pa.-based credit rating agency. And if at some point General Growth will decide to sell the assets to raise additional funds, the CMBS investors might not be entitled to the proceeds.

Yet it’s still unclear whether smaller owners outside the protection of a company-wide bankruptcy filing would get the same favorable treatment from the courts.

“I think a lot of people think that this case might be relatively unique to these unusual [circumstances], where there are so many properties and the business operation is so integrated,” says Finkelstein. “It would be very interesting to see if you had a developer with a bad residential project and a good office project and a good industrial project [in an SPE], if the same thing would have happened. Maybe not.”

--Elaine Misonzhnik

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Law firm Wachtell, Lipton, Rosen & Katz distributed two recent commentaries on the ruling. You can read both at the Traffic Court blog.