Presenting a live 90‐minute webinar with interactive Q&A Partnership and LLC Bankruptcies: Partnership and LLC Bankruptcies: Unique Issues Under the Code Navigating the Fallout from Partner or Entity Bankruptcy T d ’ f l f 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific WEDNESDAY, JANUARY 5, 2011 T oday’ s faculty features: Mark E. Leipold, Partner, Gould & Ratner, Chicago Robert N. H. Christmas, Partner, Nixon Peabody, New York John Collen, Partner, Tressler, Chicago The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
Transcript
Presenting a live 90‐minute webinar with interactive Q&A
Partnership and LLC Bankruptcies: Partnership and LLC Bankruptcies: Unique Issues Under the CodeNavigating the Fallout from Partner or Entity Bankruptcy
Robert N. H. Christmas, Partner, Nixon Peabody, New York
John Collen, Partner, Tressler, Chicago
The audio portion of the conference may be accessed via the telephone or by using your computer's speakers.Please refer to the instructions emailed to registrants for additional information. If you have any questions,please contact Customer Service at 1-800-926-7926 ext. 10.
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Copyright, 2010
By JOHN COLLEN
PREPARED FORPARTNERSHIP AND LLC BANKRUPTCIESPARTNERSHIP AND LLC BANKRUPTCIES
CLE WEBINARJanuary 5, 2011
Sponsored ByStrafford Legal Teleconferences
#356717
About the AuthorJohn Collen is a partner in the Chicago office of Tressler, LLP, where he heads the firm’s Insolvency, Restructuring and Workouts practice. He is an adjunct professor in the Bankruptcy LLM Program at St John’s Lawan adjunct professor in the Bankruptcy LLM Program at St. John’s Law School in New York, where he teaches Partnership and LLC Bankruptcies. He is a widely published author and frequent speaker on bankruptcy topics. He is a fellow of the American College of Bankruptcy,bankruptcy topics. He is a fellow of the American College of Bankruptcy, and is included in Illinois Super Lawyers®, and in Marquis Who’s Who in American Law.
John can be reached at jcollen@tresslerllp com or by phone at (312) 627John can be reached at [email protected] or by phone at (312) 627-4193.
John Collen Partner
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John Collen, PartnerTressler LLP
233 S. Wacker Drive, 22nd Floor Chicago, Illinois 60606
I. STATE LAW GENERALLYAPPLIES POST PETITIONAPPLIES POST-PETITION 28 U.S.C. §959(b) provides:
“Except as provided in section 1166 of title 11, a trustee, receiveri t d i di i t f thor manager appointed in any cause pending in any court of the
United States, including a debtor in possession, shall manageand operate the property in his possession as such trustee,receiver or manager according to the requirements of the validl f th St t i hi h h t i it t d i thlaws of the State in which such property is situated, in the samemanner that the owner or possessor thereof would be bound todo if in possession thereof.”
28 U.S.C. §959(a) provides in part:
”Trustees, receivers or managers of any property, including debtorsin possession, may be sued, without leave of the court appointingthem with respect to any of their acts or transactions in carrying onthem, with respect to any of their acts or transactions in carrying onbusiness connected with such property.”
John Collen Partner
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John Collen, PartnerTressler LLP
233 S. Wacker Drive, 22nd Floor Chicago, Illinois 60606
II. THE CODE TRUMPS STATE LAW AUTHORIZING GOVERNMENT DISCRIMINATION 11 U.S.C. §525(a) provides, in relevant part:
“ a governmental unit may not deny revoke suspend or refuse to renew a license permit. . . a governmental unit may not deny, revoke, suspend, or refuse to renew a license, permit, charter, franchise, or other similar grant to, condition such a grant to, discriminate with respect to such a grant against, deny employment to, terminate the employment of, or discriminate with respect to employment against, a person that is or has been a debtor under this title or a bankrupt or a debtor under the Bankruptcy Act, or another person with whom such bankrupt or debtor has been associated solely because such bankrupt orwhom such bankrupt or debtor has been associated, solely because such bankrupt or debtor is or has been a debtor under this title or a bankrupt or debtor under the Bankruptcy Act, has been insolvent before the commencement of the case under this title, or during the case but before the debtor is granted or denied a discharge, or has not paid a debt that is dischargeable in the case under this title or that was discharged under the Bankruptcy Act ”Bankruptcy Act.
§525 is a corollary to §1108, which provides that “Unless the court . . . orders otherwise . . . the trustee may operate the debtor’s business” in a chapter 11 case11 case.
John Collen Partner
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John Collen, PartnerTressler LLP
233 S. Wacker Drive, 22nd Floor Chicago, Illinois 60606
III. PROPERTY OF THE ESTATE:CODE TRUMPS STATE LAW In general, “property of the estate” is “all legal and equitable interests in property, wherever located”. 11
U.S.C. §541(a). (Individual debtors can exempt certain property, not relevant here).
The definition is expansive, and is designed to facilitate a comprehensive administration of property for benefit of creditorsbenefit of creditors.
11 U.S.C. §541(c) provides: “1. Except as provided in paragraph (2) of this subsection, an interest of the debtor in property becomes
property of the estate under subsection (a)(1), (a)(2), or (a)(5) of this section notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law –(A) that restricts or conditions transfer of such interest by the debtor; or(B) that is conditioned on the insolvency or financial condition of the debtor, on the
commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in
tproperty.
2. A restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.”
This negates claims prohibiting the transfer of property to a trustee or to a bankrupt if such claims would vitiate a filing.g
John Collen Partner
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John Collen, PartnerTressler LLP
233 S. Wacker Drive, 22nd Floor Chicago, Illinois 60606
IV. ARE LOAN PROVISIONS REQUIRINGOUTSIDE DIRECTOR APPROVAL TO FILE
BANKRUPTCY ENFORCEABLE? Short answer is: “yes, but directors must act as true fiduciaries, not
as tools of the lender.” This Issue was addressed in the General Growth case, 409 B.R. 43, 64 (Bankr., S.D.N.Y., 2009).
“... If Movants believed that an ‘independent’ manager can serve on a board solely for the purpose of voting “no” to a bankruptcy filingboard solely for the purpose of voting no to a bankruptcy filing because of the desires of a secured creditor, they were mistaken. . . directors and managers are fiduciaries to the corporation, and ordinarily, to the shareholders.”
As an aside, can it ever be a breach of fiduciary duty not to file bankruptcy?
John Collen Partner
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John Collen, PartnerTressler LLP
233 S. Wacker Drive, 22nd Floor Chicago, Illinois 60606
V. IPSO FACTO CLAUSES• In re Morgan Sangamon Partners, 269 B.R. 652 (Bankr. N.D.Ill. 2001) enforced an ipso facto
clause and dismissed a bankruptcy filing of a partnership based on a clause stating that the bankruptcy of a partner dissolves the partnership. The Court’s technical reasoning: §365(e)(2)(A) “revives” ipso facto clauses in contracts falling under §365(c)(1).
Section 365(c)(1) provides:( )( ) p
“The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if --
(1)(A) applicable law excuses a party other than the debtor to such contract or(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment;”
Section 365(e)(1) provides:
“Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be pp y p yterminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on --
John Collen Partner
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John Collen, PartnerTressler LLP
233 S. Wacker Drive, 22nd Floor Chicago, Illinois 60606
(A) the insolvency or financial condition of the debtor at any time before the closing of the g
case; (B) the commencement of a case under this title or; (C) the appointment of or taking possession by a
trustee in a case under this title or a custodian before suchtrustee in a case under this title or a custodian before such commencement.
(2) Paragraph (1) of this subsection does not apply to an executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties ifassignment of rights or delegation of duties, if--
(A)(i) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the trustee or to an assignee of such contract or lease whether or not such contract or leasean assignee of such contract or lease, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(ii) such party does not consent to such assumption or assignment; or
(B) such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor.
John Collen Partner
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John Collen, PartnerTressler LLP
233 S. Wacker Drive, 22nd Floor Chicago, Illinois 60606
“Subject to the provisions of section 365, the trustee may use, sell, or lease property under subsection (b) or (c) of this section, or a plan under chapter 11, 12, or 13 of this title may provide for the use, sale, or lease of property, notwithstanding any provision in a contract, a lease, or applicable law that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title concerning the debtor, or on the appointment of or the taking possession by a trustee in a case under this title or a custodian, and that effects, or gives an option to effect, a forfeiture, modification, or termination of the debtor’s interest in such property.”
Section 541(c)(1) is quoted above.
In re Dougherty Construction Inc 188 B R 607 (D Neb 1995) reached the exact oppositeIn re Dougherty Construction, Inc., 188 B.R. 607 (D.Neb. 1995) reached the exact opposite conclusion in a case involving an LLC. The Court found that individually and collectively, Bankruptcy Code Sections 363(l), 541(c)(1) and 365(e)(1) block the operation state law.
But, see, In re Leo Ehman, 319 BR 200, (Bankr. D. Ariz., 2005): If membership agreement is “ t ” th §365( )(1) li if t th §541( )(1) li“executory,” then §365(e)(1) applies; if not, then §541(c)(1) applies.
So what is an executory contract? The prevailing, but not sole, definition is the “Countryman Definition” -- a contract so far unperformed on both sides that the failure of either side to complete performance would be a material breach.p p
John Collen Partner
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John Collen, PartnerTressler LLP
233 S. Wacker Drive, 22nd Floor Chicago, Illinois 60606
VI. ASSIGNABILITY OF GENERAL PARTNEROR MANAGING MEMBER INTERESTSOR MANAGING MEMBER INTERESTS
Trustee may assume or reject any executory contracts of the debtor. §365(a).
In order to assume an executory contract, trustee must: (a) cure defaults or provide assurance defaults will be cured; (b) compensate or provide assurance of prompt compensation of actual pecuniary loss; and (c) provide adequate assurance of future performance. §365(b).
§365(c)(1) is set forth previously.
• This means personal service contracts can not be assigned over the objection of a non debtor partya non-debtor party
• But, State law may prohibit unreasonably withholding consent. See, In re Schick, 235 B.R. 318 (Bankr. S.D.N.Y. 1999).
• Beware of In re Catapult Entertainment, Inc., 165 F.3d 747 (9th Cir., 1999), prohibiting assumption if assignment is prohibited. Depends on “actual" vs. hypothetical assignee.
John Collen Partner
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John Collen, PartnerTressler LLP
233 S. Wacker Drive, 22nd Floor Chicago, Illinois 60606
“Except as provided in subsections (b) and (c) of this section notwithstanding aExcept as provided in subsections (b) and (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection.”
§365(f)(3) provides:“Notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law that terminates or modifies, or permits a party other than the debtor to t i t dif h t t l i ht bli ti d h t tterminate or modify, such contract or lease or a right or obligation under such contract or lease on account of an assignment of such contract or lease, such contract, lease, right, or obligation may not be terminated or modified under such provision because of the assumption or assignment of such contract or lease by the trustee.”
John Collen Partner
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John Collen, PartnerTressler LLP
233 S. Wacker Drive, 22nd Floor Chicago, Illinois 60606
A [A]n LLC is neither a corporation or aA. [A]n LLC is neither a corporation or a partnership, as those terms are commonly understood Instead an LLCcommonly understood. Instead, an LLC is a hybrid." (In re ICLNDS Notes Acquisition LLC 259 B R 289 292Acquisition, LLC, 259 B.R. 289, 292 (Bankr. N.D. Ohio 2001))
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Member Issues Member Issues
A Single Member LLCA. Single Member LLC1. Partnership: LLC dissolves upon the
bankruptcy of its sole memberbankruptcy of its sole member2. Corporation: Bankruptcy of member would
not cause dissolution of LLCnot cause dissolution of LLC
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3. State Law3. State Lawa. Delaware LLC Statute
1) Continuity.a) *Treated as a corporation: Bankruptcy of sole
member does not cause dissolution of LLC
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2) Springing Members Allowed:a) A member that becomes a member only upon the
bankruptcy or dissolution of another member.(i) A "Springing Member" may be admitted as a ( ) p g g ymember without any interest in the LLC or requirement that it make a capital contribution
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4. In re LaHood, 437 B.R. 330 (C.D. Ill. 2010) , ( )(holding that provisions of operating agreement for LLC, which purported to place limitations or restrictions on debtor'splace limitations or restrictions on debtor s interest as result of his bankruptcy filing, and on which other member relied in asserting that debtor was disassociated from LLC for wrongful conduct and that trustee did not have right to participate intrustee did not have right to participate in the winding-up of LLC, were unenforceable pursuant to the Code)
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1. Bankruptcy trustee of single member LLC1. Bankruptcy trustee of single member LLC can cause liquidation of LLCa. In re Albright, 291 BR 538 (Bankr. D. Colo.
2003).
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III Bankruptcy filing by theIII. Bankruptcy filing by the partnership or LLC entity p p y
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LLC Issues LLC Issues
A BankruptcyA. Bankruptcy1. Voluntary Petitions
a LLC Authority: Authorization to file Voluntarya. LLC Authority: Authorization to file Voluntary Bankruptcy Petition
1) If member-managed and treated as a partnership:a) any "general partner" can file petition 11 U.S.C. §
303(d)b) any non-consenting "general partner" may contest
the bankruptcy filingc) Query: Same considerations for an LLC?
(i) general partner liability( ) g p y
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2) If manager-managed,a) Query: Whether manager has requisite authority to
cause bankruptcy filing or must solicit the members?(i) Tendency -- Corporation
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3) Bankruptcy filing for dissolved LLC to wind up affairs. In re Midpoint Development, LLC, 313 BR 486 (Bankr. W.D. Ok. 2004)a) Analogize to dissolved corporations
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2. Involuntary Petition2. Involuntary Petitiona. Partnership -- then a member who did not join in
the filing of the petition can challenge the bankruptcy filing.
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3. Common Issues:3. Common Issues:a. Executory Contracts:
1) Articles of Organization/Operating Agreementa) Is it Operating executory contracts that can be
rejected?(i) In re Daugherty Constr., Inc., 188 B.R. 607 (Bankr.D.Neb. 1995);
b) Circumvent Bankruptcy Remote Provisions
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c) Yes.(i) In re Daugherty Constr., Inc., 188 B.R. 607 (Bankr.D.Neb. 1995);(ii) Allentown Ambassadors, Inc. v. Northeast ( ) ,American Baseball, LLC, et al. (In re Allentown Ambassadors, Inc.), 361 B.R. 422 (Bankr.E.D.Pa. 2007); (iii) Broyhill v. DeLuca (In re DeLuca), 194 B.R. 65 (Bankr.E.D.Va. 1996) rev'd on other grounds;(iv) Milford Power Co., LLC v. PDC Milford Power, ( ) , ,LLC, 866 A.2d 738, 750 (Del.Super. 2004) Sumlin Const. Co., LLC v. Taylor, 850 So.2d 303 (Ala. 2002)
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d) No.(i) In re Tsiaoushis 383 B.R. 616 (Bkrtcy.E.D.Va.,2007) aff’d on appeal In Tsiaoushis, 2007 WL 2156162 2007 WL 2156162 (E.D.Va.);(ii) Samson v. Prokopf (In re Smith), 185 B.R. 285, 293 (Bankr.S.D.Ill. 1995);(iii) In re Garrison-Ashburn, L.C., 253 B.R. 700 (Bankr.E.D.Va. 2000); and(iv) In re Capital Acquisitions & Mgmt. Corp., 341 ( ) p q g p ,B.R. 632 (Bankr.N.D.Ill. 2006).
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2) Member bankruptcya) What would the impact be of the rejection
(i) Illinois LLC: Member Bankruptcy(a) Disassociating member -- no right to(a) Disassociating member no right to participate management
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3) LLC bankruptcya) Ability to reject operating agreement
(i) Causing a liquidation (M.A.D.)(a) Not debtor/creditor dispute(a) Not debtor/creditor dispute(b) Member-Member dispute
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b. Members/Managers/LLC fiduciary duties g yvariable (Delaware)
of good faith and fair dealing(i) In re Regional Diagnostics, LLC v. Zelch, 372 B R 3 28 30 (Bkrtcy N D Ohio 2007B.R. 3, 28-30 (Bkrtcy. N.D. Ohio 2007(ii) Majkowski v. American Imaging Management Services, LLC, 913 A.2d 572, 593 (Del. Ch. 2006):
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Alter Ego/Piercing the "LLC" VeilAlter Ego/Piercing the LLC Veil
A Some states specifically provide thatA. Some states specifically provide that alter ego applies1 Yes: California/Minnesota1. Yes: California/Minnesota2. Most are silent
B C L G dB. Common Law Grounds1. Piercing the Veil of a Non-Corporate Entity
Ta. Two types1) Creditor2) Trustee (reverse piercing)) ( p g)
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2. Courts, in general, applying corporate law2. Courts, in general, applying corporate law regarding piercing the corporate veil.
a. Two prong test:1) that the parent and the subsidiary operated as a single
economic entity, and
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a) factors include(i) adequately capitalization;(ii) solvency;(iii) payment of dividends or distributions;(iii) payment of dividends or distributions;(iv) maintenance of corporate records;(v) officers and directors (managers) functioned properly;( i) t f liti b d(vi) corporate formalities were observed;(vii) dominant shareholder siphoned corporate funds; and(viii) corporation [LLC] simply functioned as a facade for the dominant shareholder
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2) an overall element of injustice or unfairness is present.
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Planning Issues Planning Issues
A Choice of lawA. Choice of lawB. Limitations on Fiduciary DutiesC Add th it t fil b k t iC. Address authority to file bankruptcy in
LLC Operating Agreement.
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Partnership and LLC BankruptciesUnique Issues Under the Code: NavigatingUnique Issues Under the Code: Navigating
the Fallout from Partner or Entity BankruptcyBankruptcy
IV. Bankruptcy Remote Entities
Robert N H ChristmasRobert N. H. Christmas
Nixon Peabody LLP
Recent increase in use of SPEs
• The past decade has seen a dramatic increase in the use of special-purpose entities (SPEs) in a variety of contexts, including throughout structured finance and securitization markets. SPEs, usually created in the form of LLCs or limited secu a o a e s S s, usua y c ea ed e o o Cs o edpartnerships, are also sometimes referred to as "single-purpose entities" or "bankruptcy remote entities."
• Borrowers and their lenders have believed that using SPEs can provide more credit security to the lender – resulting in lower interest rates to the borrower.
• By using an SPE, an organization seeks to separate cash-producing portions of its business from other, riskier portions of the larger business by transferring the financial assets to an SPE.
• The primary purpose of the isolation and transfer of financial assets to an SPE is toThe primary purpose of the isolation and transfer of financial assets to an SPE is to insulate the lender or investors from the insolvency and bankruptcy risks of the original borrower or originator that formed the SPE.
SPE organizational documents contain provisions intended to isolate SPE assets from risk associated with the assets, liabilities and performance of the
t l t i h lparent or larger enterprise as a whole.
Restrictions may include the ability of the SPE to:
– Engage in any activity other than owning, operating and/or acquiring a g g y y g, p g q gspecified asset or collection of assets;
– Enter into mergers, consolidations or dispositions of the asset(s);
– Commingle assets, including cash flows and other revenue generated byCommingle assets, including cash flows and other revenue generated by the asset(s);
– Incur any debt or guaranty other than the subject loan or trade debt strictly related to it;
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[continued]
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• SPE org. documents restrict filing for bankruptcy protection without the consent of independent directors.
i. SPE organizational documents frequently require that the board of directors include at least one independent director.
ii. SPE organizational documents may also require that the independent director consider the interests of an SPE lender; however, such a provisiondirector consider the interests of an SPE lender; however, such a provision may be limited “to the extent permitted by law.”
iii. For example, directors of a Delaware corporation must be cognizant that direct fiduciary duties are owed to the company, not its creditors. See N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007).
Result: Reduction in the overall cost of borrowing for the originator, on the basis that the use of an SPE (as generally assumed by lenders and investors) lowers the risk of insolvency and therefore lowers the credit risk
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investors) lowers the risk of insolvency and therefore lowers the credit risk.
But is this true?
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GENERAL GROWTH PROPERTIES
I. The business:I. The business:
• General Growth, the second-largest U.S. mall owner, owned and managed more than 200 U.S. malls. It filed for Chapter 11 bankruptcy protection in April, 2009 with $27 billion in debt.
• the filing included 166 SPEs (each an individual mall owner) in the bankruptcy filing.
• independent directors who sat on the SPE boards were dismissed on the eve of the filingeve of the filing– at the mall/property level, the documents had the standard language
requiring independent director approval of a bankruptcy filing.
– the documents did not require notice of dismissal
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the documents did not require notice of dismissal
– the new directors voted in favor of the filing
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II. The first battle – the bad faith motion. Lenders to approximately 20 SPEs filed motions seeking dismissal of their borrowers’ bankruptcy cases on the
d th t th b k t fili i “b d f ith” Th L d ’grounds that the bankruptcy filings were in “bad faith”. The Lenders’ principal arguments were:
• The cases were filed prematurely because the SPEs were not in any immediate financial distressimmediate financial distress
• The SPEs failed to negotiate with the lenders prior to filing for bankruptcy
• General Growth improperly replaced the independent managers of the S fSPEs with new managers on the eve of bankruptcy
• The SPE debtors cannot confirm a plan over the lenders’ objections
4343
The decision: In August, 2009, the bankruptcy court issued a decision denying the motions to dismiss. In re General Growth Properties Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009)
• Judge Gropper rejected the “prematurity” argument on legal grounds (id at 57)Judge Gropper rejected the prematurity argument on legal grounds (id. at 57), holding that SGL Carbon, 200 F.3d 154 (3d Cir. 1999), and other cases cited by the lenders are not relevant because they involve litigation claims and liability itself was speculative
• Judge Gropper also rejected the prematurity argument on factual grounds (id. at 58)g pp j p y g g ( )
– Although the SPEs were current on debt service and none of the loans had a maturity prior to March 2010, Judge Gropper found that the SPEs were in varying degrees of financial distress due to
• Cross defaults to other financings• Cross defaults to other financings
• Guarantees of other financings
• High loan-to-value ratios
U t i t t th t f fi i
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• Uncertainty as to the prospects for refinancing
– declined to establish an “arbitrary rule” that a debtor cannot file a Chapter 11 petition if the debt it is seeking to restructure is not due within one, two or three years
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• On bad faith, the court applied a two-prong test which looks to (i) objective futility in pursuing a bankruptcy filing, and bad faith in filing the petition
– Citing decisions in U.I.P Engineered Products, 831 F.2d 54 (4th Cir. 1987), and In re Mirant Corp., 2005 Bankr. LEXIS 1686, 2005 WL 2148362 (Bankr. N.D. Tex. Jan. 26, 2005), Judge Gropper applied a “family filing” standard
• “Whether to file a Chapter 11 petition can be based in good faith on considerations of the [corporate] group as well as the interests of the individual debtor” 409 B.R. at 63.
• Making frequent reference to General Growth’s reliance on cash flow from the SPE J d G l d t h i th i t f thSPEs, Judge Gropper placed greater emphasis on the importance of the subsidiaries to the health of the bankrupt parent than on the benefits flowing to the subsidiaries from the relationship. Id., at 62-63.
• But what about the directors? Were they not required to look to the
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interests of creditors – under applicable Delaware law on fiduciary duty in insolvency?
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No -- these mall owners were solvent. So, the directors owed duties to the shareholders.
•Judge Gropper held that the directors and managers of the SPEs were obligated to consider the interests of the shareholder, General Growthin determining whether to authorize a bankruptcy filing. 409 B.R. at 64-6565.
•Delaware corporate law provides that the directors of a solvent corporation have fiduciary duties to shareholders, even in the “zone of insolvency”. Id. At 64 (citing N. Am. Catholic Educ. Programminginsolvency . Id. At 64 (citing N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007)).
•The decision discounts modifications to the fiduciary duties of directors and managers contained in the SPEs’ operating agreements and
§18 1101 f C ( )
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authorized by §18-1101 of the Delaware Limited Liability Co. Act. (Id.)
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What are the lessons from the General Growth bad faith motion?
• Better documentation– Creditors should receive advance notice when an independent director is replaced.
– To reduce opportunities for director shopping – and to avoid relationships that might suggest a conflict of interest – independent directors should come from nationally recognized companies that provide such individuals to similar corporationsg p p p
– Require independent directors to have independent advisors
– Spell out the fiduciary duties of independent directors
– Given the court’s note of approval on GGP’s selection of replacement directors who pp pwere familiar with restructuring, a parent/sponsor may be unable to justify removing an already well-qualified independent director with relevant experience and exposure to insolvency.
• Review the context in which SPE operates
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– Financial health of parent
– type of assets and whether they are central/have great importance to parent
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III. The second battle – cash collateral/adequate protection.
The structure:The structure:
• GGP commingled SPE funds in its own account, then used this account to pay all expenses of the SPEs, including those of cash-flow negative ones.
E ti ll it l l d d i t l N tit• Essentially it regularly made unsecured intercompany loans. No entity guaranteed the intercompany loans, and recipients could benefit from the liquidity without providing any collateral.
• However many of the SPE loan documents for SPE debtors in GGP• However, many of the SPE loan documents for SPE debtors in GGP contained “cash-trap” provisions providing that after an event of default, the SPE could no longer upstream some or all of its cash to GGP’s centralized operating account. Instead, the funds would be transferred directly from a lockbox account according to a specific payment hierarchy set forth in the
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lockbox account according to a specific payment hierarchy set forth in the credit agreement.
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The motion:
At the beginning of its chapter 11 case, GGP sought to continue its existing cash management system including upstreaming cash from property level entities into a centralized operating accountsystem, including upstreaming cash from property-level entities into a centralized operating account.
– Since this constituted a use of the SPE lenders’ cash collateral, the property-level SPEs offered the lenders several types of adequate protection, including first priority liens on the intercompany claims for upstreamed cash and the excess cash in the main operating account and second priority liens on certain DIP financing collateral.
The objections:
Many of the SPE lenders objected, claiming that the use of cash generated from their respective SPEs was a violation of the “cashtrap” provisions.
The decision (412 B.R. 609, 610-11 (Bankr. S.D.N.Y. 2009)):– permitted GGP to upstream cash from the property-level entities to the parent
– conditioned the lending of money from one debtor estate to another debtor estate based on providing (a) adequate protection to the lenders of the debtor transferor, and (b) adequate protection from the debtor transferee to the debtor transferor.
Ad t t ti t k th f f i t t t t l d t f ti
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– Adequate protection took the form of interest payments to lenders, payment of operating expenses for the properties, and replacement liens for the lenders.
– Notably, it held the cash-trap provisions did not entitle lenders to receive additional protections to those already afforded by the Bankruptcy Code, and that the SPE lenders’ protection need only be adequate, not identical to protections fixed by prepetition contracts.
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Lessons learned on GGP cash collateral: -- Practitioners should focus on provisions that preserve separation.
SPE d th i ffili t d th i l d h ld f ll l k t h fl d– SPEs and their affiliates, and their lenders, should carefully look at cash flow and other structures that might lead a court to disregard an SPE’s separateness covenants.
– Practitioners can rebut the appearance of inextricable connections by drafting procedures for control of SPE incomeprocedures for control of SPE income.
– all SPE income should pass through a creditor-controlled hard lockbox.
– Debt service and other SPE expenditures paid from lock bock according to a specific priority structure.
– Assuming the SPE continues to generate income, the lockbox mechanism should provide that the cash available from the lockbox will be applied first toward SPE debt obligations in event of parent insolvency.
– The SPE entity itself should have final priority, allowing income to be upstreamed to the parent only after satisfying all ongoing SPE obligations
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the parent only after satisfying all ongoing SPE obligations
(continued)
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Cross-default provisions
corporate separation is undermined if the loan documents provide– corporate separation is undermined if the loan documents provide that the parent’s bankruptcy or insolvency automatically triggers an event of default for an SPE.
When GGP determined which of its SPEs should enter bankruptcy– When GGP determined which of its SPEs should enter bankruptcy, these cross-default provisions helped justify the Chapter 11 filings of the solvent SPEs. (See also GGP, 409 B.R. at 57-58).
• Post GGP provisions should describe a parent’s bankruptcy or• Post-GGP provisions should describe a parent s bankruptcy or insolvency as a possible event of default, to be decided at the sole discretion of the creditor. Such a provision protects creditors against an affiliate’s insolvency but allows them to decide if, and when, an
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affiliate’s insolvency would negatively impact its investment in an SPE.
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General Growth showed that bankruptcy remote is not bankruptcy proof
Th GGP PlThe GGP Plan
• Ultimately, the lenders gained greater control over the SPEs
– at least two independent directors not affiliated with the SPE, and approved by the lenders, were required
– lenders obtained the right to consent to any new or replacement independent director if not employed by a corporate service provider
– for possible future bankruptcy filings for an SPE, the organizational documents utilized provisions under the Delaware Limited Liability Company Act (18-1101 et. seq.) which narrowed the scope of a director’s fiduciary dutiesnarrowed the scope of a director s fiduciary duties
• Independent directors were required (i) to consider only the interest of the SPE as a standalone entity; and (ii) to consider the interests of creditors of the SPE and not consider the interest of the member or any direct or indirect beneficial owner of the member.
– lenders provided advance relief from the automatic stay under section 362 of the Bankruptcy C d i th t f b t b k t filiCode in the event of a subsequent bankruptcy filing.
– The ultimate parent of the SPE agreed to provide a “non-recourse carve-out guarantee” (also known as a “bad boy” guarantee) that would, in addition to customary recourse provisions (i.e., fraud, misappropriation, misapplication, etc.) provide the lenders with full recourse to the parent entity if the SPE (i) files a subsequent voluntary bankruptcy case; (ii) fails to have an i l t b k t di i d ithi 180 d (iii) k i t f th
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involuntary bankruptcy case dismissed within 180 days; (iii) makes an assignment for the benefit of creditors; (iv) admits that it is insolvent or cannot pay its debts as they become due; or (v) intentionally interferes with the lender exercising remedies after an event of default.
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The “Bad Boy” or “Non-Recourse” Guaranty
Although most CMBS loans are non-recourse parties commonly carveAlthough most CMBS loans are non-recourse, parties commonly carve out indemnification and guaranty provisions for losses resulting from the particularly egregious acts of the SPE and its sponsors
– certain acts -- including a voluntary bankruptcy filing or a failure to g y p y gmaintain SPE status, triggers the guaranty
– the guaranty provides additional security for a mortgage loan by ensuring that a lender’s expectations are met or, if the expectation is broken that the lender will have a remedy and be adequatelyis broken, that the lender will have a remedy and be adequately compensated
– particularly with a creditworthy guarantor that is itself unwilling to enter bankruptcy, the “bad boy” guaranty deters the Chapter 11
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enter bankruptcy, the bad boy guaranty deters the Chapter 11 filing of an SPE and prevents actions that could generate significant liabilities for the guarantor
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“Bad Boy” guarantees may be jurisdictionally complicated to enforce
• In re Extended Stay Inc., 418 B.R. 49 (Bankr. S.D.N.Y.2009) – Chapter 11 filing triggered the non-recourse carveout, and purchasers of the
mezzanine debt sought to enforce the guaranty – in state court.
– The guarantors argued that because the state court contract action derived from the bankruptcy, it was a “core” proceeding that should be addressed by the bankruptcy p y, p g y p ycourt.
– The court disagreed, finding that “a claim by a non-debtor against a non-debtor involving guarantees…is external to the bankruptcy process.” The mere fact that bankruptcy was the contingent triggering event did not convert the claim into one “arising under” federal lawarising under federal law.
– Because the plain language of the guaranty agreement allowed no right of offset or indemnity against the borrower, ESH as debtor was isolated from any financial harm relating to the guarantors’ liability. As a result, the court concluded that the bankruptcy estate would be unaffected by the state court action.
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• Also – there are obvious conflicts if a director is also a “bad boy” guarantor
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• GGP is not the first case involving independent directors and bankruptcy. GGP built on prior case law, which shows that the existence of an independent director(s), in and of itself, will not “protect” an SPE’s secured lender(s) against the SPE filing for bankruptcy (or being involuntarily put into bankruptcy).
• Kingston Square 214 B R 713 (Bankr S D N Y 1997)Kingston Square, 214 B.R. 713 (Bankr. S.D.N.Y. 1997)– Secured creditor commenced foreclosure action against eleven debtor SPEs, each of which held
real estate and was controlled by a common principal.
– The independent director appointed by the secured creditor had been general uninvolved in operations and refused to consent to approve a bankruptcy filing against the creditor’s position
– In order to protect the unsecureds and limited partners (all likely wiped out in foreclosure), the debtors’ principal solicited creditors of the SPEs to file involuntary cases
– Lender moved to dismiss the cases as collusive and in bad faith, designed to neutralize the independent director
H ldHeld:
– No illegal collusion or bad faith because (i) the debtors were eligible for relief and (ii) no court order restricted their access to such relief.
– Decision suggests that the independent director had breached fiduciary duty to the SPEs by refusing to consent to a voluntary Chapter 11 petition.
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g y p p
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Other potential issues
• Substantive consolidation.– In re Central European Industrial Development Company LLC, 288 B.R. 572 (Bankr.
N D C lif 2003) fi t t di tl id th b t ti lid ti f SPEN.D. Calif. 2003), first case to directly consider the substantive consolidation of a SPE, the court declined to apply it. See also In re Doctors Hospital of Hyde Park, Inc. 360 B.R. 787 (Bank N.D. Ill. 2007).
• Transferability and valuation of debtor’s economic Interest in any nondebtor partnership or LLCpartnership or LLC
– If SPE is a partner, its partnership interest is property of the estate, but partnership property is not. FDIC v. Howard Shoreline Assocs., 183 B.R. 33, 36 (D. Conn. 1995).
– Most courts that have been confronted with the issue have concluded that a debtor’s economic interest in the partnership or limited liability company i e an interest ineconomic interest in the partnership or limited liability company, i.e., an interest in profits and surplus, is transferable by the trustee but remains subject to the terms and conditions of the partnership/operating agreement or applicable nonbankruptcy law.
– Agreed buy-out prices and analogous provisions, if resulting in a forfeiture, are disguised ipso facto clauses and are not enforceable. Connally v. Nuthatch Hill
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Assocs. (In re Manning ), 831 F.2d 205 (10th Cir. 1987);In re Grablowsky , 180 B.R. 134, 136-38 (Bankr. E.D. Va. 1995); Cutler v. Cutler (In re Cutler ), 165 B.R. 275, 277-80 (Bankr. D. Ariz. 1994).
