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August 24, 2009
REIT and Real Estate Restructurings and Bankruptcies –Further Observations from the Front Lines
As CMBS and other secured real estate lenders and borrowers continue to consider theimplications of the recent ruling in the General Growth (GGP) bankruptcy (see our memo of August 12
), it is worth keeping in mind that even if “bankruptcy remote” special purpose entities(SPEs) are joined in bankruptcy proceedings of REITs and REOCs, the Bankruptcy Code andSPEs’ unique structures should provide SPE creditors with certain protections from some – butcertainly not all – of the risks that bankruptcy entails.“Consolidation” Risk. While the bankruptcy case of an SPE may be
con-solidated (i.e., jointly administered) with that of its parent, this should not be confused with themore fundamental economic risk of
consolidation: the treatment of the assets andliabilities of multiple debtors as if they were assets and liabilities of a single debtor and the at-tendant dilution of the claims of creditors of the more solvent entities (e.g., an SPE with an over-secured mortgage that is not liable on the debt of its parent REIT) by creditors of the less solvententities (e.g., a REIT with corporate-level unsecured debt). Substantive consolidation is rare.Typically, some combination of an inability to distinguish which entity owns particular assets(unlikely in the case of most SPEs) and confusion among creditors as to which entity is obligatedon their claims (also unlikely) is required. Moreover, even in a substantive consolidation case,secured lenders’ liens on assets are respected, although the liens of mezzanine lenders on equityinterests of consolidated entities may not fare as well. The GGP court was not presented with,and made clear it was not addressing, the issue of substantive consolidation. Indeed, the courtdescribed an SPE’s “principal” purpose as being protection from substantive consolidation, incontrast to the avoidance of bankruptcy proceedings.DIP Financing and Cash Collateral Risk. As with all secured creditors of bankrupt enti-ties, mortgage lenders to SPEs in chapter 11 face the twin risks that their liens will be “primed”by providers of post-bankruptcy “DIP financing” and that the cash flow generated by their col-lateral will be employed by the SPE and its affiliate debtors for general corporate purposes, not-withstanding lockbox or similar arrangements. However, secured lenders are entitled to “ade-quate protection” of their interests, giving them some leverage over the terms of any priming orcash collateral usage. In GGP, the debtors did not prime the liens of prepetition lenders but did,after a contested hearing, receive permission to upstream cash generated at SPEs. As adequateprotection, the court granted the SPE lenders, among other things, liens on the intercompanyclaims arising from the upstreamed cash. However, while the intercompany claims have prioritystatus (and need to be paid back in full before any unsecured creditor of GGP can receive anyrecovery), the ultimate ability of the parent to repay these intercompany debts depends in part onthe excess value of the SPEs themselves, which remains to be seen.Cram-Up Risk. The “cramdown” provisions of the Bankruptcy Code (colloquially, in thecase of a secured creditor, “cram up”) permit a plan of reorganization to be approved over thedissent of a class of creditors if the plan is “fair and equitable”. Even an over-collateralized loanneed not be paid off in cash in a bankruptcy case, and in today’s climate of scarce refinancingcapital, non-payment and partial payment have become common. With respect to secured credi-