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Partnership and LLC Bankruptcies: Unique Legal Issues

Navigating Partner or Entity Insolvency Amid Inconsistent and Confusing Treatment Under the Code

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WEDNESDAY, JUNE 13, 2012

Presenting a live 90-minute webinar with interactive Q&A

Rosa J. Evergreen, Attorney, Arnold & Porter, Washington, D.C. Robert N. H. Christmas, Partner, Nixon Peabody, New York Ken Samuelson, Partner, Samuelson Law Offices, Washington, D.C.

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Partnership and LLC Bankruptcies

Ken Samuleson Samuelson Law Offices ksamuelson@samuelson-law.com 202.494.0848

Please download or print the PDF Reference Material document prepared by Mr. Samuelson as his presentation will follow this document. You can also access corresponding pages from the PDF Reference Material during the program on the webinar platform under the handouts tab in the Conference Material section.

The other

Members don’t care about your bad boy guaranty. File the LLC.

6

More than

just a charging

• rder. I got

it all.

7

Junior “member” without much power: Your time will come!

8

If you do a

workout instead, I’ve got a present for you.

9

Partnership and LLC Bankruptcies Unique Legal Issues

Stafford Publications CLE Teleconference – June 13, 2012

Rosa J. Evergreen Arnold & Porter LLP 555 Twelfth Street, NW Washington, DC 20004 -1206 Rosa.Evergreen@aporter.com 202-942-5572

Characteristics of a Partnership

• Relationship governed by state law/agreement.
• Laws of agency: general partner is an agent for the

partnership.

• “Bundle of rights”:

– Rights in specific property of the partnership – Rights in his or her “partnership interest” – Rights to participate in management of the partnership

11

Partner/Member Bankruptcy Issues Generally Not Specifically Addressed in the Bankruptcy Code

• Bankruptcy law is focused on business/company and

individual bankruptcy filings.

• The Bankruptcy Code generally does not specifically deal with

the issues raised when a partner or member files for bankruptcy.

• Partner/Member issues addressed mostly in case law.

12

Unique Issues Raised by the Bankruptcy Filing of Partner/Member

• Partner/Member bankruptcy filings raise unique legal issues,

including:

– What are “estate” interests – Whether the bankruptcy filing leads to the dissolution of the partnership/LLC – Whether the partner/member can retain his or her management rights after the bankruptcy filing – Impact of section 365 on partnership and LLC agreements – Implication of ipso facto provisions – Impact of bankruptcy filing on right of first refusal provisions – Applicability of buy-out provisions in bankruptcy

13

Section 541: Property of the Estate

• Upon the filing of a petition in bankruptcy, a bankruptcy

“estate” is created pursuant to section 541 of the Bankruptcy Code.

• The bankruptcy “estate” consists of all equitable and legal

interests the debtor has, including property and contractual rights.

14

Management of the Estate

• The estate is managed by the debtor itself, as a “debtor in

possession” or by a trustee appointed by the court.

• “The statutory and decisional authority is clear that a

bankruptcy trustee is the successor to property of the debtor’s estate and is the legal representative of the estate. The Trustee succeeds to the property of the debtor’s estate.” In re Modanlo, 412 B.R. 715 (Bankr. D. Md. 2006).

• The debtor in possession’s/trustee’s duty is to serve the

estate for the benefit of creditors.

15

Management Rights When Partner/Member Files Bankruptcy?

• The status of the management rights is often a contested

issue when the partner/member files bankruptcy.

• The filing of bankruptcy by the partner/manager, if found to

result in dissolution or termination of partnership/LLC interest, may preclude trustee from assuming the contractual rights of the partner/manager, including management rights.

16

Effect on Partnership or LLC When Partner/Member Files Bankruptcy?

• Possible dissolution of partnership or LLC.
• Under the Uniform Partner Partnership Act (UPA), the

bankruptcy of a partner generally dissolves the general partnership.

• Applicable state laws frequently provide for dissolution of LLC

if a member files bankruptcy.

• Dissolution provisions often conflict with federal bankruptcy

law principles.

• Disagreement among the courts on whether dissolution

provisions should be given any effect in bankruptcy.

17

Courts Do Not Agree on Whether Dissolution Provisions Should Apply

• In re Sawyer , 130 B.R. 384 (Bankr. E.D.N.Y. 1991): finding

that under New York law, the filing of a chapter 7 case by the general partner resulted in dissolution of the partnership.

• In re Modanlo, 412 B.R. 715 (Bankr. D. Md. 2006): finding that

the filing of bankruptcy by sole member of LLC dissolved the LLC by operation of law, but chapter 7 trustee “resuscitated” the LLC by filing amendment to operating agreement.

• In re Clinton Court, 160 B.R. 57 (Bankr. E.D. Pa. 1993):

general partner’s prior filing of a bankruptcy petition did not dissolve general partnership and, therefore, did not bar non- debtor general partner from filing subsequent bankruptcy petition on behalf of the partnership.

18

Transferability of Rights to the “Estate”

• Economic rights/benefits v. management rights:

– In re Garrison–Ashburn, L. C., 253 B.R. 700 (Bankr. E.D. Va. 2000): “[t]here is no question that the economic rights, that is the membership interest, becomes property of the estate.”

• What becomes property of the estate when a member/partner

files bankruptcy depends on the facts and circumstances:

– Applicable state law and/or the operating agreement of partnership or LLC may provide that any partner or manager who files for bankruptcy withdraws from the partnership or LLC. – Enforceability of such provisions subject to debate among the courts.

19

Withdrawal Provisions Enforceable?

• Bargained for rights/personal nature of management

agreements.

• Skeen v. Harms, 10 B.R. 817 (Bankr. D. Colo. 1981):

– “A general partner is in a fiduciary relationship with the limited partners. It is important that he have no conflict of interest. Moreover, an agreement among partners is unique in the law. It is not only a legal relationship, but it is also a personal relation or status, somewhat as marriage is a relation or status.” – “When the only general partner in a limited partnership becomes a debtor-in-possession, there is an inherent conflict of interest . . . [h]e is a different entity.”

20

Withdrawal Provisions Enforceable? (cont’d)

• Withdrawal provisions conditioned on the bankruptcy filing

may be unenforceable:

– Section 365(e)(1): ipso facto provisions prohibited. – Section 541(c)(1)(B) states in pertinent part that “an interest of the debtor in property becomes property of the estate. . . notwithstanding any provision in an agreement . . . that is conditioned . . . on the commencement of a case . . . .”

21

Public Policy Reasons for Withdrawal After Bankruptcy Filing

• Partners and members have voluntarily associated in the

business.

• Partnership/LLC may be formed by unique and personal

relationships.

• Partnership/LLC often a closely held entity.
• Possibility of competing interests of management and the

bankruptcy “estate.”

22

Implication of Transfer of Management Rights on Multi-Member LLC

• In re Albright, 291 B.R. 538 (Bankr. D. Colo. 2003): finding

because there were no other members in the LLC, the trustee

• btained all of the debtor’s rights, including the right to control

the management of the LLC.

• In re Milford Power Company v. PDC Milford Power, 866 A.2d

738 (Del. Ch. 2004): finding clause that deprived debtor minority member of its ability to participate as a member in the governance of the LLC enforceable and discussing the policy justifications for such clauses.

• In re Modanlo, 412 B.R. 715 (Bankr. D. Md. 2006): finding

trustee could continue to participate in management, but noting the result may have been different if there were other members.

23

Considerations Related to Transferability

• f Management Rights
• Transferability of debtor’s management rights depends on a

variety of factors, including:

– Nature of the operating agreement – Applicable state law – Whether or not other members can be compelled to accept performance from a third party – Case law precedent/jurisdiction – Unique aspects of specific partnership/LLC and/or partner/manager – Whether any party objects

24

Ability to File Involuntary Petition Against Partnership/Company

• Split of authority as to whether a partner/member who is a

debtor him or herself in bankruptcy has the authority or standing to file petition for the partnership/company.

• In re H & W Food Mart, LLC, 2011 WL 6989927 (Bankr. N.D.

Ga.): a bankruptcy petition filed on behalf of a Georgia limited liability company was not authorized as the operating agreement specifically provided that the manager ceased to be a manager on the occurrence of filing bankruptcy.

• In re A-Z Electronics, LLC, 350 B.R. 886 (Bankr. D. Idaho

2006): debtor’s managing member, who had filed for chapter 7 relief, lacked authority to file chapter 11 petition for the limited liability company but the chapter 7 trustee had standing.

25

Assumption/Rejection of Executory Contracts

• Section 365 of the Bankruptcy Code permits the debtor-in-

possession/trustee to assume or reject executory contracts.

• Executory contracts are often defined as a contract where

material performance by both sides remains.

– The term “executory contract” in the Bankruptcy Code refers to a contract

• n which performance remains due to some extent on both sides. In re

Mirant Corp., 440 F.3d 238 (5th Cir. 2006). – Countryman test: an executory contract is “a contract under which the

• bligation of both the bankrupt and the other party are so far unperformed

that the failure of either to complete performance would constitute a material breach excusing the performance of the other.”

• Executory contracts may include management agreements,

leases, operating agreements, etc.

26

Executory Nature of Partnership Agreements & LLC Agreements

• Courts have differing views of whether partnership

agreements and LLC agreements are executory contracts:

– A number of courts have held that partnership agreements and LLC agreements are executory contracts. – Other courts have found that partnership agreements and LLC agreements are not executory contracts.

27

Executory Nature of Partnership Agreements & LLC Agreements (Cont’d)

• In re Ehmann, 319 B.R. 200 (Bankr. D. Ariz. 2005): noting that courts consider, in deciding

whether the agreement is executory, whether there is “some material obligation owing to the company by the member.”

• In re Prebul, 2011 WL 2947045 (Bankr. E.D. Tenn. Jul. 19, 2011): commenting that

“[w]here the operating agreement imposes no duties or only remote and hypothetical duties, it is not an executory contract” and “where the operating agreement both requires

• ngoing capital contributions and imposes management duties, it has often been deemed

executory.”

• In re Allentown Ambassadors, Inc., 361 B.R. 422 (Bankr .E.D. Pa. 2007): providing that

“[i]n this inquiry, the four corners of the parties' agreement are examined to determine whether both parties have material, unperformed obligations as of the commencement of the bankruptcy case.”

• In re Tsiaoushis, 383 B.R. 616 (Bankr. E.D. Va. 2007) aff’d 2007 WL 2156162 (E.D. Va.

July 19, 2007): “[t]he analysis used to determine whether a particular limited liability company operating agreement is an executory contract under Bankruptcy Code § 365(e)(1) is clear . . . [t]here is no per se rule . . . [e]ach operating agreement is separately analyzed.”

28

Section 365(c)(1)

• Section 365(c)(1) provides that a trustee is unable to assume
• r assign an agreement if applicable nonbankruptcy law

excuses the nondebtor party from accepting performance from an “entity other than the debtor or debtor in possession.”

• The classic example is “personal services” contracts, which

contracts courts generally agree cannot be assigned.

• State law – i.e., applicable nonbankrupcty law - often prohibits

the assignment of a member’s/partner’s management agreement.

29

Differing Tests Under Section 365(c)(1)

• “Hypothetical Test”: non-consensual assumption of an

executory contract or unexpired lease barred where applicable nonbankruptcy law would prevent assignment to a hypothetical third party.

• “Actual test”: nonconsensual assumption of an executory

contract or unexpired lease prohibited only where applicable nonbankruptcy law precludes the assignment of such agreement and the debtor actually intends to assign it.

30

Differing Tests Under Section 365(c)(1) (Cont’d)

• Courts examine the “facts and circumstances,” with a focus
• n the type of partner/manager and partnership/LLC at issue.
• In re Antonelli, 148 B.R. 443 (D. Md. 1992): “[a]pplication of

the rule, however, calls for a particularized, practical approach … the question of whether or not management power in a partnership is assignable turns not upon the status which ‘applicable law’ generally accords to partnership agreements but upon the materiality of the identity of the partners to the performance of the obligations remaining to be performed under the partnership in question” (emphasis added).

31

Section 365(e)(1): Ipso Facto Provisions

• Provisions of contracts that modify rights and duties solely on

account of a bankruptcy proceeding are generally unenforceable as ipso facto provisions under section 365(e)(1) of the Bankruptcy Code.

• Provisions that cause a partnership/LLC to dissolve or that trigger

buy-out options solely on account of a bankruptcy proceeding of the partner may be unenforceable as ipso facto clauses.

• Exceptions exist to section 365(e)(1) in the Bankruptcy Code.
• 365(e)(2)(A)(i): “applicable law excuses a party, other than the

debtor, to such contract or lease from accepting performance from

• r rendering performance to the trustee or to an assignee of such

contract or lease, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties.”

32

Ipso Facto Clauses in Partner/Member Bankruptcy Filings

• LaHood v. Covey, 437 B.R. 330 (Bankr. C.D. Ill. 2010):

concluding that the provisions of the operating agreement purporting to place limitations or restrictions on the member’s interest as a result of his bankruptcy filing were unenforceable.

• In re Dixie Management & Inv., Ltd. Partners, 2011 WL

1753971 (Bankr. W.D. Ark. May 9, 2011): finding provision of LLC statute specifying that dissociation results from bankruptcy filing conflicted with federal bankruptcy law and was ineffective.

33

Ipso Facto Clauses in Partner/Member Bankruptcy Filings (Cont’d)

• In re Tsiaoushis, 383 B.R. 616 (Bankr. E.D. Va. 2007) aff'd, 2007 WL

2156162 (E.D. Va. July 19, 2007):

– Chapter 11 trustee filed adversary complaint against LLC of which debtor was a member and sought to enforce the provisions of LLC's operating agreement that provided that the LLC would be dissolved upon the bankruptcy of a member and that, upon dissolution, members could proceed to sell or liquidate LLC's property – LLC’s manager opposed the trustee’s request, asserting that the operating agreement was an executory contract and that the provision for automatic dissolution was an unenforceable ipso facto clause – The court concluded that the operating agreement was not an executory contract and that therefore section 365(e)(1) of the Bankruptcy Code was not applicable – The operating agreement was valid and enforceable

34

Transfer of Economic Interests in Partnership/LLC

• The interest of a general partner/manager in the partnership/LLC

(i.e., profits and surplus) is property of the estate under section 541

• f the Bankruptcy Code.
• The trustee generally will be authorized to transfer partner/member

economic interests – e.g., interests in profits – although, the transfer generally remains subject to the terms and conditions of the agreement and/or applicable non-bankruptcy law.

• Baldwin v. Wolff, 690 N.E. 2d 632 (1st Dist. 1998): finding

bankruptcy trustee could assign limited partner's right to distributions.

• In re Dean, 174 B.R. 787 (Bankr. E.D. Ark. 1994): finding that the

restrictions contained in agreement related to the transfer of interests were not invalidated by any provision of Bankruptcy Code.

35

Right of First Refusal

• Rights of first refusal are generally enforceable unless

triggered by the bankruptcy.

• In re Todd, 118 B.R. 432 (Bankr. D.S.C. 1989): partner
• bjected to sale of partnership interest to third party;

bankruptcy court held that partner’s right under applicable state law to match price offered was valid and enforceable by bankruptcy court.

36

Right of First Refusal: Ipso Facto Clause

• In re The IT Group, Inc., Co., 302 B.R. 483 (D. Del. 2003):

– Applicable law did not excuse members from rendering economic performance to an assignee, therefore, the court concluded that section 365(e)(2)(A) did not apply and the default provision in the agreement was an unenforceable ipso facto provision. – The court concluded, however, that the right of first refusal was not an ipso facto clause; instead, the right of first refusal was triggered by any transfer of interest and not by the member filing for bankruptcy. – Accordingly, assumption and assignment of the debtor’s economic interest was subject to the other members’ right of first refusal.

37

Buy-Out Provisions

• There is disagreement among the courts whether agreed buy-
• ut provisions may be non-enforceable ipso facto clauses.
• Courts generally have concluded buy-out provisions cannot

be abrogated in bankruptcy, unless agreement would operate to effect “a forfeiture, modification, or termination.”

• In re Catron, 158 B.R. 629 (E.D. Va. 1993), aff'd. mem. 25

F.3d 1038 (4th Cir. 1994): holding that section 365(e)(1) did not invalidate the provision in the partnership agreement permitting the non-bankrupt partners to buy out the debtor’s interest upon the debtor’s filing for bankruptcy.

38

Buy-Out Provisions (Cont’d)

• Connally v. Nuthatch Hill Assocs. (In re Manning ), 831 F.2d

205 (10th Cir. 1987):

– Partners entitled under the partnership agreement to buy-out the debtor general partner’s interest in the partnership for a “discount” – i.e., 75%

• f the value of the debtor’s capital account -- which was less than

debtor’s share of the value of partnership. – The Tenth Circuit remanded to the bankruptcy court to examine, among

• ther things, whether there were any ipso facto provisions in the

agreement related to the buy-out.

39

Buy-Out Provisions (Cont’d)

– According to the Tenth Circuit, if “the partners, in fact, did intend to allow a severe penalty upon dissolution by bankruptcy,” ipso facto provisions would likely be implicated. – Given the “discount,” the court found that the buy-out provision may also be prohibited under sections 363(1) and 541(c) as a “modification” of estate property. – The Tenth Circuit noted that “valuing the bankrupt’s interest, not at appreciated fair market value, as is typically done upon the death or incompetency of a partner, but instead at book value produces not only a modification but has the added effect of requiring [the debtor] to virtually forfeit his interest ….”

40

The Buy-Out Price

• Buy-out price may be subject to higher and better offers.
• In re Cutler, 165 B.R. 275 (Bankr. D. Ariz. 1994): buyout

restriction at predetermined price was unenforceable; trustee could sell the estate’s interest to the highest bidder.

• In re Grablowsky, 180 B.R. 134 (Bankr. E.D. Va. 1995):

“While the partnership agreements in the case sub judice are not punitive in that they provide for the purchase of the debtor's interest at the fair market value, they are limiting in derogation of the Bankruptcy Code by purporting to preclude the sale of the interests by the Trustee to third parties who may be willing to pay the estate more than the fair market value for the interests. The estate is entitled to any bonus that may arise from the freedom to sell such interests to any willing purchaser; only in that way can the Trustee realize the greatest value of the assets for the estate.”

41

Partnership and LLC Bankruptcies Unique Legal Issues

Robert N. H. Christmas Nixon Peabody LLP

rchristmas@nixonpeabody.com 212-940-3103

43

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 partnerships, 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 to

insulate the lender or investors from the insolvency and bankruptcy risks of the

• riginal borrower or originator that formed the SPE.
• How?

44

Typical SPE organizational provisions

SPE organizational documents contain provisions intended to isolate SPE assets from risk associated with the assets, liabilities and performance of the parent 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 specified asset or collection of assets; – Enter into mergers, consolidations or dispositions of the asset(s); – Commingle 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; [continued]

45

• 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 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 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. But is this true?

46

GENERAL GROWTH PROPERTIES

• 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 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 – the new directors voted in favor of the filing

47

• II. The first battle – the bad faith motion. Lenders to approximately 20 SPEs

filed motions seeking dismissal of their borrowers’ bankruptcy cases on the 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 distress

• The SPEs failed to negotiate with the lenders prior to filing for bankruptcy
• General Growth improperly replaced the independent managers of the

SPEs with new managers on the eve of bankruptcy

• The SPE debtors cannot confirm a plan over the lenders’ objections

48

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),

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)

– 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
• Guarantees of other financings
• High loan-to-value ratios
• 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

49

• 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

SPEs, 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

interests of creditors – under applicable Delaware law on fiduciary duty in insolvency?

50

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
• bligated to consider the interests of the shareholder, General Growth in

determining whether to authorize a bankruptcy filing. 409 B.R. at 64-65.

• 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. 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 authorized by §18-1101 of the Delaware Limited Liability Co. Act. (Id.)

51

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 corporations – 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 were 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

– Financial health of parent – type of assets and whether they are central/have great importance to parent

52

• III. The second battle – cash collateral/adequate protection.

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.

• 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

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

• perating account. Instead, the funds would be transferred directly from a

lockbox account according to a specific payment hierarchy set forth in the credit agreement.

53

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 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. – 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.

54

Lessons learned on GGP cash collateral: -- Practitioners should focus on provisions that preserve separation.

– SPEs and their affiliates, and their lenders, should carefully look at cash flow and

• ther 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 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

• bligations 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

(continued)

55

Cross-default provisions – 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, 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 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 affiliate’s insolvency would negatively impact its investment in an SPE.

56

General Growth showed that bankruptcy remote is not bankruptcy proof

The 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 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 Code 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 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;

• r (v) intentionally interferes with the lender exercising remedies after an event of default.

– (continued)

• In re Zais Investment Grade Ltd. VII,455 B.R. 839

(Bankr. D.N.J.. 2011)

– a Cayman Islands-based SPE that issued notes in a collateralized debt obligation (“CDO”) transaction. Zais used the note proceeds to buy securities and pledged the securities as collateral for its obligations to the noteholders. – Held: case filed in good faith, and CDO structured to be bankruptcy proof/SPV may be debtor under the Bankruptcy Code.

Delaware does not follow General Growth

• Since General Growth, the Bankruptcy Court in Delaware has ruled in the opposite

direction on a number of grounds, in In re JER/Jameson Mezz Borrower II LLC, 461 B.R. 293 (Bankr. D. Del. 2011).

– Jameson Mezz Borrower II LLC (“Mezz II”) was subject to a UCC auction for Mezz II’s

• nly asset – its membership interest in JER/Jameson Mezz Borrower I, LLC (“Mezz

I”). Prior to the Chapter 11, Mezz II’s sole lenders issued a notice of intention to Mezz

• I. The notice was preceded by the maturity date of Mezz II’s loan, when it became

apparent that Mezz II was unable to repay its debt. – Mezz II was created to acquire a chain of 103 hotels known as the Jameson Inns and Signature Inns for approximately $400 million. – The organizational structure of the debtors included certain operating companies that

• wned real estate and four affiliates known as the mezzanine borrowers, formed for

the sole purpose of borrowing additional funds: (i) Mezz I, the sole member of the

• perating companies; (ii) Mezz II, the sole member of Mezz I; (iii) Mezz III, the sole

member of Mezz II; and (iv) Mezz IV, the sole member of Mezz III.

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• The junior lenders replaced the non-independent directors of the debtors,

and instructed the sole non-independent director of Mezz II to file a voluntary chapter 11 petition (on the eve of the auction). Mezz I, III and IV filed petitions about a week later.

• The Motion: Days after Mezz II filed its petition but before Mezz I and the
• perating companies filed theirs, Mezz II’s lenders moved to dismiss Mezz

II’s petition and to obtain stay relief to foreclose on their collateral. They sought to dismiss Mezz II’s petition with prejudice pursuant to sections 1112(b) and 349(a) of the Code, arguing that the petition was filed in bad faith as a litigation tactic designed to forestall the foreclosure. Mezz II contended, however, that the petition was filed in good faith with an honest intent to reorganize its affairs and maximize its value for its constituents.

• Holding: case dismissed with prejudice

– The court considered many of the same factors as the GGP court, but concluded that the case had been filed for an improper purpose: Mezz II (i) had only one

asset (the interest in Mezz I); (ii) had few, if any unsecured creditors who, if they existed, were not pressuring Mezz II before the filing; (iii) had no ongoing business

• perations or employees; (iv) filed the petition on the eve of foreclosure, solely to
• btain the automatic stay; (v) had no cash or income; and (vi) had no opportunity of

reorganization because its sole lenders would opposed any plan of reorganization. – The case was a two-party dispute between Mezz II’s lenders and lenders to Mezz II’s

• affiliate. The court also found compelling a statement by Mezz II’s sole non-

independent director, who admitted that the Mezz II bankruptcy petition was filed to stop its lenders’ UCC sale and that the primary beneficiaries of the bankruptcy filing were its affiliates’ lenders. – While the bankruptcy court concluded that it should (as Mezz II argued) consider the debtors as a group, absent substantive consolidation, Mezz II had no chance of confirming a plan over its lenders’ objection because the lenders were its only

• creditors. There would be no accepting class of any plan it proposed. Further, Mezz II

presented no evidence that more value would be realized in bankruptcy. – Absent good faith and a legitimate purpose, there was cause under section 349(a) to dismiss with prejudice. In addition, the Mezz II lenders were entitled to relief from the automatic stay under section 362(d)(1) as their interests were not adequately protected, and under section 362(d)(2) that the lenders’ collateral was not necessary for an effective reorganization – as one was not possible.

• There were some differences in the facts:

– The timing of the filing of the petition. In GGP, the SPE debt had not yet matured and the debtors had extensively investigated restructuring

• ptions. In Mezz II, the debt had matured and creditors were in the

process of foreclosing before the filing.

• Therefore, while GGP seems to encourage the filing of a chapter 11

petition sooner rather than later, Mezz II illustrates the dangers of filing too late. – Unlike GGP, Mezz II only had one creditor and one asset, and therefore could not cram down a plan over the Mezz II lenders’ objections. In GGP, two of the moving lenders actually acknowledged that there was a reasonable likelihood that the debtors could successfully reorganize.

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The “Bad Boy” or “Non-Recourse” Guaranty Although most CMBS loans are non-recourse, parties commonly carve

• ut 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 maintain 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 adequately compensated – particularly with a creditworthy guarantor that is itself unwilling to 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 court. – 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 law. – Because the plain language of the guaranty agreement allowed no right of

• ffset 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.

• Also – there are obvious conflicts if a director is also a “bad boy” guarantor

• - but they are enforced
• Bank of Am. v. Lightstone Holdings, LLC, 32 Misc. 3d 1244[A], 2011 N.Y.
• Misc. LEXIS 4412, 2011 NY Slip Op 51702[U] (Sup. Ct., New York Cty.,

2011)(Extended Stay principal and developer liable on guaranty that made guarantors liable upon the borrower's bankruptcy filing).

• UBS Commercial Mortg. Trust 2007-FL1 v. Garrison Special Opportunities

Fund L.P., 33 Misc. 3d 1204[A], 2011 N.Y. Misc. LEXIS 4634, 2011 NY Slip Op 51774[U] (Sup. Ct. N.Y. Cty. 2011) (same judge and holding as Lightstone -- guaranty that made guarantors liable upon the borrower's bankruptcy filing).

• Wells Fargo Bank, N.A. v. Cherryland Mall L.P. and Schostak, 295 Mich
• App. 99, 2011 Mich. App. LEXIS 2360 (Ct. App. 2011) (court enforced

springing recourse provisions based on failure to maintain SPE status and SPE’s solvency). -- Note, the decision was retroactively overturned by the legislature, while the lender has promised a legal battle over its

• constitutionality. (Footnote: the bad boy’s brother was state-wide GOP

chairman, but legislative leaders disclaimed his involvement in the bill’s passage.)

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• GGP is not the first case involving independent directors and bankruptcy. GGP built
• n 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)

– 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 Held: – 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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Other potential issues

• Substantive consolidation.

– In re Central European Industrial Development Company LLC, 288 B.R. 572 (Bankr. N.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 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 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

• 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).