Substantive Conslidation, CMBS, GGP

June 17th. D-Day for many lenders in the General Growth (GGWPQ) bankruptcy case. Why?

From Reuters:

group of creditors and loan servicers is scheduled to ask U.S. bankruptcy Judge Allan Gropper on June 17 to dismiss about a dozen malls from the case.

Chicago-based General Growth set up each mall as a special purpose entity — a separate company — that protected General Growth from each of the malls’ obligations. Each SPE was be governed by independent directors, and each entity’s cash was to be managed separately. They were intended to be “bankruptcy remote.”

During the hearing next week, the creditors of the SPEs will argue that General Growth put the SPEs into bankruptcy in order to give the company more leverage from which to negotiate loan modifications and extensions.

The commercial real estate and the lending sectors will be watching this hearing and the overall bankruptcy, said experts speaking at the Commercial Mortgage Securities Association conference in New York.

“I think the debtor (General Growth) is inclined to fast track this, and we will have to wait to see what proposals come out short of a dismissal to see if the a negotiated exit is possible,” Cross said.

When General Growth filed for bankruptcy protection in April, it swept 166 of its malls along with it, replacing the directors with new ones who voted to put the SPEs into bankruptcy. The entities in bankruptcy were facing $24 billion of debt, about $15 billion of which consisted of commercial mortgage-backed securities.

The remainder of General Growth’s other 200 or so malls are joint ventures and are not in bankruptcy nor is the General Growth’s management company.

Will the judge rule to consolidate or not?

When a corporation files for bankruptcy, the court must address a fundamental question: Are these entities legally distinct or should they be collapsed?

Substantive consolidation is the pooling of the assets and liabilities of technically distinct corporate entities. For the purposes of confirming a Chapter 11 plan or for liquidating assets under Chapter 7, the creditors of the previously distinct subsidiaries are creditors of a single debtor. Although courts use language akin to “piercing the corporate veil,” the doctrines are quite distinct—instead of pooling assets vertically (e.g. parent and subsidiary), substantive consolidation pools asserts horizontally (e.g. subsidiary and subsidiary).

Is this valid in the GGP Chapter 11? In many instances, yes. What we have brewing is a ruling of the lending agreements vs the actual structure and operations of the SPE. In many instances in the malls in question, there was no defined separate director (or whether or not there was one is debatable) and cash flows were not managed independently from other operations. This enables them to be consolidated under Chapter 11. The consolidation will be done on a mall by mall ruling but expect many to be folder into the current filing.

How does this effect shareholders. Directly, it doesn’t as we only care about the big picture (what is left after debt claims settled). Indirectly, it does. If GGP is victorious in this ruling, they then will have more sway over debtholders. The more debt that can be extended, the stronger the resulting entity that emerges remains. Also, the fewer moving parts in a filing, the faster it is then able to emerge from Chapter 11.

Disclosure (“none” means no position):