Judge Strikes a Blow to SPE Game

That which the lawmakers won't stop, that which the regulators won't stop, the judges just might:

The judge in General Growth Properties Inc.'s bankruptcy case rejected creditors' motions to dismiss several properties from the case, clearing the way for the mall owner to begin talks with its lenders about long-term debt extensions that would eventually allow it to exit bankruptcy court.

In a decision Tuesday, Judge Allan Gropper of the U.S. Bankruptcy Court in Manhattan ruled against the arguments of loan servicers ING Capital Loan Services LLC and Helios AMC LLC and lender Metropolitan Life Insurance Co. The three had separately argued that the General Growth malls they financed with mortgages are structured as individual "special purpose entities" that shouldn't be included in a broad corporate bankruptcy filing.

This entire "SPE" game has been a scam from the outset. Banks and others have used this scheme for years under the claim that the SPEs are "separate" entities.

But they're not - they are sponsored and controlled by the parent - just like any other subsidiary. The same thing holds true for banks that have stuffed somewhere around $2 trillion in tranched "assets" into these SPEs (e.g. credit card receivables, etc) and then have claimed that they should not have to count these as "assets" against their capitalization, thereby avoiding having to reserve against them as well as count them against capital ratios.

The Judge in this case said "NUTS!" and effectively destroyed this argument. All other Commercial Real Estate REITs now have to be considering whether they are also subject to this same treatment (the answer is "Yes!") and what that might mean for them and their investors.

Let me be clear: Off-balance sheet games are nearly always improper. In fact, I'll go so far as to say that they should simply never be allowed. I thought we learned this after ENRON, when the company used these "off balance sheet" games to hide transactions that were non-performing and in fact intended to be shoved under the rug where regulators and investors couldn't find them.

In fact we learned nothing. The banks and REITs ignored the ENRON debacle and regulators and law enforcement ignored it too, never mind that had ENRON been forced to consolidate all of its SPEs and SPVs everyone would have known that the firm was insolvent long before the lights went out.

The rule of law is supposed to protect investors and the general public against scams of various sorts, including attempts to hide losses and shield entities with actual and constructive control from being able to partition off certain pieces of themselves from a general bankruptcy. This is inherent in bankruptcy law and in the protection afforded to all creditors - if you have a subsidiary you have to ask for that subsidiary to be excluded from a bankruptcy, and you must demonstrate that you're not simply engaged in a shell game trying to keep creditors from obtaining their just recovery.

In this case the gambit failed, as, in my opinion, it should have.

It is ironic that more than a decade after ENRON we are forced to depend on Judges to do the job that regulators and lawmakers are charged with - protecting the public and investors from attempts to ramrod various loss-hiding schemes and games through the courts and up the rear ends of investors.

Unfortunately there is no evidence that we're going to see similar care paid to to the SPEs and SPVs that BANKS have put together, and which played prominently in the outrageously-loose extension of credit without reasonable defense throughout the decade from 2001-2007.

This commentator wants to know why not, and why it is that after nearly a decade has passed - plenty of time to force all this game-playing to stop and for these "assets" to be consolidated - we have instead seen banks and other entities expand their use of SPEs and SPVs instead of demanding that this sort of fraudulent accounting STOP.

Comments

[Lew Richards:]

While I would certainly support a greater transparency to these types of transactions, including a ban on such off-balance sheet transactions, it seems to me that there is a larger issue here. The fact is that GGP, when they entered into the arrangements which led to the creation of the SPE's, they knew what the intent of the structure was, agreed to it, and realized that the lenders were counting on it as an important aspect of accepting the risk of those loans. What the Judge in this case has really done, therefore, has said in effect that no one can place trust in any business agreement.
I would also note that a large portion of GGP's arguments in terms of includeing the SPE's was that they were never truely separate; their cash flow was needed to maintain the operating cash flow of the company, cash flow that paid for the salaries and administrative costs of the management and leasing structure that supported the properties. If that argument is true, it begs the question as to why the management company is not a part of the bankruptcy. It would also lead one to ask why they did not put ALL of their entities in bankruptcy, as surely the affiliates involved in their JV's (and the few wholly-owned properties not included in the banktruptcy) are just as interdependent as these.
No, it is obvious that Judge's ruling on the SPE's was not in line with the arguments of this blog, but merely an attempt by the Judge to act in a manner that he considered in the best interests of GGP in its attempts to resolve its bankruptcy issues. This is unfortunate because it creates unintended precedent and undermines a basic tenet of contractural law...that both sides of the contract have a right to depend upon the terms agreed to in the document.

Aug 12 02:17 PM

[malach hamo...:]

the misleading nature of this article derives from a lack of understanding of the initial transactions; there was no SPE used to keep assets off of the balance sheet. the sole purpose of the SPE was to supposedly protect a lender on a specific property isolated in the SPE from being subject to the jurisdiction of the bankruptcy courts were the parent to file.

however, the court has upset that scheme which was not presented to screw the public or mislead anyone; rather it was presented to facilitate a more natural loan on the property which could be made without regard to the creditworthiness of the parent company, GGP

this practice had been challenged in other bankruptcy proceedings; but it wasn't until the GGP case, by far the largest real estate failure of the current meltdown, that a major decision effectively challenged the entire system

lenders had been deluding themselves into thinking that they could insulate their loans from the overall liquidity issues of a multi-property reit. they were just given a very rude wake up call which will reverberate throughout real estate finance for years to come

Aug 12 06:39 PM

[Karl Denninger:]

The misleading happened when these entities created these SPEs in the first place.

There is no separation. The cash flow inures to the benefit of the parent and the parent exerts what amounts to operational control.

The ENTIRE PURPOSE of an SPE is to set up a fiction - a fiction that creates a "heads I win, tails you lose" situation. The law is not supposed to permit this, and in this case the judge saw through the transparent nature of the attempt and said "nope!"

The claim that lenders "relied" on this is immaterial. You can't make an agreement to do an unlawful thing, no matter how many people agree.

THe judge didn't "rewrite" anything - he disallowed what has become a pernicious SCAM, and it is about time this sort of nonsense was stopped.

If you want a completely separate company then set one up with a separate funding path and separate means of raising capital and exerting control.

The entire purpose of the SPE is to trade on the "superior" credit quality of the parent WHEN TIMES ARE GOOD but pretend there is no connection WHEN TIMES ARE BAD.

That sort of nonsense must stop.

Aug 13 08:12 AM

[Lew Richards:]

Again, I would have to disagree with the author. That the lenders relied on the integrity of the structure is definitely relevant. Previously, a lender would have instituted other protections in their pursuit of balancing their risks...whether that be recourse, guarantees, or whatever. In these cases, the borrowers agreed to trade the protections the SPE's were to provide so as not to allow the lenders to access their other assets. The SPE's not only protected the lenders from the issues of the parent, they also would prevent the lenders from going after other assets of the borrowers should the project fail and the SPE default on their loan. This seems like a fair trade to me and nothing at all devious. The Judge in this case chose to ignore the basis of the transaction in order to favor the borrower...and, by extension, the other creditors of the borrower.

Aug 13 09:49 AM

[REITBull:]

Karl,

I would have to agree with the first two posters on this. I do not agree, in this case, that the entire purpose of the SPE was to set up a fiction. The SPE is used to secure the lender's right to the property it is lending against. In turn, it limits GGP's exposure if they were to default on debt service. Had GGP defaulted on a loan, the lenders would only have a right to the property in the SPE and could not go after GGP's other assets. The SPE was suppose to protect both parties. I do agree that seperate funding paths should have been used and is probably what hurt the lender's argument in this case (I haven't read the ruling yet). But I do not think it should have been enough to overrule the loan covenants. Had the tables been turned and GGP walked away from a property, do you think the judge would have allowed the secured lenders to go after GGPs other assets?

Aug 13 10:10 AM

[REITBull:]

Lew-Sorry for rehasing your argument. I didn't see it before I posted.


On Aug 13 09:49 AM Lew Richards wrote:

> Again, I would have to disagree with the author. That the lenders
> relied on the integrity of the structure is definitely relevant.
> Previously, a lender would have instituted other protections in their
> pursuit of balancing their risks...whether that be recourse, guarantees,
> or whatever. In these cases, the borrowers agreed to trade the protections
> the SPE's were to provide so as not to allow the lenders to access
> their other assets. The SPE's not only protected the lenders from
> the issues of the parent, they also would prevent the lenders from
> going after other assets of the borrowers should the project fail
> and the SPE default on their loan. This seems like a fair trade to
> me and nothing at all devious. The Judge in this case chose to ignore
> the basis of the transaction in order to favor the borrower...and,
> by extension, the other creditors of the borrower.

Aug 13 10:16 AM

[Securitizer:]

The author is completely wrong in this instance. The remaining commentators are correct in all respects.

Aug 13 12:46 PM

[REITBull:]

I just had the opportunity to read the ruling and it is much more limited in scope than I originally thought. The ruling was limited to whether or not GGP acted in good faith when including the SPE's in the parent company BK. There is a key quote on page 42: "Nothing in this
Opinion implies that the assets and liabilities of any of the Subject Debtors could properly be substantively consolidated with those of any other entity." The ruling, while not ideal for the SPE lenders, does not appear to adversely effect their lien positions.

Aug 13 03:57 PM

[Lew Richards:]

If the assets and liabilities cannot "be substantively consolidated with those of any other entity," does that not imply that each of the SPE's is, effectively, a stand alone bankruptcy? And if that is the case, and the lenders and the SPE cannot reach agreeable terms on an extension and/or reduction in debt so that at the proper time those assets can reasonably be refinanced (remember that many of the loans on these SPE's do not come due until 2010 and beyond), does that not imply that the lenders can effectively force GGP to sell the underlying real estate in order to satisfy the loan regardless of how the parent company bankruptcy evolves? I guess I'm not sure, based on what you have quoted, what the Judge's ruling really did other than to allow the SPE's to enter bankruptcy (which, individually, they could always do) earlier than would have been anticipated under more ordinary circumstances.


On Aug 13 03:57 PM REITBull wrote:

> I just had the opportunity to read the ruling and it is much more
> limited in scope than I originally thought. The ruling was limited
> to whether or not GGP acted in good faith when including the SPE's
> in the parent company BK. There is a key quote on page 42: "Nothing
> in this
> Opinion implies that the assets and liabilities of any of the Subject
> Debtors could properly be substantively consolidated with those of
> any other entity." The ruling, while not ideal for the SPE lenders,
> does not appear to adversely effect their lien positions.

Aug 13 04:15 PM

[REITBull:]

"If the assets and liabilities cannot "be substantively consolidated with those of any other entity," does that not imply that each of the SPE's is, effectively, a stand alone bankruptcy?"

That is a good point Lew and I don't know what the precedent is. My personal feeling is that the SPE lenders should have the right to foreclose and sell to satisfy the loan if reasonable terms cannot but reached. I would be suprised if the judge allowed them to be crammed down to satisfy other creditors outside of the SPE, but again I don't know what the precedent is here. Judging by his statement, he was not ruling on that issue at this point. The lenders could ultimately choose to modify the loans which may benefit both GGP and the lenders if it is determined that the property could not be sold for a reasonable price in foreclosure. But you are correct, the ruling only addressed the motion to dismiss made by the SPE's. The only way they could have been excluded is if GGP was found to have acted in bad faith.

Aug 13 05:20 PM

[Securitizer:]

On Aug 13 04:15 PM Lew Richards wrote:

> If the assets and liabilities cannot "be substantively consolidated
> with those of any other entity," does that not imply that each of
> the SPE's is, effectively, a stand alone bankruptcy?

Based on the ruling, I would have to say it is not clear what will happen. Even though it has not substantively consolidated the entities, the ruling does not respect the entities as separate companies when determining whether a bankruptcy filing of a subsidiary is proper. The judge quotes a 1987 ruling on page 28 that states that whether or not a subsidiary filed in good faith is irrelevant if the parent filed in good faith. To me, this seems to upset the notion that subsidiaries are to be treated as separate entities from their parents (absent established factors indicating that they operated as one entity).

Aug 13 07:03 PM

[thurston:]

Hello, thanks to the above for their comments. One thing that comes to mind from reading GGP pleadings submitted prior to this decision is that the following, "the SPE lenders should have the right to foreclose and sell to satisfy the loan", this may be correct but the lenders were not complaining that GGP was behind on or not making its payments.

Rather, the lender's concern was that some of the SPE's were in fact making their payments on principle & interest AND had money left over.

GGP want to "sweep" the excess funds (beyond what was needed to make loan payments) back to the mother ship (as it were) whereas the lenders did not want the SPE's to remain in BK so that this would not happen, so that any excess income not needed to make P&I payments on the loans would remain segregated in the SPE adding to the security of the lender to that particular SPE. Under these circumstances, the lenders were not that concerned about their right to foreclose on the property in the SPE because there was no reason to foreclose, the loan was performing, they just wanted the SPE to not be diluted as a result of sending excess funds to the corporate parent.

REITBull wrote:

> "If the assets and liabilities cannot "be substantively consolidated
> with those of any other entity," does that not imply that each of
> the SPE's is, effectively, a stand alone bankruptcy?"
>
> That is a good point Lew and I don't know what the precedent is.
> My personal feeling is that the SPE lenders should have the right
> to foreclose and sell to satisfy the loan if reasonable terms cannot
> but reached. I would be suprised if the judge allowed them to be
> crammed down to satisfy other creditors outside of the SPE, but again
> I don't know what the precedent is here. Judging by his statement,
> he was not ruling on that issue at this point. The lenders could
> ultimately choose to modify the loans which may benefit both GGP
> and the lenders if it is determined that the property could not be
> sold for a reasonable price in foreclosure. But you are correct,
> the ruling only addressed the motion to dismiss made by the SPE's.
> The only way they could have been excluded is if GGP was found to
> have acted in bad faith.

Aug 14 01:04 AM

[REITBull:]

Thanks for the clarification Thurston. With that quote, I was probably getting ahead of the current ruling and looking down the road to when these maturities will be coming due.


On Aug 14 01:04 AM thurston wrote:

> Hello, thanks to the above for their comments. One thing that comes
> to mind from reading GGP pleadings submitted prior to this decision
> is that the following, "the SPE lenders should have the right to
> foreclose and sell to satisfy the loan", this may be correct but
> the lenders were not complaining that GGP was behind on or not making
> its payments.
>
> Rather, the lender's concern was that some of the SPE's were in fact
> making their payments on principle & interest AND had money left
> over.
>
> GGP want to "sweep" the excess funds (beyond what was needed to make
> loan payments) back to the mother ship (as it were) whereas the lenders
> did not want the SPE's to remain in BK so that this would not happen,
> so that any excess income not needed to make P&I payments on
> the loans would remain segregated in the SPE adding to the security
> of the lender to that particular SPE. Under these circumstances,
> the lenders were not that concerned about their right to foreclose
> on the property in the SPE because there was no reason to foreclose,
> the loan was performing, they just wanted the SPE to not be diluted
> as a result of sending excess funds to the corporate parent.
>
> REITBull wrote:

Aug 14 09:21 AM

[Securitizer:]

Note that the cash collateral order suspended principal payments on the SPE property level loans. The SPEs are only paying interest on their loans (at pre-default and pre-ARD rates). Cash that was to be paid to principal has been distributed upstream to pay the DIP financing and for shortfalls at struggling properties.


On Aug 14 01:04 AM thurston wrote:

> Hello, thanks to the above for their comments. One thing that comes
> to mind from reading GGP pleadings submitted prior to this decision
> is that the following, "the SPE lenders should have the right to
> foreclose and sell to satisfy the loan", this may be correct but
> the lenders were not complaining that GGP was behind on or not making
> its payments.
>
> Rather, the lender's concern was that some of the SPE's were in fact
> making their payments on principle & interest AND had money left
> over.
>
> GGP want to "sweep" the excess funds (beyond what was needed to make
> loan payments) back to the mother ship (as it were) whereas the lenders
> did not want the SPE's to remain in BK so that this would not happen,
> so that any excess income not needed to make P&I payments on
> the loans would remain segregated in the SPE adding to the security
> of the lender to that particular SPE. Under these circumstances,
> the lenders were not that concerned about their right to foreclose
> on the property in the SPE because there was no reason to foreclose,
> the loan was performing, they just wanted the SPE to not be diluted
> as a result of sending excess funds to the corporate parent.
>
> REITBull wrote:

Aug 14 11:46 AM

[thurston:]

I was basing my thought on a statement in GGP's pleadings "DEBTORS’ MEMORANDUM OF LAW IN OPPOSITION TO THE MOTIONS OF ING CLARION CAPITAL LOAN SERVICES LLC AND WELLS FARGO BANK, N.A., AS TRUSTEE, ET AL., TO DISMISS THE CASES OF CERTAIN DEBTORS AND DEBTORS IN POSSESSION" submitted on June 8th to Judge Gropper in the SPE matter, see Page 3:

"REORGANIZATION IS NOT OBJECTIVELY FUTILE. Because they have nothing to say about this requirement, Movants ignore it. Not only do Movants fail to offer any evidence of objective futility, but the facts they assert and that are disclosed in their depositions – that the project entities presently have positive cash flows and are current on their loans – dispel the notion that a restructuring here would be futile. Rather, these claimed facts establish a reasonable likelihood that the debtors can successfully emerge from bankruptcy. The motions fail for this reason
alone."

I am interested to locate the cash collateral order to which you refer but it does not seem to me that GGP was asking to suspend principle payments in these SPE's based on the above. I understood that GGP was asking that the cash flow above and beyond P&I be funneled back to the parent & that the SPE's remain in BK. As a long holder of GGP stock, I guess it means that we are not reducing our debt and are piling up a cash war chest (because based on the above statement we could be "current" on our loans but don't have to pay the principle) which would give the company flexibility in the days ahead.


On Aug 14 11:46 AM Securitizer wrote:

> Note that the cash collateral order suspended principal payments
> on the SPE property level loans. The SPEs are only paying interest
> on their loans (at pre-default and pre-ARD rates). Cash that was
> to be paid to principal has been distributed upstream to pay the
> DIP financing and for shortfalls at struggling properties.

Aug 14 01:26 PM

[Securitizer:]

Look at page 17 of the 47-page order....

"The final cash collateral order, entered on May 14, 2009 (ECF Docket No. 527), however, had various forms of adequate protection for the project-level lenders, such as the payment of
interest at the non-default rate, continued maintenance of the properties, a replacement lien on the cash being upstreamed from the project-level Debtors and a second priority lien on
certain other properties."

The cash collateral order (along with all other court documents) can be found at:

www.kccllc.net/General...

click on "Court Documents" at the upper left. it is document #527, from 5/14/09. See page 23 of that order.

On Aug 14 01:26 PM thurston wrote:

> I was basing my thought on a statement in GGP's pleadings "DEBTORS’
> MEMORANDUM OF LAW IN OPPOSITION TO THE MOTIONS OF ING CLARION CAPITAL
> LOAN SERVICES LLC AND WELLS FARGO BANK, N.A., AS TRUSTEE, ET AL.,
> TO DISMISS THE CASES OF CERTAIN DEBTORS AND DEBTORS IN POSSESSION"
> submitted on June 8th to Judge Gropper in the SPE matter, see Page
> 3:
>
> "REORGANIZATION IS NOT OBJECTIVELY FUTILE. Because they have nothing
> to say about this requirement, Movants ignore it. Not only do Movants
> fail to offer any evidence of objective futility, but the facts they
> assert and that are disclosed in their depositions – that the project
> entities presently have positive cash flows and are current on their
> loans – dispel the notion that a restructuring here would be futile.
> Rather, these claimed facts establish a reasonable likelihood that
> the debtors can successfully emerge from bankruptcy. The motions
> fail for this reason
> alone."
>
> I am interested to locate the cash collateral order to which you
> refer but it does not seem to me that GGP was asking to suspend principle
> payments in these SPE's based on the above. I understood that GGP
> was asking that the cash flow above and beyond P&I be funneled
> back to the parent & that the SPE's remain in BK. As a long holder
> of GGP stock, I guess it means that we are not reducing our debt
> and are piling up a cash war chest (because based on the above statement
> we could be "current" on our loans but don't have to pay the principle)
> which would give the company flexibility in the days ahead.

Aug 20 11:10 AM