The Financial Crisis of 2008 - 2009: Exigent Circumstances and Bankruptcy Precedents in the US
Marcia Goldstein -
Ronit Berkovich -
Bankruptcy practitioners found themselves in the trenches of the financial crisis of 2008-2009. Not only were bankruptcy filings front page news, but they also spurred new developments in bankruptcy law and practice necessitated by the unique circumstances of the economy during that time.
Participants
Ronit Berkovich
Weil, Gotshal & Manges LLP
New York
Marcia Goldstein
Weil Gotshal & Manges LLP
New York
Creative uses of existing bankruptcy principles were a critical component in saving companies and jobs and preserved billions of dollars in value. Whether the bankruptcy tools and approaches developed in this exceptional period will be accepted by bankruptcy courts in other circumstances remains to be seen. This article provides an overview of some of the unique aspects of some of the largest and most complex chapter 11 cases of this period – those of Lehman Brothers, the automobile giants (Chrysler and General Motors), and General Growth Properties.
Lehman Brothers, Chrysler and General Motors: Using 363 Sales to Preserve Businesses and Jobs
At approximately 2:00am on 15 September 2008, Lehman Brothers Holdings Inc. (LBHI) and certain of its affiliates commenced the largest set of chapter 11 cases in US history. Until that time, Lehman Brothers was the fourth largest investment bank in the United States, with consolidated assets of over $600 billion, and liabilities of at least that amount. It operated a massive, global business 24 hours a day, 7 days a week. Through and among its nearly 4,000 different subsidiary entities and 25,000 employees, Lehman’s business produced hundreds of thousands of transactions at the speed of light and on a worldwide basis each day, moving billions of dollars around the world for the benefit of its customers. Lehman’s chapter 11 cases were filed in the context of unprecedented global turmoil in the financial markets and the initial phases of Lehman’s chapter 11 cases were equally tumultuous.
Upon filing, Lehman’s focus was to regain control of its assets and operations in an effort to preserve value in the face of a worldwide loss of confidence and a virtual financial panic. Its primary concern was to avoid the loss of thousands of jobs, customer dislocation and the significant loss in value that would result from a liquidation of one of Lehman’s primary divisions, Lehman Brothers Inc (LBI), - its broker-dealer and the operating entity for the Lehman’s North American capital markets and investment banking businesses.
Immediately upon Lehman’s chapter 11 filing, Barclays Capital expressed its interest in acquiring Lehman’s North American capital markets and investment banking businesses. The contemplated sale posed a number of problems: how to effect the transfer of the assets of LBI, which as a broker dealer was ineligible for a chapter 11 filing; the fact that the businesses of LBI were extremely sensitive to market forces and potentially a sharp drop in value if the sale was not completed quickly; and Barclays, the potential buyer, requiring that the sale be approved within five days.
With the cooperation of the Securities Investor Protection Corporation (SIPC), the bankruptcy court, despite objections, and taking into account the urgency of the situation, approved the procedures for the sale under section 363 of the Bankruptcy Code at a hearing on 17 September 2008. On 19 September 2008, SIPC caused LBI to be placed into a proceeding under SIPA, which was assigned to the same bankruptcy judge overseeing Lehman’s chapter 11 cases, and a coordinated sale hearing was held in both cases. An avalanche of objections, both oral and in writing, were filed, and continued to be filed even after the hearing began. The judge kept the hearing in session until midnight, offering all objectors the opportunity to be heard and then issued a decision overruling the objections and approving the sale. Denial of the sale would have resulted in turmoil and an unraveling of unpredictable magnitude for the financial markets and the global economy, causing the suspension of thousands of trades, the liquidation of collateral positions at a rate unmatched in history, and incalculable volatility, distress and destruction of value. The unique circumstances justified the transaction of unprecedented magnitude and speed.
Although unprecedented, the Lehman sale is not alone during this period. Two of the iconic “Big Three” US automobile manufacturers, Chrysler and General Motors, after struggling to avoid bankruptcy, followed suit, albeit in very different contexts. In these situations, the United States government (through the US Department of Treasury) stepped-in. The US Treasury’s intervention in the Chrysler and General Motors’ chapter 11 cases was unique in many respects. What first seemed to be “bridge loans” under the Trouble Asset Relief Program (TARP) to help GM and Chrysler weather the storm soon became a means to restructure a good portion of the US automotive industry in bankruptcy. At the time, it was widely believed that the failure of GM or Chrysler could have led to a systemic failure, affecting thousands of other companies in the US automobile industry and millions of jobs, as well as extending the already severe general economic crisis the country was enduring. Indeed, at the time, the automotive industry employed one in ten domestic workers and directly provided and supported more than 4.7 million jobs. It was one of the largest purchasers of domestically manufactured steel, aluminum, iron, copper, plastics, rubber, and electronic and computer chips. Almost 4 per cent of the US gross domestic product, and almost 10 per cent of US industrial production by value, was related to the automotive industry.
Chrysler filed for chapter 11 on 30 April 2009. At the time, Chrysler’s liabilities included, among other things, a $6.9 billion senior secured loan provided by a group led by JP Morgan and a $4 billion subordinated TARP loan from the US Treasury. Chrysler also had a $10 billion liability to the union retirees’ health care trust, known as a VEBA, and approximately $5.34 billion in trade debt. Chrysler and the US Treasury decided that rather than restructure as a stand-alone company, Chrysler’s best chance for viability was a partnership with another entity and ultimately settled on a strategic alliance with Fiat SpA.
To consummate the sale, Chrysler filed an emergency motion in the early stages of its case to sell its assets pursuant to section 363 of the Bankruptcy Code in an expedited time frame. The most vociferous objection to the sale was filed by certain Indiana pension funds, which held $42 million of the $6.9 first lien secured loan. The Indiana pension funds argued that the sale violated the Bankruptcy Code’s priority scheme and was a sub rosa plan of reorganisation, or a plan disguised as a sale in order to avoid the voting and strict creditor protection requirements necessary to confirm a plan. Specifically, the Indiana pension funds argued that the proposed sale violated their rights under the absolute priority rule and that, as dissenting senior creditors, they were entitled to payment in full before any junior creditors or equity holders were paid. Instead of payment in full, their collateral was transferred to New Chrysler and the first lien secured lenders would receive 29¢ on the dollar. At the same time, junior creditors, including the governmental entities, the VEBA, and the other creditors whose liabilities were being assumed by New Chrysler, received equity or other substantial value in the transaction. Furthermore, the Indiana pension funds argued that they did not consent to a “release” of their collateral, as required by the loan documents.
The court overruled the Indiana pension funds’ objections, primarily on the basis that it was the purchaser (New Chrysler) that was deciding to provide value or allocate equity to Old Chrysler’s other creditors; that value was not coming from Old Chrysler, and thus was not a distribution on account of pre-petition claims. The court found that New Chrysler, as purchaser, had negotiated with various constituencies that were contributing to the new venture: Fiat was contributing technology and expertise, the governmental entities were receiving equity in consideration for making a $6 billion loan to New Chrysler, and funding the VEBA with equity was part of a bargained-for exchange between the union and New Chrysler, the consideration for which included a new labour agreement with a six-year no-strike clause.
Moreover, the $2 billion the first lien lenders were receiving exceeded the liquidation value of $800 million. The court also rejected the Indiana pension fund’s argument that the they did not consent to a sale of their collateral free and clear of liens. Based on the court’s interpretation of the underlying loan documents, the first lien secured lenders agreed to be bound by certain actions of the administrative agent and collateral agent, taken at the behest of a majority of such lenders. In this case, far greater than a majority (92.5 per cent) of the first lien secured lenders had consented to the sale.
The bankruptcy court’s approval of the sale was appealed directly to the Second Circuit Court of Appeals, which affirmed the bankruptcy court’s opinion based on the reasons stated therein but stayed the sale’s closing so that the Indiana pension funds could appeal to the United States Supreme Court. The Supreme Court stayed the sale for one day but refused to hear an emergency appeal at the time and allowed the sale to close. Although the Supreme Court subsequently vacated the Second Circuit’s opinion, the effect of that move remains uncertain, as the Supreme Court did not provide a reason and did not vacate the bankruptcy court’s decision or direct the Second Circuit to do so.
General Motors, filed for chapter 11 on 1 June 2009. Like Chrysler, GM was overwhelmed by financial and operational problems, including colossal retiree obligations and an overextended dealership network. GM’s primary liabilities at the time of its filing included (i) a $19.4 billion secured loan from the US Treasury; (ii) approximately $5.4 billion of non-US government secured debt; (iii) approximately $25 billion in unsecured bonds; (iv) $20.56 billion owed to GM’s union retiree’s health care trust (VEBA); and (v) approximately $5.4 billion in trade debt.
Although it was clear that General Motors needed to lower its debt burden to remain viable, there was also a fear that the company could not survive a prolonged bankruptcy process. Specifically, based on surveys, both General Motors and the US Treasury believed that consumers would be reluctant to purchase cars and trucks from a bankrupt company due, among other things, to concerns about the company’s ability to stand behind its products. To minimise any erosion in value from a prolonged bankruptcy, General Motors and the US Treasury decided that a quick “363 sale”, in which the US Treasury, the largest secured creditor, would purchase the company’s assets through credit bidding its debt and continue the operations of the company as “New GM” was the optimal strategy.
Thus, on the same day General Motors filed its chapter 11 petition, it also filed an emergency motion under section 363 to sell substantially all of its assets to New GM as quickly as possible. General Motors argued that its assets were fragile and any delay in the 363 sale would result in continuing revenue erosion and further loss of market share to other domestic and foreign manufacturers. It was absolutely critical to demonstrate to consumers, employees, suppliers, and other stakeholders that a “new” GM – one that was viable and competitive – would quickly emerge from bankruptcy.
GM received over 850 objections to the sale and, after a three day evidentiary hearing, the court approved the sale. The court held that it is now well-established that a chapter 11 debtor may sell all or substantially all its assets pursuant to section 363 of the Bankruptcy Code prior to confirmation of a chapter 11 plan, when a court finds a good business reason for doing so. In particular, the court realised that, with no liquidity of its own and the need to quickly address customer doubt, General Motors did not have the luxury of selling its business under a chapter 11 plan and determined that absent the proposed sale, it was highly probable that General Motors would have to liquidate.
As in Chrysler, many disgruntled creditors argued that the 363 transaction was a sub rosa plan of reorganisation because certain creditors of GM (mainly, GM’s union retiree’s health care trust (VEBA) managed by the United Auto Workers) became equity holders of New GM while other creditors were left to recover from Old GM’s sale proceeds under a future chapter 11 plan. As in Chrysler, the court held that the decision to “cherry pick” certain liabilities was the prerogative of the purchaser (New GM) and did not violate US bankruptcy law. The treatment of creditors in a section 363 context, the court held, is dictated by the fair market value of those assets of the debtor that the purchaser in its business judgment elects to purchase. A purchaser cannot be told to assume liabilities that do not benefit its purchase objective. Thus, the disparate treatment of creditors occurs as a consequence of the sale transaction itself and is not an attempt by the debtor to circumvent the distribution scheme of the Bankruptcy Code.
Following the 363 transaction, New GM took over Old GM’s assets and continues to operate outside of bankruptcy as a private company. It is expected to go public some time in the near future. Old GM, however, still operates in bankruptcy and is in the process of liquidating its remaining assets so as to be able to distribute the proceeds of the 363 sale, primarily its 10 per cent stake in the New GM, to its creditors pursuant to a chapter 11 plan.
These precedents for extremely quick sales that in certain cases result in selected creditor groups receiving value from the purchaser are extraordinary, but rooted in existing case law and practices under section 363. Whether future courts will limit the decisions in Lehman, Chrysler and GM to circumstances of perceived systemic risk, whether in financial markets or where an entire industry is at stake, remains to be seen.
General Growth Properties: Real Estate Restructuring or Shake-Up
General Growth Properties Inc (GGP) is a publicly traded real estate investment trust (REIT) and the ultimate parent of approximately over 600 subsidiaries, joint venture subsidiaries, and affiliates (General Growth), which own and manage over 200 shopping centres. By late 2008, General Growth had roughly $25 billion in outstanding indebtedness, over $18 billion of which was secured by mortgages on project-level real property. Due to the collapse of the credit markets, and the commercial mortgage backed securities (CMBS) market, General Growth was unable to refinance its maturing mortgage debt, leading to cross-defaults within its unsecured debt facility and bonds.
Starting on 16 April 2009, GGP and 387 of its affiliates filed voluntary petitions for chapter 11 under the Bankruptcy Code. To date, a total of 262 project-level GGP debtors confirmed consensual plans of reorganisation to restructure over 100 loans aggregating approximately $14.71 billion of debt. General Growth’s size, and the complexities of the financing inherent in its business model presented a variety of novel restructuring issues, which have impacted the real estate industry profoundly.
A substantial majority of General Growth’s secured project debt was held in CMBS, which are investment securities that represent claims to cash flows from various commercial mortgages. In a typical CMBS transaction, multiple commercial mortgages are sold to a trust qualified as a real estate mortgage conduit (REMIC), which in turn sells certificates entitling the holders to payments from principal and interest on a large pool of loans.
General Growth’s bankruptcy highlighted certain structural aspects of CMBS loans that impede efforts to renegotiate the debt terms outside bankruptcy. By the end of 2008, the collapse of the real estate finance market prevented General Growth from refinancing approximately $9.9 billion in CMBS debt that would mature by 2012. The servicing structure of the CMBS loans, however, left General Growth without the ability to negotiate an out-of-court restructuring unless and until an event of default had occurred or was imminent.
Specifically, as is typical with CMBS loans, General Growth’s CMBS loans were serviced by “master servicers” that were responsible for the day-to-day administration of performing loans but lacked the ability to amend loan agreements in any material manner. Although “special servicers” possessed significant flexibility, subject to certain consent rights, to modify the terms of loan agreements, servicing responsibility for these CMBS loans would not transfer from a master servicer to a special servicer until certain default-related events occurred or if the master servicers determined that a payment default was “imminent” and unlikely to be cured within 60 days. Moreover, rules governing REMICs at the time prohibited most loan agreement modifications from being performed prior to default or reasonably foreseeable default. (Notably, the IRS has subsequently modified and relaxed these rules). Consequently, General Growth’s attempts to contact the special servicers (either through master servicers or directly) proved futile. The structural impediments General Growth encountered with respect to its CMBS loans were among several factors that ultimately frustrated efforts to negotiate an out-of-court restructuring.
Notably, more than 160 of the GGP debtors were special purpose entities (SPEs) formed to obtain secured property-level debt. Each had certain attributes designed to decrease the likelihood that the SPE would file for bankruptcy as a result of financial distress elsewhere in the corporate structure. These attributes include at least one independent director (for a corporation) or manager (for an LLC); operational restrictions in organisational and loan documents; limitations on ability to incur indebtedness; prohibitions on mergers, asset sales, liquidation, or consolidation; and “separateness covenants” that required the entity to maintain separate corporate identity. In addition, many of the SPEs had market-standard SPE provisions in their organisational documents that required the unanimous consent of the board (including independent managers) prior to filing the SPE for bankruptcy. Before filing the majority of its SPEs for bankruptcy, and in accordance with the terms of the SPEs’ organisational documents, General Growth removed and replaced the existing independent directors or managers from the boards of such entities.
Following the commencement of the GGP debtors’ cases, various project-level secured lenders filed motions to dismiss the chapter 11 filings for their respective SPE debtors arguing that: (i) the filings were premature; (ii) the filings were in bad faith because the SPEs allegedly had sufficient cash flow to service debt, the debt did not mature for one to three years after the filing date, and there had been no negotiations prior to filing; and (iii) the SPEs’ managers lacked authority to file because the interests of General Growth or the GGP debtors as a whole should not be considered when deciding whether to approve filing.
The court issued an opinion denying the project-level lenders’ motions to dismiss, exposing potential weaknesses in market-standard SPE documents, and making it clear that the SPE structure will not, on its own, prevent a nominally “bankruptcy remote” entity from obtaining relief under chapter 11. Specifically, the court found that: (i) although the project-level SPEs may have been able to meet their current debt service obligations, the “disarray in the financial market made it uncertain whether they would be able to refinance debt years in the future;” (ii) independent managers reached the decision to file after participating in a detailed board process; (iii) the project-level entities’ operating agreements did not alter the general rule that independent managers are entitled (if not required) to consider the interests of shareholders when deciding whether to file; (iv) “it was ‘clearly sound business practice for [the parent] to seek Chapter 11 protection for its wholly-owned subsidiaries when those subsidiaries were crucial to its own reorganization plan’ … the nature of a corporate family created an ‘?“identity of interest” … that justifies the protection of the subsidiaries as well a the parent corporation;’?” and (e) General Growth was under no obligation to engage in any pre-petition negotiations and, indeed, the structural limitations of the CMBS loans would render such negotiations futile.
The bankruptcy court’s opinion is significant as it established that insolvency and imminent loan maturities are not necessarily pre-requisites for a good faith bankruptcy filing. It also clarified that directors and officers of SPEs that are part of an integrated enterprise may consider the interests of the enterprise as a whole when determining whether to seek bankruptcy protection. Further, the Bankruptcy Court’s opinion underscores the importance of process and due deliberation by directors and officers of SPEs when determining whether to file for bankruptcy.
Many of the SPEs’ loan documents contained “cash-trap” provisions, providing that after an event of default, the SPE could no longer upstream some or all of its cash; the funds would be transferred from the lockbox account and applied to a specific payment hierarchy articulated in the credit agreement rather than be upstreamed to a centralised operating account for all of General Growth.
Upon filing, General Growth sought to continue its existing cash management system, including upstreaming cash from project-level entities into a centralised operating account. Since this constituted a use of the project-level lenders’ cash collateral, the project-level entities offered the secured lenders various forms 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. Certain project-level secured lenders objected, claiming that using cash generated from project-level entities was a violation of their “cash-trap” provisions. The court overruled those objections, permitting the General Growth Debtors to upstream cash from the project-level entities to the parent, holding that the cash-trap provisions did not entitle lenders to receive additional protections to those already afforded by the Bankruptcy Code, and that the lenders’ protection need only be adequate, not identical to protections fixed by pre-petition contracts. The court held that assets isolated by cash-trap provisions in SPE documents are not beyond a debtor’s reach for use as cash collateral, and further demonstrated that SPE entities, frequently labelled as “bankruptcy remote”, should not be viewed as “bankruptcy proof”.
The General Growth decisions, not surprisingly, have motivated real estate lawyers (and other finance lawyers who utilise SPE structures) to rethink SPE documentation, to tighten governance provisions and, where state law might permit, to contractually modify fiduciary duties. The impact on real estate financings and future CMBS transactions is not yet known.