GGP Business Model and 2009 Bankruptcy Filings

General Growth Properties, Inc. (GGP) is the ultimate parent company of approximately 750 wholly-owned subsidiaries, joint venture subsidiaries and affiliates, including various Special Purpose Entities or SPEs. The GGP Group owns and manages over 200 shopping centers in 44 states in the United States. As of December 31, 2008, the GGP Group's capital structure included approximately $18.27 billion in debt, partly secured by mortgages on the individual properties of the company. The secured debt consisted of both conventional mortgage debt as well as debt that was securitized in the Commercial Mortgaged-Backed Securities (CMBS) market. The typical mortgage loan for the GGP Group had a three to seven-year term, with low amortization and a large balloon payment at maturity. Penalties for failure to repay or refinance upon maturity included a steep increase in interest rate, a cash requirement, and a requirement that certain expenditures be submitted to the lender for approval. The GGP Group sought to avoid these penalties by refinancing its loans prior to the maturity date.  

As the credit crisis spread to the CMBS market in the latter half of 2008, prompting a change in commercially acceptable loan terms, the GGP Group was unable to refinance its maturing debt or to obtain new financing. After experiencing liquidity problems and defaulting on various loans, approximately 390 debtors within the GGP Group filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code in April 2009. Thereafter, certain Lenders, as well as the servicers to certain CMBS lenders, of the GGP Group debtors filed motions to dismiss the bankruptcy cases of twenty of the GGP Group's SPE Debtors. The Lenders argued that the bankruptcy cases of these SPE Debtors were filed prematurely in that there was no imminent threat to the financial viability of the SPE Debtors, which were cash-flow positive. The Lenders further argued that the filings were in bad faith since there was no possibility of confirming a plan over the objection of the Lenders and, therefore, no real chance of reorganization, and because the SPE Debtors replaced their independent managers just prior to the bankruptcy filings.

The SPEs of the GGP Group were bankruptcy-remote entities, as evidenced by various provisions in their organizational documents including (i) prohibiting consolidation of GGP’s various SPEs, (ii) restricting mergers and asset sales, and (iii) requiring that one or more "independent" directors or managers be retained by each SPE. Such features are consistent with common practice in the securitization market. The bankruptcy-remote structure of the SPE is an important consideration for commercial real estate lenders in protecting loan collateral from becoming subject to the risks of bankruptcy. Specifically, independent directors or managers not associated with an SPE, its parent or affiliates would be more likely to consider a bankruptcy filing objectively without the motivation to use such a filing to benefit the equity holders of the SPE. Conventional wisdom was that the existence of independent directors or managers eliminated the risk of a bankruptcy filing.

However, in the case of the GGP Group, these features of the SPE structure failed to prevent the SPE Debtors from filing for bankruptcy. On August 11, 2009, the U.S. Bankruptcy Court for the Southern District of New York issued a decision in In re General Growth Properties, Inc., et al. (Bankr. S.D.N.Y., Case No. 09-11977) that denied the motions to dismiss the bankruptcy cases of the SPE Debtors holding, as a general matter, that there was no evidence of prematurity or bad faith in the filings by the SPE Debtors. 

The Bankruptcy Court Ruling

In denying dismissal, the U.S. Bankruptcy Court for the Southern District of New York applied the standard for the dismissal of a bankruptcy as outlined in the case of C-TC 9th Ave. P’ship v. Norton Co. (In re C-TC 9th Ave. P’ship), 113 F.3d 1304 (2d Cir. 1997), stating that grounds for dismissal exist if it is clear on the filing date "there was no reasonable likelihood that the debtor intended to reorganize and no reasonable probability that it would eventually emerge from bankruptcy proceedings."  The court analyzed both the objective futility of the SPE Debtors' bankruptcy filings and whether the debtors exercised subjective good faith.  

In determining that the bankruptcy filings of the SPE Debtors were not premature, the Court found:
 

• Insolvency is not a requirement: Although the SPE Debtors were cash-flow positive at the time bankruptcy was filed and certain of the SPE Debtors did not have debt maturing for several years, the Bankruptcy Code does not require that a debtor be insolvent when a bankruptcy case is filed under Chapter 11. The state of the CMBS market and the difficulties of the GGP Group in refinancing and obtaining new loans demonstrated that each of the SPE Debtors was in severe financial distress and had ample justification for filing the Chapter 11 petitions.
   
• SPE may consider the interests of the group: The SPE Debtors were justified in considering the interests of the entire GGP Group in deciding to file for bankruptcy. Although each SPE was a separate entity, many of the mortgage loans were guaranteed by other GGP entities, and certain loans were advanced by one lender to multiple debtors. The Court noted that the Lenders to the SPEs were aware that they were extending credit to an entity that was part of a much larger group, and that there were benefits as well as possible detriments from this structure.  
   
• Ability to confirm a plan not a requirement to a bankruptcy filing: The Court found that the debtors were not required to prove that a plan for reorganization is confirmable in order to file a petition under the Bankruptcy Code.
   

In addition, the Court determined that the Lenders failed to demonstrate that the SPE Debtors exercised bad faith in filing petitions for bankruptcy based on the following:
 

• No requirement for negotiation with Lenders prior to a bankruptcy filing: Although the Court acknowledged that there are often good reasons for such negotiations to take place, the Bankruptcy Code does not require that a borrower negotiate with its lender prior to filing a petition. The Court found that there was no evidence that pre-filing negotiations would have been adequate to deal with the problem and, further, that there was no evidence that the Lenders would have been willing to work with the SPE Debtors.
   
• The discharge and replacement of Independent Managers by the SPE Debtors did not constitute bad faith: The Court found that while the SPE Debtors terminated their independent managers on the eve of the bankruptcy filings and replaced them with select individuals to serve as successor managers in order to facilitate the SPE Debtors' bankruptcy filings, these actions did not constitute subjective bad faith sufficient to require the dismissal of the bankruptcy cases. The SPE Debtors did not violate any provisions of their corporate documents. In addition, the Court noted that the successor independent managers exercised their rights to support the bankruptcy filings of the SPE Debtors in a manner consistent with their fiduciary duties, as the independent managers do not have a duty to keep the SPE Debtors from filing for bankruptcy, but rather a duty to act in the interests of a company and its shareholders or equity owners.
   

Ultimately, in denying the motions of the Lenders to dismiss the cases, the Court noted that although the bankruptcy filings pose an inconvenience to the Lenders by partially interrupting the cash flows of the SPE Debtors and requiring the appointment of special servicers for the CMBS obligations, the fundamental creditor protections that the Lenders negotiated and that the SPE structure represents were in place and would remain in place during the bankruptcy cases. These include protections against the substantive consolidation of the SPE Debtors with any other entities.

Conclusion

The Court’s decision in the GGP case highlights significant points and considerations relating to the use of SPEs in securitization market, including that:
 

• The financial difficulties of a corporate group could result in the bankruptcy filing of a solvent, bankruptcy-remote SPE.
   
• The termination and replacement of independent managers or directors of an SPE may not be evidence of bad faith of an SPE if such termination and replacement complies with the organizational documents of the SPE.  This may prompt Lenders to require in the loan documents that they be notified prior to changes in the managers or directors of SPEs.
   

Undoubtedly, the full impact of the GGP case will become evident as the lending industry adjusts its expectations and practices in dealing with bankruptcy-remote SPE entities in light of this decision.

Authored By:

Robyn Young
(212) 332-3527
ryoung@sheppardmullin.com 

GGP Business Model and 2009 Bankruptcy Filings

General Growth Properties, Inc. (GGP) is the ultimate parent company of approximately 750 wholly-owned subsidiaries, joint venture subsidiaries and affiliates, including various Special Purpose Entities or SPEs. The GGP Group owns and manages over 200 shopping centers in 44 states in the United States. As of December 31, 2008, the GGP Group's capital structure included approximately $18.27 billion in debt, partly secured by mortgages on the individual properties of the company. The secured debt consisted of both conventional mortgage debt as well as debt that was securitized in the Commercial Mortgaged-Backed Securities (CMBS) market. The typical mortgage loan for the GGP Group had a three to seven-year term, with low amortization and a large balloon payment at maturity. Penalties for failure to repay or refinance upon maturity included a steep increase in interest rate, a cash requirement, and a requirement that certain expenditures be submitted to the lender for approval. The GGP Group sought to avoid these penalties by refinancing its loans prior to the maturity date.  

As the credit crisis spread to the CMBS market in the latter half of 2008, prompting a change in commercially acceptable loan terms, the GGP Group was unable to refinance its maturing debt or to obtain new financing. After experiencing liquidity problems and defaulting on various loans, approximately 390 debtors within the GGP Group filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code in April 2009. Thereafter, certain Lenders, as well as the servicers to certain CMBS lenders, of the GGP Group debtors filed motions to dismiss the bankruptcy cases of twenty of the GGP Group's SPE Debtors. The Lenders argued that the bankruptcy cases of these SPE Debtors were filed prematurely in that there was no imminent threat to the financial viability of the SPE Debtors, which were cash-flow positive. The Lenders further argued that the filings were in bad faith since there was no possibility of confirming a plan over the objection of the Lenders and, therefore, no real chance of reorganization, and because the SPE Debtors replaced their independent managers just prior to the bankruptcy filings.

The SPEs of the GGP Group were bankruptcy-remote entities, as evidenced by various provisions in their organizational documents including (i) prohibiting consolidation of GGP’s various SPEs, (ii) restricting mergers and asset sales, and (iii) requiring that one or more "independent" directors or managers be retained by each SPE. Such features are consistent with common practice in the securitization market. The bankruptcy-remote structure of the SPE is an important consideration for commercial real estate lenders in protecting loan collateral from becoming subject to the risks of bankruptcy. Specifically, independent directors or managers not associated with an SPE, its parent or affiliates would be more likely to consider a bankruptcy filing objectively without the motivation to use such a filing to benefit the equity holders of the SPE. Conventional wisdom was that the existence of independent directors or managers eliminated the risk of a bankruptcy filing.

However, in the case of the GGP Group, these features of the SPE structure failed to prevent the SPE Debtors from filing for bankruptcy. On August 11, 2009, the U.S. Bankruptcy Court for the Southern District of New York issued a decision in In re General Growth Properties, Inc., et al. (Bankr. S.D.N.Y., Case No. 09-11977) that denied the motions to dismiss the bankruptcy cases of the SPE Debtors holding, as a general matter, that there was no evidence of prematurity or bad faith in the filings by the SPE Debtors. 

The Bankruptcy Court Ruling

In denying dismissal, the U.S. Bankruptcy Court for the Southern District of New York applied the standard for the dismissal of a bankruptcy as outlined in the case of C-TC 9th Ave. P’ship v. Norton Co. (In re C-TC 9th Ave. P’ship), 113 F.3d 1304 (2d Cir. 1997), stating that grounds for dismissal exist if it is clear on the filing date "there was no reasonable likelihood that the debtor intended to reorganize and no reasonable probability that it would eventually emerge from bankruptcy proceedings."  The court analyzed both the objective futility of the SPE Debtors' bankruptcy filings and whether the debtors exercised subjective good faith.  

In determining that the bankruptcy filings of the SPE Debtors were not premature, the Court found:
 

• Insolvency is not a requirement: Although the SPE Debtors were cash-flow positive at the time bankruptcy was filed and certain of the SPE Debtors did not have debt maturing for several years, the Bankruptcy Code does not require that a debtor be insolvent when a bankruptcy case is filed under Chapter 11. The state of the CMBS market and the difficulties of the GGP Group in refinancing and obtaining new loans demonstrated that each of the SPE Debtors was in severe financial distress and had ample justification for filing the Chapter 11 petitions.
   
• SPE may consider the interests of the group: The SPE Debtors were justified in considering the interests of the entire GGP Group in deciding to file for bankruptcy. Although each SPE was a separate entity, many of the mortgage loans were guaranteed by other GGP entities, and certain loans were advanced by one lender to multiple debtors. The Court noted that the Lenders to the SPEs were aware that they were extending credit to an entity that was part of a much larger group, and that there were benefits as well as possible detriments from this structure.  
   
• Ability to confirm a plan not a requirement to a bankruptcy filing: The Court found that the debtors were not required to prove that a plan for reorganization is confirmable in order to file a petition under the Bankruptcy Code.
   

In addition, the Court determined that the Lenders failed to demonstrate that the SPE Debtors exercised bad faith in filing petitions for bankruptcy based on the following:
 

• No requirement for negotiation with Lenders prior to a bankruptcy filing: Although the Court acknowledged that there are often good reasons for such negotiations to take place, the Bankruptcy Code does not require that a borrower negotiate with its lender prior to filing a petition. The Court found that there was no evidence that pre-filing negotiations would have been adequate to deal with the problem and, further, that there was no evidence that the Lenders would have been willing to work with the SPE Debtors.
   
• The discharge and replacement of Independent Managers by the SPE Debtors did not constitute bad faith: The Court found that while the SPE Debtors terminated their independent managers on the eve of the bankruptcy filings and replaced them with select individuals to serve as successor managers in order to facilitate the SPE Debtors' bankruptcy filings, these actions did not constitute subjective bad faith sufficient to require the dismissal of the bankruptcy cases. The SPE Debtors did not violate any provisions of their corporate documents. In addition, the Court noted that the successor independent managers exercised their rights to support the bankruptcy filings of the SPE Debtors in a manner consistent with their fiduciary duties, as the independent managers do not have a duty to keep the SPE Debtors from filing for bankruptcy, but rather a duty to act in the interests of a company and its shareholders or equity owners.
   

Ultimately, in denying the motions of the Lenders to dismiss the cases, the Court noted that although the bankruptcy filings pose an inconvenience to the Lenders by partially interrupting the cash flows of the SPE Debtors and requiring the appointment of special servicers for the CMBS obligations, the fundamental creditor protections that the Lenders negotiated and that the SPE structure represents were in place and would remain in place during the bankruptcy cases. These include protections against the substantive consolidation of the SPE Debtors with any other entities.

Conclusion

The Court’s decision in the GGP case highlights significant points and considerations relating to the use of SPEs in securitization market, including that:
 

• The financial difficulties of a corporate group could result in the bankruptcy filing of a solvent, bankruptcy-remote SPE.
   
• The termination and replacement of independent managers or directors of an SPE may not be evidence of bad faith of an SPE if such termination and replacement complies with the organizational documents of the SPE.  This may prompt Lenders to require in the loan documents that they be notified prior to changes in the managers or directors of SPEs.
   

Undoubtedly, the full impact of the GGP case will become evident as the lending industry adjusts its expectations and practices in dealing with bankruptcy-remote SPE entities in light of this decision.

Authored By:

Robyn Young
(212) 332-3527
ryoung@sheppardmullin.com 

In fact, it is a good idea for all companies who receive government funding (e.g., defense contractors, health care providers, academic institutions) to look closely at their internal compliance programs, and modify them to reflect the recent changes in the FCA. This article is intended to offer some specific suggestions, and also encourage companies to have their programs amended, and implemented by legal counsel who are receptive to flexible billing arrangements including flat fee schedules.
 

II. MANY OF THE HURDLES TO LITIGATING FALSE CLAIMS ACTIONS HAVE BEEN REMOVED

The following are some of the more significant changes to the FCA: 
 

(1) There is essentially no time bar for the government to intervene in the private party ("relator") action – the government can easily have its complaint relate back to the timely filing of the relator action.

(2) The government can now essentially "deputize" private parties and local governments to aid in the pursuit of these actions, by sharing documents and testimony that the government has obtained through Civil Investigative Demands ("CIDs"). The FCA now expressly authorizes the sharing of information obtained under a CID with "any qui tam relator," with federal, state or local government agencies, and with other interested persons (i.e., courts, consultants, auditors, experts, arbitrators) if it is done in connection with an investigation, case or proceeding. Thus, it is even more important now to involve legal counsel early on in negotiating the parameters of the CID, and coordinating the company's response.

(3) The universe of potential relators has been expanded dramatically, and can include contractors and agents, all of whom appreciate the considerable financial windfall that relators recover in qui tam actions with treble damage awards. Since the 1986 amendments, qui tam plaintiffs have accounted for more than half of the over $21.5 billion recovered under the FCA, with the plaintiffs recovering anywhere from 15-30% of the government's recovery. Thus, companies need to worry not only about disgruntled and terminated employees who may recast themselves as possible "whistleblowers," but also contractors with whom relations have become strained for any reason.  The FCA anti-retaliation provision now applies to contractors and agents in addition to employees.

(4) Subcontractors or others who submit a bill for payment to a recipient of government funds can now be held liable under the FCA, even if their bill is not submitted to the government directly. The definition of "claim" in the FCA has been expanded to include these indirect claims, so long as the funds involved are used on behalf of the government or in furtherance of a government program or interest. For example, in the context of federally insured mortgages, the government support is provided based on a private entity certifying that the borrower has complied with a variety of criteria underlying the loan agreements, any of which could form the basis of a false claims action, even if the certifying entity is not submitting a claim to the government.

(5) In amending the FCA, Congress specifically rejected several court decisions that made it more difficult for plaintiffs to establish liability. For example, the Allison Engine requirement that a claim or statement must be designed "to get" false claims paid or approved has been relaxed considerably, with the FCA amendments:
 

These amendments to Section 3729 clarify that the False Claims Act was intended to extend to any false or fraudulent claim for government money or property, whether or not the claim is presented to a government official or employee, whether or not the U.S. Government has physical custody of the money, and whether or not the defendant specifically intended to defraud the U.S. government. With this change, the additional elements read into the statute by the Supreme Court and the D.C. Circuit decisions are vitiated, and Allison Engine and Totten would be overturned by this legislative action.
 

February 5, 2009, Statement of Sen. Patrick Leahy, Chairman, Senate Judiciary Committee, Introduction of Fraud Enforcement and Recovery Act of 2009. Thus, the specific intent element that the United States Supreme Court imposed in Allison Engine, to keep FCA enforcement from becoming effectively "boundless," has been removed. To establish FCA liability now, the plaintiff only needs to prove that the false statement was "material" to the government's decision to pay a false claim. "Material" is defined loosely as "having a natural tendency to influence, or be capable of influencing, the payment or receipt of money or property." 

In addition, there are further amendments moving through Congress that would also increase the number of FCA plaintiffs. Most significantly, the "public disclosure" defense to qui tam suits would be greatly weakened by eliminating the FCA defendant's right to move to dismiss a relator complaint based on the public disclosure bar. Further, the bills would redefine what constitutes "public disclosure" to make it more narrow, and also allow a court to dismiss a qui tam action only if the "allegations relating to all essential elements of liability of the action or claim are based exclusively on the public disclosure of allegations or transactions…." When viewed in the context of the vast amount of public information that is available through the Internet, the elimination of this defense for defendants could exponentially increase the number of private plaintiff suits. Given the speed with which the recent amendments were approved by Congress and signed by the President, there should be little doubt that further amendments in favor of qui tam plaintiffs are just a matter of time.

III. THE GOVERNMENT IS TARGETING THE MORTGAGE LENDING BUSINESS, AND USING THE FCA TO DO IT

These changes also come with considerable bite behind them with the government approving substantial spending budgets for enforcement purposes. The bill authorized $155 million a year for hiring fraud prosecutors and investigators at the Justice Department for fiscal years 2010 and 2011, with the expectation that the FBI can double the number of its mortgage fraud task forces nationwide – from 26 to more than 50. 

Finally, if there is any remaining doubt that the FCA is a powerful tool that the government is using to prosecute mortgage fraud, then the following remarks are worth considering, in addition to the cases that the government has been litigating in the last year. In introducing the Anti-Fraud Legislation that included the amendments to the FCA, Senator Patrick Leahy said, "The federal government has spent hundreds of billions of dollars to stabilize our banking system, and Congress will soon spend even more to restart our economic recovery. But to date, we have paid far too little attention to investigating and prosecuting the mortgage and corporate frauds that has so dramatically contributed to this economic collapse." Similarly, President Barack H. Obama in signing the bill stated: "This bill nearly doubles the FBI's mortgage and financial fraud program, allowing it to better target fraud in hard-hit areas. That's why it provides the resources necessary for other law enforcement and federal agencies, from the Department of Justice to the SEC to the Secret Service, to pursue these criminals, bring them to justice, and protect hardworking Americans affected most by these crimes."

Recent cases are a good indication of the mortgage industry practices that are coming under scrutiny. In June 2009, Beazer Homes USA Inc. agreed to pay $5 million to the United States, plus contingent payments of up to $48 million dollars to be shared with victimized private homeowners, to resolve allegations that Beazer Mortgage Company was involved in fraudulent mortgage origination activities with federally insured mortgages. Beazer allegedly induced unqualified home buyers to enter into Federal Housing Administration ("FHA") insured mortgages, and, then, when the buyers defaulted, the FHA was wrongfully required to pay on the mortgage insurance claims.

Similarly, mortgage lenders who offer HUD-insured mortgages are becoming the subject of false claims actions. In this scenario, the HUD approved lender can "directly endorse" a mortgage for low and middle-income buyers under certain conditions, but can be held liable if the lender submitted unqualified loans to the HUD for insurance endorsement, without disclosing that the loans did not satisfy FHA guidelines. (Nat'l City Mortgage, June 2, 2008, $4.6 million settlement; and RBC Mortgage, November 25, 2008, $10.71 million settlement).

Presently pending in the United States District Court in Los Angeles, California is an action against mortgage lender Capmark Finance, Case No. CV 09-04104 RSWL (JCx), in which, the government is seeking to recover damages and penalties under the FCA arising from Capmark's submission of allegedly false documents and claims to HUD's multifamily mortgage insurance program. Specifically, the complaint alleges that Capmark engaged in fraudulent conduct to obtain HUD mortgage insurance in connection with two loans made by Capmark that financed the borrowers' acquisition of two existing residential nursing home facilities. When the loans defaulted, HUD sustained losses by having to pay $25.9 million dollars in mortgage insurance claims. In the Department of Justice press release for the Capmark case, the Department of Justice representative stated, "Mortgage fraud is a top priority for this Administration, especially when public dollars are at stake. We will aggressively pursue fraud claims against federal mortgage insurance programs, which are so vitally important to this economy." Thus, all loans at risk of default that are covered by government mortgage insurance are ripe for possible false claims actions.

IV. IT IS A PRUDENT BUSINESS PRACTICE FOR COMPANIES, INCLUDING THE MORTGAGE LENDING SECTOR, TO PROTECT THEMSELVES THROUGH EFFECTIVE COMPLIANCE PROGRAMS AND REGULAR INTERNAL AUDITS

There are a number of reasons why it is in a company's best interest to have a current and effective compliance program in place. Early discovery of possible FCA violations can create opportunities for voluntary disclosure, provide a basis for resolving the problems through a negotiated settlement, and shorten the damages time period by identifying problems early on. In light of the recent amendments to the FCA, compliance programs should be updated along the following lines, with additional modifications tailored to the particular needs of the company: 
 

(1) Schedule internal audits of all agreements that involve federal funds that may be at risk, including, without limitation, federally insured loans to at risk borrowers.

(2) Establish an alert system for identifying agreements where the payments are overdue, and there is a risk that the contract will be breached, or the property foreclosed in the case of a mortgage loan.

(3) Establish an audit system of agreements involving subcontractors with whom the company has either terminated the relationship, or the relationship has become strained, in order to ensure that the underlying agreements were handled properly and, therefore, there is no basis for a qui tam complaint by a subcontractor or, alternatively, any problems can be identified and addressed.

(4) Evaluate the advantages and disadvantages of having a hotline system for contractors and agents to report FCA concerns, now that they are included in the class of possible qui tam plaintiffs.

(5) Remind all company departments that prompt notice to management upon receipt of any subpoena or government inquiry is essential. Now that the documents and testimony produced in response to a CID can be shared more broadly, it is even more critical that companies work with legal counsel in complying with these requests.

For further information concerning our Government Contracts Practice, contact our Practice Group Leaders, Bryan Daly in Los Angeles at (213) 617-5466 and Anne Perry in Washington, D.C. at (202) 218-6875.

Authored by:

Michelle Sherman
(213) 617-5405
msherman@sheppardmullin.com

and

Peter Morris
(213) 617-5414
pmorris@sheppardmullin.com

The Chrysler Sale Transaction and Indiana Pensioners' Objections

Chrysler LLC and 24 of its domestic direct and indirect affiliates filed for Chapter 11 protection on April 30, 2009 in the United States Bankruptcy Court for the Southern District of New York. Shortly thereafter, Chrysler filed a motion seeking approval of the sale of substantially all of its operating assets to "New Chrysler" in exchange for $2 billion in cash and the assumption of certain liabilities. As part of the transaction, New Chrysler entered into two agreements with the UAW: a new collective bargaining agreement in which the UAW made unprecedented concessions and a settlement agreement relating to a 2008 class action that established a voluntary employees' beneficiary association, or VEBA, to fund legacy retiree health care obligations. Pursuant to the settlement agreement, the VEBA would be funded with a 55% membership interest in New Chrysler and a new $4.587 billion note. The remaining membership interests in New Chrysler would be issued to U.S. and Canadian governmental entities and a subsidiary of Fiat S.p.A. Ultimately, New Chrysler would be funded entirely by the U.S. and Canadian governments, contributing $6 billion in senior secured financing to support New Chrysler's operations after the sale.

The Indiana pension funds which challenged the sale held approximately $42 million (less than 1%) of Chrysler's $6.9 billion first-priority secured debt pursuant to an Amended and Restated First Lien Credit Agreement secured by substantially all of Chrysler's assets. The Indiana pension funds raised multiple objections to the proposed sale, including that it violated the Emergency Economic Stabilization Act of 2008 and the Troubled Asset Relief Program. However, its primary complaint was that the sale transaction constituted a sub rosa plan of reorganization that violated the priority scheme of the Bankruptcy Code because it sold all of the first lien lenders' collateral and essentially distributed the proceeds of the sale to unsecured trade creditors and the UAW.

Lesson One: A Quick Sale is Nothing More Than a Quick Sale

Section 363 of the Bankruptcy Code authorizes a debtor-in-possession, after notice and a hearing, to use, sell or lease property of the estate outside of the ordinary course of its business. However, a sale of assets under section 363 that, in essence, would direct or effectuate the terms of a reorganization plan is considered an impermissible sub rosa plan of reorganization. The rationale for barring such attempts is that they deprive creditors of the comprehensive protections normally afforded to them in the plan confirmation process, including formal disclosure, an opportunity to vote on acceptance and a fully noticed confirmation process. While a section 363 sale requires court approval and gives creditors the right to object, the more stringent and time-consuming plan confirmation requirements are not present. Thus, where a section 363(b) sale would preempt or dictate the terms of a plan, the sale should not be authorized. The Indiana pension funds argued that the Chrysler sale transaction was a sub rosa plan of reorganization in that it would sell their collateral to New Chrysler, which would use it to satisfy over $20 billion in unsecured creditor claims, leaving the first lien lenders with only 29% of the value of its collateral.

In rejecting this argument, the Court noted that the standard in the Second Circuit for determining whether to authorize a section 363 sale prior to and outside of the plan confirmation process is, simply, whether there was a "good business reason" for such a sale. The Court held there was an articulated business justification for the sale and for the necessity of completing it quickly. Moreover, the Court held that the sale was not a sub rosa plan of reorganization because the Debtors were receiving fair value for the assets being sold and all of the proceeds from the sale would be paid to the first lien lenders. 

Avoiding Violations of the Priority Scheme

Chapter 11 of the Bankruptcy Code requires, among other things, that a plan be fair and equitable and not discriminate unfairly among similarly situated creditors. The absolute priority rule, a fundamental principle of U.S. bankruptcy law, provides that a plan is fair and equitable if an unsecured creditor or other priority creditor receives full value for its claim or, if it does not receive full value, thatthe holder of any junior claim will not receive any property on account of such junior claim.  The words 'fair and equitable' are terms of art meaning senior interests and claims are entitled to full priority over junior ones.  The Indiana pension funds argued that allowing Chrysler "to ignore the priority scheme established by the Bankruptcy Code while selling substantially all of their assets, in permanent derogation of the Indiana Pensioners' property rights, would turn the law on its head." Specifically, they argue that the sale violates the priority scheme of the Bankruptcy Code because (i) the first lien lenders will be not be paid in full while U.S. and Canadian governmental entities, junior lienholders under Chrysler's TARP debt, will receive value; and (ii) the first lien lenders' $4.9 billion unsecured deficiency claim will ultimately be treated differently than the general unsecured claims of certain trade creditors and the UAW.

In rejecting these arguments, the Court emphasized three points. First, the membership interests in New Chrysler were not issued to the UAW and the U.S. and Canadian governments on account of their prepetition claims, but rather were issued as consideration for the contribution of new value. The U.S. and Canadian governments are providing New Chrysler with approximately $6 billion in funding, while the UAW is providing New Chrysler with a skilled workforce under a more competitive cost structure and a more restrictive collective bargaining agreement. Second, the membership interests in New Chrysler were issued pursuant to agreements between each party and New Chrysler, and not Chrysler as debtor. The consideration provided by New Chrysler was not value that would otherwise inure to the benefit of Chrysler's estate, so the agreements did not divert value from Chrysler's estate or allocate proceeds from the sale of its assets. Finally, parties to contracts that are assumed in a bankruptcy case are entitled to cure payments and adequate assurance of future performance -- the Bankruptcy Code recognizes that certain creditors may receive more favorable treatment than other creditors, either in their class or a higher priority class, as part of a sale, and that such disparate treatment does not violate the priority rules. 

Adequacy of Notice is in the Eye of the Beholder

Rule 2002 of the Bankruptcy Rules requires at least 20 days notice of a section 363 sale, unless otherwise ordered by the Court. While the Chrysler sale hearing began more than 20 days after Chrysler filed its sale motion, the Indiana pension funds, as well as many other parties, objected to the abbreviated and rushed sale process. As the Indiana pension funds stated in their objection, Chrysler "acted as if they were selling a Chrysler LeBaron and not a multinational corporation with billions of dollars in assets." They argued that the sale process effectively precluded anyone but New Chrysler from bidding on Chrysler's assets, was inherently unfair and failed to maximize the sale price. 

In holding that the notice provided was adequate, the Court focused on the need for expedited relief to prevent the erosion of the value of Chrysler's assets. The Court found that despite the complexity of the transaction, notice of the sale was adequate where information about Chrysler's troubles were known worldwide prior to the bankruptcy, there had already been an extensive marketing attempt, and the assets were "wasting" away. Adequacy of notice is to be judged on what is adequate under the circumstances of each case.

The Lessons

The Chrysler bankruptcy case demonstrate the flexibility of the Bankruptcy Code, which has permitted Bankruptcy Courts to adapt to and confront the challenges and turmoil of these unprecedented economic times. The Bankruptcy Court's decision to approve the Chrysler sale transaction relied upon the familiar values underlying U.S. bankruptcy law: equity, rehabilitation and the right to a fresh start. Although other Bankruptcy Courts, faced with less dire consequences, may act with more deliberation, the effect of the Chrysler bankruptcy case, and the precedent it has set, is undeniable.

Authored By:

Malani J. Cademartori
(212) 332-3847
mcademartori@sheppardmullin.com

and

Blanka Wolfe
(212) 332-3822
bwolfe@sheppardmullin.com

What is a committee?

The formation of an official committee of unsecured creditors is provided for under section 1102 of the U.S. Bankruptcy Code. Pursuant to section 1102, the U.S. Trustee is tasked with forming the unsecured creditors' committee (and any other committees the U.S. Trustee may deem necessary) as soon as possible after a debtor files for chapter 11 relief. Accordingly, the process for choosing and appointing a committee will begin within days after the bankruptcy filing with the U.S. Trustee sending solicitation letters and questionnaires to the largest unsecured creditors identified by the debtor as part of its chapter 11 petition. The solicitation letters will designate a date, time and place for an organizational meeting at which the U.S. Trustee will review the completed questionnaires and choose a committee who represents the general unsecured creditor body in both type and amount. An unsecured creditors’ committee can be comprised of anywhere between three and eleven members, but is usually made up of no less than five and no more than seven members. On occasion, creditors hoping to garner a spot on the committee which were not originally contacted by the U.S. Trustee or listed among the ranks of the largest creditors of a debtor may be able to do so by exhibiting they have expertise and knowledge in the debtor’s particular industry, or by demonstrating that their claims are not adequately represented among the largest creditors designated by the debtor and solicited for committee membership. In some cases, an additional committee representing the debtor's shareholders or bondholders may also be appointed if the U.S. Trustee and bankruptcy court sees a need and there is sufficient interest to do so.

Once formed, the committees has the right, subject only to bankruptcy court approval, to retain and consult counsel and other professionals of their own choosing to represent the committee as a whole (as opposed to the individual members and their individual interests). Committees will generally retain counsel and/or financial advisors immediately after formation through an expedited interview process. As a statutorily created entity, both the "reasonable" fees and expenses of the professionals selected to represent the committee, and the "reasonable" expenses (but not the fees) incurred by the committee members in serving on the committee, are paid and reimbursed out of the debtor's estate. In this way, the committee members do not come out of pocket for their service on the committee.

It should be noted, however, that the fees and expenses for the attorneys and professionals retained by each individual member to represent its own specific interests, issues and claims in the bankruptcy case will not be paid for by the debtor's estate and will be the sole responsibility of the individual member as a single creditor of the debtor (please also note that it is advisable to retain individual counsel in connection with the bankruptcy case even if serving on a committee, since the committee is representative of all creditors and not individual interests which may, from time to time, be adverse to a specific creditor's interests).

What are the committee's responsibilities?

Committees can play an integral role in shaping the course of a bankruptcy case. Although the ordinary day-to-day operations of a chapter 11 debtor's business are normally determined by the debtor's existing management, a committee can influence both the long-term strategy of the debtor's business and affect any decisions it made out of the ordinary course of a debtor's business and which may affect creditors generally.

As mentioned above, the committee's purpose is to represent the interests of all unsecured creditors of the debtor, and to act as a watchdog for those interests while the bankruptcy case is pending.

In pursuing this purpose, the committee, through its professionals, will need to investigate and become knowledgeable about the debtor's business and its background, and be involved in the debtor's decision making. The committee will, therefore, be in a unique position to review the liabilities and assets of the estate and to influence or sometimes take action where necessary. For example, a debtor may not want to dispute a creditor's claim if they are dependent on that business relationship in the debtor's on-going business or may resist avoiding a transfer made to an insider. In these situations, the committee may be the only party willing and able to ask such questions or bring such actions derivatively to augment the estate for the benefit of all creditors.

In addition and most importantly, the committee will have the unique role of acting as advisor to the bankruptcy court in the bankruptcy process. For example, bankruptcy courts will often look to the committee any time a debtor seeks court approval to enter into an agreement outside the ordinary course of business or dispose of any assets. Ultimately, and through the discharge of these duties and actions, the committee is integral to the direction and success of a debtor's bankruptcy case, and will assess and influence whether the debtor reorganizes or liquidates and the distribution that unsecured creditors will receive under either scenario.

The advantages and disadvantages of committee service.

Serving on a bankruptcy committee is a somewhat significant responsibility.

Time Commitment. Serving on a committee may require a considerable amount of time. The time commitment will vary depending on the complexity of the case; however, the typical committee may meet several times a month, usually via telephonic conference for minimum disruption. In any event, the time spent on the committee is going to take time away from other business activities, and in most cases will be time which would not have been spent on an insolvent party from whom you are likely to recoup on a fraction of what you are owed. In addition, since service is voluntary, committee members are not directly compensated for the considerable time they may expend (although committee members do receive reimbursement for expenses as described above).

Acting as a Fiduciary. The committee and its members have a fiduciary duty to act in the best interests of the unsecured creditors as a whole. As such, committee members have a duty they must discharge and for which they are accountable. Specifically, as a fiduciary, committee members are prohibited from using the confidential information gained in their service on the committee to their own advantage or from trading on their claims (or any securities held by such members in the debtor) based on such information. Practically speaking, this would prohibit any such member from taking any action which may appear to be in violation of this duty, including effectively prohibiting any securities or claims trading because of an assumption that such trading was based on insider information. Nevertheless, any committee member may pursue and defend its claim and defend against any claims brought against it by the estate, provided the committee member does not use any confidential information it learns as a member of the committee.

There are, however, significant advantages to serving on a committee:

Providing your opinion. The committee has a fiduciary responsibility to represent the interests of all similarly situated parties, i.e. all the unsecured creditors. As such, a bankruptcy judge relies heavily on the committee's opinions and recommendations, as opposed to the self-interested view of one creditor. Being a member of the committee enables a creditor to influence how their own claim is treated and their recovery, along with the claims of all creditors.

Sharing costs and cutting down costs. Because the committee will hire its own attorneys and financial advisors, a creditor serving on the committee may often find that its interests are, necessarily, aligned with the entire committee in taking action or objecting to an action. Asserting those positions through the singular voice of the committee and its professionals saves costs to the individual creditor in taking or opposing action on its own. Moreover, while payment from the debtor's assets will decrease the amount of the estate available to pay creditors in the long run, the cost of those professionals is disbursed evenly among all the creditors which the committee is formed to benefit.

Networking opportunities. Participating on a committee provides a unique opportunity to work with other individuals involved in the same industry. Due to the committee's access to confidential information and heightened knowledge of case developments, many members view committee service as a way to sustain or strengthen the existing business relationship with the debtor and other committee members, who may provide vital business to the creditor.

Conclusion

While bankruptcy may connote worry and fear, the actual process can provide significant opportunities for the creditor solicited to serve on a committee. Although committee service requires a considerable time commitment accompanied with extensive responsibility, a creditor may find that they have excerpted more control in an environment where creditors often find themselves feeling somewhat helpless. Committee service should be seriously considered in consultation with counsel to discuss the advantages and disadvantages of committee service in a particular situation, but should always be considered.


Authored By:

Malani J. Cademartori

212.332.3847

mcademartori@sheppardmullin.com

• Delayed Recognition of Debt Cancellation Income for Debt Repurchased, Replaced or Modified During 2009 or 2010. A corporation or business recognizes cancellation of debt income ("COD") when the taxpayer or a related party repurchases its debt for less than the amount outstanding or modifies or replaces the debt so it has a lower issue price.  ARRTA allows the COD to be deferred until 2014 and recognized over the next five years through 2019.  If deferral is elected, deductions for original issue discount ("OID") on direct or indirect replacement debt are similarly deferred.  COD so deferred is accelerated into income upon cessation of business, liquidation, or sale of all or substantially all the assets of the business (or the day before it files a bankruptcy petition) or, in the case of an S corporation or partnership, upon sale, exchange or redemption of an interest or death of a shareholder or member.
• Temporary Allowance of Deductions for OID on Modification or Exchanges Into High-Yield Discount Obligations.  Corporations cannot deduct unpaid OID representing a yield higher than six percentage points over the applicable federal rate on debt with a term of 5 years or more.  ARRTA temporarily suspends this disallowance for exchanges or modifications after September 1, 2008 and before December 31, 2008, provided the old debt itself was not a high-yield discount obligation, does not have contingent interest, and is not held by a person related to the issuer.  Thus, such publicly traded debt can be exchanged without COD arising as a result of trading at a discount in the secondary market, and privately held debt can be modified debt so it has substantial OID without COD (such as due to deferring payments of interest).  IRS can temporarily use higher rates to determine high-yield discount status.
• Extension of Bonus Depreciation and Increase in Small Business Expensing. Businesses can deduct for regular and alternative minimum tax ("AMT") purposes 50% of the cost of most depreciable tangible personal property, computer software, qualified leasehold improvements and certain other property acquired and placed in service during 2009 as well as during 2008.  Also, taxpayers can write-off immediately up to $250,000 of tangible personal property and computer software purchased during 2009, subject to phase out if such purchases exceed $800,000.
• Extension of Election to Accelerate Pre-2006 AMT and Research Credits In Lieu of Bonus Depreciation. As under prior law, instead of bonus depreciation a corporation may elect to increase its limits on use of pre-2006 AMT and research credits up to the lesser of 6% thereof or $30 million.  Different elections for 2008 and 2009 are allowed.
• Preservation of NOLs Following Ownership Changes Pursuant to Loans Under EESA. The limitation on using net operating losses ("NOLs") of a corporation after a more than 50% ownership change does not apply to a change required under a loan agreement or commitment with Treasury under the Emergency Economic Stabilization Act of 2008 to rationalize costs, capitalization and capacity with respect to manufacturing workforce of, and supplies to, the corporation, or to certain later ownership changes, provided the corporation is not more than 50% held by one or related persons (other than a voluntary employees benefit association).  IRS Notice 2008-83 is overturned for post‑January 16, 2009 deals not previously committed (Notice 2008-83 granted similar relief to banking institutions).
• 5-Year Carryback of NOLs for Smaller Business. A business with average gross receipts up to $15,000,000 for its prior three years may elect to carry back five years any NOL for its taxable year beginning or ending in 2008.
• Temporary Suspension of S Corporation 10-Year Built-In Gain Rule. S corporations that have not been C corporations for more than seven years can sell built-in gain assets during 2009 or 2010 without incurring corporate-level tax, rather than having to wait until more than 10 years after electing S corporation status.
• Expansion of Qualified Small Business Stock Rule for Investments Before 2012. For qualified small business stock acquired after enactment and before 2012 and held five years, 75% rather than 50% of gain will be excluded.
• Numerous Other Business Incentives. ARRTA includes numerous other incentives for business investment and activity, including credits for hiring veterans and disconnected youth, expansion of industrial development and other tax-exempt bond provisions, credits for renewable energy products and projects, and many other new tax benefits.

Authored by:

John R. Bonn

(978) 594-0170

jbonn@sheppardmullin.com

Pursuant to applicable Treasury Regulations, we notify you that the information in the foregoing flyer does not constitute legal or tax advice, cannot be used for the purpose of avoiding any tax penalties that may be imposed on any person, and may not be used or referred to in promoting, marketing or recommending a partnership or other entity, investment plan or arrangement to any person. No limitation is hereby imposed on disclosure of tax treatment or structure of any transaction.

Rule B Attachments

Under Rule B, a party may obtain security for a maritime claim that has not yet been reduced to judgment or arbitral award.  Rule B Attachments can be issued by the court where the action on the merits is pending or by any court where the defendant has assets so long as the defendant itself is not located or otherwise found in that jurisdiction.  Thus, while the type of claim must be within that court's admiralty jurisdiction (i.e., arising from a maritime tort or contract), the underlying dispute need not have any connection to the particular court's geographical district or even the United States.  In addition, a claimant can obtain a Rule B Attachment on an ex parte basis, without notifying its opponent in advance.  In fact, many shipping companies only learn their funds have been attached when a puzzled business partner inquires about a payment not received.

Rule B Attachments are popular because they are effective.  In Winter Storm Shipping, Ltd. v. TPI, the Court of Appeals for the Second Circuit held a Rule B Attachment can intercept and attach an electronic funds transfer (EFT) in the hands of an intermediary bank, including the New York Clearing House banks in Manhattan that process virtually all transfers of U.S. currency (or USD transfers) made worldwide.  Because shipping industry transactions are generally in U.S. currency and usually pass through one of the New York Clearing House banks, Rule B Attachment proceedings have become exceptionally popular in the Southern District of New York (which includes Manhattan) where they now comprise approximately 30% of all new cases filed.

Relief under U.S. Bankruptcy Law

Foreign shipping companies facing financial difficulties or the threat of Rule B Attachment can protect themselves through the United States bankruptcy laws.  When a company files for bankruptcy certain automatic protections are triggered.  First, in most cases, the filing will act to suspend a debtor's past, pending and current liabilities and obligations, providing the debtor with opportunity and time to reorganize its business operations and financial arrangements, while allowing the debtor to continue to manage its business and maintain control of its assets and corporate governance, subject only to certain restrictions and the supervision of the bankruptcy court.  Second, upon a bankruptcy filing, the law imposes an automatic, statutory stay, which suspends the continuation or commencement of any action, proceeding or any other formal or informal attempt to recover claims against the debtor or its assets – anywhere in the world.  There are certain exceptions to the automatic stay and a creditor can request the court to grant relief from the stay.  Generally though, the protections of the automatic stay under the U.S. Bankruptcy Code will provide a debtor with breathing room and the ability to protect its assets during the proceeding, giving it time to catch its breath and, perhaps, chart a new course.

Foreign companies can protect themselves through Chapter 15 of the Bankruptcy Code.  Although Chapter 15 does not commence a full-blown bankruptcy case within the United States, it can provide a foreign debtor in an insolvency proceeding outside of the United States with certain protections, including the automatic stay, to protect assets in the United States.  Specifically, a foreign shipping company that has commenced an insolvency proceeding abroad, may be able to stay all actions against it, including pending Rule B Attachments, by filing a Chapter 15 case soon after the commencement of its foreign proceedings.  The Board of Directors of Armada (Singapore) Pte. Ltd. recently filed a chapter 15 petition in the Bankruptcy Court for the Southern District of New York for recognition of the company's insolvency proceeding in Singapore, for exactly that reason – to protect its assets against potential Rule B Attachments.

To qualify for protection under Chapter 15 of the Bankruptcy Code, a foreign debtor's authorized foreign representative must file a petition for recognition of the foreign insolvency proceeding, meet certain statutory requirements, notify all relevant parties and attend a hearing for approval of such recognition.  A foreign representative can also seek provisionally to stay any execution or action against the debtor's assets from the time it files a petition for recognition through the time when the Bankruptcy Court makes its decision whether or not to approve the recognition of the foreign proceeding.  If approved, the Bankruptcy Court will enter an order recognizing the foreign proceeding either as a "foreign main proceeding," if the foreign proceeding is pending in the country where the debtor has its main interests, or as a "foreign non-main proceeding," if the foreign proceeding is pending in a country where the debtor has a place of operations to carry out non-transitory economic activity.  The scope of protections afforded to a foreign debtor will differ depending on whether the court determines the foreign proceeding to be a main or non-main proceeding.  Specifically, the automatic stay against all proceedings applies only upon the recognition of a foreign main proceeding.  Alternatively, while the recognition of a foreign non-main proceeding does not trigger the general automatic stay, it does grant the Bankruptcy Court the power to stay the commencement or continuation of individual or specific actions against the debtor's assets, and to suspend the right to transfer, encumber or otherwise dispose of the debtor's property and assets within the United States. 

No one is yet certain where the shipping industry is headed or the extent of the damage that has been done.  In the midst of this uncertainty, United States bankruptcy law may provide some needed relief to enable shipping companies to reorganize.

Authored by:

Edward H. Tillinghast, III
(212) 332-3529 - etillinghast@sheppardmullin.com

Greggory B. Mendenhall
(212) 332-3825 - gmendenhall@sheppardmullin.com

Charles S. Donovan
(415) 774-2994 - cdonovan@sheppardmullin.com

Elizabeth Rotenberg-Schwartz
(212) 332-3800 - erotenberg-schwartz@sheppardmullin.com

Malani J. Cademartori
(212) 332-3847 - mcademartori@sheppardmullin.com

Blanka Wolfe
(212) 332-3822 - bwolfe@sheppardmullin.com

• State and Local Taxes.  At least 25 of the 50 states impose successor liability on a purchaser of assets with respect to unpaid taxes of the seller, unless the purchaser either (i) withholds the taxes from the purchase price or (ii) obtains a clearance certificate from the government.  Usually, but not always, the transaction must involve substantially all the assets of the business or a termination of business by the seller.
• Bulks Sales Act.  Failure to comply with a state bulk sales act, if applicable, generally results in liability for the purchaser to creditors of the seller.
• Certain Product Liabilities.  A buyer may inherit seller product liabilities pursuant to judicial doctrine.
• Collective Bargaining Agreements.  A purchaser of assets may be required to recognize and bargain with a union that represented the seller's employees
• Certain Underfunded Pensions. If the seller participates in an underfunded multiemployer union pension plan, a sale of its assets results in immediate withdrawal liability.  Some courts hold a buyer liable for a seller's delinquent contributions and withdrawal liability despite disclaimer in the asset purchase agreement.
• Environmental Liabilities. A buyer may be liable for seller liabilities under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 or other environmental laws.
• Regulated Industries. If the seller engages in a business subject to special governmental regulation, then additional issues arise concerning potential exposure of an asset purchaser to seller liabilities.
• De Facto Merger or "Mere Continuation" of Seller. Pursuant to common law developed by the courts, a seller and buyer may be considered to have undergone a "de facto merger" or the buyer may be considered a "mere continuation" of the seller, with the result that the buyer is liable to creditors of the target.
• Fraudulent Transfers. Obviously an actually fraudulent sale can create successor liability.  However, both state and federal law may treat a transfer as "fraudulent" -- and thereby expose the buyer to liabilities of its seller –in various circumstances, most commonly where the seller is insolvent before or after the transfer.

Authored by:

John R. Bonn

(978) 594-0170

jbonn@sheppardmullin.com

Assuming or Rejecting the Lease.  When a debtor files for bankruptcy and seeks to reorganize its business under chapter 11, the debtor will generally retain possession of its property and continue to manage its business as a debtor in possession.  The debtor has broad rights to either assume, assume and assign, or reject commercial leases (and other contracts and leases to which it may be a party), subject only to court approval.  By assuming a lease, the debtor is choosing to continue under the terms of the lease and accepts all burdens and obligations related to the lease.  If rejected, however, the debtor will be relieved of its obligations under the lease, leaving the non-debtor with an unsecured claim for damages based on a breach of the lease.

When the chapter 11 debtor is the tenant:

• Before a tenant-debtor may assume an unexpired lease of non-residential real property, it must: (1) cure any monetary defaults, or provide adequate assurance that any monetary defaults under the lease will be promptly cured; and (2) provide adequate assurance that all obligations under the lease will be satisfied in the future.  For tenant-debtors seeking to assume a lease in a shopping center, additional showings are required for adequate assurance of future performance, including evidence of the source of rent and assurances that any percentage rent due will not decline substantially.
• If the tenant-debtor rejects the lease of non-residential real property, the tenant will be required to immediately vacate the premises.  In addition, the rejecting tenant-debtor will still be required to address any claims made against it for past due and unpaid rental and other monetary obligations, and may be exposed to damages for rejection of such lease, including future rent.

When the chapter 11 debtor is the landlord:

• Similarly, if a landlord-debtor assumes an unexpired lease of non-residential real property, it must first: (1) cure any monetary defaults, or provide adequate assurance that any monetary defaults under the lease will be promptly cured; and (2) provide adequate assurance that all obligations under the subject lease will be satisfied in the future.
• However, if a landlord-debtor rejects an unexpired lease of non-residential real property, the non-debtor tenant will have the option to treat the lease as terminated or retain its rights under the lease for the duration of the lease and any renewal or extension periods thereof.  The landlord-debtor must allow the tenant to exercise its rights, including with respect to the amount and timing of payment of rent and any other amounts due, and to possession, use, quiet enjoyment, subletting, assignment and hypothecation.  If the non-debtor tenant opts to remain, the landlord-debtor is not required or obligated to actively perform their duties and responsibilities under such lease.  The tenant, however, is entitled to offset any damages incurred by the tenant by virtue of the landlord-debtor's non-performance of its obligations under the lease against the rental or other payments it is required to make.  Rejection of a lease of non-residential real property in a shopping center where the non-debtor tenant opts to continue its use of the premises will not affect the enforceability of any provision pertaining to radius, location, use, exclusivity, tenant mix or balance within the shopping mall.
• In the event that either a tenant-debtor or landlord-debtor seeks to assume and assign a lease of non-residential real property to a third party: (1) the debtor party must still first cure any monetary defaults, or provide adequate assurance that any monetary defaults under the lease will be promptly cured; and (2) the proposed third-party assignee must provide adequate assurance of its future performance under such lease from and after assignment.  In addition, before a shopping center lease is assigned to a third party, the proposed assignee must provide adequate assurance that it is able to perform under the lease, including compliance with all restrictive covenants and the ability to maintain the tenant mix or balance within the shopping center will not be disturbed.

Timeframe.  In 2005, Congress reduced the time in which a tenant-debtor may assume, assume and assign, or reject an unexpired lease of non-residential real property to 120 days of the bankruptcy filing.  The debtor may be granted one 90-day extension of this 120-day period, however, if the tenant-debtor wishes to seek further extensions thereafter, it must first attain written approval of the non-debtor landlord.  If assumption has not occurred within the required time period, the unexpired lease is deemed rejected.

This 210 day cap has significant implications for retail debtors.  Prior to this change the time to make a decision for assumption or rejection was often virtually unlimited (and remains virtually unlimited for landlord-debtors), allowing a retailer to evaluate sales at a particular store for one, if not two, holiday seasons.  Now, the decision must be made within seven months.

Assignment of Leases.  Many leases have provisions purporting to restrict or prohibit assignment (as well as provisions which state that the lease will terminate upon bankruptcy).  There are, however, specific Bankruptcy Code sections which render such provisions generally unenforceable in the bankruptcy context.

The ability to assign a non-residential real property lease can provide a significant opportunity to retail debtors who hold leases below market rates and are able to find third-party buyers to purchase the rights under, and thereby take over, these leases.  This not only provides proposed assignees with an opportunity to step into the shoes of the debtor on below-market unexpired commercial leases, but also provides the retail tenant-debtors with additional capital with which to administer their estates.  Note that with respect to shopping center leases, limitations such as radius, location, use, or exclusivity will continue to be enforceable, even in the bankruptcy context.

If the Debtor is a Sublandlord.  If you are a tenant under a sublease and the sublandlord files for bankruptcy, your right to occupy the property will likely be terminated if the sublandlord rejects the master lease (the lease between the ultimate landlord and your sublandlord).  You may retain your rights to possess the property, however, if you have a non-disturbance agreement with the ultimate landlord or if you are a third party beneficiary of a non-disturbance clause in the master lease.

Get prompt legal advice. Whether the debtor is a tenant or a landlord, commercial leases will be affected by any bankruptcy proceeding. The above discussion provides only a brief snapshot of the complexities involved when a business holding commercial leases as either a landlord or debtor files for bankruptcy. In order to protect your rights, get prompt legal advice any time bankruptcy proceedings are involved.

Authored by:

Richard Brunette

(213) 617-4174

rbrunette@sheppardmullin.com

and

Kristy E. Young

(415) 774-3153

kyoung@sheppardmullin.com