Could the bankruptcy of a single company bring the securitization market to its knees? No, we aren’t talking about Citigroup or Bank of America, but General Growth Properties (GGP). As if all of this talk of bankruptcy isn’t depressing enough, behind it lurks another set of issues, perhaps even more unsettling – and with the potential to up-end the entire market for securitizations. A court ruling expected on May 8, 2009 in the Southern District of New York Bankruptcy Court promises to be a nail biter. General Growth Properties’ bankruptcy actions are no small issue, as they could threaten GGP, the broader commercial mortgage-backed securities (CMBS) market and even more broadly, the entire construct of securitization.

This is no small issue: securitizations act as a form of financing that sweeps together everyone from real estate to credit cards, and from student loans to even jet engines. Companies from Citigroup, Sallie Mae, and Willis Lease Finance Corporation (which introduced jet engine securitizations) are all players in a vast market. More creative securitization transactions have included David Bowie’s music royalties and even the Arsenal Football Club’s ticket sales. For good measure, securitizations also raise their own fair share of fiduciary duty issues.

A quick primer: GGP was founded in 1954 by the Bucksbaum family. The company has altered between public and private organization structures, but has been a major deal maker and force in the commercial real estate world for decades. GGP is currently organized as a real estate investment trust (REIT) and owns the second largest retail portfolio in the U.S. GGP grew aggressively during the real estate boom with debt finance acquisitions, but by 2008, it was billions of dollars in debt and unable to cover its obligations.

GGP used all the financing options available to it, including some of the most innovative securitization-based structures. GGP was a near-poster child for securitization. Using a traditional real estate structure, GGP set up separate entities to hold many of its properties, each funded through mortgages secured by malls held at the operating entity level. Innovatively, however, these entities were set up as bankruptcy-remote special purpose entities (SPEs), and the loans were then sold off in and repackaged into CMBS, aka securitized real estate debt, that was then sold off to the marketplace.

Oddly, bankruptcy (or more accurately, bankruptcy remoteness) lies at the foundation of every securitization. A company cannot just up and securitize anything that it wants, free from oversight. The key to securitization is that the assets and the assets alone are separated and rated. If the assets aren’t separate and legally distinct from the obligations and assets of the issuer, then what is created is a run of the mill corporate bond. One of the most common ways to accomplish this legal separation is through the establishment of a bankruptcy-remote SPE. Two important requirements are for the SPE to have at least one independent director and that the unanimous consent of the directors is required for the SPE to file for bankruptcy. The idea behind this is that independent directors have a fiduciary duty to all stakeholders in the SPE.

Imagine the CMBS investors’ shock at GGP’s next move – shock, because the very point of bankruptcy-remoteness is that, in the event of parent company bankruptcy, the remote SPE (which, recall, holds the collateral securing the loan) is not included in the parent company’s estate. GGP had 273 SPE affiliates, of which 115 thought it prudent to remain outside of bankruptcy court, while 158 voted to be included in the REIT’s petition Throwing protocol to the wind (and along with it the legal pretense on which many a securitized structure rests), GGP itself has attempted to consolidate some of its SPEs into its bankruptcy case under the doctrine of substantive consolidation. Substantive consolidation is a bankruptcy law doctrine that, in certain circumstances, allows separate bankruptcy proceedings, like those of a debtor and its affiliates, to be combined for administrative purposes. Could GGP have received some savvy legal advice from Weil, Gotshal & Manges, its bankruptcy counsel?

To understand why they’re attempting to do this, a brief walk through capital structure is helpful. GGP is over-leveraged… but it appears that many of its SPEs aren’t. If the GGP bankruptcy was left to its own, parent-level devices, senior security holders would have a chance for recovery, while junior creditors (and equity holders) would have a lot less of a chance. These chances are upped if the assets available for distribution can be magically increased. Enter SPEs, positively brimming with cash flow and performing assets, even after paying off their own creditors. These are facts that equity holders as experienced as the Bucksbaum family and Pershing Square’s Ackman, who owns about 25% of GGP and is it debtor in possession lender, are sure to see this recovery rate boosting potential. So it appears GGP is using substantive consolidation to cleverly (or under-handedly, depending on your perspective) shift assets back into the parent, even though the affiliates in this case are bankruptcy-remote.

If any of GGP’s SPEs are solvent (and reportedly, some are) then the bankruptcy filings give rise to several concerns. First, director fiduciary duties to SPE stakeholders may have been breached by voting for the solvent entities to declare bankruptcy. This is a red flag, especially considering that for bankruptcy to have been declared, the independent directors must have voted for it (or perhaps, at minimum, not voted against it). Second is the artful but disturbing possibility that these bankruptcy filings represent an end run on the collateral that CMBS investors thought secured their investment. Adding further complication, inter-creditor issues get quite messy. It is unclear how to balance the interests of the junior creditors of GGP’s capital structure against those of the SPE’s own creditors. If this case sets precedent, then it will be the latest in a serious of recent events that seem to advantage junior members of the credit structure in unexpected ways.

This casts a shadow over CMBS relating to REITs and other real estate operating companies. Many have used CMBS-lubricated funding lines to cheaply finance expansion. However, GGP’s substantive consolidation, if allowed to stand, calls into question the security of the underlying collateral on all CMBS. This risk is exacerbated by its short fuse – i.e. both GGP and many other real estate companies financed via short-term debt, requiring near-term renewal. Chickens may shortly come home to roost for success on GGP’s substantive consolidation attempt may boomerang and quash already reduced investor demand for CMBS…making real estate financing even more expensive. As we’ve seen in recent months, when financing markets enter a deep freeze, asset prices shortly follow – calling into question the future of commercial real estate transactions.

As if this weren’t enough cause for pause, the erasure of SPE remoteness would likely affect the securitization market overall, beyond CMBS. If GGP (the debtor) can collapse its SPEs into its corporate structure over creditor objections, a Pandora’s box will have opened. Out of it may pour more frightening scenarios, in which future creditors may attempt to similarly pancake other SPEs into their parent companies in other not-yet-dreamed-of bankruptcies. Imagine the field day of creditors of insolvent special investment vehicles (SIV) now able to access the sponsoring bank’s assets. In sum, GGP’s substantive consolidation could imperil the legal separation of assets that underlies asset-backed securitizations.

The securitization market has been a key financing route for companies as diverse as Target, JP Morgan, and Honda. However, this financing route has been crimped by the credit crisis and could be further reduced if GGP’s motion for substantive consolidation is allowed to set precedent. The accompanying fallout might not be contained to just the commercial real estate market and could possibly seep out to the rest of the securitization market. GGP’s bankruptcy filing promises a courtroom showdown, plenty of drama, and far reaching consequences.

Published: May 5, 2009