Move by General Growth Rattles Malls' Investors

By KRIS HUDSON and LINGLING WEI When General Growth Properties Inc. sought Chapter 11 protection last month, it took a step its biggest debt holders had believed was impossible: It took 166 of its malls into bankruptcy with it. The surprised debt holders had believed the malls would be insulated from the parent's bankruptcy because of the way General Growth had structured the assets. General Growth's action has rattled investors throughout the $700 billion market for securities backed by commercial mortgages, or CMBS. Investors in other deals had also figured their investment was insulated from a parent company's bankruptcy. Now they're worried that General Growth's move will set a precedent that could affect them. General Growth is the single largest CMBS borrower in the U.S. The CMBS market has grown up over the past two decades to become the major source of financing for commercial real estate. Some of General Growth's biggest lenders have filed objections to the company's approach in bankruptcy court. A hearing is scheduled Friday to consider, among other things, whether General Growth can use cash flow from the 166 malls as part of its restructuring. "The filing for so many of these well-capitalized, performing malls is an outrage," says Richard Jones, a lawyer at Dechert LLP, which represents some secured creditors in the General Growth bankruptcy case. "The company is doing something that would damage the entire CMBS industry." General Growth's goal in taking the malls with it into Chapter 11 was to improve its bargaining position with lenders down the line, company executives said in court papers and media conference calls. In particular, General Growth hoped to be better positioned to bargain with its creditors to extend the terms of its debt and avoid foreclosure, the executives said. But arranging the bankruptcy petitions for the malls required some maneuvering because of how their debt was structured. In past years, to get the malls' mortgages, General Growth had set up 166 "special purpose entities" whose sole purpose was to borrow money. SPEs are attractive to lenders because, according to legal experts, they are "bankruptcy remote," meaning their cash flows are dedicated to paying debt service. The lenders issued securities backed by the SPEs. Holders of securities expect the structure would ensure they'd be paid even if the parent company went bust. General Growth had to get approval from the board of each SPE before the malls could file for Chapter 11, legal experts say. In the weeks before the bankruptcy filings, General Growth replaced directors -- originally selected by Corporation Service Co., which specializes in staffing such boards -- on roughly 90% of its SPE boards. But fewer than 10 individuals were brought in because the boards are small and their memberships overlap so much, with each director serving on scores of boards, according to people familiar with the situation. All 166 boards subsequently backed having their malls enter Chapter 11. In papers filed Wednesday in U.S. bankruptcy court in New York, General Growth argued the CMBS investors' objections to including the SPEs "appear grounded in the misperception that 'bankruptcy remote' means 'bankruptcy proof.'" In addition, according to people familiar with the matter, while bylaws and loan documents involving SPEs sometimes prohibit such board replacements, some of the General Growth entities' bylaws allowed the borrower to replace SPE directors, and the documents governing the others didn't prohibit it. A major issue in the bankruptcy case is General Growth's request to draw cash flow from its malls and use it at the corporate level or in other areas of the company. Such transfers of money within the corporate structure used to be routine at General Growth, as they are at other similarly structured real-estate companies. But, now that General Growth is in Chapter 11, its CMBS lenders want to enforce the malls' status as separate entities and keep the malls' extra cash flow from being siphoned away to pay other creditors, namely unsecured lenders. To prevent that, General Growth took several steps in its bankruptcy filing that might aid any argument it ultimately makes to continue drawing cash flow from the malls for corporate use, according to people familiar with the matter. Among them, General Growth pledged to continue paying interest on its mortgages, possibly making it more difficult for CMBS holders to argue they should be allowed to foreclose. It also pledged to provide its mortgage lenders "adequate protection," meaning they will have an administrative claim in any liquidation scenario to cash flow drawn from their properties by the parent company. But lawyers representing four CMBS special servicers handling loans on 39 General Growth malls argued in their court papers that each entity is separate from the company and thus should retain all of its own cash flow. One servicer, ING Clarion Capital Loan Services LLC, filed a motion Monday to have eight CMBS-financed malls that it handles removed from bankruptcy, arguing that their loans aren't in default and they needn't be there. Write to Kris Hudson at kris.hudson@wsj.com and Lingling Wei at lingling.wei@dowjones.com