August 24, 2009

REIT and Real Estate Restructurings and Bankruptcies –

Further Observations from the Front Lines

As CMBS and other secured real estate lenders and borrowers continue to consider the
implications of the recent ruling in the General Growth (GGP) bankruptcy (see our memo of
August 12), it is worth keeping in mind that even if “bankruptcy remote” special purpose entities
(SPEs) are joined in bankruptcy proceedings of REITs and REOCs, the Bankruptcy Code and
SPEs’ unique structures should provide SPE creditors with certain protections from some – but
certainly not all – of the risks that bankruptcy entails.

“Consolidation” Risk. While the bankruptcy case of an SPE may be procedurally con-
solidated (i.e., jointly administered) with that of its parent, this should not be confused with the
more fundamental economic risk of substantive consolidation: the treatment of the assets and
liabilities of multiple debtors as if they were assets and liabilities of a single debtor and the at-
tendant dilution of the claims of creditors of the more solvent entities (e.g., an SPE with an over-
secured mortgage that is not liable on the debt of its parent REIT) by creditors of the less solvent
entities (e.g., a REIT with corporate-level unsecured debt). Substantive consolidation is rare.
Typically, some combination of an inability to distinguish which entity owns particular assets
(unlikely in the case of most SPEs) and confusion among creditors as to which entity is obligated
on their claims (also unlikely) is required. Moreover, even in a substantive consolidation case,
secured lenders’ liens on assets are respected, although the liens of mezzanine lenders on equity
interests of consolidated entities may not fare as well. The GGP court was not presented with,
and made clear it was not addressing, the issue of substantive consolidation. Indeed, the court
described an SPE’s “principal” purpose as being protection from substantive consolidation, in
contrast to the avoidance of bankruptcy proceedings.

DIP Financing and Cash Collateral Risk. As with all secured creditors of bankrupt enti-
ties, mortgage lenders to SPEs in chapter 11 face the twin risks that their liens will be “primed”
by providers of post-bankruptcy “DIP financing” and that the cash flow generated by their col-
lateral will be employed by the SPE and its affiliate debtors for general corporate purposes, not-
withstanding lockbox or similar arrangements. However, secured lenders are entitled to “ade-
quate protection” of their interests, giving them some leverage over the terms of any priming or
cash collateral usage. In GGP, the debtors did not prime the liens of prepetition lenders but did,
after a contested hearing, receive permission to upstream cash generated at SPEs. As adequate
protection, the court granted the SPE lenders, among other things, liens on the intercompany
claims arising from the upstreamed cash. However, while the intercompany claims have priority
status (and need to be paid back in full before any unsecured creditor of GGP can receive any
recovery), the ultimate ability of the parent to repay these intercompany debts depends in part on
the excess value of the SPEs themselves, which remains to be seen.

Cram-Up Risk. The “cramdown” provisions of the Bankruptcy Code (colloquially, in the
case of a secured creditor, “cram up”) permit a plan of reorganization to be approved over the
dissent of a class of creditors if the plan is “fair and equitable”. Even an over-collateralized loan
need not be paid off in cash in a bankruptcy case, and in today’s climate of scarce refinancing
capital, non-payment and partial payment have become common. With respect to secured credi-

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tors, a plan is fair and equitable if, among other alternatives, it allows the creditors to retain their
liens and provides for new or “rolled over” debt in an amount, and with a value equal to, the se-
cured claim. However, the appropriate interest rate, maturity and covenants of the new obliga-
tions are not specified by the Bankruptcy Code. Most courts refer to the market in deciding such
terms, but some courts allow for the possibility that the market is inefficient (a serious risk in to-
day’s financial climate) in choosing terms that will not result in the new instrument trading at
par. In addition, the 2004 U.S. Supreme Court decision in Till v. SCS Credit Corporation – a
chapter 13 case of uncertain applicability in chapter 11 – suggests that cramdown rates in the
range of prime plus 1 – 3% are appropriate. Certain GGP shareholders have publicly floated the
notion of cramming up GGP SPE debt with seven-year paper at current interest rates. Whether
such terms would pass muster before a court depends on any number of factors. However, in the
recent Spectrum Brands case secured creditors facing both a reinstatement and cram-up fight
reached a consensual agreement with the debtor that gave them a 250 bps margin bump, a
LIBOR floor and an actual shortening of maturity relative to their prepetition credit agreement.
This and other cases settled both in and out of court in recent months suggest that the uncertainty
surrounding cramdown tends to lead parties, where debt is secured but cannot be refinanced, to
compromise solutions – rates not so high as might be incurred in a refinancing, nor so low as the
rates that prevailed in the recent bubble financing years.

Timing Risk. A basic risk associated with bankruptcy is one that is difficult to avoid, that
of timing. Lenders to SPEs will generally be barred by the automatic stay from foreclosing their
collateral during the pendency of a bankruptcy, perhaps as long as two years. The stay will ap-
ply even in the case of an SPE that qualifies as a “single asset real estate” debtor (mortgage – but
not mezzanine – lenders to which are entitled to certain special protections under the Bankruptcy
Code), so long as the mortgage – but not mezz – lenders receive current interest at their non-
default rate. Exclusive control over the bankruptcy case by a debtor (which bankruptcy courts
can, but only infrequently do, abrogate prior to the 18-month, statutory maximum) represents
risk for senior creditors who fear that collateral values will continue to decline over time, option-
ality for junior creditors, mezz lenders and equity that might be out-of-the money at the time of
the bankruptcy filing, and opportunity for those who choose to play in the distressed investment
space.

Many of the issues that are cropping up in the ongoing wave of REIT and real estate re-
structurings and bankruptcies are novel, and many of the issues that arise in bankruptcy in the
ordinary course have not been previously applied to the complex real estate financing structures
created in recent years. It is important to appreciate, but not to exaggerate, the hazards now fac-
ing both lenders and borrowers.

Adam O. Emmerich
Robin Panovka
Richard G. Mason
Eric M. Rosof
Joshua A. Feltman

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