Checking in to Bankruptcy & Workouts: Options for Your Distressed Hotel

By: Joseph J. Wielebinski

Mar 24, 2010

While the recently popular lender/borrower game of "extend and pretend" has allowed lenders and hotel owners to play nice with each other while hotels have faced these unprecedented economic times, this game may be winding down as lenders begin to take a more aggressive stand on loan maturities/defaults. This article provides insights into some of the practical and legal options for the hotel owner when the lender begins to exercise its legal remedies.

First, let's examine some of the cards that the hotel owner-borrower holds. For one thing, troubled hotel loans are more difficult for lenders due to the myriad of management and franchise affiliations, licenses and permits, extensive vendor relationships, marketing efforts, significant workforce involved, etc. These contracts and relationships typically do not factor into the "normal" non-operational real estate workout and/or foreclosure (for example, warehouses or strip retail centers), but are common in hotel ownership and are critical to the value of the hotel asset. In addition, the lender's lien position may be subordinate to the hotel management and franchise agreements, another reason for the lender to compromise and attempt to work with the existing borrower and hotel manager even when the loan is in default.

Workouts & Related Options
Given these unique advantages, what are the possible approaches a hotel owner can take when facing the lender's attempts to collect on the loan or enforce its liens against the property? The most obvious answer is a loan workout/modification/extension. Many industry experts have observed that banks do not want to write down loans because this action requires an increase in their bad debt and capital reserves.

If the owner-borrower can move the lender toward a workout scenario, the first step is normally the negotiation of a pre-workout agreement (PWA). A PWA is an agreement outlining the current situation faced by the parties and the parameters of the parties’ respective rights and obligations in attempting to negotiate a consensual resolution. The PWA may be a lender's attempt to protect itself during negotiations of the existing loan. Perhaps such protections are reasonable, but the owner-borrower should not admit any defaults or waive any rights in the PWA. Sometimes lenders will attempt to use the PWA to obtain concessions from the owner-borrower before allowing workout negotiations, and the owner-borrower must decide whether the requested concessions are necessary, prudent or will impair the owner’s ability to exercise rights or undertake actions that might be necessary if the workout negotiations fail.

Sale of Hotel
A hotel owner might also consider a sale of his hotel. Though this article will not examine this option in depth, a sale may be good approach if the owner is not willing or able to retain the hotel for another three to five years, when industry pundits believe values may return to more normal conditions. If there are no guaranties of the hotel loan by the owner-borrower's principals or if the bank is willing to reduce or eliminate any guarantor deficiencies, the owner-borrower and lender might also want to consider an agreed upon "short sale," which is a sale of the hotel for less than the loan balance. In addition to eliminating the debt of the owner-borrower to the lender, the benefit of a short sale is that the borrower stays involved with the hotel until the sale is consummated, such that the lender does not have to get involved with the ownership and management issues that arise from a foreclosure or deed in lieu of foreclosure.

A hotel owner may seek the appointment of a receiver if it does not operate the property and determines that the property’s distress is caused by current management. In the hotel context, most receivers are hotel management companies (or in states like Texas that require that individuals serve as receivers, officers at hotel management companies that hire their management companies to manage the hotel asset). Termination of the current management agreement may result in a breach of contract claim from the current management company, but oftentimes in these circumstances the current management company and the lender are both in a state of frustration and the appointment of a receiver and termination of current management can be orchestrated on a consensual basis, allowing a fresh face and approach to hotel management and, from the lender's perspective, an independent third party managing the hotel for the mutual benefit of the owner and the lender. For more information on that topic, read The Why, What and How of Hotel Receiverships by Robert (Bob) H. Voelker, Joseph J. Wielebinski, James M. McGee and Lee J. Pannier.

Foreclosure is an option that may seem unpalatable, but it should be considered as well. Handing over the keys to a hotel may be the best alternative if the debt significantly exceeds the value of the hotel, the loan is non-recourse and a workout or a sale or other viable options are unavailable. In fact, it may be a way to avoid any liability to which the guarantors may be exposed by filing bankruptcy. Loan documents frequently contain a provision that states if the borrower files bankruptcy, the entire loan becomes guarantied by the guarantor.

Before filing bankruptcy, a hotel owner should consider several issues. First, under recent loan documents, the owner-borrower is likely a special purpose entity (SPE), and the act of filing bankruptcy may require approval from independent directors and/or unanimous approval from all directors. If such directors have some connection to the lender, they may not vote for a bankruptcy that thwarts the lender’s ability to protect its collateral. (As a side note, it is not yet clear whether provisions dictating such director approval are legally enforceable.) In addition, the owner should recognize that filing bankruptcy can be an expensive option, and the owner should only file while he has sufficient cash on hand to cover bankruptcy related expenses such as legal fees in addition to ongoing operational costs. Also, before choosing the bankruptcy route, the owner should determine if any principals or affiliates executed a personal guaranty. As mentioned above, many guaranty agreements provide for "springing liability" of the guarantors upon a bankruptcy filing.

Assuming filing for bankruptcy is the best option, there are some bankruptcy specific issues hotel owners should take into account. Post-petition hotel room revenues are subject to restricted use (see Bankruptcy Code § 552(b)(2)). That is, the mere filing of bankruptcy does not then allows the owner to use post-petition hotel room revenues as he pleases; these funds are subject to restricted use, either the party(ies) with an interest in the revenue consents or the bankruptcy court authorizes such use because the lender’s interests are “adequately protected.” Additionally, the owner should verify whether the loan documents provide for a lender security interest in or restricted use of hotel room revenues; however, frequently in brand managed hotels there is a side agreement (for example, cash collateral agreement) between the lender, borrower and hotel manager that allow the hotel manager to continue to use cash collateral despite the security agreement.

One of the larger issues during bankruptcy is the owner-debtor's ability to deal with executory contracts (for example, those contracts that have not yet been fully performed) such as hotel management agreements and service contracts. Under the Bankruptcy Code, the owner-debtor has three options with respect to pre-petition executory contracts: the owner-debtor may 1) assume such contracts, 2) assign such contracts (after assumption) or 3) reject such contracts. Taking the example of the hotel management agreement (HMA), an owner-debtor may assume an HMA, but in order to obtain bankruptcy court approval to do so, if the owner-debtor is in default of the HMA, the owner-debtor must: 1) cure or promptly cure any defaults, 2) compensate for any actual losses resulting from default under the HMA and 3) provide adequate assurance of future performance under the HMA. The good news under option two — assignment — is that under the Bankruptcy Code, an HMA is typically assignable regardless of a prohibition against assignment contained in the HMA. With assignment, the owner-debtor still must satisfy the list of items required to assume the HMA. Finally, the owner-debtor may reject the HMA. In fact, rejection may actually increase the value of the hotel, as many potential purchasers want to change brands or managers and don't want to be restricted by the terms of the existing HMA. Consider, however, the owner-debtor remains liable for possible damages resulting from rejection of the HMA, though these damages are an unsecured claim in the bankruptcy case.

One of the main advantages of bankruptcy is the owner-debtor's ability to sell property of the estate, including the hotel, free of all liens, claims and encumbrances under § 363 of the Bankruptcy Code. A successful bankruptcy sale may allow an owner to more readily market the property and sell it at an increased price because such encumbrances are eliminated.

In the Meantime
While determining which of the aforementioned paths to take, consider improving your hotel operations by perusing the article here, authored by Real Estate Shareholder Richard O. Kopf.