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Speed Bumps in the Road to Bankruptcy for Hotels and Resorts
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By Robert B. Kaplan, Hotel Lawyer in JMBM's Bankruptcy, Insolvency and Restructurings Group
November 2008

Making hotel mortgage loans and dealing with troubled hotel loans is always more complex than with other real estate assets. Some of these issues have been nicely summarized at www.HotelLawBlog.com in a current series of articles on troubled hotel mortgage loans.

A lot has changed since the mid 1990s when there was an estimated wave of some 2,000 hotel bankruptcy filings. The veteran hotel lawyers in JMBM's Global Hospitality Group® represented many major lenders, the FDIC and RTC, and also a number of noteworthy borrowers in cleaning up that mess.

The Bankruptcy Reform Act of 1994 adopted several substantial changes, including a "fix" to the vexatious "rents vs. accounts" issue that plagued hotel lenders through the mid 1990s.* Another of these changes related to what constitutes a "single asset" bankruptcy entitling the secured creditor to expedited relief from the bankruptcy stay. While a single hotel in a special purpose entity might intuitively seem to be a single asset entity, there appear to be two views on this subject, perhaps depending on the facts, or perhaps depending upon the jurisdiction considering the issue. 

If you don't know what the "rents vs. accounts" fracas is all about, then don't worry about it, because you are unlikely to encounter it today. But prior to the 1994 amendments, some courts (like the court in the infamous Northview case in 1991) held that revenues derived by hotels were not "rents" (income from real estate) capable of being secured by a note and deed of trust. Instead, they were in the nature of "accounts" or accounts receivable, and therefore were personal property requiring UCC filings, a "security agreement" and appropriate personal property descriptions. And even if properly described and secured by UCC-1s and security agreements, post-petition revenues were exempt (and are still exempt) from the security interest, like the revenues from any operating business (but unlike the rents derived from real estate). However, this issue can be addressed with a proper cash collateral order. 

First, I want to focus on a practice that became very common in the mid 1990s and continues today. However, with a long period of good economic times, this practice has not been tested in the crucible of bankruptcy litigation. There are significant implications for all hotel turnarounds, workouts, bankruptcies and receiverships, and for other asset classes as well.

How can a "Special Purpose Entity" borrower ever file bankruptcy if lender appointed directors must approve the filing? 

Since the mid 1990s, the typical hotel loan has required the borrower to put each hotel asset into a special purpose corporate entity. The corporate entity's organic documents typically require that for a bankruptcy filing to be made, approval must first be obtained from "independent" directors (e.g. independent of the borrower) appointed by the lender. The expectation was that the lender-appointed directors would NOT approve the filing of a bankruptcy, because bankruptcy would delay a lender completing foreclosure in the event of a hotel loan mortgage default.

JMBM's hospitality lawyers are currently representing a lender in a matter where the debtor completely ignored the requirement of getting independent director approval for bankruptcy filing. Here's how this issue shapes up.

This is a question of first Impression!
The concept of requiring special approval for a corporation to file bankruptcy is embedded in many thousands of hotel and other real estate secured loan structures. In recently undertaking an engagement representing a hotel lender, we found that there was no reported bankruptcy case in the United States evaluating the validity of a requirement that in order to file bankruptcy, a corporate entity must either get the approval of certain "independent" directors, or must have a unanimous approval of all directors.

The variations of this theme will undoubtedly be tested in the Financial Crisis as more lenders seek to foreclose on their hotel collateral and to prevent borrowers from delaying their process with bankruptcy filings, or as borrowers seek ways around the requirement to save their projects or extract lender concessions.

JMBM's hotel lawyers represent both hotel lenders/creditors and hotel/borrowers. So we will follow the development of legal principles in this area with great interest in the many jurisdictions where it is likely to evolve.

Borrowers will Say:
Debtors will argue that the approval requirement for a bankruptcy filing is void because it is against the public policy of permitting bankruptcy reorganizations, and blocks access to the bankruptcy courts. They may also argue that requiring unanimous approval of the board, or approval by the outside directors appointed pursuant to the loan documents is unenforceable as too high a requirement and void under corporate governance policies as well.

Lenders will say:
Creditors will argue that this is enforceable under state law governing the organization and operation of corporations, limited liability companies or whatever entity is involved. They will certainly say that the provision was a part of the bargained-for-consideration among sophisticated players and does not block access to the bankruptcy courts. It just requires the business judgment of independent directors who will be held to their fiduciary obligations.

The business judgment rule will presumably protect these independent directors, IF THEY PROPERLY INVOKE THE RULE. The business judgment rule only protects directors who actually exercise their judgment by identifying an issue, getting appropriate advice, giving due consideration to the information, and properly documenting the their decisions. This means that outside directors will need likely need independent counsel, independent appraisers and careful guidance to properly exercise their "business judgment" and gain protection of the rule. 

Who wins?

There is no bankruptcy authority on this critical issue. We suspect that the bankruptcy courts may have divergent opinions initially, and that eventually, a consensus may develop at least in certain circuits, on a jurisdiction-by-jurisdiction basis. This makes prediction of result difficult until the results begin to form a pattern.

Pro-debtor bankruptcy judges probably will not enforce the independent director requirement and may hold them void as a matter of public policy. Pro-creditor bankruptcy judges will enforce the independent director requirements on the ground that they were negotiated between sophisticate parties in a commercial setting.

Until some controlling authority develops, at least where borrowers feel that they have some equity, they are likely to try filing bankruptcy without independent director approval, or trying to position the independent directors for breach of fiduciary duty liability for failing to act in the best interests of the corporation, and preferring the lender constituency. This is likely to cause independent directors to seek independent counsel and appraisals for the ensuing battle.

Relief from stay provisions for "single asset" bankruptcy cases. 

As noted the new wave of bankruptcies will test loan structures and provisions developed since the mid 1990s and never tested before, as with the requirement for unanimous board approval for bankruptcy filing.

We look now at an issue that hotels, resorts, marinas, sports facilities and other hospitality-related assets will likely present to many lenders seeking to use the expedited relief from bankruptcy stay provisions available to creditors in certain "single asset" bankruptcy cases.

One commentator argued, perhaps only half tongue-in-cheek, that every hotel should have a gift shop, if only to avoid single asset real estate status in bankruptcy. 

Can a hotel ever be a "single asset" for bankruptcy purposes? And who cares? 

Since the mid 1990s, lenders on hotels, resorts and other hospitality properties have generally required their borrowers to transfer the asset being financed into a "special purpose" entity which will own only the asset being mortgaged. Intuitively, a corporation with only one asset would seem to be a "single asset" entity, but does that work under the Bankruptcy Code, and why is it important to lenders and borrowers?

This determination has important consequences. If a bankruptcy involves a "single asset" (or "single asset real estate" as it is often called), the proceedings will tilt greatly in favor of the secured creditor. In a single asset real estate bankruptcy, the creditor will be entitled to relief from the bankruptcy stay as a matter of law, unless the debtor does one of two things within 90 days of filing.

The debtor must either: 

1. file a plan of reorganization which has a reasonable possibility of being confirmed in a reasonable time, or 
2. start making interest only payments at the non-default contract rate of interest
These are often difficult to accomplish unless the asset is really viable and cash flowing.

And if the bankruptcy court finds that the hotel does not involve a single asset real estate bankruptcy, the creditor will likely be delayed in more protracted proceedings and greater costs.

But, why isn't a single hotel a "single asset"? How could a borrower with a single hotel possibly avoid this single asset rule that gives creditors an expedited relief from the bankruptcy stay?

When is a hotel NOT a "single asset"? 

The expedited relief from stay provisions are set forth in section 362(d)(3) of the Bankruptcy Code for cases which involve "single asset real estate" or SARE as defined in section 101(51B) of the Code. The idea is that creditors should not be unduly delayed from foreclosing where there is a single real estate asset and therefore minimal chances of a successful bankruptcy reorganization.

The courts generally hold that there are certain requirements for a debtor to qualify as a SARE debtor, as follows:

1.  The real property must constitute a single property or project (other than residential property with fewer than four residential units). 
2.  The real property must generate substantially all of the income of the debtor.
3.  The debtor is not a family farmer and is not engaged in any substantial business other than operation of the real property and activities incidental thereto. 
4.  [a limitation of secured debt to $4 million was eliminated by the Bankruptcy Code amendments in 1994.] 
The classic cases for single asset real estate involve a single office building or apartment house passively held for income. Properties involving an operating business, like hotels, are more problematic. Thus, the 9th Circuit Bankruptcy Appellate Panel (or BAP) found that at least a full-service hotel did not qualify as SARE. In the case before it, the Court said that the "hotel is sufficiently active in nature to constitute a business other than the mere operation of property." The gift shop, restaurant and bar, among other things included in the operation of a 63-room full service, constituted other "substantial business" than the operation of real property. (CBJ Dev., Inc., 202 B.R. 472-473). 

And another case where the hotel was operated without a gift shop or restaurant, also held that the hotel business itself was more than "the business of operating the real property" and the property was therefore not single asset real estate.

In fact, some courts have declared a wide range of hospitality properties to be non-SARE, including properties involving one of the following 

  a marina 
  a golf and ski club 
  a property with golf pro shop and golf-related services
One commentator argued, perhaps only half tongue-in-cheek, that every hotel should have a gift shop, if only to avoid single asset real estate status in bankruptcy. 

But creditors make take hope from a case decided in Tennessee where a 126-room Comfort Inn was held to be a single asset. 
The classic cases for single asset real estate involve a single office building or apartment house passively held for income. Properties involving an operating business, like hotels, are more problematic.

What does this all mean in terms of debtor or creditor strategy? 

As noted above, debtors may open gift shops if only to defeat single asset status. Otherwise, they face relatively short proceedings unless they either present a plan of reorganization within the first 90 days after the bankruptcy filing (or a court-approved extension), or start making payments.

Where it is clear that a case is a single asset case (like an office building or an apartment house), the strategy is for the lender to wait 90 days, and if the debtor has not done one of the required things (i.e. filed a plan of reorganization, or started making interest payments), then the lender would move for relief from stay.

But, when there is doubt about the single asset status -- as there will normally be with hotels, resorts, marinas, and sports facilities -- the lender should normally move quickly to file a motion for the bankruptcy court to determine if it is a single asset case. If you have a hotel, you probably need to make this motion unless there is governing law in the jurisdiction involved.

And if the bankruptcy court finds that the hotel does not involve a single asset real estate bankruptcy, the creditor will likely be delayed in more protracted proceedings and greater costs.

The lender wants a determination of the single asset status early, because if it turns out to be a single asset case, the statute gives the lender relief from the bankruptcy stay the LATER of 90 days after the petition's filing, or 30 days after court determines it is a single asset. 

Another strategy that we recommend in appropriate situations is adding a provision to any workout or forbearance agreement. In substance, the lender wants to include a representation or warranty by the debtor that the debtor qualifies for single asset real estate status to be governed under the appropriate provision of the Bankruptcy Code, and acknowledging that the lender is entering into the forbearance agreement in reliance on this representation and undertaking . We don't know if this works yet, but it is worth a try, and a lot of covenants may be enforceable if made in a workout that would not have been valid when the loan was originated.


Robert Kaplan is a partner in JMBM's Bankruptcy, Insolvency and Restructurings Group and a senior member of the Global Hospitality Group® -- a team of 50 seasoned professionals with more than $50 billion of hotel transactional experience, involving more than 1,000 properties located around the globe. 

Bob represents lenders, special servicers, hard money lenders, community banks, national banking associations, distressed debt investors, and equity investors, positioning them for the best possible outcome by acting expeditiously to preserve value and increase cash flow. His industry experience and his knowledge of the current capital markets -- where distressed assets often include complex deal structures and securitized loans -- allows him to bring creative and effective strategies to the table. When aggressive litigation is the best strategy, he is a vigorous and effective advocate for his clients. 

Bob represented the securitized lender in the Chapter 11 bankruptcy case filed by the Clift Hotel in San Francisco, and in the subsequent negotiations and successful sale of the loan to a third party. The lender -- acting by and through GMAC Commercial Mortgage Corporation as special servicer -- was the holder of a $60 million loan secured by a Deed of Trust on the Clift Hotel. He has also served as counsel to JER Robert Company, AMRESCO Management Inc. and Midland Loan Servicer their in its capacity as special servicers on troubled hotel loans in CMBS pools.

To read more about hotel workouts, go to www.HotelLawBlog.com and select "Workouts" For more information, contact Robert Kaplan at 415.984.9673 or rkaplan@jmbm.com.

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Contact:

Jim Butler
Chairman, Global Hospitality Group
Jeffer, Mangels, Butler & Marmaro LLP
1900 Avenue of the Stars, 7th Floor
Los Angeles, CA 90067-4308
(310) 201-3526 direct
jbutler@jmbm.com
www.HotelLawBlog.com

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