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Of Paper Clips and Staples
Evolving Legal Structures for Hospitality REITs

By Jeffer, Mangels, Butler & Marmaro LLP, April, 1998

Recent events herald a period of rapid evolution of hospitality REIT legal structures. CapStar Hotel Company and the American General Hospitality REIT will merge to form a so-called "paper-clip" REIT, and Hudson Hotels has just announced plans to go public using the same structure. Meanwhile, legislation has been introduced in Congress by the ranking finance committee members of both parties that will curtail future growth of the three so  - called paired share or "stapled" hotel REITs -- Patriot American, Starwood, and MediTrust. Finally, Bristol Hotel Company and the FelCor Suite Hotels REIT have gone in a different direction altogether, announcing a merger that depends on an informal alliance rather than on paper-clips or staples.

Why staple or paper-clip?

In order to avoid corporate-level income tax, hotel REITs must lease their hotels in compliance with a variety of tax rules. Chief among these is that the tenant must be left with a profit potential after paying rent, management fees, and operating expenses. The effort to recapture this loss of earnings (or "leakage") for the REIT's shareholders has driven the recent evolution of the hotel REIT structure.

The new CapStar / American General REIT (to be called "MeriStar") will use a paper-clip structure. Initially, the tenant and the REIT will both be owned by the same shareholders so that the tenant's earnings are captured by the REIT's shareholders. Unlike stapled shares that may be traded only in pairs (an arrangement available to a handful of REITs grandfathered from a 1984 tax code change that made pairing illegal), MeriStar's paper-clip shares may be traded singly or in pairs. MeriStar will attempt to align the interests of the REIT and the tenant through reciprocal rights of refusal to force sharing of business opportunities, change of control conditions to the refusal rights and the leases, and partial overlapping of directors.

Presumably, Hudson Hotels will follow a similar path when it goes public, and it is conceivable that if the proposed anti-stapling legislation becomes law, Patriot American, Starwood, and MediTrust will move towards a paper-clip structure. Surprisingly, Bristol and FelCor did not follow the MeriStar lead. The surviving Bristol tenant and the new FelCor REIT will have only 40 % overlapping ownership, and apparently, no rights of refusal or other legal constraints to encourage sharing of business opportunities. Bristol will, in effect become a fully independent operator.

Questions unresolved.

While paper-clip structures are very innovative and may present some intriguing opportunities under the right circumstances, JMBM's REIT experts are working with clients to address a number of unanswered questions, including the following:
 

- the evolving  REIT structure will bring a new level of legal complexity and challenge to the hospitality industry.

JMBM is a full-service, business law firm of more than 140 attorneys with offices in Los Angeles and San Francisco and with an independent network of over 1,600 lawyers in more than 75 cities world-wide. We have been involved in hundreds of transactions spanning the globe and representing over $12 billion in total sales, financings, and acquisitions of lodging and leisure properties and companies. We handle: financing, acquisition, sale, bankruptcy, ownership structure and dispute issues, securities, litigation, mergers and acquisitions of companies, union and employment matters, employee benefits, repositionings, management of franchise matters, recreational use agreements, trademarks, litigation of any sort, insurance claim, disaster, timeshare and vacation ownership, tax, foreclosure, and virtually every other challenge.