News for the Hospitality Executive
Hotel Bankruptcy Issues -- Special Purpose Entities Getting Approval to File Bankruptcy
|By Jim Butler, April 21, 2009
Distressed hotel loan bankruptcies and restructurings are on the rise. Now we are starting to see some new issues tested. As The Great Recession of 2008 continues to set record unemployment levels and send shockwaves through the economy, hotel bankruptcies are on the rise. Sure a lot of lenders are tending to extend maturities, work out forbearance restructurings or go for uncontested receiverships, but we are starting to see some bankruptcy filings as well.
And just as the economy is in "uncharted waters," some loan structuring terms or approaches that were developed in the 1990s have not been fully tested, if at all, by a severe downturn or serious litigation. One of those devices that has been quite popular is the use of a "special purpose entity" or SPE.
Dealing with troubled hotel loans has always been more complex than other real estate assets. But after the great real estate collapse in the early 1990s, when there was an estimated wave of some 2,000 hotel bankruptcy filings, many lending innovations were implemented. These included the invention of the CMBS market by the RTC, use of special purpose entity structure for borrowers, non-recourse loans with "bad boy" claw backs , and even amendments to the Bankruptcy Code to eliminate the "rents" versus "accounts" issue with hotel collateral and to expand the definition of SARE (or Single Asset Real Estate) bankruptcies entitling lenders to expedited relief from stay.
With the exception of a couple of "hiccups," the economy has generally performed so well over the past 15 or so years, that we have not had a flood of bankruptcies to test the effectiveness and enforceability of these creative lending approaches.
But the current economic crisis looks poised to change all that. So, today, we are going to look at issues raised by use of a special purpose entity or SPE which has been a prevailing practice for many years now.
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 the corporate borrower to file bankruptcy, 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 hinder a lender getting a receiver appointed or 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. The debtor's principal just signed the papers himself without even seeking approval from the independent directors. 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.
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.
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|Also See:||Workouts and Special Servicing for Hotel Mortgage Loans: What Is So Different About Troubled Hotel Loans / Jim Butler / November 2008|
|Speed Bumps in the Road to Bankruptcy for Hotels and Resorts / Robert B Kaplan / November 2008|