News for the Hospitality Executive
| By: Rob
A recently released industry report indicates that there are approximately 300 hotels in California that are in foreclosure or default, representing a nearly five-fold increase since January 1, 2009. According to data compiled by Smith Travel Research (STR) and STR Global, hotels across the United States have recorded declines in all three key performance metrics: occupancy, ADR (average daily rate), and RevPar (revenue per available room). In year-over-year national comparisons, occupancy dropped 9.7 percent to 61.1 percent, ADR declined 10.2 percent to $98.12, and RevPar decreased 18.9 percent to $59.97. Some industry analysts predict that the 300 hotels that are in foreclosure or default in California may well double by the end of the year as values continue to plunge and more hotel owners are unable to pay their mortgages or refinance their loans at maturity.
Unlike other real estate assets, hotels are unique because they involve real estate (land and improvements) and an ongoing business. The issues relating to the real estate component are generally no different from the issues encountered with other real estate assets. It is the ongoing business component of hotels that creates issues lenders and special servicers may not equipped to handle. Moreover, unlike office buildings and shopping centers, where rents are usually locked in for 3, 5 or more years, revenue from hotels fluctuates daily depending on occupancy and rate, making hotels more vulnerable to market conditions. For this reason, hotels require strong management and asset management.
The purpose of this article is to give a brief overview of some of the issues lenders and special servicers should consider before taking back a hotel whether by foreclosure or deed in lieu of foreclosure.
General Background: Not All Hotels Are Equal - Franchised, Brand Managed and Third Party Managed Hotels
Hotels are either independent, meaning that they have no affiliation with a particular brand, or branded, meaning that they identify with a particular hotel company’s brand. Hotel company in this context means any one of a number of hotel companies which have created brands (or identities). A few of the more familiar hotel companies are Hilton, Marriott, Starwood, InterContinental and Choice Hotels. Each of these hotel companies in turn has developed a family of brands. For example, Hilton’s family of brands includes Conrad, Hilton, Doubletree, Embassy Suites, Hilton Garden Inn, Hampton, Homewood Suites, Home 2 and Hilton Grand Vacations. Each of these brands drives business, establishes rate and indentifies in the mind of the consumer whether the hotel is full service, limited service or extended stay, and whether it is a 3-star or 4-star or 5-star hotel. Just to drive home this point, what do you picture when the names Motel 6 and Ritz Carlton are mentioned? The imagery derives in part from the brand: Motel 6 connotes simplicity and affordability while Ritz Carlton means high end and expensive.
Generally speaking, hotels are either owned by a hotel company (or by a joint venture consisting of the hotel company and an investor) or by a third party who is independent of any hotel company that provides a brand. In the latter situation, the hotel owner will usually enter into a management agreement or franchise agreement with the hotel company. When the owner enters into a management agreement with a hotel company (sometimes referred to as a brand management agreement), the hotel company will manage the day to day operation of the hotel and lend its name (brand) to the hotel. The owner enjoys the benefits of the brand, including inclusion in the brand’s reservation system and sales and marketing systems and use of the brand’s trade name, logo, service marks and other intellectual property. When the owner enters into a franchise agreement, a hotel company will again lend its name (brand) to the hotel and the owner will enjoy all of the same benefits as if it had a brand management agreement, but the hotel company does not manage the day to day operation of the hotel. Instead the owner will either self-manage (if it is qualified), or more commonly it will enter into a third party management agreement with an independent hotel management company (known as a third party operator) to manage the hotel. A third party operator is not associated with any particular brand. Selecting the right brand and operator is crucial, as it is generally known to affect the value of a hotel by as much as 25%.
If a lender or special servicer (collectively referred to as “lender”) is thinking about taking back a hotel, there are a number of legal issues that should be considered, including, among others, the following.
The Comfort Letter
A comfort letter is an agreement that a hotel company typically gives to a lender at the time the loan is made when the hotel owner/borrower and hotel company have entered into a franchise agreement. It governs the rights and obligations of the lender and hotel company under the franchise agreement after the hotel is taken back by the lender.
The lender must first determine whether there is a comfort letter and, if so, what it provides. Must the lender give notice of default to the hotel company and, if so, when must the notice be given? If the hotel owner/borrower has defaulted under the franchise agreement, must the lender cure the default and, if so, how much time will the lender have to cure the default? What if the default involves substandard guest satisfaction scores for service or physical condition of the hotel? Will the hotel company give the lender an opportunity to improve these scores? If the lender desires to retain the franchise agreement, can the existing franchise agreement be assigned to the lender, or will the hotel company require the lender to enter into a new franchise agreement using the hotel company’s current form? In either case, will the lender be required to pay an application fee or other fees? Will the lender have to upgrade the hotel in accordance with the hotel company’s product improvement plan (PIP)? If the lender enters into a franchise agreement with a hotel company knowing it will sell the hotel in the short term, will the hotel company agree to allow the lender to assign the franchise agreement to its buyer? If the hotel company has the right to terminate the franchise agreement under the Comfort Letter, say for example because the lender refuses to cure the hotel owner’s/borrower’s default, will the lender be able to continue to operate the hotel under the hotel company’s brand until it secures a replacement brand? How much time will the lender have to find a new brand?
Additionally, there are a number of other issues that must be vetted with the hotel company. For example, will the hotel company allow the lender to enter into an interim franchise agreement allowing the hotel to remain under the hotel company’s brand and to have continued access to the hotel company’s reservation system? If the lender is not sure whether the brand is the correct brand for the hotel, it may want the ability to sell the hotel unencumbered by the franchise agreement to afford the buyer the flexibility of re-branding the hotel.
If the franchise agreement is retained by the lender or its transferee and if the franchise agreement requires full service food and beverage (including the sale of alcoholic beverages), will the lender be able to obtain a transfer of the liquor license from the holder of the license? If not, will the lender be in default under the franchise agreement? These and other issues must be discussed with the hotel company before a lender takes back a hotel (see discussion below under the heading “Liquor licenses”).
Subordination, Non-Disturbance and Attornment Agreement (SNDA)
Whether a hotel is subject to a brand management agreement or third party management agreement, a lender must review the SNDA before taking back a hotel. The SNDA addresses the rights and obligations of the hotel owner/borrower, lender and the manager. With a SNDA given by a hotel company under a brand management agreement, the hotel company typically requires the lender or any transferee of the lender to retain the brand management agreement and to recognize the hotel company. In other words, the lender has no contractual right to terminate the brand management agreement. If the SNDA does not permit the lender to terminate the brand management agreement, the lender will not have much leverage to renegotiate the brand management agreement. The results are mixed under third party management agreements, some permit termination without payment of liquidated damages, some permit termination with liquidated damages and others prohibit termination.
If the SNDA allows termination of the management agreement, deciding whether to keep or terminate the existing manager and brand is among the key issues a lender will have to carefully consider when taking back a hotel. From a lender’s perspective, a lender will want the best of both worlds – following repossession of the hotel, it will want the ability to retain the brand (whether under a brand management agreement or franchise agreement) or terminate the brand without payment of any liquidated damages or other termination fee. If a lender elects to terminate the management agreement, it will want input from labor counsel regarding its exposure for employee related liabilities. Will the lender have successor liability? Must the employees of the hotel be given notice under the federal Workers Adjustment and Retraining Notification Act (“WARN Act”)1 or comparable state law? Is the hotel subject to a collective bargaining contract? Will the lender be bound by the collective bargaining contract? Will it have a duty to bargain? If it becomes the owner of the hotel, can it have withdrawal liability under health and welfare and pension plans?
If the decision is to retain the management company, the lender must review the management agreement. Can the lender take an assignment of the management agreement or must it into a new management agreement? If it assumes the existing management agreement, can the lender renegotiate some of its terms? For example, can the lender get the right to approve the general manager or other members of the hotel’s executive staff? Can the lender have approval rights over the operating and capital budgets? Will the lender be required to fund FF&E reserve accounts? Must the lender perform renovations to the hotel, or will the hotel company defer them? Can the lender terminate if the manager fails to satisfy certain performance criteria? Can the lender terminate the management agreement upon sale of the hotel? Has the manager advanced funds to the hotel owner/borrower as “key money” or to cover operating shortfalls? If so, will the lender have the obligation to repay them? Will the hotel company agree to give the lender a termination right upon payment of liquidated damages? Will the hotel company agree to subordinate all or some portion of its fees to payment of the hotel’s departmental and operating expenses from gross revenues?
If a franchise or brand management agreement is terminated, the lender will not be able to operate the hotel under the hotel company’s brand or have access to the hotel company’s reservation system. This can be catastrophic to the operation of the hotel. If the lender loses the ability to retain the brand (whether under a brand management agreement or franchise agreement), the hotel company will likely notify guests with advance reservations, and these guests may cancel their reservations, resulting in a loss of income. Moreover, without a brand, the hotel company will require the lender to remove all indicia of the brand (signs, logos, and any operating supplies containing the name or identity of the brand) from the hotel. Furthermore, if the hotel company removes the brand and the lender is forced to go with another brand from a different hotel company, the new hotel company may require the lender to upgrade the hotel to that company’s current “standards”. Conversely, a lender may want to terminate a hotel’s affiliation with a brand, either because the brand may not be the best brand to drive occupancy and rate or because a likely buyer for the hotel may be a hotel company with a different brand.
In deciding whether to retain the brand, a lender may want to terminate the management agreement, especially if it is a long term, no-cut agreement, and instead operate the hotel under a franchise agreement with the hotel company. In order to make an informed decision, the lender should get input from a number of consultants, including brokers, appraisers and hotel consulting companies (such as HVS, PKF and Jones Lang LaSalle). The decision will rest on the evaluation of the hotel’s performance vis-à-vis its competitive set. These consultants can also help the lender to determine whether the hotel should be sold in the short term or held until the market rebounds. Again, this will depend on the financial performance of the hotel (i.e. are the hotel’s revenues sufficient to pay for operating expenses and real estate taxes, or must the lender use its own funds and, if so, for how long?).
Equipment leases, operating contracts, licenses and permits
The operation of a hotel frequently involves a number of equipment leases, operating contracts, licenses and permits, without which the hotel is not able to operate. A lender thinking about taking back a hotel must carefully asses which of the equipment leases, operating contracts, licenses and permits are essential for the operation of the hotel. Some hotels have certain off-site but related amenities, such as a parking structure, spa, golf course or marina. Will these amenities be available to a lender or its transferee post foreclosure? And, if so, under what terms? Will the absence of any of these amenities constitute a breach of the franchise agreement or have an adverse impact on the hotel’s gross revenue? Or worse, if the related structure is a parking garage that is required in order to comply with applicable parking requirements, will the loss of the parking structure cause the hotel to be in violation of zoning laws?
Again, because a hotel is an on-going business, many licenses and permits are required that are not necessary for other types of real estate. Because of the importance of maintaining these licenses and permits, a fairly generic list of licenses and permits for a full service hotel located in San Diego, California can be found in Appendix 2. A lender must determine whether the hotel owner’s/borrower’s licenses and permits are transferrable or whether the lender must obtain them from the issuing source.
Since under California law lenders are unable to take a direct security interest in any type of liquor license issued by the California Department of Alcoholic Beverage Control (“ABC”), lenders must give special consideration to how they or their transferees will be able to sell liquor.
Upon default by a borrower under a loan agreement, a lender who desires to maintain alcoholic beverage operations at the property should seek to have a reputable receiver appointed who has experience in operating similar properties (provided, of course, that the loan documents allow for the appointment of a receiver upon default). As the receiver will only have authority over the property rightfully owned by the lender as set forth in the order granting the appointment of the receiver, it is important for the lender to make sure that the order expressly provides that the liquor license is part of the lender’s property over which the receiver has authority.
Once a receiver is approved, it may exercise all of the privileges of the liquor license for a period of 60 days without being required to transfer the license (See California Business & Professions Code §23102(b)). This 60 day period may be extended by the ABC for good cause. Accordingly, a lender may maintain food and beverage operations at the hotel while it looks to find a buyer, or while it enters into an agreement with a third-party manager to take over operations.
When a buyer or a third-party manager has been found, the receiver will have the authority to transfer the liquor license to this party upon consummation of the purchase and sale agreement or the management agreement, as the case may be. To do so, a liquor license transfer application must be filed with the ABC. As part of this application, the ABC will require a court order authorizing the sale of the liquor license to the buyer or third-party manager.
It generally takes between 60 and 90 days for the ABC to approve the transfer of a liquor license, however, a temporary permit may be requested upon filing of the transfer application with the ABC provided that the liquor license being transferred is the license that was already in place at the hotel. The issuance of a temporary permit will enable the buyer or third-party manager to operate the food and beverage operations in a relatively seamless manner upon filing of the application.
Therefore, while there are many challenges that a lender who desires to maintain operations at the hotel upon foreclosure will face, these challenges are by no means insurmountable and can be overcome with the assistance of counsel experienced in the transfer of liquor licenses.
As the owner of a hotel, the lender will need to make sure that it is the named insured under the insurance policies covering the hotel. This will involve more then reviewing the franchise and management agreements to determine what they require. The lender must also review the various operating contracts (such as a parking/valet parking operator management agreement) to see whether the hotel owner (now lender) is required to name any third party as an additional insured under the general liability insurance policy. Failing to cover such third party could result in the lender having liability to the third party in the event of a claim.
Hotels have been a target for
TOT (Transient Occupancy Taxes)
TOT ordinances are fairly uniform throughout California. Under these ordinances, the “operator” holds the TOT paid by a guest in trust for the local tax and revenue agency. Since operator is typically defined to include a mortgagee in possession, will a lender have any liability for unpaid TOT? What can a lender do to protect itself from this exposure?
Because hotels consist of real estate and an ongoing business, lenders will have many issues to consider before taking back a hotel. Since some of these issues may result in liability to the lender or force the lender to incur costs and expenses that were not considered, lenders must assemble the right team to perform the necessary due diligence, just as a buyer would undertake when purchasing a hotel. The team should consist of a hotel consultant, appraiser, broker and real estate and labor counsel experienced in dealing with hotels. For more information regarding the subject of this article, please feel free to contact Rob Nicholas at Haas & Najarian at (415) 788-6330 or firstname.lastname@example.org. Haas & Najarian is located at
To learn more about Haas & Najarian, visit its website at www.hnattorneys.com.
ABOUT THE AUTHOR: Rob Nicholas, a partner at Haas & Najarian LLP, specializes in representing owners, developers and managers in the acquisition, financing, management, leasing, construction and disposition of commercial real property, with an emphasis on hotels. He also has extensive experience in the negotiation and drafting of hotel management agreements (on behalf of owners and managers) and in the review and negotiation of hotel license agreements, subordination and non-disturbance agreements and comfort letters. Mr. Nicholas is an allied member of the Asian American Hotel Owners Association, the Academy of Hospitality Industry Attorneys, the American Hotel & Lodging Association, and is a member of the Real Property Section of the American Bar Association (Hotels and Hospitality Subsection) and the California State Bar and San Francisco Bar Association. Mr. Nicholas enjoys an “AV” rating in Martindale-Hubbell.
ABOUT HAAS & NAJARIAN: Since its inception in 1973, Haas & Najarian LLP has provided legal counsel to a diverse client base in the areas of real estate, entity structuring and formation, taxation, estate planning and trust administration, employment law and litigation/alternative dispute resolution. The Firm’s Hotel Real Estate Practice Group represents owners and developers locally and nationally in the acquisition, disposition, financing, leasing, construction and management of hotels and other hospitality properties. Many of the Firm’s attorneys have significant experience in negotiating hotel management, license and operating agreements. In order to better serve its hotel and restaurant clients, the Firm recently hired Baxter Rice, a past director of the California Department of Alcoholic Beverage Control, as an in-house consultant to advise clients on and to facilitate the acquisition and transfer of liquor licenses in California. Mr. Rice works with Dan Kramer, Esq. in providing legal representation and counsel regarding all aspects of liquor licensing, including working with lenders and receivers in making sure a troubled hotel will be able to continue to provide alcoholic beverages to its guests.
U.S. Department of Labor Fact Sheet Regarding the WARN Act
WARN offers protection to workers, their families and communities by requiring employers to provide notice 60 days in advance of covered plant closings and covered mass layoffs. This notice must be provided to either affected workers or their representatives (e.g., a labor union); to the State dislocated worker unit; and to the appropriate unit of local government.
In general, employers are covered by WARN if they have 100 or more employees, not counting employees who have worked less than 6 months in the last 12 months and not counting employees who work an average of less than 20 hours a week. Private, for-profit employers and private, nonprofit employers are covered, as are public and quasi-public entities which operate in a commercial context and are separately organized from the regular government. Regular Federal, State, and local government entities which provide public services are not covered.
Employees entitled to notice under WARN include hourly and salaried workers, as well as managerial and supervisory employees. Business partners are not entitled to notice.
What Triggers Notice
Plant Closing: A covered employer must give notice if an employment site (or one or more facilities or operating units within an employment site) will be shut down, and the shutdown will result in an employment loss (as defined later) for 50 or more employees during any 30-day period. This does not count employees who have worked less than 6 months in the last 12 months or employees who work an average of less than 20 hours a week for that employer. These latter groups, however, are entitled to notice (discussed later).
Mass Layoff: A covered employer must give notice if there is to be a mass layoff which does not result from a plant closing, but which will result in an employment loss at the employment site during any 30-day period for 500 or more employees, or for 50-499 employees if they make up at least 33% of the employer's active workforce. Again, this does not count employees who have worked less than 6 months in the last 12 months or employees who work an average of less than 20 hours a week for that employer. These latter groups, however, are entitled to notice (discussed later).
An employer also must give notice if the number of employment losses which occur during a 30-day period fails to meet the threshold requirements of a plant closing or mass layoff, but the number of employment losses for 2 or more groups of workers, each of which is less than the minimum number needed to trigger notice, reaches the threshold level, during any 90-day period, of either a plant closing or mass layoff. Job losses within any 90-day period will count together toward WARN threshold levels, unless the employer demonstrates that the employment losses during the 90-day period are the result of separate and distinct actions and causes.
Sale of Businesses
In a situation involving the sale of part or all of a business, the following requirements apply. (1) In each situation, there is always an employer responsible for giving notice. (2) If the sale by a covered employer results in a covered plant closing or mass layoff, the required parties (discussed later) must receive at least 60 days notice. (3) The seller is responsible for providing notice of any covered plant closing or mass layoff which occurs up to and including the date/time of the sale. (4) The buyer is responsible for providing notice of any covered plant closing or mass layoff which occurs after the date/time of the sale. (5) No notice is required if the sale does not result in a covered plant closing or mass layoff. (6) Employees of the seller (other than employees who have worked less than 6 months in the last 12 months or employees who work an average of less than 20 hours a week) on the date/time of the sale become, for purposes of WARN, employees of the buyer immediately following the sale. This provision preserves the notice rights of the employees of a business that has been sold.
The term "employment loss" means:
(1) An employment termination, other than a discharge for cause, voluntary departure, or retirement;
(2) a layoff exceeding 6 months; or
(3) a reduction in an employee's hours of work of more than 50% in each month of any 6-month period.
Exceptions: An employee who refuses a transfer to a different employment site within reasonable commuting distance does not experience an employment loss. An employee who accepts a transfer outside this distance within 30 days after it is offered or within 30 days after the plant closing or mass layoff, whichever is later, does not experience an employment loss. In both cases, the transfer offer must be made before the closing or layoff, there must be no more than a 6 month break in employment, and the new job must not be deemed a constructive discharge. These transfer exceptions from the "employment loss" definition apply only if the closing or layoff results from the relocation or consolidation of part or all of the employer's business.
An employer does not need to give notice if a plant closing is the closing of a temporary facility, or if the closing or mass layoff is the result of the completion of a particular project or undertaking. This exemption applies only if the workers were hired with the understanding that their employment was limited to the duration of the facility, project or undertaking. An employer cannot label an ongoing project "temporary" in order to evade its obligations under WARN.
An employer does not need to provide notice to strikers or to workers who are part of the bargaining unit(s) which are involved in the labor negotiations that led to a lockout when the strike or lockout is equivalent to a plant closing or mass layoff. Non-striking employees who experience an employment loss as a direct or indirect result of a strike and workers who are not part of the bargaining unit(s) which are involved in the labor negotiations that led to a lockout are still entitled to notice.
An employer does not need to give notice when permanently replacing a person who is an "economic striker" as defined under the National Labor Relations Act.
Who Must Receive Notice
The employer must give written notice to the chief elected officer of the exclusive representative(s) or bargaining agency(s) of affected employees and to unrepresented individual workers who may reasonably be expected to experience an employment loss. This includes employees who may lose their employment due to "bumping," or displacement by other workers, to the extent that the employer can identify those employees when notice is given. If an employer cannot identify employees who may lose their jobs through bumping procedures, the employer must provide notice to the incumbents in the jobs which are being eliminated. Employees who have worked less than 6 months in the last 12 months and employees who work an average of less than 20 hours a week are due notice, even though they are not counted when determining the trigger levels.
The employer must also provide notice to the State dislocated worker unit and to the chief elected official of the unit of local government in which the employment site is located.
With three exceptions, notice must be timed to reach the required parties at least 60 days before a closing or layoff. When the individual employment separations for a closing or layoff occur on more than one day, the notices are due to the representative(s), State dislocated worker unit and local government at least 60 days before each separation. If the workers are not represented, each worker's notice is due at least 60 days before that worker's separation.
The exceptions to 60-day notice are:
(1) Faltering company. This exception, to be narrowly construed, covers situations where a company has sought new capital or business in order to stay open and where giving notice would ruin the opportunity to get the new capital or business, and applies only to plant closings;
(2) unforeseeable business circumstances. This exception applies to closings and layoffs that are caused by business circumstances that were not reasonably foreseeable at the time notice would otherwise have been required; and
(3) Natural disaster. This applies where a closing or layoff is the direct result of a natural disaster, such as a flood, earthquake, drought or storm.
If an employer provides less than 60 days advance notice of a closing or layoff and relies on one of these three exceptions, the employer bears the burden of proof that the conditions for the exception have been met. The employer also must give as much notice as is practicable. When the notices are given, they must include a brief statement of the reason for reducing the notice period in addition to the items required in notices.
Form and Content of Notice
No particular form of notice is required. However, all notices must be in writing. Any reasonable method of delivery designed to ensure receipt 60 days before a closing or layoff is acceptable.
Notice must be specific. Notice may be given conditionally upon the occurrence or non-occurrence of an event only when the event is definite and its occurrence or nonoccurrence will result in a covered employment action less than 60 days after the event.
The content of the notices to the required parties is listed in section 639.7 of the WARN final regulations. Additional notice is required when the date(s) or 14-day period(s) for a planned plant closing or mass layoff are extended beyond the date(s) or 14-day period(s) announced in the original notice.
No particular form of record is required. The information employers will use to determine whether, to whom, and when they must give notice is information that employers usually keep in ordinary business practices and in complying with other laws and regulations.
An employer who violates the WARN provisions by ordering a plant closing or mass layoff without providing appropriate notice is liable to each aggrieved employee for an amount including back pay and benefits for the period of violation, up to 60 days. The employer's liability may be reduced by such items as wages paid by the employer to the employee during the period of the violation and voluntary and unconditional payments made by the employer to the employee.
An employer who fails to provide notice as required to a unit of local government is subject to a civil penalty not to exceed $500 for each day of violation. This penalty may be avoided if the employer satisfies the liability to each aggrieved employee within 3 weeks after the closing or layoff is ordered by the employer.
Enforcement of WARN requirements is through the United States district courts. Workers, representatives of employees and units of local government may bring individual or class action suits. In any suit, the court, in its discretion, may allow the prevailing party a reasonable attorney's fee as part of the costs.
A Typical List of Permits and Licenses for a Full Service Hotel
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