As the hotel industry proceeds into the first quarter of 2002, we continue to witness the cycle of hotel distress and restructuring that began last year. The process of de-flagging and rebranding a hotel before or after restructuring is a core aspect of this cycle. In the first quarter, we have seen the first attempt to reject a major brand management agreement in a bankruptcy proceeding � in this case, the Ritz-Carlton agreements relating to a hotel in San Juan. Other hotels now are progressing into and through bankruptcy, following the same pattern of distress evolving into failure and restructuring that we saw ten years ago.  Reflagging will continue and increase in 2002.

The early indications suggest that this cycle of restructuring is following the familiar sequence of earlier cycles, although this cycle may be evolving at a faster pace and with some new elements. While each failure no doubt feels personal and unique to the participants, in fact the cycle continues in a predictable pattern. The elements typically include:

� Deteriorating relationship between owner and operator.

In our experience, few hotels proceed to litigated or adversarial forms of restructuring without a relatively prolonged period of discord and deterioration of the relationship between brand and owner. The fact that the parties resort to formal dispute reflects a break down of constructive negotiation.  Typical topics of dispute driving owners to litigation are budget approval deadlocks, declining or disappointing margins of profitability, inadequately justified deviations from projections, and unexplained or unauthorized intercompany assessments or allocations by the management company and its affiliates. Some restructuring actions are proceeded by formal declarations of default and litigation on other issues. These cases seem to be increasing in number, with a significant uptick in litigation in the last half of 2001.

In each cycle, the first hotels into the dispute and bankruptcy process tend to be those that were most financially stressed prior to the downturn. Typically, these early failures can be associated with the impact of significantly increased competition and with particularly damaging operating practices, both of which are likely to have involved specific claims of breach and injury. As a rule of thumb, hotels under the stress of fraud and mismanagement will make any early appearance in the failure cycle, and will have a high likelihood of open dispute and litigation before their actual failure.

� Triggering event affecting owner and/or lender.

So long as an owner is able to meet current obligations, disputes seem to drag on unresolved. The decision to seek some confrontation or restructuring is usually triggered by a change in the position of the owner that the owner deems significant and not retrievable without unilateral action. Among these changes, any that demand new investment or funding by the owner are the most likely to trigger aggressive action. The classic triggers in past cycles have been either a cash call made by the operator to cover operating losses or a cash funding obligation imposed by a need to advance funds for taxes or debt service. In this cycle, the prospect of negative cash flow from operations and the resulting need to fund debt service from one�s pocket seems to be driving many confrontations.  There are, nonetheless, management companies who are accelerating the process by special calls and new capital projects, and some have failed to produce 2002 budgets on their contractual schedules so that the confrontation is not yet squarely before them. Some management companies have also refused to make cash distributions in order to conserve cash, triggering debt service failures. Many owners have sought concessions from their lenders, only some of whom have granted these. Few have granted concession beyond year end 2001. These will not be adequate to deal with the continuing cash flow problems of 2002.

When banks were themselves very distressed in the last cycle of the early 1990�s, their regulators forced them to be inflexible on issues of loan performance and forbearance in enforcing debt service obligations. This forced owners to take action to restructure when the owners might have found lenders more indulgent or patient in better times. Lenders now appear to be in generally better shape and able to show some flexibility, but lenders who have emphasized hotel lending are under increasing pressure and can be expected to become less flexible.

In the current cycle, a rigidity is visible now in the response by securitization lenders who lack cash reserves to support any degree of patience or to provide interim financing, and who may have springing guarantees or other types of collateral that will allow them to force early action by owners/ debtors. Some of these lenders appear to be applying a strict enforcement formula and time-table as a matter of policy or servicing obligation. Since many of these lenders insisted on bankruptcy remote and single purpose entities as their borrowers in the original loans, the principals behind those entities are now well set up to turn their backs on the properties without personal consequences.  All of these factors and the rapid escalation of insurance costs appear to be combining to produce a particularly quick descent into receivership for franchised hotels with securitized mortgages.  The mid-market franchise hotel with closed-end investors and a high vulnerability to destructive new competition seems particularly prone to this pattern of failure.

� Reactive bankruptcy.

In general, the owner/debtor�s decision to seek bankruptcy protection suggests some belief on its part that there is recoverable value still to be found in the property. Where conditions are deteriorating quickly, the decision may come much earlier or with relatively little pressure from the lenders and others. Where the owner elects not to file bankruptcy and allows the hotel to go into foreclosure, the decision signals a belief that there is no recoverable value, and the principals of the owner are not exposed to other creditors. Because hotels have complex creditor groups (including trade creditors, tax and labor claims) that are best resolved in bankruptcy, bankruptcy will continue to be the most logical forum to resolve hotel failures.

In most jurisdictions, it is understood by the parties that the owner/debtor will defer any bankruptcy filing until the lender initiates whatever action indicates the imminent appointment of a foreclosure receiver. Before such a receiver takes control, the owner/debtor will commence the bankruptcy proceeding and render the receiver powerless.

Where the lender seeks a resolution in bankruptcy, it may either trigger the filing by a signaling its intention to foreclose or by reaching agreement with the debtor on the terms of the bankruptcy. In the latter case, the bankruptcy may be �pre-packaged� in part or whole by agreement between the lender and owner about the steps and actions that the owner will take and to which the lender will consent or not object. In the case of such agreement, the owner/debtor usually seeks and obtains some concession from the lender to incentivize its filing and quick resolution of the bankruptcy. In that way, the debtor also acts in reaction to the lender�s direction.

� Cash collateral arrangement.

If the lender has properly documented its collateral arrangements, it should have rights to control the use of cash revenues arising after the commencement of the bankruptcy proceeding.1 The arrangement for use of cash collateral is ultimately spelled out in an order of the bankruptcy court and becomes the main tool held by the lender to limit the benefits flowing to the management company and control its involvement. At the same time, the cash collateral order becomes the debtor�s blueprint for how it is permitted to operate and use revenues in the proceeding. These orders are of vital importance to the bankruptcy of an operating hotel. Because the cash collateral order is entered within hours or days of the filing of the bankruptcy proceeding, the skill and sophistication of its preparation is a key event in any hotel bankruptcy.

As part of cash collateral orders and supervision of the debtor�s affairs, bankruptcy courts can impose intrusive supervisory and reporting obligations on the management companies. In the last cycle, it was this aspect of the bankruptcy process that brought to light many of the intercompany and operational practices that fueled the litigation of the mid-1990�s. Rebate arrangements and inter-company allocations, for example, were extensively illuminated under the supervision of the bankruptcy courts and receivers.

� Rejection of material obligations as executory contracts.

A key issue in hotel bankruptcies is the amendment or rejection of major contracts that have contributed to the hotel�s distress. Collective bargaining agreements, management and franchise agreements are typically rejected in bankruptcy. The ability to reject these contracts arises under section 365 of the Bankruptcy Code. This section permits the rejection of executory (that is, not fully performed) contracts. A contract counterparty injured by early termination through rejection may assert a damage claim against the debtor�s estate, but the claim for damages may be defeated if there is evidence that the contract counterparty was in breach and the termination justified by cause. The termination damage claim of the management company is also classed as an unsecured obligation, placing the management company in one of the lowest tiers of priority. If the management com-pany exercised significant control of the hotel or arguably contributed to the distressed situation, it may find itself in the lowest tier of insider unsecured creditors.

The standard for rejection is that, �it is enough, if, as a matter of business judgement, rejection of the burdensome contract may benefit the estate.�2 This is generally viewed as a very low threshold, and appears adequate to permit rejection of virtually every hotel management agreement. In the current cycle, few management companies appear to anticipate the likelihood of rejection and the
other consequences to them of insolvency of the hotels under their management and franchises. Labor unions have already proven to be much more responsive in trying to address restructuring requests from hotel owners in order to avoid bankruptcy and preserve their collective bargaining position. As the predictability of rejection is factored into the behavior of management and franchise companies, they will be forced to deal with the conflict between their short term revenue-driven behavior and their longer term prospects of maintaining operating agreements. To date, few companies have confronted this conflict.

� Exit of property from bankruptcy.

Once a hotel�s operations are changed by the introduction of new operations and elimination of unfavorable or burdensome contracts, the hotel may be removed from the bankruptcy proceeding in a number of ways. For example, there may be a sale to a third party from the bankruptcy, so that the debtor holds cash proceeds and can distribute them to other creditors. There may also be a motion by the lender to lift the automatic stay and permit the lender to foreclose in a foreclosure sale to itself or a third party. A motion to lift the stay or sell the hotel usually receives a favorable and accelerated hearing if the hotel is demonstrably operating at a loss or if the hotel is otherwise declining in value. In the current cycle, the combination of projected negative cash flow and uncertain prospects over an indefinite period makes early sale or foreclosure more likely.  There may also be a plan proposed by the debtor or another party to provide an exit to the debtor with the property still in its hands or transferred pursuant to the plan. Such plans usually offer the creditors with some compensation or benefits and may include the introduction of new investment from some source. Approval of a plan generally requires some degree of consent by creditors.  Approved plans generally allow some of the participants to receive tax advantages, such as the possibility of avoiding tax on imputed income from debt forgiveness.

� Resolution of damage claims.

When the hotel property has left the estate of the debtor by one of these means, the major remaining asset of the estate may be a claim against the management company or other terminated contractors. At the same time, the terminated contractors may have substantial claims for compensation against the debtor�s estate that must be resolved to wind up the proceeding.3 It is usual for a hotel or similar property to be sold or its disposition otherwise resolved long before the damages and termination claims are resolved. The ultimate recovery from the terminated management company may prove to be the most important source of payment of unsecured creditors of the estate.

A current bankruptcy case involving the San Juan Ritz Carlton hotel illustrates this pattern. 

The hotel was opened in December 1997 and failed to produce sufficient cash flow to service its debt in any year thereafter. Other questions about the operation of the hotel emerged. Demands for information by the owner were repeatedly rebuffed, culminating in an action to compel access and the production of information brought by the owner in Delaware Chancery Court.4 Under Delaware procedures, the owner obtained an order for expedited trial to be held within less than 100 days, or in December 2000. After a limited trial of the claim but before final decision by the trial court, the owner obtained limited access to its files in January 2001. The information obtained then and further deterioration of performance led to the commencement of a federal action by the owner against Ritz Carlton and various of its affiliates in March 2001. As described by Marriott International, Ritz Carlton�s parent company and a defendant in the action: 5

On March 30, 2001, Green Isle Partners, Ltd., S.E. (Green Isle) filed a 63- page complaint in Federal district court in Delaware against The Ritz-Carlton Hotel Company, L.L.C., The Ritz-Carlton Hotel Company of Puerto Rico, Inc. (Ritz-Carlton Puerto Rico), Marriott International, Inc., Marriott Distribution Services, Inc., Marriott International Capital Corp. and Avendra L.L.C. (Green Isle Partners, Ltd. S.E., v. The Ritz-Carlton Hotel Company, L.L.C., et al, civil action no. 01-202). Ritz-Carlton Puerto Rico manages The Ritz-Carlton San Juan Hotel, Spa and Casino located in San Juan, Puerto Rico under an operating agreement with Green Isle dated December 15, 1995 (the Operating Agreement).

The claim asserts 11 causes of action: three Racketeer Influenced and Corrupt Organizations Act (RICO) claims, together with claims based on the Robinson-Patman Act, breach of contract, breach of fiduciary duty, aiding and abetting a breach of fiduciary duty, breach of implied duties of good faith and fair dealing, common law fraud and intentional misrepresentation, negligent misrepresentation, and fiduciary accounting. The complaint does not request termination of the Operating Agreement.

The claim includes allegations of: 

1. national, non-competitive contracts and attendant kick-back schemes; 
2. concealing transactions with affiliates; 
3. false entries in the books and manipulation of accounts payable and receivable; 
4. excessive compensation schemes and fraudulent expense accounts; 
5. charges of prohibited overhead costs to the project; 
6. charges of prohibited procurement costs; 
7. inflation of Group Service Expense; 
8. the use of prohibited or falsified revenues; 
9. attempts to oust Green Isle from ownership; 
10. creating a financial crisis and then attempting to exploit it by seeking an economically oppressive contract in connection with a loan; 
11. providing incorrect cash flow figures and failing to appropriately reveal and explain revised cash flow figures.

Although we believe that the lawsuit described above is without merit, and we intend to vigorously defend against the claims being made against us, we cannot assure you as to the outcome of this lawsuit nor can we currently estimate the range of any potential loss to the Company.

In June 2001, with unpaid debt service mounting up and its lender appearing to become more aggressive, the owner petitioned for bankruptcy protection under Chapter 11 of the Bankruptcy Code, which provides for reorganization and continued operation. The petition was filed in Florida where the owner had offices. A minimal cash collateral order was put into effect that left Ritz Carlton in operation of the hotel under the general terms of its preexisting agreements. The debtor then requested and was granted an extension of its exclusivity period, or the time in which it had the sole right to propose a plan to reorganize the hotel. This protected the owner/debtor from any effort by Ritz Carlton or others to propose a plan of reorganization hostile to the owner/debtor for several months.  Notwithstanding the fact that the bankruptcy proceedings materially reduce the short term cash obligations of the hotel (such as current debt service), this hotel did not operate in bankruptcy at a level sufficient to cover even current operating expenses and Ritz Carlton fees out of current revenues. Cash on hand was rapidly eroding even before September 2001. Rejection of the management agreement was probably inevitable, but was accelerated and made more certain when Ritz Carlton sought to block payment of the professionals advising the owner/debtor. Ritz Carton asserted a prior right to hold and use all available revenues, refusing them for use in the restructuring and for payment of professionals.  By taking this position, Ritz Carlton set up its rights in direct contradiction to those of the professionals and the goal of reorganization. This led to the obvious result that the debtor applied to reject the Ritz Carlton agreements on December 14, 2001.

In its application to reject the management agreement, the debtor cited the Prime Motors case as precedent. It gave as its grounds and as a basis for its �business judgment� that:

Rejecting the Operating Agreement will benefit the Debtor�s estate because (i) it will allow the Debtor to engage another operator with greater accountability, at a reduced cost, and without limitations upon the Debtor�s ability to reorganize; (ii) rejection will enhance the prospects for greater profits and thereby increase the value of the Property; (iii) rejection will enable the Debtor to reposition the Property based upon current market conditions; and (iv) rejections will enable the Debtor to have a more meaningful role in the management of the Property, budgeting [footnote omitted], marketing, and other significant business decisions. Accordingly, it is within the Debtor�s sound business judgement to reject the Operating Agreement.

A decision to approve rejection would facilitate the possible sale of the hotel without the burden of the management agreement and without the operating cost structure associated with the Ritz Carlton brand.  Expert testimony at any eventual hearing on the application to reject is likely to focus on the improvement in value and saleability resulting from rejection. The court has already approved the retention of an adviser for a sale or restructuring transaction, and has ordered that the advisor be paid currently.

After a rejection, the owner/debtor would retain its claims against the hotel operator in the federal action, now transferred to Puerto Rico at the motion of Ritz Carlton. Ritz Carlton may have an unsecured claim to termination compensation for its contract�s rejection, but Ritz Carlton would need to prevail on most or all of its defenses in this federal action or in any similar adversary action 8 to be entitled to compensation for a termination without cause. A loss on any of the major claims in the federal action might be sufficient to establish that Ritz Carlton was in breach of its obligations, was terminated for cause, and therefore was not entitled to any compensation. In general, management companies have not fared well in making damage claims for termination in these circumstances. 

Overall, this case appears typical of an �early cycle� hotel failure, where the parties have proceeded into litigation over claims of fraud and mismanagement. They then transfer that fight to the bankruptcy court. After an extended and multi-front battle, the decision to exit the debtor from the investment by a sale is forced by deteriorating performance and by the action of the bankruptcy court. In this case, much time and value was used up in motion practice (such as venue challenges, motions in limine, etc.) that have little practical value in bankruptcy settings and are not favored by the bankruptcy courts. These strategies reflect a conventional civil litigation approach that is not compatible with the bankruptcy process.  The changed forum calls for new strategies.

We will continue to move forward into this latest cycle with smoother, faster and more consensual resolution, as the parties re-learn the realities, principles and procedures of insolvency that have not been part of their work for the past several years. As the potential of rejection and the other consequences of insolvency are better understood and absorbed, we will see readjustment of expectations and practices.  In the shorter term, we anticipate more frequent litigation and higher stakes in disputes as these lessons are learned or relearned.

An Update � September 2002

After this advisory was first published, the bankruptcy court refused to allow rejection of the management contract. This was primarily based on the opposition of the secured lender, arguing that the risk of injury to the asset was not demonstrably outweighed by any benefit. As is usually the case, the court deferred to the wishes of the secured lender, with which the debtor had not reached no agreement on its rejection motion. Ritz Carlton also had negotiated with the lender separately and offered immediate concessions in regard to its fees and other charges to match or exceed the argued benefits of the proposed replacement management agreement. While this decision left Ritz Carlton in management, it did not constitute an assumption of the arrangement.

For more a year and a half after the initial filing, no reorganization plan was proposed or put to a vote.  No buyer or source of replacement financing had emerged in that time. The court ultimately ended the debtor�s period of exclusive entitlement to propose a plan, opening the field to proposals by other parties who are unlikely to provide many rights to the original equity holders. The court also lifted the protection that it had given to an individual associated with the debtor as someone argued to be essential to the debtor�s reorganization efforts, exposing him to renewed claims and suit by creditors and other parties. In doing this, the court appeared to express increasing frustration with the lack of progress toward a resolution.

In Puerto Rico, the federal litigation did not move forward quickly as Green Isle took steps to restart the claims in a Florida proceeding related to the bankruptcy filing. After a jurisdictional dispute, the federal court in San Juan claimed control of the case and threatened to dismiss the claims with prejudice if they were pursued elsewhere. Whether the claims will now move forward remains to be seen.  Green Isle has also sought discovery under Rule 2004 (relating to assets of the estate) from its secured lender, which is currently seeking a protective order against the examination. With many other troubled properties in the difficult Puerto Rico market and an important convention project in development, the government affiliated lender may seek to put this situation behind it, together with its negative impact on the lender�s ability to lend to new and additional projects.

Since the commencement of the federal litigation and subsequent bankruptcy, many factors have altered the situation. The markets for hotel investment and lending have contracted. Puerto Rico, even beyond other markets, has felt the aftermath of September 11 and the economic downturn. Extensive publicity about other litigation and the weak performance of luxury hotels has affected the perception of Ritz Carlton and its ability to create and maintain value. How this bankruptcy will be resolved remains uncertain. The progress of the case continues to be typical of an early cycle bankruptcy in which a particularly troubled property succumbs to relatively minor deterioration. As the downturn continues around it, progress in the bankruptcy is made slowly. The possibility that no plan will emerge cannot be ruled out. The existence of the federal litigation, if adequately preserved by Green Isle, does indicate that Ritz Carlton, at a minimum, should be motivated to seek a resolution through a plan to protect its own interests. Ritz Carlton and Marriott are the most likely proponents of a plan as this case goes forward, with the original investors in Green Isle either pursuing a place in that plan or electing to abandon the investment.

A Further Update � February 2003

This update reports on the progress of the case after the 2002 update. 

As predicted in the previous update, Ritz Carlton and Marriott emerged as the proponents of a bankruptcy plan in late 2002. The position of the secured lender had been taken over by an affiliate of a New York-based real estate fund. The new holder of the debt joined with the Marriott entities in proposing a plan. Among the terms in the plan as proposed:

• The secured lender or its affiliate would acquire the hotel assets of the debtor and would enter into an agreement on undisclosed terms for continued operation by Ritz Carlton.
• The cash paid into the bankruptcy estate for the asset purchase, if any, would be added to the several million dollars of cash generated during the bankruptcy. The secured loan documents had failed to create an adequate lien for the benefit of the secured lender, so these funds were available to the unsecured creditors. The combined funds would be distributed to more junior and unsecured creditors.
• Claims of Ritz Carlton and Marriott affiliates as unsecured creditors would be subordinated below those of the unaffiliated general unsecured creditors, making it more likely that those unsecured creditors would recover on their claims.
• Claims of individuals and companies affiliated with the debtor and its principals would be relegated to the lowest priority, below those of Ritz Carlton and Marriott affiliates.
• Certain other claims would be disallowed or treated unfavorably.
• Ritz Carlton and Marriott would receive a release of the claims against them.

Ritz-Carlton continues to manage the hotel.
 

To discuss these topics further, please contact K.C. McDaniel at (212) 940-8536 or [email protected], or William Bosch at (202) 625-3595 or [email protected].

The material contained herein is not to be construed as legal advice or opinion.
© 2002 and 2003 Katten Muchin Zavis Rosenman. All rights reserved. Katten Muchin Zavis Rosenman is a law partnership including professional corporations.