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From PLI’s Course Handbook

Commercial Real Estate Financing 2009: How the World Changed

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How hotel Projects Go wrong and what to do about the management contracts

K.C. Mc Daniel

K.C. McDaniel PLLC

How Hotel Projects Go Wrong And What to Do about the Management Contracts

By K.C. McDaniel

|K.C. McDaniel |

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K.C. McDaniel advises investors and lenders engaged in hotel development, financing and ownership, including private and public funds, institutional investors, commercial bank lenders and commercial developers. She has acted as receiver’s counsel and special counsel for debtors and creditors in hotel bankruptcies and liquidations, and as an arbitrator and expert in disputes involving hotels. Ms. McDaniel currently works with clients in the United States, Europe and the Middle East dealing with underperforming hotel investments and disputes arising from the financing and operation of hotels.

She appears in Who’s Who of International Business Lawyers and has been listed as a leading practitioner in hotel and real estate by Chambers, Euromoney and other industry surveys. She has been cited in the Wall Street Journal, Forbes Magazine, the New York Times and elsewhere in the financial press for her work in the hotel industry.

Ms. McDaniel is a member of the American College of Real Estate Lawyers. After more than twenty five years in large firm practice, she now works independently as K.C. McDaniel PLLC and is admitted to the bars of New York and the District of Columbia.

How Hotel Projects Go Wrong And What to Do about the Management Contracts

Hotel loans fail – and historically have failed more frequently and with greater losses than loans secured by most other categories of commercial real estate. Hotel loans in the current market are no exception.

In the current cycle, hotel loans were under stress well before the Wall Street meltdown took hold. Hotels led all classes of real property in loan default rates for several years, making up 9% of CMBS loan defaults in 2006 and 10% in 2005, and 8.9% of all cumulative defaults at the end of 2006. In early 2008, one rating agency optimistically reported improved performance of hotel loans included in CMBS pools, noting that only 3.5% of 2007 loan defaults involved hotels.[1] Also significant to the rating agencies, hotel loans through 2007 had gone bad with the highest rates of realized losses for any property loan type in 2005 and 2006, with losses over 44% for both years. This loss rate fell to 32% in 2007.[2]

With the sharp reversal of the economy, 2008 now appears to have been a year of an increasing hotel loan defaults. Reporting of some of these defaults may have been deferred into 2009 by short loan extensions as well as by reliance on a 90-day default as the threshold for mandatory reporting. Nevertheless, the speed and breadth of the economic downturn has pushed some hotels from normal performance into negative cash flow and hand-over to mezzanine or mortgage lenders in less than even 90 days. The 2008 failures appear to reach deeply into the segments of full service, resort and convention hotel properties. Like luxury retailers, these were once viewed as more resistant to downturns. These are likely to require longer, more complex and expensive work-out processes, which the rating agencies associate with higher levels of realized losses. Given the dearth of new hotel financing and the limited interest of potential hotel buyers, there may be other factors adding to realized losses.

Whether or not loans enter the statistics for reported default in 2008, losses on such loans are unlikely to be recognized in 2008 but will appear in later periods. Lenders and loan servicers dealing with troubled hotels are finding few or no quick resolutions available to them, with refinancing and sale both difficult to achieve. Central to the problems facing the lenders and servicers are the obligations taken on by lenders in the loan documentation in favor of the management companies operating the hotels. Lenders widely failed to anticipate which tools they would need to deal with management companies in the context of loan defaults.

How Hotel Loans Go Wrong

Hotel loans fail because the business of the hotels fails to achieve the goal of their investors. Hotel loans are in their fundamentals loans secured by operating businesses. Hotel loans go into default in making current payments or upon maturity because the business of the hotel does not produce sufficient net distributable cash, whether that cash might come from operations or refinancing. Hotels also fail because their debt matures at the wrong part of the business cycle. While hotel projections and hotel feasibility studies rarely suggest that even one year of lower performance might occur, historic hotel performance patterns have routinely included cycles of downturns, cycles of excess supply, and therefore periods of obvious potential for loan default.

Events of abrupt economic disruption tend to bring down first the hotels which have been under prolonged stress. As was observable after September 11, 2001, hotels already under stress from other, unrelated causes are likely to be the first to go into loan default, while hotels with histories of sound performance and positive creditor relationships did not go into default at all. In the present cycle, we are again seeing this pattern, but with fewer solid relationships with sound creditors. We are seeing three common scenarios of hotel stress now accelerating into project failures:

Scenario 1. The Market Is Not There.

The most common, but generally least accurate, explanation given for a hotel’s loan default is that the market demand for the hotel unexpectedly declined without fault or error on the part of the brand or management team. The owner may be accused by those operating the hotel of “overleveraging” by having financed the hotel at a level believed prudent based on the projections for the hotel’s performance. Because “the market failed” the recommended solution argued to be continued funding of the hotel until “the market comes back.” Alternatively or in addition, it may be suggested that the owner needs to add facilities, services or other new investment to attract new business.

In this scenario market demand for the particular hotel is described as insufficient to allow the hotel to distribute cash to pay debt service. This focus on debt service is in fact misplaced, because a hotel cannot obtain financing without demonstrating to a lender that it also has the potential to return profits to equity investors. The potential is demonstrated through longer term stabilized performance with adequate return, expressed through the debt service coverage ratio. The real issue facing the hotel is a lack of return on the total investment, both debt and equity. Even if funds from operation are available to pay debt service from month to month, the hotel may still not be able to refinance on maturity of the loan or achieve a sale with a profit that will reflect expected return to investors. Lack of return to investors makes impossible a sale for an acceptable price and will produce an appraised value too low to allow refinancing.

A hotel may generate insufficient cash and thus insufficient return because the amount of original investment was excessive relative to the actual amount and value of the demand in the market. Or, the hotel may be insufficiently profitable because one or more of the basic assumptions and decisions (about location, choice of brand affiliation, management company, size, facilities, target market, available air service, etc.) were wrong when first made or became wrong as conditions changed.

In 2007 and 2008, loans were indeed going into default after market conditions changed and, for the near or intermediate future, those markets may not support adequate demand for refinancing or sale at a profit. The some of the early waves of these failures seemed to be triggered by problems in the airline industry that reduced available seat capacity or materially increased fares. For example, a resort or convention center hotel may have anticipated demand that did not materialize, in part because the location had lost all or a material part of its scheduled air service and has seen soaring prices or few available seats for potential guests. If such a hotel has few or no prospects of service being restored or increased to the point that seats will again be competitively priced, its market is indeed changed.

Faced with fundamental adverse change of this type in a market, the lender to the hotel or its owner must make a choice among the few alternatives. The basic choices are to hold or to sell. If the hotel is held, can the business plan for the hotel be changed to fit better with the market conditions and improve results to achieve profitability? Will this require new investment? Or are the obstacles to the hotel operating profitably so comprehensive or so insurmountable that market demand will always be inadequate no matter what the business plan? Should the lender therefore move to a disposition? These are questions which should have been in front of the owner, lender, franchisor and management company from their first recognition of underperformance. Once a debt default occurs, the answers must be found quickly. Conditions in the current market increase the need to act promptly, and effectively eliminate the option of making an increased investment in the hotel for an indefinite period.

Information is critical to the lender in this scenario, and perhaps even more in the additional scenarios discussed below. It is rarely clear beyond question that a hotel is in fact failing without fault or error on the part of operator, brand or owner. The lender must consider whether “market failure” is indeed the correct explanation, such that no other options exist but hold or sell. There are few unbiased participants in the hotel’s operation who will provide neutral and competent information, and several who are likely to obstruct or distort information which might lead to their ouster. If it is indeed a case of “market failure” that has led to loan default, the lender may still need to decide whether to move to a quick disposition, or to try to operate the hotel on the same or different terms pending a disposition. This leads to the question of whether the brand affiliation and management company add or subtract value in a disposition. Given the history of failure, old relationships are unlikely to add value, yet those contacts may be the only sources of information for the lender. Thus, the lender’s or indeed the borrower’s first challenge may be to acquire information essential to its decisions from the hotel or, if necessary, from third party sources.

Scenario 2. The Market Is There, But the Profits Are Not Reaching the Owner.

An accurate explanation for hotel failure is usually much more complex than simple market failure. Rarely is a hotel so poorly planned and developed that there is absolutely no potential market that will support the hotel through changing conditions. If another hotel is operating successfully in the same market, then “market failure” is presumptively neither the correct nor complete explanation. Some factor or combination of factors is causing the distressed hotel to fall short of its market potential. A more likely explanation for that failure comes under the category of “lack of alignment” or conflict of interest among the parties involved in the hotel. That is, the goals and incentives of the investor are not adequately reflected in the goals of those marketing and operating the hotel. The ultimate goal of adequate return on the investment for the owner is not being met.

Hotels are relatively unique among real estate investments for their potential to be affected by this type of conflict of goals. This potential arises from the essential character of hotel operation as an operating business. In some senses, only healthcare facilities share the qualities of an operating business and offer comparable scope to be affected by operational decisions.[3] The conflict or lack of alignment between the investors and those in control of the hotel’s operation has been increasingly raised in disputes between investors and operators. Investors have asserted it as at the root of the patterns of higher level of investment failure for owners of hotels, in that the investor and operators are, in a fundamental sense, in different businesses.

Lack of alignment may manifest itself in several different ways. A hotel may be perceived by an investor not to be earning what it could or should. An investor may attribute this to property-specific poor management or weak marketing. Damage from lack of alignment, however, more often follows from well-directed and focused management, because that management is very efficiently aimed at the profit of those controlling the operation. Hotels underperform for their owners or lenders because the benefits of controlling the hotel, broadly defined, exist and are being exploited by efficient action of the management company and its affiliates. Put simply, those in control of the hotel direct the operation to maximize the profits to their affiliated group. There may be a successful business operating in the hotel, but it is not the business of owning the hotel. To understand or recognize that the business is being run with an adverse impact on the investor takes a detailed understanding of how those in operational control profit and how the actions leading to that profit affect the investor. The cumulative impact of incremental, self-interested decisions by those in day-to-day operational control can be harm to the investor and subvert the long term interests of the owner.

The damage arising from conflict of interest is rarely visible as it occurs and is almost never checked by audit or financial supervision. In its essence, the damage comes from the operator or licensor being able to use its control over aspect of the hotel’s business to serve its own, separate business goals and those of its brand group. For example, among the business practices currently in issue with owners are the brand-related frequent traveler or loyalty programs. Operational decisions are made about virtually every aspect of the program -- how many rooms will be provided for redemption of awards, how much to pay to the hotels in compensation for redemptions, what constitutes an “expense” of the program for which the brand group may pay itself, etc. Each of these decisions has the potential to hurt an owner and add to the profits of those in control of day-to-day operation. There are no neutral standards.[4]

Situations in which self-interest of a brand group may impact a hotel’s profitability have appeared to multiply in the last decade. Recent litigation by owners has attacked use of hotel resources to support the proliferation of new brands and new hotels. The brand group has been held to have subverted its non-competition undertakings by cross marketing, central rate setting and use of a collective website and reservation system to sell competing properties. Liability has been imposed for the development of supposedly independent projects for new brands using of confidential data from existing projects and brands. Affiliates’ interests and “brand identity” have been cited by brand groups to justify use of existing hotel resources to support “guest loyalty” programs, sales of timeshare and vacation ownership projects, discounted or free use of hotel facilities for “employee familiarity programs”. Guest loyalty programs have expanded to become virtual-money systems, in which points are bartered, used in payment for purchases, distributed as sales fees, or otherwise used or paid in general marketing and promotion. All of these programs or activities have been cited as sources of financial distress in hotels.

There has also been a virtual explosion of charges assessed by brand groups on hotels under their control. The current business model of some brand groups seeks to use control over managed or licensed hotels to build the group’s profits – to make more income from the existing number of rooms under license or management. While growing revenues allows a management company to take a percentage of the increase in revenues, its profits increase much more simply by new charges to the hotel, because the entire charge flows to the company. This is not a new phenomenon and has been associated with income pressure on hotel management companies. Over the last two decades, profits of brand groups have been increased by maintaining or increasing “management fees” charged to hotels, while simultaneously increasing or adding charges for amounts “allocated” to hotels under a variety of categories. Allocations are made under older contracts via “chain allocations” or “system charges” or simply as a “cost of operation”. The charges have been added in ways not visible to owners or lenders, or presented in a misleading manner. The charges and allocations were in many cases not anticipated when management and license contracts were negotiated. Many allocation charges now include overhead and capital investment expenditures. In some cases these broader charges are disclosed to some degree in the operating agreements and franchise disclosures. In the case of older contracts without these provisions, however, the charges have been made regardless of the more limited language in the management agreements.

Dealing with poor performance due to lack of alignment is particularly complex because the benefits to the brand group are often opaque to the lender and owner. The compensation visible as paid to the operator may not be any measure of the benefit it actually receives, and what it or its affiliates actually receive in substance is unlikely to be disclosed by conventional audit. Benefits created and transferred through frequent guest programs and allocations are particularly hard to identify and monitor because they are invisible to property-level audit. Historically, brand groups have become most aggressive in extracting value for themselves without regard to owner’s profit in deteriorating markets. Indeed, the highly-litigated practices of vendor kickbacks and aggressive allocation systems trace back to the profit pressures of the 1980’s and the disputes continue to be played out in the industry.

A further aspect of “lack of alignment” is the willingness of brand groups to increase their capital demands on distressed hotels. Although claimed to be done to raise brand standards, these demands are generally issued by brand groups which expect that added expenditure will maintain or enhance gross revenues in a difficult market. The benefit of this flows directly to the profitability of the brand groups through “license” fees paid to brand franchisors or “base” fees paid to operators. Both types of fees are calculated as a percentage of revenues. Brand groups have also created many categories of charge also tied to revenues – marketing fees, chain costs, service fees, etc. The net effect of increased charges of this type is erosion of profits left to the owner. Growth of gross revenues vastly outweighs maintenance of profits to owner in importance to operators and brand groups. Revenues particularly outweigh profits to owner in markets where revenues are falling. Moreover, demands for capital expenditure often have no adverse impact on operators. Capital demands aimed at revenue maintenance or revenue enhancement therefore most often fall on owners when owners can least afford the costs. The outstanding capital shortfalls, or the threat of them, then overshadow every attempt by the owner to refinance, raise equity or sell a hotel.

As the emphasis on revenue-based income shows, incentive fees and compensation tied to profit has become a minor or irrelevant category of benefit to management companies and licensors. There is generally no effort to bring forward an ROI justification for new expenditure demanded from the owner of an individual hotel. Management companies strongly and often successfully resist any such investment criteria limiting their ability to call capital. The capital investment is demanded as a matter of brand standards.

Demands for new capital may also add to damage from other self-interested activities. They are falling now with particular force on owners of brand-operated resorts or brand-operated hotels in other leisure destinations. In such hotels, a high proportion of guests are cashing in points for redemption rooms or other awards under brand-run frequent traveler programs. Or they may be making use of rooms as employee benefits or for affiliate use in marketing time shares, condos, or other brand-related businesses. These programs routinely fail to compensate hotel owners to the level that their hotels could or would operate in the market without the burdens of the programs. To the extent that such programs have been allowed to take precedence over the profitability of individual hotels for individual owners, they harm the owners. Indeed, a full hotel operating under some current contracts can still be unprofitable. As in past downturns, where we have seen the hotels most heavily stressed by these practices be among the first to descend into debt default, resort and convention hotels seem to be part of the first waves of failure now.

Faced with a hotel pushed into default by self-interested management, owner and lender face first the problem of identifying what practices are in effect. This requires information of a type and level of details that very few management agreements or loan documents specified or provided. In current loan failures, battles over access to and ownership of crucial operational information are being waged in many cases of brand-managed hotels. Once information is obtained, owner and/or lender need to plan out how to restructure the operating relationship. Their goal is to restore an alignment of interests between those investing in and those operating the hotel that directs sufficient cash flow to maintain the hotel. Both owner and lender need to aim at reestablishing their ultimate ability to refinance the debt, sell or carry out some other desired exit strategy.

Scenario 3. Market Demand is Adequate, the Hotel May Be Profitable Day to Day, But the Hotel Is Not Operating Within Its Means.

As noted above, capital calls to pay for new investment to maintain or enhance revenues and issued during a business downturn can damage a hotel badly. Such calls in the past have usually been issued to managed hotels as special initiatives and to respond to material changes in market conditions. However, the presumption that periodic capital calls for additional investment may be routine has expanded and is reflected in recent operating agreements. The presumption directly conflicts with the concept of investment through bankruptcy-remote special purpose entities, which in any case have difficulty raising new capital. Such demands for new capital are adding to hotel failure in this cycle.

For over a decade, many hotel lenders have required owners to invest through special-purpose entities or SPE’s. The concept of an SPE was evolved in the rating process, and was imposed as a requirement to ensure the separation of risks and the limitation of the risks of one project. This allowed each project to be underwritten as an independent credit. Funds distributed to investors are net income and other returns to them. The concept of such separation through use of SPE’s was incorporated in CMBS[5] underwriting models to facilitate ratings and thus to support securitization. Inherent in the use of such entities and models was the idea that the investments were closed-end. An investment (in this case a hotel) would generate sufficient cash flow to meet its own operating expenses and capital needs and make distributions to investors. The investment would not be exposed to other liabilities or contingencies. If funds could be called or clawed back from investors, the concept of an SPE was no longer valid.

Hotel brand groups have aggressively expanded provisions allowing the brand groups to compel owners to make additional investment. In franchise licenses, the franchisor brand groups had previously had provisions requiring compliance with brand standards and allowing the brand group to require renovation to brand standards. These were usually defined as the standards then in effect in hotels sharing the brand name. Franchisors began to escalate demands for compliance with higher standards, with resistance by owners who felt that they were being held to higher standards. In response, franchisors changed their licenses to strengthen their ability to enforce demands for added investment. The old provisions were supplanted over time by new provisions for mandatory periodic refurbishment on an accelerated schedule. Renovation was now required to be completed to as-new condition and to comply with written guidelines then in effect. To enforce compliance with the investment obligation, higher and higher liquidated damages were imposed on owners who chose to leave rather than comply or were pushed out. Indeed, some franchisor brand groups adopted business plans in which a material percentage of its franchisees would be pushed out by such demands, allowing the brand group to continue to recruit new properties into the brand system on more favorable terms.

Provisions for mandatory additional investment for brand standards had been less routine in management agreements than in franchise agreements. In part, this was because management companies were expected to budget and execute a capital replacement plan as a core obligation of their management. A call for more capital could be interpreted as a breach of its management obligations. Management companies had also had some profit-based compensation through their incentive fees, usually a percentage of profits to the owner and often a percentage calculated after a return on capital. Few owners were willing to pay such an incentive fee on profits that were later called back as a mandatory new investment.

Nonetheless, management companies sought to add provisions that could allow them to call for additional investment without any investment return criteria. This was done to facilitate competition and growth of revenues without a need to assure increased profits to owners. Unfortunately, the basis to analyze a hotel as a closed-end investment fell apart when a hotel could face demands for new capital to continue in stable operation. Lenders and rating agencies gave the risks of such future calls no apparent weight in their models. Notwithstanding the underwriting of hotels as closed-end investment, we are seeing many hotels subjected to calls for new investment by way of property improvement plans, brand standard upgrades and new brand specifications. The consequences include increased conflict between lenders and owner on one side and brand groups on the other side. Such calls, if deemed a financial obligation under the operating agreements, may render a hotel insolvent as an SPE may have no method to raise the additional capital and thus be unable to meet its liabilities.

In most franchised and managed hotels, there is now a risk that a level of profitability sufficient to meet day-to-day requirements, satisfy debt service obligations and pay a return to investors will prove illusory. If more investment is demanded, whatever the profits have been in the past may not be adequate in the short or intermediate term. Market conditions and/or the specific terms of the operating agreements may produce, accelerate or exacerbate periods of inadequate or negative cash flow, which are likely to coincide with the calls.

We are seeing demands for additional investment and additional improvements even in this tumultuous economy, to the point that demands are being issued to hotels in foreclosure or on the eve of bankruptcy filings. The calls appear to be occurring precisely where and when brand competition is accelerating: where hotels feel the impact of corporate retrenchment, withdrawal of air service, and fewer discretionary travelers. These pressures are increased when an operator fails or refuses to change its business plan to reduce expenditures or change its focus from gross revenues to profit for the owner. There may be other reasons for the capital demands. In some cases, the expenditures for projects are demanded because the work or purchasing supported by the investment is itself a profit center for the brand group through fees, commissions or rebates from vendors. Compliance with brand standards or new brand initiatives by capital projects may also be a factor in bonuses, and indeed a major factor in bonuses if performance is otherwise weak. Capital demands also may be nothing more than a negotiating tactic or sabotage, as when a call will be issued to an owner or lender attempting to sell a property. This may be done to try to favor a bid from an affiliate of the operator, or simply to try to insert the operator into the sale negotiation in a position of power.

Faced with shortfalls or capital calls in excess of reserves, the owner or lender must decide whether to fund advances to make up the shortfalls or pay the calls. In some cases the owner cannot or, in view of poor long term prospects, will not choose to make new advances. The decision whether to fund then falls to the mezzanine lender, if any, and ultimately to the secured lender.

This third scenario is perhaps the most difficult scenario for owners and lenders to address. No factor causing hotel failure here arises from neutral or external factors. The calls do not arise from a change of assumptions or new market conditions or other external risks that can be anticipated in the model. Rather, the issues result from an intentional exercise of powers held or claimed by the operator and its affiliates. These powers may have been granted to them or, more frequently, are claimed by them to have been implied in the operating agreements. Having failed to rule out capital calls or otherwise deal in advance with the risk of shortfalls and capital calls, owner and lender face a management company or franchisor operating on the basis of its own separate interests. These are in conflict with the interests of the owner and lender, who must deal with taking back control and direction of the hotel from what are now adversaries. The hotel must be taken back within the limitations imposed by market conditions and by the cost and availability of funds needed to cover immediate and short term cash needs.

Tools For Response

In each of the three scenarios described above, the owner and/or the lender is likely to want some change in one or more of the material terms in the relationship with those operating the hotel. In the first scenario of market failure, short term or interim operation will require immediate changes to limit expenditure and minimize losses. If the market has truly failed, the brand has proven not to be effective or the right match and needs to be changed. Whether operation continues for a period or the sales effort begins immediately, the hotel’s longer term prospects and value requires that the brand be terminated. Sale in the longer term, to realize the full potential of the property, is likely to require that the property be conveyed free and clear of burdensome brand and management obligations. This most often requires termination of the operating arrangements prior to closing. In the second scenario of misaligned interests, the operator’s actions need to be brought back into compliance with the interests of the owner and lender. This might simply mean bringing the operator back into compliance with its agreement, but more often the operator’s problematic conduct is claimed to be permitted under existing agreements. In such case, the management agreement may need to be revised, clarified or strengthened to require different and correctly aligned conduct. If neither enforcement nor renegotiation is sufficient to align the operation with the goals of the owner and lender, the management and brand relationship may need to end. Finally, the third scenario of destructive capital demands is based on a brand group or management company willing to impose loss, damage and possible insolvency on its owner. This will ultimately be resolved only by eliminating the risk of mandatory additional investment. That is not likely to be possible within the existing operating agreements or current operators.

The Roots of Failure and Mistakes Already Made

At the root of the conflict between investor and operator is a basic assumption about their relationship: that the investor can be allowed to fail while the brand group or management company succeeds. The operator’s and licensor’s decisions to act in conflict with the owner (or the lender as a successor to the owner) are premised on a belief that somehow the operator and licensor will retain the material benefits of control over the hotel notwithstanding the consequences to the owner. The owner may fail, lose the hotel in foreclosure or bankruptcy, or the lender may not be repaid in full, but the brand group and management company will remain in place.

This assumption may rest simply on a commonsense conclusion that, after the owner fails, the lender or other successor owner will find it cheaper to keep the brand in place. Where the hotel is underperforming moderately, the high cost of reflagging a property may be significant in a decision about changing the brand affiliation. In recent years, however, the belief has been tied to the formal terms of written agreements between brand group and lender. Called by a variety of names including “SNDA” or “non-disturbance” agreement, or “tri-party” agreements or “comfort” letters, these provide that the lender will cause the franchise, management or other affiliation to be retained after loan default, including through foreclosure or bankruptcy. Some will be recorded as interests in real property; others will be unsecured letter agreements.

Formal agreements between lenders and hotel operators referring to non-disturbance rights originated in relation to hotel operating agreements structured as operating leases. Prior to and through 1980’s, the owners of significant hotel portfolios included institutional investors such as insurance companies, pension funds and other regulated investors. These owners were technically restricted from making direct investment in operating businesses, including hotels. Direct management of such assets was forbidden. Hotels were therefore run through “operating leases.” These were in form leases but in substance had provided a high degree of owner control and had many elements of agency management agreements. Regulatory prohibitions on direct operation of hotels ended, but many of these lease-like provisions continued to appear in hotel management agreements. Among these were covenants of quiet enjoyment, references to payments to owners as “rent”, owner responsibility for building systems, and provisions for attornment by managements companies to lenders. By the late 1980’s hotel ownership began to attract less sophisticated owners from outside the United States, tax shelter investors, and fund investors with less familiarity with hotel investment. Some of these investors and their lenders viewed a brand-name operator or a brand affiliation as a necessary and significant assurance of future value in the nature of a credit lease. They were willing to agree to non-disturbance language when asked to do so, and in some cases sought SNDA agreements as they would have done in a leased building. Brand groups obviously did not discourage this. In markets with many new hotel projects, the brand groups were often able to insist on SNDA protections that assured them of long term management regardless of profits. Attornment clauses then expanded to include non-disturbance provisions taken from leases and to include provisions for recordation of the management agreement as an interest against real property title. Some also imposed affirmative funding obligations on lenders as well as owners.

These provisions so highly protective of management were not welcomed by experienced investors and some long term owners. Sophisticated conventional lenders providing loans for hotels also tended to modify or bar pro-management and pro-brand group terms. They also litigated successfully to have non-disturbance provisions overridden by agency principles allowing termination at will.[6]

The CMBS lending market, however, proved far less self-protective and largely conceded the issue of non-disturbance to the brand groups and management companies. CMBS originators proved willing to give concessions such as SNDA provisions to brand groups and management companies, in part as a business development tool. Hotel management companies began coordinated loan programs with CMBS lenders. In these, the management or franchisor companies worked with CMBS loan originators to offer new or refinancing loans to franchisees or owners of managed hotels. The loan originators were given guarantees or other credit enhancement from some member of the brand groups, but may not have scrutinized the operating agreements as closely as they should have done. The rating agencies, also entangled in conflicts of interest, raised few or no objections to hotel loans with non-disturbance clauses and other pro-manager terms. They also ignored the expanding provisions allowing capital calls and demands for advances, and in fact underwrote the loans as if to closed-end SPE’s. When the new hotel development reached its frenzied peak in the late 1990’s and again after 2003, non-disturbance provisions appeared to be treated by brand groups, lenders and rating agencies as boilerplate clauses of no importance to the rating. Some rating analysts even seemed to add value for non-disturbance provisions.

Some owners and lenders, obviously uncomfortable with the provisions, resisted outright non-disturbance obligations. They however failed to deal fully with the problem that agreements, while not providing explicitly for non-disturbance or recordation against the real estate interests, could still result in the lender being forced to retain the brand. One type of provision with this effect allowed termination of the brand management companies but gave lenders and other successor owners an unrealistically brief period to opt out of continuing the brand management and affiliation agreements. Some allowed termination of the agreements, but only after completion of all foreclosure steps and on a time schedule or at a cost that made the power of termination difficult or impossible to exercise. Others allowed “cures” of the notice of termination by a relatively nominal payment from the management company, insufficient to support refinancing. “Comfort” letters also tended to impede any alternative other than continuation of the brand affiliation, as by requiring decision without adequate time to collect and analyze information.

In some cases not even a written agreement was required to drive a lender or owner into keeping a brand. Management companies improved their chances of continuing in control of a hotel simply by remaining in interim management after a default. Inexperience, the lack of an alternative manager, the threat of unknown costs and delays, and a reluctance to acknowledge prior underwriting errors could combine to make a lender overlook how the management company had contributed to the project’s failure. We are seeing this pattern develop in the current cycle as overburdened, inexperienced and underprepared servicing personnel are clinging to existing management arrangements.

The same blindness that lenders had toward non-disturbance provisions seems to have been applied by them to a variety of other dangerous provisions. Provision for open-ended capital calls were passed without comment.

Particularly bad were the provisions for “performance termination” that were approved and used in ratings when they in fact entrenched management companies. Lenders awarded non-disturbance rights to hotel management contracts on the theory that the contracts allowed termination for poor performance. The provisions, as a practical matter, raised impossibly high barriers to termination even in the event of abysmally poor performance by the management company. The provisions did little more than given management companies a series of defenses to termination and tools to eviscerate any potential for termination by other means. “Competitive sets,” which establish a supposedly comparable group of hotels to test performance, are highly unlikely to be failed at all or with any degree of certainty. Arbitration, which severely disfavors owners, has been inserted in many agreements.

Most fundamentally, the CMBS lenders and the rating agencies ignored the importance of agency law to the rights of owner and lender. Lenders have accepted the assignment to them as collateral of contracts purporting to waive agency law for the benefit of the operator and thus for the lender as successor. This waiver is likely to be deeply entrenched but obscurely presented in the clauses of the contract. Agency law, and in particular its central obligation of loyalty due from the agent, had been the core protection for owners in their relationship with operators. From the late 1988’s through the late 1990’s, owners and lenders repeatedly and successfully enforced their rights under agency law to be protected against conflicts of interests and the taking of hidden profits by their agents. This line of cases culminated in a major appellate decision affirming that agency law’s right of termination trumped non-disturbance assurances.[7] This appellate decision had a profound impact on the major management companies, reinforced by decisions applying the principle to allow termination of management at specific hotels. The precedent was used to allow termination of long-term contracts and the award of material damages for business practices by which management companies preferred their own interests to those of the owners.

These cases resulted in, among other defensive strategies, the insertion of new contract language of waiving fiduciary and agency relationships and for the exclusive remedy of arbitration. Very few owners or lenders realized the significance of these changes. Even less did they notice statutes enacted in Maryland (the jurisdiction in which several major hotel group parent companies were formed and/or have their headquarters) to gut the use of agency law to allow terminate and other agency remedies against hotel management companies.[8]

Rating agencies have also contributed to the disintegration of lending standards. They have failed to note the practical implications of clauses in management agreements which impede recovery of value after debt default. One excuse given for this has been that the rating agencies did not have the historic data necessary to calculate the risks associated with those provisions. This failure seems to demonstrate one more impact of the same conflicts of interest and poor judgment in the rating process infecting CMBS real estate lending.

Tools to Deal with Problems

As the discussion above should make clear, any owner or lender facing possible hotel loan default needs information. This includes information about causes of financial distress, information about how the hotel is in fact being operated, and the information about operational alternatives available in the market. None of this information is particularly easy to collect, and brand groups and management companies have been particularly adamant in this cycle about withholding the type of information that owners and lenders need. Collection of current information is a critical early step, and often an accurate indicator of how aligned or adversarial to the owner those involved in management will be.

Owners and lenders also need to evaluate where they are likely to carry out their disputes or resolutions. Hotel lending in the last decade has broadly embraced the forms and practices of CMBS lending, including minimal or no attention to the issues of treatment after default of loans secured by hotels. At best, the rating agencies were among the earlier participants in the market to call attention to the unusually high rate of loan failure and realized losses affecting hotel loans in CMBS pools. These were eventually recognized as warnings of fundamental underwriting issues. Even before warnings were issued about sub-prime and alt-A residential loans, rating agencies were backing away from hotel loans and indicating their anticipation that hotel loans might be a factor in downgrading of CBMS securities. Annual publications such as Fitch Research’s “Conduit Loan Default Study” and “Loan Loss Study” had pointed to hotel loans for several years as being vulnerable to further losses in an economic downturn.[9]

The force of the warnings from some of the agencies was diluted by the willingness of the same and other agencies to continue to rate new pools of hotel loans. There was an apparent reluctance to downgrade already-rated pools that included hotel loans. Nonetheless, agencies were seen to pay increased attention to loan failure statistics, which placed hotel loans in one of the groups with most failures and defaults. This reached the point in 2006 and 2007 that pools with hotel loans were particularly quick to be criticized and downgraded by analysts. Hotel related debt found its way into CDO’s. Hotel loans were well on the way to being toxic collateral in the CMBS market before that market was recognized to be gorged with other toxic loan products in late 2007. Conventional lenders such as regional banks, foreign lenders and unregulated lenders remain possible sources for hotel loans, but even their interest in the hotel loan category is uncertain. This impedes sale and refinancing, leaving few options for owners and lenders secured by ailing hotels.

The first issue after a loan default, or even before imminent default, is how to respond to shortfalls and demands for funding by management companies. As in previous cycles, some lenders have already received funding demands that exceed both the balance due on their loans – which the borrower has already failed to pay – and the appraised value of the hotel. Some hotels have closed abruptly as a result. Servicers, already strained by other obligations to advance, are not funding many requests. Whether they fund or not, lenders are concluding, as they have in the past, that they must end the brand relationship and contracts to allow renegotiation, sale or another exit strategy. They therefore look to renegotiation and to two paths of legal action to take control over the direction and operation of a failed hotel. One such path is toward foreclosure. The other path is via bankruptcy.

Restructuring Through Negotiation

In the early phase of this cycle, we did not see many constructive efforts toward resolution of hotel loan defaults by negotiated restructuring without litigation between any of owner, operator or lender. This may come in a later phase, but it may also reflect the intense financial pressures on each of the parties and the highly unpredictable business environment. The parties have no apparent guidance or template as to what results should be agreed, and lack any formula for future operation that will assure that the hotel survives or the management continues. On the part of the brand groups, there is a fear that any concessions made to one owner relating to brand-wide charges or other brand-wide practices will ultimately become known to other owners, who will push to have the same concessions. Many hotels are in fact overstressed by excessive fees and system charges imposed on them at the peak of the market. The hotels will not be able to return to operation at those levels in any market operating at historic norms. Hotel management companies may think it easier in the short term to lose a hotel from their brand group by insolvency or via a confidential arbitration process, rather than make a concession that could become an issue with other owners. Too, no single concession is likely to resolve the failure of a hotel, because so many factors are contributing to the current problems. In a sense, it is the entire brand management model that is in issue. Interestingly, we see new branded products being promoted as alternatives to the established brands and their management models. In concept, these new branded products are affiliation groups more closely aligned with the financial interests of hotel owners and lenders. They offer shorter term contract, no hidden charges, and compensation that is aligned with profit to owners. As reservation systems become more integrating with internet offerings and less with brand websites and brand marketing, these branded products may become attractive alternatives.

Restructuring in Foreclosure

“Foreclosure” of a hotel does not describe the same process in every jurisdiction or for every type of hotel, and thus management contracts are not affected in the same way. Among the variable elements is how receiverships are integrated with the foreclosure process and applied to a hotel. Except in cases of substantial negative cash flow, a lender will usually seek to continue a hotel in operation. This may be for a short term, pending analysis of the options, or for a longer term through a sale or credit bid. A lender seeking continued operation is likely to consider an application for a receiver, if for no other reason than to avoid diversion of revenues.

But will a judge appoint a receiver? Appointment of a receiver of rents upon request of a lender may be routine in the jurisdiction, but hotel revenues in part or whole may not always be deemed “rents”. Even if a receivership is possible, which ownership or management functions will the judge assign to the receiver? Receivers of rents have a fairly limited and well defined scope of responsibility. Hotel receivers face a much greater range of potential operating decisions needing to be made. Will the judge require the employment of a professional manager as well as a receiver? What level of compensation and what formula for compensation will the judge order? Hotel receiverships are generally much more expensive than other receivership, particularly if standard percentages used for net rents are applied to gross revenues. And how will the judge deal with the issues of franchisors, existing management contracts, vendors, unions and concessionaires? Will the judge retain or remove the management company? These are matters far beyond the normal competence of foreclosure courts, and may in fact be outside the authority of any statutory receiver in foreclosure. And what about the operating business liabilities? Will the judge order reserves established for WARN Act and other plant-closing obligations? For operating taxes and liabilities? How will the judge deal with cash flow and use of non-real estate property during the proceeding? Many courts have little or no written guidance on these issues. Judges appear to be led as much by their prior experience with hotel foreclosures as by the principles of law. They may also leave to the lender much of the work of crafting the receivership order. All of this is made more complicated because receivers are often political appointees and not chosen by lenders. Judges are highly disinclined to find fault with any receiver or master that they appoint. What comes out of the foreclosure process is, to put it mildly, unpredictable. If a hotel must sit in the foreclosure or sale process for longer periods, the problems become exacerbated and may expand to the full range of operating, budgeting and capital replacement issues.

In fact, a lender could have foreseen that foreclosure was unlikely to be the best forum to deal with a distressed hotel. State courts dealing with foreclosure lack the background and tools giving them the practical ability to deal with unsecured creditors, labor issues, management agreements, or coordination of a negotiated sale. Receivership may be the usual path taken, but it is rarely the satisfactory mechanism for handling most of these issues.

There is also uncertainty about the application of three-party or non-disturbance agreements during and after the receivership and foreclosure process. First, is the management agreement an interest in real property or a simple business contract that does attach to the real property? Second, is the receiver obligated to continue it, or free to terminate it? Are non-disturbance agreements trumped by the foreclosure sale process? Is the receiver in fact a receiver of the real property or of the borrower’s entire business pending foreclosure? Foreclosure practice is in fact unclear on this, however certain the law may appear. The fact that very few cases of this type ever reach the point of decision on appeal makes unlikely any greater clarity in the near future.

By the time the lender reaches the point of foreclosure, the lender may have realized that its ability to remove the management company or break the ties to the brand group is central to whether and how much value will be recovered. It may also realize that, while it wants to deliver the hotel to some future buyer free and clear of the brand affiliation and management contract, the lender does not want that just now. The brand group and management company may resist this, opposing foreclosure to protect their contracts. This makes the process of obtaining a sale order slower, more complex, and more uncertain. Even if an order for sale without the burden of the management and other brand obligations is obtained, the lender or indeed the original owner still faces a possible claim for damages. If terminated, does the management company then have an indemnity or recourse to the lender or a right to sue the former owner for damages for its early termination? Is the lender liable for its failure to return the hotel to the old management? These questions are being examined in cases now working their way through the courts.

Restructuring in Bankruptcy

Historically, experienced lenders to larger hotels and casinos have preferred to work out failed loans in federal bankruptcy proceedings. For the last fifteen years, the bankruptcy laws have in fact been more explicit and more certain in their application to operating hotels than any set of state foreclosure rules. This can be attributed to action taken by institutional lenders, investors, operators and the Resolution Trust Corporation (“RTC”) to deal with a breakdown in hotel lending in the early 1990’s. Hotel loan defaults in the late 1980’s and early 1990’s were followed by and in some cases contributed to savings and loan and bank failures. Both cycles of failure eventually left the RTC as the largest hotel owner in the United States. Hotel dispositions from the RTC portfolio were however limited, in large part because courts of several states had concluded that hotel revenues were not income from real property. Rather, they were ordinary business income or collections of accounts receivable not covered by pledges of leases and rents and not within the lien of a real estate lender. This forced hotel lenders to vie with unsecured lenders and borrower affiliates for hotel revenues, and few lenders were willing to make new loans without certainty that they held secured liens on hotel revenues as they would hold liens on rent. By specific amendment of the bankruptcy laws, hotel revenues were recharacterized as rental income which could be made available as cash collateral for the continued operation of the hotel during a federal bankruptcy proceeding. This change applied only in federal bankruptcy proceedings, but in such proceedings lenders by-passed the issues of state court receivership and foreclosure, This assured hotel lenders of consistent treatment of their liens in federal bankruptcy courts. Further, federal bankruptcy courts were both experienced in and equipped with the legal tools to deal with the interlaced issues of hotels as operating businesses. They had precedents and legal guidance for dealing with matters such as labor agreements, unsecured but essential vendors, provision of working capital loans, and termination of executory contracts, including management agreements. The U.S. Trustee’s offices also had substantial experience with the recurring issues of hotel failure, operation and successful resolution. All of these participants were prepared to work towards continued operation. Where a borrower would cooperate in filing a bankruptcy, the lender often preferred to be in federal bankruptcy court.

Bankruptcy also presents a forum for multi-party negotiation that might not otherwise exist. Lenders and attorneys not regularly in bankruptcy courts may fail to appreciate the degree to which the bankruptcy process operates to force parties into consensus and concession. Bankruptcy, for better or worse, has a statutory timetable with accelerated processes for decision of many contested issues, even to the point of empowering bankruptcy courts to impose decisions when the parties fail to engage with each other or vote when asked to do so. In comparison with foreclosure as practiced in most states, the participants in bankruptcy can more correctly gauge within a fairly narrow range what options they have and the schedule they face. If they fail to act on an issue or oppose a proposed action, the court can effect a decision as to which their rights of appeal are quite limited. The bankruptcy court can and will act with a speed that seems improbable to lawyers accustomed to other courts and, as experience litigators will remind you, the immediate risk of an adverse decision is one of the most powerful settlement tools. Bankruptcy judges are often highly effective in guiding settlement by signaling their probable action on an issue. The practical consequence of the bankruptcy process is that negotiations occur and are completed. Management companies, brought to understand that they are facing immediate termination under one or another of the powers of the court or the debtor, do come to terms with lenders and owners.

Unfortunately, the architects of the CMBS market and structuring decisions supported by the rating agencies took lenders away from bankruptcy and drove them back into state courts for foreclosures. Many of the so-called CMBS criteria – use of SPE companies as borrowers, springing guarantees against filing of bankruptcy, cash trap accounts – do not arise in tax or other law but in the rating models. The model for CMBS lending assumed that bankruptcy would be invoked as a defense against lenders, and risked changing the character or terms of a loan so that the assumptions used in rating the loan would be invalidated or action to realize on the loan would be frustrated. CMBS loan originators thus required the use of bankruptcy-remote ownership structures and other actions though to facilitate rapid liquidation of hotels via foreclosure or a deed in lieu. Lenders of other types, including conventional bank lenders, tended to incorporate this approach in their own loan documents, adopting many of the same bankruptcy-remote features and guarantee requirements to prevent bankruptcy. In doing so, some lenders expected to add a possible exit strategy for themselves, through sale of their loans into securitization. As a result, borrowers now have neither the ability nor motivation to use bankruptcy to resolve management company and other creditor problems, even when urged to do so by the lender. The lenders have thus surrendered or cut themselves off from the benefits and protections that bankruptcy might have offered them, including the ability to have a brand-affiliated management company removed on a predictable schedule via a lien-free sale of the hotel under section 363 or via rejection of the management contract as an executory contract. The ability to deal with other liabilities under these same clauses and to preserve the hotel as an operating business is also gone. We are currently seeing lenders begin to reconsider the desirability of working out hotels in bankruptcy court.

The Issues of Special Servicing

Additional complexity has arisen in regard to bankruptcy and other negotiated restructurings of hotel operations due to the procedures adopted and principles applied in special servicing, the related pooling and servicing agreements and the tranche or tiered structure of CMBS debt. When special servicing of hotel debt first appeared as an issue in bankruptcy cases, it became clear that bankruptcy judges were content to accept CMBS servicers as agents for the lenders as they would accept representatives of secured lenders generally. The court, however, would not modify or reinterpret bankruptcy concepts to accommodate assumptions or structures of the CMBS market. For example, a bankruptcy restructuring typically contemplates some changes in secured debt provisions – a change of maturity date or interest rate, the capitalization and addition to the debt of accrued interest and fees, non-collectibility of some default interest and penalties, or some reduction of principal. Special servicers who thought that “REMIC rules” limited their or the courts’ ability to approve such changes were given short shrift by judges.

Every issue in a hotel loan failure seems to be made more complicated by involvement of servicers. Whether or not a loan has in fact been pooled for CMBS purposes, it may be handled by a special servicer after default.

Owners with hotel loans in bankruptcy were among the first to experience the impact on servicing as practiced in the CMBS market. Servicers had assumed that bankruptcy would be unavailable to borrowers. They were surprised to see that bankruptcy courts not only allowed bankruptcy filings, but also deemed hotels to be operating businesses and not subject to the faster track for single-asset bankruptcies. Judges had little or no reluctance about permitting the use of revenues for continued operation by the debtor. Advances, which are particularly likely to be required in hotel loan defaults, do not fit easily into the servicing process, and servicers were highly reluctant to made advances if at all possible to avoid. Courts were quite comfortable allowing debtor-in-possession financing. Servicers bent on liquidating hotel collateral as quickly as possible collided with judges with a different view of the bankruptcy process. Bankruptcy courts were in fact inclined to see the entire CMBS arrangement as irrelevant to the bankrupt debtor. Among other factors, the debtor had not signed the pooling and servicing agreements or known their contents. The power of the servicer to act in bankruptcy was questioned, and serious questions raised about the authority of servicers to negotiate plans contrary to contractual limitations, the need for formal approval of interest holders, the servicers’ power to take action that would change the rating of classes of securities, and the servicers’ potential liability for proceeding without waivers or approvals of tranche interest holders. The forms of pooling and servicing agreements then in use created more issues than they resolved. These agreements were in fact not agreements to which debtors were parties or by which the bankruptcy courts were bound to consider as debtor obligations. The servicer’s compensation structure came in question. Among other things, the compensation structure dealt differently with outcomes of restructuring or of liquidation. This suggested conflict of interest as to the motivation of the servicer. Bankruptcies often included claims against lender or servicer as assets of the estate

As of the date on which this is written, servicers have not yet proved themselves effective in working out or otherwise resolving large hotel loans. They have certainly not done so with notable success. The default and loan loss record of hotels continues to be poor, providing opportunities for some but more distress for others.

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[1] U.S. CMBS Loan Default Study: 1993-2007, Fitch Ratings, June 9, 2008; .

[2] U.S. CMBS Loss Study: 2007, Fitch Ratings. Oct. 13, 2008. The rating agency attributed the one-year improvement to only limited service hotels being in the group of loans resolved with losses. Limited service hotels, which typically are not brand-managed, were viewed as working out faster and therefore less expensively in terms of realized losses due to foreclosure costs.

[3] Unsurprisingly, loans secured by real estate involved in healthcare is the category most nearly approaching hotels in default and realized losses. Healthcare real estate has rivaled hotels in these statistics in some recent periods.

[4] Little noticed among owners and lenders, the accounting standards for guest loyalty programs have been amended to consolidate the programs with the general operations of the parent companies. This was done in recognition of the fact that the terms of the programs were so easily changed that they had potential to be used to manipulate recognition of income and expense, and to defer recognition of taxable income. This is an evolving area of GAAP or IFRS regulation. See, e.g., International Finance Reporting Interpretations Committee (IFRIC) released Interpretation 13 Customer Loyalty Programs (IFRIC13).

[5] That is, collateralized mortgage-backed securities.

[6] Government Guarantee Fund of Finland v. Hyatt, a Third Circuit decision, remains the most important case on this subject. See footnote __ below.

[7] Government Guarantee Fund of the Republic of Finland v. Hyatt, 95 F.3d 291 (3rd Cir. 1996). The court held that non-disturbance was not enforceable against a principle, but suggested that failure by the principle to perform the covenant by terminating without cause might be relevant to damages. Upon remand, the trial court found cause for the termination of Hyatt and did not award it any damages. The case was settled before a decision on the damages to be awarded against Hyatt.

[8] Title 23 of the Commercial Law of Maryland purports to negate agency remedies of at-will termination in regard to hotel operating agreements, assuring management companies that they are entitled to specific performance and protecting them from enforcement of agency obligations not explicit in the agreement. Few sophisticated owners have agreed to the application of Maryland law since this enactment, but hotel companies have also sought to achieve a somewhat similar result by simply negating the existence of an agency relationship in the provisions of their contracts.

[9] See, e.g., “CMBS Loan Losses: Property Type Highlights and Trends,” M.O’Rourke and S. Merrick, Fitch Ratings, 2003.

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