Blast from the Past The Return of Hotel Bankruptcies
In the early '90s, hotel bankruptcies filled court dockets like health care cases did in the decade's later years. A combination of overbuilding of hotels, a national recession and the Gulf War generated dozens of hotel filings throughout the country. However, by 1993, the hotel industry was on the rebound, and profits skyrocketed each year through 2000, when industry profits topped a record $24 billion. But what goes up must come down (especially in real estate), and by 2001, the hotel industry again suffered from more overbuilding and a worsening economy.
Nevertheless, few in the hotel industry were predicting the plethora of bankruptcies that plagued the industry years earlier. That was until the tragic events of Sept. 11. With the nation reluctant to return to air travel, hotel occupancies have plummeted. As a result, hotel owners strapped for cash once again are considering bankruptcy as an option to save their investments.
There have been a number of important changes that have occurred in the hotel industry and in the bankruptcy laws that will affect hotel bankruptcy cases this time around. This article will explore some of them and discuss how they will shape a hotel owner's ability to confirm a plan.
Hotel Industry Changes
In the late '80s and early '90s, hotels in bankruptcy sometimes had a fair market value that was less than half of the secured debt against them. This was because many appraisals from the '80s had grossly overvalued hotels when loans had been obtained, and lenders had been willing to make loans that were at amounts as high as 100 percent of the hotel's appraised value, which was often well over 100 percent of the real value (often as much as 120 percent). As a result of this large discrepancy between their loan balance and collateral value, lenders often had two powerful weapons with which to contest plan confirmation. The first involved the requirement of §1129(a)(10) of the Code that a debtor obtain at least one impaired, non-insider class to accept its plan. The debtor could often create only two impaired classes under its plan—one consisting of the lender's secured claim and the other consisting of general unsecured claims. Because class acceptance of a plan requires one-half in number and two-thirds in amount of class members voting on the plan to accept it, a lender only needed to hold a deficiency claim of one-third of the unsecured claims voting on the plan to block acceptance by the unsecured class. As a result, when the lender voted both its secured and unsecured claims against the plan, it prevented the debtor from obtaining an accepting impaired class. The second concerned the ability of an undersecured lender under §1111(b) of the Code to elect to have its entire claim treated as secured, as opposed to being bifurcated into secured and unsecured claims. In some instances, the lender's deficiency claim was so large that when the lender made the §1111(b) election, it could prevent plan confirmation because the debtor was unable to show that it could repay the lender's full debt over a reasonable period of time.
For the most part, there will be few instances this time around when there is a great discrepancy between the outstanding loan amount and the fair market value of a bankrupt hotel. Lenders learned from their past mistakes and implemented stringent lending requirements on their borrowers, often insisting on the investment of substantial equity of between 25 and 35 percent of the hotel's value and requiring that the hotel's cash flow substantially exceed its debt service, usually by at least 1.4 times. Although bid prices for hotels have declined in most of the country over the past year (and especially since Sept. 11), the loss in perceived value has often reduced the owner's equity in the hotel, not caused the lender's loan to become undersecured. Consequently, there will be more hotels filing for bankruptcy this time around that are worth close to, if not more than, the secured debt against them.
The kinds of institutions that have been lending to hotels also have changed over the past 10 years. Back in the '80s, savings and loans were frequent lenders to the hotel industry. Soon thereafter, the savings and loan industry found itself in a severe crisis and required substantial government intervention, with the Resolution Trust Corp. (RTC) often taking over these institutions and their loans. In the '90s, Wall Street firms discovered the hotel industry and made numerous hotel loans, many of which were packaged with other loans and securitized for the public to purchase. Aside from implementing more stringent lending criteria than their savings and loan predecessors, Wall Street firms used state-of-the-art loan documents and properly perfected their interests in the hotels and their income, having the benefit of court rulings on such issues as the characterization of hotel income, discussed in more detail below. Whether the change in the identity of the typical hotel lender will impact the lender's tactics in bankruptcy court remains to be seen. The RTC sold its hotel loans, often in large groups, to strategic investors that had no interest in continuing a lending relationship, but instead just wanted to obtain title to the hotels. The Wall Street loans that became securitized are now controlled by a handful of servicing agents. Generally, these servicers are large lending institutions, such as GMAC, that are not in the business of owning or acquiring hotels. Only time will tell whether they want to continue the lending relationship, obtain title to the hotels or have the hotels sold to the highest bidder.
Just as the lenders to the hotel industry have changed in the past decade, so too have the owners of hotels. In the late '80s, many hotels were owned by limited partnerships consisting of passive investors. Most of these limited partnerships were established before the mid-'80s, when the tax laws still allowed limited partners to take losses of the partnership and defer payment of taxes as long as they owned that investment or "traded into" the ownership of another qualifying real estate investment. These limited partners often had little interest in the hotel other than as a tax benefit. In the carnage of the early '90s in the hotel industry, many of these limited partners were unwilling to contribute money to fund a reorganization plan and lost their ownership interests. The new owners that have acquired the hotels are sophisticated investors or operators who are motivated by profits, asset appreciation and management fees, not tax benefits. Also, more than one-third of hotels in the country—and more than 50 percent of the limited-service hotels (i.e., no restaurants)—are now owned by Asian-Americans, who almost always operate their own motels with members of their families. These new kinds of owners have a substantial motivation to contribute funds to a reorganization plan to retain their income as well as their ownership.
Bankruptcy Law Changes
The Bankruptcy Code, and how courts have interpreted it, also has changed in some substantial ways since the last downturn in the hotel industry. These changes fall into three main categories: (1) use of cash collateral, (2) lifting of the automatic stay and (3) providing new value.
Use of Cash Collateral
Before 1994, many courts ruled that a secured creditor lacked a cash collateral interest in the hotel's post-petition cash until it had both perfected and enforced its interest in the cash. Enforcement under most states' laws occurred only when the secured creditor sequestered the hotel income or obtained the appointment of a receiver to collect it. Because hotel owners invariably filed for bankruptcy before either event could occur, many hotel lenders found that they lacked a secured interest in the post-petition income of the hotel at the time of bankruptcy. Under the 1994 amendments, this result was corrected by changes to §§363(a) and 552(b), which now specifically recognize that post-petition hotel income is cash collateral for which the lender needs to take no additional steps to enforce its interest.
The 1994 changes to the Code did not resolve all of the hotel cash collateral issues. State law still defines whether hotel income is accounts receivable or rent. Thus, if it is accounts receivable under state law and the lender fails to properly file a Uniform Commercial Code (UCC) financing statement covering accounts receivable, the lender will not be perfected in the hotel's post-petition income. This was a major issue in cases filed during the last hotel downturn because most loan documents provided that the hotel's income was rent, and few lenders had filed UCC financing statements covering accounts receivable. After all, when these loan documents were drafted in the '80s, few attorneys anticipated that courts would rule that hotel income was something other than rent. However, as a result of those cases, lenders changed their loan documents to characterize hotel income as both rent and accounts receivable, and recorded appropriate UCC financing statements covering the hotel's income.
Lifting of the Automatic Stay
The 1994 amendments to the Code also added a new concept, called the "single-asset real estate case." "Single-asset real estate" is defined in §101(51B) as "real property constituting a single property or project...which generates substantially all of the gross income of a debtor and on which no substantial business is being conducted by a debtor other than the business of operating real property and activities incidental thereto having aggregate non-contingent liquidated secured debts in an amount no more than $4 million."
Just because a hotel has less than $4 million of secured debt against it does not mean that it will qualify as single-asset real estate. There is some case law holding that a full-service hotel, which by definition offers its guests food and beverage service through a restaurant or catering services, is not single-asset real estate because those very services constitute more than merely providing a guest room. See Centofante v. CBJ Dev. (In re CBI Dev.), 202 B.R. 467 (B.A.P. 9th Cir. 1996).
For single-asset real estate debtors, §362(d)(3) was enacted in 1994 to require that the court modify the automatic stay in favor of the secured creditor unless the debtor, within 90 days after the entry of the order for relief (or such later date as the court grants for cause within that 90-day period), files a reorganization plan with a reasonable possibility of being confirmed within a reasonable time or commences monthly payments to its secured creditors equal to interest at a current fair market rate on the value of the secured creditors' interests in the real estate. In light of this requirement, lenders now have a powerful tool that can accelerate the pace of hotel cases where the hotel is worth less than $4 million, which will be true for many limited-service hotels, especially those outside of major markets.
Providing New Value
The last major change to the law affecting hotel cases since the last industry downturn came not from Congress, but rather from the U.S. Supreme Court. In 1999, the Court issued its decision in Bank of Am. Nat'l. Trust & Sav. Assn. v. 203 N. LaSalle St. P'ship., 119 S. Ct. 1411 (1999). In that opinion, the Justices discussed the new value corollary (or exception) to the absolute priority rule.
The absolute priority rule, as set forth in §1129(b)(2)(B) and (C) of the Code, prevents a junior class from receiving or retaining any property under a plan if a senior class rejects the plan and is not being paid in full under it. However, under the new-value corollary, a junior class (usually the existing equity-holders) can retain an interest in the reorganized debtor when a senior class (usually the unsecured creditors) is not being fully compensated if that junior class contributes money or money's worth that is necessary for the debtor's reorganization and is in an amount equal to or greater than its retained interest in the debtor.
Before 203 N. LaSalle, there was some dispute among the circuits as to whether the new-value corollary even existed. If it did not, the viability of many hotel bankruptcy cases (and most other single-asset real estate cases of any size) would be seriously jeopardized because there would be little ability of existing owners to emerge from bankruptcy still owning their assets. In 203 N. LaSalle, the Supreme Court did not explicitly decide whether the new-value corollary exists, but held that if it did, the debtor did not satisfy it because it retained the exclusive right to bid for the equity in the reorganized debtor. The Supreme Court did not describe what a debtor must do to satisfy the new-value corollary, and only a handful of courts since 203 N. LaSalle have tackled that question. See In re Davis, 262 B.R. 791 (Bankr. D. Ariz. 2001); In re Situation Mgmt. Sys. Inc., 252 B.R. 859 (Bankr. D. Mass. 2000); In re Global Ocean Carriers Ltd., 251 B.R. 31 (Bankr. D. Del. 2000). Clearly, it would seem that having competitive bidding in the bankruptcy court would satisfy the new value corollary. Also, it would seem that terminating the debtor's exclusive period to file a plan so that others could propose a plan for the debtor's equity would satisfy it. See "A Roundtable Discussion: Supreme Court Decision in 203 N. LaSalle," 7 ABI L. Rev. 389 (Winter 1999), for a discussion of the 203 N. LaSalle ruling.
The new round of hotel cases should go a long way toward answering the question of what a debtor must do to satisfy the new-value corollary to the absolute priority rule. Because a handful of people in the hotel industry made a great deal of money by purchasing discounted hotel loans from the RTC in the last downturn, many investors in the industry are now poised to take advantage of any opportunities in the next cycle of hotel bankruptcy cases by either buying distressed loans from lenders or purchasing properties out of bankruptcy. As a result, courts will be called upon to decide how hotel owners must offer their hotels for sale to other interested parties.
The changes in the hotel industry and in the bankruptcy laws over the past eight years will pose challenges to both litigants and judges in resolving hotel bankruptcy cases. Because of the changes to the Code and the 203 N. LaSalle decision, hotel owners will have a somewhat more difficult time in confirming plans over their secured creditors' objections, but there is enough left unresolved by the Supreme Court's opinion to provide them the ability to confirm cramdown plans under the right circumstances.