Blast from the Past The Return of Hotel Bankruptcies

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Dec/Jan 2001

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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.

<h3>Hotel Industry Changes</h3>

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.

<h3>Bankruptcy Law Changes</h3>

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.

<h3>Use of Cash Collateral</h3>

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.

<h3>Lifting of the Automatic Stay</h3>

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 <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. CBJ Dev. (In re CBI Dev.), 202 B.R. 467
(B.A.P. 9th Cir. 1996)</a>.

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.

<h3>Providing New Value</h3>

The last major change to the law affecting hotel cases since the last industry
downturn came not from Congress, but rather from the <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…. Supreme Court. In
1999</a>, the Court issued its decision in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… of Am. Nat'l. Trust & Sav.
Assn. v. 203 N. LaSalle St. P'ship., 119 S. Ct. 1411 (1999)</a>.
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 <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Davis, 262
B.R. 791 (Bankr. D. Ariz. 2001)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Situation Mgmt. Sys.
Inc., 252 B.R. 859 (Bankr. D. Mass. 2000)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Global Ocean
Carriers Ltd., 251 B.R. 31 (Bankr. D. Del. 2000)</a>. 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.

<h3>Conclusion</h3>

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.

Journal Authors

David M. Neff

Journal Date

Saturday, December 1, 2001 - 12:00

Bankruptcy Rule

2001