September 14, 2009
By David Neff

Most hotel owners are good at what they do: buying and operating hotels. What they’re not particularly good at—because they have little if any experience—is dealing with a hotel that becomes financially distressed. They usually try to reach out to their lender to provide some form of relief under their loan that involves reduced mortgage payments, deferral of capital expenditure reserve payments and no infusion of new equity. When that fails and the lender commences foreclosure proceedings and owners are wondering what to do next, the topic of bankruptcy arises often. The following are things to consider before deciding whether or not to file for bankruptcy.

1. A bankruptcy overview

Bankruptcy law is federal law that applies throughout the country. Bankruptcy cases are presided over by bankruptcy judges who hear only bankruptcy cases. There are three primary chapters of the Bankruptcy Code under which debtors seek relief:

• Chapter 7, which individuals and corporations use for straight liquidation of their assets by a court-appointed trustee;
• Chapter 11, which individuals and corporations use primarily to reorganize and sell assets through an orderly liquidation; and
• Chapter 13, which individuals with debts under a certain amount use to reorganize.

2. Chapter 11—What is it?

Chapter 11 is available to individuals and companies that want to maintain control over their assets during a bankruptcy case and seek to confirm a plan, which basically is a contract between the debtor and its creditors. The plan can provide for the sale of the debtor’s assets to the highest bidder or can provide that the debtor will retain its assets and make payments to creditors on their claims.

3. What do you need to do to file?

Chapter 11 is relatively easy and quick to file. You need to:

• fill out a two-page petition;
• prepare a list of your 20 largest unsecured creditors, including their addresses and amounts owed to them;
• prepare a list of all of your creditors, including names and addresses; and
• pay a US$1,039 filing fee.

The more difficult part is retaining a good bankruptcy attorney to file your case. To do that, you’ll need a substantial amount of money, typically ranging from US$50,000 to US$250,000. This retainer may be the only source the lawyer can look to for payment, so it’s usually steep. If you don’t have access to your hotel’s cash—for instance, if a third party, like one of the brands, is controlling it—you’ll likely have to pay the retainer out of pocket.

4. What’s the goal of Chapter 11?

The goal of most Chapter 11 cases is to confirm a plan of reorganization. If the value of the hotel is less than the mortgage against it, then that plan usually will seek to reduce the lender’s secured claim to the current fair market value of the hotel and pay an amount to the trade creditors while the owners retain their interest in the hotel.

5. What are the key hurdles to confirming a plan?

The bankruptcy code lists more than a dozen requirements a plan must meet to be confirmed. Of those, four have particular significance in almost every hotel bankruptcy case.

First, the plan must be feasible, which means the debtor must show it’ll be able to make all of the payments called for by the plan. Projections of future operating results will be key to establishing feasibility.

Second, the plan must be accepted by at least one class of creditors that’s impaired under the plan, without considering the votes of insiders. This is the downfall of many plans. A plan must place creditors in separate classes for voting purposes. Creditors holding collateral (such as a lender) must be placed in their own class with regard to that secured claim. That means there will be one class consisting of the lender’s secured claim, one class consisting of unsecured claims and one class consisting of equity holders. The votes of the equity holders—whether they’re voting claims they hold in the unsecured class or their equity interests in the equity holder class—don’t count for purposes of obtaining that one accepting class of impaired creditors.

If the lender rejects your plan, you have to look at another class for an accepting vote. If your only other class is the unsecured creditors, you may be in trouble because most courts require the lender’s deficiency claim (i.e., the difference between the fair market value of the hotel and total amount of the lender’s claim) to be placed in the same class as the unsecured creditors. Class acceptance requires the affirmative vote of at least one-half in number and two-thirds in dollar amount of the class members voting on the plan. Thus, if the lender controls just one-third of the dollar amount of claims in that class, that class will be a no vote. If there’s no other accepting impaired class, the plan can’t be confirmed.

Third, the plan must be fair and equitable in its treatment of the lender’s new secured claim. That basically means the plan must pay that claim a market rate of interest during a market period of time at market amortization. If the court can’t determine a market rate of interest, it’ll use the prime rate and increase it to reflect the risk to the lender of not getting repaid over the term of the plan.

Fourth, the existing equity holders can’t retain their interests in the hotel ownership entity unless they put in fresh cash in an amount deemed sufficient by the bankruptcy court. Consequently, such amount will vary depending on the facts of each case, but it’ll usually need to be substantial. As a result, an equity holder has to ask himself whether it makes sense to put new money into the hotel. The answer may depend on:

• whether the owner is also managing the hotel and wants to preserve that flow of management fees;
• whether the owner owns the hotel as part of a 1031 exchange and needs to retain ownership to avoid an adverse tax event; and
• whether the owner truly believes it makes financial sense to invest more money into the hotel.

6. Is there any reason not to try Chapter 11 if negotiations fail?

One big reason we haven’t seen more Chapter 11 cases—and nowhere close to the volume of cases we saw in the late ’80’s and early ’90’s—is most commercial mortgage-backed securities financing that took place required the principal of the hotel owner to provide a springing guaranty that would take effect on certain bad boy acts, one of which was if the hotel owner filed for bankruptcy. Few owners with assets worth protecting have been willing to risk that personal liability by filing bankruptcy for their hotels.

7. So what does this all mean to a hotel owner?

Even if you have no intention of filing for bankruptcy, you need to know what it may mean for your hotel before you approach your lender for loan modifications. Lenders know what bankruptcy may mean for them and you. If you make a proposal to them that a bankruptcy court would never confirm in a plan, it’s unlikely the lenders are going to find it acceptable. The sooner your proposals are more realistic and provide better treatment for them and you than would occur through a Chapter 11, the more likely you can reach a workout with your lender, if one is possible.