The Next Chapter (11) In Buying Distressed Hotels: Bankruptcy Sales

These are tough times in the hotel business.  The recession has squeezed room rates and net operating income.  The credit crunch means new borrowing is available only at lower loan to value ratios near 50%, on already beaten down values.  At the same time, many tens of billions of dollars of existing hotel loans are maturing or otherwise in default, leaving the owners with little ability to sell or refinance at for amounts sufficient to pay off existing debt.

However, out of problems come opportunities.  For many owners, the next chapter in their hotel's storied history may be Chapter 11-of the Bankruptcy Code.  That may be good news for hotel buyers, because while there are pitfalls, there are also unique opportunities in the bankruptcy process for buyers of hotels to reduce costs, increase value, and even obtain unconventional financing terms not otherwise available.

Some Opportunities for Buyers in Bankruptcy

Buying a Hotel Free of the Management Agreement. 

Outside bankruptcy, if buyers financially encourage an owner to breach its existing management agreement to sell the hotel to them as a replacement manager/operator, they face litigation from the terminated manager for interference with contract. 

In bankruptcy, however, the debtor has the power (and perhaps even a duty) under Bankruptcy Code Section 365 to "reject" burdensome executory contracts-including management agreements--if that will increase the value of a hotel to a buyer.  To some buyers (especially those who want to re-flag the hotel and come in as the manager as well as owner), a hotel may be worth many millions of dollars more if it comes without a long-term existing management agreement in place.  And, unlike the case outside bankruptcy, a buyer conditioning an offer on rejection of the existing management agreement generally cannot be sued in state court for participating in the bankruptcy sale process under those terms.  (Bankruptcy law can even allows rejection of collective bargaining agreements with onerous terms, although such labor agreements have a higher standard for rejection, under Bankruptcy Code Section 1113.)

Buying a Hotel Free of Existing Secured Debt.

Outside bankruptcy, many hotels-especially those bought or renovated in 2006-2007-often have several holders of secured debt (a senior loan, a junior loan or mezzanine debt, as well as, sometimes, mechanics liens for unpaid contractors who worked on renovations) that total much more than the value of the hotel today.  In view of the negative current cash flow of many properties and other operational challenges, few senior lenders are foreclosing and seeking to resell the hotels immediately, and there are several difficulties with buying at a foreclosure sale.  Those circumstances make it difficult for a prospective purchaser to reach a deal to buy the hotel.

In bankruptcy, though, the owner can often sell a hotel "free and clear" of liens and other property interests under Bankruptcy Code Section 363(f), with the liens attaching instead to the proceeds of sale.  That allows a buyer to get clean (unencumbered) title even while paying less than the amount of the existing secured debt.  Even if there are fights among existing secured creditors over their lien priority, that doesn't have to prevent a sale in bankruptcy, because those disputes can be sorted out over the proceeds after the sale is completed.

Buying a Hotel Without Paying Recording or Real Estate Transfer Taxes.

Outside bankruptcy, sale of an expensive hotel can trigger substantial state and local recording or real estate transfer taxes.  In San Francisco, for example, the recording/transfer tax is 1.5% on transactions larger than $5 million.  For a $100 million hotel property changing hands in San Francisco, these taxes alone are a $1.5 million transaction cost.  Rates in some other cities, like New York, can be twice as high (combined state and city.)

In bankruptcy, however, if a hotel is sold under the provisions of a confirmed Chapter 11 plan of reorganization, the buyer and seller avoid payable recording and real estate transfer taxes on the sale, under Bankruptcy Code Section 1146.  The savings on transfer of a $100 million hotel in New York would be over $3 million.   And, unlike other cost savings, which are realized over time (e.g., reduced management fees or labor expenses), this is an immediate benefit fully realized by the buyer at closing.

The ultimate principals of the seller can also reap tax benefits from a sale of a hotel in bankruptcy.  Under Internal Revenue Code Section 108, debt discharged in a bankruptcy does not create cancellation of debt income for the owner, which could otherwise flow through to the partners or members (in the case of an LLC), which can save millions of dollars in tax liabilities in some circumstances.

Assuming Existing Debt to Buy a Hotel.

Outside bankruptcy, existing debt is typically due on sale of a hotel (and often even on change in ownership), or such a transaction can result in the imposition of "default interest" at a much higher rate than the original note rate.  Even in the absence of such provisions, the debt on many hotels is maturing shortly, in a market where replacement financing is unavailable on comparable terms.

In bankruptcy, senior debt can be modified (subject to certain limitations) under a plan of reorganization to extend the maturity date, and potentially even modify the interest rate, as well as to allow for transfer of the property to new ownership, without triggering the due on sale clause or other negative consequences such as default interest charges.  Thus, a confirmed bankruptcy plan can modify specific terms of the secured debt for the benefit of a hotel buyer using that debt to help finance the transaction. 

The Basics of the Bankruptcy Process

To understand bankruptcy asset sales, it is helpful first to get an overview of the bankruptcy process.  If a hotel owner files for Chapter 11 bankruptcy relief, the automatic stay-a federal injunction under the Bankruptcy Code-halts foreclosures, lawsuits, collection actions, or attempts by third parties to obtain property of the owner in bankruptcy.  The owner continues to manage its affairs, and bankruptcy law creates some breathing room to allow the owner to financially reorganize.  Without court permission, the debtor is prohibited from paying pre-bankruptcy unsecured debts, and can even suspend paying secured debts for a time.  Typically, the court authorizes use of revenues generated from the property to pay current operating expenses during the case. 

The provisions of the Bankruptcy Code also provide other tools to aid a financial restructuring:  The debtor can reject burdensome contractual obligations, set aside certain pre-bankruptcy transfers that unfairly favored some creditors or investors, set aside unperfected liens, and sell assets free and clear of liens with the liens attaching to the proceeds of sale.

The ultimate goal of a Chapter 11 is generally to confirm a plan of reorganization, which substitutes the obligations in the plan for the pre-bankruptcy debts.  A plan divides creditors into separate classes (typically, each secured debt obligation is in a separate class, and other classes include a class of general unsecured creditors, like trade debt, and a class of relatively small claims of less than a specific dollar amount.) 

The bankruptcy debtor generally has a four month exclusive period to propose a plan of reorganization (a period often extended by the bankruptcy court, up to an additional 14 months).  There are numerous requirements to confirm a plan of reorganization, but if it meets those requirements, a plan can do things like reinstate secured debts by curing defaults (thereby undoing the default rate which may have been triggered), extend the maturity of secured debts, and even reduce the pay rate or interest rate of those debts.  The plan can pay unsecured creditors cents on the dollar over time. 

One of the key requirements for plan confirmation is that at least one class of impaired creditors (those whose legal rights are altered by the plan) has to vote in favor of the plan, not including the vote of the owners or other "insiders."  A class votes in favor of the plan if both a majority in number of creditors, and two-thirds of dollar amounts of claims, of creditors actually voting in such class votes in favor of the plan.  (Creditors who don't vote, either for or against, are simply ignored.)  If there are substantial unsecured creditors in the case, the U.S. Trustee (an arm of the Justice Department overseeing the bankruptcy process) typically will appoint an unsecured creditors committee, which, among other things, will negotiate with the debtor over the terms of the plan, with the goal of being able to recommend to creditors that they vote for the plan.

The Bankruptcy Code Section 363 Asset Sale Process

Even before any plan of reorganization is proposed, a debtor can file a motion to sell, with court permission, a hotel (or other asset) under Bankruptcy Code 363.  The process is different from sales outside bankruptcy in many respects. 

First, sales in bankruptcy are generally "as is," with very limited representations, warranties or indemnities from the seller.  Second, there typically are few or no contingencies other than bankruptcy court approval for the sale.  Third, the purchase agreement is typically subject to overbids, as part of a process approved in advance by the bankruptcy court.

Typically, a debtor offers the hotel for sale and sets up a data room for due diligence.  Potential bidders are qualified, and after several rounds of negotiation, the highest and best offer is accepted as the "stalking horse bid."  The purchase agreement negotiated with that stalking horse bidder is subject to bankruptcy court approval and typically subject to higher bids, setting the floor for a final auction.

As part of the process, savvy buyers frequently negotiate, as part of the agreed sale procedures approved by the bankruptcy court, a "break up" fee (if they are outbid) and minimum overbid increments (with the first increment higher than the initial bid plus the break up fee.)  Break up fees are typically lower than in non-bankruptcy transactions, to prevent undue discouraging of rival bids.  This varies some by bankruptcy court district, and is often heavily negotiated, but often ranges between 2% and 5% of the sale price.

At the final auction (which is often overseen by the bankruptcy court) any qualified bidder under the sales procedure order can bid more for the hotel, and the stalking horse bidder can then raise its bid as well.  At the conclusion of the auction, the debtor (generally in consultation with the unsecured creditors committee) selects what it believes is the highest and best offer.  This is sometimes an "apples vs. oranges" comparison, because one offer, for example, may be for a higher nominal amount, but include a lower up front cash component or result in additional costs to the estate (for example, it is conditioned on the debtor rejecting a management agreement, which would increase the amount of creditor claims to be paid by the bankruptcy estate). 

The court ultimately determines which bid is in the best overall interests of the bankruptcy estate and enters an order approving the sale.  If the court finds that the winning bidder is a buyer "in good faith," the order approving the sale is irrevocably binding under Bankruptcy Code Section 363(m), even if it is later challenged, or even reversed on appeal (unless the sale is stayed pending appeal, an extremely rare occurrence).

Some Tactical and Practical Options and Issues in Bankruptcy Sales

Instead of the auction process described above, the debtor could propose a plan that calls for a sale to a specific buyer.  This has some potential advantages and disadvantages:  First, from the buyer's perspective, it is more certain, because it sets up a sale, not just an auction.  Second, if the hotel is sold through a bankruptcy plan, as discussed above, the transfer is free of transfer taxes.  Third, under some circumstances, a bankruptcy plan can modify and extend the secured debt currently on the property and transfer the property with some or all of that debt still on it.  That is particularly attractive during a credit squeeze, when other sources of financing are limited.

One disadvantage of transferring a hotel under a bankruptcy plan (compared with the sale motion described above) is that it requires a vote of creditors and satisfaction of numerous confirmation requirements under bankruptcy law.  That, in turn, means at least one class of impaired creditors must vote in favor of the plan.  In order to induce unsecured creditors to vote in favor of a plan, the plan typically must provide them with some recovery (even if their debts would otherwise be wiped out in a foreclosure), thereby requiring either a negotiation with the secured lender or for the buyer to pay more than it might through a sale pursuant to Bankruptcy Code Section 363.  Because a sale through a reorganization plan is subject to the bankruptcy court's determination of whether all plan confirmation requirements have been met and sufficient creditor approval, it is necessarily a more risky process than a pre-plan sale.

Occasionally, buyers and owners negotiate a sale of assets in advance of bankruptcy in consultation with the major creditors, and use the bankruptcy process to confirm a plan that is substantially pre-negotiated even before the bankruptcy is filed, shortening the process.

Final Notes

Like anything else that involves going to court, bankruptcy is inherently uncertain, and there are challenges as well as opportunities.  But the bankruptcy route comes with powerful tools to increase the value of a hotel to buyers, to consummate deals that would otherwise be difficult or impossible to do, to avoid millions of dollars of transfer taxes otherwise payable on a sale, and even to allow buyers to assume existing secured debt extended or restructured under a Chapter 11 plan.

[*] Dean Gloster is a partner and Gary Kaplan is special counsel at Farella, Braun + Martel LLP, a San Francisco law firm with a national hospitality practice, where they lead the restructuring, bankruptcy, and creditors' rights group.  Dean Gloster recently spoke at the American Lodging Investment Summit on restructuring hotel debt in bankruptcy and selling hotels in the bankruptcy process.