As we all fasten our seat belts for a rough ride in the Global Financial Crisis, commercial real estate has begun to feel the pain. Hotels will share the fate of the economy, commercial real estate, the airlines and consumer confidence. It does not look pretty.

Some say that after Labor Day 2008, "the hospitality industry fell off a cliff" with gross revenue declines reaching 20% or even 30% in some markets. See "Hospitality Lawyer: Special Servicers and Special Asset teams confer in Dallas for top special servicing conference".

The implications of this kind of change are bad for the hotel industry and hotel lenders as the liquidity crisis, rising cap rates, and tighter underwriting standards have made refinancing difficult or impossible. Maturity defaults were already threatening with billions of debt coming due in 2009, 2010 and 2011, but travel cutbacks and a deepening global recession foreshadow increased loan payment defaults on hotel loan mortgages as well.

In fact, the phones have really started ringing in bankruptcy department for JMBM's Global Hospitality Group® lawyers as creditors seek assistance in collecting or enforcing their debt, and borrowers urgently explore their options. Partner, Bob Kaplan, handles creditor bankruptcy issues, and he thought it would be valuable to extend our series of articles on troubled hotel mortgage loans.

Part 1 Special Purpose Entity approval to file bankruptcy.

Hotel loans are more complex and challenging. Making hotel mortgage loans and dealing with troubled hotel loans is always more complex than with other real estate assets.

A lot has changed since the mid 1990s when there was an estimated wave of some 2,000 hotel bankruptcy filings. The veteran hotel lawyers in JMBM's Global Hospitality Group® represented many major lenders, the FDIC and RTC, and also a number of noteworthy borrowers in cleaning up that mess.

The Bankruptcy Reform Act of 1994 adopted several substantial changes, including a "fix" to the vexatious "rents vs. accounts" issue that plagued hotel lenders through the mid 1990s.* Another of these changes related to what constitutes a "single asset" bankruptcy entitling the secured creditor to expedited relief from the bankruptcy stay. While a single hotel in a special purpose entity might intuitively seem to be a single asset entity, there appear to be two views on this subject, perhaps depending on the facts, or perhaps depending upon the jurisdiction considering the issue. But this fascinating subject will be the discussed in Part 2 of this article (see Speed bumps in the road to Bankruptcy for hotels and resorts. Part 2 - Can a hotel ever be a "single asset" for bankruptcy purposes?).

In Part 1 of this article, I want to focus on a practice that became very common in the mid 1990s and continues today. However, with a long period of good economic times, this practice has not been tested in the crucible of bankruptcy litigation. There are significant implications for all hotel turnarounds, workouts, bankruptcies and receiverships, and for other asset classes as well.
 
If you don't know what the "rents vs. accounts" fracas is all about, then don't worry about it, because you are unlikely to encounter it today. But prior to the 1994 amendments, some courts (like the court in the infamous Northview case in 1991) held that revenues derived by hotels were not "rents" (income from real estate) capable of being secured by a note and deed of trust. Instead, they were in the nature of "accounts" or accounts receivable, and therefore were personal property requiring UCC filings, a "security agreement" and appropriate personal property descriptions. And even if properly described and secured by UCC-1s and security agreements, post-petition revenues were exempt (and are still exempt) from the security interest, like the revenues from any operating business (but unlike the rents derived from real estate). However, this issue can be addressed with a proper cash collateral order.

How can a "Special Purpose Entity" borrower ever file bankruptcy if lender appointed directors must approve the filing?
Since the mid 1990s, the typical hotel loan has required the borrower to put each hotel asset into a special purpose corporate entity. The corporate entity's organic documents typically require that for a bankruptcy filing to be made, approval must first be obtained from "independent" directors (e.g. independent of the borrower) appointed by the lender. The expectation was that the lender-appointed directors would NOT approve the filing of a bankruptcy, because bankruptcy would delay a lender completing foreclosure in the event of a hotel loan mortgage default.

JMBM's hospitality lawyers are currently representing a lender in a matter where the debtor completely ignored the requirement of getting independent director approval for bankruptcy filing. Here's how this issue shapes up.

THIS IS A QUESTION OF FIRST IMPRESSION!!!
The concept of requiring special approval for a corporation to file bankruptcy is embedded in many thousands of hotel and other real estate secured loan structures. In recently undertaking an engagement representing a hotel lender, we found that there was no reported bankruptcy case in the United States evaluating the validity of a requirement that in order to file bankruptcy, a corporate entity must either get the approval of certain "independent" directors, or must have a unanimous approval of all directors.

The variations of this theme will undoubtedly be tested in the Financial Crisis as more lenders seek to foreclose on their hotel collateral and to prevent borrowers from delaying their process with bankruptcy filings, or as borrowers seek ways around the requirement to save their projects or extract lender concessions.

JMBM's hotel lawyers represent both hotel lenders/creditors and hotel/borrowers. So we will follow the development of legal principles in this area with great interest in the many jurisdictions where it is likely to evolve.

BORROWERS WILL SAY:
Debtors will argue that the approval requirement for a bankruptcy filing is void because it is against the public policy of permitting bankruptcy reorganizations, and blocks access to the bankruptcy courts. They may also argue that requiring unanimous approval of the board, or approval by the outside directors appointed pursuant to the loan documents is unenforceable as too high a requirement and void under corporate governance policies as well.

LENDERS WILL SAY:
Creditors will argue that this is enforceable under state law governing the organization and operation of corporations, limited liability companies or whatever entity is involved. They will certainly say that the provision was a part of the bargained-for-consideration among sophisticated players and does not block access to the bankruptcy courts. It just requires the business judgment of independent directors who will be held to their fiduciary obligations.

The business judgment rule will presumably protect these independent directors, IF THEY PROPERLY INVOKE THE RULE. The business judgment rule only protects directors who actually exercise their judgment by identifying an issue, getting appropriate advice, giving due consideration to the information, and properly documenting the their decisions. This means that outside directors will need likely need independent counsel, independent appraisers and careful guidance to properly exercise their "business judgment" and gain protection of the rule.

WHO WINS?
There is no bankruptcy authority on this critical issue. We suspect that the bankruptcy courts may have divergent opinions initially, and that eventually, a consensus may develop at least in certain circuits, on a jurisdiction-by-jurisdiction basis. This makes prediction of result difficult until the results begin to form a pattern.

Pro-debtor bankruptcy judges probably will not enforce the independent director requirement and may hold them void as a matter of public policy. Pro-creditor bankruptcy judges will enforce the independent director requirements on the ground that they were negotiated between sophisticate parties in a commercial setting.

Until some controlling authority develops, at least where borrowers feel that they have some equity, they are likely to try filing bankruptcy without independent director approval, or trying to position the independent directors for breach of fiduciary duty liability for failing to act in the best interests of the corporation, and preferring the lender constituency. This is likely to cause independent directors to seek independent counsel and appraisals for the ensuing battle.

The other "speed bump" that we will look at next time is whether a hotel can ever qualify for the expedited relief from stay provisions for "single asset" bankruptcy cases. See Part 2.

Robert Kaplan is a partner in JMBM's Bankruptcy, Insolvency and Restructurings Group and a senior member of the Global Hospitality Group® - a team of 50 seasoned professionals with more than $50 billion of hotel transactional experience, involving more than 1,000 properties located around the globe.

Bob represents lenders, special servicers, hard money lenders, community banks, national banking associations, distressed debt investors, and equity investors, positioning them for the best possible outcome by acting expeditiously to preserve value and increase cash flow. His industry experience and his knowledge of the current capital markets - where distressed assets often include complex deal structures and securitized loans - allows him to bring creative and effective strategies to the table. When aggressive litigation is the best strategy, he is a vigorous and effective advocate for his clients.

Bob represented the securitized lender in the Chapter 11 bankruptcy case filed by the Clift Hotel in San Francisco, and in the subsequent negotiations and successful sale of the loan to a third party. The lender - acting by and through GMAC Commercial Mortgage Corporation as special servicer - was the holder of a $60 million loan secured by a Deed of Trust on the Clift Hotel. He has also served as counsel to JER Robert Company, AMRESCO Management Inc. and Midland Loan Servicer in their capacity as special servicers on troubled hotel loans in CMBS pools.

To read more about hotel workouts, go to www.HotelLawBlog.com and select "Workouts" For more information, contact Robert Kaplan at 415.984.9673 or rkaplan@jmbm.com.

JMBM's Distressed Assets Expertise
JMBM's Global Hospitality Group® includes an experienced Distressed Assets Team that mobilizes quickly to address the complex issues surrounding distressed hospitality properties and stalled developments. Whether it is a solution to a lender's troubled loan or the response to a buyer's opportunity, we work quickly to preserve value and increase cash flow.

Because hotels are special assets, with operating companies, numerous issues come into play in a workout or bankruptcy scenario. Because we have represented creditors, owners and investors in the hospitality arena for more than two decades, we do not need to "get up to speed" on the special issues.

Regardless of where we are in the market cycle, JMBM's Distressed Assets Team is involved, day in and day out, in restructuring and working out deals that go sideways. Our experience -- together with our knowledge of the current capital markets where distressed assets often include complex deal structures and securitized loans -- allows us to bring creative and effective strategies to the table. When aggressive litigation is the best strategy, we are effective, rigorous advocates for our clients' interests.

For information about how we can help, contact one of the senior members of the team, below.
Jim Butler 310.201.3526 JButler@JMBM.com
Neil Erickson 310.201.3516 NErickson@JMBM.com
Robert Kaplan 415.398.9673 RKaplan@JMBM.com
Guy Maisnik 310.201.3588 GMaisnik@JMBM.com
David Poitras 310.201.3571 DPoitras@JMBM.com
Richard Rogan 415.984.9606 RRogan@JMBM.com

This is Jim Butler, author of www.HotelLawBlog.com and hotel lawyer, signing off. We've done more than $50 billion of hotel transactions and more than 100 hotel mixed-used deals in the last 5 years alone. Who's your hotel lawyer?

Our Perspective. We represent developers, owners and lenders. We have helped our clients as business and legal advisors on more than $50 billion of hotel transactions, involving more than 1,000 properties all over the world. For more information, please contact Jim Butler at jbutler@jmbm.com or 310.201.3526.

Jim Butler is one of the top hospitality attorneys in the world. GOOGLE "hotel lawyer" or "hotel mixed-use" or "condo hotel lawyer" and you will see why.

Jim devotes 100% of his practice to hospitality, representing hotel owners, developers and lenders. Jim leads JMBM's Global Hospitality Group® -- a team of 50 seasoned professionals with more than $50 billion of hotel transactional experience, involving more than 1,000 properties located around the globe. In the last 5 years alone, Jim and his team have assisted clients with more than 100 hotel mixed-use projects -- frequently integrated with energizing lifestyle elements.
Jim and his team are more than "just" great hotel lawyers. They are also hospitality consultants and business advisors. They are deal makers. They can help find the right operator or capital provider. They know who to call and how to reach them.

Contact him at jbutler@jmbm.com or 310.201.3526. For his views on current industry issues, visit www.HotelLawBlog.com