Troubled Hotels and the Renegotiation of Management Agreements
Troubled Hotels and the Renegotiation of Management Agreements
By Irvin W. Sandman
April 18, 2007
It was the hotel industry’s “perfect storm”: the bursting tech bubble, a recession, 9-11, the war in Afghanistan, the SARS scare, and the invasion of Iraq. Many hotels faced serious trouble and some were forced to default on their secured loans.
The storm is behind us. As the hotel industry basks under sunny skies, those dark days fade from memory.
But our industry remains cyclical. Demand is leveling off, and supply is increasing. The demand for residential and vacation condominiums, which fueled the recent condo hotel craze, has seemingly evaporated in many markets.
We do not expect widespread trouble for hotels in the near future, but we can expect a troubled path for some hotels. We can use lessons from the “perfect storm” to understand this path. We are not tempting fate by refreshing our knowledge; we are shedding light on the path so it can be traveled, if necessary, with more confidence.
When a hotel faces serious economic trouble, the trouble will often lead to covenant or monetary defaults under the hotel’s secured loan. These defaults, in turn, often lead the lender to initiate workout discussions with the owner. The discussions may end in a loan restructuring, a foreclosure, a bankruptcy filing, or all three.
In the hotel industry, workouts are frequently complicated by the existence of an extra stakeholder: the branded management company that manages the hotel under a detailed management contract. This article focuses on this special aspect of the workout process–the renegotiation of management agreements. What do the parties want? Where are the leverage points? Who usually wins in the renegotiation process?
What Do the Owner and the Lender Want From Each Other?
The manager’s first task is to identify the interests and perspectives of the lender and the owner. The answer will vary, depending on whether the hotel is underwater or solvent.
In many troubled hotel cases, the current market value of the hotel is less than the secured debt encumbering it. In other words, the owner has, at least temporarily, lost its equity. The capital that is at risk then is really the lender’s. Under these circumstances, the lender usually wants either control of the hotel or actual ownership.
The owner, however, may still have an agenda. For example, a transfer of the hotel could cause a tax gain or recapture. A transfer to the lender through a foreclosure or by deed in lieu of foreclosure would trigger these tax liabilities, while producing no money to pay for the tax.
The owner often wants to defer this costly result as long as possible. Sometimes, the owner may be able to provide the lender with control without a transfer of ownership.
If structured correctly, a deal of this kind can give the owner what it wants (deferral of a large tax liability) and the lender what it wants (control). Sometimes the lender is willing to accept this offer.
If the hotel is not heavily leveraged, then the owner may have significant equity, even after taking into account any decline in value attributable to the trouble the hotel has endured.
Under these circumstances, the owner will not want to give up control. The lender may be willing to restructure the loan to accommodate short-term cash flow problems. The lender will often want concessions from the owner, such as a new contribution of capital. The extent of the lender’s flexibility often depends on the lender’s internal situation, such as the amount of foreclosed real estate it owns or whether reserves have been taken for the loan.
What do the Owner and Lender want from the Management Company?
Because the lender has the primary financial stake in the underwater hotel, the manager can expect to negotiate primarily with the lender. On the other hand, if the hotel remains solvent, then the owner’s equity still is primarily at risk and the manager can expect to negotiate mostly with the owner.
Whether the owner or the lender takes the lead in approaching the manager, both will have the same perspective: the manager must make concessions. These may include:
- A deferral of fees.
- A reduction in base fees.
- Compensating the manager based primarily on the hotel’s profitability or cash flow.
- More control over budgeting and capital expenditures.
- A right to terminate the agreement with limited termination fees.
- Enhanced performance standards.
The Leverage Points in the Renegotiation of Management Agreements.
The manager’s concession is often the owner’s or lender’s gain. What cards do the parties hold in these negotiations?
Does the Management Contract Give the Owner the Right to Terminate?
Many management agreements today have comprehensive performance clauses. These clauses tend to be unique to each deal. As a result, they need to be reviewed carefully with counsel to determine whether performance standards have been missed and, if so, what the consequences are. Obviously, if a clear termination right is triggered, the manager is at a disadvantage.
If a performance standard has been missed, however, the manager should read on–the management agreement may contain a force majeure clause that excuses performance. This clause should be reviewed with counsel to determine whether it provides relief.
The Owner’s Right to Reject the Management Agreement in Bankruptcy.
Even if the management agreement does not give the owner a right to terminate the manager, the owner has another potential weapon: Chapter 11.
Chapter 11 provides a procedure to make creditors give concessions when they are unwilling to give them voluntarily. The power to force concessions on creditors is carefully (but not always clearly) defined in the Bankruptcy Code. As a result, the negotiations with the manager, like all negotiations involving troubled businesses, are heavily influenced by what can be gained by force in bankruptcy.
Management agreements are executory contracts under the Bankruptcy Code. This means that the owner, as a debtor in possession under the Bankruptcy Code, can elect to assume or reject the agreement in bankruptcy.
If the owner assumes the agreement, then the owner must cure all past defaults and must perform the agreement in full under the Chapter 11 plan. If the owner elects to reject the agreement in bankruptcy, then the agreement, in effect, is terminated, and the manager is left with an unsecured claim for damages arising from the termination. The owner is then free to replace the manager and reflag the hotel.
The Bankruptcy Code, as interpreted by the courts, gives the owner much discretion in deciding whether to assume or reject the management agreement. Accordingly, the threat to reject a management agreement in bankruptcy is real. The manager can be replaced and left with only an unsecured damage claim instead of a valuable management contract. Unsecured claims in Chapter 11 are usually paid in “tiny bankruptcy dollars,” if they are paid at all, and so the manager’s unsecured damage claim may have limited value.
Factors that Temper the Owner’s Right to Terminate or Reject.
The right to terminate the contract under a performance clause or reject the contract in bankruptcy are powerful weapons. The manager’s leverage lies, however, in practical considerations.
First, reflagging a hotel can be expensive. Reflagging involves obvious direct costs, such as the cost of replacing signs. Also, there may be a significant cost in lost business. This is especially true if, for example, the hotel does convention business that is booked one or more years in advance, and the customers are loyal to the existing manager. The costs and risks of reflagging encourage the owner to compromise.
Second, if the owner’s only right to terminate is through use of the Bankruptcy Code, then owner must first file a bankruptcy case to use this right. The bankruptcy process is extremely expensive, both in terms of professional fees and the inevitable damage to the business good will. The prospect of this cost encourages the owner to compromise rather than do battle in bankruptcy court.
Third, rejection of the management agreement in bankruptcy usually gives the manager a very large unsecured claim for rejection damages. This claim can give the manager leverage when the owner seeks confirmation of a Chapter 11 plan. Accordingly, the owner may successfully reject the management agreement only to confront significant roadblocks to achieving the owner’s main business goals.
The Lender’s Right to Terminate under the Subordination and Non-Disturbance Agreement.
Very frequently, at the time the loan was first made, the owner, manager and lender will have signed a “subordination and non-disturbance agreement” (SNDA). The SNDA will often give the lender some right to choose to take advantage of the management agreement or foreclose free and clear of it. This type of provision often amounts to a contractual right analogous to the owner’s bankruptcy right to assume or reject the management agreement. The leverage points between the lender and the manager are then much like those between the owner and the manager, discussed above.
Who Wins in the Renegotiation Process?
Deals that work and hold together are usually ones in which everyone is benefited. The owner has the threat of rejection in bankruptcy. The lender usually has some right to escape liabilities under the management agreement upon foreclosure. The manager has many practical considerations that discourage the owner and lender from using these rights.
To successfully renegotiate the management agreement, the manager must be willing to concede some significant points. Also, the manager must be responsive to the needs of the hotel and demonstrate that the manager has the capacity to help the business meet the objectives of the owner and lender. Similarly, the owner and manager must have a realistic view of their legal remedies. Too often, the use of these remedies results in high costs and damage to the hotel’s operation, reputation and value.
Ideally, the parties to the renegotiation process understand and do not overplay their hands. If so, drastic and costly measures can be avoided, the value of the hotel can be protected, and each of the parties can achieve a result that is economically better than they could reasonably expect through litigation. The renegotiated management agreement can then be considered a win for all sides.
Management Company’s Checklist when the Hotel is in Trouble:
- Understand the parties’ interests. Does the owner have any equity left in the hotel? Or is the lender the real party in interest? Does the owner have a tax problem upon foreclosure? Understanding the stakes will help the parties navigate the process.
- Check the performance clauses. Read the management agreement to determine whether any performance standards have been missed and the consequences. Also check the force majeure clauses to see if they apply.
- Understand the owner’s bankruptcy options. Chapter 11 gives owners the right to reject a management contract. Is the owner likely to use this tool? If so, what would the benefits/expenses be for the owner? Understanding these alternatives will allow the all parties to better read their hands.
- Check the SNDA. Now is the time to see which side did the better job in negotiating the subordination and non-disturbance agreement. Does the lender have the right to terminate the management agreement upon foreclosure? Can the lender require the manager to continue to manage the hotel, even without curing defaults under the management agreement? Will the manager have continuing access to the operating revenues after the loan is accelerated? Will the manager have continuing access to the capital expenditure reserves in order to fund needed capital improvements? Does the manager have any exposure for unpaid expenses, including payroll? The answers may vary considerably and will affect the parties’ leverage.
- Assess the manager’s goals. How important is the hotel to the manager’s portfolio? If the agreement is terminated, are other, potentially better management opportunities available? Sometimes, termination of a contract might be a good thing for the manager. If so, the manager should take a firm position in any negotiations.
The challenges to hotel lenders in the current industry meltdown are daunting. By recognizing that hotels are unique as collateral, and by taking into account their distinctive attributes, lenders can avoid costly errors and increase returns on their troubled hotel assets.