Anticipating Bankruptcy by Hotel Loan Borrowers

02/01/2002

According to  the fourth quarter 2001 report of Lodging Econometrics, the accelerated decline in the operating performance of the lodging industry will continue until the middle of the first quarter of 2002 due to the events of September 11, 2001 and the recession.  Further, while the operating performance of the lodging industry may show signs of improvement by September of 2002, their effects may not be felt until the first quarter of 2003.  Many hotels will continue to undergo hardship and may opt to seek relief by filing for bankruptcy.  Once a borrower files for bankruptcy, an automatic stay takes effect, and a lender is expected to stand in line with other creditors while the borrower is offered a hiatus from its creditors.  You may be able to avoid such a predicament or at least develop in advance a plan for dealing with such an eventuality if you are vigilant in identifying early signs of potential borrower defaults.  Set forth below are some of the early signs and steps a lender can take.
 
Make Sure Loan Document Requirements are in Order

  • Conduct an Audit of Security Instruments.  You may want to conduct an audit of the security instruments to ensure that you have perfected all liens intended to be created under the loan documents.  A file audit should be performed to ensure that all security documents are in place.  You may also want to conduct an updated UCC search and a date-down of the title policy to make sure that your lien priority is intact and that the financing statements have not lapsed.  In addition, the updated title searches will provide information on whether there are any real property tax liens or mechanic’s liens outstanding.  Any liens subsequent to your mortgage (absent your consent) will most likely constitute defaults under the loan documents and may be a sign that the borrower is having difficulty meeting its obligations.

  • Conduct an Audit to make sure that all Covenants are being Satisfied.  Most loans require the borrower to submit to the lender financial and operating statements, budgets, and other operational information as on-going covenants.  You may want to make sure that the borrower is in fact complying with all covenants.  In addition, you should review all recent financial statements and operating statements to ensure that operating results are in line with any financial covenants and that no 
    extraordinary expenses or obligations have been incurred.  If your review of those items disclose any management issues or questions, clarification and resolution should be sought immediately.

  • Understand and Identify the Value of Collateral.  You may want to trigger the appraisal provision of a loan agreement (often standard) to determine the current loan to value ration and the borrower’s equity position.  This will give you a better sense of the likelihood that the borrower will file for bankruptcy protection, as borrowers often seek bankruptcy relief to preserve their equity interest in the property.  In any event, understanding the value of the real estate and other collateral will assist you in developing a strategy for dealing with a potential default.

Operational Issues

  • Take Time to Understand Hotel Operation and Business Trends.  The numbers won’t make sense unless you understand the nature of hotel operations.  For example, the room rate might be high, but the occupancy rate low, ultimately resulting in a low revenue per room.  Does that mean that the rate is not competitive or does it mean that the market is in a down cycle?  This will be hard to evaluate unless you have information about market segments and the share of the market the hotel is successfully capturing.  Understanding the hotel operations and business trends will help you better evaluate whether the borrower is operating the hotel effectively in the current market and whether it is pursuing all possible business sources to increase its revenue.

     
  • Take a Tour of the Property.  Does the hotel appear to be well maintained?   Has the borrower been skimping on maintenance and capital items?  These conclusions are difficult to reach unless you are able to see the physical attributes of the hotel.  A tour of the property will also help you evaluate whether the hotel is being operated well to survive the economic downturn.  Such evaluation is critical in determining whether remedial steps should be taken immediately.

  • Check to See if Borrower is in Default of its Obligations under Management Contracts and Other Contracts.  Have you received copies of default notices to the borrower from a management company or a franchisor.  Is the borrower about to lose the franchise or the management contract?  Have there been other defaults and are the defaults being cured timely?  What is the nature of the defaults?  All of the foregoing will impact the viability of the hotel, and the likelihood of the borrower’s success. 

Steps to Take.
 
If you conclude that the borrower is having difficulties and the operation of the hotel is suffering, you may want to consider taking one or more of the following steps:

  • Negotiate with Borrower.  Consider whether a voluntary restructure of the loan terms might permit the borrower to survive temporary market conditions and provide you with your best long-term prospect for repayment.  If the borrower is already contemplating bankruptcy or bankruptcy appears likely, consider entering into a pre-petition debt restructure with the borrower before it seeks relief under bankruptcy protection.  Any such modification should include a borrower’s waiver to oppose any motion to lift stay if it files for bankruptcy.  Note:  this waiver may not be enforceable in all jurisdictions  (consult legal counsel).
     
  • Suggest Operational Assistance.  Suggest to the borrower that it may need to retain a “work out” professional to run the hotel if you conclude that the hotel is not being operated effectively.  The borrower may be able to negotiate with the management company for it to pay for a portion of this expert advice (by fee deferment).  Do not overstep your bounds in this regard consult with legal counsel concerning potential lender liability.

  • Exercise Rights under Security Documents.  If the hotel accounts are pledged to you as collateral, you may want to take control of the cash generated by the hotel if permitted under the loan documents.  This will ensure that in the event of cash shortfall that your loan is repaid first, but most importantly, it will also be a way to monitor expenditures to ensure that the available resources are used to operate the hotel.  Again, consult legal counsel concerning avoidance of lender liability.

For additional information, please contact one of the authors listed at the top of this page.

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