Distressed Hotels and The Rights of Lenders:
Reaching Hotel Revenues in Bankruptcy
By Cecelia L. Fanelli, Esq.
and
Jonathan D. Twombly, Esq.
Cecelia L. Fanelli (cfanelli@stroock.com, 212.806.6158), is a Partner in the Hospitality Industry Practice Group of Stroock & Stroock & Lavan LLP, which Ms. Fanelli heads, and Jonathan D. Twombly, an Associate in Stroock’s Hospitality Industry Practice Group. The Group represents industry leaders from across the hospitality spectrum – from owners, investors, managers and lenders to franchisors and franchisees – and has extensive experience in negotiating hotel franchise and management agreements. Ms. Fanelli speaks and writes extensively on matters relating to the hospitality industry and has been a guest faculty lecturer at the Cornell Hotel School on a variety of franchising topics.
An economic downturn poses a critical question for hotel lenders: Does a lender continue to have a security interest in hotel revenues generated after the hotel’s owner files a petition for bankruptcy? During the rash of hotel bankruptcies resulting from the economic downturn of the early 1990s, owners and lenders frequently disputed who had control over the hotel’s cash post-petition. A majority of courts found that an owner’s bankruptcy petition cut off a lender’s security interest in post-petition hotel revenues. In passing the Bankruptcy Reform Act of 1994 (“Reform Act”), Congress added Section 552(b)(2) to the Bankruptcy Code to clarify that a secured hotel lender continues to have a security interest in post-petition hotel revenues. Because the hotel industry recovered after 1994 and remained generally strong until recently, few judicial opinions interpret Section 552(b)(2), creating some uncertainty about how courts will treat post-petition hotel revenues under this section.
Adding to this uncertainty, some case law that is unfavorable to lenders arguably survived the enactment of Section 552(b)(2). That case law provides that a hotel’s post-petition cash is subject to a lender’s security interest only when the owner self-manages the hotel and receives the revenues “directly,” but not when a manager operates the hotel and the owner receives payments “indirectly.” On a positive note for lenders, the underlying assumption of this unfavorable case law – that no agency relationship existed between owner and manager to render the manager’s receipt of revenues the same as the owner’s receipt of those revenues – was significantly undercut by subsequent developments in non-bankruptcy law, namely the 1996 Third Circuit Court of Appeals’ decision in Government Guarantee Fund of the Republic of Finland v. Hyatt Corp. 1, which confirmed that a hotel manager is the owner’s agent.
This Stroock Hospitality Industry Practice Group Special Bulletin addresses these issues and the important question that the absence of case law interpreting Section 552(b)(2) leaves open: In the current economic downturn, will courts find that Section 552(b)(2) permits hotel lenders to reach post-petition hotel revenues or will the debtor hotel owner be able to use its cash in the ordinary course of business without obtaining court or creditor approval?
Security Interests in Hotel Revenues Before the 1994 Reform Act: No Guarantee that a Lender’s Security Interest Survived a Hotel’s Bankruptcy Petition
A recurring issue in many early 1990s hotel bankruptcies was whether a lender’s security interest in a hotel’s revenues was cut off by the bankruptcy petition or fell within the exception in the pre-Reform Act Section 552(b), which allowed a pre-petition security interest in the “proceeds, product, offspring, rents or profits” of “property of the debtor acquired before the commencement of the case” to reach post-petition hotel revenues 2. If hotel revenues were found to fall within this exception, they would be considered “cash collateral,” meaning that the bankrupt hotel owner could not use them absent lender consent or court order. If the revenues were not deemed “cash collateral,” then they were considered to be accounts receivable, and the debtor/owner could use them freely. Before the Reform Act, a majority of courts ruled that the bankruptcy petition cut off a lender’s security interest because it was not in the “proceeds, product, offspring, rents or profits” of the hotel 3. However, a significant number of courts departed from this view. These decisions ranged widely in their reasoning, with some courts holding that all hotel revenues from any source were “rents” subject to the exception, 4 others holding that room charges were “rents” but services like food and beverage fell outside the exception, 5 and still others finding that hotel revenues did not constitute “rents” but still fell within the exception in Section 552(b) because they constituted “profits.” 6
The 1994 Reform Act Clarifies that Security Interests in Hotel Revenues Survive a Hotel’s Bankruptcy Petition, but Has this Amendment Finally Resolved the Issue?
Congress reacted to the confusion among courts by enacting Section 215 of the Reform Act. In the legislative history of Section 215, Congress acknowledged that competing interests are at stake where the revenues of a hotel in bankruptcy are concerned, but made clear that courts must fairly address the interests of lenders when applying the exception under Section 552(b)(2):
These revenue streams, while critical to a hotel’s continued operations, are also the most liquid and more valuable collateral the hotel can provide to its financiers. When the hotel experiences financial distress, the interests of the hotel operations, including employment for clerks, maids, and other workers can collide with the interests of persons to whom the revenues are pledged. Section 215 recognizes the importance of this revenue stream for the two competing interests and attempts to strike a fair balance between them. 7
To address security interests in hotel revenues, Section 215 amended the Bankruptcy Code by adding Section 552(b)(2), which covers “rents” 8 and “the fees, charges, accounts or other payments for the use or occupancy of rooms and other public facilities in hotels, motels, or other lodging properties.” 9 This language appears to resolve the issue of whether the exception in Section 552 definitively covers a lender’s security interest in hotel revenues. But, given the lack of cases interpreting Section 552(b)(2) and the existence of some pre-Reform Act case law that the Reform Act arguably failed to address, questions remain as to how courts will apply Section 552(b)(2) in the current economic downturn.
Does Section 552(b) Settle the Split Between Courts Over Whether “Rents” Include Only Room Charges or All Hotel Revenues?
As mentioned above, even among courts that determined that old Section 552(b) covered hotel revenues, decisions diverged on whether “rents” covered all hotel revenues or only hotel room charges. For example, the Ninth Circuit Court of Appeals held under the old statute that, although hotel room charges constituted “rent,” not “all of a hotel’s revenues are rent. The revenues derived from the sale of food and drink and from other services provided by the hotel generate ‘accounts’ that cannot be classified as rent.” The court thus refused to enforce the lender’s security interest in hotel revenues beyond room charges. 10
Arguably, the broad language of Section 552(b)(2) negates the basis for the Ninth Circuit’s ruling. This interpretation is consistent with the Congressional intent to clarify that hotel lenders’ security interests extend to “hotel revenues.” Moreover, interpreting Section 552(b)(2) to cover all hotel revenues avoids a source of potential confusion, time and expense – namely, the type of accounting ordered by the Ninth Circuit in In re Hotel Sierra Vista L.P. 11to separate out recoverable room charges from a hotel’s general revenues. Such an accounting would require the involvement of the owner and the hotel manager, substantially complicating a lender’s enforcement of its security interest. Unfortunately, courts have not yet specifically addressed whether Section 552(b)(2) reaches all hotel revenues, so certainty on this aspect of the law awaits further judicial interpretation. 12
Could a Lender’s Ability to Reach Post-Petition Hotel Revenues Depend on Whether the Hotel is Managed by the Owner or by a Management Company?
Section 552(b)(2) also arguably fails to resolve an issue raised in the pre-Reform Act case of In re HRC Joint Venture, 13 which appears to condition a lender’s ability to reach a hotel’s post-petition revenues on whether the hotel is self-managed or operated by a management company. In HRC Joint Venture, the court held that a security agreement that tracked the language of Section 552(b) and covered “[a]ll rents, issues, proceeds and profits,” as well as “revenues” from the hotel, did not survive the bankruptcy filing. Unlike other pre-Reform Act cases in which the court rejected a post-petition security interest in hotel revenues because it found that those revenues were not “rents,” HRC Joint Venture rejected such an interest because the “hotel revenues never came to the debtor.” Under the hotel management agreement (“HMA”), the owner received “remittances” from hotel operator Hyatt instead of “directly receiving” revenues from guests. The court ruled that, as “indirect payments,” “remittances” were transformed into something other than “proceeds, product, offspring, rents, or profits” of the hotel and did not fall within Section 552(b). 14 The court also found that the owner’s right to receive remittances arose anew each month, so that each post-petition remittance payment derived from a right that did not exist pre-petition, and Section 552(a) therefore barred the lender’s pre-petition security interest in the post-petition revenues. 15
An owner/debtor might contend that despite the enactment of Section 552(b)(2), HRC Joint Venture’s holding survives because, just as the old Section 552(b) did not require a finding that “remittances” from a hotel management company were “rents,” Section 552(b)(2) arguably does not require a finding that “remittances” are “fees, charges, accounts, or other payments for the use or occupancy of rooms and other public facilities in hotels.”
However, subsequent developments in non-bankruptcy case law undermine HRC Joint Venture as sound precedent. For example, the court in that case dismissed the argument that the agency relationship between Hyatt and the owner meant that, as a legal matter, the owner received the hotel revenues when Hyatt collected them. Instead, the court held that the HMA was “no mere agency agreement. It is an agreement between two principals, a property owner and a hotel operator.” Yet, only two years after this decision, the Third Circuit Court of Appeals recognized in Government Guarantee Fund of the Republic of Finland v. Hyatt Corp. 17 that an HMA clearly creates an agency relationship between the owner and the manager. The ruling in Government Guarantee Fund weakens the underlying rationale of HRC Joint Venture, which appears to be based on a fundamental misapprehension of the legal relationship created by an HMA.
Moreover, although the court in HRC Joint Venture pointed out that most cases finding that revenues constituted rents under Section 552(b) involved self-managed hotels, at least one other pre-Reform Act decision held that hotel revenues constituted rents even though a management company operated the hotel in place of the owner. 18
Will an HMA Purporting to Waive/Limit the Agency Relationship Between the Owner and the Manager Make It More Difficult for a Lender to Reach the Hotel’s Revenues in a Bankruptcy?
In recent years, lenders have provided financing to owners who entered into HMAs that attempt to disclaim or limit the agency relationship between the owner and the lender. Whether such waivers are legally enforceable is questionable. 19 However, HRC Joint Venture indicates that the presence of such a waiver in an HMA could complicate a lender’s attempt to assert its rights to a hotel’s cash in a bankruptcy. The presence of an agency waiver in an HMA might lead a court to decide erroneously that no agency relationship exists between the owner and the manager, resulting in the abrogation of the lender’s security interest in post-petition revenues if the court adopted HRC Joint Venture’s logic. The reasoning of HRC Joint Venture thus makes it crucial for lenders to monitor how the parties’ relationship is characterized in an HMA, particularly in the current economic environment.
Implications for Lenders Seeking to Satisfy a Pre-Petition Security Interest With Post-Petition Hotel Revenues
Although the lack of court decisions interpreting Section 552(b)(2) creates some uncertainty about how courts will apply this statute in the future, the broad language of Section 552(b)(2), covering not just “rents” but all “fees, charges, accounts or payments for the use or occupancy of rooms and other public facilities in hotels, motels, or other lodging properties,” should permit lenders to reach the post-petition revenues of hotels. In any event, lenders should ensure that their security agreements incorporate the language of Section 552(b)(2) and that their loan documents make lending contingent upon the relationship between owner and manager being one of principal and agent in order to avoid an adverse ruling like that received by the lender in HRC Joint Venture.
1 95 F.3d 291 (3d Cir. 1996). In the controversy leading to the Third Circuit’s precedent-setting decision in Government Guarantee Fund, one of the authors of this Bulletin, Cecelia L. Fanelli, represented the lender against the original hotel-owner/borrower in a workout of the hotel loan and then in the lender’s foreclosure on the hotel property. After foreclosure, Ms. Fanelli represented the real estate holding company set up by the lender to own the hotel in a separate litigation against the hotel management company.
2 Before the Reform Act took effect, the relevant provision of the Bankruptcy Code, 11 U.S.C. § 552, provided as follows:
§ 552 Postpetition effect of security interest.
(a) Except as provided in subsection (b) of this section, property acquired by the estate or by the debtor after the commencement of the case is not subject to any lien resulting from any security agreement entered into by the debtor before the commencement of the case.
(b) Except as provided in Sections 363, 506(c), 522, 544, 545, 547 and 548 of this title, if the debtor and an entity entered into a security agreement before the commencement of the case and if the security interest created by such security agreement extends to property of the debtor acquired before the commencement of the case and to proceeds, product, offspring, rents, or profits of such property, then such security interest extends to such proceeds, product, offspring, rents, or profits acquired by the estate after the commencement of the case to the extent provided by such security agreement and by applicable nonbankruptcy law, except to any extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise. (emphasis added).
3 See In re Brandywine River Hotel, Inc., 177 B.R. 10, 15 (Bankr. E.D. Pa. 1995) (noting that a “majority of courts nationwide” have held that hotel revenues do not fall within the exception in 11 U.S.C. § 552(b) for “proceeds, product, offspring, rents or profits” from real estate).
4See, e.g., In re Bellevue Place Assocs., 173 B.R. 1009 (Bankr. N.D. Ill. 1994).
5 See, e.g., In re Days California Riverside L.P., 27 F.3d 374 (9th Cir. 1994).
6 See, e.g., In re Miami Center Assocs., Ltd., 144 B.R. 937 (Bankr. S.D. Fla. 1992).
7 H.R. Rep. No. 103-385, 103d Cong., 2d Sess., reprinted in 1994 U.S.C.C.A.N. 3340, 3357.
8 Section 552(b)(1) covers a secured lender’s ability to reach post-petition “proceeds, product, offspring or profits” flowing from the debtor’s property. Previously, these categories and “rents” were all covered together in Section 552(b).
9 11 U.S.C. § 552(b)(2). The full text of this Section provides: “Except as provided in sections 363, 506(c), 544, 545, 547, and 548 of this title, and notwithstanding section 546(b) of this title, if the debtor and an entity entered into a security agreement before the commencement of the case and if the security interest created by such security agreement extends to property of the debtor acquired before the commencement of the case and to amounts paid as rents of such property or the fees, charges, accounts, or other payments for the use or occupancy of rooms and other public facilities in hotels, motels, or other lodging properties, then such security interest extends to such rents and such fees, charges, accounts, or other payments acquired by the estate after the commencement of the case to the extent provided in such security agreement, except to any extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise.” (emphasis added).
10 In re Days California Riverside, L.P., 27 F.3d at 377; see also In re Hotel Sierra Vista L.P., 112 F.3d 429, 435 (9th Cir. 1997) (in case arising under old Section 552(b), remanding case to district court to determine how much of a bankrupt hotel’s post-petition revenues were derived from room charges as opposed to charges for other services).
11 In the Matter of Resort Inns, Inc., No. 04-41721, 2004 WL 2201252, at *5 (Bankr. S.D. Ga. Aug. 30, 2004).
12 Section 552(b)(2)’s application is ultimately subject to the discretion of the court, based upon “the equities of the case.” Courts have generally interpreted this exception as giving them discretion to prevent a secured creditor from obtaining a windfall at the expense of the debtor or general creditors where the “trustee or debtor-in-possession use[d] other assets of the bankrupt estate (assets that would otherwise go to the general creditors) to increase the value of the collateral.” In re J. Catton Farms, Inc., 779 F.2d 1242, 1246-47 (7th Cir. 1985). The example typically given is where a creditor has a security interest in raw materials which, at the expense of the bankrupt estate, are processed into a finished product of greater value; the court in such a case may assign the excess value to the secured creditor or the bankrupt estate or allocate it between them. See id. at 1247 and In re Cross Baking Co., 818 F.2d 1027, 1033 (1st Cir. 1987). Although the “equities” exception does not seem to have been applied in hotel cases, at least one court has noted its potential applicability. In the Matter of Resort Inns, Inc., 2004 WL 2201252, at *5 (holding that lender’s security interest over post-petition hotel revenues was valid and perfected, and that before a valuation hearing it was premature for the parties to contest the effect of the debtor’s “equity cushion” in the hotel asset on the extent of the lender’s security interest).
13 175 B.R. 948 (Bankr. S.D. Ohio 1994).
14 Id. at 951-52.
15 Id. at 952.
16 Id. at 951.
17 See note 1.
18 See In re Bellevue Place Assocs., 173 B.R. 1009 (Bankr. N.D. Ill. 1994).
19 For a more detailed discussion of the viability of agency waivers in HMAs, see the Stroock Hospitality Industry Practice Group Special Bulletin, The Terminability of Hotel Management Agreements in Workouts, Foreclosures and Bankruptcies: Lessons from the 1990s for Today’s Distressed Hotels (Spring 2009), available at www.stroock.com.
