Hotel Finance: Managing Developments in Distress

This article was written for and first appeared in the Journal of International Banking & Financial Law, 2009 Volume 24, Issue 9 October

The contraction of the UK economy is taking its toll on investment, development and occupational property markets. The hotels sector is no exception. Hotel development lenders face the immediate pressures of falling property values, struggling development companies, cost overruns, equity erosion, declining REVPAR (revenue per available room) and breaches of financial and development covenants in facility agreements.

Mindful of those pressures, this feature looks at the key issues facing a lender on a hotel scheme in development phase, where the borrower is in financial difficulty and the loan non-performing.

KEY POINTS

Successful enforcement of security by hotel development lenders is not an impulsive or spontaneous act. It relies not only on a thorough understanding of market values, but also on:

• solid appreciation of the security documents;
• careful consideration of pre-enforcement and enforcement options;
• a good feel for the development contracts and third party agreements;
• the possible early involvement of an insolvency practitioner pre-appointment; and
• a clear vision in how the asset is to be developed or disposed of, together with detailed costings.

SECURITY 

Assuming that the borrower is a special purpose vehicle ('SPV'), set up solely to acquire a site and develop a hotel, the lender should have taken a full security package which would commonly include the following:

• Debenture granted by the borrower incorporating a full fixed and floating charge. In particular it would include a first fixed legal mortgage over the property and an assignment of the borrower's interest in:
• the building contract, consents, plans, appraisal, terms of appointment of the professional team, all collateral warranty agreements from sub-contractors and all other agreements or documents relating to the acquisition, construction, management, design, servicing, marketing, development, operation or use of the property including the development agreement (if any);
• the hotel agreements including any agreements relating to services including advisory and renovation, non-disturbance, management or licences;
• the agreement for sale and purchase relating to the site;
• any income, retentions, sale proceeds, VAT and any insurance proceeds relating to the property or the development; and
• any hedging.
• Third party charge on shares granted by the shareholder of the borrower;
• Subordination/ priority/ intercreditor arrangements to ensure that all debt advanced and security taken by third parties ranks in priority behind and is subordinate to the lender's debt;
• Where commercially available, a cost overrun guarantee, interest shortfall guarantee, performance bond or guarantee and/or parent company guarantee;
• Collateral warranties entered into by the lender and each contractor, sub-contractor or member of the professional team associated with the development that the lender determines has a material level of responsibility; and
• There will also normally be hedging documentation to be agreed between the borrower and the lender and non-disturbance arrangements to be entered into by the borrower, lender and hotel operator.

If there are any foreign entities involved in the borrowing structure, the lender should have obtained the customary legal opinions from local counsel.

PRE-ENFORCEMENT OPTIONS 

Providing the lender has taken a full security package it should have various options if it decides to enforce, which we will consider below. However, in many cases from a commercial perspective it will be in both the lender and the borrower's interests for the lender not to enforce its security straight away, but to consider its pre-enforcement options with a view to the development continuing so the hotel can at least reach a practical completion stage to maximise the proceeds of any sale and increase the lender's chances of recovering the full debt.

Such pre-enforcement options could include:

• amending and restating the loan to extend its term or the development targets/longstop dates; and/or
• increasing the amount of the facility or debt for equity swap; and/or
• relaxing financial and development covenants,

in return for:

• a charged cash deposit; and/or
• an equity injection; and/or
• additional security from other members of the borrowing group; and/or
• a profit share scheme or back end fee whereby the lender will participate in any profits realised from the hotel development on its completion either by way of sale or refinancing proceeds or from hotel revenue.

The lender may also seek greater control over the progress of the development by requiring more involvement by its project monitor managing the project and stipulating development or revenue hurdles which must be met by specified dates. It is vitally important for the lender to understand where the development is at in terms of budget, cashflow and timetable in the event that it does need to step in to complete the development. At the first sign of trouble it should ensure its project monitor is up to speed with the financial aspects of the development, what cost overruns have accrued and are forecast and where any potential savings could be made -- for example, a reduction in the spec of construction materials, hotel furnishings or equipment (although, this may be subject to the requirements of the hotel operator in terms of hotel quality/standard applicable to the hotel brand so the operator must be involved).

The lender should reserve its rights in relation to any breach of the terms of the loan agreement or default under the facility to avoid any implied waiver of the right to terminate.

ENFORCEMENT OF SECURITY

When considering enforcement options the lender will need to consider what its exit strategy will be. Its prime aim will be to achieve maximum recovery. A half-built hotel is unlikely to be at its most saleable and the lender should consider whether to:

• mothball the hotel pending an improvement in real estate values and occupancy rates;
• sell the incomplete works as a distressed asset, possibly in conjunction with a change of use (either as a share or asset sale);
• build out the hotel and sell following the achievement of practical completion.

Which route taken will depend upon the level of exposure of the lender and the value of the hotel at these various stages.

It may be possible that exercising the lender's rights under guarantees granted in its favour will provide sufficient funds for the borrower to bring the facility back from default and to complete the development which will usually be preferable to direct enforcement of security by the lender.

Unless the decision is to sell as is (and perhaps in any event if there is a development agreement with a local authority which is at risk) consideration to the exercise of step-in rights will have to be given.

Step-in rights are typically included in development contracts supported by debt finance, and allow the lender or its nominee (and on occasions interested third parties) to 'step into' the developer's shoes under the development contracts and build out. Step-in rights are normally exercisable where there is a default under the terms of the development loan or related development contracts, or where the contractor or one of the construction professionals gives notice of intention to terminate its terms of engagement.

In reality, the exercise of such rights is a last resort as it involves the lender (or where permitted its nominee) taking on all existing liabilities under the development contracts, but it may be the only way of preserving the main asset over which security has been taken, and at the very least, the possibility of step-in is an important negotiating chip in the lender/borrower relationship. Key points to consider before exercising step-in rights include:

• what legal liabilities will the lender or its nominee inherit -- for unpaid sums or ongoing claims;
• whether there is an opportunity to step-in on renegotiated terms;
• what the step-in procedure requires in terms of notification and timescale;
• whether short periods for exercise of step-in rights can be extended by agreement to give more time to determine a course of action;
• whether third party agreements, such as development agreements or agreements for lease are affected or compromised (for example by change of developer or extension of the contract programme); and
• how insurance arrangements should be amended and updated.

If, by contrast the decision is to sell as is, then subject to being able to secure a suitable release from the development contracts and development authority (by termination or novation under an asset sale, or by change of control under a share sale), it may be that the appointment of a fixed charge or LPA (Law of Property Act 1925) receiver will be the simplest option (although if the receiver is not an insolvency practitioner the appointment must exclude all floating charge assets). The receiver will sell the asset in its half built state and the new owner will have to engage with the contractors and development authority in order to complete the development. Unless the hotel is very near completion, this is not likely to attract a good price.

Where the intention is to complete the development, then normal practice will be to appoint an administrator provided the lender has the benefit of a qualifying floating charge (which is essentially a floating charge over all or substantially all of the assets of the company either on its own or taken with any security over the assets of the company) unless the lender is able to appoint an administrative receiver under the limited circumstances prescribed by the Enterprise Act 2002.¹

The lender must bear in mind that it has less control over an administrator than over an administrative receiver or receiver, although in practice, particularly if the purpose of the administration is the realisation of the asset on behalf of the secured creditor, the administrator will pay close attention to the wishes of the lender. A 'pre-packaged' administration (under which the asset is sold on the first day of administration under a pre-arranged deal) is unlikely unless the intention is to put the development into a clean SPV immediately.

The administrator can then complete the development and sell at practical completion of shell and core, or go on to deliver a bespoke fit out assuming that the intention is to sell to a buyer operator, or to engage an operator under an operation agreement or via a lease. Coupled with this could be the transfer of the hotel into a clean holding vehicle which could either be sold or held by the lender for a period of years.

Consideration will need to be given to:

• methods of mitigating Stamp Duty Land Tax and perhaps also VAT on the sale;
• how the new SPV might be managed and run;
• how the SPV will be held -- should it be a direct or indirect subsidiary of the lender?
• does the carrying cost of capital on an equity stake work for the lender? and
• are there reputational issues for the lender to consider in terms of the holding and any tax savings schemes?

Great care will be needed when costing the remainder of the works required to get the hotel to practical completion and/or fit-out. Unless an operator has been involved with the planning of the development, the cost of any additional works required to bring the hotel up to brand standard should not be overlooked, nor any requirements that the operator may have with regard to opening costs.

COMI

An important issue for the lender to take into consideration when exploring enforcement options is the Centre of Main Interests ('COMI') of the borrowing entity. In order to be able to use an English corporate insolvency procedure (such as administration) it is necessary for the company to be registered in England & Wales or a company incorporated in an EU state or, if incorporated outside of the EU having its COMI within an EU state (other than Denmark).

In practical terms, if it is to be demonstrated that the COMI of a company is somewhere other than in the state where it was registered and has its registered office, it must generally be shown that head office type functions are performed in that other place.

If the borrower is registered offshore and, as sometimes happens, the directors are also resident offshore, when things go wrong and the co-operation of the directors is no longer forthcoming, it is often very difficult to establish COMI in England and Wales. As a result the option of administration with all the protections from creditors and duties to cooperate with the administrators is not available.

The lender is left with the options of either a fixed charge receivership, potentially the appointment of a receiver and manager or if the transaction is large enough an administrative receiver or using the form of corporate insolvency process applicable in the local jurisdiction of the registered office of the company, none of which may be entirely satisfactory.

This can be a particular problem if the directors are unco-operative or hostile as in practical terms it will be difficult to find a forum in which to take steps to either prevent their active disruption or require their co-operation.

CONTRACTOR ISSUES

Before enforcing security, it is important that the construction contracts are properly audited so that the implications of each potential exit strategy are properly understood.

Most critically, the insolvency of the borrower/developer will typically give the contractor a discretionary right to terminate the building contract (under the Joint Contracts Tribunal 2005 forms at least). As such, where the exit strategy involves building out by appointing an insolvency practitioner to the borrower/developer, the contractor must be persuaded to treat the contract as ongoing. Contractors are understandably nervous of contracting with developers subject to an insolvency procedure and may require some form of payment security from the lender. Where the contractor will not collaborate in that process, the lender is left reliant on the exercise of its step-in rights (above) as a means of keeping the building contract alive (the position is likely to be similar under the consultants' appointments retained by the borrower/developer, and a similar audit trail needs to be followed).

Other key points to consider, in managing the contractor relationship are:

• Whether the contractor has other outstanding rights to suspend or terminate the building contract for non-payment. The timescale for the exercise of these rights is usually short and will need to be checked with the project monitor. The lender's collateral warranties should also be checked as they typically require written notice of any proposed suspension or termination (see above);
• Where monies are outstanding, the contractor also has a right to claim an unpaid sum via adjudication or litigation proceedings. Are any such proceedings underway or threatened?
• Whether the sub-contractors have served notices of suspension or termination on the contractor, as a result of their own nonpayment. This may be hard to ascertain, but again the lender's sub-contractor collateral warranties typically require notice of intended suspension or termination;
• Whether the contractor has claims for additional time and money under the building contract resulting from any non performance by the developer/borrower;
• Is there adequate control over unfixed materials, whether on or off-site? Has title in unfixed goods been properly vested in the borrower/developer, bearing in mind that only a person with title to the goods can transfer them?
• Are there any retention of title claims arising in relation to goods delivered to site but not paid for?;
• Are site security arrangements sufficient? Sub-contractors may favour 'self help' where they have not been paid, and incomplete works may be unstable or at risk of damage.
• Are project insurances being maintained as contractually required?

OPERATOR/FRANCHISOR ISSUES

To the extent the hotel is being (or is to be pursuant to heads of terms) operated by either the hotel owner/borrower under a franchise agreement or by a third party operator on behalf of the hotel owner/borrower under a hotel management agreement, a well advised lender will have sought to secure step-in rights (above) under the relevant agreement and so be able to cure any default of the hotel owner/borrower before either the franchisor or operator, as the case may be, has a right to terminate the franchise agreement or hotel management agreement. Naturally, it would be prudent for the lender to check the consequences of exercising those rights before it did so because, for example, they may give rise to funding obligations on the lender whilst the default is being cured.

As the quid pro quo for an operator agreeing to grant the lender step-in rights under a hotel management agreement the operator will require the lender to enter into a non-disturbance agreement ('NDA') pursuant to which the lender agrees that any disposal of the hotel must be accompanied by an assignment of the hotel management agreement. The hotel would therefore be sold encumbered with the hotel management agreement. Historically NDAs were only entered into if the hotel was associated with a luxury brand as it was perceived that a hotel was worth more encumbered with the luxury brand. Consequently, not that much attention was given to the implications of an NDA in the event that the lender sought to exercise its security rights. However, during the credit boom, operators often demanded (and lenders sometimes agreed) to NDAs being entered into where the hotel was flagged with a lesser brand. The existence of an NDA may therefore materially limit the lender's options with regard to a disposal of the hotel asset and needs to be carefully reviewed.

¹     Such as a project where the loan exceeds £50m.