Allocations of Risk Between Lender, Hotel Owner, Hotel Operator and Franchisor for Franchised Hotels and Managed Hotels

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1 Allocations of Risk Between Lender, Hotel Owner, Hotel Operator and Franchisor for Franchised Hotels and Managed Hotels A. Subordination Agreements 1. Background: Lender wants hotel operator to subordinate its hotel management agreement to the loan documents. If lender grants non-disturbance rights to hotel operator, lender is agreeing that if lender ever seeks a receiver or acquires control over the property through foreclosure or deed-in-lieu of foreclosure, the new hotel owner/lender will recognize and accept the hotel management agreement. 2. Lender Perspective Rights Lender wants in a Subordination Agreement: i. Subject to the non-disturbance provision, the hotel management agreement should be subordinate to lender s rights under the loan documents. If there is an inconsistency in insurance or reporting requirements, the loan document should control. i If the lender has the right to terminate the hotel management agreement on foreclosure, lender wants a provision in which hotel operator will cooperate in the transition. Hotel operator should be willing to do so as long as it gets paid for its services. In a franchised hotel, lender may want the right to terminate the hotel management agreement to replace the hotel operator but may want to keep the hotel franchise agreement in place. Lender/new hotel owner does not want to reimburse hotel operator for the previous owner s unpaid management fees or other monies owed to hotel operator. Lender would want approval of any changes in hotel management agreement or franchise agreement. v. Lender would not want hotel operator to exercise default remedies under hotel management agreement or against a franchisor under the franchise agreement without providing the lender the ability to cure such defaults. vi. v vi Lender may want the right to approve the GM or other member s of hotel s executive staff. Lenders normally want brand and operators (if a top brand) to stay in place after a loan default since the lender does not want the hotel to lose professional management, reservations systems or the significant cost of re-branding. Lenders may want the ability to terminate a hotel management agreement since the sale of an unencumbered hotel may generate more value at a 1

2 foreclosure sale since a competitive hotel operator could be the potential purchaser. 3. Branded Hotel Operator Perspective (if Hotel Managed and Not Franchised): i. Hotel operator wants to prevent lender from terminating hotel management agreement upon loan default. i Hotel operator wants the new hotel owner to satisfy the criteria in the hotel management agreement for being an acceptable hotel owner. In addition, hotel owner may want the right to terminate the hotel management agreement upon a foreclosure if the new owner is not acceptable to hotel operator. Hotel operator wants to make sure new hotel owner is not a competitor and that new hotel owner has the ability to fulfill its obligations under the hotel management agreement Hotel operator does not want to subordinate to debt service its management fee or its right to receive cash to meet its obligation to pay employees or other operating expenses. Failing to pay the hotel employees is not an option for the management company; they are its employees, and it has an obligation to pay them. For that reason, it is critically important to management companies to insist that operating expenses (including payroll as the most important example) come before debt service in the waterfall. In addition, hotel operators want to be paid for its services even if the loan is in default. v. Hotel operator wants lender or new owner to fulfill any outstanding defaults under the hotel management agreement. vi. Hotel operators want protection in the event of an owner bankruptcy. 4. Hotel Operator s Perspective if Franchised Hotel: i. Hotel operator wants to be paid a base management fee for its services if lender plans to terminate management agreement. Hotel operator does not want to subordinate its entire fee. i If lender terminates hotel management agreement, hotel operator needs sufficient notice to comply with WARN Act if as a result it will need to terminate employees. If lender wants to assume hotel management agreement upon a foreclosure, hotel operator wants lender to cure any ongoing defaults under hotel management agreement. 5. Hotel Owner s Perspective: 2

3 i. Hotel owner wants the hotel operator to be accommodating to lenders so that the hotel will be easy to finance or refinance. On franchised hotels, hotel owners and lenders often have the right to terminate the hotel management agreements if certain performance criteria are not satisfied. i Most of the provisions do not directly affect the hotel owner since the provisions address situations after hotel owner loses control over the hotel after a loan default. Hotel owners may be asked by lenders to provide recourse liability under bad boy guaranties if there is an event of default under the franchise agreement or hotel management agreement. Hotel owners (as SPEs) try to prevent their parent entities from having to guaranty obligations under a hotel management agreement or a franchise agreement. Hotel owners try to prevent lenders from having additional consent rights on non-material changes to the hotel management agreement or approval of hotel staff since it will limit hotel owner s rights in operating its business in the ordinary course. 6. Issues Typically Negotiated in SNDA i. The lender wants the ability to decide whether to preserve the existing hotel management agreement or to terminate the hotel management agreement upon a foreclosure and sell the hotel unencumbered. i The lender and hotel operator will negotiate the amount of management fee that will be subordinated to lender. The lender and hotel operator will negotiate whether the hotel operator is willing to subordinate other management commissions, incentive management fees, affiliate payments, termination fees, liquidated damages, key money or other compensation to lender. The parties will negotiate which operating expenses may be paid prior to senior debt. v. The lender wants an assignment by Borrower of all accounts maintained under the Management Agreement vi. The lender wants additional time to cure a hotel owner s default. B. Comfort Letters between Lender and Franchisor 1. Issues Important to Lender: i. Franchisor and franchisee each acknowledges that no default exists under franchise agreement. 3

4 i Lender wants the right to cure franchisee s defaults and negotiates extra cure periods for certain defaults. Lenders also usually ask for extra time to cure defaults if possession of the hotel is necessary to cure the default, for instance if for the entire length of the foreclosure process if it is being diligently pursued and, if the franchisee is in bankruptcy, while the Lender pursues a lift-stay order. If foreclosure occurs, lender wants franchisor to approve substitute hotel operator for a nominal fee and not require a new PIP. If the franchise agreement is not assignable then lender wants a nominal application/transfer fee if lender takes control. Lender wants the right to switch to another approved manager to operate the hotel under an existing franchise agreement. If foreclosure occurs, lender wants the ability for new hotel owner to assume existing franchise agreement for remaining term For the higherend brands lender wants the ability to keep the flag by having one of their REO subsidiaries enter into a new franchise agreement. Lender doesn t want to have to pay any liquidated damages owed by the hotel owner (the original franchisee). v. If lender and franchisor cannot agree on the terms of the comfort letter, lender may find that it would prefer not to have a comfort letter and negotiate with franchisor once it forecloses on the hotel in the hopes that it would have more leverage at that time. 2. Issues Important to Franchisor: i. If foreclosure occurs, franchisor wants lender/new hotel owner to agree to fund any renovations required by existing franchise agreement and cure any ongoing defaults. Some franchisors will require a new franchise agreement if the lender wants to keep the flag. If a receiver is appointed, franchisor may want the right to require the receiver enter into an interim franchise agreement (and/or if the franchisor has a management company, a management agreement). i If foreclosure occurs, franchisor wants to make sure new hotel owner is not a Competitor, Specially Designated National, or Blocked Person and is otherwise acceptable to franchisor. Lender agrees that any change in control of the hotel will be in compliance with the WARN Act. This issue may become a concern if franchisor has taken over management of the hotel and the employees belong to the prior management company or the hotel owner. Lender agrees that if franchise agreement is terminated and lender is in control of the hotel, lender will take the required steps to de-flag the hotel 4

5 and indemnify franchisor for damages if lender does not comply with the transition provisions in the franchise agreement. v. Franchisor wants to only give these rights to true senior lenders and not mezzanine investors disguised as lenders. Franchisors don t want to have a comfort letter give up the change-of-control rights to new and/or unapproved entities which would be inconsistent with the franchise agreement. Franchisors know that lenders/servicers are not operators and they are motivated to sell the hotel and thus, franchisors will give these lenders certain rights. vi. Some franchisors may insist on non-disturbance protection for their franchise agreement in the comfort letter. C. Control Agreements 1. Background: There are different forms of control agreements which enable lenders to control hotel cash revenues. You can have separate control agreements to manage funds such as these held in (i) taxes and insurance escrow, (ii) replacement reserve account, (iii) required repair account, (iv) mezzanine debt service account, and (v) cash management account. 2. Important Issues to Lender in Deposit Account Control Agreement: i. Lenders prefer that the funds would be held at its bank and that the lenders would have set-off rights. Depository bank and hotel owner agree that depository bank will take direction from lender under specified conditions and the depository bank is not entitled to any discretion in evaluating lender s assertion that a triggering event has occurred. 3. Important Issues to Hotel Owner and Hotel Operator in Deposit Account Control Agreement to Maintain Control over Waterfall Prior to Loan Default: i. Hotel owner will want to negotiate springing cash management in which lender does not have any rights to direct the use of hotel owner s funds until an event of default under the loan agreements occurs. i Hotel owner will want to negotiate when insurance premiums and taxes need to be escrowed. Hotel owners prefer a soft cash management system as set forth below. a. Property revenue is deposited daily in a Clearing Account in which hotel owner/hotel operator have no access to such funds. 5

6 b. If no loan event of default occurs, property revenue is swept into a Hotel Owner Operating Account that hotel owner controls. c. If a loan event of default occurs or if certain financial covenants are not satisfied, property revenue may be swept into a Cash Collateral Account which hotel owner has no access and which is controlled by lender. d. Hotel owner will want agreement that once a default has been cured that funds will once again would be deposited into the Hotel Owner Operating Account that hotel owner controls. 4. Important Issues to Lender in Deposit Account Control Agreement: i. Lender and hotel operator will negotiate which hotel operating expenses will be paid first if there is a loan event of default. i Lender and hotel operator will negotiate ways in which lender can monitor and control the hotel operating expenses once a loan event of default has occurred. Lender can only have a perfected security interest in the cash deposit account if it actually controls the account and can prevent hotel operator from interfering with lender s instructing or directing disposition of the funds in the deposit account Lender and hotel operator will need to structure the control account so that the property s operations match the loan document timelines (i.e., the mandated collection period before the money is swept by lender many not work well with the hotel owner s monthly cyclical needs for operating funds). v. Lender and hotel owner/hotel operator will negotiate a waterfall provision for distribution of funds if no senior loan event of default. The order in which the funds are disbursed are heavily negotiated and include these types of categories: (1) Tax and Insurance Escrow Fund, (2) monthly franchise fee if it is a franchised hotel, (3) monthly Senior Debt Service payment, (4) Replacement Reserve Account, (5) monthly Operating Expenses in accordance with related Approved Annual Budget, (6) any Extraordinary Expenses, and (7) remainder released to hotel owner or placed in a reserve as additional collateral for lender if certain financial covenants are not satisfied. All parties agree that the Accounts are in the sole control and discretion of senior lender. If there is an event of default under the senior loan, senior lender will control all disbursements from the Cash Collateral Account/Cash Management Account. 6

7 5. Differences between Blocked Control Account, Blocked Control Account (Shifting Control), Blocked Control Account (Lockbox), and Block Control Account (Lockbox Shifting Control) i. Blocked Control Account a. Agreement among hotel owner, lender and depository bank ( Bank ) b. Bank agrees that at any time it receives instructions from lender directing disposition of funds from the Account, Bank will comply with them without further instruction. c. Hotel owner/hotel operator has no right to withdraw or transfer funds from account. d. Bank has no right of offset against Account except for limited circumstances. Blocked Control Account (Shifting Control) a. Agreement among hotel owner, lender and depository bank ( Bank ) b. Bank agrees that at any time it receives instructions from lender directing disposition of funds from the Account, Bank will comply with them without further instruction. c. Until Bank receives the Shifting Control Notice from lender, hotel owner/hotel operator has the right to authorize distributions from the Account. d. After Bank receives the Shifting Control Notice from lender, hotel owner/hotel operator has no right to withdraw or transfer funds from the Account and lender will control how funds in the Account are distributed. e. Bank has no right of offset against Account except for limited circumstances. i Blocked Control Account (Lockbox Lender Control) a. Agreement among hotel owner, lender and depository bank ( Bank ) b. Hotel owner/hotel operator engages a third party processor to provide Lockbox Services and such third party processor will collect, open and process for deposit all mail received in the 7

8 Lockbox. Hotel owner/hotel operator has no right to access funds deposited into the Lockbox. c. Bank agrees that at any time it receives instructions from lender directing disposition of funds from the Account, Bank shall comply with them without further instruction. d. At the end of each business day, Bank sends funds from Account to a lender controlled account. e. Bank has no right of offset against Account except for limited circumstances. Blocked Control Account (Lockbox Shifting Control) a. Agreement among hotel owner, lender and depository bank ( Bank ) b. Hotel owner/hotel operator engages a third party processor to provide Lockbox Services and such third party processor shall collect, open and process for deposit all mail received in the Lockbox. c. Bank agrees that at any time it shall receive instructions from lender directing disposition of funds from the Account, Bank shall comply with them without further instruction. d. Until Bank receives the Shifting Control Notice from lender, hotel owner/hotel operator has the right to authorize distributions from the Account. e. After Bank receives the Shifting Control Notice from lender, hotel owner/hotel operator has no right to withdraw or transfer funds from the Account and lender will determine how funds in the Account are distributed. f. Bank has no right of offset against Account except for limited circumstances. 8