Hotel Revenues Not Subject to Absolute Assignment of Leases and Rents - A Silver Lining in the Dark Clouds of the Great Recession?

While it takes an accomplished clairvoyant to predict where RevPar ¹, ADRs² and Occupancy³ will be in the coming months, or for that matter the coming years, for those hospitality owners and operators trying to weather the economic storm there has been some positive news recently out of a place that few wish to spend "too many a night" – the United States Bankruptcy Court⁴. In the spring of 2011 an oceanfront hotel owner was successful in arguing that it is permitted to use the revenues generated from its guests' stay and use of amenities to assist in the reorganization of the company. This court ruling of first impression⁵ was made despite vociferous opposition from its secured lender. The secured lender claimed that by virtue of judicial precedent and its Absolute Assignment of Leases and Rents that it "owned" all hotel revenues⁶ and therefore the hotel owner had no funds from which to fund its proposed reorganization and accordingly the Chapter 11 bankruptcy case should be dismissed and the lender immediately permitted to foreclose on its collateral.

THE ASSET

Ocean Place Resort and Spa occupies a prominent beachfront location on the New Jersey Coast, roughly a one hour drive south of Manhattan and five miles from the Garden State Parkway. With 254 rooms, 40,000 square feet of meeting space, three restaurants, a bar/lounge, tennis courts, a parking garage and a full service spa, Ocean Place sits alongside 1000 feet of sandy beach. Its 17 acres included the "economic amenity" of a redevelopment agreement with the City of Long Branch granting it rights for a full "mixed-use" build-out approaching 1.4 million square feet.

FINANCING

Ocean Place Development, LLC, for all intents and purposes, was a single asset special purpose entity⁷. The original lender, Barclays Capital Real Estate Inc. ("Barclays") advanced, on a non-recourse basis, approximately $53,000,000 to Ocean Place (the "Loan") secured by a plethora of legal documents including a Mortgage, Absolute Assignment of Rents and Leases, a Security Agreement and UCC and fixture filings. Also included in the "collateral" was a "bad boy" a/k/a "springing" guaranty where in the case of fraud or a bankruptcy filing the loan becomes fully recourse to the borrower and its principals. The omnipotent loan structure was and is the "financing du jour" to prevent, and in the case of a risk tolerant borrower, protect the secured lender in the event of a bankruptcy filing.

LOAN DEFAULT, LOAN SALE AND ATTEMPTED FORECLOSURE

The Barclays Loan matured in January of 2008. Up until the maturity date Ocean Place was current on its loan. Post maturity it paid interest to Barclays at the default rate of 9.8% but then in January of 2010 ceased making payments. After several months of marketing of the loan for sale, in October of 2010 AFP 104 Corp. ("AFP")⁸ purchased the Loan from Barclays for a purported $40.5 million. Following the purchase AFP obtained a Judgment of Foreclosure and, subsequent to several statutory adjournments obtained by Ocean Place, scheduled a foreclosure sale for February 22, 2011. On February 15, 2011 Ocean Place filed Chapter 11 in New Jersey which stayed the foreclosure sale. At the time of the bankruptcy filing the secured lender, now AFP, was purportedly owed $57,245,372.00 (AFP "stepped into the shoes" of Barclays notwithstanding the discounted price it paid to purchase the loan).

THE FIRST BANKRUPTCY BATTLE: THE ABSOLUTE ASSIGNMENT OF LEASES AND RENTS AND "OWNERSHIP" OF THE HOTEL REVENUES

There is no argument that in order to successfully reorganize in Chapter 11, or for that matter, to pay one's own daily living expenses, that "income" is the life blood. In the case of the battle between AFP and Ocean Place that "life blood" took the form of Hotel Revenues. In bankruptcy parlance such revenue is referred to as "cash collateral." ⁹

Two days after the bankruptcy filing Ocean Place sought the court's permission to use its cash collateral, the Hotel Revenues, in order to pay its ordinary and necessary operating expenses and to reorganize. In the legal battle that ensued the secured lender, AFP argued that it "owned" the Hotel Revenues and therefore they were not available as income to assist Ocean Place in its Chapter 11 reorganization. AFP relied on the precedential authority of In re Jason Realty, 59 F.3d 423, (3d. Cir. 1995) as well as the Absolute Assignment of Leases and Rents given by Ocean Place to AFP as successor-in-interest to Barclays. The language of the Absolute Assignment of Leases and Rents defined "rents" to include: . . . all revenues and credit card receipts collected from guest rooms, restaurants, bars, meeting rooms, banquets rooms and recreation facilities, all receivables, customer obligations, installment payment obligations and other obligations now existing or hereafter arising or created out of the sale, lease, sublease, license, or rendering of services by Borrower [Ocean Place] or any operator or manager of the hotel or the commercial space located in the Improvements [the premises] or acquired by others . . ., license, lease, sublease and concession fees and rentals, health club membership fees, food and beverage wholesale and retail sales, service charges, vending machines sales and process, if any . . .whether paid or accruing before or after the filing by or against Borrower of any petition for relief under the Bankruptcy Code.

Jason Realty, a decision of the United States Court of Appeals for the Third Circuit (Delaware, Pennsylvania and New Jersey) is followed by many other federal appellate and bankruptcy courts.¹⁰ Jason Realty was a single asset limited partnership which owned and operated a two story retail and office building. Like Ocean Place it filed Chapter 11, also in New Jersey, to stave off a foreclosure sale. Like Ocean Place it also granted to its secured lender an Absolute Assignment of Leases and Rents. In Jason Realty, the Third Circuit Court of Appeals found for the secured lender, First Fidelity Bank, NA, in holding that the Absolute Assignment of Rents "evidences an absolute assignment of title to the rents, with the assignor [Jason Realty] receiving a license to collect the rents." As a result, court found that the rent proceeds from the leases were not property of the Jason Realty but rather property of the lender, First Fidelity Bank, pursuant to the Assignment of Leases and Rents. Thus, the "life blood" of Jason Realty's ability to reorganize, the rents, were not "available" to the debtor to fund its proposed plan of reorganization. In the case of Jason Realty, no rental income meant no "life blood" and the reorganization failed.

HOTEL REVENUES ARE NOT RENT

The court in Ocean Place, however, in a case of first impression¹¹, held that hotel revenues were not "Rent" within the meaning of the Uniform Commercial Code explicitly adopting an analysis of hotel revenues found in a New York case¹² and finding that the hotel room revenues were "accounts" or "payments intangible" and are not interests in the realty.¹³Specifically, the court held that hotel revenues [defined as revenues generated from room occupancy, food and beverage sales, catering, gift shop purchases, and spa and related hotel services] generated by the Debtor [Ocean Place] did not constitute "rents" and therefore the hotel revenues could be used to pay its ordinary and necessary operating expenses and to reorganize. ¹⁴

While the court did find that the secured lender had a perfected security interest in the hotel revenues as "personal property" and not rent, and was "adequately protected,"¹⁵ Ocean Place was granted permission by the bankruptcy court to use the hotel revenues, as its "life blood" to attempt to reorganize. Needless to say, AFP was not happy with the outcome. However, the case is on-going and the battles rage-on as of the date of this article.

CONCLUSION

The court in Ocean Place found that Hotel Revenues were not "rent" within the meaning of the Third Circuit Court of Appeals decision of In re Jason Realty, LLC. While the court arguably had the judicial prerogative to extend the Jason Realty decision to assignment of Hotel Revenues, its decision not to do so can be seen as a victory to hospitality owners and operators weathering the economic storm by allowing the use of the revenues to attempt to reorganize. No doubt, however, legal counsel to hospitality lenders will be scrutinizing the decision and their loan documents for a "work around." In the meantime, the question has been posed whether owners of other distressed property, such as parking garages, storage facilities and other real property that generate revenues which are not necessarily "rent"¹⁶ will seek a further legal extension of the Ocean Place decision¹⁷ .

¹ RevPar: revenue per available room; a metric used in the hotel industry which is calculated by multiplying a hotel's average daily room rate (ADR) by its occupancy rate. See Smith Travel Research Glossary:http://www.strglobal.com/Resources/Glossary.

² ADR (Average Daily Rate): a measure of the average rate paid for rooms sold, calculated by dividing room revenue by rooms sold. See id.

³ Occupancy (Occ): is the percentage of available rooms that were sold during a specified period of time. Occupancy is calculated by dividing the number of rooms sold by rooms available. Id.

⁴ In re Ocean Place Development, LLC., 447 B.R. 726 (Bankr. D.N.J. 2011).

⁵cf In re Kingsport Ventures, L.P. d/b/a Kingsport Comfort Inn, 251 B.R. 841, 846-50 (Bankr. E.D. Tenn. 2000). The Ocean Place court expressly disagreed with the Tennessee court stating ". . . the Court respectfully believes that the Kingsport court, without explanation or justification, expanded the Jason Realty holding beyond its intended reach. It is true that absolute assignments may divest a debtor of any legal right to use rents, but it is also true that there is no Third Circuit case law or supplemental evidence to suggest that this holding extends beyond assignments of interest in real property. In fact, the Kingsport court makes no mention of the UCC whatsoever." Id.

⁶ Hotel Revenues: The court in Ocean Place defined hotel revenues as including revenues generated from room occupancy, food and beverage sales, catering, gift shop purchases, spa and related hotel services. See id at 728.

⁷Hotels generally are not considered a single asset real estate entity ("SARE") under existing bankruptcy case law. See In re CBJ Development, Inc., 202 B.R. 467 (9th Cir. B.A.P. 1996). For purposes of this article, "single asset" real estate entity is used in its generic sense and not as defined under existing bankruptcy case law as Ocean Place owned no other assets other than those assets relating to its ownership, operation and potential redevelopment of the 17 acre parcel on which the hotel sits.

⁸AFP 104 Corp. is the indirect subsidiary of United Capital Corporation (OTC Pink: UCAP, formerly NYSE Amex: AFP). United Capital Corporation's website defines the company as "a diverse real estate investment and management company in the business of investing in and managing real estate properties, including the operation of full-service hotels, and manufacturing engineered products." See http://www.unitedcapitalcorp.net/. In a press release issued by United Capital Corporation in connection with the purchase of the Barclays loan "A.F. Petrocelli, United Capital's Chairman and President, noted "This is the premier ocean front location along the Jersey Shore and the only destination with direct beach front access along the North Jersey Coastline." http://www.unitedcapitalcorp.net/press/.

⁹"Cash collateral" means cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents, whenever acquired in which the [bankruptcy] estate and an entity other than the estate have an interest and includes the proceeds, products, offspring, rents, or profits of property 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 subject to a security interest as provided in section 552(b) of this title, whether existing before or after the commencement of a case under this title. 11. U.S.C. section 363(a).

¹⁰See Wachovia Bank N. A. v. Encap Golf Holdings, LLC, 690 F. Supp. 2d 311 (S.D.N.Y. 2010); First Fidelity Bank, N. A. v. Eleven Hundred Metroplex Assoc., 190 B.R. 510 (S.D.N.Y. 1995); 1st 2nd Mortgage Co., of NJ, Inc., v Ferandos (In re Ferandos), 402 F.3d 147 (3d Cir. 2005); In re Cornerstone-Cameron & Stonegate, Inc., 2007 Bankr. LEXIS 4943 (Bankr. W.D. Tenn. 2007); In re Cook, 384 B.R. 282 (Bankr. N.D. Ala. 2008).

¹¹See Note 5.

¹²See In re Kearney Hotel Partners, et.al. 92 B.R. 95 (Bankr. S.D.N.Y. 1988) (in the context of a bankruptcy avoidance action the court found that guests in a hotel . . . are mere licensees and not tenants, and . . . they have only a personal contract and acquire no interest in the realty . . .). Id at 99 citing In re Greater Atlantic and Pacific Investment Group, Inc., 88 B.R. 356, 359 (Bankr. N.D. Okla. 1988). See also In re Northview Corp., 130 B.R. 543 (9th Cir. B.A.P. 1991) (hotel revenues are personal property and not rent).

¹³ In re Ocean Place Development, LLC at 732-33.

¹⁴Id at 733.

¹⁵The term "adequate protection" is generally read as intending to protect a secured creditor from "diminution in the value of its collateral during the reorganization process."See, e.g. In re Beker Industries Corp., 58 B.R. 725, 736 (Bankr. S.D.N.Y. 1986).

¹⁶The Ocean Place court made note that pursuant to the Uniform Assignment of Rents Act ("UARA"), adopted by the Uniform Law Commission in 2005, that "rents" would include security interests in hotel room revenues. UARA sections 1-21, 7 (Pt. IB) U.L.A. 7 (2005). However, New Jersey, along with New York and Oklahoma, has not adopted UARA.

¹⁷See Room Revenues are Not "Rents": Hotel Creditors Cannot Check in to Jason Realty, 30-6 ABI Journal 24, 77 (July 2011).

FRANCIS L. GORMAN, III is Senior Counsel at Bond, Schoeneck & King, PLLC where his practice focuses on real estate development, litigation and restructurings including bankruptcies. Prior to joining Bond, Mr. Gorman served as Senior Counsel and Director of Legal for Litigation and Operations for Wilmorite Property Management, LLC, one of the nation's largest shopping center developers. Most recently, he was Director of Development for The Widewaters Group, Inc. a significant power center/hotel developer. He may be contacted at [email protected]