hotel subordination, non-disturbance and attornment agreements (stroock 2010)

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Winter 2010

Hotel Subordination, Non-Disturbance and Attornment Agreements:

The “Boilerplate” of the Boom Years Becomes Significant in the Great Recession

S T R O O C KSPECIAL BULLETIN

Strategies for dealing with distressed hotel assetsdo not fit neatly into the conventional wisdom ofhow to work out a distressed real estate loan. Hotelworkouts are complicated by the fact that there is athird party to the transaction, typically a brandedmanagement company. That branded managementcompany operates the hotel pursuant to a series ofcomplex documents, including the hotel manage-ment agreement and a subordination, non-distur-bance and attornment agreement (“SNDA”). Thefocus of this Special Bulletin is on the SNDA and itsimpact on the restructuring of troubled hotel assets.

Overview

During the boom years, parties to hotel dealsfrequently treated SNDAs as secondary to the otherloan documents. In some transactions, they receivedno more consideration than that given to standard“boilerplate” terms. However, the significance of the SNDA in a distressed hotel situation has

become clear during the most recent downturn inthe lodging market. As the economy has declinedand owners and lenders turn their attention to areview of SNDAs, many are surprised by the seem-ing lack of flexibility that they have with respect tocertain hotel assets. When a lender perceives thatpart or all of the problem with a distressed assetresults from the management of an operator who itwishes to terminate, the lender must evaluateexpress SNDA terms that at times, on their face,assure a brand manager long-term management.On the other hand, managers must evaluate theactual viability of SNDAs as the recession increasingly propels hotel assets into foreclosure and bankruptcy.

Recently, there has been a substantial amount ofconfusion and misinformation about the impact ofSNDAs. The confusion revolves around the issueof whether or not an SNDA is essentially a guaran-tee of a brand manager’s long-term management,regardless of foreclosure or bankruptcy.

HOSPITALITY INDUSTRY PRACTICE GROUP

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The purpose of this Stroock Special Bulletin is toexplore the respective leverage that owners, man-agers and lenders have in a distressed hotel situationbased upon the terms of the applicable SNDA. Webegin with a review of the basics of SNDAs and thecontrolling law that emerged from the downturn ofthe 1990s, followed by an assessment of future issuesand options.

The Basics

Briefly, the basic goals of an SNDA are to:

• Subordinate the management agreement tothe loan (“subordination”).

• Allow the manager to operate the hotel post-foreclosure, so long as the manager is not indefault under the management agreement(“non-disturbance”).

• Require a manager to recognize the lender orother purchaser in foreclosure as the owner, ifthe manager is not in default and/or the lenderdecides not to terminate it (“attornment”).

From the hotel lender’s perspective, the idealsubordination agreement provides that the manage-ment agreement is expressly subordinate to anymortgage, and that upon foreclosure (or deed inlieu), the management agreement will simply terminate. While a number of non-branded man-agement companies have been willing to enter into this “ideal” agreement, branded managers have typically resisted.

SNDAs with brand managers have becomemore stringent in their pro-manager non-distur-bance requirements, especially in the CMBS lending market. Among other protections, some branded managers have attempted to use the SNDAto obtain bankruptcy protection. Those managers

require the lender, in the event of the terminationof a management agreement in bankruptcy as anexecutory contract, to execute a new managementagreement directly with the manager. The newmanagement agreement with the lender must be onsubstantially the same terms as the terminated man-agement agreement. At the same time, some rela-tively recent subordination and non-disturbanceagreements lack attornment. In other words, inthose agreements, the lenders have agreed to allowmanagers to operate undisturbed post-foreclosure,while essentially obtaining no attornment rights.Rather, these agreements allow the manager, forexample, to elect to terminate a management agree-ment, if in its unilateral “reasonable discretion,” thereputation of the brand manager is “adverselyaffected” by the owner’s default. In those circum-stances, if a distressed property might benefit from aflag and the manager refuses to operate the hotelpost-foreclosure, the lack of an attornment agree-ment limits the lender’s options. As a result, alender must deal with a manager’s exit from an assetat a potentially difficult time.

The Effectiveness of Challenges to SNDAsDuring the Last Downturn

In this economic downturn, lenders and ownersinvolved in restructuring hotel assets are increasing-ly compelled to determine whether they have anyleverage to change a brand or whether an SNDA isan absolute bar. Well established precedent fromthe 1990s provides guidance.

Is an SNDA an absolute bar to reflagging a distressed hotel property? Assume the following setof facts. A lender forecloses on a hotel and entersinto a consent judgment in federal court that provides that its subsidiary will take title to thehotel. Shortly before obtaining title, the lendersends a notice of termination to the manager. The manager then sues the parent lender and the

h o s p i t a l i t y i n d u s t r y p r a c t i c e g r o u p s p e c i a l b u l l e t i n

subsidiary owner for “interfering” with the man-agement contract and breaching the SNDA. TheSNDA expressly provides that the managementagreement remains in place post-foreclosure.However, the lender asserts that it has the power toterminate, notwithstanding the terms of the SNDA.

Who prevails? In an actual case from the 1990sinvolving these facts, the lender prevailed despite anSNDA that stated in part as follows:

[s]o long as Hyatt is not in default (beyondany period given to Hyatt to cure suchdefault) in the payment of amounts due orthe performance of any of the other terms, covenants and conditions of theManagement Agreement on Hyatt’s part tobe performed, the interest of Hyatt createdby the Management Agreement, Hyatt’smanagement of the hotel and all of its otherrights under the Management Agreementshall remain undisturbed by any foreclosureor default under the Security Documentsand shall be recognized by Lender and itspermitted successors and assigns (the“Mortgagee”) during the term of theManagement Agreement….1

The Court approved of the manager’s termina-tion despite the express non-disturbance languagein the SNDA, reasoning that such language is notdispositive.2 Instead, the Court relied upon the factthat the manager was the owner’s fiduciary agent.It accepted the lender’s argument that the principlesof agency law permitted the foreclosing lender toterminate the manager, regardless of the SNDA’slanguage stating otherwise. The Court’s holding at the time – and apparently even in the current downturn – while surprising to some businesspersons and lawyers, is representative oflong established legal precedent. As the court in

Government Guarantee Fund of the Republic of Finlandv. Hyatt noted, relevant hotel transactional agreementsdo not create non-terminable relationships, “even if theagreements state that they do.”3 In other words, the non-disturbance provisions of an SNDA cannot trump thefact that an owner, pursuant to the law of agency, canterminate a management agreement.

Government Guarantee Fund’s sweeping endorse-ment of the application of agency principles tooverride an SNDA established the legal benchmarkfor the evaluation of SNDAs in the context of ter-mination issues. Other cases from the 1990s chal-lenging non-disturbance provisions proceeded on amore limited basis, focusing on interpretations ofthe contractual language rather than taking the posi-tion that the manager’s agency duties arising outsideof the terms of the management contract controlled.For example, in Marriott Int’l, Inc. v. Mitsui Trust & Banking Co., Ltd.,4 the Court agreed with the foreclosing hotel lender that a third party purchaser would not be bound by the management agreement. There, the relevant non-disturbanceclause provided that:

If a mortgagee comes into possession of theHotel by virtue of a foreclosure on itsMortgage or an assignment of the GroundLease in lieu of foreclosure, theManagement Company shall not be dis-turbed in its rights to peaceably occupy theHotel in accordance with the ManagementAgreement….

The Court adopted Mitsui’s interpretation that itwas required to permit Marriott to remain as manager only as long as Mitsui possessed the hotelbut not if it sold the asset to a third party.

The above precedent demonstrates the need fora careful review of both agency law and specificcontract terms in interpreting the impact of an

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SNDA. To do otherwise will likely result in anowner and/or a lender failing to assess their optionsaccurately in a restructuring.

Looking Ahead: Issues and Options

As the pace of hotel loan defaults has accelerated,5

so has the debate in the industry over whether theunprecedented events of the past year will force alasting reevaluation of the SNDA. During theboom in the hotel market from the early part of thedecade until 2007, some SNDAs were executedwith no more forethought than one would expectto be given to routine boilerplate language.Presumably, recent events will encourage a moredetailed analysis of these documents. The issue ofwhen to negotiate the SNDA in relation to the loandocuments and the management agreement is likely to be revisited. Often relegated to last placeafter the loan documents and management agree-ment are finalized, recent events underscore theneed to negotiate the SNDA at an earlier point in the transaction.

A more fundamental issue facing the market-place for hotel deals is whether SNDAs will benegotiated and executed at all. Anecdotally, a num-ber of hotel lenders have indicated that they arereevaluating the use of SNDAs. For those ownersand lenders who entered into SNDAs, not as anafterthought, but based upon a strategic calculationthat a long-term brand was of a greater benefit thanflexibility, the economy has forced a recalculation.Before agreeing to non-disturbance, lenders andowners must understand the precise risks and bene-fits in a proposed management agreement. If, forexample, a management agreement lacks realisticperformance standards, territorial non-competitionprovisions and exit strategies, the impact of a long-term brand affiliation on the asset’s value may be

significant. Absent such an assessment, an owner ora foreclosing lender in a down cycle may be leftwith a property that is difficult to rebrand or to sell.However, difficulty should not be confused withimpossibility when evaluating options. As theactions of the foreclosing lender in GovernmentGuarantee Fund established, non-disturbance provi-sions are not an absolute bar to the termination of amanagement agreement.

By Cecelia L. Fanelli ([email protected],212.806.6158), a Partner in the HospitalityIndustry Practice Group of Stroock & Stroock &Lavan LLP, which Ms. Fanelli heads. The Group represents industry leaders fromacross the hospitality spectrum – from owners,investors, managers and lenders to franchisorsand franchisees. Ms. Fanelli has extensive expe-rience in representing both domestic and inter-national lenders, owners and managers in hotelworkouts, foreclosures, receiverships, bankrupt-cies and arbitrations.

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1. The excerpt of this SNDA appears in Gov’t GuaranteeFund of the Republic of Finland v. Hyatt Corp., 960 F.Supp931, 939 (D.C.V.I. 1997). The author of this StroockSpecial Bulletin represented the prevailing lender in its chal-lenge to the SNDA.

2. Gov’t Guarantee Fund of the Republic of Finland v. HyattCorp., 95 F.3d 291, 307 (3d Cir. 1997).

3. See footnote 2 above.

4. Marriott Int’l, Inc. v. Mitsui Trust & Banking Co., Ltd, 13F.Supp.2d 1059 (D. Hawaii 1998).

5. The accelerating rate of hotel defaults is illustrated by con-ditions in the California market. Atlas Hospitality Group’sstudy on distressed hotels found that in 2009 the numberof hotels in default increased 479%, from 53 to 307.Eighty-one percent of all the hotels in default have loansthat were originated in 2006 and 2007. Approximatelyfifty-three percent of all foreclosed hotels in Californiafiled for bankruptcy.

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This Stroock Special Bulletin is a publication of Stroock & Stroock& Lavan llp © 2010 Stroock & Stroock & Lavan llp. AllRights Reserved. Quotation with attribution is permitted. ThisStroock publication offers general information and should not betaken or used as legal advice for specific situations, which dependon the evaluation of precise factual circumstances. Please notethat Stroock does not undertake to update its publications aftertheir publication date to reflect subsequent developments. ThisStroock publication may contain attorney advertising. Priorresults do not guarantee a similar outcome.

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