However, there are pitfalls and disadvantages to the acquisition of troubled debt. These pitfalls and disadvantages are important variables in the decision of whether or not to acquire the debt, even though the price for the debt may be a fraction of the principal amount owed.
The important point is that the acquisition of debt is NOT the acquisition of the underlying hotel in the absence of the completion of a successful foreclosure proceeding or a deed in lieu of foreclosure.
First, what are the advantages to acquiring troubled hotel debt?:
1. Price. Lenders and other financial institutions, for better or for worse, are simply not equipped to manage or to supervise the operations of a hotel property. In addition, bank regulations affecting many institutional lenders provide disincentives to banks to own hotels and to operate them. Thus, banks may be willing to "unload" the troubled debt -- and also to avoid the risks associated with troubled debt -- for a bargain price.
2. Bargaining power with the owner. Following the acquisition of the troubled hotel debt, the purchaser may be able to gain important bargaining power over the hotel owner in its negotiations to take over ultimate management, control and ownership of the hotel. The new lender would have at its disposal the power, following a default under the loan:
a. To seek a court-appointed receiver to control the day-to-day operations of the hotel, and to place any net operating income into a court-controlled receivership account.
b. To wrest control of the hotel away from the hotel operator, although this action would not be advisable under most laws because the new lender would be deemed to be a "mortgagee in possession," responsible to the owner for any mismanagement of the hotel if the defaults under the loan were to be cured.
c. To commence foreclosure proceedings against the hotel operator following an event of default, and to seek to control legal title to the property, and to the hotel and to the operating business following the applicable foreclosure period. In California, that foreclosure period is approximately 120 days, and the foreclosure can be "unified," or one in which the real property and the hotel business assets can be foreclosed upon simultaneously.
Second, what are the disadvantages of acquiring troubled hotel debt?:
1. Bankruptcy risk. Inherent in the purchase of a note is the risk that the borrower/hotel operator will file bankruptcy. While the act of filing bankruptcy merely "stays" or prevents the new lender's foreclosure from taking place, it also, in most circumstances, permits the borrower to retain possession and control of the hotel. This is what is termed a "debtor-in-possession."
While the new lender can generally persuade the bankruptcy court to pay some of the net operating income to the lender, this may not always be the case. In addition, the new lender is prevented from foreclosing on the real property until the court grants a "lifting of the automatic stay," which can be achieved in many situations in which the value of the property is less than the amount due and owing under the debt. This can take several weeks or several months following the commencement of the bankruptcy case.
However, if the value of the property is far less than the amount of the debt, the new lender risks a "cram down," or a situation in which the bankruptcy court will order that the amount of the debt be reduced to the amount of the true value of the property, with the remaining part of the debt being called "unsecured," and payable at only a few cents on the dollar. A "cram down" plan, or plan of reorganization will also generally call for periodic payments based only on the amount of the secured debt, with a "market" rate of interest, and payable over time. Thus, the bankruptcy court has the power to rewrite the obligation if it so chooses.
2. Payment. The borrower could, of course, continue to make or to recommence making payments on the note, keeping the obligation current. In this manner, the new lender is prevented from gaining possession or control of the property, but the new lender is presumably making a good return on its investment if it acquired the debt at a discount, with the payments being made based on the entire principal amount of the note.
3. Anti-deficiency and one-form-of-action rules. Be aware of the problems inherent in foreclosing on real and personal property and the associated inability to seek a deficiency judgment against the debtor following a nonjudicial foreclosure of real property.
4. Litigation risks. If there are irregularities or problems associated with the foreclosure sale, the lender could be subject to a lawsuit, further delaying the foreclosure sale process. In addition, if a lender is withholding funds and otherwise mismanaging the borrower-lender relationship, the lender could become subject to a lender liability lawsuit, a frequently used device by borrowers that seeks to avoid a foreclosure.
Suggested scenario: In order to avoid the various risks associated with the acquisition of the troubled hotel debt, here is a suggested scenario:
a. The hotel operator gives a deed in lieu of foreclosure to the new lender, but with the hotel operator and the new lender agreeing that the lien of the mortgage or deed of trust remains alive.
b. If liens remain on the property following the deed in lieu of foreclosure, those liens, if recorded subsequent to the date of recordation of the original mortgage or deed of trust, can be effectively wiped out by the foreclosure sale.
c. In this situation, in return for its cooperation, the hotel owner/operator's liability under the debt can be limited or eliminated entirely.