It is hard to pick any event or series of events that has adversely impacted the hospitality industry as hard as the COVID-19 pandemic. While the summer witnessed increased RevPAR in the U.S. as compared to the depths of March and April due to economies opening up, summer travel, and hotel companies obtaining Paycheck Protection Program loans to stay afloat, industry participants face a murky path back to operational and financial strength as fall moves into winter. A dramatic increase in loan defaults compared to more robust years of the past will surely lead to a corresponding increase in bankruptcies and foreclosures, which creates significant uncertainty for industry players. In this article, we explore several key issues that stakeholders in the hospitality industry should keep in mind as 2020 comes to an end and we look to the years ahead.
PPP Loan Forgiveness
Many hotel owners funded their operations in the spring and summer months through Paycheck Protection Program (“PPP”) loans. In fact, as of August 8, 2020, businesses in the Accommodation and Food Services sector have received more than 383,000 PPP loans totaling more than $42 billion. The PPP was established as part of the CARES Act, which was enacted in March 2020 to assist businesses nationwide adversely impacted by the pandemic and resulting economic downturn. PPP loans provided immediate cash to hotel owners to fund payroll, debt service, utilities and other expenses, with the promise that the loans would be forgiven if used for specified purposes.
With loan funds largely spent, many hotel owners are now preparing applications for forgiveness. A PPP loan may be forgiven if spent on PPP-delineated expenses (e.g., payroll costs, mortgage interest) during a PPP-delineated “covered period” (in general, the 24-week period following PPP loan disbursement). Generally speaking, a reduction in forgiveness will be triggered if a borrower reduces the number of its employees or hours of its employees during its covered period, or if a borrower reduces the salary or wages of its employees by more than 25% during its covered period. However, these forgiveness-reduction rules are subject to exceptions and “safe harbors” regarding which hotel owners and practitioners must be aware in order to maximize forgiveness.
One such safe harbor, which warrants discussion due to its potentially broad applicability across the hospitality space, exempts a borrower from the loan-forgiveness reduction stemming from a decrease in the number or hours of its employees, if the borrower:
|[I]s able to document an inability to return to the same level of business activity as such business was operating at before February 15, 2020, due to compliance with requirements established or guidance issued by the Secretary of Health and Human Services [HHS], the Director of the Centers for Disease Control and Prevention [CDC], or the Occupational Safety and Health Administration [OSHA] during the period beginning on March 1, 2020, and ending December 31, 2020, related to the maintenance of standards for sanitation, social distancing, or any other worker or customer safety requirement related to COVID–19.|
Though current guidance on this safe harbor is imprecise in some respects, certain conclusions can be drawn.
First, the terms of the safe harbor appear to limit its applicability to situations in which the borrower’s compliance with requirements or guidance issued by HHS, CDC or OSHA leads to the requisite downturn in business. Thus, agency guidance that restricted travel by hotel guests (for example) would likely be insufficient to trigger this safe harbor.
Next, the Interim Final Rule discussing this safe harbor, published in the Federal Register on June 26, 2020, makes clear that the safe-harbor-triggering compliance need not be directly with the requirements or guidance issued by the three federal agencies. Such compliance may instead be indirect, namely, through compliance with state or local orders that are themselves based — even in part — on guidance from the three agencies.
Borrowers wishing to take advantage of this safe harbor must certify that they have documented in good faith that their reduction in business activity stems directly or indirectly from compliance with such agency requirements or guidance. Such documentation must include copies of the applicable requirements or guidance (or state or local orders referencing such requirements or guidance) for each hotel location and relevant borrower financial records. Though the Small Business Administration has not defined “relevant borrower financial records,” examples may be profit and loss statements, cash flow statements, room revenue statements, or booking records. Further, the financial records collected should show a connection between the relevant requirements/guidance/orders and the business reduction for each hotel location. For example, to the extent that compliance with agency guidance led to a reduction in room bookings, records of bookings would be useful. If in-person dining was barred, records demonstrating a concurrent reduction in restaurant revenue would be helpful. This should be a hotel-specific exercise given that not all hotels will have been subject to the same COVID requirements. Additionally, because the safe harbor requires a reduction in business activity during the covered period as compared to the period before February 15, borrowers should compile financial records pertaining to both periods in order to demonstrate such reduction. Though such documentation need not be submitted with the borrower’s forgiveness application, borrowers must retain the documentation in their files for six years after the date the PPP loan is forgiven or repaid in full.
Additionally, though there is no explicit materiality requirement included in this safe harbor, due to the size of the benefit attendant to its application — a complete exemption to a forgiveness-reduction rule — hotel owners should ensure that they can certify in good faith that their compliance-induced business reduction was sufficiently material. Hotel owners should consider consulting with legal counsel and accounting professionals in making this materiality determination.
Re-emergence of Hotel Purchase and Sale Market
After slamming to a halt in the spring, the market for hotel sales has slowly begun to re-emerge. While buyers’ and sellers’ perceptions of the value of hotels still diverge significantly in many cases, they have started to converge for hotels in markets that are expected to recover quickly. Buying and selling any property in the middle of a pandemic involves some wrinkles, and purchases and sales involving operating businesses like hotels present even more complexities.
To ensure a smooth sale, buyers and sellers should keep the following in mind:
- Operating Covenants:
- As a seller, avoid including covenants that the seller shall operate the property “in the ordinary course of business.” Retain flexibility to modify pricing to respond to market trends and reduce staffing levels or even close the hotel (or keep a hotel closed) if needed.
- As a seller, retain the express authority to take measures necessary to comply with legal requirements and/or CDC guidelines (including, if necessary, the right to close the hotel and/or limit food and beverage operations or capacities).
- As a buyer, retain the right to be notified (or in some cases, to consent to) any measures that the seller is taking that would have a material impact on the hotel post-closing. In some cases where the closure of the hotel is necessary, buyers may want to approve the process and standards in which the hotel is operating while closed (including maintenance and security protocols).
- Build in appropriate protections around employee staffing levels and necessary WARN Act compliance. In the unfortunate event that the hotel is closed or additional staffing reductions are needed, hotel employees may be terminated or furloughed. The parties will need to address the responsibility for costs and obligations to comply with all applicable laws, including the WARN Act, as well as severance payments (including continued medical coverage) and potential withdrawal liability under any pension plan obligations.
- The pandemic has created an opening for unions to try to negotiate for new employee protections in their collective bargaining agreements. Determine what rights (if any) a buyer has to approve any amendments to the CBA.
- Closing Logistics:
- Reach out to your local title agent and/or recorder’s office early on in the process to discuss their current closing procedures and recording processes, including whether electronic recording is available. This typically varies across jurisdictions so it is best to avoid any last-minute surprises or unexpected delays. Proactively address whether any title exceptions or indemnities will be required in light of potential delays in recording or other COVID-related issues.
- Build in additional time to obtain the necessary approvals, estoppels and signatures. Hotel transactions often require the involvement of third-parties (such as management companies and franchisors, unions and liquor authorities), and they will likely be slower to respond than usual.
- Include express language in the purchase agreement that provides that: (i) signatures (other than originals required for closing) may be delivered by PDF or DocuSign; (ii) the parties intend to be bound by electronic signatures; and (iii) the parties consent to remote and e-notarizations to the extent permitted by law.
- Carefully consider notice provisions. Many offices are closed with packages going undelivered, so email notice may work best in this environment.
Mezzanine Foreclosures of Distressed Properties
A recent study by the American Hotel & Lodging Association found that half of US hotels are in danger of foreclosure. In this study, 67% of hotel owners reported they will only be able to last another six months at current projected revenue and occupancy levels absent any further government relief. These trends look even worse when looking at hotels secured by CMBS loans: a report by Trepp found that $20.6 billion in CMBS loans were thirty or more days delinquent as of July 2020, compared to $1.15 billion as of December 2019. With the prospects for government relief uncertain at best, the hotel industry is likely to see a surge of foreclosures.
The global financial crisis of 2007-08 (the “GFC”) led to a wave of hotel foreclosures, with over $13.5 billion in hotel loans in default. Industry legal practitioners dusted off their foreclosure and bankruptcy knowledge gained during prior industry downturns to shepherd distressed properties through the restructuring process. While knowledge gained during the GFC will be relevant to workouts for distressed properties in the COVID era, practitioners will face some unique twists in foreclosing on mezzanine loans in particular.
Mezzanine Foreclosures May Not Be Commercially Reasonable
A mezzanine loan typically involves a lender making a loan to the direct parent entity of an underlying mortgage borrower and such mezzanine loan is secured by a pledge of the parent entity’s equity interest in the mortgage borrower. The mezzanine loan is separate and distinct from the underlying mortgage loan, which is secured by a security interest in real property, and may involve the same or a different lender than the mortgage loan. Because mezzanine loans are secured by personal property (and not real property), they are governed by the UCC. As such, when a mezzanine lender seeks to foreclose on their loan, historically they have been able to swiftly foreclose on the pledged equity interest without any involvement of the courts.
In the COVID era, there are added wrinkles to the mezzanine foreclosure process. UCC Section 9-610(a) provides: “after [a] default, a secured party may sell, lease, license or otherwise dispose of any or all of the collateral in its present condition or following any commercially reasonable preparation or processing.” (emphasis added). This leads to the question: how can mezzanine foreclosures be “commercially reasonable” in light of the COVID-19 pandemic and related governmental orders precluding foreclosures?
To date, courts have taken different approaches to the issue. Take, for example, the recent decisions out of New York. In 1248 Assoc. Mezz II, LLC v.12E48 Mezz II LLC, a New York State Supreme Court decision concluded that defendant-mezzanine lender’s foreclosure process was commercially reasonable and could proceed virtually. In so holding, the court rejected plaintiff-borrower’s argument that the foreclosure sale should have been temporarily stayed because the terms of the sale were commercially unreasonable given Governor Cuomo’s moratorium on foreclosures of commercial properties. The court reasoned that the executive order applied only to underlying judicial mortgage foreclosures, and not UCC mezzanine foreclosures.
On the other hand, in D2 Mark LLC v. OREI VI Investments, LLC, another New York State Supreme Court decision found for plaintiff-borrower, issuing a preliminary injunction staying defendant-lender’s UCC foreclosure sale for 30 days and ordering defendant to re-notice the sale and develop a commercially reasonable plan. The court found that the plaintiff sufficiently demonstrated a likelihood of success on the merits in showing that the sale may not be commercially reasonable. The court relied on the facts that the potential bidders received only 36-days’ notice and faced hurdles in conducting meaningful due diligence because of the shelter-in-place orders. And, unlike the court in 1248 Assoc., the D2 Mark court also reasoned that Governor Cuomo’s orders served as a persuasive authority that “what is reasonable during normal business times, may not be reasonable during a pandemic.”
In a recent decision, the court in Shelbourne BRF, LLC v. SR 677 Bway LLC initially granted borrower-plaintiffs’ motion for a preliminary injunction prohibiting defendant-lender from proceeding with a UCC mezzanine foreclosure until October 15, 2020 because of COVID-19. The court held that plaintiffs established a likelihood of success on the issue that the sale was not commercially reasonable, noting that “[s]evere turmoil in the real estate market due to the pandemic makes the notion of a sale resulting in payment of fair market value highly uncertain” and that “[b]ids will likely be discounted due to uncertainty about the continued length and severity of the pandemic.” And, the court found that, while a July 23, 2020 administrative order by its terms only prohibited mortgage foreclosures scheduled to occur before October 15 and was therefore inapplicable, the logic of the order nevertheless was applicable and relevant to its holding.
However, when the preliminary injunction expired on October 15, defendant notified plaintiffs that the UCC foreclosure sale would occur on October 30. Plaintiffs once again tried to enjoin the sale but, this time around, the court issued an order permitting the sale to proceed. The court reasoned that it would be unreasonable to further enjoin the sale under the current conditions because the administrative order prohibiting mortgage foreclosures was no longer in effect and because “[f]orcing defendant to continue funding the costs that plaintiff failed to pay would be commercially unreasonable given the state of the property and the debt to the senior lender.”
Given that hotels are not likely to return to pre-COVID valuations anytime soon, mezzanine lenders should proceed with caution when undertaking UCC foreclosures.
Considerations for Accommodation Pledges
Accommodation pledges, though distinct from the collateral framework of mezzanine loans, present a similar issue as raised above. Like mezzanine loans, accommodation pledges involve a pledge of equity in a borrower entity to further secure a loan otherwise collateralized by real property and are governed by the UCC. However, unlike mezzanine loans, an accommodation pledge allows a single mortgage lender to receive both a mortgage of the interests in the real property and a pledge of equity interests in the entity that holds the ownership interests in the owner of the real property. Mortgage lenders have increasingly employed this structure in states where the mortgage foreclosure process is long and cumbersome; in those instances, enforcing on an accommodation pledge is usually quicker and cheaper than a mortgage foreclosure.
The accommodation pledge structure raises the question of whether accommodation pledges violate the public policy doctrine of “equity of redemption” and thus are commercially unreasonable, particularly during a global pandemic. The equity of redemption doctrine stands for the proposition that borrowers have a right to redeem the property from default at any time until the actual foreclosure occurs. Seemingly in contrast to this principle, an accommodation pledge allows a mortgage lender to indirectly acquire control of real property by quickly completing a UCC foreclosure on the equity interests in the borrower, rather than conducting a presumably lengthier judicial mortgage foreclosure. Therefore, borrowers may argue that UCC accommodation pledge foreclosures are commercially unreasonable and, therefore, unenforceable, especially during the COVID-19 pandemic and for the duration of the related governmental orders.
The New York decision HH Mark Twain LP v. Acres Capital Servicing LLC provides insight into this question. There, borrowers defaulted on a loan that was secured by a mortgage and an accommodation pledge, and the lender initiated a UCC foreclosure of the properties. The borrowers brought a lawsuit, arguing that the lender acted in a commercially unreasonable manner in conducting a sale of the collateral, securing the loan because the sale resulted in the potential loss of valuable historic tax credits and an absence of bidders at the sale. The lender then filed a motion to dismiss the complaint, which the court denied. The court reasoned that plaintiffs’ first cause of action on the basis of “clogging” the equity of redemption was not previously ruled on by the court and, therefore, could proceed. In addition, touching on the issue of commercial reasonableness of UCC foreclosures as discussed above, the court found that plaintiffs’ second cause of action, arguing that the lender’s sale was commercially unreasonable, could proceed as the complaint’s allegations were sufficient to overcome the motion to dismiss — the complaint alleged that “the UCC sale was commercially unreasonable for a number of reasons, including the notice, location, and scheduling of the sale, along with the price ultimately garnered for the partnership interests.”
Thus, while courts have not opined directly on accommodation pledges in relation to the COVID-19 pandemic, practitioners should be aware that borrowers may argue that a lender’s commencement of a UCC foreclosure is commercially unreasonable and “clogs” the equity of redemption. This is a particularly relevant issue for a potential purchaser of a distressed loan that includes an accommodation pledge, because a finding that the accommodation pledge is not enforceable could dramatically increase the time and cost of foreclosure.
 Paycheck Protection Program (PPP Report): Approvals through 08/08/2020, U.S. SMALL BUS. ADMIN., https://home.treasury.gov/system/files/136/SBA-Paycheck-Protection-Program-Loan-Report-Round2.pdf (last visited October 30, 2020).
 Paycheck Protection Program Flexibility Act of 2020, Pub. L. No. 116-142, 134 Stat. 641 (June 26, 2020).
 This guidance is located in the Interim Final Rule published in the Federal Register on June 26, 2020 (85 Fed. Reg. 38,204), as well as in the PPP Loan Forgiveness Application and Instructions published June 16, 2020. The SBA and Treasury periodically issue new guidance regarding the PPP. Individuals can keep abreast of new developments by monitoring the Treasury’s PPP webpage, available at https://home.treasury.gov/policy-issues/cares/assistance-for-small-businesses.
 85 Fed. Reg. 38,204.
 For a more detailed discussion of issues to consider in real estate sales generally, please see the following article: Ann Seung-Eun Lee & Nelson Alemany, Negotiating for Certainty in Uncertain Times: COVID-19 Considerations in Real Estate and Purchase and Sale Agreements, GOODWIN PROCTER LLP, https://www.goodwinlaw.com/publications/2020/07/07_23-negotiating-for-certainty-in-uncertain-times (last visited September 24, 2020).
 SURVEY: 74% OF HOTELS WILL LAY OFF MORE EMPLOYEES WITHOUT FURTHER AID, AMERICAN HOTEL & LODGING ASSOCIATION, https://www.ahla.com/press-release/survey-74-hotels-will-lay-more-employees-without-further-aid (last visited September 22, 2020).
 Historical CMBS Report: An Update on Hotel Commercial Real Estate, TREPP, https://www.ahla.com/sites/default/files/Trepp%20Historical%20CMBS%20Report%20-%20Hotel%20Commercial%20Real%20Estate.pdf (last visited September 24, 2020).
 651812/2020, 2020 N.Y. Misc. LEXIS 5099 (Sup. Ct. N.Y. Cnty. May 18, 2020).
 At oral argument, a New York State Supreme Court similarly denied a borrower’s request for a preliminary injunction seeking to prevent a U.C.C foreclosure sale, finding the borrower could not establish irreparable harm. Atlas Brookview Mezzanine LLC et al. v. DB Brookview LLC, 653986/2020, Doc. No. 72 at 36 (Sup Ct. N.Y. Cnty. October 15, 2020).
 652259/2020, 2020 N.Y. Misc. LEXIS 2978 (Sup. Ct. N.Y. Cnty. June 23, 2020).
 Id. at *15.
 652971/2020 (N.Y. Sup. Ct., August 3, 2020).
 Id. at 1.
 652971/2020 (N.Y. Sup. Ct., October 27, 2020).
 The equity of redemption doctrine is recognized in states such as New York, California, and Illinois. Andrew A. Lance & Aldo J. Mayro, Accommodation Pledges: Evaluating Validity in the Face of the Equity of Redemption, THE ACREL PAPERS (Fall 2019).
 Index No. 656280/2019, 2020 N.Y. Misc. LEXIS 2515 (N.Y. Sup. Ct. June 2, 2020).
 Id at *5.
Teresa K. GoebelPartner
Jacob M. BoyerAssociate