June 2, 2009

When Does A Settlement Make Things Worse?

Holland & Knight Alert
Barbra R. Parlin

A common scenario for hotel operators is one in which the operator finds itself in a dispute with the owner about the scope and amount of fees assessed against the property for common reservation systems, corporate overhead and the like. The owner argues that the fees are too high given the benefits its hotel receives, and may also challenge other fees assessed against the hotel’s top line revenue. Months go by, the parties get into a stalemate, until finally, cooler heads prevail and a settlement is achieved – the operator agrees to take a haircut on its fees, while the owner agrees that the compromised amount should be paid out on a monthly basis over the course of the next year. Problem solved, right?

Maybe, maybe not. If the owner files a bankruptcy case for the hotel during the period when payments are being made – a likely scenario, given that payment disputes often arise because the owner is having liquidity issues – that settlement may come back to haunt the operator.

Bound by the Settlement Terms

Under the U.S. Bankruptcy Code, the filing of a bankruptcy petition automatically stays all efforts to collect pre-petition claims against the debtor. This means that the operator likely will no longer receive its monthly settlement installment, even if that installment didn’t come due until after the filing, because the payment relates to a pre-petition debt. The amount of the operator’s claim for amounts due to it also is limited by the settlement. Even though the debtor is no longer performing its end of the bargain, the operator remains bound by the terms of the settlement and its potential claim is subject to whatever limits were imposed by the parties’ agreement.

To add insult to injury, the operator may be forced to disgorge settlement payments that it received during the period immediately preceding the bankruptcy filing. In general, the Bankruptcy Code empowers the debtor to avoid and recover payments on antecedent debts made during the 90 days leading up to the petition date where such payments would enable the creditor to receive more than it would have in a liquidation. There are a number of defenses to a preference claim, including that the payments were made in the ordinary course of the parties’ relationship, that the operator subsequently provided new value, or that the payments were a contemporaneous exchange for value. However, it is unclear whether any of these defenses would apply to payments made pursuant to a settlement of old, outstanding fees, because such payments are, by definition, payments on an antecedent debt, not a contemporaneous exchange, and also are made outside of the ordinary course. As such, the operator may be forced to disgorge any such payments that it received during the 90-day preference period.

The Bankruptcy Code’s provisions for the assumption or rejection of pre-bankruptcy contracts also may affect the operator’s rights. If the debtor assumes the contract, it generally must cure existing defaults, including paying all outstanding amounts whether they came due before or after the bankruptcy filing. Usually, the decision to assume or reject comes down to a cost benefit analysis – does the overall value of the contract to the business outweigh the cost of curing pre-filing defaults? In the case of a management agreement in default, these costs can be extremely high. Nevertheless, a contract that applies an operator’s “flag” to the property may be one of the most valuable assets that the owner has. In that case, the owner will have no choice but to assume and to pay whatever is necessary to cure undisputed, outstanding defaults. If the parties have settled pre-bankruptcy, however, then the debtor will have the option to simply assume the agreement as amended, or assume and assign the contract to a new property owner. This means the new property owner will not have to cure any defaults that previously were compromised or “waived” by the operator.

How Can an Operator Protect Itself?

First, fee disputes should be resolved quickly whenever possible, to prevent the build-up of significant unpaid fees. Dispute resolution provisions in hotel management agreements should be crafted to encourage speedy resolution of any disputes. Second, lump sum settlement payments, even if lower, may be preferable to larger monthly installments, because the preference period will run once instead of restarting every month. Settlement agreements also should be carefully crafted to permit the operator to try to assert the full amount, rather than the reduced “settled” amount, of its claim in the event that the owner files bankruptcy.

Similarly, settlement payments should be structured so that they are forward charges, due contemporaneously with payment, rather than payments on old debts. Where available, settlements should be secured by a carefully structured letter of credit or third-party guarantee, which may help ensure payment in the event that the original obligor files a bankruptcy case. Claims against the issuer of a letter of credit or against a guarantor that is not itself in bankruptcy are not barred by the automatic stay applicable to the owner/debtor, so the operator will be able to recover despite the filing.

If the operator believes a bankruptcy filing is coming, it also may have more bargaining power if it waits to settle its claims after the filing. As noted above, in most cases the property owner will consider the operator’s “flag” to be a valuable asset notwithstanding any disputes about fees due, one that it needs to keep to make viable a stand-alone reorganization or a bankruptcy asset sale. If the outstanding fee dispute has not been settled, then the debtor/owner or any new buyer may be obligated to cure any defaults – meaning it must pay the amounts actually due per the terms of the contract – before the contract can be assumed. This gives the operator significant leverage in negotiating a resolution of the defaults.

The most important lesson in all of this is for the operator to be vigilant and keep itself informed and aware of the owner’s financial condition. Long drawn out payment disputes should be avoided where possible, but if a dispute becomes inevitable, the operator should consider the impact of a bankruptcy by the owner in the future as part of its settlement strategy.

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