The Hospitality Industry Post-COVID: Finding a Path Forward

Marriott, San Francisco, Sidley Austin LLP
Image Courtesy of Jared Erondu

By Sam Newman and Gabrielle Cuskelly

Gabrielle Cuskelly, Associate

The novel coronavirus (COVID-19) has wrought dramatic economic disruption affecting the business and leisure travel markets. Occupancy rates throughout California hotels collapsed, and occupancy by leisure travelers in San Francisco was prohibited for much of 2020. Operators have been required to take extensive measures to protect the health of hotel employees and guests. As the pandemic continues, hotels fall further behind on mortgage payments and many will permanently shutter. The asset-light model hotel operators adopted over the past fifteen plus years left them uniquely vulnerable to this wave of closures, presenting unprecedented challenges to hotel management seeking a path through this storm.

COVID-19 Pandemic Impact on Hotel Brands

Since Marriott spun-off its real estate assets into an investment trust in the 1990s, most hotel brands moved to asset-light models, reducing hotel brands’ capital investment costs. This limits attendant risks, but makes hotel brands dependent on fee streams generated by hotels owned by third parties. Now,because hotels have either shuttered or experienced unprecedented declines in occupancy, hotel management companies’ revenues have been decimated.

Many hotel brands took immediate action during the initial months of the pandemic. Many hotel operators wisely drew-down on their corporate lines of credit in early to mid-March 2020. The industry at large also took drastic measures to contain costs in the following months.

Continuing Challenges as the Impact of COVID-19 Continues

These measures were not enough. Liquidity continued to dwindle with massive drop-offs of travel driving a further wave of hotel closures. Hotel operators need to evaluate options for maximizing liquidity and restructuring their balance sheets to survive as the depressive effects of the pandemic are expected to continue through next year. Despite recent upticks, occupancy remains below sustainable levels. Some bright spots“drivable” destinations for leisure travelersexist; however, critical business travel and conference activity remains anemic.

Governments around the world are no longer able to provide public assistance. While major hotel brands have not widely accessed stimulus payments, the properties feeding their cash flow have. That safety net appears poised to disappear, further reducing expected cash flows.

Foreclosure moratoria will end with properties going dark and entering uncertain futures. Business interruption insurance and legal defenses have been unavailable. Early court decisions suggest the pandemic may not be covered or afforded relief under some force majeure clauses. These issues will develop as courts evaluate provisions added or modified after prior epidemics, such as SARS.

With all this pressure, hotel operators must consider restructuring businesses and financial arrangements. Officers and directors of hotel brands must act aggressively to maximize liquidity and manage liabilities to position themselves for solutions. Publicly-traded hotel brands could seek an influx of funds to weather current depressed occupancy through share issuances or corporate bond offerings.

These efforts may benefit from a close review of financing arrangements to tip the balance of leverage in their favor. For example, many companies may engage in “asset dropdown” transactions consisting of transfers (by contribution or otherwise) of assets to newly-created subsidiaries that are not covered by the company’s existing lending facility. Such Subsidiaries may then borrow money against the transferred property free of existing liens. Intellectual property assets similar to those held by brand companies have performed well in these types of transactions executed by large retailers.

Meanwhile, this distress cycle requires focusing on managing liabilities. Certain liabilities, especially obligations to employees and the government, can accelerate. State and federal statutes put special obligations on company management to ensure these liabilities are paid. Most hotel operators are employers at most hotels, so are obligated to provide for employee liabilities (accrued wages, sick and separation pay, tax claims, etc.). While the hotel owners contractually agree to pay these liabilities or indemnify operators, when property owners fail, hotel operators will find themselves the only deep pocket available. Claims often snowball in a property shutdown pursuant to federal and state WARN Act requirements, which require 60 days’ notice of a shut-down or impose substantial claims for severance. Professionals experienced in wind down or restructuring scenarios can help manage these liabilities.

Preparing for the Future

Similarly, many hotel operators participate in multi-employer or single-employer pension plans. These plans can hold large claims against plan participants, which may accelerate as other participants withdraw. The remaining operators then face accelerating obligations.

Meanwhile, hotel management agreements and related documents, the bulk of hotel operator assets, represent a long-term flow of fees that should stabilize. Hotel operators must act aggressively to protect rights under these arrangements as hotel owners work through the process of restructuring their affairs. Property owners may seek to reject agreements in bankruptcy and convert hotel operators’ rights to unsecured claims – paid pennies on the dollar – as property owners rebrand or re-purpose for the future. Fortunately, most financing arrangements contain non-disturbance provisions with the property owners’ lenders, requiring lenders to respect these arrangements with operators. The documentation of these transactions is far from uniform, and creative challenges can be expected seeking to unseat hotel operators so owners can leverage better deals.

These challenges (and many more) will put unprecedented pressure on operators and their officers and directors to satisfy fiduciary duties to constituents. Management must act in a disinterested manner and exercise care in operation of their businesses. This means they must stay informed, retain and rely on expertise and professional assistance to address challenges and establish appropriate governance. Following best practices, from appointing independent directors to supplement business judgement to obtaining independent opinions evaluating business decisions, position operators to defend their actions later.

As the hospitality industry looks beyond the day-to-day crises resulting from the pandemic, strategies for surviving, and adapting to, future challenges are emerging. One strategy is capitalizing on synergies from scaling organization. Marriott’s acquisition of Starwood pre-pandemic suggests scaling may permit operators to streamline operations and distributions, while benefiting from strategic alliances to increase response times and allow adaptation to changes. Strategic alliances with distributors and suppliers provide the ability to implement changes on a large scale, which may provide a competitive edge in a market where health and safety standards continue to be of increased importance to travelers. Operators that are not able to exercise leverage though high purchasing power or priority of attention will face disadvantages in obtaining necessary supplies (health and safety for example, or whatever or the next valuable commodity in the hospitality space may be). These benefits must be balanced against historic liabilities of the hotel brands when evaluating such an approach for specific operators.

Streamlining operations presents another strategic option. This may take the form of re-assessing team structures, de-segregating employees by brand, modifying specialty silos, or better integrating personnel or internal processes to increase efficiency. Technological advances are also occurring at ever-increasing rates, allowing brands to consider what role technology can play in their organizations (including at the property-specific level, such as contactless check-in).

Hotel operators will be on the leading edge of legal, financial and business reactions to the COVID-19 pandemic. This industry will be a proving ground for a variety of steps and reactions as the world recovers and looks to the future. Industry leaders will have to navigate uncharted waters and the world will be watching as other market segments prepare their own approach to the dramatically changing landscape engendered by COVID-19.

Sam Newman, Partner

Sam Newman is a partner in the Los Angeles office of Sidley’s Restructuring group. Sam represents companies, and their owners, from a variety of industries through in-court and out-of-court restructurings, including Chapter 11 cases. He can be reached at sam.newman@sidley.com.

Gabrielle Cuskelly is an associate in Sidley’s Century City office and a member of the firm’s global real estate and hospitality practices. Her practice focus tilts heavily toward the hospitality industry where she advises private equity funds, management companies, investment banks, institutional lenders, life insurance companies, and other real estate investors on both cross-border and domestic transactions. She can be reached at gcuskelly@sidley.com

This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.