Negative Amortization Chapter 11 Plans as a Potential Bridge Over the Economic Recovery Gap

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Hospitality debtors with substantial equity but prolonged depressed revenues due to COVID-19 may find negative amortization, a tool used sparingly pre-pandemic, helpful in the restructuring of mortgage debt under a chapter 11 plan until operations are turned around.

TAKEAWAYS

  • Negative amortization is permissible in chapter 11 plans, even if infrequently used.
  • The pandemic recovery may present favorable conditions for debt restructurings that feature negative amortization.
  • The hospitality debtors with substantial equity may be likely candidates for such plans.

This is the eleventh in a series of alerts on insolvency topics affecting real estate. In this alert, we discuss the potential for hotels responding to the impact of COVID-19, particularly those with meaningful equity and presently depressed revenues, to confirm three-to-four-year reorganization plans that negatively amortize the mortgage debt while the debtor reestablishes its occupancy rates and revenue streams.

Hospitality Debtors’ Susceptibility to Negative Amortizing Plans Due to COVID-19

The broader leisure facilities industry, which includes hospitality, was amongst the hardest hit by COVID-19. Hotels across the country and globally are struggling to service their mortgage debts. As vaccination data comes into sharper focus, hotel industry forecasts have begun to converge on a two-to-three-year time period for recovery. These predictions may be setting the stage for a perhaps disfavored but legally permissible mechanism to help debtors address lower occupancies and revenues during the extended recovery for this sector. In light of some economic expectations for the next few years, a cram-down plan that restructures debt with deferred debt-service payments may be more appropriate now than ever.

Pre-COVID-19 Treatment of Negative Amortizing Plans

In a plan of reorganization, negative amortization occurs where part or all the interest of a secured claim is deferred and accrues, adding to the principal at a rate sufficient to preserve the present value of the secured claim. There is no per se rule against the use of negative amortization, but the application has historically been sparingly used by debtors and carefully adopted by courts when evaluating compliance with cram-down requirements. In re Club Associates, 107 B.R. 385, 398 (Bankr. N.D. Ga.1989). To confirm a cram-down plan, the bankruptcy court must find that the plan is fair and equitable under §1129(b). Courts have fashioned a non-exhaustive, 10-factor list determine if a negative-amortizing plan is fair and equitable. In re Apple Tree Partners, L.P., 131 B.R. 380, 398 (Bankr. W.D. Tenn. 1991). The list includes evaluating, for example, the proposed equity cushion, the duration of payment deferral, the interest rate, and the debtor’s financial projections, among other considerations.

While courts frequently rely upon the weight and significance of these and other factors, individual factors can be dispositive. About half of the factors ultimately rely upon valuations, which unavoidably rely upon financial projections and, in some instances, the uncertainty that may accompany them.

Hospitality Industry Hit Particularly Hard by COVID-19

Perhaps no industry’s narrative for the future is more compelling than that of hotels. While many destination hotels are operating at below 25 percent occupancy, and non-destinations hotels are operating below 10 percent occupancy, surveys indicate considerable pent-up demand. And, the adoption of long-term work-from-home strategies by more companies may result in a shift toward more conferences and in-person events for companies that value such interactions within their workforce. Bankruptcy judges are currently busy making feasibility determinations and approving plans for scores of debtors in sectors with far less reason to be optimistic.

Three cases—that have stood the test of time—support plans that would defer mortgage payments under the right conditions for the relatively long recovery periods predicted by hotel industry forecasts. The Tenth Circuit affirmed a plan with no interest or principal payments for up to three years, justified by a substantial equity cushion. In re Pikes Peak, 779 F.2d 1456, 1459 (10th Cir.1985). The Ninth Circuit Bankruptcy Appellate Panel affirmed a plan allowing interest accrual without payment for up to three years, safeguarded by a substantial equity cushion.1 In re Pine Mountain, Ltd., 80 B.R. 171 (B.A.P. 9th Cir. 1987). Plans with negative amortization periods up to four years have been approved. In re Wood, Case No. 89-0111, Civil Action No. 90-0042-C, 1991 U.S. Dist. LEXIS 20083, at *23 (W.D. Va. Nov. 11, 1991).

Features and Feasibility of a Negative Amortization Plan

If a potential debtor’s valuation indicates a comfortable equity cushion to protect secured claims throughout the payment deferment period at a sufficient rate of interest, then most of the other factors often fall into place, and a debtor can follow the guideposts in the caselaw to carefully craft a plan that employs negative amortization.

Valuation will also impact the interest rate the plan can support. The “prime-plus” methodology for determining acceptable cram-down interest rates was adopted by the Supreme Court in Till in a plan not featuring negative amortization. Notably, the Bankruptcy Court in In re Aspen Village found prime-plus to be fair and equitable in the debtor’s negative amortization plan.2

Prime-plus starts with the prime interest rate—currently 3.25%—and adds a premium to compensate the secured creditor for the risk it must bear over the life of the plan. Those premiums typically range from 1% – 3%.3 Thus, potential debtors considering negative amortization may initially contemplate interest rates in the range of 4.25% – 6.25%.

Lenders seeking to push rates upwards will likely pursue “market-influenced” methodologies, using tranche financing that have occasionally been endorsed in commercial real estate cases. See, e.g., Pacific First Bank v. Boulders on the River, Inc. (In re Boulders on the River, Inc.), 164 B.R. 99, 105 (9th Cir B.A.P. 1994). In the market-influenced approach, to the extent that a loan is less than 70% of the value of the property securing the loan, a market interest rates have prevailed. To the extent that the loan exceeds 70 percent of the value, the lender is exposed to additional risk and should therefore be compensated by a corresponding increase in the interest rate.

Lenders seeking to counter a negative amortization plan will likely challenge feasibility under § 1129(a)(11). The feasibility test requires the court to assess—by a preponderance of the evidence—whether a plan’s chance of success is probable as opposed to possible, i.e., not likely to be followed by liquidation or further financial reorganization. Pertinent factors to be considered include “(1) the adequacy of the debtor’s capital structure; (2) the earning power of its business; (3) economic conditions; (4) the ability of the debtor’s management; (5) the probability of the continuation of the same management; and (6) any other related matters which determine the prospects of a sufficiently successful operation to enable performance of the provisions of the plan.” 7 Collier on Bankruptcy ¶ 1129.02 (16th 2020).

Conclusion

Before COVID-19, bankruptcy courts somewhat sparingly permitted negative amortization plans. The present pandemic recovery may present ideal conditions for travel-related businesses (especially hotels) seeking to preserve and rebuild cash during the multiyear recovery to propose reorganization plans using negative amortization to bridge the gap. We expect bankruptcy courts to give such debtors a fair shake, particularly where they are responding to factors outside their control. Nevertheless, the path to confirmation will likely remain at least somewhat challenging. Those debtors demonstrating strong pre-pandemic occupancy and revenues, coupled with meaningful equity, will likely have the greatest shot at success. Debtors with no or insufficient equity will likely find the road to confirmation of a negative amortizing plan more difficult.

1. Interest that had accrued prior to the effective date was added to the principal amount of secured indebtedness. The entire indebtedness then accrued interest, but payments were only to be made as development of parcels of the project were completed and sold. In re Pine Mountain, 80 B.R. at 174.

2. Though found unconfirmable on other grounds (sufficient to pay the present value of the original principal but excluded an additional $3 million in penalties, fees and accrued interests claimed by the creditor), the court addressed each of the negative amortization factors to facilitate an amendment to the plan. In re Aspen Village at Lost Mountain Assisted Living, LLC, 609 B.R. 555, 574 (Bankr. N.D. Ga. November 26, 2019).

3. “[O]ther courts have generally approved 1% to 3%, but respondent claims a risk adjustment in this range is inadequate. The issue need not be resolved here; it is sufficient to note that courts must choose a rate high enough to compensate a creditor for its risk but not so high as to doom the bankruptcy plan. Till v. SCS Credit Corp., 541 U.S. 465, 468, 124 S. Ct. 1951, 1955 (2004).

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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