The Bankruptcy Court for the District of Puerto Rico (the “Court”) recently denied a creditor’s motion requesting the redesignation of a Subchapter V filing to a single asset real estate case and upheld the creditor’s 1111(b)(2) election. The Court found that operation of a motel constituted an active business not merely incidental to renting or managing real estate. The Court further found that the secured creditor’s interest in the property of $550,000 interest was not inconsequential and allowed creditor’s election to be treated as fully-secured, observing that Congress did not modify section 1111(b)’s application in Subchapter V. In re Caribbean Motel Corp. (Bankr. D. Puerto Rico, Jan. 5, 2022)2022 Bankr. LEXIS 25.
Debtor Caribbean Motel Corporation (the “Debtor”) owns real property in Cabo Rojo, Puerto Rico and operates a 40-room motel, the Motel Caribbean, at that location. Twenty-two rooms are operational. The Debtor rents rooms both by the day and by the hour – with an 8-hour minimum rental. The Debtor has a staff of 9 to 11 employees. The duties of the employees include assistance with check-in, filling food orders, accepting payment, maintenance, cleaning the rooms and replenishing linens after each visit. The motel does not have a pool, common areas, a business center, or a liquor license; does not operate a bar; does not provide any dry-cleaning or Wi-Fi service to guests; and does not operate a convenience store or gift shop. The Debtor does generate revenue, beyond room rental, from the sale of aspirin, prophylactics, and food.
The Debtor filed a voluntary petition for relief under Subchapter V of chapter 11 on June 15, 2021. OSP Consortium LLC (“OSP”) OSP filed a secured claim in the amount of $3,122,439.16. The Debtor listed in its amended Schedule A/B the Motel’s market value at $550,000.
This decision concerns three motions before the Court: (1) OSP’s motion to prohibit use of cash collateral and for entry of order authorizing OSP to seek and collect proceeds, which is not addressed in this report; (2) OSP’s motion for an order redesignating the Debtor’s filing as a single asset real estate case; and (3) OSP’s motion electing treatment of its claim as fully secured under section 1111(b)(2) of the Code. The Court denied the motions for an order for redesignation and to prohibit the use of cash collateral but allowed OSP’s 1111(b)(2) election.
The Court starts by citing 11 U.S.C. § 1182(1)(A) for the definition of a “debtor” for Subchapter V, noting that it excludes “a person whose primary activity is the business of owning single asset real estate ….” 11 U.S.C. § 101(51B), in turn, sets forth what single asset real estate (“SARE”) means. The Court noted the three “prongs” that must be proven for a case to be a SARE: “the real property must constitute a single property or project, other than residential real property with fewer than four residential units;” “the real property must generate substantially all of the debtor’s gross income;” and the “debtor must not be involved in any substantial business other than the operation of its real property and incidental activities.” The Court allocated the burden of proving these elements to OSP, citing In re 218 Jackson LLC, 2021 Bankr. LEXIS 2284, at *4 (Bankr. M.D. Fla. June 2, 2021).
OSP argued that substantially all of Debtor’s income was derived from operating a motel that rented rooms by the hour and contended that substantially all its revenue came from renting real property. OSP claimed that without the amenities of a higher-end hotel such as a complimentary continental breakfast, common areas, the rental of conference rooms for business meetings, internet service, a bar or restaurant, or concierge service, Debtor’s business activities were merely incidental to owning and renting the real estate, much like the operation of an apartment or office building. OSP cited as support for its argument Centofante v. CBJ Dev. (In re CBJ Dev.), 202 B.R. 467, 471 (9th Cir. BAP 1996), claiming debtor’s business to be more akin to the rental of apartments. CBJ Development is, of course, most often cited for the opposite proposition: hotel operations typically exclude them from the SARE designation.
Arguing against redesignation, the Debtor contended that that the services its employees performed to operate the motel were not intrinsic to merely owning or managing real estate and it relied, in part, on the substantial income generated from goods sold.
The Court found Debtor’s citation to In re ENKOGS1, LLC, 626 B.R. 860 (Bankr. M.D. Fla. 2021), a case concerning a Subchapter V debtor that owned and operated a 15-employee hotel, highly persuasive.
ENKOGS1 can be found here.
It cited ENKOGS1 for the proposition that “Sections 101(51B) and (51D)(A) of the Bankruptcy Code do not require a debtor to earn extra income from supplying extra services but instead require the debtor to do something other than merely rent hotel rooms.… With a hotel, it is easy to meet this test because a hotel debtor does more than just rent hotel rooms on a nightly basis.” Id. at 685.
The 24-hour check-in, filling food orders, accepting payment, maintenance, cleaning the rooms and replenishing linens services performed by the Debtor’s employees matched closely those of the debtor in ENKOGS1. The Court emphasized that a motel which rents its rooms by the hour, which implies a quick turnover of guests, has a need to constantly clean and disinfect the rooms, even more so nowadays due to Covid-19 safety protocols. The Court ultimately concluded that “…[e]ven if these services are included as part of the room fee paid by the guests, the motel is engaged in the operation of an active business.” The generation of 5-7% of revenue from the sale of goods was cited as a further but not the central factor in deciding that the Caribbean Motel was not SARE.
The Court then considered the Debtor’s challenge to OSP’s election to have its claim treated as fully secured. The Debtor argued, without authority, that OSP’s secured interest of 15% of the debt owed was inconsequential and asked the Court to consider other factors such as the state of property, the effect of the pandemic on the Debtor’s income, and the fact that the election makes it more difficult for the Debtor to reorganize under subchapter V because the property’s value could not sustain that level of secured debt. The Court, noting that the motel collateral is the only real estate asset of the estate and is essential to the Debtor’s reorganization under the proposed plan in all its proposed scenarios, declined to find a 15% interest inconsequential. The Court followed the reasoning of the Southern District of New York court in VP Williams Trans, LLC, 2020 Bankr. LEXIS 2587, at *16 (Bankr. S.D.N.Y. 2020)(15.6% value of the total secured claim was not inconsequential) and quoted it in offering this observation: “[i]f section 1111(b) was supposed to give way in a subchapter V case, or to have a different application in such a case, that was for Congress to say, and Congress did not do so.” Id. at *15.
Substantial case law supports the conclusion that hotel filings are rarely treated as single asset real estate cases. Even a debtor that operates a motel that rents rooms by the hour and generates 5-7% of its total revenue from the sale of aspirin, prophylactics and hamburgers, so long as it operates as a motel, can avoid treatment as a single asset real estate debtor. While it is unsurprising for a court to find that the Small Business Reorganization Act does not modify section 1111(b), it is helpful for debtors and secured creditors to see that one of the few points of creditor leverage in Subchapter V cases remains intact.
This review was written by Robert G. Harris, a partner in Binder & Malter, LLP and a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.