UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

For the quarterly period ended June 30, 2014

OR

Commission file number: 001-12073

 

W2007 GRACE ACQUISITION I, INC.

(Exact name of registrant as specified in its charter)

 

 

(972) 368-2200

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  o    Yes  þ    No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  o    Yes  þ    No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company (as defined in Rule 12b-2 of the Exchange Act):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   o    Yes  þ    No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

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TABLE OF CONTENTS

 

 

 

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EXPLANATORY NOTE ABOUT THIS DOCUMENT AND THE COMPANY; SUBSEQUENT EVENTS

This Quarterly Report on Form 10-Q (this 10-Q) is being filed in 2015 relating to the fiscal quarter ended June 30, 2014. Between June 30, 2014 and the date of this filing, there were very significant changes regarding W2007 Grace Acquisition I, Inc. (the Company), including (i) the completion of a transaction involving the sale of our entire hotel portfolio except for 10 hotels owned by Senior Mezz (defined hereinafter) and (ii) the entry into a non-binding memorandum of understanding and stipulation of settlement with respect to certain litigation involving the preferred stock of the Company as described in “Part II – Other Information, Item 1. Legal Proceedings.”

These changes have had a substantial impact on the Company.  As a result, the information presented in this 10-Q should be reviewed in light of the information presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014 filed with the Securities and Exchange Commission (the SEC) on May 1, 2015, and all other filings made by the Company with the SEC in 2015 through date of filing of this 10-Q, including the Current Reports on Form 8-K or Form 8-K/A filed on March 5, 2015, March 19, 2015, March 30, 2015, April 22, 2015, May 1, 2015, May 11, 2015 and May 18, 2015.  This 10-Q should be viewed as an historical account and should not be viewed as indicative, in any way, of any future results.

 

 

 

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Part 1 – Financial Information

Item 1. Financial Statements

W2007 GRACE ACQUISITION I, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except for share amount)

 

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

 

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W2007 GRACE ACQUISITION I, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(in thousands, except for share amount)

 

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

 

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W2007 GRACE ACQUISITION I, INC.

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN EQUITY

(in thousands, except for share amount)

 

 

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

 

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W2007 GRACE ACQUISITION I, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands, except for share amount)

 

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

 

 

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W2007 GRACE ACQUISITION I, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

1.  ORGANIZATION:

W2007 Grace I, LLC (Grace I), a Tennessee limited liability company, was formed on June 20, 2007.  Grace I is owned by W2007 Finance Sub, LLC, a Delaware limited liability company, and Whitehall Parallel Global Real Estate Limited Partnership 2007, a Delaware limited partnership (collectively, Whitehall).  WNT Holdings, LLC (WNT), a Delaware limited liability company, was organized effective July 10, 2012.  WNT is also owned by Whitehall.  The general partner of Whitehall Parallel Global Real Estate Limited Partnership 2007 and the partnerships owning W2007 Finance Sub, LLC is a wholly-owned subsidiary of The Goldman Sachs Group, Inc. (GS Group) and, therefore, is an affiliate of GS Group.  GS Group in turn also controls Goldman, Sachs & Co. (GS) and Goldman Sachs Mortgage Company (GSMC).  Consequently, GS and GSMC are also affiliates of Whitehall.

Grace I, W2007 Grace Acquisition I, Inc. (Grace Acquisition I), Equity Inns, Inc. (Equity Inns), Grace II, L.P. (Grace II) and Equity Inns Partnership, L.P. (Equity LP) entered into an agreement and plan of merger (Merger Agreement) whereby Equity Inns would merge with and into Grace Acquisition I and Grace II would merge with and into Equity LP (Merger).  The Merger was completed on October 25, 2007.  Prior to the Merger, Grace Acquisition I had no operations other than its activities in anticipation of the Merger.

Prior to the Merger, Equity Inns was a public hotel company and had elected to be taxed as a real estate investment trust (REIT) for federal income tax purposes.  Equity Inns, through its wholly owned subsidiary, Equity Inns Trust (Equity Trust), was the sole general partner of Equity LP.  Equity Inns, Equity Trust and Equity LP (and its wholly owned subsidiaries) are hereinafter collectively referred to as Equity.  Prior to the Merger, Equity owned 137 limited-service hotels located throughout the United States.

Subsequent to the Merger, Grace II changed its name to W2007 Equity Inns Partnership, L.P. (W2007 Equity LP).  As of June 30, 2014, Grace I owned all of the common shares of Grace Acquisition I and Grace Acquisition I owned a 1% general partnership interest in W2007 Equity LP (with Grace I owning a 1% general partnership interest and a 98% limited partnership interest).  Grace Acquisition I and W2007 Equity LP (and its wholly owned subsidiaries) are hereinafter collectively referred to as the Company.

Following the Merger, the Company and Grace I entered into a Keepwell Agreement, effective as of the date of the Merger (the Keepwell Agreement), pursuant to which Grace I agreed to make such cash payments to the Company as are necessary to enable the Company to satisfy its obligations to the holders of the Company’s 8.75% Series B cumulative preferred stock (Series B preferred stock) and 9.00% Series C cumulative preferred stock (Series C preferred stock) in accordance with the Company’s charter when the Company determines, or is legally compelled, to satisfy such obligations.  To date, no payments have been made and none are due under the Keepwell Agreement.  The Keepwell Agreement may be terminated by Grace I at any time upon 30 days’ prior written notice.  There are no third-party beneficiaries of the Keepwell Agreement.

On March 31, 2008, Grace Acquisition I, pursuant to Section 856(g)(2) of the Internal Revenue Code of 1986, as amended (the Code), revoked its election under Section 856(c)(1) of the Code to be a REIT for the taxable year ending on December 31, 2008.   Consequently, subsequent to December 31, 2007, Grace Acquisition I became subject to income taxes at statutory corporate rates.

The Company leased substantially all of its hotels to subsidiaries (TRS Lessees) of W2007 Equity Inns TRS Holdings, Inc. (TRS Holdings), a taxable REIT subsidiary, pursuant to certain percentage lease agreements (the TRS Leases).  The TRS Leases were necessary for the Company to comply with certain REIT provisions of the Code.  As discussed above, the Company revoked its election to be taxed as a REIT.  As of December 31, 2012, all of the TRS Leases had been terminated.

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In July 2012, WNT acquired, for $175,000,000, an option (Purchase Option) to purchase a 97% equity interest in W2007 Equity Inns Senior Mezz, LLC (Senior Mezz), a wholly owned subsidiary of the Company, from an affiliate of GSMC.  The Purchase Option was not effective or exercisable until certain notes payable of Senior Mezz and its subsidiaries had been paid in full.  On April 11, 2014, Senior Mezz and its subsidiaries refinanced the GE Mortgage Note Payable (see Note 3) and WNT exercised the Purchase Option.  As a result of the loss of control of Senior Mezz, effective April 11, 2014, the Company deconsolidated Senior Mezz and began recognizing its 3% interest in the entity using the equity method.  This is reflected in the accompanying condensed consolidated balance sheets under the caption investment in Senior Mezz.  The net assets transferred to WNT and the net decrease in equity are as follows (in thousands):

 

 

A receivable from the Company to Senior Mezz of approximately $5,063,000 is included in accounts receivable above and, at June 30, 2014, the related payable from the Company to Senior Mezz was included in accounts payable and accrued liabilities in the accompanying condensed consolidated balance sheets.

As of June 30, 2014, the Company owned 20 hotels located in 13 states, which operate under franchise agreements with Marriott and Hilton.  As of June 30, 2014, the managers of these hotels were as follows:

 

 

In addition, as of June 30, 2014, the Company owned a 3% interest in Senior Mezz which indirectly owned 106 hotels located in 34 states, which operate under franchise agreements with Marriott, Hilton, Hyatt and Intercontinental.  As of June 30, 2014, the managers of these hotels were as follows:

 

 

 

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2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Basis of presentation

The unaudited condensed consolidated financial statements include the accounts of Grace Acquisition I, W2007 Equity LP and subsidiaries of W2007 Equity LP.  Because Grace Acquisition I is the general partner of W2007 Equity LP and has control over its management and major operating decisions, the accounts of W2007 Equity LP are consolidated in the condensed consolidated financial statements of Grace Acquisition I.  All significant intercompany balances and transactions have been eliminated.

The Company prepares its unaudited condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States for interim financial information.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.  In the opinion of the Company, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.

This Quarterly Report on Form 10-Q (this 10-Q) is being filed in 2015 relating to the fiscal quarter ended June 30, 2014. Between June 30, 2014 and the date of this filing, there were very significant changes regarding the Company, including (i) the completion of a transaction involving the sale of our entire hotel portfolio except for 10 hotels owned by Senior Mezz and (ii) the entry into a non-binding memorandum of understanding and stipulation of settlement with respect to certain litigation involving the preferred stock of the Company (see Notes 8 and 9).  These financial statements and related notes should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2014 filed with the Securities and Exchange Commission (the SEC) on May 1, 2015 and all other filings made by the Company with the SEC in 2015 through date of filing of this Form 10-Q.

Some of the Company’s hotel operations have historically been seasonal. This seasonality pattern causes fluctuations in the operating results. Consequently, operating results for the three and six months ended June 30, 2014 are not indicative of the results for the year ending December 31, 2014.

Use of estimates

The Company prepares its financial statements in conformity with accounting principles generally accepted in the United States.  This requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

Investments in real estate

Real estate investments are carried at depreciated cost net of reduction for impairment.  Expenditures for ordinary repairs and maintenance are expensed as incurred.  Significant renovations and improvements, which improve or extend the useful life of the assets, are capitalized.  Full stock replacements of china, glass, silver, uniforms and linen are capitalized and incidental purchases are expensed as incurred.

Investments in real estate consist of the following (in thousands):

 

 

Depreciation is calculated using the straight-line method over the estimated useful lives of the respective assets as follows: buildings and improvements over 7.5 to 39 years; land improvements over 15 years; and furniture, fixtures and equipment, including china, glass, silver, uniforms and linen, over 3 to 7 years.  Below market ground leases were amortized over the remaining term of the related lease agreements, which ranged from 16 to 52 years as of December 31, 2013.  As of June 30, 2014, none of the Company’s consolidated hotels were subject to a ground lease.

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Assets are classified as held for sale if a disposal plan is in place, actions to achieve the sale have been initiated, a sale is probable and it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.  Sales of the Company’s investments in real estate take a significant amount of time to consummate and many changes in the terms and timing are typical in the process. Accordingly, management does not classify assets as held for sale until a contract is pending, closing is scheduled and the probability of significant changes in terms or timing is insignificant.

On May 23, 2014, the subsidiaries of Grace I and WNT entered into an agreement (the ARC Agreement) to sell their 126 hotels for a combined purchase price of $1.925 billion, subject to certain adjustments, to affiliates of American Realty Capital Hospitality Trust, Inc. (ARC Hospitality).  As of June 30, 2014, the closing of the sale was expected in the fourth quarter of 2014 and there could be no assurance that the transaction would close as scheduled, or at all.  Therefore, as of June 30, 2014 the real estate investments were not classified as held for sale as of June 30, 2014 or December 31, 2013.

Investment in Senior Mezz

The Company’s 3% investment in Senior Mezz is accounted for under the equity method of accounting.  The Company initially recognized it pro rata interest in the net assets of Senior Mezz and has also recognized its pro rata interest in Senior Mezz’s net income or loss. Management reviews the investment in Senior Mezz for impairment each reporting period. The investment is impaired when its estimated fair value is less than the carrying amount of the investment. Any impairment is recorded in equity in income (loss) from Senior Mezz.  No such impairment was recorded for the three months ended June 30, 2014.

Fair value measurements

Fair value measurements are market-based measurements, not entity-specific measurements.  Fair value measurement assumptions are classified under a hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and management’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).

In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety.  Management’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability.

Fair value measurements of financial and nonfinancial assets and liabilities are based on (1) the assumptions that market participants would use in pricing the asset or liability, if available, or (2) management’s estimates of market participant assumptions.

Certain assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments only in certain circumstances (for example, when recording impairment on long-lived assets).  The following table presents nonfinancial assets measured at fair value on a nonrecurring basis as of June 30, 2014 and 2013, and related impairment charges recorded (in thousands):

 

 

Management reviews its investments for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The impairment write-down recorded in the three and six months ended June 30, 2013 was the result of unfavorable economic conditions within the market in which the impaired hotel is located and hotel specific factors that were expected to negatively impact the future operations of the hotel.  The assumptions used both in estimating fair value through a discounted cash flow model and the undiscounted cash flow analysis are inherently judgmental and reflect current and projected trends in revenue per available room, operating expenses, capitalization rates, discount rates, and the estimated holding periods for the applicable hotels.  If an indicator of potential impairment exists, the hotel is tested for impairment for financial accounting purposes by comparing its carrying value to the estimated future undiscounted cash flows.  The amount of the impairment is calculated as the amount by which the carrying value of the hotel exceeds its fair value.

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The impairment write-down recorded in the three and six months ended June 30, 2014 was determined as the excess of the carrying value of the two impaired hotels exceeding the sum of (i) the discounted cash flows expected from the operation of the hotels through the date of sale and (ii) the discounted allocated net sale prices of the hotels, which are the Company’s best estimate of the cash flows related to the hotels.

The following table presents quantitative information about significant unobservable inputs used in determining the fair value of the above noted nonfinancial assets ($ in thousands):

2014

 

 

2013

 

 

Non-controlling interest

Non-controlling interest represents Grace I’s proportionate share (99%) of the equity of W2007 Equity LP as provided for in its partnership agreement.  As of June 30, 2014, the majority of the Company’s activities were conducted by W2007 Equity LP and its subsidiaries, and thus are reflected in non-controlling interest. However, the litigation accrual (see Note 8) has been deemed to relate to Grace Acquisition I and therefore, not reflected in non-controlling interest.

Revenue recognition

Revenues include room, food and beverage, and other hotel revenues such as guest telephone charges, equipment rentals, vending income, in-room movie sales, parking and business centers.  Revenues from the hotels are recognized when the services are delivered and are recorded net of any sales or occupancy taxes collected from guests.

Non-departmental expenses

Non-departmental expenses include hotel-level general and administrative expenses, advertising and marketing costs, repairs and maintenance, frequent guest programs, franchise fees and utility costs.  Non-departmental expenses are expensed as incurred.

Income taxes

Grace Acquisition I and W2007 TRS Holdings, Inc. (TRS Holdings; collectively with Grace Acquisition I, the Taxable Entities) are subject to federal and state income taxes. The Taxable Entities account for income taxes using the asset and liability method under which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases.

The Taxable Entities have recorded a valuation allowance equal to 100% of the net deferred tax assets due to the uncertainty of realizing the benefit of their accumulated net operating losses.  For the three and six months ended June 30, 2014 and 2013, the

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Taxable Entities’ effective tax rates were zero due to the uncertainty of realizing these net deferred tax assets.  As of June 30, 2014, the net operating losses begin to expire in 2022.

Segment reporting

As of June 30, 2014, the Company considered each of its hotels to be an operating segment, none of which meets the threshold for a reportable segment as prescribed by the authoritative accounting guidance.  The Company allocates resources and assesses operating performance based on each individual hotel.  Additionally, the Company aggregates these individually immaterial operating segments into one segment using the criteria established by the authoritative accounting guidance, including the similarities of its product offering, types of customers and method of providing service.

Reclassifications

Certain amounts in the condensed consolidated financial statements for the three and six months ended June 30, 2013 have been reclassified for discontinued operations. These reclassifications have no effect on the results of operations previously reported.

Recently issued accounting standards

In April 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2014-08 Presentation of Financial Statements and Property, Plant and Equipment: Reporting Discontinued Operations and Disclosure of Disposals of Components of an Entity (ASU 2014-08).  Under the new guidance, only a disposal of a component that represents a major strategic shift of an organization qualifies for discontinued operations reporting. The guidance also requires expanded disclosures about discontinued operations and new disclosures in regards to individually significant disposals that do not qualify for discontinued operations reporting. This guidance is effective for the first annual period beginning on or after December 15, 2014. Early adoption is permitted, but only for disposals that have not been reported in previously-issued financial statements. The Company elected to early adopt this guidance for the year ended December 31, 2014.  During the year ended December 31, 2014, the Company did not have any disposals that represented a strategic shift nor were there any property sales in the current year that would have met the definition of discontinued operations prior to the adoption of the new standard.

In May 2014, the FASB issued ASU 2014-09 Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. ASU 2014-09 will replace most existing revenue recognition guidance in GAAP when it becomes effective. The standard permits the use of either the retrospective or cumulative effect transition method. The new standard is effective for the Company on January 1, 2018, but can be early adopted on January 1, 2017.  The Company is evaluating the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting. The Company will make additional disclosures upon adoption.

In August 2014, the FASB issued ASU 2014-15 Presentation of Financial Statements – Going Concern. The new guidance establishes management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern or to provide related footnote disclosures. The amendments require management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles in U.S. auditing standards. Specifically, ASU 2014-15 provides a definition of the term substantial doubt and requires an assessment for a period of one year after the date that the financial statements are issued or available to be issued. It also requires certain disclosures when substantial doubt is alleviated as a result of consideration of management’s plans and requires an express statement and other disclosures when substantial doubt is not alleviated. The guidance is effective for the annual periods beginning on or after December 15, 2016; early adoption is permitted. The Company has not adopted ASU 2014-15, however, the Company does not anticipate that the adoption of this standard will have a material impact on the financial position, results of operations and related disclosures.

In February 2015, the FASB issued ASU No. 2015-02, Amendments to the Consolidation Analysis, which requires amendments to both the variable interest entity and voting models. The amendments (i) rescind the indefinite deferral of certain aspects of accounting standards relating to consolidations and provide a permanent scope exception for registered money market funds and similar unregistered money market funds, (ii) modify the identification of variable interest (fees paid to a decision maker or service provider), the VIE characteristics for a limited partnership or similar entity and primary beneficiary determination under the VIE model, and (iii) eliminate the presumption within the current voting model that a general partner controls a limited partnership or similar entity. The new guidance is effective for annual reporting periods, and interim periods within those annual periods, beginning after December 15, 2015 with early adoption permitted. The amendments may be applied using either a modified retrospective or full retrospective approach. The Company is currently evaluating the effect the guidance will have on its consolidated financial statements.

On April 7, 2015, the FASB issued ASU No. 2015-03, Simplifying the Presentation of Debt Issuance Costs, which requires debt issuance costs to be presented in the balance sheet as a direct deduction from the carrying value of the debt liability. This standard is effective for fiscal years beginning after December 15, 2015 with early adoption permitted and will be applied on a retrospective basis.

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The new standard will be effective for the Company on January 1, 2016 and will not have a material impact on the Company's financial position, results of operations or cash flows.

 

 

3.  NOTES PAYABLE:

The Company had the following notes payable outstanding (in thousands):

 

 

On April 11, 2014, subsidiaries of Senior Mezz refinanced the GE Mortgage with new mortgage and mezzanine loans in an aggregate amount of $976 million originated by German American Capital Corporation (the GACC Loan).  In connection with the refinancing, the “cash trap” under the GE Mortgage and the cash flow pledge of the 20 hotels which were not collateral on the GE Mortgage ceased.  As a result of WNT’s exercise of the Purchase Option and the deconsolidation of Senior Mezz and its subsidiaries, the GACC Loan is not included in the Company’s condensed consolidated financial statements as of June 30, 2014.

The Company recognized interest on the GE Mortgage under the effective interest method.  In conjunction with the repayment of the GE Mortgage on April 11, 2014, the Company wrote-off the interest accrued under the effective interest method, but which was not due or payable to the lender. This write-off resulted in a gain of $13,199,329, which is included in gain on extinguishment of debt in the accompanying combined consolidated statements of operations and comprehensive loss.

During the three and six months ended June 30, 2014, GSMC earned interest of $50,000 and $552,000, respectively, under the GE Mortgage.  No interest was earned by GSMC under the GE Mortgage in the three or six months ended June 30, 2013.

During the three and six months ended June 30, 2014, the Company paid approximately $21,049,000 of deferred financing fees, of which a fee of approximately $3,904,000 was paid to GSMC in connection with the origination of the GACC Loan.  These deferred financing fees were transferred to WNT in connection with its exercise of the Purchase Option.

Also in connection with the refinancing of the GE Mortgage, the restriction on the payment of asset management fees terminated.  In April 2014, the Company paid $4,650,000 in accrued asset management fees to Goldman Sachs Realty Management, L.P. (RMD) and RMD forgave $6,708,000 in accrued asset management fees.  This forgiveness was recorded as an increase in equity as the indebtedness was forgiven by RMD, an affiliate of the Company.

 

 

4.  PREFERRED STOCK:

In May 2008, Grace Acquisition I ceased dividend payments to its preferred shareholders due to the “cash trap” under the GE Mortgage.  The GACC Loan does not currently restrict the use of the Senior Mezz subsidiaries’ cash to the same extent that the GE Mortgage did (but it may in the future) and the pledge of the cash flow from the Company’s 20 hotels was terminated.  Grace Acquisition I’s board of directors did not declare a dividend for the 2014 second quarter due primarily to its current cash position, anticipated capital improvement projects at the Company’s hotels and the debt maturing in March 2015.  As of June 30, 2014, Grace Acquisition I had $79,855,000 in accumulated, undeclared preferred stock dividends.  Since at least six quarters of dividends on the Series B and C preferred stock are outstanding, the preferred shareholders are entitled to elect two members to the board of directors of Grace Acquisition I. Grace Acquisition I has attempted to hold three meetings to elect the new board members; however, at each meeting a quorum was not achieved and, therefore, an election did not occur.

 

 

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5.  FAIR VALUE OF FINANCIAL INSTRUMENTS:

As cash and cash equivalents and restricted cash have maturities of less than three months, the carrying values of cash and cash equivalents and restricted cash approximate fair value (Level 1 of the fair value hierarchy).   The carrying values of accounts receivable, accounts payable and accrued liabilities and accrued interest payable approximate fair value due to the short maturity of these instruments (Level 2 of the fair value hierarchy).

The fair value of the Company’s notes payable is approximately $204,820,000 and $1,200,000,000 as of June 30, 2014 and December 31, 2013, respectively. The fair value of the Company’s notes payable was estimated based on a discounted cash flow analysis using a discount rate representing the Company’s estimate of the rate that would be used by market participants (Level 2 of the fair value hierarchy).  Changes in assumptions or estimation methodologies may have a material effect on these estimated fair values.

 

 

6.  DISCONTINUED OPERATIONS:

In April and November 2013, the Company sold four of its hotels under individual mortgages.  The operating results of these four hotels have been reported as discontinued operations in the condensed consolidated statements of operations and comprehensive loss.  As the Company has a 3% interest in Senior Mezz and therefore has continuing involvement, the deconsolidation of Senior Mezz on April 11, 2014 is not reported as discontinued operations for the three and six months ended June 30, 2014 and 2013.

The following table summarizes the operating results of the discontinued operations (in thousands) for the three and six months ended June 30, 2013:

 

 

 

7.  PROPERTY TAX, GROUND LEASE, INSURANCE AND PROPERTY MANAGEMENT FEES:

Property tax, ground lease, insurance and property management fees from continuing operations consisted of the following (in thousands):

 

 

 

8.  COMMITMENTS AND CONTINGENCIES:

The Company is involved in various legal proceedings and disputes arising in the ordinary course of business.  The Company does not believe that the disposition of such legal proceedings and disputes will have a material adverse effect on the financial position, continuing operations or cash flows of the Company, other than as disclosed herein.

In September 2013, a putative class action lawsuit (the Johnson Lawsuit) was filed in the Chancery Court of Shelby County, Tennessee (the Chancery Court) by several current and former shareholders of the Series B and C preferred shares of Grace Acquisition I. The complaint, which alleges, among other things, breach of contract and breach of fiduciary duty that resulted in the loss of Series B and Series C preferred share value, names Grace Acquisition I, members of Grace Acquisition I’s board of directors, PFD Holdings, LLC (PFD Holdings), GS Group, Whitehall, Goldman Sachs Realty Management, L.P. and Grace I as defendants.

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Shortly after the filing of the Johnson Lawsuit, the defendants removed the case to the United States District Court for the Western District of Tennessee (the Federal Court). In November 2013, the plaintiffs filed a motion to remand the case back to the Chancery Court, which the defendants opposed. On July 28, 2014, the Federal Court denied the plaintiffs’ motion to remand. In addition, in January 2014, the defendants also filed a motion to dismiss the Johnson Lawsuit and the motion was fully briefed on April 24, 2104. In October 2013, a similar lawsuit was filed by another plaintiff in the same Chancery Court (the Dent Lawsuit), alleging similar breaches against several of the same defendants named in the Johnson lawsuit, in addition to a former member of the Company’s board of directors. In January 2014, the plaintiffs and defendants in the Dent Lawsuit agreed to stay that case in favor of proceedings in the aforementioned Johnson Lawsuit. In August 2014, the Company and the other defendants entered into a non-binding memorandum of understanding with respect to a settlement of the claims raised in the Johnson Lawsuit. On August 22, 2014, the parties notified the Federal Court of the proposed settlement, and the Federal Court agreed that the parties would no longer be subject to pending deadlines in the current scheduling order. On September 2, 2014, in light of the proposed settlement, defendants filed a motion to withdraw their motion to dismiss without prejudice to renew that motion later. The Federal Court granted the motion. The parties submitted the proposed settlement stipulation and related papers to the Federal Court for approval on October 9, 2014, and filed additional papers in support of settlement on December 3, 2014 and March 20, 2015. The stipulation was preliminarily approved by the Federal Court on April 30, 2015 and remains subject to final approval by the Federal Court. The stipulation of settlement generally provides for the following: (1) the effectuation of a merger that will result in exchange of $26.00 in cash for each share of Series B and C preferred stock outstanding; (2) the establishment of a $6 million fund to be distributed pursuant to a plan of allocation to sellers of the Series B and C preferred stock; and (3) an award of $4 million in counsel fees, subject to approval by the Federal Court. Therefore, during the three months ended June 30, 2014, the Company accrued $24.25 million related to the agreement which is included in accounts payable and accrued liabilities in the accompanying condensed consolidated balance sheets and in contingent loss on litigation settlement in the condensed consolidated statements of operations and comprehensive loss. The Company anticipates funding the settlement with cash on hand or, if necessary, funding from Whitehall. The Company expects that the settlement of the Johnson Lawsuit, if approved, will result in the release of those claims asserted in the Dent Lawsuit. Ongoing defense costs will be expensed as incurred.

As of June 30, 2014, all of the wholly owned hotels and hotels owned through the Company’s 3% interest in Senior Mezz are operated under franchise agreements and are licensed as Hampton Inn (43 hotels), Residence Inn (25), Courtyard (17), Hyatt Place (15), Homewood Suites (10), SpringHill Suites (7), Hilton Garden Inn (3), Fairfield Inn & Suites (2), Holiday Inn (1), Embassy Suites (1), Holiday Inn Express (1) and TownePlace Suites (1).

The franchise agreements generally require the payment of fees based on a percentage of hotel room revenue.  Under the franchise agreements, the Company is periodically required to make capital improvements to the hotels in order for them to meet the franchisors’ brand standards.  Additionally, under certain loan covenants, the Company is obligated to fund 4% to 5% of total hotel revenues to a separate room renovation account for the ongoing replacement or refurbishment of furniture, fixtures and equipment at the hotels.

As of June 30, 2014, Whitehall had guaranteed up to $6,495,000 of the Company’s obligations under the franchise agreements with certain franchisors.

The Company maintains property insurance coverage for catastrophic losses such as hurricanes, earthquakes or floods.  For such catastrophic losses, the Company may have higher deductibles or increased self-insurance risk if certain criteria are met, ultimately increasing the potential risk of loss.

In September 2007, a putative class action lawsuit was filed in the Circuit Court of Shelby County, Tennessee (the Circuit Court) on behalf of the former Series B and Series C preferred shareholders of Equity Inns alleging breaches of fiduciary duty against Equity Inns’ former directors. This complaint does not name Equity Inns or any corporate entity as a defendant. In February 2008, the Circuit Court denied the defendants’ motion to dismiss the complaint. In April 2010, the Circuit Court granted the plaintiffs’ motion for class certification, which was ultimately appealed and vacated by the Tennessee Court of Appeals and remanded back to the Circuit Court. During the second quarter of 2012, the plaintiffs filed a second amended complaint and a new motion for class certification. In April 2013, the Circuit Court granted the new motion and certified a class and three subclasses. The defendants appealed the Circuit Court’s ruling, and in May 2014 the Tennessee Court of Appeals vacated the Circuit Court’s order certifying a class and remanded the case to the Circuit Court for further proceedings consistent with its opinion. In January 2015, this action against Equity Inns’ former directors was voluntarily dismissed.

 

 

9.  SUBSEQUENT EVENTS:

The ARC Agreement was subsequently amended and restated on November 11, 2014 to exclude ten hotels from the sale (all ten of which are owned by subsidiaries of WNT), remove several closing contingencies and extend the closing date.  On February 27, 2015, 116 hotel assets, of which 20 were owned by the Company, were sold to affiliates of ARC Hospitality for a combined purchase price of $1.808 billion, of which $347 million related to the Company.

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In the sale, the Company received approximately $22.2 million in cash subject to a post-closing adjustment to reflect actual proration of certain operating items and all of the Company’s remaining notes payable were repaid at closing. The Company’s subsidiaries were issued preferred equity interests with an initial capital balance of approximately $99.8 million in a newly-formed Delaware limited liability company, ARC Hospitality Portfolio II Holdco, LLC, which is the indirect owner of the 20 hotels sold by the Company.  The ARC Agreement provides for the payment of up to $2.9 million to ARC Hospitality if the actual real estate taxes incurred by them exceed certain stipulated amounts over the years ended December 31, 2016, 2017 and 2018.

Also in the sale, Senior Mezz received approximately $106.0 million in cash subject to a post-closing adjustment to reflect actual proration of certain operating items.  Senior Mezz was issued preferred equity interests with an initial capital balance of approximately $347.3 million in a newly-formed Delaware limited liability company, ARC Hospitality Portfolio I Holdco, LLC, which is the indirect owner of the 96 hotels sold by Senior Mezz.

The buyers assumed approximately $903.9 million of existing mezzanine and mortgage indebtedness of Senior Mezz which indebtedness is secured by the 96 hotels sold by Senior Mezz.  Selling costs totaled approximately $46.8 million, of which $18.3 million related to the Company, and the carrying value of the Company’s hotels at the time of the sale was approximately $240.2 million.

W2007 Equity LP, WNT and Whitehall, an affiliate of GS Group, GS and GSMC, engaged GS and Deutsche Bank Securities Inc. (DB) to provide advisory services in connection with a potential sale or other transaction relating to the 126 hotels.  As a result of that engagement, upon consummation of the sale of the portfolio, GS and DB were paid, in the aggregate, an advisory fee of 1.10% of the aggregate consideration paid to the sellers.  GS and DB split the advisory fee 60% and 40%, respectively, resulting in a payment of $12.0 million to GS of which $2.3 million was paid by the Company and is included in selling costs described above.

On March 25, 2015, subsidiaries of Senior Mezz entered into an agreement to sell its remaining 10 hotels for $100 million.  The agreement was terminated by the purchasers on May 6, 2015 in accordance with their rights under the agreement (ARC Hospitality had previously elected to exclude the same hotels from its transaction).  While the subsidiaries of Senior Mezz expect to sell the 10 remaining hotels, there can be no assurance as to whether or when such hotels will be sold, the form of consideration which may be received in respect of such hotels or whether the consideration which may be received in respect of such hotels will be greater or less than the purchase price in the terminated agreement.  Even if a transaction for the sale of the 10 remaining hotels does occur, there can be no assurance as to when a distribution from such sale proceeds will be received by the Company.

In connection with the settlement of the Johnson Lawsuit, on May 10, 2015, Grace Acquisition I entered into an agreement and plan of merger (the Settlement Merger Agreement) with W2007 Grace II, LLC (Parent), W2007 Grace Acquisition II, Inc. (Merger Sub), and, solely for the purposes of certain payment obligations thereunder, PFD Holdings and Whitehall, pursuant to which Grace Acquisition I will be merged with and into Merger Sub, with Merger Sub surviving as a wholly owned subsidiary of Parent (the Settlement Merger).  Completion of the Settlement Merger is subject to numerous conditions including, but not limited to: (i) the approval of the Settlement Merger Agreement by the affirmative vote of a majority of all the votes entitled to be cast by the holders of Grace Acquisition I’s outstanding capital stock; (ii) the approval of the amendment to Grace Acquisition I’s amended and restated charter contemplated in the Settlement Merger Agreement; (iii) holders of no more than 7.5% of the outstanding shares of the preferred stock delivering (and not withdrawing) written notice of their intent to demand payment, if the Settlement Merger is effectuated, pursuant to Section 48-23-202 of the Tennessee Business Corporation Act; and (iv) the final approval and entry of a final and non-appealable order and judgment of a Stipulation and Agreement of Settlement dated October 8, 2014, as supplemented December 4, 2014, by the Federal Court in the Johnson Lawsuit (the Final Approval Condition).  The Settlement Merger may not be completed prior to the satisfaction or, other than with respect to the Final Approval Condition which may not be waived by the Company, waiver of the conditions to closing.

 

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s Discussion and Analysis of Financial Condition and Results of Operations includes a discussion of our unaudited condensed consolidated financial statements for the three and six months ended June 30, 2014.  This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements included in this 10-Q and with our Annual Report on Form 10-K for the year ended December 31, 2014. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.  The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the operating results for the full year.  In this report, we use the terms “the Company,” “we” or “our” to refer to W2007 Grace Acquisition I, Inc. and its subsidiaries, unless the context indicates otherwise.

FORWARD-LOOKING STATEMENTS

Throughout this Form 10-Q, we make forward-looking statements within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are not historical facts, but instead represent only our beliefs regarding future events, many of which, by their nature, are inherently uncertain and outside our control. Such statements are generally accompanied by words such as “may,” “believe,” “estimate,” “project,” “plan,” “intend,” “will,” “anticipate,” “expect” and words of similar import that convey uncertainty as to future events or outcomes. These forward-looking statements include information about possible or assumed future results of our business, financial condition and liquidity, results of operations, plans, and objectives. Statements regarding the following subjects are forward-looking by their nature:

Such statements are based on our beliefs, assumptions, and expectations of our future performance taking into account all information currently known to us and involve a number of risks, uncertainties, estimates and assumptions and are not guarantees of future performance.  Some of these risks and uncertainties are discussed in greater detail in our Annual Report on Form 10-K for the year ended December 31, 2014, including, in particular, the “Risk Factors” included in Part I Item 1A therein. Should one or more of these risks or uncertainties materialize, or should underlying estimates or assumptions prove incorrect, actual results may vary materially from those anticipated, estimated, or projected. You should not place undue reliance on such forward-looking statements.  Except as otherwise required by the federal securities laws, we disclaim any obligation or undertaking to publicly update changes to forward-looking statements, whether as a result of new information, future events, or otherwise.

EXECUTIVE OVERVIEW

As of June 30, 2014, we primarily owned premium-branded, limited-service hotels in the upscale and upper midscale segments of the lodging industry, as these segments were defined by Smith Travel Research (STR), a leading source of lodging industry data.  Limited-service hotels typically generate most of their revenue from room rentals, have limited food and beverage outlets and meeting space and require fewer employees than traditional full-service hotels. We believe premium-branded, limited-service hotels have the potential to generate attractive returns relative to other types of hotels due to their ability to achieve revenue per available room (RevPAR) levels at or close to those achieved by traditional full-service hotels while achieving higher profit margins due to their more efficient operating model and less volatile cash flows.

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In July 2012, WNT acquired, for $175,000,000, an option (Purchase Option) to purchase a 97% equity interest in W2007 Equity Inns Senior Mezz, LLC (Senior Mezz), a wholly owned subsidiary of the Company, from an affiliate of Goldman Sachs Mortgage Company (GSMC).  The Purchase Option was not effective or exercisable until certain notes payable of Senior Mezz and its subsidiaries had been paid in full.  On April 11, 2014, Senior Mezz and its subsidiaries refinanced the GE Mortgage Note Payable (see Note 3, Notes Payable in the Notes to Condensed Consolidated Financial Statements (Unaudited) contained in “Item 1, Condensed Consolidated Financial Statements (Unaudited)”) and WNT exercised the Purchase Option.  As a result of the loss of control of Senior Mezz, effective April 11, 2014, the Company deconsolidated Senior Mezz and began recognizing its 3% interest in the entity using the equity method.  The net assets transferred to WNT and the net decrease in equity are as follows (in thousands):

 

 

As of June 30, 2014, the Company wholly owned 20 hotels located in 13 states, which operated under franchise agreements with Marriott and Hilton.  As of June 30, 2014, the managers of these hotels were as follows:

 

 

In addition, as of June 30, 2014, the Company owned a 3% interest in Senior Mezz which indirectly owned 106 hotels located in 34 states, which operate under franchise agreements with Marriott, Hilton, Hyatt and Intercontinental.  As of June 30, 2014, the managers of these hotels were as follows:

 

 

The diversity of our wholly owned portfolio was such that, as of June 30, 2014, no individual hotel exceeded 10% of the total rooms in the portfolio.  Our brand and segment diversity of the wholly owned hotels that were included in continuing operations as of June 30, 2014 is illustrated by the following table:

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Brand and Segment (as defined by STR) Diversity

 

 

Franchise affiliation

The diversity of the Senior Mezz portfolio was such that, as of June 30, 2014, no individual hotel exceeded 2% of the total rooms in the portfolio.  The brand and segment diversity of the Senior Mezz hotels that were included in continuing operations as of June 30, 2014 is illustrated by the following table:

Brand and Segment (as defined by STR) Diversity

 

 

Franchise affiliation

Our hotel portfolio included upper upscale, upscale and upper midscale hotels.  This array of product offerings coupled with a property mix that was spread between suburban and urban locations helped to insulate us from various economic climates, including a depressed business travel climate.

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We believe the geographic diversity of our hotel portfolio helped to limit our exposure to any one market.  The following table illustrates our geographical presence of our wholly owned hotels that were included in continuing operations by the number of rooms as of June 30, 2014:

Geographical Diversity

 

 

The following table illustrates the geographical presence of the Senior Mezz hotels that were included in continuing operations by the number of rooms as of June 30, 2014:

Geographical Diversity

 

 

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We believe that multiple brands at the upscale and upper midscale levels helped to insulate our asset portfolio against the volatility of individual brand results relative to industry RevPAR performance.  The following tables summarize key performance indicators, by hotel, of the wholly owned hotels and the Senior Mezz hotels that were included in continuing operations for the periods below:

 

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The U.S. lodging industry continued to exhibit positive fundamentals during the first six months of 2014.  While there continued to be concerns about a slow-moving national economy and the potential adverse effect from government sequestration, corporate profits and employment continued to improve in the United States.

The strength in corporate transient, group and leisure travel, specifically in the major urban markets, continued to drive increases in occupancy and average daily rates. New hotel supply remained at historically low levels and was expected to remain low given the lack of available financing for new hotel construction. As of June 30, 2014, we believed that we would see a long and healthy recovery in the lodging industry and believed our properties would have significant opportunities to achieve significant growth in their operating cash flows and long-term economic values.

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RESULTS OF OPERATIONS

The following tables summarize the change in key line items from the Company’s unaudited condensed consolidated statements of operations and comprehensive loss (in thousands):

 

 

Comparison of the three and six months ended June 30, 2014 and 2013

Total hotel revenues

Rooms revenue for the three months ended June 30, 2014 decreased $78.9 million, or 71.0%, to $32.2 million from $111.0 million for the three months ended June 30, 2013.  The decrease in rooms revenue was principally due to the deconsolidation of the 106 Senior Mezz hotels.  Both food and beverage and other revenue, which consisted mainly of guest telephone charges, equipment rentals, vending income, in-room movie sales, parking and business centers, experienced decreases consistent with the decrease in room revenues on a percentage basis.

Rooms revenue for the six months ended June 30, 2014 decreased $72.1 million, or 34.7%, to $135.6 million from $207.6 million for the six months ended June 30, 2013.  The decrease in rooms revenue was principally due to the deconsolidation of the 106 Senior Mezz hotels on April 11, 2014.  Both food and beverage and other revenue, which consists mainly of guest telephone charges, equipment rentals, vending income, in-room movie sales, parking and business centers, experienced decreases consistent with the decrease in room revenues on a percentage basis.

Direct hotel expenses

Direct hotel expenses consisted of direct expenses from departments associated with related revenue streams (departmental expenses) and non-departmental expenses associated with operating the hotels. We experienced decreases of $22.3 million in departmental expenses and $24.8 million in non-departmental expenses during the three months ended June 30, 2014.  The decrease in these expenses was consistent with the decrease in hotel revenues over the same period.  Direct hotel expenses were 53.4% and 56.4% of total hotel revenues for three months ended June 30, 2014 and 2013, respectively, and this change was due primarily to the change in the mix of hotel brands that remain after the deconsolidation of the Senior Mezz hotels.

We experienced decreases of $20.9 million in departmental expenses and $22.9 million in non-departmental expenses during the six months ended June 30, 2014.  The decrease in these expenses was consistent with the decrease in hotel revenues over the same period.  Direct hotel expenses were 57.8% and 58.1% of total hotel revenues for six months ended June 30, 2014 and 2013, respectively.

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Property tax, ground lease, insurance and property management fees

Property tax, ground lease, insurance and property management fees decreased $5.7 million for the three months ended June 30, 2014 to $2.2 million, primarily related to the deconsolidation of the 106 Senior Mezz hotels on April 11, 2014 partially offset by higher base management fees and to a lesser extent increased real estate taxes and insurance.

Property tax, ground lease, insurance and property management fees decreased $5.4 million for the six months ended June 30, 2014 to $10.3 million, primarily related to the deconsolidation of the 106 Senior Mezz hotels on April 11, 2014, partially offset by higher base management fees and to a lesser extent increased real estate taxes and insurance.

Corporate overhead

Corporate overhead expenses increased $0.2 million to $1.5 million for the three months ended June 30, 2014 compared to $1.3 million for the three months ended June 30, 2013.  This increase was primarily attributable to an increase in legal, tax and audit fees partially offset by decreases in insurance expense, deductibles on certain insurance claims and franchise tax expense.

Corporate overhead expenses decreased $0.3 million to $2.7 million for the six months ended June 30, 2014 compared to $3.0 million for the six months ended June 30, 2013.  This decrease was primarily attributable to decreases in insurance expense, environmental expenses, deductibles on certain insurance claims and franchise tax expense partially offset by increases in legal, tax and audit fees.

Asset management fees

Asset management fees decreased $1.3 million to $0.5 million for the three months ended June 30, 2014 compared to $1.8 million for the three months ended June 30, 2013.  This decrease was due to the deconsolidation of the 106 Senior Mezz hotels on April 11, 2014 and the resultant decrease in asset management fees related to our hotels.

Asset management fees decreased $1.1 million to $2.4 million for the six months ended June 30, 2014 compared to $3.5 million for the six months ended June 30, 2013.  This decrease was due to the deconsolidation of the 106 Senior Mezz hotels on April 11, 2014 and the resultant decrease in asset management fees related to our hotels.

Depreciation and amortization

Depreciation and amortization decreased $15.3 million to $5.5 million for the three months ended June 30, 2014 compared to $20.8 million for the three months ended June 30, 2013.  This decrease was due to the deconsolidation of the 106 Senior Mezz hotels on April 11, 2014 and the resultant decrease in depreciation on our hotels.

Depreciation and amortization decreased $15.0 million to $26.4 million for the six months ended June 30, 2014 compared to $41.4 million for the six months ended June 30, 2013.  This decrease was due to the deconsolidation of the 106 Senior Mezz hotels on April 11, 2014 and the resultant decrease in depreciation on our hotels.

Equity in loss from Senior Mezz

For the three and six months ended June 30, 2014, equity in loss from Senior Mezz was $1.2 million and related to our 3% equity interest in Senior Mezz.

Interest expense

Interest expense decreased $15.3 million to $5.7 million for the three months ended June 30, 2014 compared to $20.9 million for the three months ended June 30, 2013.  The decrease was primarily due to the payoff of the GE Mortgage on April 11, 2014 and normal principal amortization on our other mortgages.

Interest expense decreased $16.3 million to $25.4 million for the six months ended June 30, 2014 compared to $41.7 million for the six months ended June 30, 2013.  The decrease was primarily due to the payoff of the GE Mortgage on April 11, 2014 and normal principal amortization on our other mortgages.

Contingent loss on litigation settlement

As discussed more fully in Note 8, Commitments and Contingencies, in the Notes to Condensed Consolidated Financial Statements (Unaudited) contained in “Item 1. Condensed Consolidated Financial Statements (Unaudited),” in August 2014, the Company and certain other defendants entered into a non-binding memorandum of understanding with respect to a settlement of the claims raised in the Johnson Lawsuit.  The agreement generally provides for the following: (1) the effectuation of a merger that will result in exchange

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of $26.00 in cash for each share of Series B and C preferred stock outstanding; (2) the establishment of a $6 million fund to be distributed pursuant to a plan of allocation to sellers of the Series B and C preferred stock; and (3) the payment of reasonable counsel fees, as awarded by the Court.  Therefore during the three and six months ended June 30, 2014, the Company accrued $24.25 million related to the agreement which is included in contingent loss on litigation settlement.  The Company anticipates funding the settlement with cash on hand or, if necessary, funding from Whitehall.  Ongoing defense costs will be expensed as incurred and could be significant.

Gain on extinguishment of debt

The Company recognized interest on the GE Mortgage under the effective interest method.  In conjunction with the repayment of the GE Mortgage on April 11, 2014, the Company wrote-off the interest accrued under the effective interest method, but which was not due or payable to the lender. This write-off resulted in a gain of $13,199,329 during the three and six months ended June 30, 2014 which is included in gain on extinguishment of debt.

Loss from discontinued operations

For the three months ended June 30, 2013, income from discontinued operations was $0.2 million.  The income from discontinued operations related primarily to the operating income on the hotels included in discontinued operations.

For the six months ended June 30, 2013, income from discontinued operations was $0.1 million.  The loss from discontinued operations related primarily to the operating income on the hotels included in discontinued operations offset by the loss on the sale of the hotels.

Net loss

As a result of the foregoing, we recorded a net loss of $19.6 million for the three months ended June 30, 2014 compared to a net loss of $4.1 million for the three months ended June 30, 2013.  Also as a result of the foregoing, we recorded a net loss of $27.6 million for the six months ended June 30, 2014 compared to a net loss of $17.0 million for the six months ended June 30, 2013.

Net loss attributable to non-controlling interest

Non-controlling interest represents the interest not owned by us in our subsidiary and, indirectly, our hotels. The net loss attributable to non-controlling interest was $(4.8) million for the three months ended June 30, 2014 compared to $3.9 million for the three months ended June 30, 2013.  This change was primarily due to the contingent loss on litigation settlement that was solely attributable to the Company.

The net loss attributable to non-controlling interest decreased to $3.0 million for the six months ended June 30, 2014 from a $16.4 million for the six months ended June 30, 2013.  This change was primarily due to the contingent loss on litigation settlement that was solely attributable to the Company.

Net loss attributable to the Company

Net loss available to the Company represents the net loss not attributable to non-controlling interests.  The net loss attributable to the Company increased to $24.4 million for the three months ended June 30, 2014 from $0.1 million for the three months ended June 30, 2013.  The net loss attributable to the Company increased to $24.6 million for the six months ended June 30, 2014 from $0.6 million for the six months ended June 30, 2013.

LIQUIDITY AND CAPITAL RESOURCES

As of June 30, 2014, the Company’s principal source of cash to meet its operating requirements was from the results of operations from the Company’s hotels.  As of June 30, 2014, the Company expected that its operating cash flows would be sufficient to fund the continuing operations of the Company, including required debt service obligations and other reserves required by the terms of its existing debt agreements.  If necessary, the Company expected to fund any short term liquidity requirements above the operating cash flows with cash and cash equivalents currently on hand as well as cash flows restricted for use under the Company’s notes payable.

As discussed previously, during the three months ended June 30, 2014, the Company accrued $24.25 million related to a memorandum of understanding related to a legal settlement.  The Company anticipates funding the settlement with cash on hand or, if necessary, funding from Whitehall.

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Periodically, certain hotels may undergo renovations as a result of our decision to upgrade portions of the hotels, such as guestrooms, meeting space and restaurants, in order to better compete with other hotels in our markets or to meet the franchisor’s brand standards.  Generally we expected to fund the renovations and improvements with cash and cash equivalents currently on hand as well as cash flows restricted for use under the Company’s notes payable.

Operating activities

Net cash flows from operating activities were $16.0 million and $42.0 million for the six months ended June 30, 2014 and 2013, respectively. The decrease in cash flows from operating activities was primarily due to the deconsolidation of the 106 Senior Mezz hotels and the payment of accrued interest on notes payable.

Investment activities

Net cash flow provided by investing activities was $23.6 million for the six months ended June 30, 2014, which consisted of $7.5 million of capital additions to hotels, $1.4 million of proceeds from insurance and a decrease in restricted cash of $29.7 million.

Net cash flow used in investing activities was $28.1 million for the six months ended June 30, 2013, which primarily consisted of $14.4 million of capital additions to hotels and an increase in restricted cash of $18.9 million partially offset by proceeds from the sale of hotels and property casualty insurance.

Financing activities

Net cash flow used in financing activities was $41.7 million and $5.7 million for the six months ended June 30, 2014 and 2013, respectively.  During 2014, the net cash flow used related to $957.4 million in principal payments on the Company’s notes payable, $976.0 million in proceeds from the Company’s notes payable, $21.0 million of payment of deferred financing costs and $38.9 million of cash transferred in connection with the exercise of the Purchase Option.

CONTRACTUAL OBLIGATIONS AND OFF BALANCE SHEET ARRANGEMENTS

As of June 30, 2014, there had been no material changes since December 31, 2013, outside of the ordinary course of business, to contractual obligations specified in the table of contractual obligations included in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2014. As of June 30, 2014, we had no off-balance-sheet arrangements with any party nor did we anticipate any such arrangements.

INFLATION

Operators of hotels in general possess the ability to adjust room rates daily to reflect the effects of inflation. However, competitive pressures may limit the ability of the companies that managed our hotels to raise room rates.

SEASONALITY

Some of the Company’s hotel operations have historically been seasonal.  Generally, hotel revenues have been greater in the second and third calendar quarters than in the first and fourth calendar quarters. This seasonality pattern causes fluctuations in the operating results. As of June 30, 2014, to the extent that cash flows from our hotel operations were insufficient to fund our operating or investing requirements, we expected to fund seasonal-related shortfalls with cash flows restricted for use under the Company’s notes payable.

CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States.  This requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the date of our financial statements and the reported amounts of revenues and expenses during the reporting period. While we do not believe the reported amounts would be materially different, application of these policies involves the exercise of judgment and the use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on experience and on various other assumptions that are believed to be reasonable under the circumstances. All of our significant accounting policies, including certain critical accounting policies, are disclosed in our Annual Report on Form 10-K for the year ended December 31, 2014.

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NON-GAAP FINANCIAL MEASURES

The following non-GAAP presentations of EBITDA and Adjusted EBITDA are made to help in evaluating the Company’s operating performance.  These measures are indicative of the Company’s financial performance that are not calculated and presented in accordance with GAAP.

EBITDA is defined as net income (loss) before interest expense and interest income, income taxes, and depreciation and amortization.  The Company adjusts EBITDA to exclude impairment charges, gains or losses on sales of investments in real estate and gains or losses on extinguishment of debt because the Company believes these charges are not indicative of the performance of the underlying investments in real estate.  The Company presents EBITDA and Adjusted EBITDA because it believes it provides an indicator of the Company’s ability to meet its future debt payments and working capital requirements, as well as an overall evaluation of the Company’s financial condition.  EBITDA and Adjusted EBITDA, as calculated by the Company, may not be comparable to EBITDA and Adjusted EBITDA reported by other companies that do not define such terms exactly as the Company defines them.  EBITDA and Adjusted EBITDA should not be considered as an alternative measure of the Company’s net loss as an indicator of operating performance or GAAP cash flows from operating activities as a measure of liquidity.

The following tables reconcile net loss to EBITDA and Adjusted EBITDA (in thousands):

 

 

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Market risk includes risks that arise from changes in interest rates, equity prices and other market changes that affect market sensitive instruments.  As of June 30, 2014, our primary market risk exposure was to changes in interest rates on our variable rate debt. As of June 30, 2014, we had approximately $50.0 million of total variable rate debt outstanding (or 24.2% of total indebtedness).  If market rates of interest on our variable rate debt outstanding as of June 30, 2014 had increased by 1.00%, or 100 basis points, interest expense would decrease future earnings and cash flows by approximately $0.5 million annually.

As of June 30, 2014, our interest rate risk objectives were to limit the impact of interest rate fluctuations on earnings and cash flows and to lower our overall borrowing costs. To achieve these objectives, we managed our exposure to fluctuations in market interest rates through the use of fixed rate debt instruments to the extent that reasonably favorable rates are obtainable. We entered into interest rate caps to mitigate our interest rate risk on a portion of our variable rate debt. We did not enter into derivative or interest rate transactions for speculative purposes.

 

 

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ITEM 4. CONTROLS AND PROCEDURES

The Company carried out an evaluation with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and 15(d)-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, these disclosure controls and procedures were not effective because the Company did not file its periodic reports within the time periods specified in the SEC rules and forms as a result of the SEC’s determination that the Company’s reporting obligation under Section 15(d) of the Exchange Act resumed January 1, 2014.  The Company is in the process of preparing and filing its past due periodic reports and intends to become current as soon as practicable.

There has been no change in the Company’s internal control over financial reporting (as defined in Rule 13a-15(e) and 15(d)-15(e) of the Exchange Act) during the three months ended June 30, 2014 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

 

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PART II – OTHER INFORMATION

 

 

ITEM 1. LEGAL PROCEEDINGS

The Company is involved in various legal proceedings and disputes arising in the ordinary course of business. The Company does not believe that the disposition of such legal proceedings and disputes will have a material adverse effect on our business, the financial position, continuing operations or cash flows, except as described below.

In September 2013, a putative class action lawsuit (the Johnson Lawsuit) was filed in the Tennessee Chancery Court, Shelby County, Tennessee by several current and former holders of the preferred stock. Plaintiffs allege that, since October 2007, the defendants named in the complaint have engaged in a scheme to oppress and then squeeze-out the holders of the preferred stock, including by allegedly suppressing the marketability of the shares, causing the Company to cease paying dividends, and purchasing 58.8% of the shares in a series of alleged “creeping” tender offers beginning in 2012. The complaint names as defendants the Company, the members of our board of directors, the majority shareholders of the Company (Grace I, Whitehall and PFD Holdings), the GS Group and Goldman Sachs Realty Management L.P. (RMD). The complaint asserts claims for breach of contract, breach of fiduciary duty, aiding and abetting, and for violations of the Tennessee Blue Sky laws and the Tennessee Business Corporations Act. On October 4, 2013, defendants removed the action to the United States District Court for the Western District of Tennessee. On November 6, 2013, plaintiffs filed a motion to remand the case to state court. The defendants filed their opposition on December 6, 2013. The remand motion was fully briefed on December 20, 2013. On July 28, 2014, the court denied the remand motion. The defendants also moved to dismiss the Johnson Lawsuit on January 23, 2014. The court entered a scheduling order governing further proceedings in the litigation on February 14, 2014, as amended on June 19, 2014 and July 28, 2014, and the parties engaged in merits and class certification discovery. Also, pursuant to the schedule, plaintiffs filed their opposition to defendants’ dismissal motion on March 21, 2014, and defendants filed their reply papers in further support of their motion on April 25, 2014. Plaintiffs moved for class certification on May 16, 2014.

After the Company announced the original purchase agreement with ARC Hospitality on June 2, 2014, defendants and plaintiffs engaged in settlement negotiations. Thereafter, plaintiffs made requests for, and defendants provided to plaintiffs, information regarding the transaction contemplated by the original purchase agreement (the ARCH Transaction). Among other information provided, the Company estimated a reasonable fair present value of the proceeds that could be distributed to holders of the preferred stock as a result of the ARCH Transaction, as announced, to be approximately $18.50 per share of preferred stock. Plaintiffs retained and consulted with two financial advisors with regard to the ARCH Transaction. During this period, the parties to the Johnson Lawsuit continued to engage in both merits and class certification discovery. On August 20, 2014, the parties entered into a Memorandum of Understanding (MOU) containing the key terms of a proposed settlement. On August 22, 2014, the parties held a telephone conference with the court, in which the court agreed that, in light of the MOU, the parties would no longer be subject to the pending deadlines in the then current scheduling order. For the court’s convenience in managing its docket, the defendants agreed to withdraw their pending motion to dismiss without prejudice. On September 2, 2014, the court granted the defendants’ motion to withdraw its motion to dismiss without prejudice to renew. The defendants may renew their motion to dismiss in the event that the proposed settlement of the Johnson Lawsuit does not become final.

The stipulation, which was submitted to the court on October 9, 2014 and amended on December 4, 2014, would settle claims with respect to two classes described in the Johnson Lawsuit: (1) the “Holder Class” consisting of any and all persons who, as of August 22, 2014 and through the effective time of the merger contemplated by the stipulation, hold the preferred stock, excluding defendants and their affiliates, persons who opt out of the Holder Class and holders of dissenting shares and (2) the “Seller Class” consisting of all persons who sold some or all of their shares of preferred stock between October 25, 2007 and October 8, 2014, inclusive, and suffered a loss, excluding the defendants, their affiliates and persons who sold shares to PFD Holdings, and persons who opt out of the Seller Class. The stipulation was preliminarily approved by the court on April 30, 2015 and remains subject to final approval by the court. A hearing on final approval is scheduled for September 11, 2015.

In October 2013, a similar lawsuit was filed by another plaintiff in the same Chancery Court (the Dent Lawsuit), alleging similar breaches against several of the same defendants named in the Johnson Lawsuit, in addition to a former member of the Company’s board of directors. The plaintiffs and defendants in the Dent Lawsuit agreed to stay this case until the motion to remand in the Johnson lawsuit was decided. As stipulated by the parties, plaintiff must file any response to defendants’ motion to stay within ten business days after notice of the federal court decision denying the remand motion. Defendants notified plaintiff of the resolution of the remand motion in the Johnson Lawsuit, and plaintiff has not filed a response to the motion to stay. The proposed settlement in the Johnson Lawsuit purports to encompass the claims asserted in the Dent Lawsuit.

 

 

ITEM 1A. RISK FACTORS

There have been no material changes from the risk factors disclosed in the “RISK FACTORS” section of the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.

 

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

 

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

 

 

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

 

 

ITEM 5. OTHER INFORMATION

We include the following additional disclosure with respect to the GACC Loan.

 

The GACC Loan has a term of two years with three one-year optional extensions, subject to certain conditions, including the following: (i) no event of default is continuing; (ii) the borrowers’ purchase (or extension) of interest rate protection for each extension option; (iii) payment of an extension fee of 0.25% for each of the second and third extension options; (iv) the  achievement of certain minimum debt yields for each extension option ; and (v) the payment of the lender’s reasonable, out-of-pocket costs in connection with the extensions.

 

The borrowers under the GACC Loan are permitted to prepay the mortgage loan at any time subject to the terms of the loan documents including the payment of the applicable spread maintenance premium and a pro rata prepayment of the mezzanine loan. Under certain circumstances, the borrowers may prepay the GACC Loan with respect to individual properties (i.e. upon their sale to a third party).  As a condition to the release of one or more individual properties, the borrowers will be required to prepay the GACC Loan by an aggregate amount equal to no less than a release price, calculated on the basis of the allocated loan amount for the applicable individual property.

 

The lender may accelerate the GACC Loan and declare the full outstanding balance (and all accrued and unpaid interest thereon) due and payable upon the occurrence of customary events of default, other than an event of default as a result of a borrower’s bankruptcy.

 

The GACC Loan is non-recourse to Whitehall and to the borrowers, subject to certain carveouts described below. Whitehall and the borrowers are liable to the extent of any actual loss, damage, out-of-pocket cost or expense, liability, claim or other obligation incurred by the applicable lender arising out of, among other things, the following (subject to certain exceptions): fraud, intentional misrepresentation, wrongful removal of personal property from the properties during an event of default, intentional physical waste, misappropriation of funds, failure to maintain required insurance policies, violations of certain special purpose entity (SPE) covenants not resulting in substantive consolidation of the assets of the borrowers with those of another person, liabilities with respect to previously divested properties and unpermitted ground lease modifications.

 

Further, the GACC Loan is full recourse to Whitehall and the  applicable borrowers in the event of, among other matters, (i) unpermitted voluntary secured financing, (ii) certain voluntary transfers of the properties or the equity interests in the applicable borrowers in violation of the provisions of the applicable loan documents, or (iii) subject to a cap on liability, voluntary bankruptcy filing or collusive involuntary bankruptcy, a consenting to appointment of custodian, receiver, trustee, or examiner, an assignment for the benefit of creditors, or violations of certain SPE covenants resulting in substantive consolidation of the assets of the applicable Borrowers with those of another person.

 

ITEM 6. EXHIBITS

The following exhibits are filed as part of this report:

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

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