UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

(Mark One)

For the quarterly period ended: March 31, 2016

or

For the transition period from                      to                      

Commission file number: 001-33738

 

Morgans Hotel Group Co.

(Exact name of registrant as specified in its charter)

 

 

212-277-4100

(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.    Yes  x    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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    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. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

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

The number of shares outstanding of the registrant’s common stock, par value $0.01 per share, as of May 9, 2016 was 34,768,044.

 

 

 

 

 

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TABLE OF CONTENTS

 

 

 

 

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FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are generally identifiable by use of forward-looking terminology such as “may,” “will,” “should,” “potential,” “intend,” “expect,” “endeavor,” “seek,” “anticipate,” “estimate,” “overestimate,” “underestimate,” “believe,” “could,” “project,” “predict,” “continue” or other similar words or expressions. References to “we,” “our” and the “Company” refer to Morgans Hotel Group Co. together in each case with our consolidated subsidiaries and any predecessor entities unless the context suggests otherwise.

We may from time to time make written or oral statements that are “forward-looking,” including statements contained in this report and other filings with the Securities and Exchange Commission and in reports to our stockholders. These forward-looking statements reflect our current views about future events and are subject to risks, uncertainties, assumptions and changes in circumstances that may cause our actual results to differ materially from those expressed in any forward-looking statement. Forward-looking statements in this Quarterly Report on Form 10-Q include, without limitation, statements regarding our expectations with respect to:

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Important risks and factors that could cause our actual results to differ materially from those expressed in any forward-looking statements include, but are not limited to, the risks discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015 and other documents we file with the Securities and Exchange Commission from time to time. Important risks and factors that could cause our actual results to differ materially from those expressed in any forward-looking statements include, but are not limited to economic, business, competitive market and regulatory conditions such as:

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Other than as required by applicable law, we are under no duty to update any of the forward-looking statements after the date of this report to conform these statements to actual results.

 

 

 

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Morgans Hotel Group Co.

Consolidated Balance Sheets

(in thousands, except share data)

 

 

See accompanying notes to these consolidated financial statements.

 

 

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Morgans Hotel Group Co.

Consolidated Statements of Comprehensive Loss

(in thousands, except per share data)

 

 

See accompanying notes to these consolidated financial statements.

 

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Morgans Hotel Group Co.

Consolidated Statements of Cash Flows

(in thousands)

 

 

See accompanying notes to these consolidated financial statements.

 

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Morgans Hotel Group Co.

Notes to Consolidated Financial Statements

 

 

1. Organization and Formation Transaction

Morgans Hotel Group Co., a Delaware corporation (the “Company”), was incorporated on October 19, 2005. The Company operates, owns, acquires, and develops boutique hotels, primarily in gateway cities and select resort markets in the United States, Europe and other international locations.  

In addition, the Company owns leasehold interests in certain food and beverage venues.  Prior to the TLG Equity Sale, discussed below, completed on January 23, 2015, the Company, through TLG Acquisition LLC (“TLG Acquisition” and, together with its subsidiaries, The Light Group, or “TLG”), operated nightclubs, restaurants, pool lounges, bars and other food and beverage venues primarily in hotels operated by MGM Resorts International (“MGM”) in Las Vegas.  

The Morgans Hotel Group Co. predecessor comprised the subsidiaries and ownership interests that were contributed as part of the formation and structuring transactions from Morgans Hotel Group LLC, now known as Residual Hotel Interest LLC (“Former Parent”), to Morgans Group LLC (“Morgans Group”), the Company’s operating company. The Former Parent also contributed all the membership interests in its hotel management business to Morgans Group in return for 1,000,000 membership units in Morgans Group exchangeable for shares of the Company’s common stock.

The Company has one reportable operating segment.  During the three months ended March 31, 2016 and 2015, the Company derived 6.6% and 6.6% of its total revenues from international locations, respectively. The assets at these international locations were not significant during the periods presented.

Hotels

The Company’s hotels as of March 31, 2016 were as follows:

 

 

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 Food and Beverage Operations

As of March 31, 2016, the Company leased and managed all but one of the Sanderson food and beverage venues.  The Company also owns three food and beverage venues subject to leasehold agreements at Mandalay Bay in Las Vegas, which are managed by TLG.  These food and beverage venues are included in the Company’s consolidated financial statements.  

Effective May 1, 2016, the Company transferred all of its ownership interest in the food and beverage venues at Sanderson to the hotel owner.  The Company will continue to manage the transferred food and beverage venues.  Prior to May 1, 2016, the Company leased and managed the Sanderson food and beverage venues, which were included in the Company’s consolidated financial statements.  As a result of this transfer, the Company impaired approximately $0.4 million of goodwill related to its ownership interest of the Sanderson food and beverage venues.  

The Light Group

Acquisition.  On November 30, 2011, certain of the Company’s subsidiaries completed the acquisition of 90% of the equity interests in TLG Acquisition for a purchase price of $28.5 million in cash and up to $18.0 million in notes (the “TLG Promissory Notes”) (“The Light Group Transaction”).  

In December 2014, the Company used cash on hand to repay and retire $19.1 million of the outstanding TLG Promissory Notes, which included the original principal balance of $18.0 million plus deferred interest of $1.1 million, as discussed further in note 6.  

The primary assets of TLG consisted of its management and similar agreements primarily with various MGM affiliates.  During the time the Company owned 90% of TLG, it recognized management fees in accordance with the applicable management agreement which generally provided for base management fees as a percentage of gross sales, and incentive management fees as a percentage of net profits, as calculated pursuant to the management agreements.

TLG Equity Sale.  On January 23, 2015, the Company sold its 90% equity interest in TLG to Hakkasan Holdings LLC (“Hakkasan”) (the “TLG Equity Sale”) for $32.8 million, net of closing costs.    

The Company has certain indemnification obligations, which generally survive for 18 months following the close of the TLG Equity Sale; however, no amounts are held in escrow for the satisfaction of such claims.  As of March 31, 2016, the Company has accrued approximately $0.3 million in liabilities related to these indemnification obligations.  

TEJ Management, LLC, an entity controlled by Andrew Sasson, and Galts Gulch Holding Company LLC, an entity controlled by Andy Masi (together, the “Minority Holders”) did not exercise their right to participate in the TLG Equity Sale.  The Minority Holders maintained the right to put their equity interests to TLG’s managing member for amounts determined pursuant to the Amended and Restated Limited Liability Company of TLG.  Hakkasan, as the current managing member, was obligated to pay $3.6 million of this amount upon delivery of the 10% equity interest in TLG held by the Minority Holders with the Company responsible for any amounts in excess of $3.6 million, as discussed below in “—Sasson-Masi Put Options.”

In addition, for the 18 months following the closing of the TLG Equity Sale, the Company has the right to purchase 49% of the equity of TLG from Hakkasan (the “Option Right”).   The Option Right does not currently trigger any accounting impact on the Company’s consolidated financial statements.

Sasson-Masi Put Options.  On January 15, 2015, each of Messrs. Sasson and Masi exercised his right to require Morgans Group to purchase his equity interest in TLG at a purchase price calculated in accordance with the Amended and Restated Limited Liability Company of TLG (the “Sasson-Masi Put Options”).  The aggregate purchase price for the Sasson-Masi Put Options was approximately $5.0 million based on the contractual formula applied as of the option exercise date of January 15, 2015.  Pursuant to the TLG Equity Sale, Hakkasan paid $3.6 million of the purchase price for the Sasson-Masi Put Options and the Company incurred and paid the remaining approximately $1.4 million.  

 

 

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”).  The Company consolidates all wholly-owned subsidiaries and variable interest entities in which the Company is determined to be the primary beneficiary.  All intercompany balances and transactions have

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been eliminated in consolidation.  Entities which the Company does not control through voting interest and entities which are variable interest entities of which the Company is not the primary beneficiary, are accounted for under the equity method.

The consolidated financial statements have been prepared in accordance with U.S. GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The information furnished in the accompanying consolidated financial statements reflects all adjustments that, in the opinion of management, are necessary for a fair presentation of the aforementioned consolidated financial statements for the interim periods.

Operating results for the three months ended March 31, 2016 are not necessarily indicative of the results that may be expected for the year ending December 31, 2016. For further information, refer to the consolidated financial statements and accompanying footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management 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 period.  Actual results could differ from those estimates.

Restricted Cash

As required by certain debt and lease agreements, restricted cash consists of cash held in escrow accounts for debt service or lease payments, insurance programs, and taxes, among others.  As further required by the debt and lease agreements related to hotels owned by the Company or one of its subsidiaries, the Company must set aside 4% of the hotels’ revenues in restricted escrow accounts for the future periodic replacement or refurbishment of furniture, fixtures and equipment.  As replacements occur, the Company or its subsidiary is eligible for reimbursement from these escrow accounts.

The Hudson/Delano 2014 Mortgage Loan, defined and discussed below in note 6, provides that all cash flows from Hudson and Delano South Beach are deposited into accounts controlled by the lenders from which debt service and operating expenses, including management fees, are paid and from which other reserve accounts may be funded.  In the event the debt yield ratio falls below 6.75%, any excess amounts will be retained by the lenders until the debt yield ratio exceeds 7.00% for two consecutive calendar quarters.  As of March 31, 2016, the Company’s debt yield ratio was 6.84%.  The Company may fall below the 6.75% defined threshold during the second quarter of 2016.  

Assets Held for Sale

The Company considers properties to be assets held for sale when management approves and commits to a formal plan to actively market a property or a group of properties for sale and the sale is probable whereby a signed sales contract and significant non-refundable deposit or contract break-up fee exist.  Upon designation as an asset held for sale, the Company records the carrying value of each property or group of properties at the lower of its carrying value, which includes allocable goodwill, or its estimated fair value, less estimated costs to sell, and the Company stops recording depreciation expense.  Any gain realized in connection with the sale of the properties for which the Company has significant continuing involvement, such as through a long-term management agreement, is deferred and recognized over the initial term of the related management agreement.

 Investments in and Advances to Unconsolidated Joint Ventures

The Company accounts for its investments in unconsolidated joint ventures using the equity method as it does not exercise control over significant business decisions such as buying, selling or financing nor is it the primary beneficiary under Account Standard Codification (“ASC”) 810-10, Consolidation.  Under the equity method, the Company increases its investment for its proportionate share of net income and contributions to the joint venture and decreases its investment balance by recording its proportionate share of net loss and distributions.  Once the Company’s investment balance in an unconsolidated joint venture is zero, the Company suspends recording additional losses.  For investments in which there is recourse or unfunded commitments to provide additional equity, distributions and losses in excess of the investment are recorded as a liability.  As of March 31, 2016, there were no liabilities required to be recorded related to these investments.

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Other Assets

In October 2014, the Company funded an approximately $15.3 million key money obligation related to Mondrian London, which is included in Other Assets and is being amortized over the term of the hotel management agreement.

In August 2012, the Company entered into a 10-year licensing agreement with MGM, with two five-year extensions at the Company’s option subject to performance thresholds, to convert an existing hotel to Delano Las Vegas.  Delano Las Vegas opened in September 2014.  In addition, the Company acquired the leasehold interests in three food and beverage venues at Mandalay Bay in Las Vegas from an existing tenant for $15.0 million in cash at closing and a deferred, principal-only $10.6 million promissory note (“Restaurant Lease Note”) to be paid over seven years, which the Company recorded at fair value as of the date of issuance at $7.5 million, as discussed in note 6.  The three food and beverage venues are managed by TLG and are operated pursuant to 10-year operating leases with an MGM affiliate, pursuant to which the Company pays minimum annual lease payments and a percentage rent based on cash flow.  The Company allocated the total consideration paid, or to be paid, to the license agreement and the restaurant leasehold asset based on their respective fair values.  The Company amortizes the fair value of the license agreement and restaurant leasehold interests, using the straight line method, over the 10-year life of the respective agreement.

Income Taxes

The Company accounts for income taxes in accordance with ASC 740-10, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the tax and financial reporting basis of assets and liabilities and for loss and credit carry forwards.  Valuation allowances are provided when it is more likely than not that the recovery of deferred tax assets will not be realized.

The Company’s deferred tax assets are recorded net of a valuation allowance when, based on the weight of available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods.  Decreases to the valuation allowance are recorded as reductions to the Company’s provision for income taxes and increases to the valuation allowance result in additional provision for income taxes.  The realization of the Company’s deferred tax assets, net of the valuation allowance, is primarily dependent on estimated future taxable income.  A change in the Company’s estimate of future taxable income may require an addition to or reduction from the valuation allowance.  The Company has established a reserve on its deferred tax assets based on anticipated future taxable income and tax strategies.

All of the Company’s foreign subsidiaries are subject to local jurisdiction corporate income taxes.  Income tax expense is reported at the applicable rate for the periods presented.

Income taxes for the three months ended March 31, 2016 and 2015 were computed using the Company’s effective tax rate.

Credit-risk-related Contingent Features

The Company has entered into warrant agreements with Yucaipa American Alliance Fund II, L.P. and Yucaipa American Alliance (Parallel) Fund II, L.P., (collectively, the “Yucaipa Investors”), as discussed in note 9, to purchase a total of 12,500,000 shares of the Company’s common stock at an exercise price of $6.00 per share (the “Yucaipa Warrants”).  In addition, subject to the terms of the Securities Purchase Agreement, the Yucaipa Investors have certain consent rights over certain transactions for so long as they collectively own or have the right to purchase through exercise of the Yucaipa Warrants 6,250,000 shares of the Company’s common stock, as discussed further in note 9.  The Yucaipa Warrants are exercisable utilizing a cashless exercise method only, resulting in a net share issuance.  See note 13 for additional information about the Yucaipa Warrants.

Fair Value Measurements

ASC 820-10, Fair Value Measurements and Disclosures (“ASC 820-10”) defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.  ASC 820-10 applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the standard does not require any new fair value measurements of reported balances.

ASC 820-10 emphasizes that fair value is a market-based measurement, not an entity-specific measurement.  Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, ASC 820-10 establishes a fair value 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 the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).

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Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access.  Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.  Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates and yield curves that are observable at commonly quoted intervals.  Level 3 inputs are unobservable inputs for the asset or liability, which is typically based on an entity’s own assumptions, as there is little, if any, related market activity.  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.  The Company’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.

Currently, the Company uses interest rate caps to manage its interest rate risk.  The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative.  This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.  To comply with the provisions of ASC 820-10, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements.  In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees.  Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties.  As of March 31, 2016 and December 31, 2015, the Company assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives.  Accordingly, all derivatives have been classified as Level 2 fair value measurements.  As of March 31, 2016, the Company had three interest rate caps outstanding and the fair value of these interest rate caps was $1.0 million.  

Fair Value of Financial Instruments

Disclosures about fair value of financial instruments are based on pertinent information available to management as of the valuation date.  Considerable judgment is necessary to interpret market data and develop estimated fair values.  Accordingly, the estimates presented are not necessarily indicative of the amounts at which these instruments could be purchased, sold, or settled.  The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.

The Company’s financial instruments include cash and cash equivalents, accounts receivable, restricted cash, accounts payable and accrued liabilities, and fixed and variable rate debt.  Management believes the carrying amount of the aforementioned financial instruments, excluding fixed-rate debt, is a reasonable estimate of fair value as of March 31, 2016 and December 31, 2015 due to the short-term maturity of these items or variable market interest rates.

The Company had outstanding fixed rate debt principal of $54.6 million and $54.9 million as of March 31, 2016 and December 31, 2015, respectively, which included the Company’s trust preferred securities and Restaurant Lease Note, discussed above, and excludes capital leases.  This fixed rate debt had a fair market value at March 31, 2016 and December 31, 2015 of approximately $62.0 million and $60.6 million, respectively, using market rates.

Although the Company has determined that the majority of the inputs used to value its fixed rate debt fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its fixed rate debt utilize Level 3 inputs, such as estimates of current credit spreads.  As of March 31, 2016 and December 31, 2015, the Company assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its fixed rate debt and determined that the credit valuation adjustments are not significant to the overall valuation of its fixed rate debt.  Accordingly, all derivatives have been classified as Level 2 fair value measurements.

Noncontrolling Interest

The Company follows ASC 810-10, when accounting and reporting for noncontrolling interests in a consolidated subsidiary and the deconsolidation of a subsidiary.  Under ASC 810-10, the Company reports noncontrolling interests in subsidiaries as a separate component of stockholders’ equity (deficit) in the consolidated financial statements and reflects net income (loss) attributable to the noncontrolling interests and net income (loss) attributable to the common stockholders on the face of the consolidated statements of comprehensive loss.

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The membership units in Morgans Group, the Company’s operating company, owned by the Former Parent are presented as a noncontrolling interest in Morgans Group in the consolidated balance sheets and were approximately $0.6 million and $0.6 million as of March 31, 2016 and December 31, 2015, respectively. The noncontrolling interest in Morgans Group is: (i) increased or decreased by the holders of membership interests’ pro rata share of Morgans Group’s net income or net loss, respectively; (ii) decreased by distributions; (iii) decreased by exchanges of membership units for the Company’s common stock; and (iv) adjusted to equal the net equity of Morgans Group multiplied by the holders of membership interests’ ownership percentage immediately after each issuance of units of Morgans Group and/or shares of the Company’s common stock and after each purchase of treasury stock through an adjustment to additional paid-in capital.  Net income or net loss allocated to the noncontrolling interest in Morgans Group is based on the weighted-average percentage ownership throughout the period.  As of March 31, 2016, there were 75,446 membership units outstanding, each of which is exchangeable for a share of the Company’s common stock.

Recent Accounting Pronouncements

In February 2016, the FASB issued ASU No. 2016-02 (“ASU 2016-02”), “Leases.”  The new standard establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months.  Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement.  The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.  A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available.  The Company is currently evaluating the impact ASU 2016-02 will have on its consolidated financial statements.  

In March 2016, the FASB issued ASU No. 2016-09 (“ASU 2016-09”), “Compensation – Stock Compensation (Topic 708): Improvements to Employee Share-Based Payment Accounting.” ASU 2016-09 is intended to simplify several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. This guidance is effective for fiscal years beginning after December 15, 2016 and for interim periods within those fiscal years, with early adoption permitted. The Company is currently evaluating the impact ASU 2016-09 will have on its consolidated financial statements.  

In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606)”, and supersedes the revenue recognition requirements in Topic 605, Revenue Recognition, as well as most industry-specific guidance.  The new standard sets forth five prescribed steps to determine the timing and amount of revenue to be recognized to appropriately depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  In March 2016, the FASB issued ASU No. 2016-08, “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations”, which further clarifies the application of the standard depending on whether the entity is a principal or an agent. In August 2015, the FASB issued ASU No. 2015-14, “Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date”, which deferred the effectiveness of ASU No. 2014-09 to reporting periods beginning after December 15, 2017 and permitted early application for annual reporting periods beginning after December 15, 2016.  The Company is currently evaluating the impact the new standard will have on its consolidated financial statements.  

Reclassifications

Certain prior period financial statement amounts have been reclassified to conform to the current period presentation.

 

 

3. Income (Loss) Per Share

The Company applies the two-class method as required by ASC 260-10, Earnings per Share (“ASC 260-10”). ASC 260-10 requires the net income per share for each class of stock (common stock and preferred stock) to be calculated assuming 100% of the Company’s net income is distributed as dividends to each class of stock based on their contractual rights.  To the extent the Company has undistributed earnings in any calendar quarter, the Company will follow the two-class method of computing earnings per share.

Basic net income (loss) per common share is calculated by dividing net income (loss) available to common stockholders by the weighted-average number of shares of common stock outstanding during the period.  Vested LTIP Units (as defined in note 8) are considered participating securities and are included in the computation of basic earnings per common share pursuant to the two-class method.  Diluted net income (loss) per common share is calculated by dividing net income (loss) available to common stockholders by the weighted-average number of shares of common stock outstanding during the period, plus other potentially dilutive securities.  Potential dilutive securities may include shares and options granted under the Company’s stock incentive plan and membership units

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in Morgans Group, which may be exchanged for shares of the Company’s common stock under certain circumstances.  In periods when the Company has net loss attributable to Morgans Hotel Group Co., the Yucaipa Warrants issued to the Yucaipa Investors, unvested restricted stock units, LTIP Units (as defined in note 8), and stock options are excluded from the diluted net loss per common share calculation, as there would be no effect on reported diluted net loss per common share, however in periods when the Company has net income attributable to Morgans Hotel Group Co., these same securities are included in the diluted net income per common share calculation to the extent they are considered dilutive.  The 75,446 Morgans Group membership units (which may be converted to cash, or at the Company’s option, common stock) held by third parties at March 31, 2016 and December 31, 2015, are not reflected in the computation of basic and diluted earnings per share, as the income allocable to such membership units is allocated and reflected as noncontrolling interests in the accompanying consolidated financial statements.

The table below details the components of the basic and diluted loss per share calculations (in thousands, except for per share data).  The Company has not had any undistributed earnings in any calendar quarter presented. Therefore, the Company does not present earnings per share following the two-class method.

 

 

 

4. Investments in and Advances to Unconsolidated Joint Ventures

 

The Company’s investments in and advances to unconsolidated joint ventures was $0.1 million and $0.1 million as of March 31, 2016 and December 31, 2015, respectively.  The Company’s income from unconsolidated joint ventures was immaterial for the three months ended March 31, 2016 and 2015.  

Mondrian South Beach

On August 8, 2006, the Company entered into a 50/50 joint venture to renovate and convert an apartment building on Biscayne Bay in Miami Beach into a condominium hotel, Mondrian South Beach, which opened in December 2008.  The Company operates Mondrian South Beach under a long-term management contract.

The Mondrian South Beach joint venture initially received nonrecourse mortgage loan financing of approximately $124.0 million at a rate of LIBOR plus 3.0%.  A portion of this mortgage debt was paid down, prior to the amendments discussed below, with proceeds obtained from condominium sales.  In April 2008, the Mondrian South Beach joint venture obtained a mezzanine loan from the mortgage lenders of $28.0 million bearing interest at LIBOR plus 6.0%.  Additionally, the Company and an affiliate of its joint venture partner provided additional mezzanine financing of $28.0 million in total to the joint venture through a 50/50 mezzanine financing joint venture.  

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In April 2010, the Mondrian South Beach ownership joint venture amended the nonrecourse mortgage financing and mezzanine loan agreements secured by Mondrian South Beach or related equity interests and extended the maturity date for up to seven years through one-year extension options until April 2017, subject to certain conditions.  Among other things, the amendment allowed the joint venture to accrue all interest through April 2012, accrue a portion of the interest thereafter, extend the mezzanine loan to April 2027 if the mortgage loan is retired, and provide the ability to provide seller financing to qualified condominium buyers with up to 80% of the condominium purchase price.  After the repayment of the mortgage debt, the mezzanine financing joint venture receives the first $5.5 million of net cash flow, the lender mezzanine financing receives the next $5.5 million, and the remaining proceeds are distributed equally between the joint venture mezzanine loan and the lender mezzanine loan.  

In March 2016, the joint venture exercised its option to extend the outstanding mortgage and mezzanine debt until April 2017.  As of March 31, 2016, the joint venture’s outstanding nonrecourse mortgage loan was $18.7 million, with interest accruing at LIBOR plus 3.8% and paid at LIBOR plus 1.5%.  The outstanding mezzanine loan was $28.0 million, with interest accruing at 4.26%.  In addition, the outstanding mezzanine debt owed to affiliates of the joint venture partners was $28.0 million.

The joint venture is in the process of selling units as condominiums, subject to market conditions, and unit buyers will have the opportunity to place their units into the hotel’s rental program.  As of March 31, 2016, 276 hotel residences had been sold, of which 161 are in the hotel rental pool and are included in the hotel room count, and 59 hotel residences remain to be sold, all of which are in the hotel program.

The Mondrian South Beach joint venture was determined to be a variable interest entity, as during the process of refinancing the venture’s mortgage in April 2010, its equity investment at risk was considered insufficient to permit the entity to finance its own activities.  Management determined that the Company is not the primary beneficiary of this variable interest entity.

Because the Company has written its investment value in the joint venture to zero, for financial reporting purposes, the Company believes its maximum exposure to losses as a result of its involvement in the Mondrian South Beach variable interest entity is limited to its outstanding management fees and related receivables, excluding guarantees and other contractual commitments.

The Company is not committed to providing financial support to this variable interest entity, other than as contractually required, and all future funding is expected to be provided by the joint venture partners in accordance with their respective percentage interests in the form of capital contributions or loans, or by third parties.

Morgans Group and affiliates of its joint venture partner have provided certain guarantees and indemnifications to the Mondrian South Beach lenders. See note 7.

Mondrian SoHo

In June 2007, the Company entered into a joint venture with Cape Advisors Inc. to acquire property and develop a Mondrian hotel on that property in the SoHo neighborhood of New York City.  The Company had a 20% equity interest in the joint venture.  Under the terms of the hotel management agreement executed between the Company and the joint venture in June 2007, the Company had a contract to manage the hotel for a 10-year term beginning on the date the hotel opened for business, which was in February 2011, with two 10-year extension options.  The Company accounted for its investment in Mondrian SoHo using the equity method of accounting.  

The joint venture obtained a loan to acquire the hotel property and develop the hotel, which matured in June 2010 and was extended several times.  In November 2012, the joint venture did not meet the necessary extension options and a foreclosure judgment was issued on November 25, 2014.  The foreclosure sale was held on January 7, 2015, at which German American Capital Corporation (“GACC”), the lender, was the sole and winning bidder.  GACC assigned its bid to 9 Crosby LLC, an affiliate of The Sapir Organization (“Sapir”), a New York-based real estate development and management organization.  The sale of the hotel property to Sapir closed on March 6, 2015.  As a result, effective March 6, 2015, the Company no longer held any equity interest in Mondrian SoHo.  Effective April 27, 2015, the Company no longer managed Mondrian SoHo.  

Mondrian Istanbul

In December 2011, the Company entered into a hotel management agreement for a Mondrian-branded hotel to be located in the Old City area of Istanbul, Turkey.  In December 2011 and January 2012, the Company contributed an aggregate of $10.3 million in the form of equity and key money and had a 20% ownership interest in the joint venture owning the hotel.

Due to the Company’s joint venture partner’s failure to achieve certain agreed milestones in the development of the Mondrian Istanbul hotel, in early 2014, the Company exercised its put option under the joint venture agreement that would have required the

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Company’s joint venture partner to buy back the Company’s equity interests in the Mondrian Istanbul joint venture.   In early 2015, as a result of settlement discussions, the Company determined that this investment was other-than-temporarily impaired and recorded a $3.9 million impairment charge for the three months ended March 31, 2015.   Subsequently, on June 26, 2015, the Company and its Mondrian Istanbul joint venture partner (and related parties) entered into a settlement agreement, which terminated all legal proceedings between the parties.  Pursuant to the settlement agreement, in September 2015, the Company received $6.5 million in exchange for the Company’s equity interest in the joint venture.  

 

 

5. Other Liabilities

As of March 31, 2016 and December 31, 2015, other liabilities included $13.9 million related to a designer fee claim.  The Former Parent had an exclusive service agreement with a hotel designer, pursuant to which the designer has made various claims related to the agreement.  Although the Company is not a party to the agreement, it may have certain contractual obligations or liabilities to the Former Parent in connection with the agreement.  According to the agreement, the designer was owed a base fee for each designed hotel, plus 1% of gross revenues, as defined in the agreement, for a 10-year period from the opening of each hotel.  In addition, the agreement also called for the designer to design a minimum number of projects for which the designer would be paid a minimum fee.  A liability amount has been estimated and recorded in these consolidated financial statements before considering any defenses and/or counter-claims that may be available to the Company or the Former Parent in connection with any claim brought by the designer.  The estimated costs of the design services were capitalized as a component of the applicable hotel and amortized over the five-year estimated life of the related design elements.

 

 

6. Debt and Capital Lease Obligations

Debt and capital lease obligations consists of the following (in thousands):

 

Deferred financing costs are amortized, using the straight line method, which approximates the effective interest rate method, over the terms of the related debt agreements.

 

(a) Mortgage Agreements

Hudson/Delano 2014 Mortgage Loan

On February 6, 2014, subsidiaries of the Company entered into a mortgage financing with Citigroup Global Markets Realty Corp. and Bank of America, N.A., as lenders, consisting of $300.0 million nonrecourse mortgage notes and $150.0 million mezzanine loans resulting in an aggregate principal amount of $450.0 million, secured by mortgages encumbering Delano South Beach and Hudson and pledges of equity interests in certain subsidiaries of the Company (collectively, the “Hudson/Delano 2014 Mortgage Loan”).  The net proceeds from the Hudson/Delano 2014 Mortgage Loan were applied to repay the outstanding mortgage debt under the prior mortgage loan secured by Hudson, repay outstanding indebtedness under the Company’s senior secured revolving credit facility secured by Delano South Beach (the “Delano Credit Facility”), and fund reserves required under the Hudson/Delano 2014 Mortgage Loan, with the remainder available for general corporate purposes and working capital.  

The Hudson/Delano 2014 Mortgage Loan was scheduled to mature on February 9, 2016.  On that date, the Company paid $28.2 million to reduce the principal balance by the same amount and extend the maturity of this debt until February 9, 2017.  Following the extension, the Company has two additional one-year extension options that will permit the Company to extend the maturity date of the Hudson/Delano 2014 Mortgage Loan to February 9, 2019, if certain conditions are satisfied at the respective extension dates, including achievement by the Company of a trailing twelve month debt yield of no less than 7.75% for the first extension and no less than 8.00% for the second extension.  The Company may prepay the Hudson/Delano 2014 Mortgage Loan in an amount necessary to achieve the specified debt yield.  The second and third extensions would also require the payment of an extension fee equal to 0.25%

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of the then outstanding principal amount under the Hudson/Delano 2014 Mortgage Loan.  Based on our trailing 12 month cash flow through March 31, 2016, the Company estimates that it would be required to prepay approximately $50.0 million of outstanding debt under the Hudson/Delano 2014 Mortgage Loan by February 9, 2017 and pay an approximately $1.0 million extension fee in order to extend the maturity date of the debt outstanding under the Hudson/Delano 2014 Mortgage Loan to February 9, 2018.

 

The Hudson/Delano 2014 Mortgage Loan bears interest at a blended rate of 30-day LIBOR plus 565 basis points.  The Company maintained interest rate caps for the $450.0 million principal amount of the Hudson/Delano 2014 Mortgage Loan that capped the LIBOR rate on the debt under the Hudson/Delano 2014 Mortgage Loan at approximately 1.75% through the February 9, 2016.  In connection with the extension in February 2016, the Company purchased three interest rate caps with an aggregate notional value of $421.8 million that cap LIBOR at 0.29% through the next maturity date of the loan.  

The Hudson/Delano 2014 Mortgage Loan may be prepaid at any time, in whole or in part.  The Hudson/Delano 2014 Mortgage Loan is assumable under certain conditions, and provides that either one of the encumbered hotels may be sold, subject to prepayment of the Hudson/Delano 2014 Mortgage Loan at a specified release price and satisfaction of certain other conditions.

The Hudson/Delano 2014 Mortgage Loan contains restrictions on the ability of the borrowers to incur additional debt or liens on their assets and on the transfer of direct or indirect interests in Hudson or Delano South Beach and the owners of Hudson and Delano South Beach and other affirmative and negative covenants and events of default customary for multiple asset commercial mortgage-backed securities loans.  The Hudson/Delano 2014 Mortgage Loan is nonrecourse to the Company’s subsidiaries that are the borrowers under the loan, except pursuant to certain carveouts detailed therein.  In addition, the Company has provided a customary environmental indemnity and nonrecourse carveout guaranty under which it would have liability if certain events occur with respect to the borrowers, including voluntary bankruptcy filings, collusive involuntary bankruptcy filings, changes to the Hudson capital lease without prior written consent of the lender, violations of the restrictions on transfers, incurrence of additional debt, or encumbrances of the property of the borrowers.  The nonrecourse carveout guaranty prohibits the payment of dividends on or repurchase of the Company’s common stock.  As of March 31, 2016, the Company was in compliance with these covenants.

(b) Clift Debt

In October 2004, Clift Holdings LLC (“Clift Holdings”), a subsidiary of the Company, sold the Clift hotel to an unrelated party for $71.0 million and then leased it back for a 99-year lease term.  Under this lease, Clift Holdings is required to fund operating shortfalls including the lease payments and to fund all capital expenditures.  This transaction did not qualify as a sale due to the Company’s continued involvement and therefore is treated as a financing.

The lease agreement provided for base annual rent of approximately $6.0 million per year until October 2014.  Base rent increases by a formula tied to increases in the Consumer Price Index, with a maximum increase of 20% and a minimum increase of 10% at each five-year rent increase date thereafter. As a result of the first contractual rate increase, effective October 14, 2014, the annual rent increased to $7.6 million.  The lease is nonrecourse to the Company.

Morgans Group also entered into an agreement, dated September 17, 2010, whereby Morgans Group agreed to guarantee losses of up to $6.0 million suffered by the lessors in the event of certain “bad boy” type acts.  As of March 31, 2016, there had been no triggering event that would require the Company to recognize a liability related to this guarantee.

(c) Liability to Subsidiary Trust Issuing Preferred Securities

On August 4, 2006, a newly established trust formed by the Company, MHG Capital Trust I (the “Trust”), issued $50.0 million in trust preferred securities in a private placement.  The Company owns all of the $0.1 million of outstanding common stock of the Trust.  The Trust used the proceeds of these transactions to purchase $50.1 million of junior subordinated notes issued by the Company’s operating company and guaranteed by the Company (the “Trust Preferred Notes”) which mature on October 30, 2036.  The sole assets of the Trust consist of the Trust Preferred Notes.  The terms of the Trust Preferred Notes are substantially the same as preferred securities issued by the Trust.  The Trust Preferred Notes and the preferred securities have a fixed interest rate of 8.68% until October 2016, after which the interest rate will float and reset quarterly at the three-month LIBOR rate plus 3.25% per annum.  The Trust Preferred Notes are redeemable by the Trust, at the Company’s option, at par, and the Company has not redeemed any Trust Preferred Notes.  To the extent the Company redeems the Trust Preferred Notes, the Trust is required to redeem a corresponding amount of preferred securities.

The Company has identified that the Trust is a variable interest entity under ASC 810-10. Based on management’s analysis, the Company is not the primary beneficiary of the trust.  Accordingly, the Trust is not consolidated into the Company’s financial statements.  The Company accounts for the investment in the common stock of the Trust under the equity method of accounting.

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In the event the Company were to undertake a transaction that was deemed to constitute a transfer of its properties and assets substantially as an entirety within the meaning of the indenture, the Company may be required to repay the Trust Preferred Notes prior to their maturity or obtain the trustee’s consent in connection with such transfer.

(d) Restaurant Lease Note

As discussed in note 2, in August 2012, the Company acquired the leasehold interests in three food and beverage venues at Mandalay Bay from an existing tenant for $15.0 million in cash at closing and the issuance of a principal-only $10.6 million Restaurant Lease Note to be paid over seven years.  The Restaurant Lease Note does not bear interest except in the event of default, as defined in the agreement. In accordance with ASC 470, Debt, the Company imputed interest on the Restaurant Lease Note, which was recorded at its fair value of $7.5 million as of the date of issuance.  At March 31, 2016, the carrying amount of the Restaurant Lease Note was $4.5 million.

(e) Capital Lease Obligations

The Company has leased two condominium units at Hudson from unrelated third-parties, which are reflected as capital leases.  One of the leases requires the Company to make annual payments, currently $649,728 (subject to increases due to increases in the Consumer Price Index), through November 2096.  This lease also allows the Company to purchase, at its option, the unit at fair market value after November 2015.  The second lease requires the Company to make annual payments, currently $365,490 (subject to increases due to increases in the Consumer Price Index), through December 2098.

The Company has allocated both lease payments between the land and building based on their estimated fair values.  The portion of the payments allocated to the building has been capitalized at the present value of the future minimum lease payments.  The portion of the payments allocable to the land is treated as operating lease payments.  The imputed interest rate on both of these leases is 8%, which is based on the Company’s incremental borrowing rate at the time the lease agreement was executed.  The capital lease obligations related to the units amounted to approximately $6.1 million as of March 31, 2016 and December 31, 2015, respectively. Substantially all of the principal payments on the capital lease obligations are due at the end of the lease agreements.  

 

 

7. Commitments and Contingencies

Hotel Development Related Commitments

In order to obtain management, franchise and license contracts, the Company may commit to contribute capital in various forms on hotel development projects.  These include equity investments, key money, and cash flow guarantees to hotel owners.  The cash flow guarantees generally have a stated maximum amount of funding and a defined term.  The terms of the cash flow guarantees to hotel owners generally require the Company to fund if the hotels do not attain specified levels of operating profit.  Cash flow guarantees to hotel owners may be recoverable as loans repayable to the Company out of future hotel cash flows and/or proceeds from the sale of hotels.  As of March 31, 2016, the Company’s potential funding obligations under cash flow guarantees at hotels under development at the maximum amount under the applicable contracts, but excluding contracts where the maximum amount cannot be determined, was $5.0 million, which relates to Delano Cartagena where construction has not yet begun.    

The Company has signed management, license or franchise agreements for new hotels which are in various stages of development. As of March 31, 2016, these included the following:

 

 

There can be no assurances that any or all of the Company’s projects listed above will be developed as planned.  If adequate project financing is not obtained, these projects may need to be limited in scope, deferred or cancelled altogether, in which case the Company may be unable to recover any previously funded key money, equity investments or debt financing.  

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Other Guarantees to Hotel Owners

As discussed above, the Company has provided certain cash flow guarantees to hotel owners in order to secure management contracts.

The Company’s hotel management agreements for Royalton and Morgans contain cash flow guarantee performance tests that stipulate certain minimum levels of operating performance.  These performance test provisions give the Company the option to fund a shortfall in operating performance limited to the Company’s earned base fees.  If the Company chooses not to fund the shortfall, the hotel owner has the option to terminate the management agreement.  Historically, the Company has funded the shortfall and as of March 31, 2016, approximately $0.2 million was accrued as a reduction to management fees related to these performance test provisions.  Until the end of 2016 and so long as the Company funds the shortfalls, the hotel owners do not have the right to terminate the Company as hotel manager.  The Company’s maximum potential amount of future fundings related to the Royalton and Morgans performance guarantee cannot be determined as of March 31, 2016, but under the hotel management agreements is limited to the Company’s base fees earned.  On January 28, 2016, the Company entered into amendments to each of the hotel management agreements relating to Royalton and Morgans, both owned by the same hotel owner.  In connection with owner’s potential sale of each of those hotels, the Company agreed to allow the owner to sell the hotels unencumbered by the current hotel management agreements.  Under each of the amendments, the owner has the right to terminate the hotel management agreements at any time upon at least 30 days’ prior written notice in exchange for paying us $3.5 million for each of the hotels upon a termination of each agreement.  The Company expects to continue to manage the hotels until they are sold.

Additionally, the Company is currently subject to performance tests under certain other of its hotel management agreements, which could result in early termination of the Company’s hotel management agreements.   As of March 31, 2016, the Company is in compliance with these termination performance tests and is not exercising any contractual cure rights.  Generally, the performance tests are two part tests based on achievement of budget or cash flow and revenue per available room indices.  In addition, once the performance test period begins, which is generally multiple years after a hotel opens, each of these performance tests must fail for two or more consecutive years and the Company has the right to cure any performance failures, subject to certain limitations.  

Joint Venture Hotels Commitments and Guarantees

The following details obligations the Company has or may have related to its operating joint venture hotel, Mondrian South Beach, as of March 31, 2016.  

Mondrian South Beach. Morgans Group and affiliates of its joint venture partner have agreed to provide standard nonrecourse carve-out guarantees and provide certain limited indemnifications for the Mondrian South Beach mortgage and mezzanine loans.  In the event of a default, the lenders’ recourse is generally limited to the mortgaged property or related equity interests, subject to standard nonrecourse carve-out guarantees for “bad boy” type acts.  Morgans Group and affiliates of its joint venture partner also agreed to guarantee the joint venture’s obligation to reimburse certain expenses incurred by the lenders and indemnify the lenders in the event such lenders incur liability in connection with certain third-party actions.  Morgans Group and affiliates of its joint venture partner have also guaranteed the joint venture’s liability for the unpaid principal amount of any seller financing note provided for condominium sales if such financing or related mortgage lien is found unenforceable, provided they shall not have any liability if the seller financed unit becomes subject to the lien of the lender’s mortgage or title to the seller financed unit is otherwise transferred to the lender or if such seller financing note is repurchased by Morgans Group and/or affiliates of its joint venture at the full amount of unpaid principal balance of such seller financing note.

The Company and affiliates of its joint venture partner also have each agreed to purchase approximately $14.0 million of condominium units under certain conditions, including an event of default.  In the event of a default under the lender’s mortgage or mezzanine loan, the joint venture partners are each obligated to purchase selected condominium units, at agreed-upon sales prices, having aggregate sales prices equal to 1/2 of the lesser of $28.0 million, which is the face amount outstanding on the lender’s mezzanine loan, or the then outstanding principal balance of the lender’s mezzanine loan.  The joint venture is not currently in an event of default under the mortgage or mezzanine loan. As of March 31, 2016, there had been no triggering event that would require the Company to recognize a liability related to the construction completion or the condominium purchase guarantees.

Litigation Regarding TLG Promissory Notes   

On August 5, 2013, Messrs.  Andrew Sasson and Andy Masi filed a lawsuit in the Supreme Court of the State of New York against TLG Acquisition LLC and Morgans Group LLC relating to the $18.0 million TLG Promissory Notes.  See note 1 and note 7 regarding the background of the TLG Promissory Notes.  The complaint alleges, among other things, a breach of contract and an event of default under the TLG Promissory Notes as a result of the Company’s failure to repay the TLG Promissory Notes following an alleged “Change of Control” that purportedly occurred upon the election of the Company’s Board of Directors on June 14, 2013.  The

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complaint sought payment of Mr. Sasson’s $16.0 million TLG Promissory Note and Mr. Masi’s $2.0 million TLG Promissory Note, plus interest compounded to principal, as well as default interest, and reasonable costs and expenses incurred in the lawsuit.  On September 26, 2013, the Company filed a motion to dismiss the complaint in its entirety.  On February 6, 2014, the court granted the Company’s motion to dismiss.  On March 7, 2014, Messrs.  Sasson and Masi filed a Notice of Appeal from this decision with the Appellate Division, First Department.  On April 9, 2015, the Appellate Division, First Department, reversed the trial court’s decision, denying the motion to dismiss and remanding to the trial court for further proceedings.  The Company filed a motion for reconsideration at the appellate court, which was denied on July 7, 2015.  The Company filed its answer to the complaint with the trial court on May 11, 2015.  On August 27, 2015, Messrs.  Sasson and Masi filed a motion for partial summary judgment with the trial court and the Company filed its opposition to that motion on October 12, 2015.  In February 2016, the plaintiff’s partial summary judgment motion was granted and the judge signed the order in March 2016 in the amount of approximately $2.8 million, although the judgment has not yet been entered.  The Company has filed its notice of appeal and may be required to post a cash bond in the amount of the judgment to secure its ability to perfect its appeal.  Plaintiffs also have a claim for attorneys' fees which the Company intends to dispute and oppose. They have not yet stated a claimed amount to the court but they have recently estimated this claim at approximately $1.0 million.  Although the TLG Promissory Notes were repaid and retired in December 2014, this lawsuit remains pending in connection with issues related primarily to the interest rates applicable to the TLG Promissory Notes.  

Environmental

As a holder of real estate, the Company is subject to various environmental laws of federal, state and local governments. Compliance by the Company with existing laws has not had an adverse effect on the Company and management does not believe that it will have a material adverse impact in the future. However, the Company cannot predict the impact of new or changed laws or regulations.

Other Litigation

The Company is involved in various lawsuits and administrative actions in the normal course of business, in addition to the other litigation noted above.  The Company has recorded the necessary accrual for contingent liabilities related to outstanding litigations.

 

 

8. Omnibus Stock Incentive Plan

On May 22, 2007, the Company adopted the Morgans Hotel Group Co. 2007 Omnibus Stock Incentive Plan.  Subsequently and on several occasions, the Company’s Board of Directors adopted, and stockholders approved, amendments to the 2007 Omnibus Stock Incentive Plan (the “Stock Plan”), to namely increase the number of shares reserved for issuance under the plan.  As of March 31, 2016, the Stock Plan had 14,610,000 shares reserved for issuance.

The Stock Plan provides for the issuance of stock-based incentive awards, including incentive stock options, non-qualified stock options, stock appreciation rights, shares of common stock of the Company, including restricted stock units (“RSUs”) and other equity-based awards, including membership units in Morgans Group which are structured as profits interests (“LTIP Units”), or any combination of the foregoing.  The eligible participants in the Stock Plan include directors, officers and employees of the Company.  Awards other than options and stock appreciation rights reduce the shares available for grant by 1.7 shares for each share subject to such an award.

The Company has granted, or may grant, RSUs to certain executives, employees or non-employee directors as part of future annual equity grants or to newly hired or promoted employees from time to time.

A summary of stock-based incentive awards as of March 31, 2016 is as follows (in units, or shares, as applicable):  

 

 

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Total stock compensation expense, which is included in corporate expenses on the accompanying consolidated statements of comprehensive loss, was $0.1 million and $0.3 million, for the three months ended March 31, 2016 and 2015, respectively.

As of March 31, 2016 and December 31, 2015, there were approximately $0.2 million and $0.7 million, respectively, of total unrecognized compensation costs related to unvested share awards. As of March 31, 2016, the weighted-average period over which the unrecognized compensation expense will be recorded is approximately 0.9 years.

 

 

9. Preferred Securities and Warrants

Preferred Securities and Warrants Held by Yucaipa Investors

On October 15, 2009, the Company entered into a Securities Purchase Agreement with the Yucaipa Investors. Under the agreement, the Company issued and sold to the Yucaipa Investors (i) $75.0 million of preferred stock comprised of 75,000 shares of the Company’s Series A preferred securities, $1,000 liquidation preference per share, and (ii) warrants to purchase 12,500,000 shares of the Company’s common stock at an exercise price of $6.00 per share, or the Yucaipa Warrants, which are exercisable utilizing a cashless exercise method only, resulting in a net share issuance.

The Series A preferred securities had an 8% dividend rate through October 15, 2014 and have a 10% dividend rate until October 15, 2016 and a 20% dividend rate thereafter.  The Company has the option to accrue any and all dividend payments.  The cumulative unpaid dividends have a dividend rate equal to the dividend rate on the Series A preferred securities.  As of March 31, 2016, the Company had undeclared and unpaid dividends of approximately $58.9 million.  The Company has the option to redeem any or all of the Series A preferred securities at par at any time.  The Series A preferred securities have limited voting rights and only vote on the authorization to issue senior preferred securities, amendments to their certificate of designations and amendments to the Company’s charter that adversely affect the Series A preferred securities.

For so long as the Yucaipa Investors own a majority of the outstanding Series A preferred securities under the terms of the certificate of designations governing the Series A preferred securities, they also have certain consent rights, subject to certain exceptions and limitations, over certain transactions involving the acquisition of the Company by any third party, other than as the result of the disposition of our real estate assets where we continue to engage in the business of managing hotel properties and other real estate, pursuant to which the Series A preferred securities are converted or otherwise reclassified into or exchanged for securities of another entity, and certain other transactions where a vote of the holders of the Series A preferred securities is required by law or the Company’s certificate of incorporation.  

As discussed in note 2, the Yucaipa Warrants to purchase 12,500,000 shares of the Company’s common stock at an exercise price of $6.00 per share have a 7-1/2 year term and are exercisable utilizing a cashless exercise method only, resulting in a net share issuance.  In accordance with ASC 815-10-15, the Yucaipa Warrants are accounted for as equity instruments indexed to the Company’s stock.  The Yucaipa Investors’ right to exercise the Yucaipa Warrants to purchase 12,500,000 shares of the Company’s common stock expires in April 2017.  The exercise price and number of shares subject to the Yucaipa Warrants are both subject to anti-dilution adjustments.

For so long as the Yucaipa Investors collectively own or have the right to purchase through exercise of the Yucaipa Warrants (assuming a cash rather than a cashless exercise) 875,000 shares of the Company’s common stock, the Company has agreed to use its reasonable best efforts to cause its Board of Directors to nominate and recommend to the Company’s stockholders the election of a person nominated by the Yucaipa Investors as a director of the Company and to use its reasonable best efforts to ensure that the Yucaipa Investors’ nominee is elected to the Company’s Board of Directors at each such meeting.  If that nominee is not elected as a director at a meeting of stockholders, the Yucaipa Investors have certain Board of Director observer rights.  Further, if the Company does not, within 30 days from the date of such meeting, create an additional seat on the Board of Directors and make available such seat to the nominee, the dividend rate on the Series A preferred securities increases by 4% during any time that a Yucaipa Investors’ nominee is not a member of the Company’s Board of Directors.  A Yucaipa Investors’ nominee currently sits on the Company’s Board of Directors.  Accordingly, the current annual dividend rate on the Series A preferred securities is 10%.    

Under the terms of the Securities Purchase Agreement, the Yucaipa Investors have consent rights over certain transactions for so long as they collectively own or have the right to purchase, assuming cashless exercise of the Yucaipa Warrants, 6,250,000 shares of the Company’s common stock, including (subject to certain exceptions and limitations):

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The Yucaipa Investors are subject to certain standstill arrangements as long as they beneficially own over 15% of the Company’s common stock.

The initial carrying value of the Series A preferred securities was recorded at its net present value less costs to issue on the date of issuance.  The carrying value will be periodically adjusted for accretion of the discount. As of March 31, 2016, the value of the preferred securities was $72.2 million, which includes cumulative accretion of $24.2 million.

See note 13 for additional information pertaining to the Series A preferred securities and the Yucaipa Warrants.

 

 

10. Related Party Transactions

The Company earned management fees, chain services reimbursements and fees for certain technical services and has receivables from hotels it owns through investments in unconsolidated joint ventures.  These fees totaled approximately $0.6 million and $1.1 million for the three months ended March 31, 2016 and 2015, respectively.

As of March 31, 2016 and December 31, 2015, the Company had receivables from these affiliates of approximately $0.4 million and $0.4 million, respectively, which are included in related party receivables on the accompanying consolidated balance sheets.

 

 

 

11. Other Expenses

Restructuring and development costs

Restructuring expenses primarily relate to costs incurred related to the Company’s corporate restructuring initiatives, such as professional fees, litigation and settlement costs, executive terminations and severance costs related to such restructuring initiatives, the Board of Directors’ strategic alterative review process costs, proxy contests, and gains and losses on asset disposals as part of major renovation projects.  Development expenses primarily relate to transaction costs related to the acquisition or termination of projects, internal development payroll and other costs and pre-opening expenses incurred related to new concepts at existing hotel and the development of new hotels, and the write-off of abandoned development projects previously capitalized. Restructuring and development costs consist of the following (in thousands):

 

 

Other non-operating expenses

Other non-operating expenses primarily relate to costs associated with discontinued operations and previously owned hotels, both consolidated and unconsolidated, miscellaneous litigation and settlement costs and other expenses that relate to the financing and investing activities of the Company.  Other non-operating expenses consist of the following (in thousands):

 

 

 

 

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12. Deferred Gain on Asset Sales

Deferred Gain

In 2011, the Company sold Mondrian Los Angeles, Royalton, Morgans, and its 50% equity interest in the joint venture that owned Sanderson and St Martins Lane. The Company continues to operate all of these hotels under long-term management agreements.

In accordance with ASC 360-20, Property, Plant and Equipment, Real Estate Sales, the Company evaluated its accounting for the gain on sales of these assets, noting that the Company continues to have significant continuing involvement in the hotels as a result of long-term management agreements and shares in risks and rewards of ownership.  Accordingly, the Company recorded deferred gains of approximately $152.4 million related to the sales of Royalton, Morgans, Mondrian Los Angeles, and the Company’s equity interests in Sanderson and St Martins Lane, which are deferred and recognized as a gain on asset sales over the initial term of the related management agreements.  Gain on asset sales were $2.0 million and $2.0 million for the three months ended March 31, 2016 and 2015, respectively.

Gain on Sale of TLG Equity Interest

On January 23, 2015, the Company completed the TLG Equity Sale, as discussed in note 1, and received proceeds of $32.8 million, net of closing costs.  In accordance with ASC 360-20, the Company recognized a gain of $1.8 million on the sale of its interest in TLG during the three months ended March 31, 2015.  The operating results of TLG’s operations from January 1, 2015 to January 22, 2015 was not significant.  

 

 

13. Subsequent Events  

 

On May 9, 2016, and as described in the Form 8-K filed with the SEC on May 9, 2016, the Company entered into a definitive agreement under which the Company will be acquired by SBEEG Holdings LLC (“SBE”), a leading global lifestyle hospitality company.  Under the terms of the agreement, SBE will acquire all of the outstanding shares of the Company’s common stock for $2.25 per share in cash.  As part of the transaction, affiliates of the Yucaipa Investors will exchange their $75.0 million in Series A preferred securities, accrued preferred dividends, and warrants for $75.0 million in preferred shares and an interest in the common equity in the acquirer and, following the closing, the leasehold interests in three restaurants in Las Vegas currently held by the Company.  The transaction, which was approved by the Company’s Board of Directors, is expected to close in the third or fourth quarter, and is subject to regulatory approvals, the assumption or refinancing of the Company’s mortgage loan agreements, and customary closing conditions, including approval of the transaction by the Company’s stockholders. The Company’s stockholders representing approximately 29% of the Company’s outstanding shares of common stock have signed voting agreements in support of this transaction, including OTK Associates, Pine River Capital Management and Vector Group Ltd.  An affiliate of Yucaipa has also signed a voting agreement in respect of its Series A preferred securities and consented to the transaction for purposes of certain provisions of the Securities Purchase Agreement between the Yucaipa Investors and the Company.

              

 

 

 

 

 

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The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q.  In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions.  Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to, those set forth under “Forward Looking Statements” in this report, “Risk Factors” in Item IA, and elsewhere in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015.

Recent Developments

 

On May 9, 2016, and as described in the Form 8-K filed with the SEC on May 9, 2016, we entered into a definitive agreement under which the Company will be acquired by SBEEG Holdings LLC (“SBE”), a leading global lifestyle hospitality company.  Under the terms of the agreement, SBE will acquire all of the outstanding shares of the Company’s common stock for $2.25 per share in cash.  As part of the transaction, an affiliate of The Yucaipa Companies (the “Yucaipa Investors”) will exchange its $75.0 million of Series A preferred securities, accrued preferred dividends, and warrants for $75.0 million in preferred shares and an interest in the common equity in the acquirer and, following the closing, the leasehold interests in three restaurants in Las Vegas currently held by us.  The transaction, which was approved by our Board of Directors, is expected to close in the third or fourth quarter, and is subject to regulatory approvals, the assumption or refinancing of our mortgage loan agreements, and customary closing conditions, including approval of the transaction by our stockholders.  The Company’s stockholders representing approximately 29% of its outstanding shares of common stock have signed voting agreements in support of this transaction, including OTK Associates, Pine River Capital Management and Vector Group Ltd.  An affiliate of Yucaipa has also signed a voting agreement in respect of its Series A preferred securities and consented to the transaction for purposes of certain provisions of the Securities Purchase Agreement between the Yucaipa Investors and the Company.

 

SBE has obtained commitments to finance the transaction through a combination of proceeds from the sale of new preferred equity in the newly-formed company to a third-party investor, liquidity from the refinancing of its existing term loans and a new revolver.

Overview

Morgans Hotel Group Co. is a fully integrated lifestyle hospitality company that operates, owns, acquires, and develops boutique hotels, primarily in gateway cities and select resort markets in the United States, Europe and other international locations.  

The historical financial data presented herein is the historical financial data for:

Effective May 1, 2016, we transferred all of our ownership interest in the food and beverage venues at Sanderson to the hotel owner.  We will continue to manage the transferred food and beverage venues.  Prior to May 1, 2016, we leased and managed the Sanderson food and beverage venues, which were included in our consolidated financial statements.  

Effective January 23, 2015, we sold our 90% equity interest in The Light Group (“TLG”) to Hakkasan Holdings LLC (“Hakkasan”) (the “TLG Equity Sale”) for $32.8 million, net of closing costs.  

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Management, Franchise, and License Agreements.  Although our hotel management agreements and franchise or license agreements are generally long-term, they may be subject to early termination in specified circumstances, or we may agree to early termination as circumstances require.  For example, on January 28, 2016, we entered into amendments to each of the hotel management agreements relating to Royalton and Morgans, with the owner of these hotels.  In connection with the hotel owners potential sale of those hotels, we agreed to allow the owner to sell the hotels unencumbered by the current hotel management agreements.  Under each of the amendments, the owner has the right to terminate the hotel management agreements at any time upon at least 30 days’ prior written notice in exchange for paying us $3.5 million for each of the hotels, or $7.0 million in total, upon a termination of each agreement.  We expect to continue to manage the hotels until they are sold.

Certain of our hotel management agreements and franchise or license agreements contain performance tests that stipulate certain minimum levels of operating performance, which could result in early termination of our hotel management, license or franchise agreements, once the performance test period begins, which is generally multiple years after a hotel opens.  As of March 31, 2016, we are in compliance with these termination performance tests and are not exercising any contractual cure rights.  We may disagree with hotel owners on how the performance criteria are calculated or whether they have been met.  In addition, some courts have applied principles of agency law and related fiduciary standards to managers of third-party hotel properties (or have interpreted hotel management agreements as “personal services contracts”).  This means, among other things, that property owners may assert the right to terminate management agreements even where the agreements provide otherwise, and some courts have upheld such assertions regarding management agreements and may do so in the future.  

Several of our hotels are also subject to mortgage and mezzanine debt, and in some instances our management, franchise or license fee is subordinated to the debt.  Some of our management agreements also may be terminated by the lenders on foreclosure or certain other related events.  With some of our existing management, franchise and license agreements we have negotiated, and with all of our new management, franchise and license agreements for hotels under development we attempt to negotiate, non-disturbance agreements or similar protections with the mortgage lender, or to require that such agreements be entered into upon securing of financing, in order to protect our agreements in the event of foreclosure.  However, we are not always successful in imposing these requirements, and some of our new development projects and existing hotels do not have non-disturbance or similar protections, which may make the related agreements subject to termination by the lenders on foreclosure or certain other related events.   Even if we have such non-disturbance protections in place, they may be subject to conditions and may be difficult or costly to enforce in a foreclosure situation.

We may also terminate hotel management, franchise or license agreements as circumstances require or as we deem appropriate.  

Operating Performance Indicators

We evaluate the operating performance of our business using a variety of operating and other information that includes financial information prepared in accordance with U.S. GAAP such as total revenues, operating income (loss), net income (loss), as well as non-GAAP financial information.  In addition, we use other information that may not be financial in nature, including statistical information and comparative data.  We use this information to measure the performance of individual hotels, groups of hotels, and/or our business as a whole.  Key operating performance indicators commonly used by us, and throughout the hospitality industry, to analyze changes in hotel revenues include:

These revenue performance indicators are affected by numerous factors, which are discussed in more detail below in “Factors Affecting our Results of Operations.”  

If we are unable to compete effectively, we would lose market share, which could adversely affect our revenues.  As such, another key performance indicator we use to evaluate our hotels’ operating performance as compared to our competitors is by analyzing each hotel’s RevPAR index, which is a comparison of a hotel’s RevPAR as compared it each hotel’s respective competitive set.  We rely on industry publications and data, namely as provided by Smith Travel Research, to perform this RevPAR index analysis.  

In addition to the above metrics we use to evaluate our business, we evaluate our operating results using certain non-GAAP financial measures, namely EBITDA and Adjusted EBITDA.  

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Factors Affecting Our Results of Operations

Revenues.  As mentioned above, changes in our hotel revenues are most easily explained by changes in occupancy, ADR, and RevPAR.  Specifically, our revenues are derived from the operation of hotels, as well as the operation of our food and beverage venues.  Specifically, our revenue consists of:

Fluctuations in revenues, which tend to correlate with changes the gross domestic product (“GDP”), are driven largely by general economic and local economic conditions but can also be impacted by major events, such as terrorist attacks or natural disasters, which in turn affect levels of business and leisure travel.  Renovations at our hotels can have a significant impact on our revenues.

The seasonal nature of the hospitality business can also impact revenues.  For example, our Miami hotels are generally strongest in the first quarter, whereas our New York hotels are generally strongest in the fourth quarter.  However, prevailing economic conditions can cause fluctuations which impact seasonality.

In addition to economic conditions, supply is another important factor that can affect revenues.  Room rates, occupancy and food and beverage revenues tend to fall when supply increases, unless the supply growth is offset by an equal or greater increase in demand.

Finally, competition within the hospitality industry can affect revenues.  Competitive factors in the hospitality industry include name recognition, pricing, quality of service, convenience of location, quality of the property or venue, and range and quality of nightlife, food and beverage services and amenities offered.  We also compete with other operators, including major hospitality chains with well-established and recognized brands as well as private short-term room and accommodation rentals.  Our competitors generally also have more established and broader reaching guest loyalty programs which may enable them to attract more customers and more effectively retain such guests.  In addition, all of our hotels, restaurants, nightclubs and bars are located in areas where there are numerous competitors, many of whom have substantially greater financial and marketing resources than us.  New or existing competitors could offer significantly lower rates and pricing or more convenient locations, services or amenities or significantly expand, improve or introduce new service offerings in markets in which our hotels, restaurants, nightclubs, bars, and other food and beverage venues compete, thereby posing a greater competitive threat than at present.

Operating Costs and Expenses.  Our operating costs and expenses consist of the costs to provide hotel and food and beverage services, costs to operate our hotel management company, costs to operate TLG prior to the TLG Equity Sale, and costs associated with the ownership of our assets, including:

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Other Items.  Other expenses we incur include:

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Most categories of variable operating expenses, such as operating supplies, and certain labor, such as housekeeping, fluctuate with changes in occupancy.  Increases in RevPAR attributable to increases in occupancy are accompanied by increases in most categories of variable operating costs and expenses.  Increases in RevPAR attributable to improvements in ADR typically only result in increases in limited categories of operating costs and expenses, primarily credit card and travel agent commissions.  Thus, improvements in ADR have a more significant impact on improving our operating margins than occupancy.

Notwithstanding our efforts to reduce variable costs, there are limits to how much we can reduce total costs because we have significant costs that are relatively fixed costs, such as depreciation and amortization, labor costs and employee benefits, insurance, real estate taxes, interest and other expenses associated with owning hotels that do not necessarily decrease when circumstances such as market factors cause a reduction in our hotel revenues.

Operating Results and Recent Trends

The performance of the lodging industry is highly cyclical and has traditionally been closely linked with the performance of the general economy and, specifically, growth in the U.S. GDP, employment, and investment and travel demand.  During 2015 and into 2016, the U.S. experienced modest GDP growth, however increased supply in our major markets, discussed below, impacted our hotels’ occupancy and constrained our rate growth during 2015 and the first quarter of 2016.  Further, the impact of the strong U.S. dollar and a weak global economy, specifically in Europe and China, has impacted, and may continue to impact, our hotels in New York City, Miami and London, where we are particularly dependent on international tourists.

The pace of new lodging supply, especially in New York City and Miami, has increased over the past several years and we expect that these trends will continue into 2016 as the new supply in these markets is absorbed.  In these markets, the new lodging supply impacted our hotels’ occupancy and constrained rate growth during the first quarter of 2016.  

Additionally, we believe the rising popularity of alternative lodging companies, such as privately-owned residential properties, including homes and condominiums that can be rented on a nightly, weekly or monthly, have had an impact on our business and operations, as travelers have opted to stay at these privately placed accommodations rather than at our hotels, especially in larger cities, such as New York City, where we have a high concentration of hotel rooms.  We believe that this trend will continue into 2016 and may have a more meaningful impact in other domestic and international markets in which we are located.

RevPAR at System-Wide Comparable Hotels, which includes all Morgans Hotel Group branded hotels operated by us, except for hotels added or under major renovation during the current period or the prior year period, development projects and hotels no longer managed by us, decreased by 4.2% (in constant dollars) in the first quarter of 2016 as compared to the same period in 2015, due to a 7.7% (in constant dollars) decrease ADR, partially offset by a 3.8% increase in occupancy.  

RevPAR from System-Wide Comparable Hotels in New York decreased 5.0% for the quarter ended March 31, 2016 as compared to the same period in 2015, due to a 5.6% decrease in ADR slightly offset by a 0.7% increase in occupancy.  RevPAR at Hudson decreased 6.8% during the first quarter of 2016 as compared to the same period in 2015, driven primarily by a 7.0% ADR decrease.    

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RevPAR from System-Wide Comparable Hotels in Miami decreased 16.0% in the first quarter of 2016 as compared to the same period in 2015, driven by an 18.3% decrease in ADR.  Delano South Beach experienced a RevPAR decrease of 9.7% during the first quarter of 2016 as compared to the same period in 2015, due to a 15.0% decline in ADR.  

Our System-Wide Comparable Hotels on the West Coast generated 7.9% RevPAR growth in the first quarter of 2016 as compared to 2015, driven by Clift, which experienced a 7.9% RevPAR increase quarter over quarter.  

RevPAR from System-Wide Comparable Hotels in London, which includes Sanderson and Mondrian London, increased 9.8% (in constant dollars) in the first quarter of 2016 as compared to the same period in 2015, driven primarily by an 11.9% increase in occupancy.  

Comparison of Three Months Ended March 31, 2016 to Three Months Ended March 31, 2015

The following table presents our operating results for the three months ended March 31, 2016 and 2015, including the amount and percentage change in these results between the two periods. The consolidated operating results are as follows:

 

 

Total Hotel Revenues. Total hotel revenues decreased 2.9% to $47.9 million for the three months ended March 31, 2016 compared to $49.3 million for the three months ended March 31, 2015. This decrease was primarily due to decreased ADR at our Owned Hotels, offset by an increase in occupancy, discussed below.

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Rooms revenue decreased 2.1% to $25.2 million for the three months ended March 31, 2016 compared to $25.8 million for the three months ended March 31, 2015. This decrease was primarily due to decreases in ADR at Hudson and Delano South Beach during the three months ended March 31, 2016 as compared to the same period in 2015, primarily due to increased competition from new supply in New York and Miami and the strong U.S. Dollar as compared to other currencies.

The components of RevPAR from our Owned Hotels, which consisted, as of March 31, 2016, of Hudson, Delano South Beach and Clift, for the three months ended March 31, 2016 and 2015 are summarized as follows:

 

 

Food and beverage revenue decreased 5.3% to $20.4 million for the three months ended March 31, 2016 compared to $21.6 million for the three months ended March 31, 2015. This decrease was primarily due to decreases in revenues at Delano South Beach and Hudson.  The revenue decline at Delano South Beach was primarily due to increased competition in Miami which negatively impacted the Delano South Beach’s nightclub, restaurants and bars.  Additionally, in July 2015, Hudson discontinued its room service offering, resulting in decreased revenues in the first quarter of 2016 as compared to the same period in 2015.  

Other hotel revenue increased 13.8% to $2.2 million for the three months ended March 31, 2016 compared to $1.9 million for the three months ended March 31, 2015. This increase was primarily due to increased spa revenue at Delano South Beach.  Effective May 2015, Delano South Beach began managing the hotels spa as a result of the termination of an operating lease with a third-party.

Management Fee—Related Parties and Other Income. Management fee—related parties and other income decreased by 21.4% to $3.1 million for the three months ended March 31, 2016 compared to $4.0 million for the three months ended March 31, 2015. This decrease was primarily due to the sale of our interest in TLG in January 2015 and termination of Mondrian SoHo management agreement effective April 27, 2015.  Excluding TLG and Mondrian SoHo, management fees decreased by $0.2 million, or 6.9%, due primarily to the impact of new supply in Miami on the operating results of our managed hotels in that area.      

Operating Costs and Expenses

Rooms expense increased 6.5% to $9.5 million for the three months ended March 31, 2016 compared to $8.9 million for the three months ended March 31, 2015.  This increase was due primarily to the increase in occupancy at our Owned Hotels noted above, along with inflationary increases.

Food and beverage expense decreased 5.7% to $13.8 million for the three months ended March 31, 2016 compared to $14.7 million for the three months ended March 31, 2015. This decrease is primarily due to reduced expenses at Delano South Beach, driven by cost savings measures implemented as a result of the decline in revenues, and Hudson, as a result of the elimination of room service, both discussed above.    

Other departmental expense increased 14.9% to $1.1 million for the three months ended March 31, 2016 compared to $1.0 million for the three months ended March 31, 2015. This increase was primarily due to increased expenses at Delano South Beach related to the hotels’ management of the spa effective in May 2015, discussed above.    

Hotel selling, general and administrative expense was relatively flat at $10.2 million for the three months ended March 31, 2016 compared to the three months ended March 31, 2015 primarily due to cost saving initiatives.

Property taxes, insurance and other expense increased 17.0% to $4.5 million for the three months ended March 31, 2016 compared to $3.9 million for the three months ended March 31, 2015.   This increase was primarily due to an increase in Hudson’s real estate tax assessment effective July 2015.  

Corporate expenses, including stock compensation decreased 29.3% to $4.3 million for the three months ended March 31, 2016 compared to $6.0 million for the three months ended March 31, 2015. This decrease was primarily due vacant positions in the corporate office, a decline in stock compensation expense, and the TLG Equity Sale completed in January 2015.  

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Depreciation and amortization was relatively flat at $5.7 million for the three months ended March 31, 2016 compared to $5.6 million in the three months ended March 31, 2015.

Restructuring and development costs decreased 66.7% to $0.7 million for the three months ended March 31, 2016 compared to $2.1 million for the three months ended March 31, 2015. This decrease was primarily due to severance-related costs incurred during the three months ended March 31, 2015, for which no comparable costs were incurred during 2016.       

Interest expense, net decreased 5.6% to $11.2 million for the three months ended March 31, 2016 compared to $11.8 million for the three months ended March 31, 2015. This decrease was primarily due to the $28.2 million prepayment of outstanding debt under the Hudson/Delano 2014 Mortgage Loan in February 2016.    

Impairment loss and equity in income of unconsolidated joint ventures decreased $3.9 million between the three months ended March 31, 2016 and March 31, 2015 as the result of a $3.9 million impairment loss of our investment in Mondrian Istanbul which we recorded in the first quarter of 2015.  We no longer record our share of equity losses on a majority of our unconsolidated joint ventures, as we have written our investment balances down to zero due to losses recorded in prior periods.  

Impairment loss on intangible asset increased $0.4 million due to the impairment of goodwill associated with our ownership interest in the food and beverage venues at Sanderson, which we transferred to the hotel owner effective May 1, 2016.  

Other non-operating expenses decreased 68.7% to $0.5 million for the three months ended March 31, 2016 as compared to $1.7 million for the three months ended March 31, 2015. This decrease was primarily due to legal costs incurred related to the Mondrian SoHo litigation, which settled in October 2015.  

Income tax expense was relatively flat at $0.1 million for each of the three months ended March 31, 2016 and 2015. 

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Liquidity and Capital Resources  

Short-Term Liquidity.  As of March 31, 2016, we had approximately $11.9 million in cash and cash equivalents.  We also had $15.3 million of restricted cash as of March 31, 2016, which consisted primarily of cash held in escrow accounts for debt service or lease payments, capital expenditures, insurance programs, and taxes.  

 

As discussed above in “Recent Developments” and in our Form 8-K filed with the SEC on May 9, 2016, we entered into a definitive agreement under which we will be acquired by SBE.  Under the terms of the agreement, SBE will acquire all of the outstanding shares of the Company’s common stock for $2.25 per share in cash.  The transaction is expected to close in the third or fourth quarter, and is subject to regulatory approvals, the assumption or refinancing of our mortgage loan agreements, and customary closing conditions, including approval of the transaction by our stockholders.  The Company’s stockholders representing approximately 29% of its outstanding shares of common stock have signed voting agreements in support of this transaction, including OTK Associates, Pine River Capital Management and Vector Group Ltd.  An affiliate of Yucaipa has also signed a voting agreement in respect of its Series A preferred securities and consented to the transaction for purposes of certain provisions of the Securities Purchase Agreement between the Yucaipa Investors and the Company.

 

If an agreement with respect to the sale of the Company is not completed, we believe that we will need to explore other alternatives, including re-engaging our process for the sale of Hudson and Delano South Beach.  Under that scenario, if we sell Hudson and Delano South Beach, we would intend to use the proceeds from those asset sales to retire the Hudson/Delano 2014 Mortgage Loan, pay transaction costs in connection with the proposed sale of the Company and provide for working capital needs.  We would use the remaining proceeds, if any, to redeem the outstanding Series A preferred securities and accrued dividends.  If the Trust Preferred Notes are accelerated, as discussed below, it would reduce the amount of Series A preferred securities and accrued dividends that we would be able to redeem.  As disclosed in note 9 of our consolidated financial statements, the Yucaipa Investors have certain consent rights over certain transactions for so long as they collectively own or have the right to purchase through exercise of the Yucaipa Warrants 6,250,000 shares of the Company’s common stock.  We cannot assure you that should the SBE transaction not be consummated that the Yucaipa Investors would not assert a right to approve any sale of the Hudson or Delano South Beach assets, which if such approval is withheld, could materially impact our ability to consummate the asset sales.

Our ability to pay interest and dividends on, and the outstanding balances of, our debt and our Series A preferred securities, fund our operations, and make anticipated capital expenditures depends upon our future operating performance and our ability to complete the sale of the Company or, to the extent the sale is not consummated, to monetize the Hudson and Delano South Beach hotels.   Prevailing economic conditions, our ability to consummate the sale of the Company, or our ability to monetize our owned real estate assets, if at all, and financial, business and other factors, many of which are beyond our control, will affect our ability to make these payments and fund operations.  

Our near term obligations, include funding operating expenses and debt service payments and likely posting an approximately $3.0 million bond to appeal a matter subject to litigation, as discussed below in “Other Liquidity Matters - TLG Promissory Notes Litigation.”  While we believe our cash on hand, including restricted cash, is sufficient to cover our short term obligations, we may not have sufficient liquidity to address unforeseen expenses or a further downturn in operating results if the sale of the Company is not consummated.   We may need to reduce operating expenses or delay certain capital expenditures in the event that operating results are below expectations and further additional restructuring and non-operating costs are incurred.  In addition, the Hudson/Delano 2014 Mortgage Loan provides that all cash flows from Hudson and Delano South Beach are deposited into accounts controlled by the lenders from which debt service and operating expenses, including management fees, are paid and from which other reserve accounts may be funded.  In the event the debt yield ratio falls below 6.75%, any excess amounts will be retained by the lenders until the debt yield ratio exceeds 7.00% for two consecutive calendar quarters.  As of March 31, 2016, our debt yield ratio was 6.84%.  We may fall below the 6.75% threshold during the second quarter of 2016.  

The $421.8 million of outstanding debt under the Hudson/Delano 2014 Mortgage Loan matures on February 9, 2017.  We have two remaining one-year extension options that will permit us to extend the maturity date to February 9, 2019, if certain conditions are satisfied at the respective extension dates, including the achievement of a debt yield (determined by a ratio conveyed as a percentage in which (i) the numerator is our trailing 12 month cash flow and (ii) the denominator is the then outstanding principal amount of debt under the Hudson/Delano 2014 Mortgage Loan) of no less than 7.75% for the first extension and no less than 8.00% for the second extension.  If the sale of the Company is not consummated, to the extent we decide to further extend the maturity date of the debt outstanding under the Hudson/Delano 2014 Mortgage Loan, we may need to prepay the Hudson/Delano 2014 Mortgage Loan in an amount necessary to achieve the applicable debt yield.  Additionally, each of the remaining extension options also requires the payment of an extension fee in an amount equal to 0.25% of the then outstanding principal amount under the Hudson/Delano 2014 Mortgage Loan.  Based on our trailing 12 month cash flow through March 31, 2016, we estimate that we would be required to prepay approximately $50.0 million of outstanding debt under the Hudson/Delano 2014 Mortgage Loan by February 9, 2017 and pay an

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approximately $1.0 million extension fee in order to extend the maturity date of the debt outstanding under the Hudson/Delano 2014 Mortgage Loan to February 9, 2018.  

Our Series A preferred securities currently have a 10% per annum dividend rate which will increase to a 20% per annum dividend rate effective October 16, 2016.  We have the option to accrue any and all dividend payments, and as of March 31, 2016, we have not declared any dividends.  The cumulative unpaid dividends also have a dividend rate equal to the then applicable dividend rate on the Series A preferred securities.  As of March 31, 2016, we had $75.0 million of outstanding Series A preferred securities and $58.9 million of accrued and unpaid dividends.  We have the option to redeem any or all of the Series A preferred securities at any time at a redemption price equal to the sum of (i) $1,000 per security and (ii) the accumulated and unpaid dividends to the redemption date.  See footnote 11 in our consolidated financial statements for more information about our Series A preferred securities.

Additionally, our Trust Preferred Notes bear interest at a fixed rate of 8.68% until October 2016, and thereafter will bear interest at a floating rate based on the three-month LIBOR plus 3.25%.  The Trust Preferred Notes may be redeemed at par.  In the event we undertake a transaction that is deemed to constitute a transfer or sale of our assets substantially as an entirety within the meaning of the indenture governing the Trust Preferred Notes, and the holders of the Trust Preferred Notes exercise their right to accelerate payment of the Trust Preferred Notes, we would be required to repay the $50.1 million outstanding Trust Preferred Notes prior to their maturity.  Alternatively, we would need to obtain the necessary consents of holders of a majority in aggregate principal amount of the Trust Preferred Notes, which may require a restructuring of these notes.   Based on preliminary conversations with the manager of our outstanding Trust Preferred Notes, a sale of Hudson and Delano Beach may be deemed to constitute a sale of the Company’s assets substantially as an entirety within the meaning of the indenture.  See “—Debt” for more information about our trust notes.  

There can be no assurances that the sale of the Company will occur.  If the sale of the Company is not consummated, there can be no assurances that a sale of our hotel assets will occur.  Further, assuming we sell Hudson and Delano South Beach, there is no assurance that a sale will occur at prices sufficient to retire all of our debt and preferred equity instruments as planned.  Under this scenario, in the event that the net proceeds from contemplated asset sales, along with other cash sources, are not sufficient, we may explore various financing options, to the extent available to us, to retire any remaining debt outstanding under the Hudson/Delano 2014 Mortgage Loan and redeem any remaining Series A preferred securities and accrued dividends.  We may have to undertake alternative financing plans, such as refinancing or restructuring these obligations, reducing or delaying capital investments or seeking to raise additional capital through issuance of common or preferred equity or convertible securities, although there can be no assurance that we can access any of these sources of liquidity on terms acceptable to us, or at all, in the future.  

We are obligated to maintain certain reserve funds at our Owned Hotels as determined pursuant to our debt or lease agreements related to such hotels which require us to deposit cash into escrow accounts which are restricted to their usage.  These reserve funds include reserves related to debt service, reserve funds for capital expenditures, which relate primarily to the periodic replacement or refurbishment of furniture, fixtures and equipment at amounts generally equal to 4% of the hotel’s revenues, insurance programs, and taxes, among other things.

In connection with the third party owner’s plans to convert the Shore Club hotel to condominiums and in accordance with the owner’s preexisting termination right, we and the hotel owner agreed to terminate our management of the hotel prior to the expiration of the management agreement.  Currently, we currently believe that our management of Shore Club will terminate effective in the fourth quarter of 2016.  We will continue to manage Shore Club in accordance with the terms of the management agreement until the termination date becomes effective.  Upon termination, we expect to receive a termination fee of approximately $3.0 million.  

Further, as discussed in “Business—Overview—Management, Franchise, and License Agreements,” if the hotel owner terminates the Royalton and/or Morgans hotel management agreements at any time upon at least 30 days’ prior written notice, that owner is obligated to pay us a $3.5 million termination fee for each hotel, or $7.0 million in total, upon a termination of each agreement.  We understand that the owner is actively marketing the hotels for sale; however, we expect to continue to manage the hotels until they are sold.  

As of March 31, 2016, we had approximately $443.3 million of remaining Federal tax net operating loss carryforwards to offset future income.  If the sale of the Company is not consummated and we pursue hotel asset sales, we believe we have significant value available to us in Hudson and Delano South Beach, and that the tax basis of these assets is significantly less than their fair values.  As of March 31, 2016, we estimate that the tax basis of Hudson is approximately $139.9 million and tax basis of Delano South Beach is approximately $65.9 million.  

Long-Term Liquidity.  Our long-term liquidity requirements include our obligations to pay scheduled debt maturities, which primarily consist of  our outstanding Trust Preferred Notes, which mature in October 2036, and the Clift lease, each as described under “—Debt.”  Additionally, we may have long-term liquidity requirements that are expected to be incurred by us or our consolidated subsidiaries beyond the next 12 months consisting of targeted renovations at our Owned Hotels and other non-recurring capital

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expenditures that need to be made periodically with respect to our properties, including a renovation of the façade of Hudson as required by Applicable Law, which must be completed by April 2018, costing an estimated $6.0 million, which we intend to fund through amounts in restricted cash and additional funds provided by the Company, costs associated with guarantees and debt maturity at our Joint Venture Hotel, the costs associated with acquisitions and development of properties under contract, and new acquisitions and development projects that we may pursue. As of March 31, 2016, our Joint Venture Hotel, Mondrian South Beach, had outstanding nonrecourse mortgage debt of $18.7 million and mezzanine debt of $28.0 million.  The Mondrian South Beach joint venture also has an additional $28.0 million of mezzanine debt owed to affiliates of the joint venture partners.  The lender’s nonrecourse mortgage loan and mezzanine loan related to Mondrian South Beach matures in April 2017.  We and affiliates of our Mondrian South Beach joint venture partner also have each agreed to purchase approximately $14.0 million of condominium units under certain conditions, including an event of default.  In the event of a default under the lender’s mortgage or mezzanine loan, the joint venture partners are each obligated to purchase selected condominium units, at agreed-upon sales prices, having aggregate sales prices equal to half of the lesser of (i) $28.0 million, which is the face amount outstanding on the lender’s mezzanine loan, and (ii) the then outstanding principal balance of the lender’s mezzanine loan.  The Mondrian South Beach joint venture is not currently in an event of default under the mortgage or mezzanine loan.  We have not recognized a liability related to the condominium purchase guarantees as no triggering event has occurred.

Other Liquidity Matters

In addition to our expected short-term and long-term liquidity requirements, our liquidity could also be affected by certain other potential liquidity matters, including at our Joint Venture Hotel and former joint venture hotel, as discussed below.

Mondrian South Beach Mortgage and Mezzanine Debt Guarantees.  Morgans Group and affiliates of our joint venture partner have agreed to provide standard nonrecourse carve-out guarantees and provide certain limited indemnifications for the Mondrian South Beach mortgage and mezzanine loans.  In the event of a default, the lenders’ recourse is generally limited to the mortgaged property or related equity interests, subject to standard nonrecourse carve-out guarantees for “bad boy” type acts.  Morgans Group and affiliates of our joint venture partner also agreed to guaranty the joint venture’s obligation to reimburse certain expenses incurred by the lenders and indemnify the lenders in the event such lenders incur liability in connection with certain third-party actions.  Morgans Group and affiliates of our joint venture partner have also guaranteed the joint venture’s liability for the unpaid principal amount of any seller financing note provided for condominium sales if such financing or related mortgage lien is found unenforceable, provided they shall not have any liability if the seller financed unit becomes subject again to the lien of the lender’s mortgage or title to the seller financed unit is otherwise transferred to the lender or if such seller financing note is repurchased by Morgans Group and/or affiliates of our joint venture partner at the full amount of unpaid principal balance of such seller financing note.  As of March 31, 2016, there has been no triggering event that would require us to accrue any potential liabilities related to any of the above mentioned guarantees.

TLG Promissory Notes Litigation. As discussed further in “Part II.  Item 1.  Legal Proceedings,” in February 2016, the plaintiff’s partial summary judgment motion in the litigation relating to the TLG Promissory Notes was granted.   While no judgment has yet been entered, the judge has signed an order for approximately $2.8 million.  We have filed a notice of appeal and may be required to post a cash bond in the amount of the judgment to secure our ability to perfect our appeal.  Plaintiffs also have a claim for attorneys' fees which we intend to dispute and oppose. They have not yet stated a claimed amount to the court but they have recently estimated this claim at approximately $1.0 million.  

Potential Litigation.  We may have potential liability in connection with certain claims by a designer for which we have accrued $13.9 million as of March 31, 2016, as discussed in note 5 of our consolidated financial statements.  

Other Possible Uses of Capital.  We may invest in new management, franchise and license agreements through key money, equity or debt investments.  To fund any such future investments, we may from time to time pursue various potential financing opportunities available to us.

We have a number of additional development projects signed or under consideration, some of which may require equity investments, key money or credit support from us.  In addition, through certain cash flow guarantees, we may have potential future fundings for operating hotels and hotels under development, as discussed in note 7 of our consolidated financial statements.

Comparison of Cash Flows for the Three Months Ended March 31, 2016 to the Three Months Ended March 31, 2015  

Operating Activities. Net cash used in operating activities was $2.9 million for the three months ended March 31, 2016 as compared to net cash used in operating activities of $5.7 million for the three months ended March 31, 2015.  

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Investing Activities. Net cash used in investing activities amounted to $1.1 million for the three months ended March 31, 2016 as compared to net cash provided by investing activities of $30.9 million for the three months ended March 31, 2015.  Net cash provided by investing activities in 2015 was primarily due to the TLG Equity Sale, which closed in January 2015.  

Financing Activities. Net cash used in financing activities amounted to $30.0 million for the three months ended March 31, 2016 as compared to cash used in financing activities of $0.6 million for the three months ended March 31, 2015. This change was primarily due to the principal paydown and maturity date extension of the Hudson/Delano 2014 Mortgage Loan in February 2016, discussed below in “—Debt.”  

Debt

Hudson/Delano 2014 Mortgage Loan.  On February 6, 2014, certain of our subsidiaries entered into a financing arrangement with Citigroup Global Markets Realty Corp. and Bank of America, N.A., as lenders, consisting of nonrecourse mortgage and mezzanine loans in the aggregate principal amount of $450.0 million, secured by mortgages encumbering Delano South Beach and Hudson and pledges of equity interests in certain of our subsidiaries (collectively, the “Hudson/Delano 2014 Mortgage Loan”).  The net proceeds from the Hudson/Delano 2014 Mortgage Loan were applied to repay outstanding mortgage debt under the prior mortgage loan secured by Hudson, repay indebtedness under our senior secured revolving credit facility secured by Delano South Beach, and fund reserves required under the Hudson/Delano 2014 Mortgage Loan, with the remainder available for general corporate purposes and working capital.

The Hudson/Delano 2014 Mortgage Loan was scheduled to mature on February 9, 2016.  On that date, we paid $28.2 million to reduce the principal debt balance by the same amount and extend the maturity of this debt until February 9, 2017.  We have two remaining one-year extension options that will permit us to extend the maturity date to February 9, 2019, if certain conditions are satisfied at the respective extension dates, including the achievement of a debt yield of no less than 7.75% for the first extension and no less than 8.00% for the second extension.  We may prepay the Hudson/Delano 2014 Mortgage Loan in an amount necessary to achieve the specified debt yield, such as we did in February 2016.  The second and third extensions would also require the payment of an extension fee equal to 0.25% of the then outstanding principal amount.   Based on our trailing 12 month cash flow through March 31, 2016, we estimate that we would be required to prepay approximately $50.0 million of outstanding debt under the Hudson/Delano 2014 Mortgage Loan by February 9, 2017 and pay an approximately $1.0 million extension fee in order to extend the maturity date of the debt outstanding under the Hudson/Delano 2014 Mortgage Loan to February 9, 2018.  

The Hudson/Delano 2014 Mortgage Loan bears interest at a blended rate of 30-day LIBOR plus 565 basis points.  Prior to the loan extension in February 2016, we maintained interest rate caps for the $450.0 million principal amount of the Hudson/Delano 2014 Mortgage Loan that capped the LIBOR rate on the debt at 1.75%.  In February 2016, we purchased three interest rate caps with an aggregate notional value of $421.8 million that cap LIBOR at 0.29% through the next maturity date of the loan.

The Hudson/Delano 2014 Mortgage Loan may be prepaid at any time, in whole or in part.  The Hudson/Delano 2014 Mortgage Loan is assumable under certain conditions, and provides that either one of the encumbered hotels may be sold, subject to prepayment of the Hudson/Delano 2014 Mortgage Loan at a specified release price and satisfaction of certain other conditions.

Notes to a Subsidiary Trust Issuing Preferred Securities.  In August 2006, we formed a trust, MHG Capital Trust I (the “Trust”), to issue $50.0 million of Trust Preferred Notes in a private placement.  The sole assets of the Trust consist of the Trust Preferred Notes due October 30, 2036 issued by Morgans Group and guaranteed by Morgans Hotel Group Co.  The Trust Preferred Notes have a 30-year term, ending October 30, 2036, and bear interest at a fixed rate of 8.68% until October 2016, and thereafter will bear interest at a floating rate based on the three-month LIBOR plus 3.25%.  These securities are redeemable by the Trust at par.  In the event we were to undertake a transaction that was deemed to constitute a transfer of our properties and assets substantially as an entirety within the meaning of the indenture, we may be required to repay the Trust Preferred Notes prior to their maturity or obtain the trustee’s consent in connection with such transfer.

Clift.  We lease Clift under a 99-year nonrecourse lease agreement expiring in 2103.  The lease is accounted for as a capital lease with a liability balance of $95.8 million at March 31, 2016.

Clift lease agreement provided for base annual rent of approximately $6.0 million per year until October 2014. Base rent increases by a formula tied to increases in the Consumer Price Index, with a maximum increase of 20% and a minimum increase of 10% at each five-year rent increase date.  As a result of the first contractual increase, effective October 14, 2014, the annual rent increased to $7.6 million.  The lease is nonrecourse to us.  Morgans Group also entered into a limited guaranty, whereby Morgans Group agreed to guarantee losses of up to $6.0 million suffered by the lessors in the event of certain “bad boy” type acts.  As of March 31, 2016, there has been no triggering event that would require us to accrue any potential liability related to this guarantee.

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Hudson Capital Leases.  We lease two condominium units at Hudson which are reflected as capital leases with an aggregate balance of $6.1 million at March 31, 2016.  Currently, annual lease payments total approximately $1.0 million and are subject to increases in line with inflation.  The leases expire in 2096 and 2098.

Restaurant Lease Note.  In August 2012, we entered into a 10-year licensing agreement with MGM, with two five-year extensions at our option subject to performance thresholds, with MGM to convert an existing hotel to Delano Las Vegas, which is managed by MGM, with two five-year extensions at our option, subject to performance thresholds.  In addition, we acquired the leasehold interests in three food and beverage venues at Mandalay Bay in Las Vegas from an existing tenant for $15.0 million in cash at closing and a principal-only $10.6 million note (the “Restaurant Lease Note”) to be paid over seven years.

The Restaurant Lease Note does not bear interest except in the event of default, as defined in the agreement.  In accordance with ASC 470, Debt, we imputed interest on the Restaurant Lease Note, which was recorded at its fair value of $7.5 million as of the date of issuance.  At March 31, 2016, the carrying amount of the Restaurant Lease Note is $4.5 million.

Joint Venture Debt.  See “— Other Liquidity Matters” and “— Off-Balance Sheet Arrangements” for descriptions of joint venture debt.

Seasonality

The hospitality business is seasonal in nature.  For example, our Miami hotels are generally strongest in the first quarter, whereas our New York hotels are generally strongest in the fourth quarter.  Quarterly revenues also may be adversely affected by events beyond our control, such as global recession, extreme weather conditions, terrorist attacks or alerts, natural disasters, airline strikes, and other considerations affecting travel.

Due to increased supply in New York City and Miami and the global economic downturn, the impact of seasonality was not as significant as in prior periods and may continue to be less pronounced in 2016.

Capital Expenditures and Reserve Funds

We are obligated to maintain reserve funds for capital expenditures at our Owned Hotels as determined pursuant to our debt or lease agreements related to such hotels.  As of March 31, 2016, approximately $3.5 million was available in restricted cash reserves for future capital expenditures under these obligations related to our Owned Hotels.  Additionally, we are required by Applicable Law to renovate the façade of Hudson by April 2018.  We believe this renovation will cost an estimated $6.0 million in the aggregate, which we intend to fund through amounts in restricted cash and additional funds provided by the Company.  

In addition to reserve funds for capital expenditures, our Owned Hotels debt and lease agreements also require us to deposit cash into escrow accounts for debt service or lease payments, insurance, and taxes, among other things.  As of March 31, 2016, approximately $9.9 million was included in restricted cash reserves for these obligations related to our Owned Hotels.  

Our Joint Venture Hotel and our Managed Hotels generally are subject to similar obligations under our management agreements or under debt agreements related to such hotels.  These capital expenditures relate primarily to the periodic replacement or refurbishment of furniture, fixtures and equipment.  Such agreements typically require the hotel owner to reserve funds at amounts equal to 4% of the hotel’s revenues and require the funds to be set aside in restricted cash.

We anticipate Clift, a leased hotel, will need to be renovated in the next few years.

 Derivative Financial Instruments

We use derivative financial instruments to manage our exposure to the interest rate risks related to our variable rate debt.  We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors.  We determine the fair value of our derivative financial instruments using models which incorporate standard market conventions and techniques such as discounted cash flow and option pricing models to determine fair value.  We believe these methods of estimating fair value result in general approximation of value, and such value may or may not be realized.

In connection with the extension of the Hudson/Delano 2014 Mortgage Loan, in February 2016, we purchased three interest rate caps with an aggregate notional value of $421.8 million that cap LIBOR at 0.29% through the next maturity date of the loan.   As of March 31, 2016, the fair value of these interest rate caps was $1.0 million.  

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On October 15, 2009, we entered into a Securities Purchase Agreement with the Yucaipa Investors.  Under the Securities Purchase Agreement, we issued and sold to the Yucaipa Investors (i)  75,000 shares of the our Series A preferred securities, $1,000 liquidation preference per share, and (ii) the Yucaipa Warrants to purchase 12,500,000 shares of the Company’s common stock at an exercise price of $6.00 per share.  The Yucaipa Warrants have a 7-1/2 year term and are exercisable utilizing a cashless exercise method only, resulting in a net share issuance.  The exercise price and number of shares subject to the warrant are both subject to certain anti-dilution adjustments.

Off-Balance Sheet Arrangements

Mondrian South Beach. We own a 50% interest in Mondrian South Beach, an apartment building which was converted into a condominium and hotel.  Mondrian South Beach opened in December 2008, at which time we began operating the property under a 20-year management contract.  We also own a 50% interest in a mezzanine financing joint venture with an affiliate of our Mondrian South Beach joint venture partner through which a total of $28.0 million in mezzanine financing was provided to the Mondrian South Beach joint venture.  As of March 31, 2016, the Mondrian South Beach joint venture’s outstanding nonrecourse mortgage debt secured by the hotel was $18.7 million and mezzanine debt secured by related equity interests was $28.0 million.  In addition, as of March 31, 2016 the outstanding mezzanine debt owed to the affiliates of joint venture partners was $28.0 million.  In March 2016, the Mondrian South Beach joint venture exercised its option to extend the outstanding mortgage and mezzanine debt until April 2017.

In addition to the mortgage and mezzanine debt, we have provided certain nonrecourse carve-out guarantees of this debt, which guarantees are only triggered in the event of certain “bad boy” acts, and other limited liquidity or credit support, as described in “—Other Liquidity Matters” above.

The Mondrian South Beach joint venture was determined to be a variable interest entity as during the process of refinancing the venture’s mortgage in April 2010, its equity investment at risk was considered insufficient to permit the entity to finance its own activities.  We determined that we are not the primary beneficiary of this variable interest entity.  

We account for this investment under the equity method of accounting.  Our recording of losses was suspended due to our investment balance reaching zero.  At March 31, 2016, our investment in Mondrian South Beach was zero.

For further information regarding our off-balance sheet arrangements, see note 4 to our consolidated financial statements.

 

 

Interest Rate Risk

Our future income, cash flows and fair values relevant to financial instruments are dependent upon prevailing market interest rates. Some of our outstanding debt has a variable interest rate. As described in “Management’s Discussion and Analysis of Financial Results of Operations — Derivative Financial Instruments” above, we use derivative financial instruments, primarily interest rate caps, to manage our exposure to interest rate risks related to our floating rate debt. We do not use derivatives for trading or speculative purposes and only enter into contracts with major financial institutions based on their credit rating and other factors.

As of March 31, 2016, the principal balance of our total outstanding consolidated debt, including capital lease obligations, was approximately $578.3 million, of which approximately $421.8 million, or 72.9%, was variable rate debt. As of March 31, 2016, the one month LIBOR rate was 0.44%.

As of March 31, 2016, the $421.8 million of variable rate debt consisted of the outstanding balance of the Hudson/Delano 2014 Mortgage Loan.  In connection with the extension of the Hudson/Delano 2014 Mortgage Loan in February 2016, we purchased interest rate caps with an aggregate notional value of $421.8 million that cap LIBOR at 0.29% through the next maturity date of the loan.  If interest rates on this $421.8 million variable rate debt increase by 1.0%, or 100 basis points, this increase would have no impact on interest expense, as our LIBOR cap was lower than the one month LIBOR as of March 31, 2016.  The maximum annual amount the interest expense could decrease on the $421.8 million of variable rate debt outstanding as of March 31, 2016 was $0.6 million, which would increase future pre-tax earnings and cash flows by the same amount annually.

As of March 31, 2016, our fixed rate debt, excluding our Hudson capital lease obligation, of $150.4 million consisted of the trust notes underlying our trust preferred securities, the Clift lease and the Restaurant Lease Note. The fair value of some of these debts is greater than the book value. As such, if interest rates increase by 1.0%, or 100 basis points, the fair value of our fixed rate debt at March 31, 2016 would decrease by approximately $16.9 million. If market rates of interest decrease by 1.0%, the fair value of our fixed rate debt at March 31, 2016 would increase by $21.4 million.

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Interest risk amounts were determined by considering the impact of hypothetical interest rates on our financial instruments and future cash flows. These analyses do not consider the effect of a reduced level of overall economic activity. If overall economic activity is significantly reduced, we may take actions to further mitigate our exposure. However, because we cannot determine the specific actions that would be taken and their possible effects, these analyses assume no changes in our financial structure.

Currency Exchange Risk

We have international operations at hotels that we manage in London and through a franchise agreement for a hotel in Istanbul, Turkey.  As we have international operations, currency exchange risks between the U.S. dollar and the British Pound and the Turkish Lira arise as a normal part of our business.  We reduce these risks by transacting these businesses primarily in their local currency.

Generally, we do not enter into forward or option contracts to manage our exposure applicable to day-to-day net operating cash flows.  We do not foresee any significant changes in either our exposure to fluctuations in foreign exchange rates or how such exposure is managed in the future.

As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including the chief financial officer, who also serves as the principal executive officer, of the effectiveness of the design and operation of our disclosure controls and procedures as defined in Rule 13a-15 of the rules promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Based on this evaluation, our chief financial officer, who also serves as the principal executive officer, concluded that the design and operation of these disclosure controls and procedures were effective as of the end of the period covered by this report.  

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15 promulgated under the Securities Exchange Act of 1934, as amended) that occurred during the quarter ended March 31, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

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PART II — OTHER INFORMATION

 

We are involved in various lawsuits and administrative actions in the normal course of business, in addition to the other litigation as noted below.

Litigation Regarding TLG Promissory Notes

On August 5, 2013, Andrew Sasson and Andy Masi filed a lawsuit in the Supreme Court of the State of New York against TLG Acquisition LLC and Morgans Group LLC relating to the $18.0 million in notes convertible into shares of our common stock at $9.50 per share subject to the achievement of certain EBITDA (earnings before interest, tax, depreciation and amortization) targets for the acquired TLG business (the “TLG Promissory Notes”), which were issued in connection with our November 2011 acquisition of 90% of the equity interests in a group of companies known as The Light Group (the “Light Group Transaction”).  See note 7 of our consolidated financial statements regarding the background of the TLG Promissory Notes.  The complaint alleged, among other things, a breach of contract and an event of default under the TLG Promissory Notes as a result of our failure to repay the TLG Promissory Notes following an alleged “Change of Control” that purportedly occurred upon the election of the Board of Directors on June 14, 2013.  The complaint sought payment of Mr. Sasson’s $16 million TLG Promissory Note and Mr. Masi’s $2 million TLG Promissory Note, plus interest compounded to principal, as well as default interest, and reasonable costs and expenses incurred in the lawsuit.  We believe that a Change of Control, within the meaning of the TLG Promissory Notes, did not and has not occurred and that no prepayments were or are required under the TLG Promissory Notes.  On September 26, 2013, we filed a motion to dismiss the complaint in its entirety.  On February 6, 2014, the court granted our motion to dismiss.  On March 7, 2014, Messrs. Sasson and Masi filed a Notice of Appeal from this decision with the Appellate Division, First Department.  On April 9, 2015, the Appellate Division, First Department, reversed the trial court’s decision, denying the motion to dismiss and remanding to the trial court for further proceedings.  We filed a motion for reconsideration at the appellate court, which was denied on July 7, 2015.  We also filed our answer to the complaint with the trial court on May 11, 2015.  On August 27, 2015, Messrs. Sasson and Masi filed a motion for partial summary judgment with the trial court and we filed our opposition to that motion on October 12, 2015.  In February 2016, the plaintiff’s partial summary judgment motion was granted and the judge signed the order in March 2016 in the amount of approximately $2.8 million, although the judgment has not yet been entered.  We have filed a notice of appeal and may be required to post a cash bond in the amount of the judgment to secure our ability to perfect our appeal.  Plaintiffs also have a claim for attorneys' fees which we intend to dispute and oppose. They have not yet stated a claimed amount to the court but they have recently estimated this claim at approximately $1.0 million.  Although the TLG Promissory Notes were repaid and retired in December 2014, this lawsuit remains pending in connection with issues related primarily to the interest rates applicable to the TLG Promissory Notes.

 

 

In addition to the risk factors below and other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015. These risks and uncertainties have the potential to materially affect our business, financial condition, results of operations, cash flows, projected results and future prospects. There have been no material changes to the risk factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015.

 

Risks Related to Our Announced Acquisition

 

Due to the proposed acquisition of the Company and the related diversion of our management’s attention from the operation of our business, our business and results of operations may be adversely affected.

 

As described in our Current Report on Form 8-K, filed with the SEC on May 9, 2016, we entered into a definitive agreement, which, subject to the assumption or refinancing of our mortgage debt, stockholder approval and various other closing conditions, and assuming the availability of financing under the commitments obtained by SBE, would result in the Company being acquired by SBE. As a result of the proposed acquisition, our management and Board of Directors have devoted, and will continue to devote, a significant amount of time and attention to the proposed transaction. In addition, we have incurred, and will continue to incur, associated expenses related to the proposed acquisition which could prove to be significant. Our business and our operating and financial results may be materially adversely impacted by the diversion of management’s time and attention and the expenses associated with the proposed acquisition.

 

If the proposed acquisition is not completed and we are not otherwise acquired, our business could be harmed and our stock price could decline.

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The consummation of the proposed acquisition of the Company by SBE is conditioned upon, among other things, the assumption or refinancing of our mortgage debt, stockholder approval and various other closing conditions, and is subject to the availability of financing under the commitments obtained by SBE. Therefore, the proposed transaction may not be completed or may not be completed in a timely manner. If the acquisition agreement is terminated and there are no other parties willing and able to acquire us at a price of $2.25 per share or higher and on other terms acceptable to us, the market price of our common stock will likely decline, and, as noted above, our business may have been adversely affected due to the diversion of management’s time and attention from the operations of our business and the costs associated with the proposed acquisition. Our stock price may also decline as a result of the fact that we have incurred and will continue to incur potentially significant expenses related to the proposed transaction prior to its closing that will not be recovered.

 

If the proposed acquisition by SBE is not completed or we are not otherwise acquired, we may consider other strategic alternatives which are subject to risks and uncertainties.

 

If the proposed acquisition by SBE is not completed, our Board of Directors will review and consider various alternatives available to us, including, among others, re-engaging in the monetizing our Hudson and Delano South Beach assets. These alternative transactions may involve various additional risks to our business, including, among others, distraction of our management team and associated expenses as described above in connection with the proposed acquisition, our ability to consummate any such alternative transaction, the valuation assigned to our business in any such alternative transaction, our ability or a potential buyer’s ability to access capital on acceptable terms or at all and other variables which may adversely affect our operations.  The Yucaipa Investors have certain consent rights over certain transactions for so long as they collectively own or have the right to purchase through exercise of the Yucaipa Warrants 6,250,000 shares of the Company’s common stock.  We cannot assure you that should the SBE transaction not be consummated that the Yucaipa Investors would not assert a right to approve any sale of the Hudson or Delano South Beach assets, which if such approval is withheld, could materially impact our ability to consummate the asset sales.

 

The acquisition agreement contains provisions that could discourage or make it difficult for a third party to acquire us prior to the completion of the proposed acquisition.

 

The acquisition agreement contains provisions that restrict our ability to entertain a third-party proposal to acquire us. These provisions include the general prohibition on our soliciting or engaging in discussions or negotiations regarding any alternative acquisition proposal, subject to certain exceptions, and the requirement that we pay a termination fee of $6.5 million if the acquisition agreement with SBE is terminated in specified circumstances.

 

These provisions might discourage an otherwise-interested third party from considering or proposing to acquire us, even one that may be deemed of greater value than the proposed acquisition by SBE to our stockholders. Furthermore, even if a third party elects to propose an acquisition, the concept of a termination fee may result in that third party offering a lower value to our stockholders than such third party might otherwise have offered.  In addition, the terms of the Company’s Series A preferred securities and the purported consent rights of the Yucaipa entities under the Securities Purchase Agreement between the Yucaipa Investors and the Company may discourage an otherwise interested third party.

 

Failure to complete the proposed acquisition could negatively impact our business, financial condition, results of operations or stock price.

 

The completion of the proposed acquisition is subject to a number of conditions and there can be no assurance that the conditions to the completion of the proposed acquisition will be satisfied or that the proposed acquisition will otherwise occur. If the proposed acquisition with SBE is not completed, we will be subject to several risks, including:

 

 

 

 

 

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The exhibits listed in the accompanying Exhibit Index 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.

 

May 10, 2016

 

 

 

 

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Exhibit Index  

 

*    Filed herewith.