Getting Comfortable with Lender Comfort Letters

As the global real estate economy continues its recovery from the severe economic recession nearly a decade ago, hotel and hospitality real estate transactions have been robust as of late. According to the "Hotel investment Outlook 2016" published by the Hotel & Hospitality Group of Jones Lang LaSalle ("JLL"), 2015 was the second-highest year ever for hotel transactions with global deals topping $85 billion. JLL predicts 2016 will see approximately $37 billion in transaction volumes in the Americas with the United States leading the way as the most liquid market.[1] In light of the anticipated ongoing transaction volume in the hospitality market, funding will be sought from public and private lending sources to finance the development and acquisition of hotels. Such hotel activity, with the exception of development of small boutique hotels or a select group of luxury upscale brands, is predominantly represented by properties flagged with one or more of the large international franchised brands. Although a mortgage loan on a hotel property may appear to be a run-of-the-mill secured real estate loan, lenders need to understand the limitations of the security of their loans on a franchised hotel property and the necessity of obtaining a "lender comfort letter" ("LCL") from the hotel brand in order to be protected more fully in the event of a default by the borrower. Borrowers/franchisees and their counsel need to recognize and accept this situation and be prepared to cooperate with the lender in working with the hotel brand regarding an LCL.

LCLs are unique documents in the franchise industry, especially in the hotel arena. Essentially, they provide a lender with a current acknowledgement that, at its election in the event of a default by a borrower/franchisee, it can rely upon continuation of the right of use of the brand and participation in the hotel brand's system or be able to terminate the relationship and bring in a different brand. The LCL provides an avenue to obtain a benefit akin to a collateral assignment of the franchise agreement. To operate a franchised hotel, a franchisee, as the owner (or lessee) of the hotel property, enters into a franchise agreement with a national or international hotel brand, the franchisor, for the right to use the brand's logos and trademarks, marketing resources, reservation system, etc. The franchisee and franchisor usually are the only parties to the franchise agreement and such agreements typically state that the franchisor is entering into the agreement with the specific franchisee based on the franchisee's experience and financial condition. Franchise agreements also often expressly prohibit a franchisee from assigning the agreement to another party - even as collateral for financing. In fact, most franchise agreements do not provide any provisions addressing financing, or if they do, they constitute brief references to the right of the franchisee to finance the hotel and the ability to obtain an LCL. Since a hotel lender is not a party to the franchise agreement between the hotel brand and the franchisee and the franchise agreement prohibits assignment by the franchisee, lenders seek some written acknowledgement and protections vis a vis an election either to continue or terminate the brand as it determines. Therefore, in the event the borrower defaults on its loan and the lender acquires the property, whether via foreclosure, a deed-in-lieu conveyance or other means, absent an LCL the lender will have no rights under the existing franchise agreement to continue to operate the hotel under the brand. Without the advantages of the brand, there could be an immediate adverse impact on the value of a hotel property.

Acquiring ownership of a hotel building and its land without any rights to use the reservation systems, tradenames and other elements of the franchised hotel brand may be a significant detriment for a lender which seeks to recoup its loan and any losses after a borrower defaults, as compared to other types of property, such as office or apartment buildings. The LCL provides a means for a lender to address resolution of this problem immediately. It brings the lender, the borrower/franchisee and the franchisor together with one agreement in which the franchisor recognizes that the lender has made a loan to the franchisee and gives the lender "comfort" that it will be able to continue to operate the hotel under the franchisor's brand if the lender so elects.

Every hotel brand has its own form of LCL, but essentially all LCLs will contain similar provisions that any hotel lender must review carefully. For example, a lender should determine if the proposed LCL provides for the franchisor to give notice to the lender of any default by the franchisee under the franchise agreement and the right, but not the obligation, of the lender to seek to cure the franchisee's default prior to termination of the franchise agreement. Additionally, probably the most important provision that a lender wants to see in an LCL is the right to elect (a) to step into the shoes of the franchisee and assume the franchise agreement in the event of a foreclosure, accompanied by a waiver of any new franchise initiation or application fees, or (b) to terminate the franchise agreement without liability for any liquidated damages under the franchise agreement which may be owed to the franchisor by the defaulting franchisee/borrower. Furthermore, the lender will want to see provisions setting forth the process for a party which purchases the hotel from the lender after a foreclosure to obtain a new franchise agreement with the franchisor. An election by a lender seeking to retain the brand under the LCL would necessitate paying the hotel franchisor any amounts then due and owing.

As mentioned, each hotel brand has its own standard form of LCL that it will issue when a lender requires its borrower to request an LCL from the franchisor. The brands typically resist modifying their standard forms other than filling in several blanks with non-substantive details of the transaction - such as the parties' names and addresses, the property information, the amount of the loan, etc. However, there is usually some room for negotiation with the franchisor's legal counsel and retaining experienced hospitality counsel to represent the lender can be crucial in obtaining beneficial provisions in the LCL based on the specifics of the transaction or the nature of the lending entity. Lenders should choose hospitality counsel who understand both a brand's hotel documents, specifically the franchise agreement and any additional license agreements, and the hotel industry generally, to negotiate with the hotel's in-house or outside legal counsel preparing the LCLs.

In summary, the continued boom in the hotel and hospitality industry creates opportunities for lenders to provide much needed capital to hotel developers and operators to respond to increased demand and market opportunities. A well-drafted LCL is essential for a lender financing the development or acquisition of a franchised hotel property and any subsequent transfer or securitization of the hotel loan. Without even a basic unmodified LCL, a lender's loan will be secured only by the real estate and improvements of the hotel, but without any right to continue to operate the hotel business under the franchise "flag" or access to the potential goodwill and revenue stream and reservations arising from the brand's business operations.  

If you have any questions regarding lender comfort letters or issues relating to the hospitality industry, please contact Donald A. Shindler at (312) 985-5913 | dshindler@clarkhill.com, Brett E. Vasicek at (313) 309-4272 | bvasicek@clarkhill.com, or another member of Clark Hill's Food, Beverage & Hospitality Group.

 

[1] http://www.jll.com/services/industries/hotels-and-hospitality/hio-2016