Comfort letters are more important than ever as franchising continues to be a dominant form of branding hotels. As many of our recent articles have noted, there has been a sea change in the hotel world. Franchise agreements have become the dominant means of branding most hotels in the US, except for a few of the most upscale and luxury brands.
This popularity of franchising has made comfort letters more important than ever simply by the predominance of the franchise model, and lender's desire to get certain protections that they feel comfort letters offer.
In today's article, my partner, hotel lawyer Robert Braun, explains what comfort letters are and the kind of provisions they usually contain.
If you are buying, building or refinancing a hotel, you'll almost certainly be looking to a bank or other lender to finance the hotel, and when you do, you'll need to negotiate dozens of documents, some long, some short, but all of them necessary to get your loan. In other articles, we have talked about the importance of subordination, non-disturbance and attornment agreements (SNDAs). SNDAs are used in the context of a hotel management agreement (HMA) -- usually only long-term branded HMAs -- to define the rights of lenders vis a vis the hotel operator in the event of the owner's/borrower's loan default, breach of the HMA, foreclosure by the lender or a deed-in-lieu of foreclosure.
But what about franchised hotels? Lenders who take security in a franchised property will want a "comfort letter," an agreement between the lender and the franchisor that defines the rights of lenders and franchisors if the hotel owner defaults on its loan obligations, the franchise agreement or other related arrangements. In other words, lenders seek SNDAs to deal with their rights and obligations with respect to HMAs. They use comfort letters to deal with their rights with respect to franchise agreements.
What is a Comfort Letter?
A comfort letter is, essentially, a form of assignment of the franchise agreement for the hotel brand. It governs the ability of a lender to operate a hotel property under a brand name after a foreclosure, receivership or other loan default.
Why do Lenders Want a Comfort Letter?
Lenders make loans on branded hotels because they believe that a hotel is more valuable if it can be operated (and sold) as a branded property. If the hotel franchise agreement is terminated, the value of the property could drop significantly. Even where there is no foreclosure, the lender may want the ability to be able to "step into the shoes" of the borrower and continue to operate the property in the shoes of the borrower under the existing hotel Franchise Agreement. More than that, a lender will want to be able to sell the hotel after foreclosure (or in connection with a receivership or similar action), and may believe that transferring the franchise to a buyer will increase its recovery. This, of course, requires the consent of the franchisor/hotel chain.
Who Writes the Comfort Letter?
Most hotel brands have a standard form of hotel comfort letter and, as a practical matter, brands will insist on negotiating from this form. When parties ask a hotel brand to use a new or different form of comfort letter, the brand may refuse or, at best, it will delay loan closing until the negotiation over the form of comfort letter is concluded. While the lender's rights under the comfort letter are limited, most institutional lenders have been willing to accept the comfort letter as providing the lender with sufficient "comfort" that it will have the ability to maintain the franchise relationship and the value of its collateral in the specified events of the owner/borrower default.
What's in the Comfort Letter?
While each hotel chain's form of comfort letter differs to some extent, most comfort letters have the following provisions:
- The lender wants the brand to give the lender notice and right (but not obligation) to cure any default by the borrower under the franchise agreement prior to a termination of the franchise agreement.
- The lender wants the ability to assume the franchise agreement and avoid the payment of the application and other initial fees charged to franchisees. Hotel chains will often charge a lender a "processing" or administrative fee, which is less than the initial fee usually charged to a new franchisee.
- The lender wants the ability to have a receiver operate the property under the terms of the existing Franchise Agreement, at least for a short period of time during the foreclosure phase. Most hotel brands are generally willing to allow the receiver to operate the hotel under the "franchise flag" for a relatively short period, provided: (i) any monetary and non-monetary defaults are cured promptly; (ii) the hotel continues to maintain the insurance coverage required by the franchise agreement; and (iii) the lender guarantees the obligations of the receiver under any short term license issued.
- If the lender acquires the hotel property as a result of foreclosure, it will typically want to sell the property quickly. As a result, the lender wants to obtain some assurances that the purchaser can also obtain a franchise agreement with the hotel chain.
- In addition, most lenders would like to be released from liability under the franchise agreement once it sells the hotel to a third party purchaser. Most hotel chains are willing to acknowledge that, in the event of a sale of the hotel to a third party that party can apply for a franchise agreement and that such application will be processed in accordance with the franchisor's then existing requirements and procedures.
What's the Challenge?
Comfort letters, while a key requirement for most lenders, are challenging to borrowers because they require the lender and franchisor to come to agree on matters that have no immediate effect on them (or on the borrower!), but can prevent the closing of critical financing. Moreover, the lender and franchisor may have a different agenda than merely the facilitating the closing of the owner's/borrower's financing transaction. For example, the lender may have other issues with the borrower, and the borrower may still be in the throes of finalizing the franchise agreement. Even in the best of situations, the borrower's counsel is often saddled with the task of negotiating a comfort letter that his or her client has little interest in, and trying to mesh the sometimes incongruent interests of the lender and the franchisor. The ultimate payoff to the borrower, of course, is the making of the loan by the lender.