Canada: Loan Transactions - The Role of Comfort Letters

Copyright 2008, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Hospitality & Tourism, May 2008

Hotel Franchise Agreements Considerations

In the hospitality industry, a franchise is a commercial relationship where the franchisor grants a right or licence to a franchisee to operate its hotel property under the franchisor's trade-mark. The franchise agreement is generally framed so as to permit the franchisor to exert operational control over the franchisee (such as quality and marketing standards) and, in exchange, the franchisee is granted the right to conduct its hotel operations under a brand name or "flag". As the franchise agreement is the main source of legal rights and responsibilities in a franchise relationship, it is imperative that it be drafted and negotiated carefully as it can have significant implications on the franchisee's ability to sell or mortgage its hotel property. The following are considerations for franchisees to take into account to ensure that they negotiate hotel franchise agreements effectively with franchisors.

Term Where a franchisee desires a shorter term for greater flexibility to reposition if the brand is not delivering as planned, the franchisee should also consider seeking renewal rights after expiration of the initial term of the franchise agreement if the arrangement is working out well.

Fees and Royalties Particularly appealing or unique projects may offer opportunities for franchisees to modify the usual fee structure and/or reduce royalties.

Territorial Protection Franchisees should try to obtain some reasonable limitation on the franchisors' ability to license or operate competing hotels (not only of the same brand, but also of related brands) in the same vicinity which will have a negative impact on the franchisee's occupancy.

Termination and Liquidated Damages Franchisees should seek early termination provisions in franchise agreements, such as on specified dates in the event that their hotels fail to achieve certain occupancy levels. Franchisors will most likely require the payment of liquidated damages before permitting the franchisee to avail itself of such a provision. In other cases, franchisors may seek a reciprocal right of early termination of the franchise agreement, without cause. Many hotel franchise agreements contain a liquidated damages clause. The reason for such a provision is to discourage the franchisee from early termination of the franchise agreement without the payment of damages, generally in an amount based upon the estimated royalties which would have been paid to the franchisor for the remaining term of the agreement. In the competitive hospitality industry, some franchisors are slowly moving away from such a provision or reducing liquidated damages in order to be more attractive to franchisees.

Property Improvement Programs Hotel franchise agreements may call for a property improvement program (PIP). For example, where a hotel property is converted from one brand to another, there may be upgrading requirements. Franchisees need to carefully consider the terms of, and properly evaluate the costs associated with, such programs.

Sale of Hotel and Transfer of Franchise Franchisees should consider negotiating at the outset for the franchisors' permission to transfer their franchises to qualified purchasers of their hotel properties, as well as the kinds of fees and PIPs that the franchisors may impose at the time of transfer.

Management Companies Management companies are increasingly more popular in the hotel industry. Where the hotel property will be operated by a third party manager, the franchisee will want flexibility in the right to retain new managers.

Dispute Resolution Many franchise agreements seek to limit the location where franchisees may assert claims, limiting them to the franchisor's location. Others may stipulate the right to arbitrate or, even better, the right to mediate, in the hotel's location.

Loan Transactions the Role of Comfort Letters

Where a hotel franchise agreement is in place, a lender will seek to preserve the brand value of the hotel property created by the franchise agreement. The lender will wish to obtain assurances in the form of a "comfort letter" from the franchisor to the effect that in the event the hotel owner defaults under its loan arrangements and the lender exercises its enforcement remedies under its loan documents, the franchisor will not terminate the franchise agreement provided that the lender meets certain conditions.

Often the comfort letter will address issues raised by the resulting change in ownership of the hotel property. A hotel franchise agreement will typically provide for a termination of the agreement if the property is transferred without the franchisor's consent. Accordingly, the primary issue to be addressed in the comfort letter will be the franchisor's consent to the continuation of rights under the franchise agreement if a change in ownership of the hotel results from the lender's exercise of its default remedies.

Additionally, the comfort letter may impose a transfer fee or require the lender or new operator to execute a new franchise agreement or a formal assumption agreement.

In other instances, the lender or new operator may wish to terminate the franchise agreement in order to reposition or "re-flag" the hotel property. Thus, the lender may request a right on its part to terminate the franchise agreement without a termination penalty or a reduced penalty.

Some comfort letters provide that the franchisor will give the lender notice and an opportunity to cure a franchisee default prior to terminating the franchise agreement or exercising its remedies.

Most comfort letters require that the lender's consent be obtained in case of any amendment to the franchise agreement.

In the context of a commercial lending transaction, the comfort letter is typically a standard form prepared by the franchisor. Although franchisees may assume there is little room for negotiation (comfort letters, like franchise agreements, being heavily weighted in favour of the franchisor for the most part), it is important for a franchisee seeking to obtain financing to recognize the role a comfort letter plays. The franchisor should request a comfort letter as early as possible to ensure that there is sufficient time to negotiate and finalize one without delay.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.