Originally published April 2, 2004
In the creative and complex world of hotel financing, many investors and developers are utilizing mezzanine loans in their transactions. Mezzanine financing provides funding to bridge the gap between the first mortgage loan and the owner's equity investment in the transaction. The borrower is usually formed as a special purpose bankruptcy remote entity in order to satisfy rating agency requirements for securitized transactions.
The mezzanine lender's primary collateral in a pure mezzanine loan is a pledge of the stock, limited liability membership interests or other equity ownership interests in the borrower. This pledge gives the mezzanine lender a security interest in the ownership interests of the borrower entity. This is quite different from the security interest in the real property which is pledged by the owner to the first mortgage lender providing the acquisition and/or construction financing. The mezzanine loan is almost always at a higher interest rate than a first mortgage loan, reflecting the lender's higher risk in this type of financing.
Mezzanine financing is now commonplace in hotel transactions. Although the mezzanine lender will not have any security interest in the hotel property, the mezzanine lender will hold a security interest in the ownership interests of the entity that owns the hotel property. Sometimes the mezzanine lender is also granted a second mortgage lien on the hotel property; however, this depends upon the ability and willingness of the first mortgage lender to permit a subordinate mortgage lien on the real property. In most cases, especially where rating agencies are involved in a securitized financing, a subordinate second mortgage lien is not permitted.
A mezzanine lender will usually review the same due diligence materials as the first mortgage lender, prior to closing the mezzanine loan. Where there is a franchise or license agreement in place permitting the hotel company's brand name or "flag" to be used at the property, the mezzanine lender will require certain assurances from the hotel company licensor with respect to its license (or franchise) agreement in the event that the mezzanine lender exercises its loan default remedies. This is necessary in order to preserve the value of the property, which is enhanced by the branding of the hotel. Similar assurances from the hotel licensor will also be required by a first mortgage lender as a condition to closing its mortgage loan. These assurances are in the form of a "comfort letter."
A comfort letter is a letter from the hotel licensor which gives "comfort" to a lender where the hotel licensor agrees that it will not terminate its license agreement if a lender exercises default remedies under its loan documents. In a first mortgage loan, the comfort letter will address the issues raised by the change in ownership of the hotel property resulting from the lender's exercise of its foreclosure default remedies. For the mezzanine loan, the comfort letter will address the issues raised by the change of control of the borrower/licensee entity resulting from the lender's exercise of its loan default remedies. Since it is possible that the mezzanine lender could be exercising its loan default remedies while the first mortgage loan remains in good standing, the mezzanine lender will require its own comfort letter from the hotel licensor.
The form and substance of the comfort letter will vary based upon the hotel brand and its approved form. In a mortgage loan transaction, it is usually a standard form prepared by the hotel licensor. Often there is little opportunity for negotiation. Since mezzanine financing is not traditional mortgage financing, the hotel company may not have a form of comfort letter for a mezzanine loan. As a result, the borrower's counsel must negotiate a form of comfort letter that addresses the unique issues of concern to the mezzanine lender. The hotel company may be referenced in the comfort letter as a "licensor" under a "license" agreement or a franchisor under a franchise agreement. In this article we refer to a hotel licensor under a license agreement, but intend to include a franchise situation as well.
A hotel license agreement will usually provide for termination of the license agreement upon any transfer of the property without the consent of the hotel licensor. Therefore, the primary issue of concern to a first mortgage lender in the comfort letter will be the hotel licensor's consent to the continuation of the license agreement if the mortgage lender (in a lien jurisdiction, for example) successfully exercises its foreclosure default remedies and obtains legal title to the hotel property. When the transaction includes mezzanine financing, there are other issues to be addressed in the comfort letter.
The mezzanine lender's exercise of its loan default remedies will result in a change of control and beneficial owners of the borrower entity, but not a change in the holder of legal title to the property, as would occur as the result of a mortgage foreclosure. Consequently, an important issue to be addressed in connection with mezzanine financing of hotels with license agreements is whether a change of control or beneficial ownership interests of the borrower without the hotel licensor's consent will create a default under the hotel license agreement. If the license agreement requires the hotel licensor's consent to a change in either the control of the borrower or the members, partners or shareholders constituting the borrower entity, then the mezzanine lender will require that the comfort letter provide for the hotel licensor's consent to the mezzanine lender acquiring control and ownership of the borrower as a result of the exercise of its default remedies. This is the most significant difference between comfort letters for mezzanine loan transactions and mortgage loan transactions, and is the key issue to be addressed for mezzanine loan comfort letters. The mezzanine lender's default remedies allow the mezzanine lender to take control and ownership of the borrower pursuant to the pledge agreement executed with the mezzanine lender; however, there is no resulting transfer of legal title to the property. By way of contrast, the mortgage lender's foreclosure remedies will result in a transfer of legal title to the hotel property.
In addition to the default remedy issues, the comfort letter for a mezzanine loan as well as a mortgage loan may also require payment of a transfer fee to the hotel licensor. This may be imposed as an administrative fee based upon the "transfer" in ownership of the hotel property. Although lenders usually do not agree to absorb assumption or transfer fees, the lenders know that the payment of certain fees based on the license agreement may be required in the comfort letter. The comfort letter for a mortgage loan may also require a new license agreement or a formal assumption agreement executed by the foreclosing mortgage lender; however, the mezzanine lender will negotiate any attempt by the hotel licensor to require execution of a new license agreement because there would not be any transfer of legal ownership of the hotel property (there would only be a change in the beneficial owners of the ownership entity). The comfort letter for a mezzanine lender should also include other provisions that the hotel licensor includes in its approved form of mortgage comfort letter, such as delivering courtesy copies to the lender of any notices of default sent to the licensee.
In order to obtain a comfort letter in time for the loan closing, the comfort letter request in a mezzanine loan transaction should be made as early as possible. The provisions of the comfort letter for the mezzanine loan will vary depending on the license agreement. Therefore, the licensor's form of comfort letter should be reviewed early in the loan process, together with the license agreement and the mezzanine loan documents.
Finally, one of the most difficult aspects of obtaining comfort letters in acquisition loan transactions is the timing of the delivery of the comfort letter. This is usually a "chicken and egg" situation, where the hotel licensor will not release its signed license agreement and comfort letter until the borrower acquires title to the hotel property, yet the lender is not willing to close its mortgage or mezzanine loan transaction without the signed license agreement and comfort letter. In practice, the lenders and the hotel licensor agree that the signed comfort letter and new license documents will be delivered either at the closing or immediately after closing, based on a signed letter from the hotel licensor. Once this is completed and a proper comfort letter has been delivered, the mezzanine lender can rest "comfortably" that it has preserved the hotel property's brand value created by the license agreement in the event that the lender finds itself owning the borrower.
The key is to make both lender and hotel licensor "comfortable" with the transaction and the protection of their respective interests. By informing the hotel licensor of the unique issues of concern to the mezzanine lender as soon as possible during the transaction, and directing legal counsel to negotiate and finalize the comfort letter without delay, the goals of all parties will be successfully achieved.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.
