When an owner sells a hotel to a purchaser, the seller typically agrees to indemnify the purchaser for certain post-closing obligations. Because many sellers are single-purpose entities (SPEs) that will hold no assets after selling their hotel, purchasers usually require security to back up these commitments. There are three different methods commonly used to ensure that a seller’s post-closing indemnification obligation is a meaningful one.
Escrow
One approach is to require that the seller deposit, in escrow, a portion of the purchase price or a letter of credit (LOC) in an amount equal to the seller’s maximum indemnification obligation.
From a purchaser’s perspective, the escrow approach is the preferred option because it ensures that sufficient cash is available to support the seller’s post-closing indemnification obligation. In the event of a dispute, however, it is common for the escrow agent to have the right to deliver the amount in dispute to a court and for the parties to resolve the dispute by way of litigation, which obviously would delay a purchaser’s ability to access the funds. Still, the escrow approach addresses the greatest concern associated with purchasing all or substantially all of the assets of an SPE in that it helps to ensure that some assets will be available to the purchaser if it ultimately is determined it is entitled to indemnification.
From a seller’s perspective, the escrow approach may be somewhat less attractive than other approaches because the seller loses the ability to invest or otherwise use the funds in escrow for the duration of the indemnity obligation. For example, where a hotel is sold for US$50 million, the seller’s indemnification obligation is capped at 10% of the purchase price. The indemnity survives one year post-closing, and the cost to the seller of escrowing an amount equal to its maximum indemnification obligation (US$5 million) for the year would be US$200,000 (assuming that the seller could have used that money to generate a 5% return by investing it or retiring debt, and further assuming that the escrowed funds would have generated a 1% return).
Net worth
A second common approach is to require the seller to maintain its legal existence and a net worth sufficient to allow it to honor its post-closing indemnification obligation.
The net worth approach may be somewhat more attractive to a seller than the escrow approach because it allows the seller to retain control over the funds that support its post-closing obligation. Accordingly, the seller potentially could earn a better return on the investment in which it places its funds than if the funds were placed in escrow and invested in a certificate of deposit or some other investment vehicle.
From a purchaser’s perspective, the net worth approach generally is less attractive than the escrow approach. First, the requirement that a seller maintain a minimum net worth rather than retaining cash or cash equivalents creates the potential for less liquidity (which may make it more difficult or cumbersome for a purchaser to recover from a seller) and for losses on the investments (which then would require an additional capital infusion from the seller). Further, the net worth approach could prove difficult to police and would require consistent monitoring by the purchaser of the seller’s net worth; indeed, a purchaser typically would not know that there was an issue with the seller’s liquidity until after an issue arose and it received financial statements or bank statements showing a deficient net worth. The purchaser also could face the challenge of finding an effective remedy against the seller, which may be a shell entity as a result of the event that caused the breach of the liquidity covenant.
The guaranty
Another method is to have a third party guaranty the post-closing indemnification obligation.
The guaranty approach often is used where a parent or related entity for the seller is a going concern with sufficient assets to support the seller’s indemnification obligations. Assuming that the guarantor signs a properly drafted guaranty obligating it to guaranty payment of any indemnity obligations arising under the contract between its affiliate seller and the purchaser, the guaranty can be a satisfactory solution to the problem of securing a seller’s post-closing indemnification obligation.
Conclusion
Parties should be mindful of the implications of bankruptcy on all of the above approaches. Certainly, the likelihood of an SPE seller filing bankruptcy post-closing is diminished where all of its hotel-related obligations are discharged in connection with the sale. However, whether a cash escrow, LOC or other security constitutes property of a possible bankrupt estate must be evaluated under applicable law.
Richard Fildes is a partner and co-chair of the Hospitality & Resorts Group at Lowndes, Drosdick, Doster, Kantor & Reed, P.A. in Orlando, Florida. William Vanos is also a partner in the firm’s Hospitality & Resorts Group.