We all know that California’s hospitality sector took a huge hit during the pandemic.¹  For many, revenues have yet to return to pre-pandemic levels.²  Ostensibly, new technologies and the “virtual culture” that developed during the pandemic have supplanted a lot of business travel and reduced overall demand. Because the hospitality industry is full of extremely capital-intensive businesses, many industry members were forced to take on massive amounts of debt during the pandemic and much of that debt had variable interest rates.³  Then, the Federal Reserve raised interest rates, which has left a lot of hospitality borrowers scrambling to refinance.

Needless to say, under these market conditions, lenders have made a significant number of hospitality loans⁴  and many of those borrowers are liquor licensees. Often one of the most important pieces of borrower’s property that a lender will want to secure is a borrower’s liquor license. If a lender forecloses on a hotel, a restaurant, or a bar and the license to sell alcohol does not come with it, then there likely isn’t much value in the collateral securing the loan.

Moreover, full bar licenses in California’s major metropolitan areas are exceptionally valuable assets in their own right. They are limited by county and can cost hundreds of thousands of dollars when available on the secondary market.

Lenders therefore are well advised to prevent a borrower’s liquor license from being alienated from the other business assets that are collateral for a loan. In so doing the lender attempts to preserve the value of their loan’s collateral by ensuring that the legal rights to operate the business come with the other business assets in the event of foreclosure. Lenders often use standard tools to accomplish this task. Typically, a lender will demand a security interest in a licensee or the license itself as a condition of the loan.  Other times lenders will ask a borrower to pledge the license to the lender in the event of a default. What’s not often known is that all of these strategies are illegal in California and in much of the United States.

When a license is transferred by California’s Department of Alcoholic Beverage Control (ABC) the purchase price of the license, inventory, and good will (at a minimum) are placed in a special escrow.  Any of transferor’s creditors can make claims against the amount held in escrow. Those creditors are paid in a statutorily defined order of priority pursuant to § 24074 of the California Business and Professions Code (B&P Code).  Under § 24076 of the California Business and Professions Code, contracts that proport to alter the priority of creditor claims are illegal.

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Courts have interpreted the language of CA B&P Code § 24076  broadly and have long held that CA B&P Code § 24076’s “purpose and policy is to prohibit all use of liquor license as security, and any such use is unlawful and void.”⁶  Arguably, under this reasoning, any agreement that has the mere effect of granting a creditor an interest in a license for the purpose of securing a loan is illegal.

Unfortunately, in practice, we have seen a number of hospitality loans for large sums of money that explicitly state that the liquor license is security for the loan. Liquor counsel is often brought in late in the process as no one else involved in the deal realized that alcohol regulations had an impact on the loan. These last minute fire drills undoing and rewriting loan documents can cause major delays and cost all parties thousands of dollars while risking both the loan and the license. Even worse are deals that have already closed with unlawful security interests built in. The result is that the lenders cannot force the transfer of the license. Moreover, even if the lender can get the borrower to agree to sell its license, lender can not pay for the license by offsetting the license’s value against the borrower’s debt because real money needs to be deposited into the liquor escrow, mentioned above.⁷

When lenders fail to account for the prohibitions of CA B&P Code § 24076 they hand their borrower a strong position to negotiate for concessions. A borrower does not have to sell its license to a lender that is foreclosing. It can surrender its license to the ABC or try to sell it to a third party, leaving the business it no longer owns dry. If the borrower does not agree to sell its license, not only is lender out the cost of the license, but it will also be out lawyer, broker, and consultant fees, and additional time while a new license is located, and an agreement is reached with a new third party. To make matters worse, bringing a new license into a business can trigger new city or county permitting and survey requirements. City and county permitting processes vary greatly between jurisdictions and can significantly increase the cost and lengthen the timeline⁸ for transferring a license since city/county approval must be obtained before a transfer application can be filed with the Department of Alcoholic Beverage Control.

Beyond that, a borrower could refuse to operate the license while it is being transferred or while a new license is located and transferred to the property as an additional means of extracting concessions from a lender.

If borrower does not agree in either of these instances, lenders’ options are not appetizing. Even if borrower agrees to sell the license, under the best of circumstances transferring a license takes three to six months. In all of these cases, the hospitality business lender hoped to use as collateral can go dry and lose a massive amount of value and good will.

It is hard to imagine why lenders would ever issue loans to hospitality businesses under these circumstances. Yet clearly many loans⁹ have been made. Given how common the practice of pledging licenses as security for loans appears to be, one wonders if much of the collateral underlying California’s hospitality sector’s debt is overvalued.

Best Practices, Planning Ahead

Fortunately, with proper planning it is possible to prevent a borrower from holding a lender hostage by withholding a liquor license. In California, we can’t use the standard set of lender tools (aka pledges, guarantees, and security interest) for these transactions. Instead, the lender has to obtain a right of first refusal (ROFR) to purchase the license at fair market value. Courts have held that options to repurchase a license in the event of a business changing ownership is not a “security interest” pursuant to CA B&P Code § 24076.¹⁰  Courts have reasoned that “Though the owners of a hotel might have sold it without assurance that they could repurchase the alcoholic beverage licenses if compelled to repossess the hotel and, to this extent, an option to repurchase the licenses in event of default of purchase of the hotel tended to “secure” or preserve the value of the sellers’ interest in the hotel, the option did not function as a “security” device within the meaning of B&PC§ 24076, prohibiting contracts for transfers of alcoholic beverage licenses affording “security” to one of the parties.”¹¹

To be clear, the above exception is a narrow one. In the above referenced case the default triggering the option to repurchase was approved in connection with the default on a purchase agreement, not in connection with default on a debt.¹²  Arguably then, the more a ROFR is tied to the enforcement of a debt the more it looks like an impermissible security interest.¹³  Conversely, the more a ROFR is made with the intent of preserving the value of a party’s interest in the licensed property in the event of a repossession the more likely it is to be enforceable.¹⁴  

How do we thread this needle? On the one hand, tying a repurchase option to a loan default may/will render the option unenforceable; on the other hand, the only time that a lender would take possession of the licensed property is in the event of a default. Based on my experience, I have developed the following strategies to solve this problem:

• Tie the license to the property giving lender or its designee a ROFR to purchase the license any time that its owner wants to alienate the license from the other collateral in any way. This means that lender will be able to stop the license from being alienated from its collateral by purchasing it.
• Avoid a violation of section CA B&P code § 24074 by setting the strike price for license at fair market value. This means that a lender would likely want to get an independent broker to help set the price at the time it triggers the ROFR. It also means that there is no argument that lender is trying to jump priority on other creditors, since the fair market value of the license is all that would be required be deposited into escrow to begin with.
• Avoid the 90 day prohibition in CA B&P code § 24076 by making it clear in the ROFR that the license will be transferred pursuant to a separate purchase agreement to be executed not more than 90 days prior to the submission of a transfer application to the ABC.
• Contractually obligate the licensee ahead of time to continue operating its license during the normal course of business in the event that lender triggers its ROFR.
• Remove all language from loan documents that reference and condition the ROFR on the loan in any other way.

The above contractual terms go a long way to making sure that the lender does not end up with a dry piece of collateral if they ever have to foreclose. That said, there are several ways in which these edits are not comparable to the position that a lender would be in if it were legal for a lender to merely take a security interest in the license. Below are a few key points that lenders using an ROFR should be aware of:

• Regardless of any ROFR, borrower has the absolute right to surrender the license to the ABC rather than trying to sell the license to anyone. To be clear, lender could sue borrower for violating the ROFR but once the license is surrendered to the ABC there is no way that lender can get it back.
• The lender is going to need to put real money into the escrow at the time that the license transfers. Lender can’t fund the escrow by offset against an existing debt. Moreover, the license may have appreciated in value. So, the amount that the lender must put in escrow may be more than the borrower initially paid for the license. The lender will likely not see any of this money back.
• At the end of the day a borrower’s promises are only as good as the depth of their pockets. If borrower chooses not to fulfill its agreements all that both sides are left with is an expensive, often pointless, lawsuit.

As a whole, the above solutions can yield a suite of loan documents that look very different than what would be used for a business without liquor licenses. This is why it is important for licensed borrowers and lenders to start work with alcohol regulatory counsel early. Gibson & Jeffery, LLP regularly helps both lenders and borrowers navigate California’s alcohol regulation to successfully close loans of many different types. If you are looking for assistance with a loan concerning a property with a liquor license please contact us for an initial consultation.

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