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 carried 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 loans,[4] and many of those borrowers are liquor licensees. Often one of the most important pieces of a borrower's property that a lender will want to secure is the 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 its collateral by ensuring that the legal rights to operate the business travel 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 goodwill (at a minimum) are placed in a special escrow. Any of the 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).[5] Under § 24076 of the B&P Code, contracts that purport 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 its "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 because 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 lender cannot force the transfer of the license. Moreover, even if the lender can get the borrower to agree to sell its license, the lender cannot pay for the license by offsetting the license's value against the borrower's debt, because real money must 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 from which 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 the lender out the cost of the license, but it will also be out lawyer, broker, and consultant fees — plus 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 timeline[8] 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 the borrower does not agree in either of these instances, the lender's options are not appetizing. Even if the 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 the lender hoped to use as collateral can go dry and lose a massive amount of value and goodwill.

It is hard to imagine why lenders would ever issue loans to hospitality businesses under these circumstances. Yet clearly many loans[9] have been made. Given how common the practice of pledging licenses as security for loans appears to be, one wonders whether much of the collateral underlying California's hospitality-sector debt is overvalued.

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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 (pledges, guarantees, and security interests) 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 an option 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 "*[t]hough 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&P Code § 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 referenced case, the option to repurchase was triggered by default on a purchase agreement, not by 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 render the option unenforceable; on the other hand, the only time 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 the lender or its designee a ROFR to purchase the license any time its owner wants to alienate the license from the other collateral in any way. This means the lender can stop the license from being alienated from its collateral by purchasing it.
    - Avoid a violation of CA B&P Code § 24074 by setting the strike price for the license at fair market value. The lender will likely want an independent broker to help set the price at the time it triggers the ROFR. It also means there is no argument that the lender is trying to jump priority over other creditors, since the fair market value of the license is all that would be required to be deposited into escrow in the first place.
    - Avoid the 90-day prohibition in CA B&P Code § 24076 by making 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 in the normal course of business in the event the lender triggers its ROFR.
    - Remove all language from the loan documents that references or conditions the ROFR on the loan in any other way.

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

    - Regardless of any ROFR, the borrower has the absolute right to surrender the license to the ABC rather than sell it to anyone. The lender could sue the borrower for violating the ROFR, but once the license is surrendered to the ABC there is no way to get it back.
    - The lender will need to put real money into escrow at the time the license transfers; it cannot fund the escrow by offset against an existing debt. The license may also have appreciated in value, so the amount required may exceed what the borrower originally paid — and the lender will likely not see that money back.
    - At the end of the day, a borrower's promises are only as good as the depth of its pockets. If the borrower chooses not to honor its agreements, all that remains is an expensive, often pointless, lawsuit

As a whole, the above solutions can yield a suite of loan documents that look very different from what would be used for a business without liquor licenses. This is why it is important for licensed borrowers and lenders to start working with alcohol regulatory counsel early. Gibson & Jeffery Law regularly helps both lenders and borrowers navigate California's alcohol regulations 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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