Courthouses haven’t been very hospitable to hotel operators. Starting in 1991 with the Embassy Suites case, which was followed by both the 1993 Marriott case and the 1996 Hyatt case, courts have determined that, contrary to the long term (often 20 or more years) contemplated in management agreements, an owner, subject only to a risk of an operator’s claim for a wrongful termination, is free to kick out the operator for any reason or for no reason at all. The courts did provide an escape-hatch allowing an operator, by having a certain financial interest in the hotel (such as a loan), to make the agency relationship one that is “coupled with an interest” and, therefore, irrevocable.
As things turned out, a strong economy and keen competition among operators for management agreements made a loan or equity participation in hotel projects not just a legal device for operators, but one that the marketplace required as an “entry fee” for the management agreement. Since the three court decisions relating to the agency relationship, owners and operators now spend considerable time negotiating those provisions of the management agreement dealing with the exact nature of the relationship. In that context, the legal term “fiduciary” became a pejorative to operators. Simply, if the operator is a fiduciary of the owner, the operator owes the owner the highest duty of loyalty based on the fiduciary’s special knowledge and the legal obligation of a fiduciary to act at all times in the best interests of the owner.
In some areas, there has never been much doubt about the operator’s duty to the owner, particularly in terms of handling monies generated by the operations of the hotel, making appropriate payments, including those to the owner, and maximizing revenue for the hotel. These areas are either obvious, unavoidable, or in the joint best interests of the owner and the operator.
There is, however, an area in which the interests of the owner and the operator are not so clearly aligned. These relate to what is often referred to in the industry as “group purchasing.” The object of group purchasing is to permit services, supplies, equipment, insurance, and myriad other items to be acquired for individual hotels at a price advantage over single property purchasing, by allowing the operator to purchase these items on a systemwide basis. Management contracts have nearly always contained such a provision, with the test being “at a price lower than that which could be achieved for this single hotel.” Equally customary in the industry is a practice among operators to retain a portion of the savings, along with commissions, rebates, incentives, and, for some items administrative fees charged by the operator.
On December 10, 1999, a jury, hearing a case in Delaware federal court, 2660 Woodley Road Joint Venture v. ITT Sheraton, rendered a verdict that many people in the industry believe has again changed the relationship between owners and operators. The jury found that, in its capacity as operator of the Sheraton Washington Hotel, ITT Sheraton had retained rebates, discounts and incentives that it collected from outside vendors supplying goods and services to the Sheraton chain — rebates, discounts and incentives that belonged to the hotel owners. In its special verdict form, the jury found ITT Sheraton further at fault, by not disclosing these monies to the owner.
How irked was the jury? Obviously, a great deal, because in addition to its verdict for general damages against the operator, it awarded the owner more than $37 million in punitive damages. What happened?
No one can read the mind of the jury, but it appears that the jury concluded that the operator was indeed the fiduciary of the owner and was guilty of actions it considered inconsistent with the obligations of a fiduciary. Among the allegations by the owner was that the operator allowed its corporate personnel to use the hotel and its services for their personal enjoyment during stays unrelated to hotel business. The jury also condemned the operator’s practice of shifting operating expenses from one year to the next in order to maximize its incentive compensation under the management agreement.
Many in the industry would look at what occurred and conclude that perhaps some adjustment of compensation to the manager was appropriate, or perhaps the manager should be terminated for cause. The jury did allow the management agreement to be terminated, but without any compensation to the operator for loss of its future management fees for the balance of the term of the management agreement. The debate between those who say the verdict was “a long time coming” and others who describe it as “simply outrageous,” has made the decision and its possible implications a frequent topic of conversation for industry business people and hospitality industry lawyers.
When and if an appeals court upholds or reverses the Woodley Road jury verdict, it will become clear whether the operator owes a fiduciary obligation to the owner. Among the questions to consider: whether Woodley Road effectively prohibits operators from retaining savings, rebates and commissions from group purchasing programs or must share them on some pro-rata basis with all of the owners in that group and whether there must be specific disclosure of each and every possible rebate commission or administrative fee, failing which an operator may be terminated summarily without recourse to the owner.
If hotel owners had their way, the management agreement might contain a provision that read:
Operator specifically acknowledges and stipulates that it is acting as a fiduciary to owner in connection with any and all aspects of the management of the hotel and operator shall, in all respects, operate the hotel in such a manner as to maximize the return to the owner. All savings, rebates, incentives and similar savings achieved by operator in connection with the operation of this hotel, including any group purchasing program, shall be disclosed in writing to owner and shall accrue solely to the benefit of the hotel.
On the other hand, the operator would prefer a provision in the management agreement that might contain the following provision:
Owner specifically acknowledges and stipulates that operator, in its capacity as manager of the hotel, is not acting as a fiduciary to owner in connection with any aspect of group purchasing, and shall be entitled to retain, and is not obligated to disclose to owner, any profit, rebate, mark up, incentive or similar payment that operator receives or retains from any source, including third-party vendors and suppliers of goods and services to the hotel. Owner hereby waives any claim that it may have to any such profit, rebate, mark-up incentive or similar sum, so long as the total of all items purchased through the operator’s group purchasing program will be at a cost lower than that which is otherwise available to the hotel from other sources.
Whether the industry likes it, Woodley Road is moving the industry in the direction of requiring disclosure and consent. While there are a number of ways for operators to “inoculate” themselves from Woodley Road-type liabilities, disclosure appears to present the best opportunity. If examined in a normal business context, group purchasing presents the real potential for a “win-win” scenario for owners and operators. For instance, if an owner independently goes to the market to obtain long-distance telephone services, a single property or several properties will not likely motivate a national telephone carrier into giving the same level of discount that it would to an entire hotel chain. This provides the opportunity for the sharing of the benefit in terms of lower cost (and therefore higher profit) to the owner, and a fee for structuring the group purchase by an operator through its national reputation. Each party understands the bargain that has been struck and accepts that portion of the benefit that comes to it via a disclosed element of the operator’s group purchasing program.
To this point, we have been considering ways to improve management agreements yet to be executed. What is the status of the thousands of management agreements that currently are in place and do not specifically deal with issues that are raised or complicated by Woodley Road,? Should existing management agreements be amended?
It would be unusual to find an owner or operator who wants to become involved in renegotiating a management agreement or proposing an amendment to the management agreement when it was not absolutely essential to do so. There is a rational fear that to open up one area for discussion may lead to a reopening of the entire agreement. Some would undoubtedly conclude that the best policy is to simply wait and see. Others may feel that because no one has yet made a claim, everything must be fine. These ostrich-like policies, consisting of action by inaction, put operators at some risk. Even before there is an appellate review of Woodley Road, disputes between owners and managers now invariably contain a Woodley Road-type claim. There is a practical, if not painless, way to address some or all of the issues.
Every hotel management agreement describes a process to deal with the annual budget. Part of the annual budget process, particularly where there are narrative discussions of assumptions by the operator and observations regarding market conditions, can be a disclosure of retained rebates, incentives, commissions and similar monies as part of group purchasing.
How much disclosure is enough? That is for each operator to decide, pending the final outcome of Woodley Road. Must each and every contract or type of group purchasing be disclosed in terms of source and specific amount? Probably not. General descriptions probably will be legally sufficient, so long as it is reasonably clear what kinds of rebates and incentives are involved. Woodley Road does, at least for the time being, cloud the resolution of management agreements and of group purchasing procedures. It also suggests that where the law works against you, a well-drafted contract can ameliorate or eliminate the problem. The future will tell us whether Woodley Road is full of potholes or a dead end for operators.
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