James Norman is a Partner in our Ft Lauderdale office
This article was originally published in Lodging Hospitality on April 11, 2012. (www.LHonline.com)
Is It Time for a New Business Model?
Just when the hospitality industry economy is starting to improve, there is a new threat to the business model: owners are literally throwing operators out - whether or not they have the contractual right to do so.
For two decades, we've seen several waves of hotel owner versus operator litigation. The major cases have been fact-specific, but the underlying basis for the owners' termination has been the Restatement of Agency, rather than the management. Some of those cases challenged the operators' right to manage the hotel for the contract term. The industry's lawyers would then "draft around" any adverse opinion, by having the contract detail the rights, duties and obligations of the parties. The result: hotel management agreements tripled in length.
Apart from litigation costs, loss of the location and brand-reputation damage, the loss of a revenue stream measured over the term of a management agreement threatens the valuation of the brand company. Revenue streams are a key component in valuation of brand management companies. If the management contract term isn't assured, revenue stream value will be discounted.
The Restatement of Agency provides that a principal (the owner) always has the power to terminate its agent (the operator), unless the agency is coupled with an interest (meaning that the operator has an economic interest in the hotel). The owner doesn't have the right to terminate the operator unless the management agreement gives that right, such as failure to pass the performance test or material breach of contract by the operator.
What happens if the owner terminates the operator, when it lacks the contractual right to do so? The owner is still liable for wrongful termination damages. If the management agreement didn't allow such termination, the termination is, by definition, wrongful. If the remaining term of the agreement is lengthy, as is typical, the damages will be measured in the millions and tens of millions of dollars.
Brand Management Concerns
Two important questions for brand managers are:
- Does the recovery of damages make the operator whole?
- Does the hotel ownership entity have the financial capacity to pay a large award of wrongful termination damages, or is bankruptcy a risk?
If the owner kicks the operator out to satisfy its own purposes, what about guests and groups with future bookings? If you decided to hold your meeting at a hotel because of your relationship or experience with a particular brand, and when you arrive, it's a different brand or no brand, who gets blamed: the owner or the operator: The operator - because the guest doesn't know what happened. If a brand has only a single location in a market, and then loses that property, it is out of that market. The loss of an important market can have major impact.
Boiled down to the core issue, the question is whether courts should have the authority to ignore the plain language of a hotel management agreement that has been negotiated by two sophisticated parties represented by experienced counsel. By applying the Restatement to hotel management agreements, courts seem to think so.
This turn of events suggests the industry is on the cusp of a dramatic revision of key business model elements, in order to preclude courts from "changing the deal."
Concern about the "sanctity of contract" is nothing new. The United States Constitution has, in Article I, Section 10, Clause 1, "the contract clause." The framers were not talking about hotel management agreements, but were concerned about states interfering with the "obligations of contract." Sound familiar?
The state of Maryland has (Title 23, Sections 101-106) effectively instructed its courts to ignore the Restatement of Agency where it is in conflict with the express terms of a hotel management agreement.
Suppose that other states don't follow Maryland's lead, or courts determine the key provisions of the Maryland law are unenforceable? Acquiescence by the brand managers is very unlikely. As in the past, the industry will respond with contract provisions designed to maintain the integrity of management agreements.
What approach could the brand managers consider in order to have the specific terms of management agreement respected by the courts? There are a number of options, each with some advantages and disadvantages.
If the state of New York adopted a statute similar to that of Maryland, New York courts would treat hotel management agreements the way they treat other types of commercial contracts between sophisticated parties - the deal is the deal. New York would be the preferred jurisdiction, because New York law is frequently the governing law in hotel management agreements. As things now stand, the treatment of long-term, hotel management agency agreements under New York law is uncertain.
Without a New York law, operators could create a Maryland special purpose entity as the operator under the management agreement and have Maryland law govern the contract. One potential disadvantage is that Maryland is a high tax state.
If courts give owners a license to "throw the operator out and fight about damages later," why not use provisions of the Restatement to prevent owners from using their power to terminate? This would require the operator acquire equity in the hotel or make a loan used to acquire or construct the property. This isn't a perfect solution. The law is not clear about an agency coupled with an interest when an equity contribution is redeemed or a loan is paid off. Neither the Restatement nor any reported case deals with whether sliver equity or key money is sufficient to create an agency coupled with an interest.
A major flaw in the "contribute equity or make a loan" strategy is that usually, neither the owner nor its lender wants the operator to be a partner or lender in the deal. The issues created in those situations are numerous and complex.
Another avenue to a solution would be a relationship other than that of principal and agent. This avoids the Restatement of Agency. The most direct method would be what used to be the European model: the master lease. In such an arrangement, the parties are landlord and tenant and no agency is involved. Careful drafting can cause "the numbers" that flow to each party to be identical to those under a management agreement. The downside is a lease is carried on the books of the operator very differently than an agency management agreement.
Indirect Approaches to Consider
An indirect approach may be warranted in some transactions. One vehicle familiar to lenders is the "bad boy" guaranty. This would be executed by the principals of the owner (rather than the ownership entity) or other "collectable" parties. Rather than a guaranty of the economic obligations of the owner, this instrument would indemnify the operator against any damages the operator might suffer from the owner's wrongful termination of the management agreement. Unlike most hotel management agreements, which eliminate punitive and consequential damages, and may even provide for liquidated damages, this "wrongful termination indemnification" could eliminate those limitations.
The bottom line is both sides of the hospitality industry need certainty when it comes to contracts, not only in this current economic environment, but later, as well, when RevPAR growth rates, surging occupancy and demand for additional rooms are the main topics of industry discussion.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.