Hong Kong: Events Outside Our Control – How Can Owners And Operators Contractually Control The Consequences?

Last Updated: 14 October 2014
Article by Andrew P.B. MacGeoch and Emily I.C. Wong
Most Read Contributor in Hong Kong, October 2018

Keywords: management contract

By definition a force majeure is an event outside the control of the parties. However, the parties to a hotel management contract can seek to control some of the consequences, including the allocation of risks, as between the hotel owner and operator.

At the time of writing (3 October 2014), Hong Kong has endured a week of heightened political tension. Core roads in Central, Admiralty and Wanchai, as well as in other parts of Hong Kong, have been closed to vehicular traffic. Entrances to hotels, shops, restaurants and offices have been impacted. Guests arriving at some hotels may have found themselves needing more than just a nice hotel car from the airport. We have seen some guests receive a police escort. Others have been making creative use of Hong Kong's extensive network of tunnels, bridges and walkways to get to their destination. The old adage, "To travel hopefully is a better thing than to arrive", would be soft comfort to a hotel guest keen to arrive and to rest their weary head upon a luxury bed. On arrival at their hotel they might find not only the doorman there to greet them, but also a welcoming committee of hundreds or even thousands of protestors.

In recent days we have also seen the horrors of surprise eruptions of volcanoes, seasonal typhoons, and floods. Earlier this year there was another coup in Bangkok and Vietnam had to face short-lived riots. Other territories are affected by war, terrorism, earthquakes and other turmoil. The rapid spread of the Ebola virus is now another factor to be assessed on the global scene.

The hotel, leisure and travel sector is impacted by all of these events which seem to be the new norm. So how do hotel owners and operators cope with these excitements, stresses and business interruptions? What does the typical hotel management agreement say on the subject and how are these issues addressed?

This article identifies those provisions in hotel management agreements to which both owners and operators should pay particular attention when negotiating agreements in today's environment.

There needs to be legal certainty and fairness in how risk is apportioned between owner and operator. This particularly applies to significant provisions that deal with force majeure, guest liability and insurance as well as performance tests and termination rights. In some cases, repair and restoration of the hotel, appropriation or forced alteration of a hotel may also be an issue.

Force Majeure

Force majeure clauses may be regarded by some as boring boilerplate provisions. Yet in the aftermath of a significant event, coup, riot, earthquake or terrorist attack, it can become key to the operation of the whole agreement.

During or following these events, hotels in a city, country or even region may experience dramatically difficult trading conditions. Hotel operators may struggle to meet their performance tests in the management agreements. Whether this will trigger performance termination will depend on how the force majeure clause is drafted and the extent to which a performance test is abated, re-calculated or waived as a result of such an event. These clauses are growing in length and sophistication and rightly so in order to deal with the collage of calamities that a hotel may experience.

Equally there may be hotel operators who continue to miss performance targets well after recovery. From an owner's perspective, it will be important that such an operator is not able to use a force majeure clause to excuse poor performance. From an operator's perspective, it is critical that it does not fail the performance test for reasons unrelated to its performance and that are not within its control.

Force majeure provisions might be used by either owner or operator and drafting need not favour one or the other. It is, however, important to ensure that there is complete clarity on what is included and when it will apply.

Liability Towards Guests

Hotel guests who are victims of these events may bring claims of negligence or breach of contract against hotel owners or operators. Of course, the success of any such claim will be highly fact sensitive. Who will typically be responsible for such claims, particularly where there is a gap in insurance coverage (which can often happen where political upheaval, riots and terrorism are the cause of injury or loss)?

Hotel ownership will always involve the assumption of risk in relation to large personal injury claims. This liability may be direct. The operator will usually insist that the owner indemnifies them for most, if not all, risks unless caused by the operator's gross negligence, fraud or wilful misconduct.

Given the extent of possible claims, owners are advised to ensure they negotiate indemnity clauses so that these are fairly balanced with reasonable carve-outs of the indemnity they give operators and ideally with some form of reciprocal indemnity from the operator to the owner. Indemnities in relation to the gross negligence of the general manager and other key staff are particularly worth arguing for, although these are usually capped.

Insurance

In deciding the type and extent of insurance necessary, it is always useful for the owner and operator to work together with their respective insurance brokers to agree on common ground.

During the negotiation of management agreements, key issues often include who bears the cost of the insurance, what happens if one party invalidates the insurance and the consequences if a specific type of insurance is not available in a particular market. The details of these provisions are often overlooked by business people when the management agreements are negotiated. However, insurance will of course be the primary means for mitigating such force majeure risks. It may seem that the chances of experiencing a force majeure event are low (a questionable assumption in the current climate); however, the impact of such an event on the business of a hotel can be dramatic.

When SARS first appeared over 10 years ago, a few hotels were able to recover under their business interruption policies. Others were less successful. Policy details are then re-written whenever major risks are identified and premia for such policies may increase significantly. Will Ebola be covered or excluded from the typical business interruption policy? It would be worth checking. As mentioned, terrorism is often excluded from insurance policies and so are political commotions and riots. Can you secure specialist insurance products to address these situations? In many instances, yes – but of course at an extra cost.

In the absence of relevant insurance policies, liabilities are likely to be borne entirely by the owner unless the hotel is located in a country where the government will step in to meet liabilities or provide other financial support in such circumstances.

Repair and Restoration of a Hotel

Where a force majeure event has significantly damaged a hotel, one of the key questions a hotel owner will likely ask is, Should I restore my damaged hotel or would it be better to start afresh with an entirely new class or even new type of property? The owner may, however, be contractually bound to the operator to reinstate the hotel and accordingly have no opportunity to exercise its preference.

Under a management agreement, the owner's obligation to reinstate the hotel usually depends on the extent of the damage. Only if the costs of repair exceed a specified threshold will the owner have the right to terminate the management agreement without payment of compensation to the operator.

What is useful from an owner's perspective is to have a lower threshold which is applicable when the damage is not covered by insurance. The determination of both thresholds is a matter for the owner and operator to negotiate. The thresholds are usually defined by reference to the cost of repair and the expected duration of the repair works. Clearly having a low threshold, particularly for damage not covered by insurance, is very important for every owner. From an owner's perspective, it would be ideal if the owner has the discretion to decide whether to undertake the repair works based on whether it is economically feasible to do so. However, from an operator's perspective, there should be an objective threshold determining whether the owner should repair the hotel.

If an owner does not repair and restore the hotel and the hotel management agreement is therefore terminated, there are two further issues worth considering: firstly, that of who is entitled to the insurance proceeds (if any); and secondly, that of whether the operator should have a right of reinstatement if the owner rebuilds a hotel after termination. An operator would argue that the insurance proceeds should be shared equitably between the parties, while an owner would argue that priority should be given to the owner's recovery of its investment. It is quite common for the operator to have a right of reinstatement if the owner rebuilds a hotel of similar class and standard within two or three years after termination, but this period should not be too long.

In some cases, operators even ask for payment of compensation from the owner in the event of such termination. Owners often try to resist this or at least limit the amount of compensation payable to the operator to the amount of insurance proceeds recovered by the owner that represents operator's loss of income for business interruption.

Appropriation and Forced Alteration of a Hotel

What happens when a hotel becomes appropriated by a government or an army? In such a situation, an owner will generally have the right to terminate the management agreement without paying compensation to the operator if the hotel is appropriated for a long period of time, often 12 months or more.

If the length of appropriation is shorter than the specified period in the agreement, the owner will normally be obliged to repair and reinstate the hotel after the appropriation unless there is an excessive cost of repair, as discussed above.

There is also a question as to whether the term of the contract should be extended in such circumstances by the period of appropriation.

In Hangzhou, China, there were reports some years ago that the local authorities might impose an order on the Shangri-La to remove the top few stories of its hotel to meet new height restrictions as part of Hangzhou's drive to attain UNESCO heritage status.

This would amount to a partial appropriation and should also be dealt with in the management agreement by providing a right to terminate if the appropriation makes it commercially or practically impossible to operate the remaining portion of the hotel as a hotel of the same class and standard.

The issue of who is entitled to any appropriation awards should also be considered. The principles discussed above in respect of entitlement to insurance proceeds for repair and restoration of a hotel apply to this issue.

Conclusion

Increasingly, hotels seem to be a victim of many events outside the control of both owner and operator. A fair and well-thought-out management agreement is needed to provide protection for the interests of both parties and to provide sufficient clarity to help both parties in the aftermath of such events. This, combined with a sophisticated strategy for insurance, should help all parties to sleep well at night – even as the protests continue.

Originally published October 2014

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Mayer Brown is a global legal services organization comprising legal practices that are separate entities (the Mayer Brown Practices). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; Mayer Brown JSM, a Hong Kong partnership, and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

© Copyright 2014. The Mayer Brown Practices. All rights reserved.

This article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein. Please also read the JSM legal publications Disclaimer.

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