Managing hotels and associated leisure facilities will inevitably give rise to a wide range of complex commercial and legal issues. In this article, we examine a few high level topics.
Operator v Owner
A major international hotel operating company will possess a highly sophisticated understanding of the provisions of its standard hotel management agreement and more importantly, the consequences of these provisions at both the corporate and operational levels. Particular examples are provisions dealing with fee structure, including centralized services, saleability, insurance and, most importantly, termination.
On the other hand, the knowledge of an owner of the agreement is likely to be limited. In other words there is often a large knowledge gap between the operator team and the owner team about the industry conventions and specific terms that underpin management agreements. For example, it maybe necessary to explain to owners that engaging an operating company does not mean that the owner will not be responsible for any losses that the hotel may make during the term of the management agreement.
During the initial period of negotiations, detailed explanations should be provided by the operator setting out in clear and understandable detail the service arrangements, which form the basis of the provisions of the hotel management agreement. In the long term, greater understanding by owners will improve the negotiation process for hotel management agreements.
Termination of operator
It is rare to find a management agreement, which contains a provision allowing the owner to terminate either at any time or on sale of the hotel without cause. On the rare occasions where operators agree to these provisions, termination is conditional on a payment to the operator.
Previously, the payment would normally be some multiple of the yearly management fee (generally in the range of two to three times). These days, the payment will more usually be an approximation of the fees that the operator would have otherwise been entitled to receive during the unexpired term of the agreement. This can amount to a very substantial payment.
Even if a without cause termination provision is absent, agreements will frequently contain performance based termination clauses. Such clauses are difficult, if not impossible, to activate, and as a result are not worth trading away other key commercial terms in order to have them included in the management agreement.
The challenge for both owners and operators is to devise a means of allowing for the termination of a hotel management agreement in circumstances where the operator clearly and demonstrably lacks the expertise or the ability to operate the hotel at an acceptable level of profitability. Otherwise, we can expect to see a significant increase in litigation relating to management agreements as the only realistic option that an owner can take if faced with the prospect of heading toward bankruptcy as hotel operating losses mount up.
Alignment of risk and reward
Previously, the common fee structure was known as "3 plus 10" where the operator's take was three percent of revenue and ten percent of profit. With such a fee structure, owner and operator risk and reward was totally unaligned. This was because the internal rate of return that the operator could generate from its revenue-based fee was normally sufficient to make the contract profitable for the operator. Even if the hotel did not generate any profit, the contract was still profitable to the operator. This fee structure has more recently been seen in the luxury five star end of the market.
There has been a gradual reduction in the quantum of base fees and a corresponding increase in incentive (profit based) fees with the result that if the hotel is not profitable, then both the operator and owner suffer– thus risk and reward are more closely aligned. More importantly, if profitability is maximized then there is generally no erosion in the overall amount of fees paid to the operator.
There is however, not any alignment of risk and reward in relation to the sale of a hotel (i.e. contracts which give the operator any incentive to maximize the sale value of a hotel by either rewarding the operator should the hotel be sold for an amount in excess of an anticipated figure or conversely punished should the sale value be less).
International hotel operating companies have in recent years disposed of almost all of their property and other non core assets and now generate almost all of their income from their management agreements.
The challenge is to come up with a remuneration mechanism, which not only embraces the operating performance of the hotel during the course of the management agreement but also takes into account the sale value of the hotel. The aim would be to incentivize the operator to provide equal attention to maximizing sale value as well as operating performance. This would have a potential side benefit of significantly reducing the desire most owners have to seek to terminate the management agreement on sale of the hotel.
Over recent years there has been an emergence of brand leverage. This is the desire on the part of an operator to get more value from their brand than was previously the case.
Some examples of brand leverage are:
- Branded residences – developments, which consist of a hotel and adjoining residential accommodation. The residences are branded using the operators intellectual property sold to the public. The operator receives a proportion of the sale price in return for making its brand available for the residences.
- Brand partners – some management agreements provide that the operator may have one or more brand partners during the life of the agreement, and allow the operator to place marketing information relating to such brand partner in the hotel (and particularly the hotel rooms). Furthermore, the owner is generally prohibited from marketing in the hotel any products or services of a competitor to any of the operator's nominated brand partners. Generally, the agreements do not provide for any payment to the owner in return for the operator's ability to access the hotel and its amenities in this fashion.
- Cross operations – some management agreements provide that if occupancy at the hotel during a particular period falls below a specified minimum, then the operator is entitled to make rooms available to members of its affiliated time share club. There is either no fee payable to the owner for this other than for incidental costs.
There is a need to create an environment where both owner and operator receive a fair return for their respective contributions. If this does not occur then there will be increasing resistance to such leverage.
Choice of law
The choice of law and the method of dispute resolution should have the following attributes:
- A sophisticated legal system and preferably a sophisticated and well-recognised alternate dispute settlement mechanism such as arbitration.
- For the Middle East region, it should be located in the Middle East.
- The procedure adopted should be as cost and time effective as possible.
However, it would be in the interests of both the operator and the owner to include in the hotel management agreement a mechanism, which seeks to resolve the dispute amicably between the parties before either party is able to refer the dispute externally.
Most, if not all, hotel management agreements place an obligation on the owner to obtain a Non Disturbance Agreement (NDA) from a financier, which is generally a tri-partite agreement between the operator, owner and the financier. Such agreements bind the financier in the event of default by the operator or owner and the financier takes over the hotel in accordance with the terms of the management agreement. They also oblige the operator to provide relevant notices to the owners, and often allow the financier an opportunity to remedy an owner's default (thus maintaining the management agreement). The obligations generally carry over to proposed purchasers of the hotel and in this respect can add to the restrictions on sale.
The interests of the operator and the financier are diametrically opposed. The operator is seeking to ensure that the financier does not act in a manner which is inconsistent with the terms of the management agreement – and in particular any provisions to the effect that the management agreement continues notwithstanding the sale of the hotel. The financier is generally seeking to maximize the price paid for the hotel on sale and this may be depressed if the financier is forced to sell the hotel subject to the management agreement.
Sale of hotel
It has generally become very difficult to get any operator to agree to any without cause termination provision either on sale or otherwise. At the same time, operators are becoming more resolute in their conviction that termination on sale is not available. So more often than not the hotel can only be sold subject to the existing hotel management agreement.
Due to this an operator normally imposes stringent requirements in relation to the sale, i.e. the proposed purchaser must not be a competitor of the operator and must have a reputation and a financial standing which is acceptable to the operator. Further, the operator may insist upon a NDA, which requires the proposed owner's financier to not act in a manner which is inconsistent with the owner's rights pursuant to the management agreement. As a further restriction on sale there may be provisions which give the operator a first or last right of refusal to buy the hotel.
The combination of all these restrictions may lead to a real cost in the sale process (including the reduction in the price that the hotel would sell for but for such restrictions). Hotel investment competes with all other forms of investment, and particularly all other forms of property investment. If factors relevant to the relationship between owners and operators are having an adverse impact upon hotel sale value, then this will have an adverse impact on hotel investment generally which will be detrimental to the hotel industry.
The negotiation process should be approached on the basis that certain restrictions are appropriate. However, there is a need to find a balance between the operator's need for such restrictions and the owner's desire to maximise sale price. Therefore we should understand the need for each restriction the operator seeks and attempt to ensure that any restriction is no more onerous than necessary in each particular situation.
Previously, an owner's capital expenditure obligations were to maintain the hotel to the level usually expected of a hotel of the same star rating as the hotel in question. It was generally accepted that this was a very imprecise standard and did not really achieve the requisite goal of ensuring that all hotels operated by a particular operator with respect to a particular brand had the same standard.
Now, most management agreements tie the owner's capital expenditure requirement to the operator's brand standards. This however runs into difficulties in practice. For a significant number of brands, the relevant brand standards are imprecise. In a number of instances, there is no ready book or brochure which sets out the brand standards in enough detail to support the contractual obligations that a number of management agreements impose or allow an owner to understand what impact the brand standard benchmark will have for item. In particular, it is generally stated that the owner will comply with the brand standards at all times and, in some instances; there is a specific termination provision available to the operator if the brand standards are not complied with. If such provisions are strictly enforced, this imposes harsh consequences onowners.
Once again the challenge is to find the balance between the operator's desire to achieve uniformity across all hotels branded the same and prudent management of FF&E and capital expenditure programmes. Also, all markets are not the same and a requirement that makes perfect sense on one market may not be appropriate in another.
Hotel management agreements are such a key component of deal execution, that operators who can deliver plain English, shorter form, and commercially reasonable agreements, and do so quickly, have significant competitive advantage over operators with lengthy agreements subject to approval at a higher level.
Overall, there is a need for owners and operators alike to explore whether and/or what improvement can be made to hotel management agreements by way of research and development. Charles Russell has a significant amount of experience in relation to advising on hotel and hospitality matters within the Middle East and has an 'on the ground' team with specific expertise in relation to this sector.
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.