Hotel Management Agreements: avoiding common causes of dispute
The hospitality industry is one where reputation and brand are of the utmost importance and driven by the quality of customer experience and continuity of service. As such, the agreements that define the parameters of hotel management arrangements should be carefully negotiated to ensure coverage of the following broad components (amongst others): clear performance metrics; defined responsibilities and obligations of both parties; a fair system of compensation; robust termination rights; a proportionate owner oversight/approvals process; and a complete dispute resolution procedure. These components will be covered in more detail in this article.
The legal framework that most commonly governs the ownership and operation of hotels is a hotel management agreement (HMA). This article will provide practical guidance on the key areas of dispute that arise from HMAs and how to avoid them arising in the first place.
The HMA
A standard HMA is a long-term commercial agreement between an owner and an operator whereby the owner of a hotel appoints an operator company to manage its asset (within certain parameters as defined within the HMA). Common obligations of the operator under an HMA include management, operation and delivery of the hotel services (usually governed by a quality standard defined within the HMA), maintaining and supervising the hotel facility and ensuring a certain quality of service and customer satisfaction. There will usually be a defined set of express limitations on the operator’s authority beyond which the owner’s express approval is required. This usually includes such things as capital expenditure relating to refurbishment above a certain defined level; entering into contracts on behalf of the owner beyond a certain minimum term; and a restriction on selling, mortgaging or otherwise encumbering the hotel facility.
Common obligations of the owner include providing a right to the operator to execute its obligations in respect of the hotel facility and not interfering with that right (beyond that which is agreed under the HMA); providing financially for operating expenses, owner’s expenses and capital expenditures (all defined in the HMA) relating to the hotel facility; and employing the employees (although this is not exclusively the case, the operator generally selects, appoints, trains, manages, supervises and sets the remuneration of the employees).
In financial terms, a standard HMA may involve the owner and operator engaging in some form of profit-sharing arrangement involving most commonly a payment of a base fee (as a percentage of total revenue) as well as an incentive fee (as a percentage of operating profit) to the operator. The owner will set aside a separate account for fixtures and fittings, license fees, services fees and marketing fees for the operator’s use which should be set out in detail in the HMA.
Common areas of dispute involving HMAs
Poor financial performance
It is sensible and proper to standardise expectations in an HMA. Financial performance standards in particular should be carefully negotiated into the HMA to avoid disputes for lack of clarity or understanding of levels of expectation between the parties.
Typical performance metrics applied within this industry are revenue per available room (RevPAR) and gross operating profit. If operators do not achieve the particular metric agreed upon, this will usually enable the owner to remedy this failure by use of a claw-back of profit provision or operation of a right of termination under the HMA. A performance measure that works well in HMAs is a dual-limbed test whereby the first limb of the test compares the RevPAR of the hotel against competitor hotels and the second limb compares the actual total revenue with the budgeted total revenue. An HMA might specifically identify a “Competitor Set” of competitor hotels against whose performance the facility in question is compared. This Competitor Set can be agreed by the parties and renewed each year. In this type of metric, if the hotel has a RevPAR of less than 80-90% against competitors or if the actual total revenue is less than 80-90% of the budgeted total revenue, that will usually be seen as an initial indicator of a failure in performance but “failure” should be defined within the HMA and can require a higher or lower percentage and/or failure of both limbs for a certain contractually-agreed period (commonly two consecutive years) in order for an actionable failure to be established. This can be negotiated to be less or more draconian depending on the parties and their particular circumstances.
Underperformance is a common but complex source of dispute and there are numerous factors at an operator’s disposal that may be used to justify poor performance. A justification that is commonly cited is lack of investment or insufficient maintenance spend by the owner. This goes back to the expectations of the parties, and the HMA can place parameters around this so that the expectations are clear and a dispute less likely. The reality of the hotel industry is that outside forces can and do impact the investment and maintenance requirements of owners, and it is advisable to ensure that there is sufficient flexibility within the HMA to allow for movement of spend, as required by the facility.
Remuneration, costs and fees
Under an HMA, the operator’s remuneration is most commonly made up of a base fee (which may be a percentage of revenue) or a designated flat fee and may also include payment of an incentive fee (defined according to agreed thresholds as a percentage of adjusted gross operating profit) designed to incentivise the operator to make the hotel a success and to manage it cost-efficiently. If a flat fee is agreed in the HMA, allowance should be made within the HMA for amendment should business rates or other ancillary costs drive up the costs of the facility.
Gross operating profit is calculated as gross revenue less operating costs and when looking to maximise gross operating profit, an owner may look to use the HMA to control the operator’s ability to incur costs by limiting spending to those items considered most likely to result in an increase in revenue. A fine balance needs to be struck between providing the operator with enough allowance to spend of its own volition without requiring express approval (so that the operator can be sufficiently reactive) with sufficient oversight and spending parameters such that spending can be controlled within an agreeable limit (thus limiting the owner’s cost exposure). Striking this balance can result in complex fee formulas being set out in HMAs and can often form the source of disputes if not captured sufficiently clearly within the HMA. Parties can avoid disputes arising by being transparent in the negotiation of these clauses to ensure that both parties fully understand the parameters, timing and implications of what has been agreed.
An HMA will set out the funding obligations of both the owner and operator and should clearly delineate between the two. An owner usually provides provision for at least the following heads of cost: furniture, fittings and equipment (FF&E); repair and maintenance; liability and insurance; capital expenditure; and working capital. It is important that the HMA sets out clearly how these funding provisions will be used by the operator to ensure that they will not be unreasonably or inefficiently depleted or misspent. A way of managing this within the HMA can be to apply a cap on spend to establish a budget that is available within a certain defined period. Additional approvals can be worked into the HMA for spending on certain classes of item or above defined thresholds but controls should always be used carefully, keeping in mind that the operator needs to be afforded the appropriate level of self-determination to enable it to run the hotel efficiently and should not be overly hamstrung by too many approval requirements.
Inclusion of provision for a reserve fund is recommended to cover the eventuality that unforeseen costs will arise and to ensure continuity of the amenities of the hotel and to preserve brand standards. Involving the operator in aligning and agreeing these budgets and any caps and limitations/ approvals at the outset of the commercial relationship can help avoid disputes and keep the parameters clear and well documented between the owner and operator.
The operator will organise marketing for the hotel as well as organising payment for staff and services provided through the hotel. How these costs are managed should be covered in detail in the HMA as well as an agreed payment structure for use of the operator’s brand if that is part of the commercial arrangement.
Branding and brand standards
If the owner is making use of the operator’s brand there should be a clear fee structure set out in the HMA which allows for the operator to recover sufficiently for this use. An experienced operator will likely have a tried and tested fee structure. This is often uncontroversial but should nevertheless be clearly set out and understood as owners may be less familiar with these processes and fee structures than the operator.
Where a well-known brand is involved, it will be of the greatest importance that guidelines are set out in respect of maintaining the standards associated with that brand. This will extend into the repair and maintenance obligations, FF&E budgets, employees and hotel amenities and will most likely impact the parameters associated with each of those aspects. Performance standards and KPIs should be clearly established in the HMA in respect of each of these so that both parties are clear on what would constitute underperformance or a breach of the performance standards between the parties. An industry standard which is regularly seen in HMAs is “good industry practice” but this is insufficient on its own and it is advised that this is accompanied by a clear set of specific obligations in relation to each aspect of service delivery that underpin this standard.
Contentious clauses and how to avoid them
HMA Term
A standard HMA term is usually a fixed term of between 15 and 25 years with exercisable renewal periods of 5 to 10 years (either upon the mutual agreement of the parties or at the operator’s discretion). When preparing an HMA, the term should be clearly specified and include provisions for renewal. The terms of HMAs tend to be fairly lengthy so that when a commercial relationship is going well, continuity in the business can be maintained. Parties to an HMA regularly include a no-fault break clause so that the HMA can be terminated if the commercial relationship is failing. The particulars of this arrangement will typically be negotiated between the parties but usually involve payment from the owner to the operator as compensation for lost fees (those fees it would have earned had the HMA run its full course). Early termination understandably carries a high likelihood of dispute so in order to reduce the impact on the parties, some HMAs include a performance-based test which essentially establishes a test for termination. This provides some level of certainty for the operator because it will be aware that if it is falling below the performance standards set out in this test, it will be exposed to an early termination under the break clause and will be able to manage its own performance to ensure that does not happen and/ or mitigate its losses if it is likely to occur, or begin negotiating some other arrangement with the owner in order to avoid being terminated. This arrangement benefits the owner because it gives them the right to exit the relationship if it is failing whilst also providing a defensible and robust termination route. The test itself will usually comprise of a market comparator (specified within the HMA) which can also be the source of dispute so must be negotiated and agreed at the outset and clearly detailed in the HMA.
Force majeure
HMAs should provide for situations where the agreement cannot be performed for a reason which is outside the control of the parties (known as force majeure, which commonly includes acts of war, terrorism, labour dispute, acts of governmental authorities and nationwide/worldwide shortages of materials). An effective force majeure clause should set out a comprehensive list of triggering events which are appropriate for the parties; whether and how the HMA can be terminated; how revenue loss will be treated/borne between the parties; mitigation obligations; and how remuneration/ fees/ costs will be handled in such circumstances.
Termination
Parties to an HMA are advised to define material breach by determining clear provisions that set out specific circumstances whereby a party can terminate the HMA, including a list of specific material breaches and other events such as insolvency events or licensing prohibitions which would impact the facility. Notice and timing requirements and fees payable upon termination (and how they should be calculated) should also be included in the HMA. The parties will usually agree that the operator be afforded the ability to remedy any breach within a certain time period prior to termination.
The parties can mutually agree on the application of a unilateral, no-fault termination under the HMA (usually accompanied by a provision that should such right be exercised, a specified amount of liquidated damages will be paid by the owner to the operator). Without mutual agreement within the HMA on this point, some jurisdictions may not allow for unilateral termination and the importance of this provision will be impacted by what type and extent of provision is made in the HMA for performance-based tests. The operator may be reluctant to agree such a provision, but it is advisable that the owner of a hotel be afforded the ability to terminate and replace an operator in an efficient manner.
In practice, it can be difficult for an owner to establish that an operator is in breach of its contractual obligations when the employees who perform the bulk of the services in the hotel are employed by the owner. The parties can agree that certain key employees (usually those with management control, like the General Manager) be employed by the operator directly which can improve the owner’s chances of establishing a breach by the operator, should the circumstances allow for it.
It is important to consider and cater for the consequences of termination in order that the business of the hotel can continue despite termination of the HMA and so that customers can continue to be served. Such considerations include clarity around the control of customer data, branding, how existing and future bookings should be managed, ensuring continuity and coverage of staff and continuity of service. Having all of these items catered for in the HMA will reduce any impact an early termination may have on the brand associated with the hotel and the business of the hotel itself.
Choice of dispute resolution forum and law
Both expert determination and arbitration are forms of dispute resolution in HMAs. Expert determination is attractive because the expert will have a wealth of relevant and industry-specific knowledge to bring to the resolution of disputes but is usually reserved for budget-related disagreements. International hotel owners and operators are also attracted to the international and confidential nature of arbitration and are understandably keen to avoid the negative publicity that can result from litigation and the impact that may have on the customer and the reputation of the brand in the marketplace.
Parties to an HMA are advised to consider the following aspects when negotiating the dispute mechanism under the HMA:
- Mediation/pre-arbitral dispute resolution with express steps and timelines to engage and complete (if such pre-arbitral steps are appropriate in the circumstances and there is no suggestion that such a mechanism could be used to cause delay);
- Clear trigger point(s) for dispute resolution proceedings; and
- Recognised dispute resolution mechanism, seat, arbitral institution, governing law and procedures governing administrative matters such as tribunal selection.
When selecting which jurisdiction’s laws govern the HMA, the parties should opt for an advanced and developed (and therefore predictable) jurisdiction that is known to both parties and one which is arbitration-friendly (if applicable). Given the complex nature of HMAs, parties to an HMA should look to achieve clarity and consistency in their choice of dispute resolution forum and governing law. Practicality should ideally play a part in this choice as well as language and ease of enforceability of judgments or arbitral awards.
Conclusion
A functional HMA is usually one that has been robustly negotiated by the parties at the outset of the commercial relationship. Beginning a commercial relationship by carefully considering what could go wrong is often something parties are reluctant to do but if handled properly by specialists who understand the detail and nuance of the points raised in this article, doing so can avoid disputes arising altogether or at least save time and costs if they do, increasing the chances of preserving the relationship.
