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Hotel Management Agreements – The Illusory Performance Test

In the negotiation of management agreements, owners take comfort from the performance test that in the most optimistic light will allow the hotel owner to terminate a management company that does not meet the standards of the performance test. But let’s look more deeply into the proposition that the performance protects the owner from the under-achieving management company.

The typical performance test these days, and they have become very standardized across the major US branded management companies (e.g., Marriott, Hyatt, Hilton, InterContinental…), looks like this:

The owner may terminate the management agreement if for two consecutive years the hotel has not achieved (a) [90 per cent] of budgeted revenue (or possibly gross operating profit) AND (b) [90 per cent] of the RevPAR of the agreed competitive set.

On face value, not bad. But here are the features that detract from the efficacy of the test to assure that the owner is getting the best possible performance from its management company:

The management company will have a cure right that usually is satisfied by the management company’s making a payment to cure one of the two year’s failures and one of the two prongs of the test, prong (a) or prong (b). Prong (a) is susceptible to cure, so the payment to bring gross revenue to within 90 per cent of budget is the route to cure. The cure payment is not an adequate substitute for hotel performance;

The cure can be a cure of either year, so the management company will choose the year in which a cure is accomplished by paying less;

The cure of either year negates both of the two years, and the slate is wiped clean;

If the management company perceived in the first of the two years in which the test was failed that it had budgeted gross revenue too optimistically, it can adjust the budget for the next year to make budgeted gross revenue more achievable. The owner must be wary of this;

The competitive may not be a high enough bar. It has to be made up of those hotels that are truly comparable and are doing well;

The test is not failed if the shortfall can be attributed to a broadly defined “event that constitutes force majeure”;

The test is not failed if owner is in breach (any breach), and this may include a failure to spend all the capex required to meet each and every brand standard;

Any termination of the agreement, whether because of a failed performance test or otherwise, is almost always conditioned on the owner’s repaying all amounts that are owed to the management company, and these can be very considerable where the management company has advanced key money or a made a loan to the owner, as are often the case with new hotels. A hotel that has been failing the performance test is not likely to have accumulated the cash to satisfy these obligations.

What can an owner do?

It would be better for the owner if the “AND” separating the two prongs were instead “OR”, but this is rarely agreed.

Make the years to which the test applies not two consecutive years, but any two of three consecutive years;

The percentages – 90 per cent in the examples – should be at least 100 per cent and arguably even more where the management company flaunts its ability in the negotiation leading up to the management agreement and has a new hotel at its disposal. The owner should seek to have the hotel under the supervision of the management company exceed the budget and the RevPAR of the competition, not just come within a respectable proximity to the budgeted revenue or the performance of the competitors;

The owner must insist always on aggressive, stretch budgets, not an easy-to-achieve “softball budget” that might be proposed by the management company after it has failed the first of the two consecutive year tests;

Be sure the competitive is a good one and that it is adjusted over time to remain truly “competitive”;

The right to cure should not be unlimited, and allow only one or two cure rights throughout the term of the management agreement;

Make the cure payment from the management company apply to the shortfall for both years, or at least negate only the year for which the payment was made (meaningful where the test applies to any two of three consecutive years);

If the management company has a right to extend the term at its expiration, condition that extension upon the management company’s not having failed the performance test, whether or not the failure was cured;

Tighten up the definition of “force of majeure” so that it applies only when there are extraordinary, unforeseen events, such as a tsunami. Do not allow a general economic downturn either globally or locally to be part of the definition of “force majeure”. The management company should be expected to manage through economic downturns;

Make only those owner breaches that directly impacted the management company’s ability to meet the performance test apply as excuses for the failure;

The obligation of the owner to repay all amounts owing to the management company as a condition precedent to termination of the management agreement should not apply where the termination arises from a failure of the performance test. This is a difficult one because the management company is not likely to agree to leave the property unless it is fully paid for all amounts owed;

Make the performance test measure the net income that flows to the owner. This is difficult because in a hotel P&L, management companies measure their performance only above those expense lines over which they argue that they have no control, such as the FF&E replacement reserve, property insurance, property taxes, capex and most importantly, debt service. But net income is ultimately the only performance outcome that is truly meaningful to the owner.

In short, if the owner is genuinely interested in having a meaningful performance test, the owner must think long and hard about what performance it wants to use as the test standard and what constitutes a failure of the test, and then negotiate hard to make the test meaningful and not an illusory cosmetic.

By Albert J. Pucciarelli, Esq.

This article appeared in eHotelier on March 21,2017


About the Author:

pucciarelli

Albert J. Pucciarelli is a partner in the law firm of McElroy, Deutsch, Mulvaney & Carpenter, LLP. He is Chair of the firm’s Hotels and Resorts and Aviation Practice Groups. From 1988 through 1998, he was a Director and Executive Vice President, General Counsel and Secretary of Inter-Continental Hotels. He has served as Chair of the Hotels, Restaurants and Tourism Committee of the Association of the Bar of the City of New York (2001-2004) and as Chair of the Aeronautics Law Committee of the Association of the Bar of the City of New York (1998-2001). He is a Director and immediate past President of the Hospitality Industry Bar Association. He has taught International Business Law as an adjunct professor at the Fordham University Graduate School of Business, and was member of that school’s Advisory Board (1996-2004). He is a member of the Cheyney University of Pennsylvania Hotel, Restaurant & Tourism Management Board. He is a Director of Skytop Lodge Corporation in Skytop, Pennsylvania, and a consulting member of Cayuga Hospitality Consultants.

The Illusory Indemnification

The major US hotel brands (e.g., Marriott, Hyatt, Hilton, InterContinental…) have become truly global in the past 20 years and many of them now franchise or manage more hotels outside the US than within the US. In the management agreements whereby these brand owners not only license their names and know-how for use by a hotel, but also oversee the day-to-day operation of the hotel, the management company assumes, and insists upon, the exclusive right to hire, train, supervise and, as necessary, terminate the employment of, all hotel-based personnel. 

In the franchise world, employees based at the hotel are employees of the hotel owning company, no matter where the hotel is located, with the franchisor having no hiring or supervisory role, although the franchisor may make training programs available to certain hotel personnel. In the management agreement context, the situation is less uniform.

In the US, the management companies generally insist upon being the employer of each and every hotel employee. The hotel-based employees receive pay checks from the management company and participate in their nation-wide benefit plans.  There are enormous synergies and policy uniformity that are achieved by making the hotel-based personnel at all levels employees of the management company rather than the hotel owning company. Even so, the recruitment and relocation costs, training costs, salaries and benefits, and termination-related payments are all above-the-GOP-line operating expenses of the “hotel” which means that they are borne by the hotel owner as routine operating expenses.

Outside the US, the employer/employee relationship is very different. Typically, all hotel-based employees are expressly required in the management agreement to be employees of the “hotel” and therefore they are employees of the hotel owning company and not the management company. The key personnel, such as the General Manager and other members of the hotel’s executive committee, may be employees of the US-based management company (e.g., Marriott), but while they are serving at the non-US hotel, they are also on the hotel’s payroll as employees of the hotel owning company and at least part of their salary is in local currency. They may also remain participants in the management company’s benefit plans and may draw a dollar-denominated salary in the U.S. from the management company that is a charge-back to the hotel owning company, with the benefit of tax-free US income for residents working abroad, currently $101,300.

Why this distinction? While not articulated in the management agreement, the motivations of the management companies seem to be (a) to avoid having a tax “presence” in the many non-US jurisdictions where they manage hotels and (b) to avoid the complexity of compliance with the local employment law regimes in each such jurisdiction.

What about liability for acts of employees under supervision of the management company? Whether in the US or not, the management agreements slavishly follow the limited indemnification obligations as follows. The hotel owning company must indemnify, defend and hold harmless the management company from all liabilities arising at the hotel, no matter that the employees are selected, trained, supervised and disciplined by the management company. The exception is for gross negligence or willful misconduct on the part of the management company in which event the indemnification obligation runs in the opposite direction, i.e., the management company will indemnify, defend and hold harmless the hotel owning company. While this may seem an unreasonable allocation of risk, it has become the industry standard, at least based upon my own experience and that of other lawyers who represent owners and management companies in the negotiation of hotel management agreements. But at least the management company is protecting the hotel owning company from those truly grossly negligent or willful acts attributable to it that may arise in the course of managing a hotel, such as grossly negligence in hiring (possibly where no background check is done when a rapist is hired) or in day-to-day operations (possibly when a slippery wet floor not cordoned off) or in employee discipline (possibly where an employee is terminated based upon age, race, religion or other protected classification). While the management company will stand behind these really bad acts of its employees in the US, what is the result where the employees – including all supervisory personnel and rank-and-file personnel – are employees of the local owning company?

Outside the US where all employees at a hotel are employees of the hotel owning company, the indemnification obligation of the hotel management company becomes much less certain and even illusory. The argument can be made that anything that takes place at the hotel, whether ordinary negligence, gross negligence or willful misconduct, is not attributable to the hotel management company because it is not even present at the hotel. In fact, one can question how the management company can even perform its day-to-day supervisory role without any employees at the hotel. The best that can be argued by the owning company is that those employees assigned by the management company to serve at the hotel for a time, remain employees of the management company.  But these employees may have no involvement in the acts in question. Consequently, the indemnification can be illusory.

So, what to do?

  1. The first line of recourse for almost all liability arising at any hotel is the general liability insurance policy. By naming both the management company and the hotel owning company as named insureds, both parties are protected no matter who technically bears responsibility under the management agreement, naturally with the caveat that the deductible will have to be allocated. The next two approaches will deal with uninsured losses or deductibles.
  2. A second approach to the problem is to provide that all acts of the hotel’s key personnel, no matter whose employees they are, are attributable to the management company. The key personnel typically are hired and trained by the management company and some may be assigned to the hotel for a time, and then move on as itinerant management company personnel to other managed hotels. It is logical and fair that the conduct of all key personnel within the scope of their employment should be deemed to constitute conduct of the management company.
  3. A third approach is to provide that any liability arising as a consequence of a policy or procedure promulgated by the management company is attributable to the management company. It is the management company’s inadequate “know-how” that caused the problem and it should be responsible.

If a hotel owner is contracting for more than the brand and reservation system (as in franchise agreements), but is looking to the management company to “supervise, direct and control the day-to-day operation of the hotel” (as is typically stated in management agreements), then the allocation of liability for matters arising at the hotel should be the same whether the hotel is in the US or not and certain acts must be attributed to the management company as set forth in numbers 2 and 3 above. Negotiation of these matters before the management agreement is executed will protect the hotel owning company and, in my view, fairly allocate risk, while not disturbing the now generally accepted principle that the management company will not protect the owning company from the results of ordinary negligence because “stuff happens” even in the best managed hotels and insurance is there for these kind of risks. But uninsured losses and deductibles should be allocated in a rational and consistent matter.

(This article also appears on eHotelier.com)


About the Author:

Albert J. Pucciarelli is a partner in the law firm of McElroy, Deutsch, Mulvaney & Carpenter, LLP. He is Chair of the firm’s Hotels and Resorts and Aviation Practice Groups. From 1988 through 1998, he was a Director and Executive Vice President, General Counsel and Secretary of Inter-Continental Hotels. He has served as Chair of the Hotels, Restaurants and Tourism Committee of the Association of the Bar of the City of New York (2001-2004) and as Chair of the Aeronautics Law Committee of the Association of the Bar of the City of New York (1998-2001). He is a Director and immediate past President of the Hospitality Industry Bar Association. He has taught International Business Law as an adjunct professor at the Fordham University Graduate School of Business, and was member of that school’s Advisory Board (1996-2004). He is a member of the Cheyney University of Pennsylvania Hotel, Restaurant & Tourism Management Board. He is a Director of Skytop Lodge Corporation in Skytop, Pennsylvania, and a consulting member of Cayuga Hospitality Consultants.