Mr. Migdal

Hospitality Law

Hotel Management Agreements Today

By Nelson Migdal, Real Estate, Shareholder, Greenberg Traurig LLP

The credit world is considered by many to be in turmoil. Real estate values as measured through investment sales are below the lofty heights of just months ago. Residential absorption is dismal in many markets. Nevertheless, the possibilities for mixed-use development, anchored by an imagination catching array of amenities, remain strong, both domestically and internationally. In such a climate, the hospitality industry is attracting interest from experienced developers, owners and operators to be sure. However, there are new players in the game who see the allure, but are less familiar with the rules.

This article provides a brief overview, both historic and current, of the law relating to hotel management agreements. The concepts and principles discussed generally apply to the relationship between hotel owners and operators. Certain ancillary and operationally-specific issues (such as termination rights to limitations on the authority of the operator with respect to purchasing goods and services for the hotel) will be only briefly introduced.

Generally, hotel management agreements prior to the early 1990's were 20- to 30-year, non-cancelable contracts that granted the operator (usually the company that controlled the hotel brand) near-total control and authority over all aspects of hotel operations. Such contracts provided little potential for removal of the operator for default or for convenience of the owner. In other words, the hotel management agreements were considered, except in a "technical-legal" sense, obligations that ran with the land. The equivalent of a "no cut" contract. This is a throwback to an earlier time when the relationship between owners and operators of hotels was more frequently structured as a lease, rather than as an agreement similar to an agency. Eventually, the hotel management industry shifted to the use of the agency agreement structure because this form presented banks and other sources of financing with an easy way to value the hotel operating company. The calculation was easy - simply project the cash flow from management fees over the term of the agreement.

A string of court decisions and jury verdicts have helped to change both the legal and business relationship between hotel owners and operators. As a result of such decisions and jury verdicts, the following observations generally summarize the current state of the primary principles that drive the negotiation process of hotel management agreements and the relationships created thereby:

• When is the operator acting as the agent of the owner and when do the legal principles of agency apply?
• When is the operator a fiduciary of the owner?
• Disclosure is king.
• Which party is the employer and why?
• When can the agreement be terminated?
• Who indemnifies whom for what? Of course the above does not encompass a complete description of the issues applicable to these agreements.

In 1991, a court determined that the owner of a hotel could terminate the agency between the owner and the operator without cause and regardless of the stated term of the management agreement, subject to liability for damages for wrongful termination, unless the operator had an economic interest in the hotel. In 1993, a court in the same state as the first court came to the same conclusion, but added that even if the operator had made a loan to the owner through a related, but legally separate entity from the operator, that would not constitute an economic interest sufficient to make the agency irrevocable.

For several years thereafter, the industry essentially ignored these two decisions as the isolated view of one state's activist courts. All of that changed in 1998 when a Federal district court in the Virgin Islands, in a lengthy series of opinions, allowed a bank to remove an operator. The court's rationale went well beyond the basic principles of agency to discuss accounting practices, communications between the owner and the operator, and very specific actions of the operator. With the question as to the applicability of agency principles resolved, it was only a matter of time before other elements of the owner/operator relationship, such as fiduciary obligations, would take center stage.

Center stage was taken by the case commonly known as 'Woodley Road'. In Woodley Road, the hotel operator was sued by the hotel owner, not only for termination of its management agreement but also for other claims ranging from breach of fiduciary relationship to fraud and civil RICO (the Racketeer Influenced and Corrupt Organizations Act). A central claim in that case was that the hotel operator accepted kickbacks and commissions from vendors with respect to the purchase of goods and services for the hotel. The jury awarded compensatory damages and punitive damages. While the damages were later reduced, the claims made by the hotel owner against the hotel operator remained.

Woodley Road also spurred also spurred other lawsuits that catalogued specific industry practices and allegations of wrongdoing by the hotel operator. As a response to litigation, many hotel operators reviewed and revised their management agreements and current operations, including accounting procedures and owner/operator communications.

Today most industry players use the management agreement as an instrument to provide disclosure and as the vehicle to set forth, with as much clarity as possible, the key flashpoints of the owner-operator relationship and methods for dispute resolution without litigation.

The flashpoints for the coming year are expected to include, employment matters, owner's right to terminate for convenience or upon sale with our without a termination fee, dealing with lenders and the subordination non-disturbance and attornment agreement (SNDA), and what lenders, owners and operators might do if the loan needs to be restructured to meet economic needs. We will discuss each issue separately.

Employment issues start with which party is going to take on the role as "employer". It is critical that the management agreement sets forth the roles and responsibilities of each party when it comes to the hotel staff. Typically, the owner is responsible for the costs of employment as an operating expense of the hotel regardless of which party is the employer. Similarly, the issues of imputation of liability for the conduct of certain employees are often the same regardless of which party is the employer. It is not unusual for the manager to be the party best equipped to deal with the legal aspects of employment issues, including collective bargaining agreements. That being said, the owner can still be the "employer" yet transfer the majority of the employment related duties to the manager through the provisions of the management agreement. The management agreement is the primary document governing the relationship between the owner and the manager and which party is the employer of the hotel employees. Because the management agreement is the vehicle for so much of what governs the parties, the agreement itself becomes important in considering the legal issues governing the allocation of responsibilities for the hotel employees.

Whether the owner has a right to terminate the management agreement if the hotel is sold is a hot topic and heavily negotiated. Often, the manager views the management agreement as steady income -- almost like an annuity -- and the termination of the management agreement upon sale of the hotel does not fit nicely into the revenue projections of the management company. Therefore, if the owner desires a termination for convenience clause or a termination upon sale clause, more often than not the operator pushes back with a request for a termination fee. Often the termination fee diminishes over the term of the management agreement and completely disappears in the later years of the term.

Dealing with lenders and the SNDA in the course of a hotel financing can put the manager and its counsel in the role of teacher. Often the SNDA is overlooked by the lender as an ancillary document and is not brought into play until the other loan documents have been just about fully negotiated. This is where the problem begins. The SNDA is a critical document for the hotel manager because it basically sets forth whether or not the management fees under the management agreement will be subordinate to the loan upon the default of the owner under its loan documents and at which point in time the subordination kicks in. To avoid the heavy negotiation of the SNDA at the tail end of the negotiation of the loan documents and pushing up against the closing date, in the negotiation of the management agreement the owner and manager will often pre-negotiate the form of the SNDA and attach it as an exhibit to the hotel management agreement. While this often resolves the issue, a less than careful hotel owner may find itself with dueling forms of SNDA because the lending community too has its battle tested forms of SNDA which are frequently exhibits to the loan application. Properly dealing with the SNDA can be very complex and time consuming. The relationship and interplay between the loan documents and the hotel management agreement requires a solid understanding of both in order to assess and address the wide variety of potential concerns.

What lenders, owners and operators might do if the loan needs to be restructured to meet economic needs will be largely governed by the parties left standing and whether or not new parties step in to assist with various aspects of the project. While the credit world is considered by many to be in turmoil and real estate values as measured through investment sales are below the lofty heights of just months ago, the hospitality industry and its players have an interesting ride ahead. In order to know the rules of the game, its important to not only look at where the industry is going, but where it came from and the hotel management agreement provides an interesting map.

Nelson F. Migdal is a Principal Shareholder at Greenberg Traurig and head of the Mid-Atlantic Real Estate practice group. He has practiced hospitality law for over 25 years. He handled the management agreements for The Echelon Place, in Las Vegas. In Panama, as owner's counsel, he obtained the first "Trump" license in Central America. Nelson is owner's counsel for The Trump Soho Project, and handled the Exclusive License with Trump in Istanbul. Nelson is an officer of the Academy of Hospitality Industry Attorneys and a member of the International Society of Hospitality Consultants. Mr. Migdal can be contacted at 202-331-3180 or migdaln@gtlaw.com Extended Bio...

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