Mr. Brewer III

Hospitality Law

Let's Make a Deal: Hotel Management Contracts in the 21st Century

By William A. Brewer III, Co-Founding & Co-Managing Partner, Bickel & Brewer

"You have undertaken to cheat me. I won't sue you, for the law is too slow. I will ruin you." - Cornelius Vanderbilt, 1853

Business is always changing and it has come a long way since the days of Cornelius Vanderbilt. Today's business is sophisticated, complicated, and dependent on the legal system. Gentlemen's agreements have given way to written contracts devised by law firms, and the hotel industry is a prime example.

This is No Arm's-Length Affair!

Business transactions are generally arm's-length affairs where each side bargains in their own self-interest. Agency relationships, however, are entirely different. In general, an agency relationship exists where one person conducts business on behalf of another. For instance, managers are generally considered to be agents of the owner because the manager operates the owner's business. The existence of an agency relationship creates significant legal implications because the law imposes special obligations upon an agent in favor of the principal. Broadly referred to as the duty of loyalty, the law requires that an agent put its principal's interests ahead of its own. This means that the agent must fully disclose all relevant information, act honestly and in good faith, and generally act obediently toward the principal.

Thus, it is no wonder that many hotel managers drive hard bargains to include a provision in their management contract that expressly disclaims the existence of an agency relationship. However, courts do not permit agency obligations to be bargained away by contract. Since Woolley v. Embassy Suites, Inc., 227 Cal. App. 3d 1520 (Cal. Ct. App. 1991), was decided by a California court in the early 90s, there has been little question that a hotel manager is an agent of the owner, and courts largely ignore any provision that attempts to say otherwise. Therefore, managers and owners need to understand the legal consequences.

A significant consequence of an agency relationship is the effects it has on the term of the contract. Importantly, under agency law, either party may decide to unilaterally terminate the agreement at any time, with or without cause. Because the hotel management relationship is one of agency, the hotel management contract may be terminated at any time at the discretion of either party. This concept is not well-accepted by managers, or most owners. After all, managers seek the financial certainty of fixed, long-term contracts, and owners do not generally relish the thought of their hotel flag being uplifted and carried away without notice.

Before either side "tears up" their contract, however, there is a solution. The important lesson here is that although one side may have the power to terminate the contract, termination could come at a steep price in terms of changes. The best practice is to clearly define in the contract what damages will be owed by the terminating party upon termination. The higher the price, the less likely a party will terminate. The management contract should include a damages formula that provides an objective means of determining the amount of money owed by the terminating party.

The formula will vary depending on the circumstances, but it is not uncommon to include a formula that requires the terminating party to pay a fixed fee plus a defined percentage of average revenue multiplied by the number of years remaining on the contract. Because parties are free to define the terms of an agency as they choose, the formula can be as creative as necessary to mitigate the risk. For instance, a boom in real estate values may provide a financial incentive to owners to terminate management contracts. Many properties were arguably worth more as condominium developments than as hotels. However, if the termination formula in the management contract had been tied to the underlying real property values, the incentive to terminate would be nullified. In addition, the parties may include a process for providing notice of an upcoming termination. If preferable, the parties may also agree to a special termination fee if one party chooses to opt out of the notice requirement.

Defining Success - Less Art And More Science

Few issues present as many contractual problems for managers and owners as articulating the definition of success. At the outset, both manager and owner expect long-lasting success under the contract. However, "success" is often defined by vague references that lack substance. For example, many contracts require "the operation of a luxury hotel" or that the hotel "shall be managed in a manner consistent with a prudently operated hotel."

To be enforceable, a contract must include terms capable of definition. The good news is that - even in the case of an ambiguous contract - a court will likely apply a substantive definition. The bad news, however, is that the judge may not insert your substantive definition. Terms like "luxury" and "first-class" have many generally accepted definitions within the hospitality industry depending on one's expert! Moreover, as multi-year commitments, hotel management contracts will be interpreted many times by many different people throughout the life of the contract. Therefore, defining success may be an area for less art and more science.

Fortunately, the hospitality industry is equipped with third-party evaluation services that can bring substance to the parties' meaning of "success." These third-party services represent a neutral, but objective, source of measurement. For example, private firms like Richey International, Mobile, and the American Automobile Association are all in the business of providing written evaluation reports that measure and communicate the level of quality offered by a particular hotel. The terms of the hotel management contract may define in detail a schedule of annual or semi-annual reviews by one or more of these firms. The contract could specify the objective criteria that will be emphasized and what constitutes an acceptable score. In addition, if more than one evaluation agency is used, the contract should specify what comparative weights should be applied to each. The parties may also agree by contract to have a company like Unifocus implement its industry-leading guest surveys. Guest surveys are one of the most effective means of comparing expectations to actual experience. Whatever the method, the goal is to construct an objective report card that provides regular feedback to the owners and managers. This report card can serve as the point of reference when determining whether the hotel's level of service meets the parties' expectation of success.

Of course, quality of service is not the only metric worth measuring. Financial results are paramount. Although financial numbers may seem inherently objective, organizations like Smith Travel Research can add certainty to the process by implementing its industry standard, RevPar and RevPar Penetration Index. As most owners and managers understand, RevPar is the financial metric that measures revenue per available room. RevPar Penetration Index is an index that measures one hotel's RevPar score against other hotels within its competitive set.

The bottom line is that merely wanting success is not enough. To be enforceable, success must be measurable. Owners and managers may be well-served to trudge through the difficult and arduous process of articulating what it means to be successful, and more importantly, how to measure it. Investing the time and effort necessary to articulate an objective, verifiable method of measuring success will pay dividends over the life of the contract.

We Won't Fight, But If We Do...

Managers and owners often rely on arbitration provisions as a means of controlling the costs of future litigation. An arbitration provision allows the parties to agree in advance to submit any future dispute arising from the contract to an arbitrator instead of a formal court. Arbitrations have a reputation of being less formal, less expensive, and more efficient. Given this reputation, it is no wonder that these provisions are often accepted without controversy. After all, who wants to be mired in a long, drawn-out, expensive lawsuit? But as with most things, the devil is in the details.

A practitioner, however, should remember that arbitration provisions may do more than merely reduce costs, they may shift costs. In fact, allocating costs to one side as opposed to the other is just one of a myriad of issues at stake in an arbitration provision. To use a sports analogy, arbitration provisions can specify home field advantage, the length of the game, the identity of the referee, and even which rules govern. A party that ignores the importance of the terms of an arbitration provision may find itself operating from a position of weakness for the duration of the contract.

The first hurdle in drafting an effective arbitration provision is admitting that a dispute may arise. This is easier said than done. No one wants to scare away a multi-million dollar deal by bringing up worst-case scenarios during the negotiation. Nevertheless, this issue is too important to ignore.

Arguably the most important issue in arbitration provisions is determining how to allocate the cost of the dispute. Of the various costs, attorneys' fees are the most critical. Commonly referred to as prevailing party provisions, these provisions require the losing party to pay the attorneys' fees incurred by the prevailing party. These provisions follow a winner-take-all approach with few holds barred. Although courts require attorneys' fees to be reasonable, the majority of jurisdictions do not place a hard limit on an award of attorneys' fees based on the total amount of compensatory damages recovered in the underlying lawsuit. For instance, courts recognize that because commercial parties may at times choose to litigate an otherwise inexpensive matter for a variety of logical reasons, fees awarded may exceed damages. This is true in hotel management disputes because, after all, a hotel manager may seek to send a message to other owners that its rights under contracts are beyond reproach. Owners may similarly litigate a small dispute with an eye toward their other more lucrative contracts. Hence, some disputes are about protecting the company, and not just the contract. If either party is uncomfortable with pure prevailing party provision, a middle ground may be to insert a good-faith exception into the provision whereby the arbitrator has the discretion to award attorneys' fees only where the losing party brought its suit in bad faith.

Another critical issue to consider when drafting an arbitration provision is scheduling the arbitration. The arbitration clock begins ticking at the moment one party serves a notice to arbitrate. Anything related to scheduling can be negotiated: e.g., how many days to allow before the arbitrators must be selected; how many days to allow before the case goes to arbitration; number of days required to complete the hearing; even how many days or weeks before the arbitrator must issue its decision. There is no right or wrong way to schedule an arbitration, but depending on the situation, some schedules may offer tactical advantages. For instance, a defendant generally has to play catch-up when caught off guard by a plaintiff, and an expedited arbitration schedule leaves little time to get organized. An expedited schedule may require that all disputes be resolved in as few as thirty days, even where the dispute involves millions of dollars. Unsurprisingly, arbitration provisions that fail to address this issue often allow disputes that drag on for years. Given that one of the purposes of an arbitration provision is to limit escalating costs and ensure that a resolution is reached in a timely fashion, the scheduling issue should be defined. The only wrong way to draft an arbitration schedule is to fail to draft one at all.

Of course scheduling and costs are just two issues to consider. An arbitration provision should also specify, among other things, which substantive law should govern the dispute; the location of the hearing; the number and selection of arbitrators; the extent to which mediation must be exhausted before proceeding to arbitration; and whether the arbitrator's final award may be publicized. Any and all of these issues can be agreed upon by the parties in advance, and if they are, the parties will reap the benefits down the road.

Just Remember This...

The goal when drafting any contract is to provide certainty and predictability to the parties. The hotel management contract is no different. The parties must understand their rights and obligations in order to appropriately conduct their business. A well-constructed hotel contract is one that defines the meaning of "success" and "failure," and further provides a predictable means of resolving disputes.

William A. Brewer III is co-founding and co-managing partner of Bickel & Brewer, with offices in Dallas and New York. Under Mr. Brewer's direction, Bickel & Brewer has become renowned for its innovative handling of disputes within the hospitality industry. For the past decade, Bickel & Brewer has represented hotel franchisors, management companies, owners, developers and investors in the highest profile litigation in the hospitality industry. He is a member of various philanthropic organizations, including the New York City Partnership and the Board of Trustees of Albany Law School. Mr. Brewer III can be contacted at 214-653-4811 or wab@bickelbrewer.com Extended Bio...

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