Mr. Brewer III

Hospitality Law

Terminating Luxury Hotel Operators for Failing to Perform

Looking beyond contractual performance standards

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

Having endured the economic crisis since the latter part of 2008, owners of hotels in the luxury segment have not been in a “business as usual” mode. Owners have incurred significant losses during this downturn. Thus, owners have demanded operator accountability for bottom-line performance and responsible decision-making as it impacts their investments. Unfortunately, in many instances, chain brand managers have refused to obey owners’ directives to reduce costs and to implement further revenue-generating measures. Such refusals raise the inevitable question: Does a manager of a hotel have a duty to act in the best interests of its principal-owner to preserve and protect the owner’s investment in the business? We answer that question with a resounding “yes.” Indeed, it is the central proposition of this article that when a hotel manager refuses reasonable directions from the owner to reduce costs, the manager loses the right to continue to manage the asset with which it was entrusted. This article discusses the rights of hotel owners to terminate their managers and the tools available to do so.

The Unfettered Power of Revocation: Removing the Disloyal Manager

When one party is granted the right to manage the business of another, the relationship is one of principal-agent. Consequently, as a matter of law, unless the managing party owns an interest in the property (i.e., holds an agency “coupled with an interest”), the principal always retains the power to revoke the agency relationship at any time and for no reason at all. This rule of agency law applies even if the contract between the parties states that it cannot be so terminated, and even if the agreement contains specific conditions relating to termination. Once the authority of an agent-manager of a hotel has been revoked by the owner, the manager must vacate the property and relinquish control of hotel operations.

In such a case, the terminated agent may have a damages claim for breach of the management agreement unless the owner can demonstrate that it was justified in terminating the agreement either because of the manager’s material breaches of contract or violations of its fiduciary duties as the owner’s agent-operator. In any post-termination proceeding, this is where the battle lines will be drawn. The hotel operator will assert that the owner did not have the right to terminate the management agreement and the agency relationship thereunder, because the conditions for a termination did not exist and/or the owner did not strictly comply with the termination provisions of the management agreement. The owner will assert that the operator breached fundamental duties that gave the owner the right and power under common law to terminate the agency relationship – irrespective of the management agreement or the termination provisions thereof.

Many hotel management agreements contain two types of termination provisions:

1. notice-and-cure provisions, pursuant to which either party has a right to terminate the contract following a failure by the other party to perform an obligation, a written notice of default, the passage of a requisite period of time (usually 10-30 days), and a failure to cure the default within the allotted time; and
2. performance-based termination provisions, pursuant to which the hotel’s failure to meet certain financial or performance criteria (which typically must occur for two or more years within a defined period) gives the owner the right to terminate the agreement.

The notice-and-cure termination provisions usually apply only to breaches of contractual obligations, and do not purport to cover violations of common law fiduciary duties owed by agents to their principals. Of course, there are likely to be serious questions whether a disloyal, uncooperative, or resistant manager is breaching provisions of the management agreement or is failing to perform specific contractual obligations. In addition, performance-based termination provisions are uncommon because the performance metrics are typically easily maintained.

Furthermore, such metrics frequently relate to performance vis-à-vis a competitive set of hotels and, thus, adverse economic conditions beyond the control of the operator will affect the competition as well. Moreover, management agreements usually permit an operator to cure a failure to meet a performance-based test by making a payment to the owner (usually in an amount sufficient to attain the minimum threshold).

So, What’s an Owner to Do? Looking Beyond Contractual Termination Provisions

Hotel owners seeking to replace inefficient managers are not constrained by the termination provisions in their management agreements. As agents of the owners, hotel operators owe an array of fiduciary duties that exist independently of, and in addition to, the contractual relationship between the parties. That is, the parties’ contractual obligations are in addition to the fiduciary duties the operator owes to the owner. Thus, fiduciary duties and contractual obligations coexist. The fiduciary duties a manager owes to the owner include duties of loyalty, care, good faith, obedience, the duty to account to the principal, and the duty to fully disclose all relevant and material information that the operator knows or can reasonably obtain. An operator’s breach of fiduciary duty constitutes a material breach of the agency relationship and allows the owner to terminate that relationship prior to the expiration of the term of the management agreement and without regard to the termination provisions of that contract.

The Operational Audit: A Prudent Precursor to Any Termination

For hotel owners, knowledge is power. Therefore, it is important that an owner have access to all possible financial and operational information relating to its hotel. Armed with that information, an owner can proactively assess the performance of its manager to determine if the manager is acting in the owner’s best interests.

In any economic turndown, there are owners who legitimately conclude that the probabilities of protecting their investments will be enhanced by a change in management. In such instances, the owner should first conduct an operational audit of the manager’s compliance with all contractual and fiduciary obligations, by availing itself of the owner’s rights to obtain information about the operational and financial performance of its hotel.

Management agreements often require the operator to “maximize patronage” or “optimize business,” or words to that effect. Even in the absence of such express obligations, hotel managers – as agents of the owners – have fiduciary duties of care and loyalty, which necessarily include the obligation to generate business for the benefit of those owners. Whether expressed or implied, such an obligation imposes on operators the duty to implement appropriate sales, marketing, and yield management strategies, which may include reducing room rates and establishing a system of promotional discounts. Operators should conduct appropriate rate and price testing to determine the price elasticity of demand and to develop a sense of the market. Depending on the type of hotel, the operator may also be required to adopt a rate management practice that is designed to maximize total hotel revenue by decreasing room rates in order to increase occupancy and, with it, non-room revenue. An owner’s investigation and audit of the operator’s compliance (or non-compliance) with the foregoing duties may reveal substantial grounds for terminating the management agreement.

On the expense reduction side, management agreements commonly require the manager to operate the hotel “efficiently” or “profitably,” or words to that effect. Again, even if such obligations are not expressed in the contract, the manager has an implied fiduciary duty to operate the owner’s business efficiently and to avoid waste and unnecessary expense. Thus, in a “down market” with occupancy declining, operators should be proactively reducing the hotel’s variable costs, especially labor expenses. Operators should make expense cuts that are not only commensurate with the hotel’s declining occupancy and revenue, but also are consistent with the expense cuts made by key competitors. If a branded management company refuses to reduce costs, the owner may well be within its rights to terminate the manager with impunity. Owners should also scrutinize their operators’ activities with respect to the purchase and procurement of goods and services on behalf of the hotel. In connection with its obligation to operate the hotel efficiently and in the best interest of the owner, an operator should engage in competitive bidding whenever feasible, implement systems to determine that it is obtaining the best prices available, and take advantage of all available cost savings opportunities for the owner, such as incentives, rebates, promotions, volume discounts and volume purchasing opportunities. Some luxury brand managers may require owners to participate in their centralized purchasing program, and charge owners a fee for such services. To earn their fee, however, operators are required to purchase goods and services for the hotel at a cost and on terms than are no less favorable than those that could be obtained from unaffiliated third parties. Owners, therefore, should demand proof that their operators are effectively engaging in the “best practices” described above and proof that they are earning their fee – i.e., that the hotel could not have made the same purchases from third parties on more favorable terms.

In addition, luxury brand operators typically provide certain “centralized services” to hotels in their chains – such as, corporate sales and marketing, advertising, and reservations services. The provision of such centralized services is a potential area for abuse by some operators who may seek to offload unrelated corporate costs onto hotel owners through centralized service charges. Similarly, operators often charge hotels for proportionate reimbursement of corporate costs purportedly relating to the provision of other management services to hotels in their system. It is critical that operators are fully transparent with respect to both centralized services charges and corporate reimbursables. Owners should demand that their operators provide sufficient backup information to enable them to determine the actual cost of providing such services to their hotels. That should include information regarding what costs are included in the total allocated expenses, how the hotel is being charged vis-à-vis the other hotels in the chain, and what surpluses are credited to the hotel vis-à-vis other properties in the chain. With respect to corporate reimbursables, the operators should provide sufficient backup for each charge to enable the owner to determine if the charge had any relationship to the hotel and, if so, the reasonableness and appropriateness of the charge.

Finally, it is a common tactic for luxury operators to justify or excuse their practices by reference to their “brand standards” or chain-wide “policies and procedures.” An owner confronted with such an argument should demand to see those standards, policies, and procedures. If the agent refuses to make them available to the owner on the basis of their alleged “confidentiality” or because of the agent’s alleged “proprietary” interest in those materials, then the alarms should sound. Put simply, an agent cannot refuse to act in the principal’s best interests by claiming some higher obligation to abide by a standard that it refuses to reveal to its principal – the owner to whom it owes fiduciary duties of loyalty, care, and candor. Indeed, a management company’s defiant refusal to provide necessary information may, itself, constitute a breach of contract and a violation of a fiduciary duty of disclosure – warranting termination.

Conclusion

Loyalty and performance from branded luxury hotel managers are most useful in economically challenging times. Agent-operators who refuse to undertake appropriate cost-reduction and revenue enhancement measures, and thus fail to act in their principals’ best interests, do not deserve the continued entrustment of their principals’ assets to them or the lucrative fees paid in connection therewith. Fortunately, owners of luxury hotels need not passively watch as the value of their investments decline due to the financial or operational mismanagement of their agent-operators. Hotel owners are armed with an array of termination rights arising out of their managers’ contractual and fiduciary duties to them. As demonstrated in this article, the exercise of those rights should be preceded by a comprehensive forensic audit of hotel finances and operations – conducted by the owners and their asset managers, with the aid of professionals – to determine whether the agent-managers have complied with all contractual and fiduciary duties owed to them.

Bickel & Brewer partner James S. Renard and Alex D. Widell contributed to this article.

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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