Ms. Gorman

Hospitality Law

Hotel Management Agreements and Bankruptcy

By Tara K. Gorman, Attorney, Greenberg Traurig LLP

The First Inquiry: Acceptance or Rejection of the Hotel Management Agreement

When a hotel owner files for bankruptcy, the bankruptcy trustee may reject any contract of the debtor (i.e. the hotel owner), including the hotel management agreement. In simple terms, in bankruptcy, accepting a contract means keeping the contract alive and in full force and effect and rejecting a contract means ending the contract to minimize the financial impact of the contract. There are a few statutory exceptions to this blanket rule. While some hotel management agreements may contain an automatic termination provision in the event either party files for bankruptcy, this type of provision is not always enforceable under bankruptcy law.

Trustees can only reject contracts which are "executory", meaning that both parties to the contract have continuing obligations under the contract. If the services have been rendered by the hotel manager, and the only outstanding obligation is payment by the hotel owner, a contract cannot be rejected because even though the hotel manager has no more obligations the hotel owner continues to have an obligation to pay the hotel manager. Since, however, hotel management agreements are generally long-term contracts and the obligations are of an on-going nature, the applicability of this exception is rare. In fact, it would be nearly impossible to find a situation whereby the hotel management is in full force and effect and there are no continuing obligations by either party. Consequently, hotel management agreements are predominantly accepted by the bankruptcy trustee.

Factors Affecting Whether to Reject the Hotel Management Agreement

Bankruptcy trustees have a fiduciary duty to the estate and, accordingly, should only reject the hotel management agreement if it is in the estate's best interest to reject the hotel management agreement. There are many factors that come into play when making this determination. These factors include anything from the strength or weakness of the hotel flag to an economic downturn to a costly mistake by the hotel manager.

In some cases, it would be beneficial to the estate to keep the hotel management agreement in place, i.e., accept the hotel management agreement. Internationally known hotel flags allow the hotel to attract guests and bring in a steady stream of revenue, and rejecting a hotel management agreement may result in a loss of a loyal customer base. The rationale for keeping a hotel management agreement in place could be as simple as the fact that the hotel manager has been fulfilling its obligations successfully. On the other hand, if a hotel manager has not been living up to the standards set forth in the hotel management agreement, rejecting the hotel management agreement provides an opportunity to place the hotel under new management. In determining whether to keep the hotel management agreement in place, the trustee will look to past performance of both the hotel and the hotel manager to confirm whether keeping the hotel manager is in the estate's best interest. For example, it is important to look to the hotel manager's track record in keeping up with books and records and fulfilling other duties under the hotel management agreement, which will affect the hotel's future profitability.

Another factor is the content of the hotel management agreement itself. If there are terms within the hotel management agreement that the bankruptcy trustee determines are not beneficial to the estate, such above-market management fees, weak hotel owner protections, or even an inefficient budget approval process, rejection of the hotel management agreement can be an opportunity to get out of one hotel management agreement and enter a potentially more owner-friendly agreement.

Even if analysis above leads to the conclusion that the hotel management agreement should be rejected, an important counterweight when deciding whether to reject a hotel management agreement is the practical implication of losing the hotel manager and possibly entering a new hotel management agreement. There is a great deal of institutional knowledge that will leave with the manager. Additionally, the bankruptcy trustee would have to make the determination of how to proceed - would the hotel be self-managed, or should the hotel owner bring in a new manager? Does the hotel owner have the capability or desire to self-manage the hotel? If not, sometimes the time and expense of negotiating a new hotel management agreement with another party may be prohibitive and preclude rejection of the hotel management agreement. There are substantial costs associated with bringing in an interim hotel manager and deflagging the hotel, should the bankruptcy trustee chooses to reject. In this case, after careful analysis, the bankruptcy trustee may determine that it is in the best interest of the estate to accept the hotel management agreement.

The Court's Role in Hotel Management Agreement Rejection

There is no prescribed deadline by which the trustee has to make the aforementioned determination. Rather than sit idly by and wait for the bankruptcy trustee to come to a decision, the hotel manager may make a motion to the bankruptcy court to compel the bankruptcy trustee to make a decision within a given timeframe determined by the court on the facts of the individual case. If, however, by the expiration of the set timeframe, the bankruptcy trustee has not yet made a decision, the hotel management agreement will automatically be deemed rejected. Therefore, it may not be in the hotel manager's best interest to rush the bankruptcy trustee's decision.

If the hotel management agreement is rejected in bankruptcy and the hotel manager contests the rejection in court, the basic test for whether a court will uphold a rejection of an hotel management agreement is the so-called "business judgment rule". Generally, the business judgment rule contends that the bankruptcy trustee must act in the best interest of the estate, and a hotel management agreement may be rejected only if rejection would put the estate and the creditors as a whole in a better position. The standard of review is not a preponderance of evidence or even a reasonable-person standard, but rather requires the court to defer to the business judgment of the debtor, and essentially ensuring that the decision to reject of the hotel management agreement is not a product of "bad faith, whim, or caprice".

There is little quantifiable guidance as to how substantial the benefit gained by rejection of the hotel management agreement must be. Cases are determined on a case-by-case basis, and since the standard dictates that the court puts itself in the shoes of the bankruptcy trustee, the rejection is usually upheld, except for situations where there is a finding of bad faith or gross abuse. Rarely, a rejection may not be permitted if it causes substantial harm to the contracting party, but no corresponding benefit to the estate.

Aftermath of a Hotel Management Agreement Rejection

The effect of rejection of a hotel management agreement is that of a breach. Rejection is not considered a termination or rescission of the hotel management agreement. Rather, the hotel manager has a claim against the estate arising from the breach caused by the rejection. In addition, the hotel manager has a claim as a creditor in the bankruptcy proceeding. This is also an important factor in deciding whether to reject the hotel management agreement. Damages arising from a breach under applicable laws may prove more detrimental to the estate than keeping a less-than-perfect hotel management agreement in place.

In the case of bankruptcy of a hotel owner and the acceptance or rejection of a hotel management agreement in bankruptcy proceedings, there are clearly a myriad of factors to consider in addition to the ones discussed in this article, and these factors will vary based on the hotel in question. In today's economic climate, lenders, owners, and managers are all realigning their views about what outcomes are most beneficial to each particular party, and it will take some time to see what decisions are made by these various parties in light of the current market. Once all the facts are laid out, it is important to weigh the upsides and downsides to both the hotel owner and the hotel manager, understand the court's approach to upholding a rejection of the hotel management agreement, and forecast the aftermath of hotel management agreement rejection to make a fully informed decision that will be in the best interest of the estate.

Rachana D. Oza is an attorney with the law firm of Greenberg Traurig. She focuses her practice on hotel acquisitions, operations, development and finance, hotel management agreements and license agreements, general commercial real estate transactions, commercial leasing, and various financing transactions involving lender and borrower representation. She can be contacted at 202-530-8539 or ozar@gtlaw.com

Tara K. Gorman is a shareholder with the law firm of Greenberg Traurig. She focuses her practice on hotel acquisitions, operations, development and finance, condo hotels, hotel management agreements, and license agreement, general commercial real estate transactions, commercial leasing, various financing transactions involving lender and borrower representation. Ms. Gorman can be contacted at 202-530-8519 or gormant@gtlaw.com Extended Bio...

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