Terminating the Hotel Management Agreement in the Mega-Merger Era

By William A. Brewer Partner, Brewer, Attorneys & Counselors | December 24, 2017

Following the recent wave of large-scale mergers and acquisitions sweeping through the hotel industry, nearly half of all the more than 53, 000 hotels operating in the U.S. today are linked to one of six industry titans – Marriott, Hilton Worldwide, InterContinental, Wyndham Worldwide, Choice Hotels, and Best Western Hotels & Resorts.

One of the consequences we see of the merger activity in today’s hospitality market is that many hotel owners are now forced to operate under the same banner as their heretofore fiercest competitor from down the street or even next door.

The current reality of today’s industry landscape is that many hotel owners are now faced with something far more insidious than increased competition from other hotels: an invisible hand directing that those who “manage” this asset “cool” the competition within their own brand umbrella and their decision-making for the purposes to serve the over-reaching interests of the chain, rather than the best interests of the owners of the hotels they manage on their behalf. This “friction” is likely to intensify in the event of a future economic downturn.

As we have seen, periods of low occupancy often spark conflicts between hotel owners and operators over the rights under their management agreements, as owners look to secure their dominance in market share, keeping potential customers coming to their own property, rather than sharing the pool of customers with other competing owners under the same umbrella, and losing out on potential revenue as operators are looking to maximize earnings for themselves, rather than the owners. Some of the new unions which have arisen from the wave of recent mergers may only exacerbate these conflicts.

As never before, the recent wave of mega-mergers makes it increasingly important for hotel owners stuck with a long-term management contract with one of the major operators to understand their rights, if needed, to terminate hotel management agreements when these relationships begin to sour because, among other reasons, owners feel decisions are being made for the brand without regard to the financial well-being of individual owners.

Even during times of economic prosperity, owners may find that a consequence of the merger is a breach of the duty of loyalty which they are owed by their operator. Willful breaches of the parties' contractual non-competition and territorial exclusivity and procurement provisions, for example, may result in substantial damages awarded to hotel owners pursuant to the laws of most states. This article examines these issues.

The Owner’s Power to Terminate the Existing Management Agreement

Historically, hotel management agreements between owners and operators had exceptionally long terms, and hotel operators and managers took the position that the owners did not have the right to terminate the management agreement, unless and until there was a material breach of the agreement by the manager.

A progeny of case law emerged during the merger wave we saw during the early 1990s, as large-scale operators were swallowed up by even larger-scale operators, which established that pursuant to principles ofagency law, the owner ( as principal ) has the absolute right to terminate the operator ( as an agent ), under any circumstances.

These cases typically rest on two legal principles. The first is that the hotel management agreement constitutes an agency agreement and, pursuant to a cardinal rule of agency law, a principal always retains the power to revoke the agency.Thus, there have been numerous cases where courts have recognized a hotel owner’s power to terminate the operator, with or without cause; one example being Gov’t Guar. Fund of Finland v. Hyatt Corp.

The seminal case ofWoolley v. Embassy Suitesserves as another example of this. ( In the interests of full disclosure, my firm represented Plaintiff Robert Woolley in this matter. ) The Court explained that“courts wish to avoid the friction and social costs which result when the parties are reunited in a relationship that has already failed, especially where the services involve mutual confidence and the exercise of discretionary authority.”

Indeed, “when a hotel owner enters into a management agreement by which it divests itself of day-to-day control of the hotel’s operation but retains ownership... [an agency contract exists and] the owner retains the right to revoke the managing agent’s control.” The Court similarly stated inP.L. Diamond LLC v. Becker-Paramount LLC, that “[i]n the hotel management contract context, courts have enforced this basic law and classified agency relationships as irrevocable.”

The hotel owner’s absolute prerogative to revoke its manager’s agency is, in fact, so closely guarded that courts have routinely rejected efforts to contract around this settled law by contractual language deeming an agencyrelationship “irrevocable.”

This is true under the laws of most states notwithstanding how the parties characterize the relationship, and even if the management agreement specificallydisclaimsany existence of an agency relationship between the parties.Although an exception to the rule applies where the agency is coupled with an ownership interest in the hotel property, courts have held that the agreement does not, by itself, create a sufficient interest in the agency to permit hotel operators to come within this exception.

The second legal principle which courts have employed to determine that hotel owners always maintain the right to terminate hotel management agreements, is that the agreements signed between owners and the umbrella brands constitute personal services contracts.

Courts have determined, for example in Weeks v. Hyatt, that it would be inappropriate to force specific performance of hotel operating agreements because such an order would impose upon the court the task of passing judgment on the quality of the parties’ performance and would controvert the Thirteenth Amendment’s prohibition against involuntary servitude.As the Woolley Court explained, in the context of a hotel operating agreement, “it is a fundamental rule that specific performance cannot be decreed to enforce a contract for personal services, regardless of which party seeks enforcement.”

Thus, in Marriott International v. Eden Roc, the Appellate Division of the Supreme Court of New York reviewed the management agreement between the hotel owner and operator and determined that the agreement “places full discretion with [the operator] to manage virtually every aspect of the hotel.” The court also found that such an agreement “is a classic example of a personal services contract that may not be enforced by injunction.”

When the Merger Results in a Breach of the Operator’s Duty of Loyalty

Hotel owners whose operators have changed their economic incentives under the wave of recent mergers should look to the case ofP. T. Karang Mas Sejahtera v. The Ritz-Carlton Hotel Company, LLC, a case in which a jury found for plaintiff P. T. Karang Mas Sejahtera ( KMS ), the owner of the Ritz-Carlton Bali Resort and Spa, against the defendant, The Ritz-Carlton Hotel Company, LLC. ( Again, in the interests of full disclosure, I should note that my firm represented KMS, in this matter.

The parent company of Ritz-Carlton, Marriott International, had entered into a partnership with Bulgari S.p.A., the Italian luxury jewelry and accessories firm, to create Bulgari Hotels and Resorts, an ultra-exclusive line of luxury hotels with its first hotel in Milan, and its second in Bali – just three miles down the beach from the existing Ritz-Carlton. Not long after the Bulgari Bali’s planned opening was announced, KMS saw that it would lose market share to the newcomer. KMS thus sued Ritz-Carlton, among other things, for breaching the duty of loyalty owed to KMS, and for the territorial exclusivity provision KMS held with Ritz-Carlton.

In the end, there was abundant evidence and testimony in favor of the Plaintiff. Ritz-Carlton not only breached the territorial exclusivity provisions of the parties’ management agreement by enabling a competitor to be built in KMS’s backyard, but also had arranged a cobranding partnership through which Ritz-Carlton was using the power of its name to market the Bulgari property within the luxury travel market. Ritz-Carlton also assisted in providing managerial expertise to the Bulgari hotel, thereby violating additional provisions of the operating agreement.

As the jury found, this was a breach of the fiduciary duty of loyalty to KMS, including the constituent obligations of non-competition and full disclosure that Ritz-Carlton owed to KMS as KMS’s agent, and in doing so, demonstrated bad faith and willfulness. Pursuant to those findings, the jury awarded KMS $382, 304 in compensatory damages, plus $10 million in punitive damages, which was $5 million more than KMS had requested, as well as an entitlement to attorneys’ fees and costs.

As owners begin to analyze the long-term consequences of the recent wave of mergers to their assets, they should take some measure of confidence from these and various other rulings that have protected hotel owners against increased same-brand competition in their respective competitive market segments.

These rulings should also encourage hotel owners to challenge potential difficulties by reminding hotel operators that they owe to property owners a set of duties to act in the best interests of the owner, and that these may well supersede the contractual terms of the management agreements signed by both parties, allowing owners the chance to make an exit from a system that is failing them.

Brewer, Attorneys & Counselors attorney Timothy H. Birnbaum contributed to this article. Mr. Birnbaum is a senior associate in the firm’s New York office.

Mr. BrewerWilliam A. Brewer III is a founding partner of BREWER, Attorneys & Counselors (formerly Bickel & Brewer), with offices in New York and Dallas. The firm has become renowned for its successful handling of major disputes in a number of industries, including the hospitality industry. The firm has represented hotel franchisors, management companies, owners, developers, and investors. Mr. Brewer is frequently published on issues affecting the hospitality industry. Testament to the significance of Mr. Brewer’s advocacy are the news organizations that routinely mention his work, The Wall Street Journal, The New York Times, Hotel Management, and Hotel Business to name a few. Mr. Brewer can be contacted at 212-489-1400 or wab@brewerattorneys.com Please visit www.brewerattorneys.com for more information. Extended Bio...

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