Mr. Brewer III

Hospitality Law

A Fight for the Flag: Battling Competition From Disloyal Hotel Operators

By William A. Brewer III, Managing Partner, Bickel & Brewer

In the evolving legal landscape between hotel operators and owners, the operator's primary goals remain the same to maximize brand recognition and revenue. These goals, however, are often in conflict with an owner's focus on his hotel's bottom line. As a result, owners should protect themselves from operators that all too frequently seek to compete against the very hotels from which they are reaping significant management fees. One way that owners can do so is by pressing the duty of loyalty that operators owe them as managers of their hotel -a duty which prevents the manager from competing with them.

A. The First Line of Defense: The Management Company's Common Law Duty Of Loyalty Bars It From Competing With The Owner

Woolley v. Embassy Suites, Inc. is often referred to as the seminal case in defining the relationship between a hotel owner and hotel manager as one of agency. In Woolley this event correctly defined an agent as "'anyone who undertakes to transact some business or manage some affair, for another, by authority of and on account of the latter, and to render an account of such transactions.'" Since then, courts have routinely held that the hotel owner-manager relationship is per se one of principal-agent. That relationship, in turn, imposes a number of duties - often described as default fiduciary duties - on hotel management companies which ensure that they fulfill their obligations under the operating agreement in a manner that gives priority to the hotel owner's best interests. Chief among these obligations is the common law duty of loyalty.

1. The Operator-Agent Cannot Compete With the Owner-Principal

The duty of loyalty requires that, unless specifically agreed otherwise, an agent must act solely for the benefit of its principal in all matters relating to the agency. This means that the agent may only act in accordance with the principal's consent - whether that consent is manifested in the contract between the parties or by separate, express approval after full disclosure. The duty of loyalty thus forbids a hotel management company from acting on its own behalf, as the agent of another in a matter in which the two principals' interests conflict, or otherwise engaging in self-dealing with respect to the subject matter of its operating agreement with the owner, without the owner's knowledge and express consent.

Of particular importance is that an agent cannot compete with its principal regarding the subject of the agency. In other words, the hotel operator may neither act as a competitor, nor agree to act on behalf of others who themselves are in competition against the hotel owner, without the owner's consent. Moreover, an agent is obligated to disclose to its principal all information material to the subject matter of the agency. That is particularly true where the agent deals with the principal on its own account. Thus, the failure by an agent to disclose even potential competitive activity is a breach of fiduciary duty, and may constitute fraud. Under these principles, a management company's failure to disclose relevant financial information to the owner may result in the right of the owner to terminate the operating agreement.

2. The Operator-Agent Must Account to the Owner-Principal for Anything It Receives of Value

Similarly, the manager has a duty to account to the owner for the money and other property the manager has received or paid out on behalf of the owner. Such accountings should be initiated by the operator when they concern matters and transactions of which the owner is unaware. Unless otherwise agreed, a manager that receives anything of value in connection with transactions conducted on behalf of the owner is under a duty to give those benefits to the owner.

3. The Operator-Agent Cannot Use Confidential Information of the Owner-Principal For Its Own Benefit

Finally, unless otherwise agreed, the duty of loyalty imposes on the agent an obligation not to use the confidential information of its principal for the agent's own benefit or to the disadvantage of, or in competition with, the principal. That rule applies to sensitive or proprietary information, such as a hotel's customer lists and operating and financial data. Above all, the manager has a duty to account for any usages of the owner's confidential data.

B. The Second Line of Defense: Preserving The Manager's Duty Of Loyalty In The Operating Agreement

For the hotel owner, an operating agreement that protects the owner from limitations on the manager's duty of loyalty is an effective means of ensuring that the management company's efforts to maximize the owner's interests. With that in mind, it behooves owners to recognize efforts by the operator to disclaim that duty, and to consider the implications of such disclaimers. In the current market, this goal may require tenacity. Management companies may attempt to have the owner waive or dilute their common law fiduciary duty of loyalty to the hotel owner in a number of different ways.

1. Waivers of Fiduciary Duty - Must Be Specific to Be Enforceable

The most obvious language in the operating agreement that purports to limit any fiduciary duties owed to the hotel owner is language of waiver. Agency relationships, such as those between hotel owner and manager, are typically contractual in nature. Accordingly, the parties are free in their written operating agreement to eliminate the default fiduciary duties owed by the manger to the owner, including a duty not to compete. However, an operating agreement cannot "write out" fiduciary duties by simply denying that an agency relationship exists between the parties. In order for a disclaimer to be effective, it must specifically and clearly state that the manager owes no duties to the hotel owner apart from those enumerated in the contract.

Owners faced with such language in draft or proposed operating agreements should carefully consider the implications it will have on their relationship with the management company. The duties the manager will owe to the owner will be limited to those detailed elsewhere in the agreement. This means that a hotel owner that accepts an operator's waiver of fiduciary obligations must anticipate all potential areas of conflict between his profit motive and that of the manager. The owner must then include in the operating agreement explicit provisions restricting the manager's freedom to act against the owner's best interests in those areas.

2. Even Express Disclaimers of Agency May Be Unenforceable

Owners who have accepted such disclaimers in their current operating agreements may not eliminated the existence of an agency or fiduciary relationship between themselves and their management company. It is well-settled law that it is not the label the parties give their contractual relationship that determines if an agency relationship is created, but rather the circumstances of the particular situation, or the actual conduct of the parties in carrying out the contract. Thus, even where an operating agreement disclaims that any agency exists, if the resulting relationship between owner and operator manifests itself in a way in which an agency relationship would normally attach, then an agency exists even if the parties did not intend to create one.

3. Other Ways Managers Attempt to Dilute their Duty of Loyalty Via the Operating Agreement

Owners should be aware of other, less obvious, ways in which operators may attempt to limit their duty of loyalty. For example, specific language in a proposed management agreement may supplant the operator's duty of loyalty by providing that it can contract for goods and services from its own affiliates, that related party transactions are permitted to exceed the costs of providing goods and services, or that such transactions can be greater than an arm's length market price. Absent the hotel owner's prior express agreement to such acts, all of them violate the operator's duty of loyalty.

The proposed operating agreement may characterize the relationship between manager and owner as something other than principal and agent. For example, it may define the operator as an "independent contractor" rather than an agent. For the reasons stated above, a court should not permit an operator to evade its common law fiduciary obligations merely on the basis of a label in the operating agreement. Nevertheless, an operating agreement containing such a designation invites conflict over the issue.

C. Going On The Offensive: Battling the Disloyal Operator

By ensuring that their operating agreement has left the manager's duty of loyalty to them intact, hotel owners that find themselves in the unfortunate position of combating disloyal competing operators will have, at a minimum, the following weapons for recourse:

1. Claims for breach of fiduciary duties.

Given the broad scope of the operator's duty of loyalty - in other words, to act always in the owner's best interests - such a claim arises not only where an operator engages in direct competition by actually operating another hotel in the same market or territory as the owner, but also when it competes in other ways.

2. Claims for injunctive relief.

Owner-principals can seek to obtain an injunction preventing the disloyal and competitive behavior being engaged in by their operators-agents.

3. Claims for breach of contract.

Owners can also sue to enforce specifically negotiated contractual provisions, such as those guaranteeing a rate of return for the owner, that mandate the operator fully disclose all information relevant to evaluating its performance under the operating agreement, or that impose restrictions on the operator from opening a competing hotel in a certain geographical area. However, in most United States jurisdictions, if an owner has the option to pursue both a tort (e.g. breach of fiduciary duty) and contract claim, it has must choose a remedy in either cause of action. It cannot elect a remedy in both.

Conclusion

The operator's common law duty of loyalty to the hotel owner is a significant weapon to ensure against unauthorized competition from the operator. Accordingly, the owner should remain aware of the scope of that duty, be wary of attempts by the operator to disclaim or dilute it in the operating agreement, and seek appropriate counsel as it considers the implications of contracts that appear to do so. Armed with such knowledge, an owner may well decide it would be preferable not to rely solely on general fiduciary and agency principles to govern its relationship with the management company, but to also to work out the possible pitfalls of the relationship within the operating agreement before finalizing the deal. Whatever that decision, the avoidance of costly litigation becomes more likely where the owner has a clear understanding of its rights, and the operator's obligations, under the management agreement.

Under Mr. Brewer’s direction, Bickel & Brewer has become renowned for its innovative handling of major disputes in a number of industries, including the hospitality industry. Not only has his work in this area changed the state of the law, but it also has resulted in the formulation of creative solutions to countless problems confronting the industry. The firm has represented hotel franchisors, management companies, owners, developers, and investors in many of the highest-profile matters in the industry. Mr. Brewer is frequently published on a wide range of legal and business issues effecting the hospitality industry. He is a member of several leading industry associations, including the American Hotel & Motel Association and the Academy of Hospitality Industry Attorneys. Beyond these associations, Mr. Brewer is active in a broad range of professional groups and philanthropic organizations. Mr. Brewer III can be contacted at 214.653.4000 or wbrewer@bickelbrewer.com Extended Bio...

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