History Lesson: Owners and Management Companies Weigh Responsibilities and Risks in Response to COVID-19
By William A. Brewer III Managing Partner, Brewer, Attorneys & Counselors | July 26, 2020
Today, the chain brand hotel companies (e.g., Marriott, Hilton, IHG, etc.) represent 69% of the rooms in supply. They do so through a variety of brands, spread over different price strata, offering different levels of facilities and services to their guests. Although the traveling public may not realize it, the brands rarely own any of the hotels within their "chain" of distribution. Rather, the owner of the hotel is either a licensee or the principal who has contracted for the asset to be managed by the brand. This was not always so.
Before the 1970s, the chains actually owned a significant percentage of their "distribution." In the '70s, a fundamental change began to emerge in the hotel industry as hotel companies moved from an asset-heavy model to being a collection of consumer brands. For example, at a hotel opening in Los Angeles on September 7, 1973, J. Willard Marriott Jr., then president of the former Marriott Corporation, announced that his company would operate the majority of its future hotels on a management?fee basis instead of being the owner.
The management?fee plan, he said, "will continue for the foreseeable future largely because under the plan the company won't have to make extensive capital commitments for hotel construction." Echoing this sentiment, in August 1976, Hugo M. Friend Jr., then president of the Hyatt Corporation, said, "hotels are too expensive for mere mortals to build..." And with that, Hyatt began shifting its business model from hotel ownership to asset management.
The economic downturn in the 1990s further fueled the industry's shift to what later became known as an "asset-light" business after hotel companies found themselves carrying large amounts of debt on their balance sheet for the properties that they could not sell as a result of the deteriorated real estate market.
Marriott, for example, built hotel after hotel, then sold or franchised them while retaining the management contracts throughout the 1980s until it found itself with 639 hotels – including 150 it was trying to sell – and a growing fear that it could not pay off its debt. As a result, in 1992, the hotel company announced it was spinning-off its underperforming real estate operations, which ultimately allowed it to grow its presence and profit without the burden of risky equity investments.
The Hotel Management Agreement
As the nation's major hotel chains shifted from hotel ownership to operating hotels for outside parties under management contracts, big-money investors with relatively little industry knowledge and experience turned to brand management chains to manage the hotels for their expertise, consistent standards, and use of the brand in marketing the hotel.
In the early days of the hotel management agreements, the brand, with its operational expertise and brand affiliation, held the majority of the negotiating power and control over the process, which resulted in long-term contracts that were favorable to the manager, but not necessarily the owners.
Under such arrangements, the owners would bear the financial risk, but typically get virtually no say about staff, marketing strategy, or room rates. As Curt R. Strands, president of Hilton International, said in July 1976 regarding these hotel management agreements, "It's the Ten Commandments. It says that we and we alone have a say in management. The only right the owners have is for a full accounting, but they can't say boo to anyone about management."
In exchange, the owners received well-trained and experienced staff – everyone from maids to managers. And for those who used a management chain, they got clout from a marquee name, in addition to a nationwide marketing program and advertising campaign.
Initially, this arrangement seemed to work well enough when the owners saw enough profits on their investments to pay the managers' enormous fees. However, when the recession in 1991 occurred, the conflicts of interest between the owners and managers became increasingly apparent.
Of particular concern to the owners was the perception that brands were advancing their own interests and placing their own national image ahead of the needs of the properties with which they were entrusted – and it was all done at the owners' expense. Compounding these issues, luxury hotels found themselves tied to the hotel operators for decades through the management agreements, which gave the operators little to no incentive to cut costs when the profits dried up.
Beginning with Woolley v. Embassy Suites, hotel owners began realizing gains in their endeavor to rebalance the scales of power. Woolley was the first case that established the legal relationship between a hotel owner and manager as that of principal and agent, and, in doing so, shifted the power to the owners by affirming their rights and establishing the principal-agent relationship between owners and operators.
In the early 1970s, a local plumber turned real estate investor named Robert E. Woolley had a vision for a new type of hotel. He saw an opportunity to create a new kind of experience for business travelers. As a traveling plumbing contractor, he was "offended" that when he wanted to hold a meeting, he would have to visit a hotel lobby or a nearby coffee shop. "Let's face it," Mr. Woolley said in an interview in 1982, "walking into most hotel rooms after a long business trip is like entering outer space. It's just a big empty bedroom."
Realizing an opportunity to enhance guests' hotel experiences, Mr. Woolley ensured that in his hotels, his guests did not stay in a standard typical single room. Rather, he wanted his guests to stay in suites, complete with a separate bedroom, a sitting room, and even a wet bar, and he made sure to provide his guests with amenities like free buffet breakfasts and complimentary cocktails. While priced to compete with most traditional hotels catering to the traveling business trade, Mr. Woolley's rooms were different in that they were the first of what became known as "all-suite" hotels, which he called Granada Royale Hometel.
In 1984, Woolley sold his Granada Royale Hometel chain to Holiday Corp., which then became Embassy Suites. Mr. Woolley, and his partner, Charles Sweeney, subsequently became general partners of 22 partnerships that owned 22 hotels, all of which were franchised by Embassy Suites, and 17 of which were also managed by Embassy Suites pursuant to 17 individual management agreements. Mr. Woolley had hoped to develop further all-suites hotels as Embassy Suites, but this arrangement was not to last.
He, like other owners, came to realize that hotel operators are not always incentivized to make decisions that are in the owners' best interests. This is especially true during times of economic hardship, when hotel owners bear all the financial risk associated with the hotel while the operator is continuously paid through management fees, regardless of whether the hotel is profitable or not.
Against the backdrop of the economic recession of the early 1990s, Mr. Woolley announced in 1990, "We are going to exit the Embassy system" as he and Mr. Sweeney found themselves ensnared in a legal battle to pull their 22 hotels from the burden of off-the-top fees that were driving their hotels into bankruptcy. At the center of the dispute was the original purchase, management, and franchise agreement. Under the purchase agreement, Woolley claimed that Embassy "mismanaged" the hotels and "intentionally" made false promises and representations, such as budget projections and costs for properties.
"We were led to believe… that the financial strategy was to market and launch a great hotel chain, which would afford us a better position and better rates in the marketplace," he said at the time. "Embassy has positioned themselves in the marketplace to build a brand in order to build more franchises and are not concerned about the…[owner's] problems, needs or desires." Thus, a battle emerged that was destined to have significance for the entire industry – or at least for the thousands of owners of hotels managed by chain brands.
The result of Woolley changed the dynamics of hotel-management agreements. Previously, brand managers were able to advance their interests and national images regardless of the economy, while owners bore all the risks. The Woolley ruling established that hotel managers owed owners fiduciary duties, including the duties of good faith, loyalty, fair dealing, and full disclosure.
A "fiduciary" is one who transacts business, or who handles money or property, which is not his own or for his own benefit, but for the benefit of another person, to whom he stands in a relation implying and necessitating great confidence and trust on the one part and a high degree of good faith on the other part. The core duty of a fiduciary is the duty of loyalty. This duty requires the fiduciary to put the interests of the beneficiary first and to forego personal advantage aside from compensation in the exercise of its tasks.
This means that the agent fiduciary must communicate all information relevant to the transaction he is to perform to his principal. He must also account to the principal for all money and property which he has received or paid out on his principal's behalf. Thus, as a fiduciary, operators are required to subordinate their self-interest to that of the owner.
Woolley held that a hotel owner had the power to terminate its hotel manager, regardless of the terms of their management agreement. The California First District Court of Appeal explained that "a principal who employs an agent always retains the power to revoke the agency" and held that "it should always be within the power of the principal to manage his own business and that includes the power of the principal to reassume the control over his own business which he has but delegated to his agent." Thus, the Woolley decision established that if a manager breached its fiduciary duties, an owner could terminate a management agreement without penalty.
Woolley set a new precedent for the changing relationships between hotel owners and brand managers, bringing balance to the power struggle between hotel managers and owners often locked together for management agreements with terms that continue for decades.
Aftermath of Woolley
During the downturn of 2007-2008, the hospitality industry gained new insight into the legal obligations that are owed to hotel owners after a jury slapped the Ritz-Carlton Hotel Co. with a verdict in KMS v. Ritz-Carlton that sent shockwaves throughout the legal landscape of hotel management agreements. In that case, an Indonesia-based hotel owner, P.T. Karang Mas Sejahtera, or KMS, who owned the Ritz-Carlton Bali Resort & Spa was awarded $382,000 for actual damages, and $10 million in punitive damages, attorney's fees and injunctive relief against the hotel's operator, Ritz-Carlton, and its parent company, Marriott International Inc., for fraud, breach of contract and breach of fiduciary duty.
KMS v. Ritz-Carlton centered around the development and opening of the Bulgari Bali Hotel. The Bulgari Bali was the first resort under the Bulgari Hotels & Resorts chain and was established through a joint venture between Marriott and Bulgari SpA, a high-fashion Italian jeweler. At issue was the fact that Ritz-Carlton began managing Bulgari Bali Hotel even though it was already managing the Ritz-Carlton Bali Resort & Spa, which was located "just a few miles" away. In doing so, Ritz-Carlton violated its fiduciary duties to the owner of Ritz-Carlton Bali Resort & Spa.
An agent is under a duty to act solely for the benefit of the principal in all matters connected with the agency. An agent may not act for an adverse party without the principal's consent, nor may they act secretly in the same transaction on their own account. Throughout the duration of the agency, an agent may not give their time and effort to a competing interest. Since the agent owes individual allegiance to their principal, they may not represent both parties to the transaction without first disclosing their dual role and obtaining the consent of both principals.
In its complaint, along with several other claims, KMS alleged that Ritz-Carlton abused its privileges as operator of the KMS hotel and used confidential and proprietary information owned by KMS to plan and develop the competing Bulgari hotel while concealing those profits from KMS. KMS also argued that the Ritz-Carlton was contractually bound not to use the Ritz-Carlton name and brand to operate another hotel in Bali without KMS' consent, but that the hotel operators nonetheless used the Ritz-Carlton name, assets, and resources in opening and operating the Bulgari hotel, which lacked any credibility or "established standard of excellence."
The jury apparently agreed, and found that KMS successfully demonstrated that Ritz-Carlton violated its fiduciary duties by opening and operating a competing property in disregard of its responsibilities as an agent of the Ritz-Carlton Bali. In developing a new brand at KSM's expense, the jury found that Ritz-Carlton breached its fiduciary duty to KSM. As a result, a clear message was sent to hotel operators, reminding them of the fiduciary duties that they owe to the hotel owners whose assets they manage, and the importance of placing the owner's interests ahead of their own.
A Pandemic's Effects on the Future
Hotel operators assume significant legal responsibilities when they undertake to serve as a fiduciary of a hotel owner. Managers of hotel assets owned by others should act as fiduciaries and maximize the economic performance of each asset they manage. Moreover, a brand operator should not place their own interests above the owner's. Thus, it is an operator's duty, among other things, to act in good faith, to be loyal, to fully disclose material information, and to act in the best interest of the owner such that they operate the hotel in a financially efficient and cost-effective manner.
In times of uncertainty, the fiduciary obligations of every hotel operator should take on increased significance. As the pandemic continues to wreak economic havoc globally, and with a possible continued recession around the corner, hotel operators have a legal responsibility to their owners to give immediate attention to particular issues that may arise over the course of the hotel's operation and management.
A failure to uphold these duties may result in an owner's loss of trust and confidence in the operator's management, and operators who breach their fiduciary duties will entitle owners to terminate their hotel management agreements with immediate effect.
Victoria Lee from the New York office of BREWER contributed to this article.
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