Hotel Management Agreements

Using a Letter of Intent (“LOI”) Instead of a Bullet-Point Term Sheet – Be Sure to be Clear About the Legal Effects of an LOI

Is an LOI legally binding? The general rule: look to the language of the LOI to determine if the parties intend to be bound to all or some portions of the LOI. Most litigation regarding the enforceability of LOIs arises because the parties did not clearly reflect their intention concerning enforceability. This is particularly so if the LOI contains the material provisions of a contemplated transaction and there is no unequivocal expression of the intent of the parties to the contrary. Yet in the hotel management agreement context, the LOI is useful and worth the effort, time and risk precisely because it is a way to conclude the negotiation of the material terms of the agreement prior to launching into the tedious and often protracted negotiation – mainly between lawyers – of the text of the definitive agreements. In the international context, the “management agreement” can consist of five or more separate agreements. It is almost always more efficient to ascertain if there is a meeting of the minds on the material (“key”) business terms first.

Notwithstanding a finding that a LOI does not constitute a contract, courts may impose a “good faith duty of negotiation”. These states are California, New York, Illinois, Maryland and Massachusetts. In other jurisdictions, no such right is recognized and is expressly excluded. They are Tennessee, Kentucky, Texas and Washington.

New York case law has also given us “Type I” (binding) and “Type II” (non-binding) LOIs. The United States Court of Appeals for the Second Circuit in a treatise-like opinion, explored the development of these two types of LOIs applying New York law in the case of Vacold LLC v. Cerami (545 F.3d 114 (2008))

For more on the subject of enforceability, please refer to:

“Term Sheets and Letters of Intent – The Contractual Ether World” presented by Alston & Bird LLP (333 South Hope Street, Los Angeles, CA 90071) at the Association of American Corporate Counsel meeting on October 15, 2008.

Express Disclaimers

To make it more likely that a court will not construe the LOI as binding (except in respect of those few provisions that the parties intend to make binding), consider explicit disclaimers that include:

This document is non-binding in every respect and is for discussion purposes only
The parties will not be bound in any respect until and unless a written agreement is signed and executed
There is no binding agreement yet relating to the subject matter, written or oral
The parties understand that the negotiation may not result in any enforceable contract
This document does not constitute an “agreement to agree”
In addition, do not use contractual language, particularly the verb “shall” when expressions such as “may”, “intend to” and “would” can be used instead

Binding Provisions

• Confidentiality
• Exclusivity (e.g., Manager will not negotiate with another hotel developer or owner until the earlier of [DATE] or this LOI is canceled by agreement of the parties
• Representations (e.g., Ownership of the land or validity of the option to acquire…)
• Due diligence deliverables
• Governing law
• Preparation and delivery of the definitive agreements – timing
• Submission of the deal terms for Board approval (Not a good idea to wait until the definitive agreements are executed)
• Waiver of any claims for non-approval by a party’s board
• Waiver of the good faith duty to negotiate

Settle the Key Terms

These are terms that generally are the basis for negotiation of the typical Management Agreement and the time to identify and settle them is now. If addressed later, these issues, or any one of them, have the potential to be “show stoppers”. Generally confronting key issues in the midst of negotiating the definitive agreements can be expensive or can impose pressure upon a party to “cave” on the point “at this late stage and after all the expenses we have incurred”. Consequently, it is at this stage that the parties must identify for themselves the terms they insist upon. How the terms are phrased will dictate later how they are rendered in the definitive agreements. The alternative of having a term sheet with a few bullet points – “kicking the can down the road” – usually is not a good strategy.

What are the Key Terms for a Typical Hotel Management Agreement?

Identification of the Parties (Can be an issue on the Developer’s side)

• Is the Developer entity the ultimate owner or will the Developer be a partner, member or shareholder in the entity into which equity investments will be made and that will own the project?

Description of the “Hotel” or the “Project”

• Is the key count a critical element for the management company?
• Is the parking garage included in the “Hotel” and therefore it will be managed by the manager and its revenue stream will be included in the Hotel’s “Gross Revenue”?
• Is commercial space to be managed as part of the Hotel or leased to an operator? (Affects how its revenue is treated)

Residences

• Will they be branded, marketed and managed by the Manager?
• Will there be a Rental Program?
• What Hotel amenities will be available to residence owners?
• What are the branding and management fees?
• Was is the split of rental proceeds with residence owners?

Where residences are involved that are branded and managed by Manager when they are included in the “Hotel” pursuant to a Rental Program, a branding fee will be paid to Manager. In addition, the Manager will benefit from the inclusion of the rental revenue from the residences in the Hotel’s Gross Revenue and typically insists that 100% of the rental revenue be so included and then the unit owner’s share of the rent (say 30-40%) is paid. Hotel Gross revenue is further enhanced by the provision of Hotel amenities, such as room service and maid service, to the residences even when they are occupied by the unit owner. These arrangements will vary depending upon the physical configuration and the perceived uplift in value attributable to the brand. The key terms should be included in the LOI.

The Developer’s /Owner’s Financing Terms

• Limitations on Loan-to-Value
• Requirement for the Developer to obtain a Subordination and Non-Disturbance Agreement (“SNDA”) for the benefit of the Manager

Term

• Typical: 30 years renewable at Manager’s election
• Negotiated:
  • Early no-fault termination by Owner with a payment of Liquidated Damages; expect a long “black-out” period
  • Manager’s renewal option subject to Manager’s not having failed the Performance Test
  • Termination Upon Sale – tough to obtain
  • SNDA may provide the lender with termination rights upon or some time after foreclosure or acceptance of a deed in lieu of foreclosure

Performance Test

• Typical: the two-prong test – e.g., Manager does not achieve 85% of RevPAR of the Competitive Set AND fails to meet 90% of Budgeted Gross Revenue (or GOP or NOI) for two consecutive years after the ramp-up period and failure is not due to Force Majeure Rooms Out of Service
  • Manager will demand cure rights and will have to cure only one of the two failed prongs (not the RevPAR prong of the test) and for only one of the failed years, and the clock is thereby reset
• Negotiated: Owner will counter with higher percentages and a failure in any two of three consecutive years; Owner may also ask that “AND” be changed to “OR” – not likely to be allowed
  • A More Meaningful Test: Owner Must Obtain a Targeted ROI – not likely to be agreed by Manager because several key expense items are beyond the Manager’s control, such as property taxes and debt service

Fees

• Revenue Based Fees:
  • “Base Fee” – Typical: 3% of Gross Revenue
  • “Marketing Fee” – Typical – 1% of Gross Revenue
  • Negotiable? Maybe a ramp up in early years of a new hotel
  • For an existing hotel, Owner may seek a fee that is a higher percentage, but only of Gross Revenue in excess of previously achieved levels; this will be resisted by the big brands
• Earnings Based (Incentive) Fees: Rewards not just volume (Gross Revenue) but operating efficency
  • Typical: 10% of Gross Operating Profit – i.e., Gross Revenue MINUS Operating expenses – i.e., just those expenses that are within the control of the Manager and therefore include routine departmental expenses, but do not include:
  • FF&E Reserve (negotiable)
  • Capital Expenditures
  • Property Insurance
  • Property Taxes
  • Debt Service
  • Distributions/Dividends
  • Owner’s Income Taxes
• Some Variations on Incentive Fee Formulae:
  • Earned as a percentage of Gross Operating Profit but only paid to the extent of Net Operating Income in Excess of Owner’s Priority which is typically a percentage of project cost increased by subsequent capital expenditures; earned but not paid fees accumulate and may or may not bear interest and are paid to the extent of excess NOI after current Incentive Fees are paid
  • Or a higher percentage – say 25% – of Net Operating Income (all expenses before depreciation and income taxes)
  • Or for an existing hotel, a higher percentage but only of Gross Operating Profit in excess of a previously achieved level

There are many variations that are the ‘stuff’ of hard negotiation

Other Charges/Fee

• Central Service Charges – e.g., reservation charges (typically $X per reservation), reward programs (typically a percentage of Room Revenue generated by the reward-program member who is a guest at the hotel), employee training charges, brand marketing charges and more – be sure to limit these to the extent possible to cost recovery and make them apply in the same manner as they apply to all other hotels in the chain
• Voluntary (Optional) Programs – such as optional purchasing programs, technical services for improvements, employee training seminars, quality audits and more

Restricted Area / Radius Restriction

• Owner will seek to restrict Manager from operating or franchising the brand and its other brands in the same or similar market niches within a defined territory surrounding the hotel; generally blocks for urban centers, entire countries for remote areas
• Manager will resist and will seek to limit the brands to the same brand only and if the brand restriction applies to other brands owned by Manager, Manager will seek an exception for “chain acquisitions” of other brands and may also seek to exclude variations on the use of the restricted brand, such as “Brand XXX Residences”; Manager may also seek to have the restricted area shrink or disappear after a number of years

Credit Enhancements

• Assistance from the Manager to fund the project to build or acquire the hotel
  Some examples:
  • Equity Participation
  • Subordinated/Mezzanine Loan
  • Key Money
  • Fee Subordination (e.g., Incentive Fee with an Owner’s Priority)
  • Debt Service Guaranty
  • Contribution of Technical (and Other) Services

Budget Approval by Manager

• Budget more than operating expenses; an employment plan, a marketing plan, a CAPEX plan…
• Owner wants more than a right to review the budget that the Manager prepares; Owner wants approval right; the budget process is the Owner’s most significant remaining operational involvement once the Hotel has been turned over to the Manager’s day-to-day control
• Some items may be excluded as outside Manager’s control, such as utility costs
• Items in dispute can be set at the prior fiscal year’s level plus a CPI-based increase pending resolution by an “Expert”

Employees: Who is the Employer?

• In the US, Manager typically will employ all hotel employees. This can have the (unintended) consequence of preventing the Owner from obtaining a roster of each employee’s salary and benefits
• Outside the US, Owner will be the employer, but Manager will assign (second) certain of its personnel to serve in key positions…possibly the entire Executive Committee. If Manager is terminated, these employees will usually exit the property when the Management Agreement is terminated (or expires)

Hiring and Firing Key Personnel

• Owner typically requests and obtains the right to interview candidates and approve the hiring of “key personnel” e.g., General Manager, Controller, Director of Marketing and Sales
• Owner not likely to have the right to fire any personnel (each employee should serve one master) but should have the right to have Owner’s views taken into account when reviewing the performance of key personnel or at least Owner’s complaints should be given good faith consideration

Insurance Types (except property) and Levels Will generally be specified by Manager and both Manager and Owner will be named insureds. This eliminates a right of subrogation.

Conclusion

Dealing with these key provisions at the LOI stage is essential to knowing whether or not you have a deal. It is better to know this prior to all the sturm and drang among the lawyers over the definitive agreements. No point in kicking the can down the road only to find out that in addition to the loss of time and incurring of legal fees from the negotiation of the definitive agreements, there is no deal.

With permission of HospitalityLawyer.com

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