Hotel management agreements: what could go wrong?

The hotel industry continues to face significant challenges. With increased costs of supply, staff shortages and many consumers tightening their spending, hotel owners and operators are under more pressure than ever to maintain profitability. This economic backdrop can lead to real pressures on their commercial and contractual relationships.

There are a number of different legal structures that are commonly used to govern the ownership and operation of hotels. This article focuses on hotel management agreements (HMAs) and considers some of the key risk areas for disputes that may arise from this type of contract.

The key features of HMAs

Under a standard HMA model, the owner holds the real estate of the hotel and appoints a management company (or operator) to operate the hotel. There is almost always a profit-sharing arrangement between the parties. For example, in some HMAs the owner retains most of the profit but pays the operator a management fee comprising both a fixed and an “incentive” element based on profits or other financial metrics.

HMAs tend to be long-term agreements, sometimes with terms extending into decades. Termination rights are therefore very important, particularly for owners so they can terminate if they intend to sell the premises or if the hotel is not performing financially.

Key areas for dispute

Some common areas for dispute relate to:

Poor financial performance

Underperformance against financial metrics set out in the HMA is a common cause of disputes. The main metric is often RevPAR (revenue per available room) or gross operating profit, with operators often required to hit a benchmark set against competitor businesses year-on-year. A failure to meet this threshold will trigger a remedy for the owner, such as a claw-back of profit or even a right of termination. However, determining responsibility for underperformance can be difficult. The owner may blame low revenues on business inefficiencies, poor marketing or poor customer service by the operator. On the other hand, the operator may blame the owner for failing to keep the premises refurbished and in good repair.

Use of hotel funds and levels of authority

It is very important that the HMA clearly sets out the boundaries of the operator’s authority to use hotel funds, both in terms of amounts and purpose. The definitions of the key components of the profit-sharing mechanism should be carefully drafted to avoid uncertainty about how costs should be allocated into different “buckets”, including which costs must be absorbed by the operator or owner and which can be factored into profit calculations.

Service delivery

In addition to financial metrics set out in an HMA, operators are usually required to meet other performance standards relating to the provision of services in “good faith”, in a “prudent and experienced” manner or “in accordance with good industry practice”. Ideally, to reduce the risk of disputes, those standards should be clearly defined in the HMA, including precise KPIs which set out specific and objective measures which provide clarity for both parties.

Repair obligations

Although an HMA does not create a landlord-tenant relationship, repair obligations are usually split in the same way as they are in commercial leases, with the owner responsible for structural repairs and significant refurbishment and the operator required to maintain the interior and be responsible for damage caused by those it permits to enter onto and use the premises. There is also usually a “notice and action” mechanism, whereby operators are expected to notify the owner of repair issues so the appropriate party can take action to address them.

Brand and brand standards

These issues are often important to both parties. For example, luxury hotel operators will be unhappy with a poorly maintained building which can damage their customer experience. Equally, an owner of a building with its own significant brand may be affected by the actions of the operator, even at another location, such as being fined for employment-related issues or allegations of greenwashing.

The naming of hotels can cause tension, particularly where both the owner and the operator have strong brands. In Bouverie No. 1 Ltd v De Vere Hotels & Leisure Ltd, for instance, the operator rebranded the hotel from “The Belfry” or “The De Vere Belfry” to “De Vere at the Belfry” which led to a claim by the owner for breach of the HMA.

HMAs typically set out brand standards to which both parties must adhere, and which regulate the use of the hotel brand in the marketing of the hotel. These standards can govern all elements of the hotel’s brand, including design scheme, colour scheme, and often lobby and room layouts, many of which have become defining features of hotel brands.

Early termination

There are many reasons why a hotel owner in particular might wish to terminate an HMA early. These range from a desire to sell the hotel real estate or change the use of the building to bringing in a new management company in the hope that they will yield higher profits.

However, given the long contractual terms of HMAs, early termination often comes with significant financial penalties for the terminating party unless it can prove that the other party has breached the contract.

Force majeure

HMAs will often provide for situations where the agreement cannot be performed for a reason which is outside the control of the parties, although these provisions are not always clear or exhaustive.

This was a key issue during the Covid-19 pandemic, when there were questions over whether HMAs could be terminated, who should bear the brunt of the revenue losses, whether management fees could be withheld, and the extent to which each party was obligated to take steps to mitigate their losses. The pandemic was a reminder that seismic and unpredictable shocks are very possible and, particularly for long term contracts such as HMAs, terms should be included to set out clearly how risks will be shared in the event of such events.

Customers and data

When owners and operators part ways, there can be disputes over which assets should stay with the owner and what should leave with the operator. Customer data and existing bookings are increasingly a subject of these disputes given their value. Any HMA should clearly set out which party will be responsible for the customer relationship and which will retain customer information at the end of the agreement. The HMA should also set out the relationship between the parties in relation to data protection, so that it is clear whether they are both independent data controllers, or one is the processor of data controlled by the other. That is important to ensure compliance with data protection requirements during the agreement but also the management of customer data at its end.

How are HMA disputes dealt with?

Many HMAs provide that disputes between the parties will be resolved by expert determination or by arbitration. Expert determination can be particularly effective in resolving financial disputes about budgets or performance more swiftly and cost-effectively than litigation.

HMAs often also include arbitration clauses. Arbitration can be faster than litigation but, perhaps more significantly, it is a confidential process. The hospitality world has a relatively small number of big players so parties are often keen to avoid the negative publicity that may arise from litigation. The highly international nature of the hotel industry also makes arbitration attractive as a mutually acceptable option. If the arbitration provisions in the HMA are drafted clearly, they can help avoid issues around service, jurisdiction and enforcement that may arise in litigation.

Important clauses in an HMA

Careful drafting of HMAs can reduce the risk of future disputes and ultimately save the parties significant costs further down the line. Clauses should always be tailored to the specific scenario, though there are certain provisions which are particularly important in an HMA:

• Owner approval rights: Owners nearly always require the operator to seek specific authorisation before making payments or entering contracts above a certain value threshold or duration or making key personnel changes.
• Financial metrics: Different metrics might be more or less appropriate in certain circumstances, for example where the quality of rooms varies very significantly, or large-scale events cause peaks and troughs in revenue. Likewise, where the owner-operator relationship spans multiple venues, the parties may consider whether financial performance averaged across the chain would be a better benchmark.
• Force majeure: The HMA should list the triggering events in full, and explain clearly what happens to the obligations of each party if those events occur.
• Pre-emption rights: In the event of a sale by the owner, it may be beneficial to some operators to have a first right to buy the hotel, to prevent the closure of a potentially profitable venue.
• Performance standards or KPIs: General standards like “good industry practice” should be backed up with a schedule breaking down the obligations in detail.
• Repair obligations: The contract should be clear exactly who is responsible for what, including how much notice of issues needs to be given and the consequences of not doing so.
• Termination: The HMA should be clear about the circumstances which will entitle either party to terminate. Particular consideration should be given to:
  • How any termination fee is calculated, and
  • How much notice needs to be given.
• Consequences of termination: The HMA should clearly set out the steps which each party is required to take on termination, with customer data, existing bookings and staffing all being hotly contested topics.
• Liability and insurance: Unfortunately accidents and incidents can happen, whether involving customers, employees or other third parties. The HMA should clearly set out how liabilities should be dealt with, including which party should obtain insurance against specified risks and the terms of the insurance cover required.
• Dispute resolution: The HMA should set out how the parties will resolve any dispute that arises between them, including whether they would prefer arbitration or litigation and whether expert determination will be used to resolve disputes in specific areas.
  
  

The financial pressures in the hotel sector are unlikely to ease any time soon and it is likely that we will see a rise in hotel management disputes as a result. Hotel businesses should be thinking about litigation risk from the outset, when contracts are first negotiated. HMAs are complex contracts and careful drafting can avoid numerous problems further down the line. If disputes do arise, seeking early legal advice on how to interpret HMA provisions is vital.

Many thanks to trainee Tom Chapman for his help in writing this article.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, June 2024