By Alexandra R. Cole

Alexandra R. Cole is a partner in the Chicago office of Perkins Coie LLP.

Purchasing a hotel or resort property is much more like buying an ongoing business than buying a commercial real estate property. This is why a hospitality property is often referred to as a “business in a box.” In addition to the normal real estate due diligence issues, the purchase contract must include provisions that are comparable to those found in the purchase contract for a manufacturing plant. This article will not examine the entire list of representations, warranties, and due diligence items that are standard in most transactions, but it will highlight some of the more unique issues that arise in hotel transactions.

Employee Issues

Whose Employees Are They?

Something that may not have occurred to a first-time purchaser of a hotel is that the employees might be employed by any of the following: (1) the manager or operator of the property, (2) a special purpose entity owned or controlled by the manager, possibly also jointly controlled by the manager and the owner, (3) the existing ownership entity, or (4) a special purpose vehicle owned solely by the existing owner. It is vital to know whose employees they are to determine whether or not certain other issues will arise. For instance, if the manager employs the employees and will continue to manage or operate the hotel after the purchaser buys it, there will be fewer issues regarding whether the transfer triggers certain terminations, which would in turn trigger provisions of the WARN Act or employee coverage issues, discussed below.

The contract between the purchaser and the owner will likely contain a representation referencing or requiring a complete list of all employees with their salaries, positions, and terms of employment. This list also should include information about employees who were discharged at any time during the three-month period before the closing date, including the date of the employee’s discharge. Because of privacy and liability issues, a manager not a party to the contract may not be willing to fully disclose this information to anyone other than its principal, that is, the existing owner of the property. Therefore, the seller of the property must decide whether to give an unqualified representation or warranty based on the information supplied by the manager.

A situation may arise in which the executive staff employees are employees of the manager and the existing owner employs all other staff. In that instance, a careful review of the management agreement and thorough questioning of the comptroller will be helpful in sorting things out.

WARN Act

The Worker Adjustment and Retraining Notification Act, 29 U.S.C. §§ 2101–2109 (WARN Act), was designed to require employers to give employees at least 60-days prior written notice of a plant closing or mass layoff. Buying a hotel would not appear to involve a “plant closing” or “mass layoff” because most employees would normally remain employed. But practitioners should consider the definitions in the statute and the fact that the “employer,” as described above, would change.

The term “plant closing” is defined as “the permanent or temporary shutdown of a single site of employment, or one or more facilities or operating units within a single site of employment, if the shutdown results in an employment loss at the single site of employment during any 30-dayperiod for 50 or more employees excluding any part-time employees”. Id. § 2101(a)(2). The term “mass layoff” is a reduction in force that:

(A) is not the result of a plant closing; and

(B) results in an employment loss at the single site of employment during any 30-day period for—

(i) (I) at least 33 percent of the employees (excluding any part-time employees); and

(II) at least 50 employees (excluding any part-time employees); or

(ii) at least 500 employees (excluding any part-time employees).

Id. § 2101(a)(3).

A requisite number of employees must experience employment loss to trigger WARN. An “employment loss” is: “(A) an employment termination, other than a discharge for cause, voluntary departure, or retirement, (B) a layoff exceeding six months, or (C) a reduction in hours of work of more than 50 percent during each month of any six-month period.” Id. § 2101(a)(6). It is necessary therefore to review the work force history for the period 90 days before the closing and allocate the risk of triggering the WARN Act between the purchaser and the seller. It is also helpful to check the local jurisdiction to determine if more stringent local legislation expands the time frames or obligations of the WARN Act.

Practitioners need to ensure that WARN Act provisions are contained in the purchase contract that allocate the risk of triggering WARN Act termination costs. Once the seller has provided the representation regarding the employee statistics discussed above, the practitioner can draft a provision that prohibits the seller from discharging more than a certain number of employees (a number that will vary depending on the size of the work force), except for good cause, during the three-month period before the closing date. If the seller does not abide by this provision, or if the seller’s representations and warranties are inaccurate when made at the closing, the seller should be responsible for any costs or liabilities that arise under the WARN Act.

To balance this obligation and liability of the seller, often the purchaser may agree to maintain the employment level of the business (including hiring not fewer than a certain number or percentage of the employees who were employed at the business as of the closing, plus the number of employees that were discharged by the seller, other than for good cause) for a period of three months after the closing. To the extent that the purchaser does not abide by this provision, the purchaser should be responsible for any costs or liabilities that arise under the WARN Act. The three-month period is often used to split the risk between the parties because the timeframe under WARN is six months for “employment loss.” Obviously, any allocation is possible and, if there is a more stringent local statute, the provision should be adjusted accordingly.

As an alternative to sharing the risks, the purchaser may wish to allocate all responsibility to the seller. In that case a provision requiring seller’s employment of all employees at the property to terminate at the closing would be included, in which case the employees would cease to participate in any employee benefit plans maintained by or for the benefit of the seller. If this occurs, the purchaser could offer employment to each individual whose employment is terminated, with no obligation on the purchaser’s part to extend offers of employment to any such terminated employee of the seller. The seller would retain responsibility for any terminated employee of the seller, which includes the payment of benefits or entitlements. The seller, and one or more of the employee benefit plans, would also be obligated to comply with the health care continuation requirements of the Employee Retirement Income Security Act (ERISA), 29 U.S.C. § 1161-1168 (2002), as applicable. Further, the seller would be responsible for the timely delivery of notices required to be given to its employees under the WARN Act, either before, or as a result of, the contemplated transaction. For a full and helpful discussion of these issues, see Garrett J. Delehanty Jr., The WARN Act in Hotel Transactions, Probate & Property (Mar./Apr. 1998), at 38.

Housing Obligations

In some resort communities, the law requires the resort owner to provide housing and other amenities to accommodate the necessary employees. These requirements are sometimes contained in development agreements with the local municipalities and are often tied to certain tax benefits or tax holidays in exchange for a job commitment. These requirements may also be imposed by legislation because affordable housing would be unavailable in the surrounding high-end resort community without an obligation on the employer to provide such housing for lower paid service employees.

Union Contracts

Many hotel workers are governed by collective bargaining agreements. Understanding a client’s continuing obligations under these agreements may be the key to a hotel’s achieving its goals for its progress and the allocation of certain financial responsibilities between the purchaser and the seller. The most frequent financial issue that arises between the purchaser and the seller in this context is the status of union pension liabilities and whether or not a withdrawal obligation will arise because of the transaction.

In general, a purchaser will be required to assume some contracts, and the seller will want to avoid withdrawal liability that could be triggered by the purchaser. If the seller has underfunded the plan, however, the purchaser will want to preserve the seller’s liability for that portion. These are very fact-intensive issues, the assessment of which requires input from local counsel and ERISA counsel.

When the purchaser bears the risk, it can assume responsibility for all contributions required to be made to the plans, in accordance with the terms of the collective bargaining agreements. During the period commencing on the first day of the plan year following the closing date and ending on the expiration of the fifth such plan year (the Contribution Period), the purchaser will be required to provide to the plan either a bond, letter of credit, or an escrow in an amount and manner meeting the requirements of ERISA, 29 U.S.C.§ 1384. If the purchaser withdraws during the Contribution Period, the seller may be secondarily liable for any withdrawal liability it would have incurred if the withdrawal liability of the purchaser is not paid. Therefore, the seller may also request specific assurances on continuing compliance with ERISA during the Contribution Period. Finally, the purchaser must agree to indemnify the seller against the imposition of any secondary liability or liability resulting from the purchaser’s failure to provide a bond, letter of credit, escrow, or other security. If the seller is to bear the risk of withdrawal liability, the purchaser will need provisions for withholding money at the closing to cover this continuing liability of the seller or receive some other creditworthy indemnity.

Insurance Issues

Practitioners should consider the following items when reviewing insurance:

• Responsibility for Obtaining Insurance—The allocation of responsibility as between the manager or the owner is governed by the management agreement. Some management contracts require the owner to purchase insurance through its programs. The client will need to investigate whether the costs are competitive and what kind of flexibility the owner will have for insurance coverage.

• Terrorism Insurance—Lenders often require terrorism insurance if a high-profile resort or large urban hotel is involved.

• Sexual Harassment Liability Coverage—If ever there is a business that warrants this insurance, the hospitality industry is one. So, it is important to know whether the owner or manager has carried it to ascertain if the indemnities for pre-closing liabilities are meaningful.

• Allocation of Manager’s Insurance Costs—Issues can arise as to the proper allocation of worker’s compensation insurance and loss experience if the manager has carried this insurance.

Casinos

With more and more jurisdictions allowing casinos, hotel owners and franchisees need to be cognizant of the special issues involved when a hotel property includes a casino. The gaming industry is highly regulated in all jurisdictions, which makes it vital to have experienced local counsel to help with the compliance process. Additional time for due diligence and closing may be required to comply with licensing requirements. Interim contractual arrangements can be created for the existing casino operator to continue to operate until new licenses are obtained, but this provision is often not optimal from the perspectives of both the purchaser and seller. Generally, both parties want to have as little ongoing responsibility to each other as possible.

In addition to licensing issues, special proration provisions apply to outstanding bets and chips. Some leeway is allowed in how these provisions are handled, but local regulations also affect who bears responsibility for these liabilities. For example, a provision may be inserted that requires the purchaser, or the casino operator as the seller’s agent, to redeem any of the following: (1) any chips or tokens of the seller relating to the use and operation of the business, which are presented by guests to the purchaser for payment within 120 days after the closing, up to an amount equal to the credit given by the seller to the purchaser at the closing; (2) any racebook and sportspool tickets that are presented by guests to the purchaser for payment within 60 days after the closing, provided the seller gives a credit for such amount; (3) all sportspool and racebook gaming involving the NBA or NHL, the results of which are unknown at closing; and (4) all accrued gaming obligations as of the closing relating to any keno games, provided the seller gives a credit for such amount.

The seller may be responsible for redeeming any chips or tokens presented by guests in excess of any credit given by the seller to the purchaser, to the extent they are redeemed by the purchaser during the 120-day period. The purchaser may agree that within five days of the closing, it will not redeem any of the seller’s chips or tokens in excess of $1,000 that are presented by a single customer. It is also possible that all accrued and accruing gaming obligations relating to any incremental progressive prizes associated with table games, slot machines, and other coin operated gaming equipment shall be paid, as of closing, to the casino operator. Finally, the seller may pay the casino operator all amounts bet before the closing for sportspool and racebook gaming, other than bets involving the NBA or NHL, and the purchaser or the casino operator shall be responsible for all liabilities for such bets. These examples of allocation of gaming revenue will have to be tailored to the specific laws regarding the timing and dollar amounts of the redemptions.

Management and Franchise Agreements

The first issue for due diligence is to review the management and franchise agreements that govern the property. Some management contracts are styled as long-term leases. Although this arrangement is less frequent now, there are some old contracts still around, and there are some jurisdictions where they are still commonly used. These are real leases, governed by all the customary rules, with rent based on profitability of the hotel. These arrangements, absent a default in payment of rent or other material obligations, are not terminable except in accordance with their terms.

Management contracts in the United States, however, are just that, contracts, and are therefore terminable. They have been held to be agency contracts, terminable at will, but subject to liability for damages that arise if they are terminated in violation of the contractual provisions. See Woolley v. Embassy Suites, Inc., 278 Cal. Rptr. 719, 724 (Cal. Ct. App. 1991); Pacific Landmark Hotel, Ltd. v. Marriott Hotels, Inc., 23 Cal. Rptr. 2d 555 (Cal. Ct. App. 1993); Government Guarantee Fund of the Republic of Finland v. Hyatt Corp., 95 F.3d 291, 300-06 (3d Cir. 1996). Until these cases, there was uncertainty as to whether the manager could be terminated and evicted from the property. Now, it is quite clear that the agency relationship can be terminated at will unless the agency relationship is “coupled with an interest” that is truly an economic ownership interest of substance.

The law is not clear, however, as to what is sufficient to create an agency “coupled with an interest” so as to prevent termination. Monetary compensation alone is not sufficient, nor is the grant of a de minimis interest in the hotel. ITT Sheraton’s 1% holding in the entity that owned the hotel was held insufficient to prevent the owner from exercising its power of termination. 2660 Woodley Road Joint Venture v. ITT Sheraton Corp., No. 97-450-JJF, 1998 WL 1469541 (D. Del. Feb. 4, 1998); see also Michael C. Shindler, The Precedents and the Principle: An Update on Hotel Management Agreements and the Laws of Agency, 39 Cornell Hotel & Restaurant Admin. Q. No. 3, at 9 (June 1998).

A logical extension of the agency relationship is to impose fiduciary duties on the manager. See 2660 Woodley Road Joint Venture v. ITT Sheraton Corp., 2002-1 Trade Cas. (CCH) ¶ 73,601 (D. Del. 2002).  As a result, inappropriate profit-sharing or self-dealing arrangements that benefit the manager may turn a “non-terminable” management contract into one that is cancelable due to breach of fiduciary duty. One of the best ways to ferret out improper arrangements is to review all vendor contracts, including all that were negotiated at the “corporate” level. Hotel operators routinely receive bulk discounts, rebates, and other benefits from vendors. Third-party management agreements should spell out in reasonable detail whether and to what extent the operator may “use” or “profit from” the hotel owner’s property, and most sophisticated owners and asset managers carefully review management company charges against provisions in the management agreement. When the hotel management agreement is silent on the issue, however, the owner should perform its own operational audit to determine whether the manager is properly upholding its fiduciary status.

Franchise agreements in the hotel industry, as in other industries, are also regulated and governed by various statutes. Therefore, the agreements are quite standard. Key provisions of interest, other than the term and fees that must be reviewed in due diligence, are the existence and scope of any transfer restrictions, radius restrictions, and estoppel provisions (because the lender will want some ability to obtain certain assurances from the franchisor).

Personal Property

Personal property plays a more important role in hotel transactions than in most real estate deals. The day after the closing, the client will want to make sure that the guests will have beds to sleep on and televisions to watch. To defray capital costs, hotel owners and developers sometimes will lease personal property rather than buy it. Obviously, whether certain property is owned or leased makes a difference as to

• the purchase price,

• the allocation of the purchase price between real property and personal property,

• the transferability of the personal property, and

• the extent of the financing that can be obtained for the acquisition.

Special Zoning Considerations

Because many hotels and resorts are in unique locations, there may be special zoning issues, such as

• coastal development and ownership restrictions,

• off-site parking requirements,

• the higher probability of legal nonconforming use, which can limit renovation and expansion, and

• historic landmarks.

National Service or Supply Contracts

Hotel management companies often negotiate system-wide contracts for certain services, such as pest control, cable or satellite service, and long-distance telephone service. Historically, management companies were unwilling to disclose the full financial terms of these contracts to owners and potential purchasers and would provide only the basic charges allocated to a particular hotel. Now that full disclosure by the agent to the principal is so clearly in the public’s mind, it has become easier to receive and review such contracts.

Concessions

Certain operations at the hotel may be contracted out to independent contractors. In addition to the more obvious ones, such as valet parking and the gift shop, the contracts should be reviewed for providing entertainment or various leisure activities, such as beach sports and excursions.

Often a hotel or resort is located adjacent to a golf course that the resort does not own or control. Careful review of any agreements governing the resort’s rights to secure tee times is vital if it is important to the purchaser that the property provide this amenity. Issues to watch out for are the number of guaranteed tee times, how far in advance they must be released back to the club for assignment, and what ratio the hotel’s allocation of cost bears to the number of tee times allocated to its use.

Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR Act)

In 1996, the HSR Act was amended to exclude the acquisition of a hotel or motel, its improvements, such as golf, swimming, tennis, restaurant, health club or parking facilities, and other assets incidental to the ownership and operation of the hotel or motel, from the requirements of the HSR Act. 15 U.S.C. §§ 15c-15h,18a, 66 (2003). See Raymond J. Werner, Antitrust Relief Comes to Major Real Estate Transactions, Probate & Property (Jan./Feb. 1997), at 4. Before its amendment, the HSR Act required notifications to the Federal Trade Commission and Department of Justice of business combinations, mergers, and sales of businesses involving transactions meeting various thresholds of value and revenues for antitrust compliance purposes. Because hotels were considered businesses for the purpose of notification without a specific exemption, many transactions needed to be reported when no real risk of market dominance existed. Note, however, that ski facilities and gambling casinos are excluded from this exemption. So there still may be resort acquisitions that require compliance with the HSR Act.

Conclusion

From even this cursory review of employee, insurance, management, agency, and licensing issues inherent in most sales of hotel or resort properties, it is clear that practitioners representing clients involved in such transactions will need to have particular expertise not customarily required for purely real estate transactions. Other aspects of dealing with hospitality property will be covered in a forthcoming issue of Probate & Property.