Typically, hotels operate under one of two different configurations. In the first configuration, the hotel is run by a management company that owns a prominent brand and that operates the hotel under that brand. A management company of this kind is often called a “branded manager.” The relationship between the branded manager and the hotel owner is usually governed by a detailed management contract. The contract is long and complex because the branded manager needs to protect its brand and assure that it will be able to operate the hotel in a way that builds the brand, or at least does not hurt it.
In the second typical configuration, the hotel operates under a brand that the hotel owner franchises under a franchise agreement. If the owner does not operate the property itself, then the owner may hire a nonbranded manager to run the hotel. These nonbranded management agreements tend to be shorter and less complex because the management company does not have its own brand to protect while operating the hotel.
Branded Management Contracts
The branded management contract creates a relationship that is rather unique to the hospitality industry. Under it, the management company brings with it an established brand that it owns, and it operates all aspects of the hotel in accordance with “brand standards” that the management company has established. To the guest, the hotel appears as though it belongs to the brand owner, not the hotel owner. The branded manager uses many programs to drive guests to the hotel, such as frequent guest rewards programs and branded marketing programs. Accordingly, most branded managers believe that they, not the owner, “own” the guests and their goodwill.
This relationship creates a natural tension between the hotel owner and the branded manager. The owner wants to save money and take advantage of the management company’s existing brand equity. The branded manager wants to spend the owner’s money to improve the product, ensure good service, and thereby increase brand equity. The tension is not unlike the tension between a franchisor and franchisee. The typical management contract reflects this: it is about as long and detailed as a hotel franchise agreement and a nonbranded management agreement combined.
In dealing with the branded manager, the buyer and seller of a hotel, and their respective counsel, should keep this natural tension in mind. The tension influences most issues that arise between an owner and the management company, including issues that arise in the sale context.
An initial question for the prospective buyer is whether the brand is the right brand for the hotel. If not, the buyer will buy the hotel only if the branded management contract is terminated. The buyer and seller must determine whether there is a way to effect the termination, and the buyer will need to plan for the transition. If the brand is right for the hotel, then there may still be an opportunity to renegotiate some of the management contract’s terms.
Can the Branded Management Contract Be Terminated? If the buyer wants to rebrand the hotel, then the parties need to look at the management contract to see if there is a basis for termination. Some branded management contracts have a termination-on-sale clause, often exercisable for a price. If so, the path to termination and the cost should be apparent. If there is no termination-on-sale clause, then the parties should evaluate any performance clauses in the contract. Branded management contracts often have such clauses, which allow for termination if certain performance levels are not achieved. Given the very negative economic environment the last few years, there is a good chance that the performance requirements, if any exist, have not been achieved. Buyer’s counsel should check for time deadlines within which the right to terminate must be exercised that could affect a closing timeline. Counsel should also check any force majeure clause that could allow the branded manager to claim it is entitled to relief from the performance clause’s requirements.
If there is no apparent right to terminate, other potential contract breaches may provide a way to encourage termination. For example, is there an exclusive territory provision that may have been violated by the branded manager’s recent opening of a new hotel in the vicinity of the subject hotel? Even if there is no exclusive territory provision, is the new hotel potentially or actually competitive? If so, the management company may have breached agency and fiduciary duties. If the right to terminate is tenuous or absent, the parties may still want to approach the branded manager to “talk about the future.” The management company may have come to the same conclusion as the buyer—that the hotel belongs with a different brand. A negotiated termination might then be possible.
Can the Branded Management Contract Be Improved? If the buyer concludes that the existing brand is right for the hotel, the buyer should nevertheless look to see if the terms of the management contract can be improved. In a sale context, the branded manager is often concerned that the buyer will be a competing branded manager. The buyer who wants to maintain the branded manager may use the branded manager’s concern as a way to renegotiate key provisions of the management contract. If there are grounds for termination, then the leverage to renegotiate will be enhanced. For example, the buyer should consider whether the terms of the following clauses need improvement:
• Fees—Does the fee structure provide adequate incentives for good performance? Are the fees reasonable in the current environment?
• Budget Controls—Does the contract allow adequate control over the budget and performance under it? As noted above, there is a natural tension between the owner and the branded manager: the owner wants to save money and take advantage of the management company’s existing brand equity; the branded manager wants to spend the owner’s money to improve brand equity. This tension often plays out in the budgeting process. Making sure that the budgeting provisions provide a balance gives some basis to push the budget in the desired direction.
• Performance Clause—Does the contract set out performance goals that encourage the management company to stretch and that allow for termination if it fails to reasonably perform? There are a number of ways to structure these clauses. Most frequently, they compare the hotel’s performance with its “competitive set.”
• Termination on Sale—Does the contract give the owner the right to terminate if the hotel is sold? Other branded managers are often the most logical buyers of hotels. If there is no right to terminate on sale, then there will be a smaller pool of buyers when it comes time to sell the hotel.
• Corporate Marketing and Operational Programs—Does the contract limit the management company’s right to impose new programs or charge for them? Hidden fees, corporate programs, centralized services, and rebates are all current hot topics. The programs sometimes have questionable benefits for the hotel, and so attaching some strings, if possible, could be worthwhile.
• Territory Protection—Does the contract limit the management company’s right to run another, potentially competing hotel in the neighborhood? If there is territory protection, the language should be examined carefully. Branded managers often own many different brands or own, manage, and franchise hotels. Is it important to have protection from each of these activities? Sometimes no protection is better than just a little. A branded manager has certain fiduciary duties not to compete, unless the contract provides permission to compete. The owner may be better off relying on these protections rather than accepting a very truncated or toothless territory provision. Silence may be golden by comparison.
Negotiating a New Branded Management Contract. If the buyer will be terminating the existing branded manager and has chosen another branded manager to take over, a new management contract will need to be negotiated. Do not underestimate the amount of time it will take to negotiate and reach agreement on the issues. Branded management contracts are long, detailed, and usually written in favor of the management company. But because most branded management contracts are the stock in trade of the branded manager, it is often willing to negotiate freely over the terms of the contract.
In addition to the clauses discussed above, consider also the following two topics:
• Dispute Resolution—Is the venue and dispute resolution process acceptable? Arbitration provisions often work to the benefit of the management company, for a variety of reasons. Mediation provisions, however, tend to benefit both sides by encouraging early settlement.
• Property Improvement Plan—The branded manager typically wants the owner to spend money to improve the property and enhance the equity in the brand. The tension between the interests of the owner and the branded manager will make this negotiation a give-and-take process.
Indemnity Provisions—A Red Herring? Most management contracts prepared by managers state that the owner must indemnify the manager for all claims arising from the operation of the hotel, unless the claim arises from the manager’s actions in breach of the management contract or from the manager’s “gross negligence or willful misconduct.” Inevitably, the owner asks why the owner should indemnify the manager for the manager’s ownnegligence.
The issue is not as tough as it may seem at first. The most useful example to get to the bottom of the issue is guest slip-and-fall claims. Owners usually recognize that guests can get hurt and make claims such as this, usually asserting that the manager was negligent. Owners always insure against these claims. Owners do not often suggest that the cost of this insurance should be borne by the manager. They recognize that negligence claims are a risk of ownership. For this reason, they should realize that they already are paying for the risk of the manager’s negligence, and this is as it should be.
Furthermore, the owner’s indemnity for the manager’s negligence is intended to dovetail with the owner’s insurance. If the management contract’s indemnity clause were to exclude claims arising from the manager’s negligence, then the owner’s insurance carrier could argue, when a claim of negligence arises, that the insurance does not cover the manager because the owner is not liable for the manager’s negligence. As a result, excluding indemnity for the manager’s negligence can result in the carrier’s getting off the hook for claims intended to be covered by the insurance.
This analysis usually brings the discussion to the question of who should be liable for negligence claims if there is no insurance. The extent of insurance coverage is almost always determined by the owner. If there are gaps in the insurance, they are there by the choice of the owner, not the manager. This fact, together with the fact that the cost of the insurance is admittedly an owner’s cost, suggests that the liability for uncovered negligence claims should be left in the owner’s column. For these reasons, the manager’s position usually does not seem as unreasonable as it may first appear.
Transition Issues. If the branded management contract is to be terminated, transition issues may need to be addressed. If the buyer plans to engage another branded manager or to franchise a brand and engage a nonbranded manager, then that manager will likely be willing and able to handle many of the transition issues. If the buyer plans to manage without the aid of a management company, the existing branded management contract should be examined. It will normally contain specific provisions about the parties’ responsibilities upon termination or expiration of the contract. The issues raised by any liquor license involved in the hotel’s operation should also be considered as discussed below.
Nonbranded Management Contracts
Most of the unique attributes of a branded management contract do not exist in nonbranded management contracts. The nonbranded manager usually does not have its own brand to protect, and the hotel’s guests usually are unaware that the nonbranded manager is even involved. As a result, the nonbranded manager acts more like a simple agent of the owner and should approach the nonbranded contract with much more flexibility.
If the buyer does not want to keep the management company, it should insist that the manager be terminated at the closing. If the nonbranded management contract does not have a termination-on-sale clause, the costs of termination should rest with the seller.
If the hotel is franchised, what does the franchisor think about the management company? Are there other nonbranded managers that are better able to deliver results under the franchised brand?
The nonbranded management contract should give the owner significant control over all aspects of the operation, including budgeting, bank accounts, right to terminate on sale, right to assign the contract, right to terminate for inadequate results, and the right to terminate without cause (possibly for a reasonable fee). If the proposed fee structure is not at market, renegotiation will be necessary.
If new financing arrangements or a new branded management contract will be undertaken at the time of the purchase, the parties should not underestimate the time it may take for the lender and the branded manager to reach agreement on the terms of a subordination and nondisturbance agreement. Lenders and branded managers often start from completely different perspectives. The lender often thinks of the branded manager as just another unsecured creditor that can be brushed aside by foreclosure. The branded manager, however, usually believes that it is more in the position of a trustee because all of its actions under the management contract benefit the value of the hotel. The manager therefore concludes that it should make no difference if the lender has become the owner of the hotel—the lender should still pay for the branded manager’s work for the benefit of the lender’s property. These opposing perspectives usually take some time to resolve, unless the lender and the branded manager have worked through the issues on other deals.
“System License Agreements”—Franchise Agreements
As discussed above, a branded management contract is like a franchise agreement and a management agreement combined. Many of the issues arising between the buyer/seller and the branded manager apply to the relationship between buyer/seller and the franchisor. Once again, the first question for the prospective buyer is whether the brand is the right brand for the hotel. If the prospective buyer has not worked with the brand before, it should perform significant due diligence, which would include obtaining a current Uniform Franchise Offering Circular (UFOC) and reading it; contacting other franchisees of the brand to find out what they think of the brand, its future, and the character of the franchisor; and asking what significant challenges face the brand. Furthermore, if the buyer does not know the hospitality industry or the brand very well, it should engage a qualified, experienced consultant to help decide on the brand positioning of the hotel.
Terminating the Franchise Agreement. If the buyer determines that the brand is not good for the property and that it will buy only if the franchise is terminated, then the buyer and seller will need to determine whether there is a way to effect the termination. The options are quite similar to those recommended when attempting to terminate a branded management contract. Investigation for a termination-on-sale clause, performance clauses, and potential contract breaches are in order. Usually, the franchise agreement will call for liquidated damages if the agreement is terminated without cause. The damages are usually more than one would like to pay, but at least they suggest an outer limit on what will be required to accomplish the termination. If the right to terminate is absent or very costly, the buyer may still want to approach the franchisor to have the “let’s talk about the future” discussion. The franchisor may be willing to terminate the franchise agreement for some lower price. Because franchisors usually are in the volume business, however, it is less likely that the franchisor will be willing to terminate early without a significant fee.
Renegotiating the Franchise Agreement. If the buyer concludes that the existing brand is right for the hotel, then it should still determine if the terms of the franchise agreement can be improved. If there are grounds for termination, leverage to renegotiate will be enhanced. The buyer should then consider some of the points raised in the following section.
Negotiating a New Franchise Agreement. If the buyer has done its due diligence, has determined that the existing franchisor should and can be terminated, and has selected (after similar due diligence) a new brand, then it is worthwhile to check with existing franchisees and consultants to determine the extent to which the franchisor negotiates with potential franchisees. Some franchisors negotiate freely. Others are unwilling to negotiate at all. Also, a franchisor’s willingness to negotiate may change from year to year, depending on market conditions. If negotiation is a possibility, the buyer should consider in particular the following hot spots:
• Term of the Agreement—Shorter is better because it gives the flexibility to reposition if things are not turning out as planned.
• Termination on Sale—Does the contract give the right to terminate at a reasonable price if the hotel is sold?
• Performance Clause—If the brand is just not delivering, can the contract be terminated for a reduced fee?
• Termination Without Cause—Are the liquidated damages clauses tolerable?
• Corporate Marketing and Operational Programs—Does the contract limit the franchisor’s right to impose new programs or charge for them?
• Territory Protection—Does the contract limit the franchisor’s right to franchise, manage, or own potentially competing hotels in the neighborhood? If there is territory protection, look at the language carefully to make sure it is providing the protection needed. Competition from, for example, a newly built, similarly branded hotel nearby can be devastating.
• Venue—Many franchise agreements call for any dispute to be handled where the franchisor is located. If the right to arbitrate, litigate, or mediate in the hotel’s location can be achieved, the cost to resolve a dispute will probably be reduced.
• Property Improvement Plan—Very often, a new franchisor will require one. Because the franchisor often wants to spend more than the owner, the terms must be negotiated.
Sale of liquor often makes the difference between profitability and unprofitability. In every state, liquor sales are permitted only by entities that hold current licenses and comply with detailed regulations regarding changes in ownership. Although liquor sales are vital and depend upon complying with complex laws, liquor law compliance is a frequently neglected area in hospitality industry acquisitions. There is no good excuse, however, for neglecting liquor law due diligence. The downside of a real problem is at best red ink and loss of custom and at worst a botched deal. If it is a friendly acquisition, both seller and buyer have parts to play.
The seller’s first task is to provide information for a licensing audit. The buyer’s liquor law counsel looks at the seller’s licenses and the entity or entities that hold them, as would the regulatory agency in the licensing locale, and makes a determination whether any eligibility issues exist and whether all changes since licensing, or the last approved change, have been duly reported. If confidentiality considerations permit, counsel compares the information compiled from the seller with information held by the regulatory agency. Often discrepancies are found between information in the hotel company’s records and information on file with the agency. Such discrepancies usually require catch-up compliance tasks before the sale, with the cooperation of the seller.
The buyer must undergo a similar audit of its own organization. Buyer’s counsel is then in a position to estimate the document production load and time required to comply with the law in each licensing jurisdiction. If an entire chain is to close simultaneously, the longest pre-closing approval time line becomes the critical path.
Liquor law counsel’s review of the sale agreement should be early enough to introduce changes designed to avert problems. Depending on how and where the licenses are held, some technical requirements will be reflected in the buy/sell agreement, by addendum if necessary. Moreover, the agreement must assure that both pre-closing and post-closing management teams provide all pertinent information and all necessary signatures and fingerprints on the schedule needed for approval of the transaction. Providing this information often requires assent in advance to invasive personal disclosures to regulatory agencies by persons who were unaware of this obligation.
If the audits reveal eligibility or timing issues, counsel must devise strategies for preserving the deal. Work-arounds may include restructuring ownership of the license, two-stage closings accompanied by temporary concession agreements, blind trusts for “tied house” issues, and other devices, new or old, limited only by the resourcefulness of counsel and the needs of the parties.
Even if no work-arounds are necessary, counsel will shepherd the application through the approval process to assure compliance with transaction warranties and applicable liquor law. Finally, counsel puts the information adduced in achieving regulatory compliance for the transaction into a licensure database for accurate and timely maintenance of the licenses by the new owner.
Lender Requirements for Manager
Given the volatility of the hotel market, lenders and investors have been careful in lending and investing in hotel properties. The more traditional institutional lenders have been sensitive to the perception that hotels are suffering and some have been less than enthusiastic in investing in these types of properties. Those lenders that have committed to lend are mindful of the terms of their loan commitments and have paid close attention to the terms of the management contracts for the hotel properties. Lenders frequently ask themselves the following questions about the management contract. Is the manager required to make debt payments before paying itself its management fee? Has the manager agreed to a lock box? Has the manager agreed to apply hotel revenues in accordance with the lender’s cash flow priorities? Can a manager cure defaults to avoid an owner default under its loan documents? Can a lender terminate a manager’s rights upon a loan default? Can a lender terminate management upon foreclosure or deed in lieu of foreclosure? Otherwise, is there a nondisturbance clause in the subordination agreement? What rights does the owner or lender have over an operating budget; a furniture, fixtures, and equipment (FF&E) budget; or a larger capital expenditure budget? Are thesebudgets in the control of the manager? Who owns the operating revenue accounts and the FF&E accounts? Does the manager agree to let the lender hold or have discretionary authority over these accounts before or after default? Does the manager have a right to advance its own money to fund operations and make repairs and improvements to the property? Satisfactory answers to these questions may determine whether financing will be available.
Most managers are required by a lender to execute a subordination and attornment agreement to protect their rights in the event of a loan default. A lender will typically include language in the subordination agreement to protect it from liability for prior obligations of the owner/borrower (including payment of fees or expenses) and to permit the lender to modify its agreements with the borrower as it deems appropriate. The agreement will also likely permit the lender to exercise the owner’s rights to terminate the management agreement in accordance with its terms or, in the event of foreclosure or delivery of a deed in lieu thereof, to terminate the management agreement without cause. Furthermore, the agreement will likely provide that at any time after the lender has acquired title to the mortgaged property, the manager shall attorn to the lender and be bound by all of the terms, covenants, and conditions of the management agreement for so long as the management agreement shall be in effect, with the same force and effect as if the lender were a party to the management agreement.
Intellectual Property Issues
Most hotel contracts will provide that, as part of the sale, the seller shall be required to turn over to the buyer its operation and reservation records as well as sales information. This information is usually found in the form of computer data. The buyer might have difficulty in using these data because it will require the former owners or manager to deliver to the buyer proprietary software, and the right to use such software is typically excluded from the transfer of the hotel unless addressed by the parties.
Aside from the proprietary issues regarding management’s software, the buyer should also make sure that as part of the sale it acquires all of the rights of the prior owner to its hotel name, trademarks, and other similarly protected rights. The buyer should also consider whether there are other aspects of the hotel’s operations (for instance, restaurants, shops, golf courses, or other facilities with similar requirements concerning intellectual property rights) that it would want to acquire.
Because the purchase of a hotel is not only the purchase of real property but also the purchase of an existing business, the operational adjustments that are made at closing are one of the critical considerations for any buyer. Although typical items are prorated in most real estate transactions (including real estate taxes, personal property taxes, utility bills, and special assessments), consideration must be given to particular items that may be unique to hotels. Address the following issues in the purchase and sale agreement:
• The exact definition and time line of the proration period.
• Indemnification of the buyer from any claims resulting from the seller’s failure to pay prorated items.
• The specific items to be prorated, including security deposits together with interest thereon held by seller pertaining to any leases; prepaid rents and all room and other deposits and advance payments under booking arrangements and trade-out agreements; gift certificates for use of the property facilities; cash in the hotel operating accounts; revenue generated by booking of guest rooms and the provision of other services through and including the night before the closing date; and accrued and unpaid obligations of the seller and its manager under its salary and employee benefits arrangements in place as of the closing for employees whom buyer plans to retain.
• Arrangements for hotel guests to sign new deposit box or other appropriate receipts on the day before the closing for baggage, personal property, laundry, valet packages, and other property of hotel guests checked or left in the care of seller.
• The detailed definition of “taxes” and their allocation.
• Certified governmental liens and pending governmental liens.
• The date of transfer of utilities and the allocation of any associated deposits.
• All rents, charges, and payments under the leases, service contracts, and license agreements that are assigned to and assumed by buyer.
• Other costs, expenses, and charges that are or may become liens against the property.
Sometimes a buyer is obligated to purchase the inventory in the gift shops. A buyer should pay particular attention to items that may be obsolete once the closing takes place—such as logos of a former franchisor. A buyer should try to take the position that items in open cases or otherwise stocked in rooms are part of the ongoing operational supplies of the hotel included in the purchase price, not subject to additional payment by the buyer.
The imposition of sales tax on the sale of personal items is common in many jurisdictions. Because a portion of the hotel consists of personal property (room furnishings, beverage inventory, among others), these items are subject to the same sales tax as imposed on the sale of a particular item in a store. In those jurisdictions where sales taxes are imposed, there is often a “single sale” or a “casual sale” exemption from retail sales tax. This exemption typically applies to the single transfer of all personal property that is part of a nonretail sale in gross. In some jurisdictions, however, this exemption may not apply. If a seller fails to collect or cause a collection of sales tax when due, the seller is often liable, and in most jurisdictions where there is transferee liability, the buyer may also be liable for the payment of retail sales tax as well as any penalties that may arise as a result of failure to pay such taxes. The contract of sale should provide for certain covenants requiring the seller to obtain proof of payment of such taxes. In addition, the contract should include surviving indemnifications for failure to pay the required sales tax.
In addition to sales tax on the sale of personal property, other taxes may be due for hotel operations. These taxes include occupancy charges and local hotel taxes, which are based on the revenues collected by the hotel operator. The obligation to pay these taxes is also often binding on subsequent purchasers of the hotel properties even though they were for charges that accrued before the date of the transfer. The purchase and sale agreement should address the collection and payment of all sales tax, hotel accommodation tax or the equivalent, and any and all taxes for any employee required to be paid or collected by seller in the operation of the property. A buyer should request sales tax clearance certificates, if issued in the applicable jurisdiction, from the appropriate governmental authority, verifying that the seller (or the management company) has paid all required sales taxes, use taxes, and state unemployment compensation contributions or other taxes required of it as an employer for the property through the closing date. It would also be prudent to require indemnities that would survive closing for as long as the statutory period for the imposition of tax penalties remains open.
Local Jurisdictional Issues
It is typical for attorneys who represent clients purchasing a hotel outside of the state where the attorney practices to hire local counsel in the state where the property is located. Inquiries to be addressed to local counsel include whether the contract complies with local and state law; what is the proper timing and procedure for the payment and proration of real estate taxes; what is the procedure by which such taxes are paid to the local taxing authorities (for instance, are taxes paid in arrears or currently, and if in installments, what are the dates of such installments); what is the likelihood that the transaction will trigger an increase in the taxes; on what basis is the property assessed; is there any transferee liability that may be imposed for sales tax, hotel accommodation tax, or employment or other taxes; if any transferee liability is imposed, how does one obtain confirmation from the taxing authority that all the relevant taxes payable by the seller have, in fact, been paid; and whether there are any procedures to obtain a release from the taxing authority or whether there is a requirement or customary mechanism to hold back any funds at closing in connection with potential transferee liability.
Local counsel should request a letter from the relevant building and zoning authority that confirms the existing zoning classification of the property; that the use of the hotel is a conforming use within such classification; the absence of any zoning violations, including conformance or permitted nonconformance with height restrictions and setback requirements; and that the available on-site or off-street parking is adequate within the relevant zoning classification.
Local counsel should request a letter from the appropriate local governmental agencies stating that there are no building code or other violations in connection with the hotel. In addition, when contacting licensing or permitting agencies (such as the building department, health department, fire marshal, occupational safety office), local counsel should determine when each agency last inspected the property or amenity, obtain any written reports generated as a result of those inspections, and determine whether, as a result of the conveyance or as a condition to obtaining a new license or permit, the agency will require a new inspection of the property and its operations that might require retrofitting or upgrading of any of the property’s facilities.
It is customary to allocate the purchase price to the land (10%), improvements (70%), and FF&E (20%). Local counsel should advise about any special considerations in connection with the allocation (for example, real estate tax assessments, personal property tax assessments, personal property transfer tax).
If transfer taxes or mortgage taxes might be imposed, local counsel should so advise and provide information regarding any special rules that might allow the buyer to limit the payment of any mortgage tax or that might affect this aspect of the transaction.
Local counsel should also indicate any special title insurance endorsements that may be available or customary for the owner’s or mortgagee’s title insurance policy, any special escrow closing requirements, or any other issues unique to the purchase and sale of a hotel in that jurisdiction.
It would also be helpful for local counsel to review the existing licenses and permits and provide a list of what licenses and permits (and from what agencies) are necessary for the operation of the hotel and its amenities.
The sale of a hospitality property is a complex transaction requiring counsel well versed in the intricacies and eccentricities of such properties, including their management contracts, franchise agreements, financing requirements, liquor licenses, and taxation issues. With adequate knowledge of these issues, counsel can address these items and related issues first in the purchase and sale agreement and then throughout the closing process.