In most cases, the negotiation of a hotel Management Agreement begins with the proposed Operator providing the Owner with a copy of its standard form Management Agreement. It would be a mistake for the Owner to be focusing its negotiating efforts primarily on the management fees, or to assume that the standard "boilerplate" clauses are non-negotiable, and fail to give careful review and consideration to the detailed terms of the agreement. The fact is even the largest hotel chains are generally prepared to negotiate, and those detailed provisions can take on tremendous importance over the operating life of the hotel.
For example, it is common for the initial draft of the agreement:
- To provide the Operator with a right to operate over a fairly lengthy term, perhaps with one or more lengthy renewal periods;
- To require that the Operator manage in accordance with its standard operating policies, but not otherwise impose specific performance benchmarks;
- To provide the Owner with little or no input with respect to the operations of the hotel.
If the Owner executes the first draft of the agreement he could find himself having little contractual ability to control cost overruns and to generally ensure that the Operator maximizes hotel profits.
The extent to which the Owner will be able to negotiate changes will depend on the market and the respective bargaining power of each party. In Dubai, for example, it is reasonable to assume that the tremendous level of interest and development in this City is a factor that lends strength to the Owner's position. Many hotel chains have been keen to expand their operations here. Some commentators have suggested, however, that as the number of hotel properties in Dubai continues to increase the competition for name brand hotels will become more intense and the pendulum could swing the other way. As one writer recently commented, "a single hotel brand can only be represented in any one destination with a limited number of properties... a destination such as Dubai can only sustain so many Fairmonts or Sheratons. "*
Regardless of the Owner's position at the time in question, it is worthwhile investing considerable effort at the negotiating stage to attain the best result possible. In paragraphs which follow, we will review some of the key issues to consider.
Duration (Term) of the Agreement
The initial draft presented by the Operator may offer a lengthy term with perhaps several lengthy renewal periods exercisable by the Operator. Ideally the Owner will want to negotiate for as short a term as possible (for example 3 to 10 years in length). Not only does limiting the length of the term provide a means of replacing the Operator if its performance does not meet expectations, it allows the Owner to limit its potential liability. The Owner may, for example, have to pay compensation to the Operator if it exercises a voluntary termination right. As we will see below, the amount of compensation paid may be dependant on the number of years left in the term.
Similarly, the Owner should try to limit the Operator's renewal rights if possible. The initial draft of the Management Agreement may provide for one or more lengthy renewal periods with the option exercisable by the Operator. Ideally, the Owner would prefer to be the party controlling the option. If the Operator insists on having the right to renew, a fall back position would be to make any renewal conditional upon compliance with a performance benchmark and the terms of the agreement generally.
Standard of Operation
The initial draft may require only that the Operator operate in full compliance with its own standards and policies. In the case of a large, reputable chain that may well be a respectable standard.
Nevertheless, the agreement should provide a specific performance benchmark.
In choosing a benchmark, it may be dangerous to refer to a particular brand name as that could potentially involve a varying standard over time. Instead, the Agreement could require that the Operator:
- operate within a standard equivalent to at least the top third of hotels (by room rate) in the relevant marketplace;
- meet a minimum forecasted profit level.
The second approach has advantages because it is clear and certain, and can be nicely incorporated into the default and termination clause (e.g., a failure to achieve the benchmark in two consecutive years would constitute an event of default).
Management Fees
The management fee will typically consist of two elements: a base fee (for example 2% of gross revenue) and an incentive fee (for example 9% of net profit). The base fee is usually the larger of the two because, while the percentage amount is lower, it is calculated on gross revenues. One could argue that a large base management fee provides a motivation for the Operator to maximize gross revenues whether or not that increases the costs and thereby results in a reduction of the net profits that would otherwise be realized. It can also be argued that the incentive fee rewards the management company for efficient and profitable management of the hotel. A possible strategy, therefore, is to try to keep the base fee as low as possible.
The Owner may also wish to exclude certain revenue producing areas of the property, such as the retail spaces and kiosks, from the Management Agreement in order to prevent the Operator from including those revenues in the calculation of its fee.
Fees for Design and Technical
The agreement may include provisions in which the Operator provides technical services on the design of the hotel and preparations for opening. This could involve the signing of a separate "Technical Services Agreement". The Owner, on the other hand, can take the position that the Operator should "throw in" as many of these services as possible as part of the basic services for which it has already been compensated. The outcome of this issue will likely come down to bargaining power.
Fees for Chain- Wide Services
Operators will usually try to charge a few percentage points of gross revenue for chain-wide services such as advertising and marketing. On the one hand, it may be more efficient to pay for the services on a chain-wide, rather than hotel-byhotel, basis and the Operator can potentially realize cost savings for the Owner.
On the other hand, there exists the potential for abuse. The Owner may wish to confirm that all parties benefiting from the chain-wide services are being allocated their fair portion of the costs, that the Owner is not being charged for services that provide no real benefit to it, and that the Operator is not passing down corporate overhead costs.
When it comes to negotiating the Agreement, the Owner can take the position that these fees should form part of the management fee and try to restrict them. Failing that, the Owner can at least seek to cap or minimize such additional charges. Once again, bargaining power may play an important role.
Expenses
As a general rule the Operator will try to obtain separate reimbursement (above and beyond the management fee) for as many expenses as possible. The Owner, on the other hand, should try to limit the extent to which these expenses can be reimbursed. The Owner can take the position that the management fee is allinclusive, or that certain specified expenses should be part of the Operator's cost of doing business. Failing that, the Owner can add insert a condition of "reasonableness" throughout the expense provisions.
Major Expenditures
The agreement should limit the Operator's right to make major expenditures whether of a capital or operating nature and even if "required by new laws ". These types of expenditure should require Owner approval, to allow the Owner to at least consider other ways to deal with any problem that may exist. The Operator will have a legitimate concern to ensure the Owner funds the hotel properly, but it is reasonable to impose limits and controls.
Reserve Fund
The Management Agreement will likely provide for the creation of a reserve fund for FF&E and capital improvements. This type of fund is both standard and necessary, but the Owner should ideally retain as much control over the fund as possible. The Owner should argue for exclusive control (with a requirement to give consideration to the Operator's recommendations) and, failing that, mutual control. It can be useful to stipulate in advance the amount to be paid into the FF &E fund (for example 3% of gross revenue with payments abating once a specified amount has been accumulated and not spent).
Complimentary Rooms and Services
It is a somewhat well known fact that the hotel and leisure industry can provide some favorable perks and privileges for employees and staff, including the occasional use of free hotel rooms and services. Although this practice is both common and accepted, it is important to carefully scrutinize the agreement with a view to minimizing potential abuse. For example, the Owner can require approval for any such arrangements beyond a certain level. A requirement of reasonableness and disclosure can be inserted throughout.
Similarly, if the Operator intends to offer complimentary hotel stays under a frequent visitor program, the Owner may wish to obtain disclosure of the policies before committing to any such arrangements.
Budgets and Financial Reporting
It is important to negotiate an obligation on a part of the Operator to prepare and deliver operating, capital expenditure and FF &E budgets and for the right of the Owner to review an approve them. The Agreement will also need to say what happens if the parties disagree on the budget. For example a simple dispute resolution process can be put in place, and a provision added that the amount approved for the line item in question in the previous fiscal year apply until the issue has been determined.
The Agreement should also include an obligation on the part of the Operator to provide a compete, detailed, accurate and timely of the hotel's financial results, which should be audited from time to time. It is based on these reports that the Owner of the hotel can establish how effective the Operator has been in its management of the hotel.
Books and Records
The Management Agreement should require that the books and records for the hotel be kept at the premises if at all possible. The agreement should also provide that all books and records be delivered to the Owner on termination and that the Operator should not keep copies except as required by law.
Staff
The Operator will generally have control over the selection, hiring, training and dismissal of employees. However, the Owner should try to retain a right to approve and dismiss the key positions: for example, the General Manager, Controller, Director of Human Resources, Director of Sales, and Food and Beverage Manager.
The Brand Name
The Management Agreement will include provisions whereby the Operator will grant the Owner a temporary license to the use of the hotel brand name. If at all possible, the Owner should take steps to ensure that if the Management Agreement ever terminates the Owner will not immediately and automatically face "the loss of the flag". For example, the Owner can request a temporary back up license to become effective on any termination of the Management Agreement for an interim period.
Non-Hotel Areas
To the extent the hotel includes any space that does not form part of hotel operations (e.g. retail units, kiosks, a public parking garage, a spa) the agreement should specify whether the Operator will be involved in operating that space and entitled to compensation. If the Operator will not be responsible, the Owner should include language to that effect in the Management Agreement and expressly remove the income stream from calculation of the Operator's fees. If, on the other hand, the Operator will be taking on responsibilities relating to nonhotel, the agreement should contain specific terms and conditions outlining what those responsibilities are. The Operator may, for example, take on responsibility for leases and licenses granted to the operators of retail units and kiosks in a retail mall area forming part of the hotel building. In this case, the Operator should expressly assume the responsibilities typically associated with management of such properties, including the securing of new tenants, collection of rents, and enforcement.
Lender Protection
In order to make the hotel more attractive to potential lenders, the Owner should ideally obtain a provision that will subordinate the Management Agreement (and payment of the management fees) to the lender's mortgage. This will ensure that, if an event of default were to occur, the lender would be able to collect its debt service prior to payment of the fees. The lender would also have the ability to terminate the Management Agreement after foreclosing on the property.
The Operator will almost certainly take the opposite position and require that any mortgages or encumbrances be subordinated to the Management Agreement. It may be necessary to run the proposed clauses by the lender if in fact a lender is already involved.
Limitation of Liability
The Owner should try to limit its liability to its interest in a hotel. In contrast, the Owner will not want the Operator's liability to be limited in any way.
The Operator may take entirely opposite positions on these issues. Owners need not, however, accept a no liability clause (protecting the Operator) simply because the Owner may routinely expect to see such a clause in other consultant / contractor type agreements. The Owner should at least try to ensure that the Operator is responsible for its default under the Agreement, gross negligence and intentional acts, and those terms are commonly found in the agreements.
Termination Rights
The Management Agreement should ideally provide a number of termination rights for the Owner:
- The Owner should of course be able to terminate for breach on the part of the Operator (and failure to remedy breach the within a reasonable period of time - e.g., 30 days);
- The Owner should be able to terminate if the Operator becomes bankrupt of insolvent;
- It is reasonable to insist upon a termination right in cases where the Operator has failed to meet a specified performance standard (see discussion on Standard of Operation, above).
- Depending upon bargaining power, the Owner may be able to include voluntary termination rights - for example a right on the part of the Owner to terminate upon sale or transfer of the hotel, or at any time on 6 months notice once a minimum period (e.g., the first 2 years of the term) has elapsed.
In the case of a voluntary termination as referred to above, it is customary for the Owner to pay compensation. This may, for example, involve payment of (x) multiplied by (y), where (x) is the Operator's average fees during the preceding 12 months and (y) is a period of time (e.g., 2 years). Item (y) may well be a point of negotiation between the parties, with the Owner obviously preferring a shorter period.
Non-Compete Provision
It is typical for the Owner to try to limit the ability of the Operator to operate a competing hotel within a certain distance from the hotel in question (for example, within a five 5 mile radius) so that the Operator does not have a conflict of interest. Without a non-compete clause, the Owner may find itself in the uncomfortable position of fiercely competing for customers with a hotel that is operated by the same operator under the same flag.
Conclusion
As will be apparent from the above, negotiating a hotel management agreement can sometimes be a lengthy and complex process. The initial draft provided by the Operator may provide little protection for the Owner on some key issues and there may be significant changes required. In the end, the time and effort spent during the negotiation process can be a wise investment indeed. A properly drafted Management Agreement can reduce the stresses of hotel ownership by allowing more control for the Owner over hotel operations and expenses and thereby, hopefully, helping to improve the bottom line.
Mark Doucet
© Al Tamimi & Company 2005
