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The Ten Hot Management Agreement Issues in Asia
In our view the ten hot issues are:
1. Sign Them Up: There is frenetic activity by many operators in many jurisdictions to sign up management agreements.
2. No Leases Thanks: Operators like management agreements and dislike leases.
3. In For The Long Haul: It's getting harder to prematurely terminate an operator without cause.
4. No Termination: It's also getting harder to terminate an under performing operator.
7. The Retail Market: Developers are moving heavily into the retail market (eg Condo Hotels) with enhanced risk.
8. Brand Leverage: Savvy operators are leveraging brand value (eg branded residences and brand partners).
9. Brand Standards: The Brand Standard is increasingly becoming the benchmark for CAPEX spending.
10. Agency Out: Operators are moving away from "agency" relationship with owners to minimise complications (eg obligation to disclose "secret" profits).
We will now discuss each of these in greater detail.
1. Frenetic activity by operators
Most major multi-jurisdictional operators have unprecedented expansion plans throughout Asia. However, this does not mean that operators are prepared to take a soft approach to negotiation. In fact, we are seeing just the opposite.
2. Operators like Management Agreements and dislike Leases
With management agreements the business risk relating to the operation of the hotel usually rests with the owner of the hotel. On the other hand, with leases, the business risk usually would rest with the tenant which, in a hotel context, would mean the hotel operator.
Generally speaking, operators are risk averse and are resisting being responsible for any aspect of the business risk associated with a hotel. Interestingly leases remain the norm in Japan, and this will be discussed in the next edition of the Newsletter.
Usually a hotel operator's desire or willingness to take on business risk in relation to a hotel is directly proportional to the attractiveness of the hotel to the operator. For example, if a hotel is perceived to be a "trophy" hotel, then an operator will be more likely to accept a requirement to take on business risk. Allied to this is the fact that predictability of revenue and profit tends to be fairly strong with a "trophy" hotel.
These income guarantees can either be provided as an absolute commitment on the part of the operator or on a "stand aside" basis. In the former situation if a guaranteed payment is made then there is no ability on the part of the operator to have the monies refunded to it at some later stage. On the other hand, in a "stand aside" situation the monies are effectively loaned by the operator to the owner and are capable of being repaid to the operator in certain circumstances over the remaining life of the contractual arrangement.
For operators, tenure is the name of the game. Operators want to ensure, to the maximum extent possible, that when they enter into a contractual arrangement with an owner, little scope exists for the agreement to be terminated before its full term has expired.
Traditionally, owners were able to negotiate provisions which entitled them to terminate at any time during the life of the management agreement without cause. It is becoming extremely unusual to find such provisions except in relation to "trophy" properties. If an operator is prepared to agree to such a provision then the amount of the termination fee required is becoming increasingly larger. Previously, operators were prepared to agree to a termination fee which was usually an amount which equated to three to five years' fees. We are now witnessing situations where the fee that the operator requires in consideration for giving the owner this right is the discounted present value of the management fee income stream for the balance of the term.
It has also been relatively common to find a provision which allows an owner to terminate the management agreement on the sale of the hotel. Whilst these provisions continue to be significantly more common in management agreements than without cause termination provisions, operators are hardening their position and the opportunity to end up with such a provision in a management agreement is becoming that much more difficult to achieve. If an operator is prepared to agree to such a provision then more often than not it is not available to the owner for an initial period (usually up to five years from the commencement date of the management agreement).
The usual actual to budget provision provides that the owner will be entitled to terminate the management agreement without compensation if actual performance falls below budgeted performance by a specified percentage (which is normally in the 80%-90% range).
The actual performance to budget test has the following problems:
The usual REVPAR test provides that the owner will be able to terminate should the revenue per available room (REVPAR) fall below a specified percentage (usually in the 80%-90% range) of the average REVPAR for a number of specified hotels which form the competitive set for the hotel.
The REVPAR test has the following problems:
In our experience the current crop of termination provisions which relate to under-performance contain so many qualifications and carve-outs that, in a practical sense, owners are unable to terminate the operator under these provisions.
5. Owner sale provisions
These provisions allow for changes in the economic control of the hotel either by a sale of the hotel itself or a sale of majority interest in the ownership interests of the entity (eg company, trust or limited partnership) which owns the hotel.
It is usual for operator approval to be required on an arms length sale. Increasingly this is creating issues where the owner or the ultimate holding entity of the owner is publicly listed. In such circumstances it is impossible for the owner to prevent a change in control (eg as a consequence of hostile takeover) and hence find itself potentially in breach of the management agreement and subject to a claim for damages.
Conversely, and amidst the current buyout activity, operators are seeking to maximise the ability to acquire or be acquired without any need to consult with, or seek the approval of, the owner. Accordingly, from an owner's perspective, the operating company it is dealing with on the day the management agreement is signed, may become a different operating company during the life of the management agreement with the owner being powerless to do anything about it.
Operator attitudes to non-disturbance agreements (NDA) are definitely hardening. An NDA is an agreement between the owner, the operator and the owner's financier which brings the financier into a contractual relationship with the operator. The purpose of an NDA is to prevent the financier from dealing with the hotel in a manner which ignores the contractual rights the operator has under the management agreement. Also, the financiers may want to ensure the operator continues to manage the hotel if the owner defaults under its financing arrangements. An NDA can adversely impact on the financier's ability to maximise the sale value of the hotel because the NDA usually requires the financier to sell the hotel subject to the management agreement (when a higher sale price could be achieved through a sale unencumbered by the management agreement).
Operators increasingly are placing an absolute obligation (as opposed to using reasonable efforts) on owners to obtain an NDA in the operator's prescribed form, even if the operator was not providing any financial contribution to the owner. Until recently it was relatively easy to convince an operator not to require an NDA in circumstances where only on-going management fees were at risk.
As a consequence of the operator's hardening position, negotiations are focussing on identifying circumstances where the operator would be prepared not to insist upon an NDA. These "carve-outs" can take a variety of forms but relate to the identification of the financier being an institutional bank or other form of institutional organisation and a specification that the loan to value ratio be below a specified percentage (usually around 75%).
Financiers too are adopting a harder line in relation to the obligation for an NDA and the provisions which the financier wants in the NDA to protect its position. Needless to say, the positions taken by the operator and the financier are usually diametrically opposed and can end up leaving the owner (and its tireless legal advisers) as the "meat in the sandwich" trying to broker a compromise between two warring factions.
NDA's are also an issue when viewed from the perspective of the sale of the hotel, as the management agreement not only imposes an obligation on the initial owner's financier but any financier to a future assignee of the management agreement. Care needs to be taken to ensure that the terms of the NDA
7. The retail market
For more information on this specialised class of hotel product, please refer to the article on condo hotels in an earlier edition of the Newsletter (if you would like us to forward a copy of this Newsletter to you then simply send us an email).
8. Leveraging brand value
Savvy operators are leveraging brand value in a number of inventive ways including:
Brand leveraging potentially imposes restrictions on owners which need to be understood:
9. Brand standards
Increasingly the operator's Brand Standards for the type of hotel with which the hotel is intended to be branded are the benchmark for CAPEX expenditure (as opposed to determining CAPEX expenditure by reference to the hotel's competitive set or some other form of external comparison).
This approach raises a number of compliance issues for owners which can be illustrated as follows:
Increasingly management agreements provide for termination by the operator in circumstances where the owner fails to comply with the Brand Standards. Whilst such a provision is understandable from an operator's point of view to ensure brand integrity, this obligation can be particularly difficult with condo hotels as discussed in our previous newsletter referred to above (due to the difficulty in collecting CAPEX funding from retail investors).
Before leaving this topic it should also be noted that there remains an on-going conundrum as to how to adequately and effectively deal with issues and disputes which arise between owners and operators as to whether Brand Standards have been complied with in a particular respect - particularly when failure to comply may result in termination of the management agreement by the operator.
10. The movement away from agency relationship
Traditionally the relationship between an owner and an operator under a hotel management agreement was based on agency. The operator managed the hotel as agent for the owner. In a significant number of jurisdictions the law imposes what is known as "fiduciary" obligations on an agent. These obligations would not apply if the agency relationship did not exist. In particular, the law imposes an obligation on the agent not to make any profit from its position as agent except profit which is properly disclosed to its principal.
Over the last ten years there have been a number of court cases, particularly in North America, where owners have sought to challenge the fact that an operator has made an undisclosed profit (eg through dealings with related parties or rebates etc arising out of purchasing arrangements).
This concept is particularly troubling to international hotel operators not so much because they want to make an undisclosed profit from their role as manager of a hotel but because their operations have become so complex that they cannot be certain that in all instances no aspect of their financial arrangements could be considered to be an undisclosed profit.
Some operators have sought to deal with this by putting in the management agreement words to the effect that any profit generated in such circumstances is deemed to be disclosed and therefore free from attack. It is not entirely clear whether this approach effectively deals with the problem from the operator's perspective.
Some operators have adopted a different approach and have taken the significant step of converting their relationship with the owners from a relationship based on agency to a relationship based merely on contract. In most jurisdictions, mere contractual relationship generally does not attract fiduciary obligations in the same way that an agency relationship does.
From an owner's perspective the change from agency to contract takes away a basic protection (ie the operator's inability to make a secret profit) and so consideration needs to be given to what wording needs to be inserted into the management agreement to ensure that problems do not arise between the owner and the operator over the term of such an agreement.
Contact: Graeme Dickson
Source: Baker & McKenzie
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