Risk and reward in management contracts
The use of management contracts, in the hotel industry, is one of several ways of maximising return on investment for both operator and owner. While the relationship between the parties can be structured in a variety of ways, the starting position is that the operator (the manager) operates the hotel in accordance with specified operating standards (where relevant, its own brand standards) for a fee (usually a combination of a base fee calculated on turnover and an incentive fee calculated by reference to gross profits).
Typically, the owner employs the staff and is responsible for furnishing and maintaining the property. Crucially, the owner carries the risk of profit and loss, subject to the manager carrying out its obligations under the agreement.
This is to be contrasted with the position under a lease where the lessee bears the operational business risk. However, in recent years the distinction between management contracts and other forms of operating structures based on risk allocation have become blurred. Increasing use is being made of:
- leases with rentals based upon turnover; and
- management contracts where the operator guarantees minimum income levels for the owner.
Negotiating the agreement
The starting point is usually a standard form management agreement prepared by the management company providing the manager with the right to operate the hotel using its own operating standards, usually with little direct input from the owner. The extent to which a manager will be willing to concede changes to its "standard form" document will depend upon the balance of power between the parties, which can be influenced by:
- the nature of the property – is it a high profile property?
- the nature of the manager – is it a large and well capitalised brand owner?
- whether the manager is being required to invest capital in the hotel or the hotel owner/operator; and
- the fee structures.
A manager investing its own capital or whose fees are calculated by reference to hotel profit rather than turnover is likely to be less flexible – arguing that its interests and those of the owner are sufficiently aligned through the fee mechanism.
Chain services
Larger operators may provide a number of services in addition to basic management of the hotel including access to their reservations systems, marketing support, purchasing and insurance. The management contract should clearly state the exact scope of the services to be included within the basic management fee and those services which will be charged under a different payment structure. Misunderstandings can and do arise as to the basis on which such services are to be supplied. Recent high profile litigation involving Marriott's listing fees and purchasing rebates has highlighted the need for clarity and careful negotiation.
Where the agreement is silent, a manager acting as agent for a hotel owner (usually the case where the manager purchases on the hotel's behalf) owes a fiduciary obligation not to profit from its relationship unless such profit is disclosed and agreed (rebates and listing fees fall into this category).
Measuring delivery
While the manager operates the hotel in accordance with its own operating standards, it is unusual for the owner to secure more than a right of inspection on reasonable notice. Although the use of third party inspectors and mystery guests is sometimes provided for (at the owner's cost), performance is measured on the whole by reference to financial results. These include:
- performance against budget. The effectiveness of this measure depends on the owner rights (if any) to approve or review the budget;
- monitoring operating statistics such as REV PAR, percentage occupancy and average room rate; and
- assessing cost per reservation, comparing central and local reservations, and revenue generated through the different reservation mechanisms used by both hotel and operating chain. These are supplementary indicators rather than the main basis of assessing performance.
The bases on which fees are calculated may also have considerable influence on how the hotel is run - whether for turnover or profit. While a manager will look for a high proportion of its fees to be fixed or based upon turnover, an owner will want to maximise fee elements calculated by reference to gross profit generated to incentivise the manager to control costs and not to pursue high-volume, low-profit business. Defining "gross profit" carefully will be important as this is an area which could be open to interpretation and/or manipulation in certain circumstances.
Building in change mechanisms
Most hotel management contracts have a term of between10 and 20 years (including renewal periods). It is inevitable that there will be developments in both technology and management practices over this period which both parties may wish to adopt. However, unless the manager's remuneration is purely profit related, the owner will want the ability to consent to expenditure in excess of any agreed budget.
Where additional expenditure is required due to changes in the manager's operating or brand standards or are required to maintain a hotel's star rating, the ability to refer the issue to an independent third party can be inserted. In the case of large branded managers (such as Hilton and Marriott) reference to, and approval by, an owners' association may be used instead.
Termination
A well-drafted agreement should deal with the circumstances in which the relationship can be ended prematurely and the consequences of termination. Standard termination rights should apply in any event (un-remedied material breach, insolvency and non-payment), but other provisions may require more careful thought:
- change of control of the operator. A manager should be wary of agreeing to a broad ranging provision of this nature but will find it difficult to resist a provision permitting the owner to terminate where the manager is acquired by an operator with competing hotels within a specified geographical area; and
- termination for convenience. A long-term management contract can potentially reduce the value of the hotel asset since it will make the property unattractive to owner operators and to financial investors who have established relationships with other managers. Offering compensation, even on relatively generous terms, may be more than outweighed by the uplift in asset value. Owners are likely to find it easier to negotiate a compensation formula (typically one to five years fees or a an amount based on historic profits) upfront, particularly where there is competition for the property from potential managers. A well-advised manager unable to resist a provision of this nature should seek to restrict its application to sales to third parties.
Employees
In the UK and Europe, the owner will typically employ all staff, except for specified key managers retained by the manager. EU legislation governing the automatic transfer of employees on the transfer of an undertaking usually has limited application where the manager of a hotel changes or a new manager is appointed for the first time employees employed by the manager full time in the hotel arguably have a right to transfer their employment to a replacement manager or the hotel owner). However, developing case law in this area, differing national interpretations of EU legislation and the costs of getting it wrong make it essential that a well-advised manager seek appropriate indemnification from the owner against employee claims arising other than through its own default, and against claims that employees have automatically transferred to it under applicable EU or local law.
In other jurisdictions such as the US and Australia where equivalent legislation does not apply, there may not be an automatic presumption that the owner will employ staff. In such a situation, both manager and owner will wish to set out the basis on which staff are to be employed, the allocation of responsibility for employee benefits (including pensions), liability for employee claims and whether/how staff are to be transferred on termination of the agreement.
Insurance and indemnification
Since its interests in the profits of the business and potential earnings under the agreement are usually limited, a manager will wish to limit its exposure to claims from both third parties and the owner in a number of ways, including:
- wide-ranging indemnification from the hotel owner from claims from customers and third parties where these do not arise from the manager's default; and
- an obligation on the owner to take out appropriate insurances (or permit the manager to do so on its behalf covering the risks associated with operating the hotel) and to name the manager as an assured or beneficiary, if required.
Conclusions
Management Contracts govern a long-term association between manager and owner. While many agreements will be negotiated from a standard template agreement, it is vital that care and consideration is given to key areas relevant to the specific needs of the parties involved. While the inevitable focus of both manager and owner is on the core financial provisions, it is essential to consider whether other provisions are appropriate as drafted and whether bespoke drafting is required. Differences of jurisdiction, the balance of power and the nature of the services to be performed will influence the terms of the agreement.
Contact point
If you would like to find out more about how hotel management contract issues impact upon the hotel industry please contact the following partner from our CMS International Hotel Group: Richard Price, on +44 (0)20 7367 2066 or at richard.price@cms-cmck.com.
