Strange Bedfellows: Hotel Owners and Managers as Partners
 
October 1, 1999
 
James M. "Jim" Norman- Ft Lauderdale

It is said that politics makes strange bedfellows. Politics has nothing on the hospitality industry.

Within the hospitality industry, the most complex, if not the strangest, relationship is that which exists where the hotel manager also is a partner in the ownership entity of the hotel. This relationship was born of the necessity to create an agency coupled with an interest, so that long-term management contracts will not be terminable at-will by the owners, thereby avoiding the outcomes of the Embassy Suites, Marriott, and Scopbank cases.

The problem that results from this strategy and structure, however, is that the legitimate business interests of the manager, in its capacity as the manager under the management agreement, are often at odds with the interests of the other partners in the ownership entity, including, in its capacity as a partner, the manager itself. To have even reached this point, the parties have necessarily successfully negotiated a management agreement and a partnership or joint venture agreement dealing with such thorny issues as: structure of management fees, the annual budget process, performance standards for the manager, management agreement termination rights in favor of the owner in the event of a sale, reflagging rights, capital expenditures, capital call responsibilities and limitations, and transaction exit fees for various parties. Each of these issues, and numerous others, should have been concurrently negotiated as management agreement issues and, as major decisions (being those requiring the consent of all or a supermajority of all of the partners) in the joint venture. This is not an easy task, since the customary provisions of a partnership agreement on these points are not normally complicated by having the party against whom protection was intended having a vote on whether or not the action should be taken, and if so, when and how.

The relationship between and among partners is legally and practically different from that of principal and agent, the basic relationship between owners and managers. Therein lies much of the problem. Partners are clearly fiduciaries of each other, owing to each other the highest duties of care and disclosure with respect to business activities. Any exception must be clearly delineated in the partnership agreement, which, by its execution, amounts to acceptance by all partners. Principals and agents, in the abstract, are supposed to have, in the case of the agent to the principal, a fiduciary relationship. However, the interpretation of this relationship and the extent to which they are fiduciaries varies considerably from jurisdiction to jurisdiction, and the law does recognize the commercial overlay in situations where, such as in a hotel, the agent is providing certain services to the principal on a fee basis.

The law does not yet provide much assistance in dealing with operational financial matters from which a manager may legally be entitled to benefit, such as retention of rebates and competition arising from the acquisition of competing brands in a geographic area otherwise protected in the management agreement. In contrast, a partner's fiduciary constraints would, in most situations, prohibit these. Under many management agreements, depending on the jurisdiction whose law governs the management agreement, retention of rebates and competition by brand acquisition may be something permitted to a manager. Even where the partnership agreement permits the manager-partner to block a termination, the manager's vote to do so may be a violation of its fiduciary obligations to the other partners. Look for these issues to generate the next wave of cases that will transfix the attention of the hospitality industry and send lawyers off to devise and draft contract provisions to avoid the effect of these soon-to-come court opinions.

Managers often try to further reduce the fiduciary nature of the relationship by drafting contract language describing their relationship with the owner as that of independent contractor. The extent to which these matter, if at all, is one of a small degree, given the nature and extent to which the manager of a hotel manages and deals with the owner's funds, employees and property, and has the ability to incur significant liabilities to the owner. This is the stuff of which disputes and terminations are made.

The key to avoiding a "train wreck" scenario is the setting forth of all business issues, whether management agreement-related or partnership agreement major decisions-related, at the beginning of the negotiations and as part of the concurrent negotiation of both documents. In each case, a threshold determination is whether monies (management fees) flowing to the manager do so as the result of the performing of services under the management agreement (whether base fee or incentive), or whether the funds represent a return on, or return of, the cash investment made by the manager in its capacity as a partner.

In the current market, managers often attempt to structure their "equity contribution" as the "last money in," or "to only be paid in if required for operating capital." In most cases, the base management fee, set at a level consistent with the market, is paid as a priority. The mechanics of the incentive fee, especially where it is based on a "return on owner's equity formula," or on a lofty gross or net operating income threshold, is in something of a conflict with the return to the partners, which now includes the manager. An equitable resolution may be determined by whether other partners are taking fees such as development fees or asset management fees. In any event, it is an issue to be dealt with carefully at the beginning of the relationship and not first hammered out when a problem with the hotel has occurred.

Similarly, the supremely important annual budget process may present a conflict between what the manager wants to accomplish as an enhancement to its management fee, or in some cases, its entire licensed hotel system, versus the capitalization and net operating income preferences of the owner. This is a place where dispute potential is very high, and careful negotiating and agreement drafting are essential. It is also, depending upon the relative size of the manager's investment (which in practical terms says whether the manager is mostly a manager and only marginally a partner, or is a real partner with a significant economic stake in the ownership entity), where a pre-approved third-party arbitrator or mediator, who resolves disputed budget issues, may be an effective procedure. If the manager's stake is minimal, however, the use of such a third party may have the effect of encouraging disputes, rather than forcing the parties to resolve them in a practical, fair and business-like manner.

Another troubling area in this complex relationship is that of manager performance standards and the right of the owner to terminate the manager for its failure to meet defined performance standards established in the management agreement. Performance standards, management agreement term, termination on sale, and default remedies are all incendiary issues in the negotiation of a management agreement. Purely numeric or formulaic standards may not appropriately evaluate whether the manager is doing a good job in a down or overbuilt market. Accommodating a potentially unfair result can be done with provisions designed to evaluate the manager against relative performance standards, often based on a competitive market set. This approach only works with a carefully selected set of same-market and similar-product competitors, with a pre-established method of periodic revisions and updating. When the manager is also a partner and an owner, it is not only a contentious issue, but one which is a major impediment to resolving the partnership agreement. An in-depth discussion of performance standards is outside the scope of this article.

Termination of the management agreement, because of a default with respect to compliance with performance standards or as a result of a sale of the hotel, creates the need to deal with the manner of the manager's exit from the partnership. There are a number of potential solutions to compensating the manager in the event that the manager's income stream from the management agreement ends prematurely. The manager's first choice would be a requirement for unanimous consent of the partners before a sale of the hotel could occur. For the other partners, who will likely constitute a super majority of the ownership partners, this is not going to be acceptable.

It is necessary to balance interests of the manager, who has equity money in the project in the expectation of a long-term management agreement, with one or more of the other partners, who may want to sell. Where the manager does not have sufficient voting power to prevent the sale from going forward, but has agreed to a termination-on-sale provision in the management agreement, some compensation is appropriate. The elements of provisions dealing with termination of the manager and the management agreement for either of these two reasons might include: a priority return of the manager's equity, together with the greater of what its interest is then worth by appraisal or by virtue of the sale; a minimum required return; a termination fee; or an appraised buyout, together with one or more of the other compensation elements. Dealing with a termination based on a default by the manager under one or more of the performance standards or other criteria of the management agreement is a very different story. Here, the management agreement should stand on its own, with a mandatory "call" by the other partners of the manager's partnership interest, pursuant to a buyout formula in the partnership agreement. As the amount of the manager's equity contribution goes above what is sometimes referred to as "sliver equity" the more these issues will be dealt with in partnership agreement, rather than management agreement, provisions.

The object of all parties should be to have a successful project, with the manager and every partner treated fairly, given their respective investment, responsibilities and risks. Careful structuring of the transaction and drafting of detailed provisions of the management agreement and partnership or joint venture agreement dealing with these sensitive issues is the best way to assure that these "strange bedfellows" stay together.

________

Mr. Norman is Chairman of the Hospitality Group Steering Committee and practices in the Fort Lauderdale office. He can be reached at 954-468-7888 or at jnorman@hklaw.com.