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.