Negotiating Hotel Management Agreements: Why Does It Take So Long?
January 14, 2008
Nina R. Eldred- Washington
James M. "Jim" Norman- Ft Lauderdale
Isn’t There a Better Way?
Hotel owners and operators disagree about many things. One area of universal agreement, however, is that the process of negotiating hotel management agreements and their related technical service agreements and license agreements takes longer than anyone believes it should. It’s not uncommon for the period from finalization of a letter of intent and term sheet to signing the definitive agreements to be six months, and sometimes longer.
Is there something inherent in the nature of these agreements that consumes so much time? Is it the sport of negotiation for points? Is it a conspiracy among lawyers and consultants who are rewarded when the process drags on and on?
If everyone (yes, including the lawyers) thinks that the process should be much shorter, why are these transactions not concluded far more rapidly? If the parties have agreed on a term sheet, why does translating the term sheet into definitive agreements take so long, especially when the operator is using its “standard form” (which the owner or its counsel is often familiar with) and when experienced industry professionals and counsel are involved in the process?
To be sure, a hotel management agreement (and the related agreements) are complex, long-term agreements involving properties often costing tens of millions of dollars with management and fees also involving millions of dollars. No one disagrees that these are important, complex and highly detailed agreements. In addition to the increased legal and consulting costs involved in a protracted process, the delay in finalizing the management agreement may create lost opportunities for both the owner and the operator. There is also a risk of “missing the market” and having construction costs or new government regulations cause significant project cost escalations. Finally, there is the potential damage to the relationship between the parties after months of contentious negotiations. The solution to this quagmire is that both sides need to be highly motivated and committed to accelerating the negotiation process as much as possible. This commitment creates a mutually beneficial relationship in which each party’s interests are aligned.
Analyzing the Process
An analysis of the process for drafting and negotiation of the term sheet and the definitive documents illuminates some of the problems. Generally, the operator submits its standard form term sheet containing the operator’s desired terms. This will include, as a general rule, base and incentive management fees, a long initial term and multiple extension terms, a conservative (in the owner’s view) performance test (if one appears at all), significant limitations on sale termination, coupled with a large termination fee and a small area of protection with respect to only one of the company’s brands. The owner, on the other hand, wants low base and incentive management fees with a ramp up, a much shorter agreement term, much larger area of protection, an aggressive performance test, and the ability to terminate the operator in the event of the sale, for a modest fee.
The parties (sometimes with counsel, sometimes without) then proceed to negotiate these business terms, incorporating the result of their negotiations in a term sheet. It is at this point that a cause for delay is infused into the process. Both sides want to expedite the signing of the letter of intent and term sheet. Driven by that intention, a number of the more contentious terms and particular details, are deferred or left in a general or vague state, with the parties thinking that “we’ll work that out in the definitive
agreements.”
In our recent Hospitality Alert entitled “Zen and the Art of the Letter of Intent” (Holland & Knight, July 2, 2007), the need to have critical terms set forth with precision, clarity and detail in the term sheet is stressed. Certain accounting terms, which may appear to be minor items that can be negotiated later, actually reflect major business points. Another “detail” that can bedevil the negotiation process arises when a mixed-use project has been designed only to the programmatic stage, and it thereafter becomes apparent that the developer’s vision of the project and the operator’s vision are quite different. This can arise when a developer is building a hotel only as a vehicle to sell real estate while the operator has in mind a hotel that will be a credit to its brand.
Following the execution of the letter of intent and term sheet, the operator normally has its counsel provide a draft of the management agreement to the owner. The operator’s standard form of agreement is intended to be protective of the operator and the brand while recognizing the owner’s interest in the bottom line. The owner and its counsel are primarily interested in the economics of the hotel project and in not turning over too much control to the operator, while being somewhat mindful of the operator’s need to maintain the integrity of the brand (the brand being one of the main reasons the owner chose the operator to begin with). Each side has a different view of how these goals should be achieved in the management agreement, with the owner believing that the operator’s form agreement is slanted too strongly in the operator’s favor, protecting the brand at the expense (literally) of the owner, while the operator often feels that the owner wants too many controls over the running of the hotel and is willing to sacrifice the integrity of the brand for the owner’s short-term economic gain.
Resetting Expectations
As the owner’s counsel reviews the initial draft of the agreement and provides comments, it is often the start of the respective counsel heading out to the football field to start “the game.” If the owner’s counsel views the ball (the initial draft) on the 30-yard line, the objective of the owner’s counsel in the redraft is to move the ball to the opposite
30-yard line. Many counsel believe that this is what the client expects of them. In addition, some counsel (on both sides) seem to forget that lawyers are no longer paid by the word nor are they still in law school, where they receive credit for each and every point raised, regardless of its materiality. In addition, technology which should and often does help to expedite the drafting process by providing quick ways to make revisions, check cross references and avoid unintentional drafting errors, often aids in the protracted negotiations, as it has become too easy for counsel to simply redraft a document in its entirely rather than raise conceptual issues for discussion. In co-opting the drafting, in addition to revising substantive points, counsel can pepper the document with countless phrases and provisions in its arsenal such as “subject to the annual budget,” when there may be no direct correlation to the annual budget; “notwithstanding anything to the contrary,” when neither party is aware of anything to the contrary in the agreement; and a variety of other potential land mine provisions that seem far removed from the LOI and term sheet.
Because of the nature, as well as the length and bulk, of management agreements that has resulted from a series of court cases over the last several years, the preparation of these drafts and responses takes a lot of time. Each side is forced to digest not only what the contract language says, but also the contract’s impact on its business plan and the practical operation of the hotel, all adding to the total time involved.
Thus, both the initial draft and the initial response can set the stage for protracted negotiations and a breeding ground for mistrust. What one party views as “flushing out issues” already in the term sheet is often viewed as “retrading” by the other side. The damage to the relationship between the parties should not be underestimated, as unlike litigation which marks the end of a relationship, the negotiation of the management agreement is the start of a long-term working relationship between the parties, setting the tone for the way in which numerous issues will be resolved in the future.
The process of exchanging comments and drafts proceeds, slowly, over a number of months. The drafts go back and forth as the ball moves from one side of the field to the other. The positions of the parties on any given issue, (and there will be tens of issues being discussed) will depend on the leverage of the respective parties including such factors as how badly does the owner want this particular brand, and how badly does the operator want this particular location. These are normal business considerations that drive transactions of every type. With hotels and hotel management agreements, however, the stakes are simply higher.
There Is a Better Way!
Unless there is an inherent deadline, such as expiration of a governmental approval that the parties cannot control, negotiations conclude when each party has concluded that it has given all it will and gotten all it can. The process has taken a timeframe equal to several changes of season, and the management agreement, now likely swollen with exhibits to well over 100 pages, is ready for signature. How might the process have been improved and accelerated?
The answer is relatively simple, but getting the two sides to embrace it is the challenge. It is the subject of frequent discussion, but rarely undertaken. In a nutshell, the solution is nothing more and nothing less than “start in the middle.”
Before anyone makes a speech about how “every deal is unique,” “every brand is unique” and “every owner is unique,” it is important to note that there are certainly a number of issues and terms that industry professionals would agree where the “middle” is. This determination does not lend itself to a scientific conclusion, but most experienced industry professionals and counsel would likely come up with a number at around 80 percent. Yes, it is certainly true that each hotel company and each owner developer (and each lender, if we’re going to include a discussion of the non-disturbance agreement) has their individual hot buttons. However, the overwhelming majority of issues have at one level an industry standard – that’s where you wind up at the end of the negotiations; and on a brand-by-brand and owner/developer-by-owner/developer basis – an acceptable resolution. It might also be argued that “starting in the middle” will merely be viewed by the other side as a competitive advantage and they will still want to move the ball another 30 yards up the field, thus placing the party that started in the middle at a further disadvantage. This problem can be solved by making it clear that the middle ground is a fair and firm position and not merely a negotiating tactic. This solution would involve eliminating “the game” and having everyone commit to checking their egos at the door. Yes, the remaining 20 percent or so of the issues will need to be determined based on a wide variety of factors; however, in almost every case, they can be resolved. The difficult issues are best resolved at the letter of intent stage.
If the difficult issues are resolved as a part of the negotiation of the letter of intent and term sheet, then the boilerplate and more standard provisions of the management agreement could (and should?) be resolved as a function of the initial draft, and first redraft of the management agreement. That would leave things like exhibits relating to amenity access agreements, rental program management documents and à la carte services to be worked out. In some cases, the elements of a mixed-use project are not developed enough to finalize the scope of the operator’s responsibilities or the distribution of economic costs and benefits, however, even in these cases the outstanding issues can be isolated with many of the remaining issues resolved.
To create a win-win scenario, wouldn’t all the players involved in the game benefit by having a hotel management transaction go from letter of intent to signed management agreement in 30 days? It doesn’t happen often, but it can be accomplished using the technique described, but only if the parties and their counsel come to the table with the right attitude.
Any takers?
For more information, email Jim Norman or Nina Eldred at jim.norman@hklaw.com or nina.eldred@hklaw.com, respectively, or call toll free, 1-888-688-8500.