In 1962, Neil Sedaka, with his lyricist Howard Greenfield, wrote “Breaking Up is Hard to Do.” That same year, Sedaka recorded the song for the first time. He later recorded a new version in 1975. With a few word changes here and there, it might be the anthem for pre-commencement termination of hotel management agreements, an issue that is arising more and more often as debt and mezzanine financing are more difficult to arrange than has been the case in a number of years.

Since market cycles cannot be controlled, both brand operators and developers have to find a way to live with these challenges. The developer and the brand both want the deal done as quickly as possible. The brand operator wants the location and the expansion of the brand, and the developer needs to be able to announce the branding of the project in order to create value that will be meaningful to lenders, investors and purchasers. In some situations, the branding is critical to governmental approvals, as well.

The New Reality

What happens if one or more of these scenarios occur?:

• the project does not receive final governmental approval
• the last piece of equity can’t be found
• the debt markets require a loan to value ratio that bears little or no resemblance to the project proforma
• market conditions preclude sufficient pre-sales before the management agreement-required commencement date, and funding under the construction loan doesn’t occur

A year or two ago, these situations were highly unlikely. Today, these and similar problems are everyday matters for developers.

Most hotel management agreements provide for a number of milestones that the developer must achieve in order to keep the transaction in good standing. These milestones generally include construction commencement, construction completion and hotel opening. These dates may have built-in grace periods or extensions for force majeure. Some agreements may have pre-sale requirements or rental program minimum participation requirements. Failure of the developer to timely achieve these milestones may give the operator the right to declare a default and terminate the agreement. This, in turn, may subject the developer to a risk of paying a substantial termination fee to the operator. At this point, the developer will have lost not only dollars, but the brand. This default may also expose the developer to being in default under the loan commitment, construction loan, purchase and sale documents (in the case of a condominium hotel or branded residences), and internal partnership or joint venture agreements.

The importance of carefully negotiating the milestones cannot be overstated. By nature, developers are optimists which goes hand-in-hand with their proclivity to being risk takers. When the lender gives an estimated date for closing on the construction loan, or the general contractor provides the construction schedule, those dates should not be relied on as outside dates for the management agreement. It’s not that anyone wants a delay, but to paraphrase the much-touted bumper-sticker phrase, “things happen.”

In the ideal world, the hotel management agreement (and the related technical services, branding, marketing and license, and centralized services agreements) would be signed immediately after all governmental approvals have been obtained, design documents are ready for operator review, the construction loan has been closed, the project governing documents and rental program documents have been completed and the entire project is the subject of reservation agreements with purchasers who are ready to convert to binding purchase agreements, thereby making it a sold-out project. Unfortunately, the ideal world exists only in Fantasyland. Realityworld requires a more honest look at how long things will really take to complete, with due consideration given to all the elements and interests that will require changes and additional time to complete. How many novels require no rewrites? You get the picture.

The Brand’s Stake

It’s not only the developer who is “invested” in the project. When a brand operator commits to a project site and agrees to an area of protection, it has essentially agreed to pass up other possible projects to brand and operate. This is a serious commitment by the brand operator, which will also invest time and money in the preparation and negotiation of the management agreement and related contracts. Following execution of the agreements, press releases are issued, and brand Web sites contemplate a future opening of the property. If the deal is later terminated for any reason, the brand suffers something of a black eye. If the termination occurs after condo hotel units or branded residences are sold, then notwithstanding disclaimers and indemnities, the brand, potentially “the last balance sheet standing,” becomes a litigation defendant.

Balancing the risks and appreciation of the fact that both developer and brand will suffer if the project does not proceed is the first step. The challenge is to provide realistic and fair rights and obligations on the part of both sides. If a project is not going to go forward, it is better that everyone knows it early in the process – the earlier the better.

In the current market, many deals have what is, in essence, a financing contingency. The developer has some period, generally not more than a year, to obtain any required financing. In this context, financing would include any additional equity needed to close the construction contract. In this scenario, if the financing cannot be arranged within the time permitted, then either party has the ability to terminate the agreements, usually without payment of damages, except for technical services fees and expenses accrued to date.

The Cost of a Breakup

The longer the amount of time provided to the developer to terminate based on financing or some other contingency, or even for “convenience,” the more likely that some fee will be due to the brand operator, and the fee will become progressively larger. Fees paid to the operator in the event of a termination before construction commences, or, following commencement of construction, but before opening of the hotel are often referred to as “breakup fees.” Upon payment of the breakup fee, the agreements terminate and each party is released from their obligations to each other. One obligation that does often survive these early terminations is the “reinstatement.”

The Project Proceeds

In a reinstatement provision, if the developer later proceeds with the project within a stated period (generally two to five years), the brand operator has what amounts to a right of first refusal to have the original transaction terms reinstated. This protects the brand operator from a developer who decides to change brands or gets a better deal from another brand. Reinstatement provisions often have a number of other aspects, the discussion of which is beyond the scope of this article.

It is rare that pre-commencement termination is automatic. Far more likely is that one or both parties have the option to terminate if a milestone is missed or a termination right vests under the terms of the agreement. When the project is proceeding, even if on a delayed basis, whether those delays are construction, sales or otherwise based, the parties often choose not to terminate agreements in which so much has been invested. This is especially true when the relationship between developer and brand remains good – an important component of which is forthright and frequent communication.

When It’s Just Not Working Out

At some point, a deal may not make sense to one or both parties. If the contract terms have not been thought through or the relationship has degenerated, there will be a default situation which creates the potential for very significant damages and an ugly dispute. For both developer and brand, every effort should be made to avoid this situation, starting with a realistic approach to the original deal term sheet and the management and related agreements, and continuing through the technical services and pre-commencement stages of the project.

With apologies to Neil Sedaka and Howard Greenfield,

Don’t take your brand away from me
Don’t leave my project and take a fee
If you go then I’ll be blue
‘Cause breaking up a deal is hard to do.

For more information, email Jim Norman at jim.norman@hklw.com or call toll free, 1-888-688-8500.