Hotel operators are ultimately service providers whose services are remunerated by a set of fees. This financial arrangement is embedded in hotel management agreements.
In a number of special circumstances, hotel operators may provide a financial commitment to entice a hotel owner to favour that hotel operator over its competitors. This financial commitment may appeal to a hotel owner for a variety of reasons. It may be necessary to deal with a shortfall in capital funding that the hotel owner is otherwise unable to obtain. It may also be presented to the hotel owner's potential financier as a tangible demonstration that the hotel operator has "skin in the game".
A hotel operator's financial commitment may be offered in different forms and each can be tailored to the particular circumstances of each transaction. The precise qualities of any financial commitment is a function of the commercial drivers, creativity and ingenuity of the contracting parties and their advisers.
Baker McKenzie, being a global law firm, acts for hotel owners and a broad cross-section of both domestic and international hotel operators in many jurisdictions globally. Our long term involvement advising our clients in this industry has enabled us to gain a perspective and make some observations on the subject of financial incentives.
In this newsletter, we will focus on the more common forms of financial commitments being:
- Key money
- Performance guarantee
- Incentive fee stand aside
- Cure payments in the context of performance tests
Let's begin by describing what we mean by each of these terms.
Key money is generally a financial incentive that is paid to a hotel owner by the hotel operator. Payment of the key money is usually prescribed in an agreement as a contractual obligation on the hotel operator to pay a sum of money to the hotel owner at a certain time or once certain conditions are satisfied. The obligation to pay usually crystallises on or following a certain period of time after the commencement of the management agreement or the operations of the hotel.
A performance guarantee is another form of financial incentive from a hotel operator presented as a contractual obligation to pay a specified sum of money to the hotel owner if the hotel operator fails to achieve a certain financial target during an agreed period of time. The financial target is usually a benchmark Gross Operating Profit assessed against the actual outcome for each Operating Year during the agreed period.
Where the hotel is new, the financial commitment usually applies after the anticipated hotel ramp up phase comes to an end and the hotel enters the stabilised earning phase (e.g., commencing from the start of the first or second or third full Operating Year of the hotel) and is typically for a relatively short period (typically 3 to 5 years).
Incentive Fee Stand Aside
A hotel operator may agree to defer the whole or part of its incentive fee where the earnings of the hotel in any Operating Year do not meet agreed owner distribution or Gross Operating Profit benchmarks. The deferred fees would usually become payable to the hotel operator in subsequent years where the hotel's financial performance exceeds those benchmarks.
A management agreement may contain a performance test, which gives the hotel owner the right to terminate the agreement if certain performance benchmarks are not achieved by the hotel operator. Some performance tests give the hotel operator the right (but not the obligation) to avoid termination if a payment (usually referred to as a "cure payment") is made to the hotel owner. A cure payment is not really a financial incentive (in the same way as key money or a performance guarantee) but rather a price that a hotel operator is prepared to pay to prevent the risk of early termination by the hotel owner because of under performance. That said it is still a form of financial commitment from the hotel operator to the hotel owner.
We set out below what we consider to be the key issues around these financial incentives and common to other forms of financial commitments which may be offered by a hotel operator.
|1. Are there, and should there be, any condition which needs to be satisfied to trigger the obligation to make a financial commitment?||
Generally, a payment obligation is (and should be) qualified by a number of conditions, e.g., the hotel owner is not in breach of the agreement, that certain thresholds have been met, or where the hotel is to be built, practical completion has been achieved and the hotel has commenced operation, etc.
It is usually the case that certain conditions are to be satisfied before a hotel operator is obliged to provide the financial commitment. The conditions would relevantly relate to matters and outcomes that ensure that the hotel operator obtains its management tenure on the agreed terms of the management agreement.
Each of the specified conditions needs to be carefully considered to ensure that it is reasonable, can be objectively assessed and not overly broad or discretionary in its application.
|2. Is the financial commitment refundable?||
Whether a financial commitment is refundable or not is essentially a commercial point of negotiation between the parties.
If the financial commitment is refundable then the circumstances under which it is refundable need to be carefully considered and clearly expressed in the Letter of Intent and the management agreement.
|3. Who bears tax liability on receipt of a financial commitment and any repayments?||
Some agreements provide that the income tax liability of the payment and any repayments is borne by the payer and not the recipient. Others restrict this liability to any withholding tax obligation.
Both hotel operators and hotel owners should seek advice on any tax implications in relation to the payment or receipt of financial commitments in the relevant jurisdictions that the parties are tax domiciled or where payments are made or received as any tax or levy impost may substantially impact on the burden or benefit as the case may be of the financial commitment.
|4. Is the benefit of a financial commitment restricted to the initial hotel owner?||
A financial commitment may be intended to benefit the initial hotel owner or be available to any owner of the hotel for the duration of the commitment.
This is a commercial point which should be addressed by the parties in the Letter of Intent. If the benefit is only for the owner whom the hotel operator has agreed to provide the financial commitment then this needs to be expressly documented (usually in a side letter or deed).
Additional consideration may be given to extend the benefit of the financial incentives if there is any re-organisation of a corporate hotel owner or transfer of the hotel to the owner's related entities.
|5. Is the performance guarantee and/or cure payment referenced to Gross Operating Profit or some other benchmark?||
The threshold which triggers a performance guarantee payment and/or cure payment may be referenced to an adjusted Gross Operating Profit which is generally lower than Gross Operating Profit.
If the benchmark is an adjusted Gross Operating Profit then the relevant adjustment factors or principles, including any conditions which the performance guarantee is subject to (e.g., force majeure), should be appropriate and equitable to both parties.
|6. Is the performance guarantee or cure payment designed to top up the entire deficiency or is it qualified in some manner?||
The financial commitment may be to cover a shortfall in the hotel's financial performance or only extend to the forfeiture of management fees or discrete components of these fees (e.g., incentive fees only).
There is a range of variables on the scope and terms of a guarantee and the hotel operator's obligation or right to cure a failure to achieve agreed performance targets. These should be subject to detailed negotiations and clearly set out in the Letter of Intent.
|7. Would it be beneficial to include an example of the calculation for the Performance Guarantee and/or Cure Payment?||
The calculation of the Performance Guarantee or the Cure Payment can be complex giving rise to the potential for disputes between parties.
In our experience, where a provision seeks to deal with complex arithmetical calculations or varied outcomes under distinct conditions then, to avoid misunderstandings between the parties, it is always helpful to include a formula (rather than describing the calculation or intended outcome in words) and attach to the hotel management agreement a variety of working examples of the relevant amounts.
|8. Is the obligation to make the financial commitment legally enforceable?||If the financial commitment is set out in a separate standalone document and not the hotel management agreement then it may not be legally enforceable. There is a common law legal principle that an obligation (in this case to provide a financial commitment) may not be enforceable if there is not some form of consideration from the recipient of the benefit of the obligation. Financial commitments are commonly found in separate documents where they are intended to apply to or benefit the one hotel owner. A financial commitment needs to be appropriately documented to ensure that it is legally enforceable by the party intending to benefit from it.|
|9. To what extent should these issues be addressed in the discussions regarding the Letter of Intent?||Unnecessary delay and friction can arise in the documentation of the hotel management agreement if the terms of a financial commitment are not sufficiently detailed in the Letter of Intent. Financial commitments and incentives are significant commercial issues to both hotel owners and hotel operators and as such deserve reasonable time and effort to ensure they are adequately considered and dealt with in the Letter of Intent.|
|10. Who are the consultants which should be used and when should their involvement commence?||
While we would (of course!) recommend that both the hotel owner and hotel operator engage lawyers with extensive industry experience and expertise in relation negotiating hotel management agreement, hotel owners may consider seeking advice from experienced commercial negotiators with current market knowledge and insight to assist the hotel owner in reaching terms on any financial commitment with a hotel operator.
There is rarely a situation where an experienced consultant (legal or otherwise) has represented a waste of money or been engaged too early in the process.
Summary and Conclusion
Financial commitments have long featured in the negotiation of hotel management agreements.
However, we trust that from reading this newsletter you will appreciate that while the parties may reach a high level commercial agreement in relation to any financial commitment, there are nuances on the terms and details of the financial commitment that need to be properly documented consistent with the intent of both parties.
We have seen numerous instances where not enough thought has been given to the terms of a financial commitment in the Letter of Intent which leads to protracted hotel management agreement negotiations. There are further unfortunate situations where the requisite detail is not in the hotel management agreement and the parties are then involved in costly and time consuming dispute resolution procedures in an effort to reach a workable outcome.