What are the legal implications of COVID-19 for hoteliers?
The hospitality sector has been deeply shaken and affected by the 2019 Novel Coronavirus (COVID-19) which continues to spread across the globe. This has directly impacted hotel occupancy rates and revenues that the hotels are able to achieve per available room (RevPAR) as countries around the world are imposing travel bans, quarantining citizens and isolating the infected in an attempt to stop the spread of the new virus.
The disruption to the operation of hotels and the unexpected nature of the outbreak may result in hotel owners and operators having to consider whether the virus can be classified as an event that could prevent the operator from managing its hotels. With operators closing entire floors of hotel rooms, restaurants and cafes, as well as renegotiating contract terms with suppliers of goods and placing employees on unpaid leave, the reality of the virus is hitting home.
The legal agreement
The hotel management agreement (HMA) is the most common form of agreement governing the relationship between the owner. The concept of force majeure is dealt with in a number of places in a HMA and gives rise to a number of different consequences.
What is a force majeure?
The concept of force majeure derives from the French civil law system and is frequently incorporated into commercial contracts that are governed by common law systems due to the limited remedies otherwise available to the contracting parties when the contract becomes either impossible, difficult or onerous to perform due to events outside the affected party's control.
Operators will argue that the definition of a 'force majeure event' in a HMA should be wide enough to cover global epidemics, pandemics, disease related events and travel disruption. Owners will often argue that these events should be limited to the country within which the hotel is located.
Under which laws will the HMA be considered?
It is also important to consider the governing law clause when negotiating the HMA as this may also have an impact on whether COVID-19 can be classified as a force majeure event. Most force majeure regimes are "open" or inclusive in the sense that the event does not need to be specifically listed as a force majeure event, provided the event meets the requirements of the objective test.
About half the HMAs in the Gulf region are governed by English law and therefore it is important to understand the common law perspective.
Under common law, what constitutes a force majeure event and the precise objective test depends on the specific wording of the clause within the agreement. If the agreement provides that a force majeure event must "prevent" performance, the operator must generally demonstrate that its performance has become legally or physically impossible and not merely more difficult or more expensive. By contrast, if the provision refers to the event "hindering or delaying" performance, then the threshold will generally be lower and force majeure may be satisfied if performance remains possible but has become substantially more onerous.
English courts have found that the affected party must generally have been "ready, willing and able" to perform the agreement, but for the force majeure event. English courts also tend to take a dim view of claims that a change in economic or market circumstances affecting the profitability of an agreement may be a force majeure event.
Under English law, the remedies available to the parties are a matter of drafting and need to be sufficiently certain to be enforceable. Typically, the affected party is excused from relevant non-performance while the force majeure event persists. Again, depending on the drafting, this can take effect as an extension of time or general suspension of the affected party's obligations.
If the non-performance of the operator caused by COVID-19 is prolonged or permanent (such as the long-term closure of the hotel) then the HMA may provide for the termination of the agreement.
United Arab Emirates Law
The UAE is a civil code jurisdiction. Force majeure exists as a doctrine under Article 273 of the UAE Civil Transactions Code and was also derived from the principle established in the French Civil Law. The principle applies automatically to commercial contracts governed by UAE law where the contract contains no FM provisions. Article 273 reads as follows:
- In contracts binding on both parties, if force majeure supervenes which makes the performance of the contract impossible, the corresponding obligation shall cease and the contract shall be automatically cancelled.
- In the case of partial impossibility, that part of the contract which is impossible shall be extinguished, and the same shall apply to temporary impossibility in continuing contracts, and in those two cases, it shall be permissible for the obligor to cancel the contract provided that the obligee is aware.
The UAE law recognizes and differentiates between partial and total impossibility of performing a contractual obligation in terms of an FM event. In such event, the impossible part of the obligation shall cease to exist. The affected party still has the option to terminate the contract and inform the other party of such termination. The same principle applies to temporary impossibility.
Under the provisions of article 273 of the Civil Code, if the court found that the FM test was met, the court dissolves the contract and returns the parties to their status before entering into the contract. In assessing whether an event is a FM event, the Court of Cassation assesses, in its discretion, whether the event is extremely unavoidable and unforeseeable to be rendered an FM event.
The UAE Civil Transactions Code also recognizes the principle of "hardship event" or "changed circumstances". Article 287 of the UAE Civil Transactions Code stipulates that:
"If a party proves that the loss arose out of an extraneous cause in which he played no part such as a natural disaster/act of God, sudden accident, force majeure, act of a third party, or act of the affected person, he shall not be bound to make it good in the absence of a legal provision or agreement to the contrary."
The application of the hardship theory is more flexible than force majeure. It is sufficient that the hardship event renders the performance of the obligation onerous, or more onerous than it should be in the normal case, not impossible.
The UAE courts upheld that in the event of hardship, the court may lessen the obligation of a party in an agreement or lessen the amount of damages agreed between the parties. For instance, if an event occurs which does not prevent a party from performing their obligation, but would cause grave loss to this party if the obligation was performed, the Court, in its discretion and in the interests of justice, may decide to reduce the onerous obligation.
As a matter of practice, the party seeking to rely on the event of force majeure ought to notify the other party of its intention to do so. The party seeking to rely on the event of force majeure ought to also seek to mitigate any loss it incurs as a result.
Saudi Arabian Law
The position in Saudi Arabia, under shariah law, is that force majeure can generally be claimed irrespective of whether the contract explicitly provides for it. However, the threshold is high and the burden of proof rests on the claimant. The court would consider several factors in making its determination.
The party asserting force majeure must prove that performance on the contract has become impossible or frustrated due to events outside its control and that other remedies are ineffective or unavailable. Moreover, a Saudi court would consider the duration or likely duration of the event and the terms of the agreement (is the remaining period of the HMA for two year or ten years, for example). An event that lasts or is likely to last for a few months may not be deemed sufficient by the court to excuse a party of its contractual obligations.
The court may also consider other factors, such as the possibility that the claimant could have tried to negotiate different contractual terms.
It is unlikely that a Saudi court would find that diminished revenues arising from a contractual arrangement would amount to force majeure as financial losses are deemed part and parcel of ordinary business dealings.
Generally, there is no duty on the party relying on a force majeure event to notify the other party of its occurrence or impact (assuming the event is not commonly known). However, if notification could have induced the other party to undertake remedial actions and the party nonetheless did not notify, the court may take this into consideration as a factor in assessing the strength of the force majeure claim. Therefore, albeit it is not a requirement under the law for the affected party claiming force majeure to notify the other party, the affected party should do so to strengthen its force majeure claim in court.
Under Saudi law, a party who invokes force majeure has a duty to mitigate its losses.
What should we be thinking about?
During these challenging times, it is important for hotel owners and operators to review their agreements carefully with particular regard to the force majeure and governing law provisions (including any time bars or other procedural requirements).
Performance tests - The performance test will include an obligation on the operator to ensure that:
- the RevPAR meets the pre-agreed percentage of the average RevPAR of a group of competitive hotels within a certain distance of the hotel (often known as the competitive set); and
- the operating profit of the hotel is no less than a pre-agreed percentage of the forecasted gross operating profit set out in the budget.
However, a 'carve out' is typically argued by the operator, so that they are not required to achieve the requirements of the performance test in the event of a 'force majeure'.
Enduring Periods of Force Majeure - some HMAs afford both the owner and operator the right to terminate if an event of force majeure persists for an extended period of time. This right of termination may become importation where closure of the hotel is warranted and the timeframe for its reopening is unclear or unlikely.
Working Capital - The impact of COVID-19 of the hotel industry has highlighted the importance of working capital reserves. While the trend has been to reduce these reserves to the minimum amount possible, the current circumstances prove the need for sufficient working capital reserves to be maintained for periods long enough to either (i) allow a force majeure event to subside and business to resume or (ii) allow the hotel owner sufficient time to make a claim under its business interruption policy and receive the proceeds of insurance.
Insurance - The policy wording of hotel owner's property all risk insurance, and in particular, the business interruption component of that policy need to be carefully considered. The policy wording needs to respond in circumstances that go beyond physical damage to the hotel, so as to capture pandemic type circumstances where the hotel remains physically intact but the hotel business collapses for an extended period of time.
Employee Relations - Hotel employees are at the heart of the guest experience and are the cornerstone of the hospitality industry. The mass layoff, furlough or leave without pay arrangements that are being implemented across the industry are placing this core element of the hotel at risk. Better strategies need to be adopted to address the issue of staff retention in circumstances like the present, where business activity suddenly comes to an end. The long term effects of these mass layoffs have yet to be felt but will no doubt have long reaching repercussions for the industry as a whole, and may forever damage the reputation of the hospitality industry.
Debt Financing - While central banks are looking to provide relief to affecting industries and business owners, hotel owners need to begin talks with their lenders to agree the rescheduling of debt and alternative security packages, as hotel valuations decline triggering loan to value ratio recalculations. Complex and disruptive outcomes can arise if the lenders are not on board and actively engaged in the process.
Hotel Closure - With many hotels running at less than 10% occupancy, owners are considering partial or complete closure of their hotels until such time as the pandemic subsides. We have seen some countries in Europe order the closure of all hotels. Owners need to pay careful attention to the terms of the HMA as in some instances, particular with agreements that were not extensively negotiated, provisions exist that require Owner's to continue to pay management fees in circumstances where the business of the hotel has been disrupted or the hotel has been closed.