Keys to Effective Management Contract Negotiations

Booming hotel and resort mixed-use projects present significant opportunities for hotel developers, but the developer-owner must retain critical rights when negotiating agreements with hotel management companies. Despite experience as real estate developers, owners can be burdened by onerous terms simply due to lack of experience. For practical insights, Lodging Hospitality spoke with Albert Pucciarelli, chair of one of the leading hotel and resorts practices in the country for New Jersey's third largest law firm, McElroy, Deutsch, Mulvaney & Carpenter. Pucciarelli was a member of the board, executive vice president and General Counsel of InterContinental Hotels from 1988 to 1998.

Pucciarelli says that while the owner typically delegates total day-to-day control to the hotel management company, paying management fees based upon gross revenue and operating income, the owner also retains ultimate economic responsibility for the hotel operation and for funding working capital, capital improvements and below-the-line expenses.

The owner stands to gain or lose far more than the management company if the hotel is poorly managed. Their interests are not completely aligned, he says. The owner needs protections to help drive bottom line income from the property, while the management company will fight to protect their key interests — fees derived solely from above-the-line operations while enhancing the brand experience and brand value which they sell to other hotel owners.

Q Is there one area of protection that is more critical to the owner's interests than others?

A Absolutely. Owner approval of the annual budget of the hotel is a must-have. It must be real approval, not merely “review and comment.” Annual budget really means the management company's annual business plan for the hotel, which also includes capital expenditure requirement for the next year and the ensuing five years and not just usual above-the-line operating budgets.

Q What key parts of the annual business plan are usually able to be negotiated by the owner? Which are off-limits?

A Owners must have approval over such items as planned uses of the reserve for replacement of furniture, fixtures and equipment, operating cash needs, an employment plan, a revenue plan and a marketing plan, among others.

The management company's proposed annual business plan should be presented to the owner no later than 60 days before the commencement of the next fiscal year with a period of time thereafter, typically 30 days, for the owner to approve or reasonably reject the plan in whole or in part.

However, the management company will not allow an owner to reject a budget because of expense items beyond the control of the management company — for example, salaries and utilities. The management company also will not permit budget rejection based on the owner's objections to anticipated central services charges such as reservation fees, guest recognition or reward program fees and other charges the management companies allocate among hotels in the chain.

If management asks for the right to increase expenditures by the same percentage as the percentage increase in revenue beyond budgeted revenue, owners should resist. Not all revenue requires additional expenditures and if so, the increase is not necessarily proportionate to revenue increases. Non-emergency increases in expenditures must be subject to owner approval.

Q Are there additional, specific protections that an owner must seek?

A Owners must approve the selection of key hotel personnel, such as the general manager, the controller and the director of marketing and sales. Owners also must be able to reject any expense reimbursement to the management company unless the expenses are incurred pursuant to an approved budget. An example would be travel of management company personnel in connection with the provision of technical services for the design of hotel improvements.

Importantly, the owner also should insist upon a meaningful performance test which, if failed, gives the owner the right to terminate the management company. Customary performance tests typically include two criteria: one where the management company must achieve a daily room rate comparable to that of an agreed competitive set of hotels, and a budget test where the management company must achieve the results contemplated in the approved business plan.

There will be debate whether the management company must fail on both criteria and over a period of two or two out of three consecutive years before the test is deemed failed and whether the management company will have cure rights where it can make a payment to stave off termination.

Developers need to be diligent and thoughtful as they pursue agreements for their properties and, in particular for projects with mixed-used components.

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