Originally published on HotelExecutive.com
In the hotel industry, the myriad of complex business relationships also creates legal land-mines for the unwary in terms of hospitality litigation. In that regard, hotel asset managers, hotel operators and franchisors should be extremely mindful of their legal obligations to their client, the owner of the hotel. Even if the hotel is a single asset, there are potentially four groups that, for a better term, have their fingers in the pie – the owner, hotel asset manager, hotel operator and franchisor. But at the end of the day, each of these relationships confer legal rights for the benefit of the owner and potentially, to the detriment of the asset manager, hotel operator and franchisor.
Hotel Asset Managers
In this day and age, it is very common for an owner of multiple hotels (whether it be individual owners, investors, and lenders) to hire an asset management company to oversee the hotel operator’s day-to-day management of the hotel. For instance, the hotel asset manager will have oversight of operations and the physical asset (the hotel), which includes monitoring ongoing financial performance, the competitive set, the hotel asset, provide support and review of the budgeting process and advise ownership as to management issues.
The hotel asset manager will also manage the hotel by advising the ownership as to optimum investment strategies, the investment community, select and oversee operators, franchise affiliations and consultants, negotiate and administer contracts and approve/monitor capital expenditures. In addition, the hotel asset manager should oversee the actions of the franchisor as well. Regardless of what role the hotel asset manager has undertaken, it will review and analyze daily-reports, financial statements, and other hotel reports prepared by the hotel operator. Even though the hotel asset manager is one step-removed from the hotel operator, the owner is relying on the hotel asset manager to be its “eyes and ears” for the hotel owner. Simply said, the hotel asset manager is the agent for the hotel owner.
Hotel Asset Managers Bound by Agency Law Principles
Historically, the Bible of Liability in the hospitality industry has been the RESTATEMENT (SECOND) OF AGENCY. It has served as the basis for seminal legal changes in the hospitality industry that now generally govern the conduct of hotel operators, and is relied upon extensively in hotel management disputes and is equally applicable to hotel asset managers. Under agency law principles, the hotel asset manager is the agent for the owner, its principal and is legally bound to disclose anything and everything to the owner, its principal. Generally speaking, the failure to disclose such information would constitute a breach of fiduciary duties. The elements of a claim for breach of fiduciary duty are: (1) existence of a fiduciary duty; (2) breach of that duty; and (3) damage caused by the breach.
As an agent of the owner, the hotel asset manager owes certain fiduciary duties to the owner and those duties include but are not limited to, the following: (a) a duty to act in the owner’s best interests; (b) a duty of loyalty; (c) a duty to disclose all information relevant to the owner affairs (candor); (d) a duty to keep and render accounts; (e) a duty not to accept secret payments or other amounts not authorized by the owner; (f) a duty to ensure that the principal’s profits are maximized; (g) a duty of care and skill; (h) a duty of good conduct; (i) a duty to act only as authorized; (j) a duty to obey; and (k) a duty not to act for an adverse party without the principal’s consent.
A hotel asset manager’s intentional breach of a fiduciary duty is a tort for which the plaintiff may recover punitive damages. While it is a general rule in many jurisdictions that courts allow the recovery of punitive damages where the defendant, in committing a tort, acted willfully, maliciously, or fraudulently, where punitive damages are awarded for breach of fiduciary duty, the actual motives of the defendant and whether the defendant acted with malice are immaterial. But something more than a simple breach is required for the recovery of punitive damages; the acts constituting the breach must have been fraudulent, or at least intentional. An intentional breach may be found where the fiduciary intends to gain an additional benefit for himself.
The hotel asset manager can get into trouble real quick if it fails to monitor reports prepared by the hotel operator, fails to review third-party contracts or avoids “drilling-down” in the financial data, agreements, and contracts to understand the operational side of the hotel. And sometimes, the big hotel asset management companies might have a cozy relationship with national hotel operators and/or hotel franchisors and on occasion, look the other way, because the hotel asset manager is more concerned with cementing future hotel asset management assignments.
In 1925, the Hotel Association of New York City designed a hotel account system to provide uniform classification of revenues, expenses, assets, liabilities and equities for hotels to attain and provide comparable financial statements. The system has since then been adopted by the American Hotel & Lodging Association (“AH&LA”) and is now referred to as the ”Uniform System of Accounts for the Lodging Industry.” In addition, the American Hotel & Lodging Educational Institute provides industry leadership in certifications necessary to operate hotels pursuant to the “Uniform System of Accounts for Hotels.”
i) Violations of the “Ten Commandments”
Notwithstanding these operational “Ten Commandments”, the landscape is replete with litigation against hotel operators. For example, there have been cases where the operator has “cooked the books” to obtain incentive fees. Specifically, the hotel operator allegedly ordered items in the last quarter of the calendar year and told the hotel’s vendors to bill the hotel in the first quarter of the next year, in order to obtain an incentive bonus. It’s a simple equation — the hotel operator fraudulently understated the hotel’s expenses to increase net operating income to achieve its performance bonus. That could be called theft, conversion, fraud or any number of things that would serve as the basis for a lawsuit.
ii) Control of Hotel Operations Equates to Potential Liability
In another case, the hotel operator (also the franchisor) threw an expensive party at the owner’s hotel but the hotel received no benefit at all – – the party was for the sole benefit of the hotel operator (and franchisor), yet the owner’s hotel was charged the costs for throwing the party. Despite uniform financial controls that are essentially mandated by the “Ten Commandments”, hotel operators still manage to open themselves up for litigation by doing bad acts.
In the context of hospitality litigation, it is much easier to find negligence, malfeasance and/or willful misconduct against the hotel operator because their scope of involvement is “more-hands-on”, more “real-time” and covers a “24/7” cycle with day-to-day operations of the hotel, as opposed to the asset manager that reviews reports after the fact. From an operational stand-point, the hotel guests, the restaurant guests, the bar and lounge patrons and banquet guests all “trigger” immediate responses, needs and crisis’s, whether someone falls, is too drunk, gets food poisoning or the invitee of the guests causes a problem. For the hotel operator, the potential for liability is exponential vis-à-vis the hotel asset manager, due to guest check-ins and check-outs, safety issues, food & beverage operations, convention/meeting room banquets, and failing to implement competent financial controls at the hotel property level so the owner can make money.
iii) Hotel Operators Are Bound by Agency Law Principles
In the past two decades or so, there has been a plethora of hotel management contract decisions that held “hotel owners had the power to terminate a hotel management contract based on agency law principles.” For a long time, the legal rationale for terminating hotel management agreements was based on the RESTATEMENT (SECOND) OF AGENCY. That is true, because the RESTATEMENT (SECOND) OF AGENCY sets forth the common law concept that a principal (hotel owner) has the power to terminate an agent (hotel operator) at any time unless the agency is coupled with an interest (which means an economic interest by the hotel operator in the hotel). But despite these adverse rulings, national hotel operators have attempted to disclaim that hotel management agreements constituted an agency relationship – – but the courts looked to the actual relationship of the parties and held that the “common law of agency trumps explicit contract language.”
In 2011, the Court in the Turnberry decision re-affirmed with crystal-clear clarity, that the hotel owner, based upon agency law principles, can terminate a hotel management agreement:
The notion of requiring a property owner to be forcibly partnered with an operator he does not want to manage its property is inherently problematic and provides support for the general rule that a principal usually has the unrestricted power to revoke the agency.
iv) Agency Coupled With an Interest
With regard to an economic interest, the courts have further held that for an agency to be coupled with an interest, the hotel operator must have a specific, present, economic interest in the hotel i.e., an equity interest or key money in the deal to create an agency coupled with an interest. But recent decisions seem to suggest that hotel operators have an uphill battle to argue their hotel management contract is an agency coupled with an interest and therefore, the hotel owner cannot terminate the hotel management contract.
v) Personal Services Contracts
In Marriott International v. Eden Roc and RC/PB, Inc. v. The Ritz Carlton Hotel Company, the RESTATEMENT (SECOND) OF AGENCY was not the basis for terminating the hotel management contracts. Instead, in the Eden Roc and Ritz Carlton cases, which applied New York and Florida law, respectively, the courts held that because the hotel operator had a broad delegation of power of discretionary authority that required the operator to exercise special skill and judgment, that the hotel management agreements were personal services contracts and could not be enforced by injunction or specific performance.
Both court’s analyzed the hotel management contracts under “the concepts of involuntary servitudes and assessed the difficulties courts would encounter in supervising the performance of special skills and judgment,” and ruled hotel management contracts may not be enforced by injunction or specific performance. Both holdings resulted in the hotel owners having the power to terminate hotel management agreements under the theory the contract was a personal services contract and not an agency law concept.
In summary, California, New York and Florida courts have held that hotel owners can terminate hotel management contracts under agency law principles (unless an agency is coupled with an interest) or as personal services contracts. It appears the law is now settled.
vii) Wrongful Termination and Damages
But it is extremely important for the hotel owner to understand, that although it has the power to terminate a hotel management contract under either theory, the hotel owner may not have the contractual right to terminate the hotel management agreement. Therefore, the hotel owner may be liable for wrongful termination and the hotel operator may seek damages for the remainder of the hotel management contract term. So, the moral of the story is simple – – the power or right of termination can be expensive.
Although agency law principles have been applied in the context of terminating hotel management contracts (and should be applicable to asset managers), franchise agreements have been generally immune from these legal challenges. The reason is simple — the franchisor doesn’t really exercise control over the franchisee, unlike hotel operators that control the entire hotel operation for the hotel owner.
Historically, franchisees’ have filed lawsuits against franchisors for claims such as wrongful termination and nonrenewal, breach of contract (failing to provide support, training, advertising, territorial protection and the like), claims for market withdrawal by franchisor, the ability to transfer a franchise, misrepresentation claims (earnings, revenue, success/failure rates, etc.), encroachment claims (area of protection clauses), failure to provide certain disclosures pursuant to Federal Trade Commission mandates, antitrust claims and breach of fiduciary duty claims (advertising fund expenditures). However, filing lawsuits based on agency law principles and breach of fiduciary duty are far and few between.
In 1998, a little known lawsuit was filed that could serve as the guide post for future lawsuits that could find an agency law relationship between the franchisor and franchisee. In the Empire Holdings LLC v. Radisson Hotels Int’l case, the New York Supreme Court (trial court) came dangerously close to ruling that an agency relationship existed between the franchisor (Radisson) and its franchisee (Empire Holdings). In the Radisson case, the dispute dealt with the franchisee’s right to terminate the franchise agreement if Radisson failed to produce a fixed number of gross room reservation nights through Radisson’s national reservation system in a fiscal year. One of the claims against Radisson was based on agency law and an alleged breach of fiduciary duty. In the franchise agreement, there was a clause stating that Radisson was the “agent” for Empire Holdings as it related to booking hotel reservations, etc. In denying Radisson’s motion to dismiss, the court stated in dicta that Radisson’s role as an “agent” for Empire Holdings in booking hotel reservations could result in a fiduciary relationship between the franchisor (Radisson) and franchisee (Empire Holdings). Although the Supreme Court in New York is a trial court, the door was opened, albeit very little, to finding a franchise agreement constituted a fiduciary duty relationship between the franchisor and franchisee.
Agency law principles and fiduciary duties are found in the context of control — the hotel operator controls the operation, management, and pursue strings of the hotel. In other words, the more control the party has, the more likelihood there will be an agency relationship between the two parties. In the context of a franchise agreement, there is generally no control by the franchisor over the operation, management, and pursue strings of the hotel. But as illustrated in the Radisson case, if the agreement remotely states or implies the franchisor is the agent for hotel reservations, or the agent for collecting marketing fees, etc., or requires the franchisor to be in charge of funds paid by the franchisee to the franchisor, then the traditional agency law principles and fiduciary duties might be applicable to franchise agreements. Arguably, if the franchisor is controlling funds paid to it by the franchisee and misuses those funds, then the franchisee could bring a claim for conversion, which could be the catalyst to trigger agency law and fiduciary duty obligations and related claims against the franchisor.
The evolution of case law can take years. But I suspect there is a franchise agreement that effectively vests more than “nominal control” in the franchisor over the franchisee’s operation. That test case could be the one that finds a franchise relationship can be terminated like a hotel management agreement under agency law principles. If that time comes, then the franchisee’s power to terminate a franchise relationship versus its legal right to terminate, must be balanced against a wrongful termination claim by the franchisor and subsequent damage claims. When that ruling is decided, it will send shock-waves through the entire hotel industry and immediately create a “new” legal relationship between the franchisor and franchisee.