EB-5 and the Tenant Occupancy Issue as Applied to Hotel Employees

by Jeffer Mangels Butler & Mitchell LLP
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Since the release of its “Tenant Occupancy” Notice on February 17, 2012, the U.S. Citizenship and Immigration Services (“USCIS”) has begun issuing Requests for Evidence on pending regional center applications and exemplar I-526 petitions that involve “tenant occupancy models”. These Requests for Evidence articulate a new USCIS policy to reject “tenant occupancy” job creation models for employment created by tenants under leases in certain cases. Such Requests for Evidence have also been issued recently with respect to hotel projects that do not have any leases or tenants and that are operated under the industry-standard hotel management agreement. Apparently the USCIS may be questioning whether hotel operators operating a hotel under a hotel management agreement are similar to tenants operating a business under a lease. The answer is no, as explained further in this article.

It is possible that there is a general misunderstanding of the roles of the hotel owner and hotel operator under the industry-standard hotel management agreement. In fact, the economic substance of a typical hotel management agreement is far different from a lease of any form of real property. This article is written for the EB-5 community to explain the hotel management agreement and the nexus between the EB-5 investment and the job creation methodology, in the hope that it will shed light on this crucial issue for EB-5 financing of hotel developments.

A Hotel Management Agreement is Not a Lease. As we will discuss further in this article, one key difference between a hotel management agreement and a lease is that, unlike a lease where the tenant bears the risk of loss of operating the business enterprise, under a standard hotel management agreement, all risk of loss and all expenses of the hotel are born solely by the hotel owner – not the hotel operator. Another key difference is that, unlike a lease where the tenant’s employees move when the lease terminates, hotel employees tend to stay with the same hotel, even if the hotel operator changes, or the owner sells the hotel. The reasons for this are explained further in this article.

It may be helpful to our non-hotel industry readers to know that our firm has been active in the hotel industry for more than 25 years, and that we have negotiated and advised clients on more than a thousand hotel management agreements in the U.S. and abroad with all of the major hotel brands as well as the independent “non-branded” hotel operators. Our description of the typical terms of a hotel management agreement is based upon our experience in the hospitality industry.

Until the 1980s, hotel operators commonly leased hotels (as the tenant and operator) to expand their brands while avoiding the greater capital cost of purchasing the real estate. The problem with this lease model is that it leaves the hotel company obligated to pay rent and other operating expenses, and even exposes the hotel company to risk for operating losses – just like tenants under office or retail leases. They wanted a means to avoid that risk of loss.

A hotel management agreement is an agreement for services of the hotel manager. That is why the hotel management agreement has become the dominant means for brands and operators to expand their presence, and the hotel management agreement itself has evolved into a specialized form of services agreement, where the hotel owner retains all of the potential profits and losses of hotel operations, and the hotel manager acts as the hotel owner’s exclusive agent in managing the hotel, for which the hotel manager receives a management fee.

A hotel management agreement is essentially an agreement between a principal, the hotel owner, and an agent, the hotel manager, under which the hotel manager undertakes to manage the hotel as the agent of the owner. In recent years, some hotel management companies have tried to eliminate their fiduciary duties to hotel owners created by this agency relationship. They have usually deleted pervasive references to the operator being the agent of the owner, and by expressly disclaiming an agency relationship with the hotel owner. Instead, these operators have sought to characterize their relationship as that of an independent contractor providing management services to the hotel owner.

In any event, whether characterized as an agency or a services agreement, one thing is clear under a hotel management agreement: the hotel owner bears total responsibility for all of the costs of operation of the hotel, and the hotel owner is entitled to all of the net profits of the hotel. In the case of a branded hotel management agreement, such as an agreement with Hilton, Hyatt, Marriott, Starwood, InterContinental or any of the other hotel brands, the hotel manager agrees to use its own name in the operation of the hotel, whereas in the case of a non-branded hotel management agreement, the hotel manager does not use its own name in operation of the hotel.

The standard hotel management agreement provides that the hotel manager will control and manage all of the operations of the hotel in return for a fixed management fee, provided that the owner exclusively bears all obligations to pay all of the costs of operation of the hotel, and to fund any required capital improvements or repairs.

Hotel employees are always controlled by the hotel manager. Under the standard hotel management agreement, the hotel manager, as exclusive operator of the hotel, has the authority to hire, train, supervise and fire employees of the hotel. The employees of the hotel are often employees of the hotel manager, but in some cases the hotel owner is designated as the employer of the hotel employees. Regardless of who is the employer, however, the hotel manager is always responsible for all decisions with respect to the employees of the hotel. The hotel owner, even if it is the direct employer of the hotel employees, typically has little if any control over the hotel employees, other than owner approval rights over the executive staff of the hotel.

The hotel owner is always responsible – solely responsible – for all employee salaries and costs. Although the hotel owner typically does not employ or control the hotel employees, under the typical hotel management agreement, the hotel owner is solely responsible for direct and indirect labor and employment costs and liabilities. These include salaries, wages and benefits, and any liabilities for employment related claims (harassment, discrimination, wage and hour violations, and the like). If the revenues from operation of the hotel are not sufficient to pay all such, the typical hotel management provides that the hotel owner must pay such costs and indemnify and hold the operator harmless from such costs and liabilities. Practically speaking, this means the owner must make additional cash contributions into the hotel operating account to fund any shortfalls in the hotel payroll and related expenses of the hotel.

The hotel manager receives management fees and the hotel owner retains the net profits of the hotel operation. Under the typical hotel management agreement, the hotel manager receives a management fee, usually consisting of a base fee equal to a specified percentage of gross revenues of the hotel and an incentive fee consisting of some percentage of the net profits of the hotel, plus reimbursement for certain expenses of the hotel manager that are considered costs of the hotel, such as centralized marketing and purchasing services. The hotel owner retains all net profits from operation of the hotel, as well as all of the economic risks of ownership and operation of the hotel, including operating expenses in excess of hotel revenues. Because the hotel manager receives only fees and not profits of the hotel operation, the hotel management agreement typically provides that the hotel owner is required to indemnify the hotel manager for any losses it incurs in operation of the hotel, except in the case of the hotel manager’s gross negligence or willful misconduct. Hotel owners are often surprised to find that even if a loss is caused by the hotel manager’s negligence, the hotel owner is responsible to pay for the loss, unless it was caused by the hotel manager’s gross negligence or willful misconduct.

The economic risks between a hotel management agreement and a lease are different. In comparison with a typical commercial lease, the relationship between a landlord and a tenant is quite different than that between a hotel owner and hotel manager. In a lease, the tenant pays rent to the landlord, and the tenant bears the economic risk of the business enterprise conducted on the premises. In a hotel management agreement, the hotel owner pays a management fee to the hotel manager, and the hotel owner bears the economic risk of the hotel enterprise. In a lease, the tenant employs its own employees and the tenant is responsible for all of the costs of employment, including salaries, wages and benefits. In a hotel management agreement, the hotel owner is responsible for all of the costs of the hotel employees, regardless of whether the hotel owner or the hotel manager is the employer of the hotel employees.

Hotels do not move from one location to another. A tenant of an office building or retail center can take a business enterprise to another location and conduct the same business. A hotel is a unique business enterprise that is a hybrid of a real estate investment and an operating business. As such, the building itself is part of the value of the hotel enterprise. The hotel owner can only preserve the value of the hotel enterprise by preserving and continuing to operate the hotel in its existing location. Even if a hotel manager terminates a hotel management agreement, the hotel owner can only retain the value of that enterprise by continuing to operate the hotel, if necessary by finding a new hotel manager. The hotel manager cannot move the hotel enterprise to a new location, because it is not the owner of the hotel enterprise, it is only a service provider to the hotel owner.

Hotel employees will often remain at the same hotel, even after a hotel management agreement terminates or the hotel is sold. Even when a hotel management agreement expires or otherwise terminates, the vast majority of the hotel employees will continue to work at the hotel under the next operator. In fact, the hotel management agreement will often provide that the hotel owner has a right to solicit the existing hotel employees to remain employed at the hotel. This would never be the case in a typical office or retail lease, where the employees would move with the tenant, or lose their employment altogether. Even if the hotel is sold by the owner, the hotel employees are usually rehired by the new hotel owner. As this experience demonstrates, the job opportunities created by a new hotel are long lasting.

When a new hotel is opened, it does not mean that the old hotel will cease operations or reduce the number of employees. When a new hotel is opened near an existing hotel, it is typical that the existing hotel will remain in operation. Even if the existing hotel changes hotel brands or hotel managers, both hotels will still require a minimum number of employees to remain in operation. Therefore, a new hotel in the same area as an existing one will generate new jobs as opposed to shifting or relocating employees from the already existing hotel.

Hotel employees have a strong nexus to the hotel enterprise rather than to the hotel manager. For all of these reasons, the USCIS should view hotel employees as the employees of the hotel enterprise, regardless of whether their actual employer is the hotel owner or the hotel manager. The nexus between the EB-5 investment and job creation in the hotel context is so strong that it continues to exist regardless of whether the hotel owner or the hotel manager bears ultimate responsibility for employment.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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