The Strategic Bankruptcy Option
Some owners have decided that they'll deliberately breach their long-term management agreement and then argue about the damages in court. If things don't work out in court, there's always the strategic bankruptcy option.
The operator side of the industry isn't likely to allow this to go unchallenged. For example, there is a statute in Maryland that enforces the terms of the management agreement, but in a given factual situation, Maryland law may or may not apply. Courts outside Maryland may refuse to enforce the Maryland statute. One solution might be similar laws in all states, but that's not likely to happen anytime soon. All this leaves a certain level of uncertainty. However, it is human nature to distrust uncertainty. In business, the higher the level of uncertainty, the greater the degree of distrust.
Other strategies, such as a master lease arrangement, are inconsistent with the accounting and tax models for operators. Operators are unlikely to agree to shorter terms in their management agreements and are even less likely to grant easy and inexpensive termination options for owners. To do so would damage the corporate valuations of revenue-stream valued management companies.
These operator ouster cases arise frequently enough to have operators looking for a way around this legal issue. This happens after any significant court decision that contravenes the industry-standard management agreement provisions. This also explains why where a 25-page management agreement was typical in the 1980s, 100 or more pages is now commonplace.
What Might We See Next?
Hotel operators might look back a couple of decades to when lenders trying to recover their security for a loan gone bad found themselves bogged down in bankruptcy court. Their response — the surrender of security agreement.
Those loan transactions were non-recourse. The borrower was usually a single asset entity and the principals were not guarantors of the debt, although there might be a "bad boy" guaranty for a few items. Under the surrender of security agreement, the lender could recover its damages for delay in recovering the security for the loan caused by the borrower filing bankruptcy or taking steps to delay the lender's legal remedies. The principals of the borrower indemnified the lender for those "delay in recovery" damages, but not the debt.
Might this be a new "kryptonite" in the form of an indemnity agreement that is part of the hotel management agreement? Would it function as a weapon to discourage wrongful termination by owners? With such an indemnity agreement in force, a hotel owner's principals must now consider the damages that a hotel operator may recover following a wrongful termination of the management agreement. This claim would be outside any bankruptcy of the hotel ownership entity.
The operator's damages could be structured to include many items customarily excluded from the damages provisions of management agreements, such as consequential and punitive damages. The damages would not be for obligations of the ownership entity, instead, the damages would include the financial detriment the hotel operator sustains from brand-reputation damage, and loss of the location and the revenue stream. These damages would not necessarily be limited to those recoverable against the hotel ownership entity under a liquidated damages provision and would likely include the operator's attorneys' fees and costs for enforcing the indemnity agreement.
Termination Agreements — Each Case Is Unique
If the object is to discourage deliberate, wrongful termination, will an indemnification agreement work? Each case will be different, but human nature has certain self-preservation drivers. The principal with substantial, personal assets at risk who has agreed to indemnify an operator is far less likely to embrace the ouster of the operator than one who does not. Where the bankruptcy of the hotel owner does not shield their fortune from a massive damages claim, are they as likely to ignore the termination provisions of the management agreement they negotiated, presumably in good faith?
If the hotel owners want to include a provision that allows them to unilaterally terminate the agreement after the passage of some number of years, the payment of an early termination fee, or because the hotel is being sold, the parties are free to negotiate such a clause. The free market, rather than the courts, would determine what is, and what is not, part of the management agreement transaction.
Will courts refuse to enforce what might be called the "wrongful termination indemnity agreement" in the same way as happens with management agreements under agency law? This is possible, but not likely. Agency agreements and personal service contracts often get unique treatment from courts, thanks to the Restatement of Agency. Other commercial agreements, such as loan documents and indemnity agreements, are governed by each state's commercial law. The range of damages that might ultimately be recoverable under a wrongful termination indemnity agreement will likely differ from state to state, but the amount of those damages will undoubtedly be very substantial. Very careful drafting of the indemnification is essential to complying with applicable state law and maximizing the recoverable damages.
Will we see the wrongful termination indemnity agreement become part of the hotel management agreement deal structure? The market will ultimately decide whether this will become a part of the owner/operator relationship. Undoubtedly, other approaches will be conceived, utilized and tested.
The author acknowledges Summer Associate Benjamin A. Taormina, who worked in our Fort Lauderdale office, for his contributions in the preparation of this article.