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Weekly UpdatesThis classic Cornell Quarterly article from the 1980s is the first in a series of classic articles leading up to the journal's fiftieth anniversary in 2010. The CQ began publishing in 1960 as a "forum for serious discussion by all interested and competent parties of the problems and progress of the hotel industry; to report without abridgment the operational ideas of leaders in the field; and to bring to all hoteliers the results of investigations and studies by Cornellians and other researchers," in the words of founding dean Howard B. Meek. By the 1980s, ownership in the hotel industry was separating from operations, and management was increasingly a function of chains, rather than independents. Articles in the CQ covered nascent topics that have since matured, including yield management, market differentiation, and management contracts. Also popular at the time were articles on quality assurance, which is little discussed twenty years later. By 1989, management contracts reflected changes in the structure of the hotel industry. In this classic Cornell Quarterly article, Professor James J. Eyster explained his research on the current terms of management contracts. This article is of interest in part as a comparison to the findings in the newly published book on management contracts, written by Professor Eyster with Cornell Professor Jan deRoos, The Negotiation and Administration of Hotel Management Contracts (4th edition).
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THE SHIFTS that have occurred in relative bargaining power between owners and operators have resulted in a maturing of the management-contract concept, so that a more equitable sharing of risks and decision making now exists. In the May issue of The Quarterly, I described and analyzed trends in operator loan and equity contributions and in management-fee structures, based on my survey of operators, owners, consultants, and lenders.
The focus of this article is on the changes in the following contract provisions: (1) the length of the contract term and renewal options, (2) contract-termination provisions, (3) operator-performance provisions, (4) budget-approval procedures, and (5) dispute-settlement mechanisms. The article concludes with a summary of implications for the future of management contracts.
Term and Renewal
The length of the contract's initial term, the number of renewal terms, the length of each renewal term, and who holds renewal options are major concerns to the owner, the operator, and the lender. A long contract term provides stability for all three parties but decreases the owner's and lender's flexibility and can be a significant disadvantage to an owner if he unilaterally removes the operator, since the remaining term and renewal periods serve as a basis for a negotiated owner-operator settlement. A shorter contract term increases the flexibility of each party but is considered to be a major drawback for the operator who wants to manage the property over an extended period of time to realize a return for the significant upfront costs and effort involved. The lender is often the party that determines the length of the initial contract, because the lender generally wants the contract's term to coincide with that of the permanent financing.
Exhibit 1 illustrates the lengths of initial terms, number of renewal terms, and lengths of each renewal term stipulated in the contracts of owners and operators interviewed. Chain operators are able to negotiate longer initial and renewal terms than independent operators are, because the chains bring with them an established brand recognition that contributes significantly to the identity of the property: Chain operators estimate that they need, on average, a term of at least eight to ten years to recover their start-up costs and to make their time and effort in the project worthwhile. Independent operators, on the other hand, say they need a minimum of five years for start-up properties and two to three years for existing properties to make the contract worth their while. Due to increased competition and decreased terms of permanent financing vehicles within the United States, chain operators and lenders are often willing to accept initial terms often to 15 years instead of the 20-year contract that was the industry standard for many years. Independent operators, who do not benefit from a chain name, can usually negotiate a maximum initial term of only ten years. When either a chain or independent operator contracts with an owner-in-foreclosure, contract terms usually range from six months to one year with a minimum of one year's management tee to be paid in the event the contract is terminated within the year.
Two other issues are important. The first involves which party can exercise the option to renew. The second involves what becomes of the contract if the owner sells the property.
Contracts have historically given the operator the sole option to renew, and this position is still the most prevalent. In cases where the owner possesses significant relative bargaining strength, however, an owner sometimes gains the option to renew or negotiates conditions on the operator's option to renew--usually; the achievement of specified performance levels.
What becomes of tire contract when the owner wishes to sell the property prior to the expiration of the contract's full term is a significant negotiating issue. The major negotiating points center on the following:
* whether the operator has a preferential right to purchase the property;
* whether the operator has the right to approve the purchaser:
* whether the management contract survives the sale; and
* if the contract is terminated on sale, what the basis is for operator compensation.
Both chain and independent operators state that although a lengthy contract term provides a feeling of stability, the parties still have the flexibility to agree to terminate the contract at any time if the owner-operator working relationship becomes untenable or if termination is mutually beneficial for other reasons.
Contract-Termination Provisions
A contract outlines specific termination rights granted to the owner and to the operator. These rights vary depending upon the original intent of the contract and upon the relative bargaining strengths of the owner and the operator. By virtue of its intent, a contract between an owner-in-foreclosure and an operator, under which the operator acts as a caretaker for the property, has more liberal termination provisions than a contract between a developer-owner and an operator, where the intent is to establish a long-term property investment by the owner and a long-term management investment by the operator.
Typical termination provisions. All contracts contain three provisions for termination, regardless of the contract's term or the relative bargaining strengths of the two parties. These provisions allow either the owner or the operator to terminate the contract if (a) the other party fails to keep, observe, or perform any material covenant, agreement, or provision, and the default continues for a period of 30 days after that party is given notice to cure the default; (b) the other party files a petition for bankruptcy or reorganization or assigns his property on behalf of creditors; or (c) the other party causes the property's licenses to be revoked or suspended.
Most contracts also permit the operator to terminate the contract if (a) the owner fails to maintain an agreed-upon minimal balance in the property's operating bank account; (b) the property is significantly damaged or destroyed by fire or other casualty; or (c) the property is condemned in whole or in part.
The intent of the above provisions is clear. Both the owner and the operator wish to protect their position if the other party defaults on any contract provision or becomes unable to function as an economic entity. Moreover, the operator wants to protect his or her position in the venture by having the right to terminate the contract if the owner is unable to meet the financial obligations of providing working capital or rebuilding a damaged property.
Three other provisions for contract termination usually require negotiation. These are (a) the owner's desire for the option to terminate the contract without cause; (b) the operator's concern about the contract in the event of the property's sale; and (c) the owner's desire to include an operator-performance provision in the contract.
Termination without cause. A provision permitting the owner to terminate the contract without cause is a part of 77 percent of contracts involving owners-in-foreclosure but far fewer contracts with developer-owners. Exhibit 2 summarizes the frequency of this termination clause, required notice periods, and penalty-fee amounts to be paid. With owner-in-foreclosure contracts, both parties realize that the contract will likely be in effect for a short, indeterminate period of time and that the owner-in-foreclosure needs to maintain as many options as possible to improve profitability and sell the property. If the provision appears in a developer-owner's contract, it shows that the developer-owner has significant bargaining power relative to the operator.
In all contracts providing the owner an option to terminate without cause, the owner is required to pay the operator a penalty fee if the owner exercises the option. The penalty amounts are usually a multiple of the most recent 12-month management-fee amount or projected management-fee amounts (based on the agreed-upon pro forma) for a specified period of time. The basis of the penalty fee usually decreases as the remaining portion of the contract term decreases. While operators historically have strongly opposed provisions permitting owners to terminate without cause, they have recently been somewhat more willing to consider the provision when it spells out the specific cost to the owner to terminate--thereby sparing both parties the expense of litigation and the uncertainties regarding a settlement upon unilateral termination by the owner. When this provision occurs in the contract, the lender holding the first mortgage usually requires that the owner obtain the lender's approval before the option can be exercised.
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