Hotel-management agreements must balance the competing interests of the hotel owner for the right to sell the hotel clear of any management agreement against the operator’s desire for a long-term management agreement, which will extend beyond any sale of the hotel. These competing interests can be addressed by giving the hotel owner the right to terminate the management agreement upon sale of the hotel, but only after the operator is given the first opportunity to buy the hotel to protect its interests.
Jennifer R. Schultz
The provision in a hotel-management agreement creating this right of first offer, or ROFO, for the benefit of the operator is fraught with challenges for the hotel owner and hotel operator, which can lead to litigation between the two. This article will raise awareness of these dangers from the perspective of the hotel owner and operator, suggest protections for both parties in the use of the ROFO and provide alternatives to the ROFO.
What makes a ROFO problematic?
The ROFO gives the operator the right to purchase the hotel even after the owner indicates interest in terminating the management agreement upon sale of the hotel. However, the operator must commit to do so quickly, and at a price and terms set by the owner, generally without substantial negotiation between the two. This puts the operator’s purchase at the whim of the owner, which can be especially burdensome for operators who are not in the business of owning hotels and need to seek a partner for any purchase. But it also can create hidden problems for owners because operators might use the ROFO as a negotiating tool to get a different deal from the one for which they originally bargained.
A commonly drafted ROFO will have the following structure and parts:
Before the hotel owner may offer the property to any buyer, the owner must first offer to sell the property to the operator.
The owner sets the price and terms under which the operator must purchase the hotel; agreements usually include a 30- or 60-day ROFO exercise period during which the operator must irrevocably agree to purchase the property under the owner’s price and terms, or lose the purchase right.
If the operator does not agree to purchase the property during the exercise period, then the owner has a defined period of time to offer the property to any other buyer but may not agree to a sale price less than an agreed amount below the ROFO price (as a means of ensuring the owner does not set an artificially high ROFO price). If the owner fails to sell the property during the secondary time period, the ROFO process will be retriggered.
Problems for a hotel owner
A serious problem for hotel owners is that inclusion of a ROFO in any form puts marketable title of the property at risk. Most jurisdictions recognize a ROFO as a sufficient legally cognizable interest in the property such that the offeree has a reasonable likelihood of being able to obtain a lis pendens on the property in the event of a dispute, which will cloud marketable title and effectively block the owner from selling the property to any other willing buyer.
Even if a hotel owner is willing to risk a lis pendens, a second, potentially avoidable, problem arises from the inclusion of “soft” language in the ROFO, such as provisions that require the hotel owner to set the ROFO price “reasonably” or “in good faith.”
Inclusion of even one of these “soft” phrases is an obvious anchor for a litigation claim by an offeree. A related problem arises where the language of the ROFO is not exact or specific enough. Hotel owners should strive to include, with specificity, any terms about which they wish to foreclose any future debate with the operator. The combination of soft language with broad or missing terms creates a breeding ground for future problems.
Where a ROFO is so easily litigable, the balance of power shifts toward the operator, putting considerable pressure on a hotel owner to provide substantial justification for its ROFO price and terms, or to not trigger the ROFO at all thereby effectively eliminating the owner’s bargained-for right to an early-termination sale.
Problems for a hotel operator
Even though the ROFO is intended to protect the interests of hotel operators, most of the power rests with the owner to control the process. This power imbalance can be made worse for the operator absent key language to transform the ROFO into a “firm offer” or “option contract,” which would mean the owner may not rescind the offer (once made) during an agreed upon set period of time. Many states have strict requirements to find that a ROFO is a “firm offer” or “option contract” and will hold that unless the ROFO provision includes specific language, the hotel owner may rescind the offer, regardless of how far along the operator is in the process. This could be true even where an operator indicates an interest (but not an acceptance) in exercising the ROFO, shares detailed information of its plans with the owner and commences due diligence. While a court might ultimately come down on an owner who abuses this right repeatedly, an owner is generally left with a fair amount of leeway to change his or her mind regardless of the consequences that might have on the operator, unless the ROFO is a “firm offer” or “option contract”.
Another problem for operators is thatROFOs are frequently silent on terms that are key to the operator’s exercise of the ROFO. Two areas operators should be vigilant to include are a required immediate and fulsome diligence period, and defined obligations for properties that are encumbered with mortgage loans.
Specifically, defined diligence periods are important for operators because even though an operator is familiar with the hotel it manages, that does not mean an operator has the knowledge necessary to purchase the property. Operators need the same diligence and information sharing that any other buyer would insist on, and because operators proceeding under a ROFO are under a strict time constraint during the exercise period, they need the diligence period to begin immediately upon a ROFO trigger. Where properties are encumbered with mortgage financing, the ROFO should address whether the property will be sold free and clear of the financing.
How to craft a less troublesome ROFO
From a hotel owner’s perspective, a ROFO free of all soft language is the safest bet. The inclusion of “reasonable” or “good faith” language in connection with ROFO price and term-setting increases the likelihood of non-frivolous litigation brought by a hotel operator. Not only do these words provide a foundation for claims of alleged breach of the ROFO provision or violation of the implied covenant of good faith and fair dealing for “misuse”, they also offer an easy hook for a declaratory judgment as to their meaning. This could elongate litigation and provide a hotel operator with more power to pressure an owner to set a ROFO price the operator can meet.
Owners also have to be careful to balance their desire to have a ROFO that infringes as little as possible on their ability to sell their property, with any areas where an owner does not want to face a future challenge from an operator. For example, hotel owners should seek to negotiate a ROFO that expressly states that it may include “any and all terms” for the sale upon its “sole discretion.”
From the perspective of a hotel operator, it is important to negotiate for the inclusion of “firm offer” or “option contract” language that provides the express assurance that the ROFO will be held open for a specified period of time. Without this, operators run a risk that the rug will be pulled out from under them. There are two other key provisions operators should consider:
The diligence period must commence immediately after the trigger of the ROFO, but the exercise period will not begin to count down until information, as specifically set forth in the ROFO, is provided in full to the operator; and
if there are any governmental or other third-party approvals required for the sale, the sale must be conditioned upon receipt of the approvals (as any third-party sale would be), and any specified time period between the operator’s acceptance of the ROFO and the closing of the sale must take into account the time required to obtain these approvals.
Alternatives to the ROFO
Because a ROFO poses risks for each party, hotel owners and operators might also consider excluding the provision altogether in favor of other less burdensome provisions.
One alternative to a ROFO is a higher early termination fee for a termination upon sale. This fee could be set at an amount that would equal or approximate the management fees the operator would have received had early termination never occurred. With this provision in place, the parties might consider forgoing a ROFO altogether. This approach provides the operator with additional security from an early termination, and could be a much less risky venture than a ROFO for an owner who will have an identifiable cost of early termination with the added benefit of being able to freely market the property.
Whatever is done, hotel owners and operators should be aware the ROFO provision can be trouble and should be given serious consideration.
Jennifer R. Schultz is an associate in the Boston office of Goodwin Procter LLP. She focuses her practice on real estate litigation in a variety of matters relating to hotels, commercial properties, REITs/REIMs, and zoning disputes. She has represented both hotel owners and operators in her work.
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