Legal issues in management deals, rates during pandemic
Legal issues in management deals, rates during pandemic
10 JULY 2020 8:26 AM

Presentations during The Virtual Hospitality Law Conference explained some of the new issues hoteliers may face regarding management contracts and pricing their rooms during the pandemic.

REPORT FROM THE U.S.—As hoteliers proceed through the coronavirus pandemic and the subsequent recovery, they will face a number of new challenges to what they previously considered normal operations.

In a series of online presentations through The Virtual Hospitality Law Conference, hospitality industry attorneys spoke about what issues hoteliers will encounter as they work through management agreements and pricing their hotels.

Management contracts
When looking at management deals, it’s important everyone understands the structure of the potential deal being discussed as there are differences between management contracts and leases, said Cliff Risman, partner at Foley & Lardner.

With a management contract, a third-party operator receives some combination of the base or base plus incentive and the balance of the net results of operations belongs to the owner of the operation, he said. In a lease, the operator comes in and leases the facility while paying the owner an agreed rent amount, which could be the base percentage with some other add-ons. The benefits or burdens resulting from their operations then falls upon the manager, not the owner.

Operators have different options when trying to win a deal, Risman said. Key money in essence is a one-time payment in exchange for the contract, and it amortizes or burns off such that if the manager receives the full benefit of the term of the contract, the obligation on the owner to repay the key money is waived, he said. Managers also sometimes make equity investments, putting down mezzanine debt in place and agree to a level of performance or reimburse the owner if certain deficits are incurred, he said.

“This is more important in the current environment than ever, because so many owners are cash-challenged at the moment,” he said. “There is a tremendous cash crunch. They've either been closed and are just reopening or have been operating at perhaps even single-digit occupancy while ownership expenses, mortgage taxes, insurance have continued to be payable.”

Many owners are looking to change managers now or in the near future, and they want someone who will bring some investment to the table and put cash into the asset, he said.

The base fees come off the top, and the manager oftentimes receives a percentage of gross revenue regardless of whether the owner is turning a profit, Risman said. Incentive fees can be more easily aligned with profitability as they normally take the form of a percentage of either gross operating profit or essentially net operating income, he said. If it’s NOI, it could be over a certain hurdle, such as a return to the owner.

“The pendulum will move more toward the alignment of risks and rewards, more toward higher incentives and lower base fees now that people have experienced some of the downside of the last several months,” he said.

Performance termination clauses are going to become prominent as a result of the pandemic. These clauses generally measure one or two years of performance or look at cash or revenue-per-available-room tests compared to the competitive set, Risman said.

“A lot of assets that were on the edge of failing these tests may not pass this year or next year depending on how and when things pick up,” he said, adding that force majeure could come into play here.

Subordination and recognition arrangements are critical when assets are foreclosed and they change hands, Risman said. Managers will want to make sure that if a hotel goes back to a lender, the lender has recognized them as the manager and have agreed to leave them in place, he said.

Price gouging
Some people might wonder why price gouging is an issue for the hotel industry as it’s hurting from the loss of demand caused by the coronavirus pandemic, said Sandy Garfinkel, attorney at Eckert Seamans. There are 35 states that have price-gouging laws, and they are typically triggered by declarations of emergency, he said. Price gouging occurs when someone raises their price by an abnormal amount in response to abnormal market conditions caused by things such as natural disasters, wars and outbreaks of disease.

Most price-gouging cases are resolved either through settlement or by persuading state regulators they’re barking up the wrong tree, he said. Some cases do go to court, however. One price-gouging case where Garfinkel is representing a hotelier client has been going on since 2016 and has been costly, he said.

Hotels have been heavy targets for price-gouging investigations and enforcement actions in recent years, he said. The pandemic hit the hotel industry early on and hard, so there’s a concern hoteliers might feel the need to make up for lost revenue by manipulating rates for their rooms, he said.

“In this environment where we have states of emergency, pending states of emergency extended, if you’re changing your pricing for your rooms, you need to be very careful about whether or not you might be violating price-gouging laws in the process,” he said.

To stay within the constraints of states’ statutes, hoteliers should know whether the states they operate in have these laws, know how they work, what the limitations on pricing are and when they go into effect, Garfinkel said. Hoteliers should also prepare themselves for potential investigations in case any disgruntled guest is upset over room rates by knowing how to defend themselves in a documentary fashion and knowing what positions to take, he said.

One problem hoteliers face in price-gouging cases is most regulators aren’t necessarily intimate with how hotels price their rooms, Garfinkel said. Many hotels use semi-automated rate-setting systems that look at factors such as timing, comp sets and demand that make automated or semi-automated change to rates several times a week or even per day.

It’s dangerous for hoteliers to rely on these systems when pricing gouging claims might arise because of “a record of price changes that could look suspicious to an outside entity that doesn’t know vagaries of how we set our prices in this industry,” he said.

Normally, regulators would look at a hotel’s rates as they were right before the state of emergency occurred to compare them current rates, he said. The challenge here is that many hotels closed or partially closed because of the pandemic, so there is little or no history of rates from recent months for a comparison.

“There’s a big gap in terms of traditional evidence that either side can use to prove whether price gouging occurred,” he said.

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