Identifying and dealing with risk management and corporate governance in the hotel industry
April 2015 | SPECIAL REPORT: MANAGING RISK
Financier Worldwide Magazine
Hotel companies are no doubt faced with similar risks experienced by companies in other sectors. Certain risk management issues such as compliance with employment and financial regulations and merger control are common to most sectors. Yet the unique ownership and management structure within the hotel industry means that hotel companies’ boards must deal with myriad risks which, in turn, present complex corporate governance issues. In this article we identify some of these complex corporate governance issues, industry specific risks and ways to manage them.
Generally, hotel management agreements (HMA) between owners and operators create an agency relationship out of which arise fiduciary duties on the operator vis-à-vis the hotel owner. In addition, the operator’s board also needs to consider its employees, the environment in which it operates including applicable regulations, potential co-management companies and of course its own shareholders. The multiplicity of stakeholders and the ensuing obligations has the potential to create conflicts of interests. Coupled with the fact that operators generally do not own the assets that form the basis of their business (instead, they essentially own a portfolio of agency contracts), operators’ boards are faced with corporate governance considerations arising from such portfolios and the risks that each relationship with owners and other stakeholders entail.
Deadlocks between owners
With the industry becoming more consolidated, and more sophisticated structures and vehicles being used to develop and purchase hotels, shared ownership has given rise to power struggles and the risks associated with partners and shareholder disputes. Whilst a shareholder dispute at owner level will clearly adversely affect the owners themselves, including the return on their investment, these legal battles may have a significant impact on the operator as well. A typical example of the variety of disputes that can arise in this context is minority shareholder petitions for unfair prejudice. Such a petition may be brought by a co-owner who claims that it is being squeezed out by the others or as a result of a disagreement relating to strategy, financing or management.
Joint venture and shareholder agreements normally include an arbitration provision. This means that most contractual claims arising from disputes between co-owners are resolved privately rather than in the national courts. One of the rationales behind this is to protect the business and avoid these disputes being open to the public eye and other industry players. Publicity is, however, not the only risk resulting from this type of dispute. Disputes of this nature could easily result in the sale of shares or the liquidation of the specific purpose vehicle company which owned the hotel. Such a change in ownership is likely to have considerable implications on the long term arrangement with the operator.
Not only does the operator owe fiduciary duties to all owners under one HMA, but at the hotel group level, duties will be owed to all the group hotels’ owners. Additionally, in instances where the operator has equity in the hotel, any dispute between co-owners will directly involve the operator as co-owner of the hotel. Aside from any impact that such a dispute might have on its own investment, the operator may end up in an awkward situation where its duties vis-à-vis its co-owners (under the relevant investment or shareholder agreement) are conflicting with its duties towards them under the HMA, including carrying on with the management of the hotel. Given the number of owners involved and the potential risks associated with each relationship, hotel operators must carefully consider any action they take when owners are in conflict.
Tensions between owners and operators
Whilst disagreements at an ownership-level may give rise to concerns for operators, the more obvious risk is that the relationship between owners and operators breaks down. As a result of the agency relationship created by the HMA, the principal can usually terminate the relationship with the agent without cause, even if there is no breach of the HMA. Few contracts grant the owners the right to terminate their HMA without cause, although the nature of the agency relationship means that this is something that owners are perfectly entitled to do, as long as the agent is adequately compensated.
The position becomes more complex if the operator is an agent coupled with an economic interest in ownership (which could be due to, for example, involvement as a lender, a shareholder or if the operator has subordinated its fees). This is likely to take the operator outside the realm of agency, including as far as termination of the HMA is concerned. In such instances, the operator’s duties vis-à-vis its co-owners will be mostly limited to its contractual duties under HMA. With regards to termination, there will usually be cross-default provisions in the relevant loan or investment agreement which will require the owner to repay the operator’s investment if the HMA is terminated. This extra layer of complexity necessitates a further risk assessment which must be carried out by the board.
Although termination of the HMA by the owner may entitle the operator to damages, losses potentially suffered by the operator as a result may not be strictly financial. The operator may lose valuable employees. Outside the US, most hotel employees are employees of the special purpose vehicle which owns the hotel, rather than the operator. Under the HMA, the operator will typically have control over the employees, including in terms of training and promotion, etc. However, because the employment contract is with the owner, the operator will lose the employees that it has invested in upon termination. Perhaps the most significant damage is the impact on the operator’s reputation and brand, as well as the knowledge in the local market that the owner has terminated the HMA, which may jeopardise its credibility towards future owners. Boards must therefore be aware of the potential ramifications of being terminated, including in terms of their obligations to their own shareholders and balance these with other risks, including the potential harmful impact of any actions by the owners on its business or brand.
Owner in financial distress
A situation in which the owner encounters financial problems is outside the control of the operator, yet its board will have to consider the resulting risks that arise. There are two primary risks in such a scenario. The first is whether the operator should try to step in and provide financial support to the owner. This may appear desirable as it will allow the business to operate (and thereby limit the impact on its own business and profits). However, the board will need to assess the severity of the financial distress, and whether it makes economic sense to make such an investment.
The second risk arises from the involvement of a lender. As HMAs will usually give an express right to lenders to terminate the HMA upon foreclosure, the operator risks its HMA being terminated if the owner defaults. One way to mitigate this risk is by entering into a Non-Disturbance Agreement (NDA) with the lender and owner. Under such an agreement, the lender agrees that if it acquires title to the property (by virtue of foreclosing on a loan under which the hotel is given as security), it will accept the HMA as if it were the hotel owner. This means that the lender will not exercise its right to terminate the HMA on foreclosure. Although this may seem like a desirable solution, in many countries banks will not sign NDAs. Additionally, the lender may not want to step into the owner’s shoes entirely; for example, it might commit to continue funding for a year only. The board then has to decide how to manage this situation, as it now has an obligation to a stakeholder that it previously had not considered. It is important for the board to be mindful of this risk during negotiations, and aim to negotiate provisions in the HMA which regulate the lender’s involvement if things go wrong.
Protecting the brand
As the hotel industry has consolidated, operators’ brands have expanded into a vast number of territories, and are often instantly recognisable to customers. Therefore, it is of vital importance to operators that the brand is protected in every location. Operators must ensure that high and consistent standards are maintained throughout all locations, which is challenging due to the geographical distance separating each establishment. Operators can reduce this risk by establishing strong brand guidelines which are communicated effectively to staff in all locations.
Brand protection may equally involve the need to enforce intellectual property rights. In addition to rights which have been registered and arise in relation to the name of the brand itself, many large hotel brands will have rights attaching to other aspects of the business. For example, many large hotels will have branded spas. Operators must be mindful of intellectual property infringement in relation to all aspects of its brand, as any infringement by an inferior brand may affect customer’s perception of the brand. This risk can be managed by registering rights appropriately and ensuring that regular intellectual property audits are carried out. Co-branding is also common within the hotel industry, for example, an operator working with external brands in its spas and restaurants. Although such an alliance may be desirable, the board must also consider the risk that relinquishing control of key parts of the hotel may cause the brand damage if standards are not maintained.
The dominance of online booking systems and the storage of data electronically has resulted in another risk to the hotel industry. Hotels collect vast amounts of personal data in order to insure themselves against any damage, and also to build up information for use in marketing and reward programs, which makes them an attractive target to hackers. Data will include names, addresses and even payment details. The consequences of data theft can be significant. All guests whose data was compromised will need to be contacted and informed of the data breach, which will be both a costly process and one that will damage the reputation of the brand.
To complicate matters, this data may be subject to conflicting data protection regulations (given that it is generally created, shared and used in more than one jurisdiction) and tends to be jointly owned by the operator, the owner and online booking systems. Such joint ownership may translate into joint liability in case of data breach. This demonstrates another instance in which the operator’s board lacks control over elements of its business, which results in complex corporate governance issues.
The nature of the hotel industry implies that both owners and operators almost invariably operate in a foreign jurisdiction. Whilst the owner will financially invest in a foreign jurisdiction by purchasing the property, the operator will also have to make a significant investment locally. For example, it might have to relocate employees, engage local suppliers and engage local advice as to whether their current business model is compliant in the new jurisdiction.
Furthermore, operating in certain foreign jurisdictions may expose owners and operators to unstable political and economic conditions, as well as corruption and legal uncertainties. Stakeholders will need to consider the various legal systems potentially relevant to their business, including local regulations, the place of incorporation of any joint venture company and the laws applicable to the agreements governing their relationships (e.g., HMAs and shareholder agreements). These will inform the way the board deals with any risks with protecting their investments and enforcing their rights, including before the local courts or via arbitration in a neutral place.
Operators’ boards have a huge number of duties toward a wide variety of stakeholders, which can potentially give rise to conflicting interests. Adding further complexity is the scale of the businesses involved, which implies that boards have to manage several owner relationships and are increasingly dealing with multiple brands potentially competing with each other. Many of the scenarios touched upon involve aspects of their business which will be outside the board’s control, e.g., disputes between owners or a data breach of the online booking system, which gives the board a difficult job when deciding how to manage its duties. Others scenarios, such as co-branding, involve board decisions as to whether to relinquish yet more control. Conversely, operators may decide to acquire further control by investing in the business, through cash injection or equity, although, additional control – as explained – may add further risks. This complicated structure means that the board has to undertake a highly complex and sector focused risk analysis which makes corporate governance in the hotel industry fundamentally different to any other industry.
Daniel Larkin is a partner and Claire Morel de Westgaver is an associate at Bryan Cave. Mr Larkin can be contacted on +44 (0)20 3207 1301 or by email: firstname.lastname@example.org. Ms Morel can be contacted on +44 (0)20 3207 1253 or by email: email@example.com. The authors would like to thank Hannah Coker, trainee at Bryan Cave, for her assistance with this article.
© Financier Worldwide
Daniel Larkin and Claire Morel de Westgaver