It has been 14 years since we published an in-depth newsletter on performance termination provisions. We initially intended to update that newsletter. However, it became clear that no update is necessary or warranted. The situation remains exactly the same in 2024 as was the case in 2010. This provision is definitely set in cement.
The reader is probably wondering why. There are many reasons.
Obviously operators wish to ensure that, to the maximum extent possible, they can "book" the full amount of the very substantial income fee streams that these agreements generate over the entire life of each agreement. These "rivers of gold" underwrite the capital value of the multi-billion dollar international hotel management companies, many of whom are publicly listed, whose share price is vitally dependent upon the consistency and predictability of these fee streams Understandably therefore operators hold out for a clause which minimises or eliminates the prospect that an owner has the power to prematurely terminate a management agreement due to chronically poor performance.
In our experience, many owners are advised as to the shortcomings of standard performance provisions but either take the view that operator under performance will not happen to them, or come under time pressure to close the management agreement negotiations and capitulate, or otherwise face the prospect that the hotel development process will be held up. Some owners with sufficient market clout (who are generally multi property owners) simply adopt the view that if there is an under performance issue then, irrespective of the management agreement's, shortcomings they will be able to convince the operator to agree to resolve the situation to the owner's satisfaction.
As a practical matter we have seen many situations where an owner faced with profound under performance has been powerless to rectify the situation and not only experience heavy operating losses but a vastly diminished sale price when the hotel is put to the market if sale is subject to the management agreement. In this newsletter we suggest ways that the standard clause in use today could be amended to allow an owner to terminate an underperforming operator.
At the end of this newsletter, we set out a typical performance termination provision (which we will discuss in detail below) followed by a suggested alternative, if incorporated, will give the clause a better likelihood that it will do what it is intended to do. The reality of negotiations inevitably means that some or all of the proposed changes will not be agreed. Any of the suggested changes will improve the provision but sufficient changes need to be made to substantially move the dial to make the provision workable in practice (hence our calibration of each of the proposed changes in the table below).
Satisfactorily dealing with the shortcomings of performance provisions is absolutely critical to the ongoing viability of the entire global hotel industry. It will become incrementally difficult to attract increasingly scarce capital to an industry where owners do not have demonstrable control over the performance capabilities of the hotel assets their capital which is invested in it.
Suggested changes to the standard performance provision
| |
The current situation |
Proposed change |
Degree of importance (out of 10) |
| 1. |
Two test hurdles need to be triggered simultaneously – usually an internal actual vs budget test and an external RevPAR comparison with similar hotels. |
One test hurdle only.
In our view while there is no clear winner we would opt for the internal actual vs budget test as it exhibits less problems. |
10 |
| 2. |
Budget provisions contain significant line items which the owner is unable to challenge. |
There should be no exceptions to a comprehensive budget approval process. |
8 |
| 3. |
A breach needs to occur in at least two (2) consecutive years to trigger. |
Only one (1) year needs to be triggered. |
10 |
| 4. |
The test usually commences in the fourth (4th) or fifth (5th) full year. |
Test period should commence in the first (1st) full year. |
6 |
| 5. |
Generally one (1) or more cure rights in return for a cure payment. |
Preferably no cure rights but no more than one (1) cure right. |
10 |
| 6. |
Cure payment in one of the trigger years only at the operator’s election. |
Cure payment for the trigger year (if more than one year then all trigger years). |
10 |
| 7. |
Cure payment calculated by reference to a percentage of budget (usually 80%-85%). |
Cure payment equal to100% of budget. |
6 |
| 8. |
Existence of any Force Majeure factors disqualifies the relevant year. |
Force majeure factors only to be taken into account to reduce the profitability hurdle. |
8 |
| 9. |
Any cure payments must be repaid. |
Cure payments not repayable. |
9 |
| 10. |
Disputes to be resolved by arbitration or the court application. |
Binding expert determination. |
8 |
Conclusion
Hotel managers have never agreed to and, in all likelihood, may never agree to performance provisions which could significantly and demonstrably increase the prospect that management contracts could be prematurely terminated for performance failure. The purpose of this newsletter is to show what needs to happen to the standard currently in use to make it workable.
If a workable performance provision cannot be negotiated then consideration should be given to trading the clause for a no fault termination provision (with a reasonable termination fee) or a manchise.
Example 1 – A performance termination provision commonly in use today
a. If in respect of any two (2) consecutive Trigger Years commencing with the Fourth (4th) Full Year:
- The average RevPar for the Hotel in each of the 2 Trigger Years is less than 80% of the weighted average Comp Set RevPar; and
- The actual Gross Operating Profit of the Hotel is less than 80% of the Budgeted Gross Operating Profit
the Owner shall be entitled to terminate this Agreement within 90 days after the expiration of the second of the 2 Trigger Years by giving the Operator 60 days written notice PROVIDED THAT the Owner will not be entitled to terminate this Agreement if the Operator pays to the Owner within such 60 day period the amount by which the actual Gross Operating Profit is less than 80% of the Budgeted Gross Operating Profit for the second of the 2 Trigger Years (“Shortfall”). Following such payment both consecutive Trigger Years will be regarded as a Trigger Year in which this provision was not breached.
b. If the Gross Revenue of the Hotel is adversely affected as a result of a Force Majeure Event, renovation or construction projects at the Hotel, or the Owner's failure to carry out its obligations pursuant to this Agreement, the Year in which such one or more events takes place shall be deemed to be a Year to which paragraph (a) does not apply. If the Owner and the Operator fail to agree that this paragraph (b) applies to any Year then within 30 days of the event which gives rise to the application of this paragraph (b) the parties will refer the dispute to Arbitration.
- If in any Comp Set Year the Gross Operating Profit exceeds the Budgeted Gross Operating Profit for that Competitive Set Year, then the Owner must within 30 days of the end of that Competitive Set Year pay the Operator an amount equal to the total of all amounts paid by the Operator to the Owner in accordance paragraph (a) (and not reimbursed to the Operator) and the Operator is authorised to deduct such amounts from the Operating Account.
- Notwithstanding any other provision of this Agreement, if this Agreement is terminated for any reason (other than as a result of a default by the Operator), then in addition to any other monies payable by the Owner to the Operator, the Owner must pay to the Operator an amount equal to any amount paid by the Operator to the Owner pursuant to paragraph (a) (and not reimbursed to the Operator). This provision will survive the expiration or termination of this Agreement.
Example 2 – A suggested alternative performance termination provision
a. If in respect of any Trigger Year commencing with the First (1st) Full Year, the actual Gross Operating Profit of the Hotel is less than 95% of the Budgeted Gross Operating Profit, the Owner shall be entitled to terminate this Agreement within 180 days after the expiration of the Trigger Year by giving the Operator 30 days written notice PROVIDED THAT the Owner will not be entitled to terminate this Agreement if the Operator pays to the Owner within such 30 day period the amount by which the actual Gross Operating Profit is less than the Budgeted Gross Operating Profit for the Trigger Year. Following such payment the Trigger Year will be regarded as a Comp Set Year in which this provision was not breached. The Operator's right to make such a payment can only be exercised on one (1) occasion.
b. If the Gross Revenue of the Hotel is adversely affected as a result of a Force Majeure Event, renovation or construction projects at the Hotel, or the Owner's failure to carry out its obligations pursuant to this Agreement, the Gross Revenue shall be adjusted by an amount agreed by the Parties taking into consideration:
- The effect of the Force Majeure Event, renovation or construction, or the
- Owner’s failure to carry out its obligations on the Hotel or the operation of the Business;
- The period which has elapsed or which is likely to elapse until, the Business is no longer affected; and
- Any other matters considered relevant by both the Operator and the Owner, and the Gross Revenue for the Hotel must be re-determined for the purposes of this provision.
If the Owner and the Operator fail to agree that this paragraph (b) applies to any Year then within 30 days of the event which gives rise to the application of this paragraph (b) the parties will follow the Binding Expert Determination procedure.
For the purpose of both these provisions, the following definitions apply:
“Budgeted Gross Operating Profit” means Gross Operating Profit budgeted in the Business Plan or Business Plans for the relevant Competitive Set Year.
“Competitive Hotels” means the following hotels: [Insert details of relevant hotels]
“Comp Set” means the selection of the Competitive Hotels agreed by the parties as forming the Competitive Set as at the Opening Date and thereafter with such changes mutually agreed following review by the parties every three years during the Term.
“Competitive Set RevPar” means [insert standard definition]
“Trigger Year” means a 12-month period commencing 1 July.
“Force Majeure Event” means [insert standard "Force Majeure' definition]
“RevPar” means the revenue per available room as determined in accordance with the Uniform System.
