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Key Legal Issues: The Battle for Control By William M. Bosch and Anthony F. Cavanaugh

William Bosch is an accomplished trial lawyer whose practice is largely focused on the representation of real estate owners and developers, as well as high-end funds that invest in real estate projects. He co-leads the firm’s interdisciplinary Hospitality Practice and regularly advises hotel owners and real estate joint venture parties in resolving disputes across the United States and internationally. Mr. Bosch has handled precedent-setting litigation and arbitration involving the enforcement and termination of hotel management agreements (including disputes involving most of the major hotel operators) and issues of fraud and racketeering, breach of contract, fiduciary duty, accounting, cost allocations, unfair trade practices, personal services, and agency. He also formulates and executes strategic plans to help clients navigate commercial and intellectual property challenges across a range of other industry sectors, including life sciences, IT, financial services and consumer products. Anthony Cavanaugh focuses on complex litigation in both state and federal courts, with an emphasis on counseling clients in the hospitality industry. He assists clients in the evaluation and, if necessary, litigation of disputes with management companies, franchisors, tenants, lenders or vendors. He has experience with the resolution of commercial disputes, including the negotiation and enforcement of management contracts, asset management, and evaluation of hotel operations. Mr. Cavanaugh also has handled cases involving toxic tort litigation, including the defense of a leading chemical manufacturer in a series of medical monitoring class actions. In addition, he has represented manufacturers and distributors of military supplies in commercial disputes. Mr. Cavanaugh graduated from the Georgetown University Law Center, where he was Editor of the Georgetown International Environmental Law Review.

“H

OSPITALITY” BY NAME AND CONCEPT encompasses caring for guests and, across many cultures, embodies notions of safe refuge, respect, graciousness, and comfort. In our experience, some management companies use the sales process before the management agreement is signed to foster a false impression that hospitality will be extended to the owner as well as to the guest. This is not always the case, and for some managers, decidedly not. In short, caveat emptor.

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398 Chapter 14 Once a potential hotel investor closes on a transaction and becomes an owner, it bears the risks of diminution of property value common to all real estate, as well as on-going exposure to operating losses and liabilities arising from operating the hotel business. But investors can misunderstand and overestimate their ability to control or even influence these business risks. This “control risk” sometimes is lost amid the negotiation of the core economic terms, especially in connection with the selection and retention of a manager to operate the hotel business. In this chapter, we build on prior publications describing the key legal issues confronting investors in hotels to highlight an emerging theme at the intersection of business and law: hotel managers proclaim that their interests are aligned with owners, but many prove otherwise in their contracts and performance. Owners dissatisfied with the manager too often have negotiated away control rights and find themselves with limited options to exert influence. This trend has increased as management companies have spent a lot of time, attention, and attorney fees developing form agreements favoring themselves with terms they claim to be non-negotiable. A prudent investor therefore distinguishes the promises of the development teams selling the skills of a manager from the legal rights, duties, and obligations undertaken by the parties under the management agreement. It evaluates the operating model and the measure of control the investor desires to maintain over the duration of the term, regardless of its anticipated hold period. And such an investor wisely evaluates the positions management companies have taken in litigation, so that it can push back when it costs the least—at the negotiating stage.

Control under Different Operating Models As an initial matter, the control risk varies with the type of operating model. This is not to say that one model is routinely better or worse than the next; they each have pros and cons. But the legal issues, including the key language in a management contract, should be evaluated by investors at the outset in the context of their appetite for control risk. Accordingly, we outline below some general characteristics of the different operating models, so that investors can be sensitive to and negotiate the control risks when they’re focused on more typical evaluation and allocation of economic risks.

Branded Hotel Management Company Model Control risk arises foremost in the operator model where the authority to operate the hotel on a day-to-day basis is delegated to a branded management company. A branded management company typically does not own the hotel property, but rather manages the hotel business on behalf of the owner. The owner pays a fee in return for the branded management company’s services, expertise, and use of the brand in marketing the hotel. Typically, that brand is incorporated in the name of the hotel. Most branded hotel companies have a business model that primarily seeks fee income, with little equity invested in hotel real estate. As J. W. (“Bill”) Marriott, Jr.

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acknowledged in describing Marriott’s growth, their goal was to reduce their proportion of ownership to one of every 100 hotels in Marriott’s global system, instead focusing their business on management contracts.1 Under this business model, in which the manager bears little to no investment risk and is compensated primarily by a percentage of hotel gross revenues, there is an inherent conflict of interest—the brand is incentivized to spend owner money in pursuit of revenues, regardless of overall profitability.2 As discussed further below, numerous disputes have arisen where the brand makes operational decisions that appear to promote brand interest ahead of owner interest. These decisions go well beyond territorial encroachment, where brands negatively affect one operation by operating affiliated properties in overlapping markets. They include, for example, evolving brand standards and decisions to move property-level services to “shared services” provided above property level by the operator’s affiliates. Some brand operators take the position that a rising tide lifts all boats—that what’s good for the brand and its shareholders is necessarily good for the owners of individual hotels. But owners increasingly are questioning this proposition. The problem is exacerbated by the presumption of brand value, which is increasingly being challenged by research studies.3 Lenders historically appeared to prefer branded operators, perhaps because of the perceived value of their reservations systems in driving revenue. But the most recent economic downturn had a dampening effect on how enamored lenders are of brands, especially as special servicers started looking more closely at expense structures.4 The rise of third-party distribution services, such as OTAs and soft-branded reservations systems, as well as consumer access to rating sites, has further diminished the advantages that used to be associated with the larger brand operators. This is not to say that all branded operators are bad, or that the branded model is inherently unfavorable to an investor. However, it is imperative that prudent investors more closely evaluate and distinguish between a branded manager’s promises and what it is contractually committed to deliver. For example, when an investor asks for proof that brand initiatives are generating incremental returns for the owner, too often they’re stonewalled by a branded management company that refuses to identify any obligation to respond to such inquiries. Then, when they look at the management contracts they have signed, some owners find that the operator has curtailed the scope of information it is contractually required to provide and/or circumscribes the owner’s ability to object as part of the annual budget review. These control elements are best addressed at the operator selection stage. The longer the term, the greater the control risk. The primary ownership risk under the branded hotel management model is the term of the agreements. Branded hotel operators typically insist on longer term contracts and press for “no cut” provisions that effectively commit the owner to bankroll the manager. They are known for negotiating so-called performance tests that are difficult (sometimes impossible) to fail, often relying on at least one “revenue index” prong that the operator knows presents no genuine performance termination risk. Owners don’t always understand that they’re being asked to hand over the keys and surrender all control over how owner money is spent. The litigation positions taken by branded management companies reveal this is precisely their objec-

400 Chapter 14 tive. Hence, when the relationship does not outlast the honeymoon following execution of the contract, disputes arise. In some instances, the owner is forced to seek judicial relief to regain control over its property, hotel business, and checkbook. These control risk pressures are exacerbated in the context of a branded hotel management company model because they are influenced by operator culture. Operator culture is inherently difficult for investors to evaluate during the due diligence phase. Whereas some branded managers promote transparency and remain focused on generating returns for owners, others are less owner-friendly. Some are simply arrogant and litigious. Some promote their own interests, including their interest in developing and growing their brands, tapping into the public equity markets and, for public companies, pursuing shareholder interests even when those are at odds with owner interests. Sorting this out is difficult when investors are enamored with the property itself and with the pro formas promising a rosy future. Managers that disclaim fiduciary duties increase control risk. Culturally, one bellwether of an owner’s ability to control its investment is the manager’s willingness to acknowledge and abide by its fiduciary duties to the owners for whom they operate. Fiduciary duties include the duties of loyalty, disclosure, and the obligation to put the interests of the owner ahead of the manager.5 These duties, even if not expressly stated, are implicit in a relationship where the owner delegates the day-to-day authority and control over the operation of the hotel, funds that operation, and agrees to bear all risk of financial loss.6 Branded management companies can be less transparent. Some have used draft management contract language and legislative initiatives in an attempt to avoid well established legal authority that they act as fiduciaries on behalf of owners. For example, Marriott and Starwood successfully lobbied the Maryland state legislature to enact Title 23 of the Commercial Law section of the Maryland Code, which is applicable specifically to parties to hotel operating agreements. The statute subordinates common-law agency principles to the express terms of an operating agreement. Among other implications, the statute allows hotel managers to argue that there are no implied fiduciary duties, even where the terms of the management contract would suggest otherwise. And where Maryland law does not apply, some of these management companies have been unabashed in proclaiming that, in their view, they do not owe fiduciary duties to the owners for whose account they ostensibly are managing the hotel. Pro forma and budget disclaimers by managers also portend increased control risk. Another cultural indicator is how the management company stands behind its financial forecasts after the management contract is signed. Given their size, branded operators tend to have development teams that engage investors and provide pro formas developed by in-house research departments. The pro formas typically have disclaimers by which the management company essentially says “do not rely on our forecasts.” Often the management agreements will include a provision such as “Owner acknowledges that any written or oral projections, pro formas, or other similar information that has been (prior to execution of this agreement) or will (during the term) be provided by Manager … is for information purposes only, and that manager … does not guarantee that the hotel will

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achieve the results set forth in any such projection, pro formas, or other similar information….” Given the unequal bargaining positions, especially as they relate to market conditions and hotel operating forecasts, investors and lenders typically have to rely on such forecasts. Legally, however, operators will be quick to point out that such reliance is misplaced, given their disclaimers. The issue is not merely one of “guarantee,” but rather goes to the heart of the investor’s due diligence. Owners confronted by a development team that will not stand behind the pro formas it offers to justify the owner’s investment, at least during the initial budget years of the engagement, should be especially sensitive to control risk, as the trust owners necessarily must place with the manager is rooted on a very shaky foundation. For most owners, control issues become evident only after a deal is signed, when the first budget is being evaluated. When the operating team, as distinguished from the brand management company’s development team, assumes responsibility for presenting operating budgets and actual performance, the romance phase can rapidly move into a period of buyer’s remorse. Branded operators increasingly are using the annual budget review process as the focal point for owner input and “control.” But as with the pro formas, branded hotel management contracts typically provide that the budget is actually just aspirational. And when the operator fails to meet an approved budget or, more typically, unilaterally revises its “forecast” during the course of the budget year, owners sometimes find themselves with few concrete remedies under the contract. In short, a manager that will not stand behind its forecasts and refuses to provide the owner with concrete approval rights and access to information is grabbing perilous and potentially long-term control over the owner’s property and bank account.

The Franchise Model Control risk can be attenuated slightly but not completely where a non-branded management company operates pursuant to the system standards of a franchise flag. Under this model, the owner enters into a franchise agreement and license with a brand (the franchisor), by which it commits to employ certain franchise systems and comply with franchisor standards. In consideration, the franchisor receives a fee, typically a percentage of revenues. Day-to-day management, however, is undertaken by a third entity (i.e., an independent management company) or by an owner affiliate (i.e., an owner/operator). Obviously, an owner-operated franchise provides greater control. However, even an independently managed franchise can provide increased owner control, because investors typically have more leverage in negotiating shorter terms and otherwise more favorable control provisions with independents. Even in an owner-operated situation, the investor cedes substantial control rights to the franchisor. The franchise agreement in most instances provides few (if any) options for owner termination without payment of liquidated damages. The brand, by contrast, typically retains several termination options and the ability to require costly owner investments to meet new system standards. As a general matter, the court decisions recognizing owner termination powers under agency

402 Chapter 14 or personal services theories (discussed further below) do not extend to a typical franchise relationship. In many respects, the branded management and franchise models have started to merge. Several of the larger brands have moved essential management functions (like accounting, human resources, procurement, sales and marketing, and reservations) above property level. Hotel employees, whether working for a branded manager or a franchisee, are increasingly removed from the information and resources needed to manage the hotel on a day-to-day basis. But under a franchise model, at least, the franchisee has some control over which systems it agrees to use and over the fees it is willing to pay for such systems. In a branded management context, some managers unilaterally enroll properties in new systems and impose additional charges without owner input or approval—and without providing backup detail when requested. These are the types of managers a prudent hotel investor would do well to avoid.

The Independent Model An independent hotel is usually managed directly by an owner affiliate or by a non-branded management company. Owner-operated independents obviously have the lowest control risk (assuming partnership equanimity), but many managed independents also offer control benefits. Shorter terms and broader owner termination rights, fewer system charges and hidden fees, increased owner access and input rights, and a culture focused more on the success of the individual property than on developing “brand equities” are the hallmarks of this model. The independent hotel also is free from brand standards so it can provide a unique experience, tailored to the market and more flexible in responding to changes in the competitive market landscape. Of course, under this model the absence of systems and brand equity portends longer ramp-up to stabilization, and success depends on the ability to hire and retain talent at the property level. But control risk is clearly reduced relative to the other prevailing models.

Control Rights in Management Contracts The primary way investors in hotels can preserve control rights is through the terms of the management contract. The following are some exemplary provisions where prudent investors can and should push back when a manager tries to assert too much control. Term and termination. The longer the term, the less control the owner has, absent a termination “without cause” provision. Owners also can negotiate for more control through a termination on sale provision and through a legitimate performance test. Managers unwilling to consider these provisions essentially are seeking to minimize the risks from their own non-performance, which should give any prudent investor pause. Of course, performance guarantees, fee stand-asides, and other similar provisions (e.g., fee caps) also can align owner/manager interests. But the owner’s ability to terminate the manager is the ultimate control mechanism. Accordingly, when managers ask for disclaimers of any kind—disclaimers of agency, disclaimers of personal service relationships, or disclaimers of fiduciary duties—hotel investors should be especially vigilant.

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Hiring and retention of employees, including the hotel’s upper management team. Where the manager seeks the contractual right to hire, train and supervise employees, including the guidance team, the owner would do well to impose reasonable limitations. For example, even where hotel employees technically are employed by the manager (or an affiliate of the manager), the owner should secure the right to approve or disapprove of the selection or retention of key guidance team personnel (such as the General Manager, Director of Sales and Marketing and Controller). Some managers have whittled away at this control measure by inserting language that the manager has the ultimate discretion to hire and retain these employees, even if the owner objects. For example, owners cede some control when they allow the manager to insert language to the effect that “if owner disapproves of three (3) candidates for the position submitted in good faith by manager … manager shall have the right to select the person to be offered the position, in its sole discretion ….” Financial reporting. Most management agreements require that managers maintain financial statements reflecting hotel operations in accordance with the Uniform System of Accounts for the Lodging Industry and generally accepted accounting principles. Managers typically are required to provide periodic accountings to owners. But the agreements often do not specify the level of detail necessary to fulfill these obligations. And while there typically are outside audit provisions, they tend to be limited to audits of financial statements, which are provided in the first instance by the operator. Greater audit rights, including the right to audit the hotel operations (not merely the financial statements), would provide some added control benefit, although a preferable approach is manager transparency and more robust disclosures in the first instance. Books and records. Most agreements also require managers to maintain and make available the hotel’s books and records, but some leave vague what constitute “books and records.” This is an essential control provision, because access to books and records permits the hotel investor to conduct its own evaluation of the manager’s performance, without relying on selective materials or summary accountings provided by the manager. Some branded managers now are trying to limit books and records just to “books of account,” which they claim are merely the periodic profit and loss statements and nothing more. Others recognize a broader definition, extending to any books and records that “relate to the operation of the hotel.” Even then, some branded managers try to limit owner access to books and records that are specific to that owner’s hotel. Under this approach, the manager takes the position that the owner/investor is not entitled to any books and records relating to, by way of illustration, corporate-level charges and programs imposed on the hotel and paid for by the owner (e.g., chain service allocation materials, regional sales office data). Other managers go so far as to contend that they are entitled to withhold the owner’s books and records on the grounds that they are proprietary to the operator, even refusing to turn over guest records, audit reports, and hotel standard operating procedures. Investors must be wary of managers unwilling to provide access to information necessary to confirm the manager’s compliance with its obligations. Fees and expenses. One area where some managers are less than forthcoming is regarding how much the owner will pay the manager for the day to day operation

404 Chapter 14 of the hotel. For these operators, management fees are the tip of the iceberg. “Corporate charges” (i.e., above-property-level fees, charges, expenses, assessments) can be many times the amount of management fees; however, these charges rarely appear in pro formas, nor are they spelled out clearly in management agreements. Some managers make these charges transparent, while others claim their methods for offloading corporate charges onto individual properties are too complicated for even the manager to explain. However, hotel investors must demand transparency. The longer the term of the agreement, the more transparency a good manager should be willing to provide into its fee structure. Procurement. Purchasing and vendor selection is another area where the owner’s rights to control the manager can be reasonably defined in the management agreement. Managers typically purchase hotel food and beverage, operating supplies, and capital goods for the owner’s account, using the owner’s credit. Investors need to be more wary of hotel managers that do not provide for competitive bidding requirements or other oversight, such as approval of vendor contracts generating purchases over a certain amount per year or access to vendor information. Some larger branded operators offload purchasing responsibility to collective purchasing organizations (which themselves are sometimes related parties of the operators). These purchasing organizations ostensibly use the combined purchasing power of participating hotels to negotiate agreements. Prudent investors should inquire as to whether a manager using these procurement services will disclose the terms of the vendor agreements, and why a particular vendor was chosen. Owners should be aware, however, that managers sometimes themselves cannot identify net prices, because those prices may contain vendor rebates, allowances, and marketing dollars. A number of disputes have arisen where some or all of these fees have gone to benefit the purchasing organization or the manager, and not to the owner who paid for the purchases. Given the manager’s ability to purchase on the owner’s account, in this context it is hard for managers to justify any disclaimer of fiduciary duties with respect to procurement—and investors should not acquiesce. Budget review and approval. One area where it may appear that the owner has negotiated for control is with respect to the approval of the budget. But looks can be deceiving. A good, transparent manager provides a detailed budget and gives whatever detail the owner needs to understand the manager’s proposal. And the owner’s ability to approve the budget, in total or in part, is another key control feature. But even if the owner has an express contractual right to participate in the budget process, some managers press for language that limits that participation to making “comments,” while reserving ultimate budget approval to the manager. For example, a management agreement may provide only that “manager shall meet with owner and shall in good faith discuss and consider all of owner’s comments concerning the budget.” A promise to consider comments in good faith may ring hollow after the ink is dried on the agreement. Dispute resolution. Owners also need to be mindful of ceding control over how disputes get resolved. Increasingly, managers are trying to wrap all operational issues into the annual budget review process. One not so transparent reason for this move is to force contract disputes into the very limited “expert”

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dispute resolution mechanisms managers suggest for budget spats. For example, some managers provide that “in the event there is a disagreement pertaining to the budget that cannot be resolved by the parties … all matters shall be determined by a panel of experts …” One of the largest branded operating companies has gone so far as to assert that all disputes theoretically relate to the budget, and therefore must enter a circumscribed express resolution process. While alternative dispute resolution (e.g., arbitration) sounds reasonable, it actually tends to favor the manager. Limitations on discovery, minimal appeal rights, a dearth of qualified neutrals, and a host of other problems end up limiting the investor’s control, which is one reason broad “arbitration provisions” are so widely promoted by management companies. Miscellaneous control provisions. There are a number of other areas where the owner can exert (or cede) control. For example, the selection of the competitive set, the assignment provisions that may allow the operator to off-load its responsibilities to third parties or affiliates, and encroachment provisions that provide territorial restrictions preventing the operator from operating a competing hotel in the investor’s market all need to be evaluated in this context.

Highlights of Recent Legal Disputes Many of the disputes in the industry that grab the headlines reflect situations where the owner trusted the manager to deliver on promises not clearly expressed in the contract and to promote the owner’s interests first and foremost—and then fought to regain control over its business. The less flexible (some might say, the more arrogant) the management company, the more likely that dispute ends up entailing a termination claim. Whereas many of the owner/manager disputes over the last two decades focused on the existence of an agency relationship, the landscape has changed as managers have moved adeptly to reduce their agency termination risks and owners, in response, have had to adapt. The most recent trend has been recognition by the courts that management agreements are contracts for “personal services,” which are always terminable at the will of either party (subject, as with a terminated agency, to damage claims for wrongful termination of contract). A personal services contract is generally recognized as one that requires the rendition of services that require the exercise of special skill and judgment.7 In most jurisdictions, a court cannot compel specific performance of a personal services contract.8 Predictably, management companies already have started to inject “disclaimers of personal services” in their agreements, and other provisions reflecting their attempt to foreclose terminations. And perhaps just as predictably, some hotel investors are signing such agreements, either unwittingly or consciously counting on such disclaimers later being held unenforceable.

The Legacy of Prior Owner/Manager Lawsuits Much has been written about the nature of the owner/operator relationship.9 Decisions in the 1990s were largely pro-owner, recognizing that management contracts establish an agency relationship. The importance of this legal concept is two-fold.

406 Chapter 14 First, an agency relationship necessarily is fiduciary in nature, meaning that the operator has duties of loyalty, disclosure, and not engaging in self-dealing (by way of illustration), even if the contract does not expressly spell this out. Second, in an agency relationship, the owner (the principal) always has the power to terminate the manager (the agent), even if it does not have the right under the contract. The seminal court decisions recognized that the only exception to this agency termination principal is where the manager has an “agency coupled with an interest.” Operators started injecting language into their draft contracts attempting to “create” an agency coupled with an interest merely by saying so. But that inartful attempt to avoid establishing an agency relationship soon was replaced by a more sophisticated effort to include disclaimers of agency and disclaimers of fiduciary duties. In some instances, brand operators pushed for legislative relief,10 which militates against using Maryland in a choice of law provision. Some operators started inserting language characterizing the manager as being a mere “independent contractor,” even though independent contractors can be agents. The result has been an erosion of the legal foundation built by prior owners,11 as some courts have been confused by the language inserted by operators. Some management companies even have seized on the broad delegation of authority to the operator to argue that no agency relationship exists, precisely because the owner has given up control over the day-to-day operation of the hotel. For example, many hotel operators insisted on including language in their form operating agreements declaring that the operator is an “independent contractor.” There is legal authority that an independent contractor also can be an agent, but the import of this language is clear – operators are setting up an argument that they are not agents, without expressly saying as much. Some operators have been particularly clever, arguing that language disclaiming any relationship “like a partnership or joint venture” also disclaims an agency relationship and fiduciary duties, without expressly disclaiming agency or even mentioning fiduciary duties. While the language here was intended to address the parties’ rights and obligations vis-à-vis third parties, operators instead have taken boilerplate language that most owners gloss over and used it to disclaim any duties of loyalty, care, or good faith in performing their obligations. In some instances, operators have buried express disclaimers of agency in this boilerplate. Some owners, for their part, have unwittingly allowed operators to use this clever drafting to create arguments that the parties “mutually intended” to allow the operator to walk away from the implied duties of loyalty, due care, diligence, and competence.

The Current Legal Landscape Marriott International, Inc. v. Eden Roc, LLP/Eden Roc, LLP v. Marriott International, Inc., et al. (the Eden Roc case) Eden Roc, LLP, the owner of the Eden Roc Renaissance Hotel in Miami Beach, Florida, brought a lawsuit in the New York Supreme Court against Renaissance Hotel Management Company and its parent company, Marriott International, for breach of the management agreement that installed Renaissance as the operator of the hotel.12 Eden Roc sought to terminate the management agreement and

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remove Renaissance from the hotel. After a failed attempt to remove Renaissance from the hotel, Eden Roc sought an injunction from the court requiring Renaissance to leave the hotel, arguing that the management agreement was one for personal services. Eden Roc also argued in a footnote that Renaissance was Eden Roc’s agent, but that the court need not reach the agency question for purposes of the motion before it.13 The trial court rejected Eden Roc’s argument that the management agreement was a contract for personal services.14 The court also rejected Eden Roc’s argument that an agency relationship arose by virtue of the management agreement, noting “the parties specified the nature of their relationship in the Agreement, stating ‘In the performance of this Agreement, [plaintiffs] shall act solely as an independent contractor.’”15 Interestingly, no mention was made of the fact that the Restatement (Second) of Agency establishes that “[o]ne who contracts to act on behalf of another and subject to the other’s control except with respect to his physical conduct is an agent and also an independent contractor.” Restatement (Second) of Agency § 14N (1958) (emphasis added). Eden Roc appealed on both the personal services and agency issues. The Appellate Division agreed with Eden Roc and reversed the lower court on the personal services argument, reasoning that the “detailed management agreement places full discretion with [Renaissance] to manage virtually every aspect of the hotel. Such an agreement, in which a party has discretion to execute tasks that cannot be objectively measured, is a classic example of a personal services contract that may not be enforced by injunction.”16 The Appellate Division also held that, “[w]hile it is unnecessary to reach the question, we note that, contrary to [Eden Roc’s] contention, the agreement is not an agency agreement. Defendant lacks control over plaintiff, the alleged agent, since the agreement provides for plaintiff to have unfettered discretion in managing the hotel’s operations.”17 The court did not elaborate on the agency aspect of its decision. In light of the Appellate Division’s order, the lower court ruled that Eden Roc had the authority to terminate and eject Renaissance from the hotel as and when it wished, subject to damage claims for wrongful termination.18 According to the court, “if Eden Roc tells Marriott/Renaissance to get out, Marriott/Renaissance must follow that directive.”19 RC/PB, Inc. v. The Ritz-Carlton Hotel Company, L.L.C. et al. (the Ritz-Carlton Palm Beach case) Almost concurrently, a Florida court tackling a similar dispute between a hotel owner and operator reached a parallel conclusion. RC/PB, Inc., the owner of what was formerly the Ritz-Carlton, Palm Beach, brought claims against the operator Ritz-Carlton and its parent company, Marriott, alleging breach of the operating agreement. RC/PB sought and received a declaration from the court that RC/PB had the power to terminate Ritz-Carlton as the operator, based on a personal services theory.20 The court’s “examination of the Operating Agreement as a whole show[ed] a delegation to Ritz-Carlton of a broad range of discretionary authority” in operating the hotel, which “‘undisputedly call[ed] for the rendition of services

408 Chapter 14 which require[d] the exercise of special skill and judgment.’”21 The court rejected Ritz-Carlton’s argument that a performance test in the contract provided an objective measure of its personal services, and also rejected the manager’s contention that its limited rights of assignment were inconsistent with a personal services relationship. The owner subsequently exercised its power to terminate the operating agreement, which had more than six decades remaining, pursuant to the trial court’s order. FHR TB, LLC v. TB Isle Resort, L.P (the Turnberry Isle case) In the case of FHR TB, LLC v. TB Isle Resort, L.P (“Turnberry Isle”), the United States District Court for the Southern District of Florida resolved both the agency and personal services issues in favor of the owner, which then paid a liquidated damages fee to the operator in consideration for the termination. In that case, the owner of the hotel formerly known as the Fairmont Turnberry Isle Resort and Club in Aventura, Florida, evicted the operator, Fairmont, from the hotel without any prior notice, on the ground that the relationship was an agency that was terminable at the will of the principal.22 Fairmont sought an injunction from the court to reinstate it as operator.23 The Turnberry Isle court denied Fairmont’s injunction, finding that the hotel management agreement created an agency relationship. The court stated “[t]he Restatement of Agency recognizes that hotel managers are agents of the owners of the properties they operate.”24 The court further held that “hotel management agreements are personal services contracts” because they call for “‘the rendition of services which require the exercise of special skill and judgment … managerial services [that were] wide-ranging and involve daily discretionary activities … [including] hiring and firing managerial personnel and hundreds of other employees, contracting for … services’ and the like.”25 M Waikiki LLC v. Marriott Hotel Servs. (the Waikiki Edition dispute) In May 2011, the owner of the Waikiki Edition Hotel filed a lawsuit in New York State against the hotel’s manager, Marriott, and boutique hotelier  Ian Schrager claiming that Marriott failed to deliver pre-opening design and development assistance it promised prior to the hotel’s opening and had mismanaged the hotel after opening. On August 28, 2011, the owner of the Waikiki Edition Hotel removed Marriott as the operator of the hotel and installed a new operator, despite a management agreement that allowed Marriott to operate the hotel for 30 years.26 Marriott filed a motion asking the court to reinstall it as the manager. Marriott argued that it was not the agent of the owner. The agreement in that instance stated that Marriott “shall act solely as an independent contractor” and that nothing will be construed “as making any party a partner, joint venturer with, or agent of, any other party.” Marriott did not raise, and the court did not reach, the issue of personal services.27 The court, troubled by the owner’s self-help ouster after the complaint for Marriott’s removal was already before the court for resolution, agreed with the manager that the status quo should not have been unilaterally altered and issued an order in August 2011 reinstalling Marriott pending a ruling on the merits. The owner filed for bankruptcy before that order could be executed.

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In the chapter 11 case, Marriott fought to take over the debtor and propose its own plan. Ultimately the matter was settled for a compromised amount under a plan that enabled the owners to retain full ownership and management of the hotel.28

Lessons for Hotel Investors Whether through the existence of an agency relationship or because a hotel management agreement is deemed a personal services contract, the courts are clear: owners have the power to terminate a hotel management relationship at will. While the recent decisions have been helpful to owners seeking to regain control over their investments, they do reflect that some courts are departing from what has been a well-accepted feature of the industry—the agency relationship between owner as principal and manager as agent. Importantly, an agency relationship, unlike a personal services contract, necessarily imposes fiduciary duties.29 Against their own interests, and perhaps unwittingly, owners have accepted language in management agreements (for example, the “independent contractor” language referenced above) that has laid the groundwork for managers’ arguments that hotel management agreements do not create fiduciary duties. Now, some managers even are attempting to have owners sign disclaimers that state that the hotel management agreement is not a personal services agreement. Owners also have accepted an erosion of control rights that later allows operators to claim that no agency relationship exists. The agency aspects of the Eden Roc decision, for example, show how some courts have used the owner’s delegation of “unfettered discretion” over the day-to-day management of the hotel to find that one of the features of agency—control by the principal/owner—is not present. This control element is a vestige of the development of agency law in the context of vicarious liability claims by third parties (for example, when a bystander is harmed by the acts of an agent). The alleged “principal” in that instance reasonably would not be liable for the harm caused by the alleged “agent” if the principal had no control over the conduct of the agent. But this control element should not apply for purposes of establishing whether an agency relationship exists in determining the scope of liability between the principal and the agent themselves.30 Until this issue is sorted out by the courts, prudent hotel investors should not accept a “broad delegation of authority” without at least reserving some control over how the agency exercises its duties.31 Notwithstanding the pro-owner court decisions in the recent Eden Roc and RC/PB cases, owners must be especially vigilant when negotiating management agreements to avoid control traps, and must continue to challenge managers’ attempts to evade their fiduciary duties.

Emerging Legal Issues The scope of legal issues facing hotel investors is vast. One emerging area that is certain to evolve further in the years ahead is cyber-security. In today’s electronic data-driven world, hotel owners and operators must be aware of increasing threats to data security and also must address guest demands for safe and reliable

410 Chapter 14 access to the Internet. Two recent and ongoing legal disputes highlight the difficulty in balancing these two issues. As owners ultimately may bear the costs, these developments are worth watching. Federal Trade Commission (“FTC”) v. Wyndham. On three occasions between 2008 and 2010, hackers gained unauthorized access into Wyndham’s computer network as well as the computer networks of several Wyndham-branded hotels. The hackers compromised payment-card information that Wyndham had collected from customers. Wyndham reported these hacking incidents to law-enforcement authorities.32 After a two-year investigation into Wyndham’s data security practices, on June 26, 2012, the FTC filed a lawsuit in federal court alleging that Wyndham had engaged in “unfair … acts or practices” in violation of the Federal Trade Commission Act 15 U.S.C. § 45(a), by failing to take “reasonable and appropriate” measures to protect the data stolen by the hackers.33 Wyndham moved to dismiss the case, arguing, among other things, that the FTC did not have the power to regulate cyber-security and, even if it did, Wyndham was not given proper notice of what cyber-security measures it was supposed to take. In April 2014, the federal judge presiding over the case rejected Wyndham’s motion to dismiss the charges.34 In July 2014, a federal appeals court agreed to hear Wyndham’s appeal of the lower court’s refusal to dismiss the charges against Wyndham. Wyndham was joined in its appeal by a number of outside groups, including the United States Chamber of Commerce, the American Hotel & Lodging Association, and the National Federation of Independent Business. The FTC was joined in its opposition to Wyndham’s appeal by a number of consumer advocacy groups such as Public Citizen, Center for Digital Democracy, Consumer Action, Center for Democracy & Technology, Electronic Frontier Foundation, and the Electronic Privacy Information Center.35 The briefing on the appeal was completed in December 2014 but the appeals court has not yet rendered a decision. Marriott Agrees to Pay $600,000 Fine to Resolve Federal Communications Commission Investigation of Wi-Fi Blocking. The FCC recently took Marriott International to task for blocking guest access to personal Wi-Fi networks at some of its properties.36 In response to a complaint from a guest of a Marriott-managed hotel, in March 2013, the FCC launched an investigation into allegations that Marriott was “jamming” guests’ personal Wi-Fi connections. In the course of its investigation, the FCC found that Marriott employees “had used features of a Wi-Fi monitoring system … to contain and/or de-authenticate guest-created Wi-Fi hotspot access points in the conference facilities” while at the same time charging those guests from $250 to $1,000 per device to use the hotel’s Wi-Fi service.37 In October 2014, Marriott admitted to the practice and agreed to pay a fine to the FCC of $600,000. Marriott also agreed to cease the practice and institute a compliance plan that includes periodic reporting to the FCC of its compliance.38 Prior to its settlement with the FCC, Marriott and the American Hotel & Lodging Association had asked the FCC to condone and allow its hotels to jam personal Wi-Fi hotspots, arguing that such hotspots might be used to launch an attack on

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the hotel’s Wi-Fi network, threaten other guests’ privacy, or slow down Internet speeds for other customers. Technology giants such as Google and Microsoft have opposed such requests, arguing that jamming access is against the public interest.39

Conclusion From minimum wage issues to management contract termination lawsuits, the scope of “key legal issues” facing hotel investors is vast. The ability to control that investment, and to exit if necessary, should be of paramount concern. Even investors with short hold periods have learned the hard way that plans often change, because the markets sometimes move in mysterious ways. If there is one central lesson to be learned from the major lawsuits in the industry, it is that trust is a currency in short supply and of diminishing value. Trusting a manager that disclaims fiduciary duties, refuses to be transparent, requires a longterm agreement, limits termination options, and insists on unfettered discretion is a recipe for disenchantment. As is often the case, it is better to evaluate key control elements at the negotiating stage. When the key players are focused on pro formas of limited utility and fee structures that depend on revenues and profits that may never materialize, the savvy investor spends the mental capital on the control features of the management contract. It is, after all, the investor’s money—and for too many managers, this fundamental feature of the owner/manager relationship is forgotten as soon as the deal has been won.

Endnotes 1. J. W. Marriott, The Spirit to Serve: Marriott’s Way (New York: HarperCollins, 2001), p. 23. 2. The so-called “incentive fee,” while intended to align owner and operator interests, is rarely a substantial part of the management company’s overall compensation, and operators sometimes find it’s more advantageous to bypass the incentive fee altogether by recouping company overhead through “operating expense” charges to the hotel in addition to the management fees. 3. See, e.g., O’Neill, J., et al., “Do brands matter? A comparison of branded and independent hotels’ performance during a full economic cycle,” International Journal of Hospitality Management 30 (2011) 515–521; HVS Rep. on Preferred Hotel Group, avail. at http:// phgcdn.com/pdfs/uploads/ HVS_Study_Summary.pdf. 4. While some branded operators have spent considerable energy courting lenders and are trying to develop pro-operator language in subordination and non-disturbance agreements (SNDAs), the most sophisticated lenders are not being hoodwinked by mere promises of brand value without actual monetary contributions (e.g., performance guarantees, fee stand-asides, key money, etc.). 5. Restatement (Third) of Agency §§ 1.01, 8.01 cmt. b (2006). 6. Woolley v. Embassy Suites, Inc, 227 Cal. App. 3d 1520 (Cal. App. 1991); 2660 Woodley Rd. Joint Venture v. ITT Sheraton Corp., No. Civ. A. 97-450 JJF, 1998 WL 1469541, at *6 (D. Del. Feb. 4, 1998) (finding that a hotel management agreement created a terminable at-will agency).

412 Chapter 14 7. See, e.g., Woolley v. Embassy Suites, Inc., 227 Cal. App. 3d 1520, 1534 (1991) (“The management contracts here undisputedly call for the rendition of services which require the exercise of special skill and judgment. These managerial services, even by Embassy’s own assessment, are wide ranging and involve daily discretionary activities. The manager’s duties include: hiring and firing managerial personnel and hundreds of other employees, contracting for utility services, landscaping, maintenance and security, processing reservations, arranging for advertising and promotion, and filing legal actions on the owner’s behalf to collect rent charges, cancel leases or dispossess guests. In other words, the contracts call for a series of complex and delicate business decisions and require mutual cooperation and trust, both of which have ceased to exist in the wake of rancorous litigation between the parties.”). 8. See Karrick v. Hannaman, 168 U.S. 328, 336 (1897) (stating in a personal services contract “it is well settled that a court of equity cannot compel the performance of the service” “against the plaintiff, and will not be enforced against the defendant”); Gov’t Guar. Fund v. Hyatt Corp., 95 F.3d 291, 303 (3d Cir. 1996) (affirming district court’s holding that “the management agreement was a personal services contract which cannot be specifically enforced”) (quoting Woolley, 227 Cal. App. 3d at 727 (Cal. App. 1991)); Weeks v. Pratt, 43 F.2d 53, 57 (5th Cir. 1930) (“A contract for personal services will not be enforced in equity by compelling the rendition of the services.”) 9. See e.g., Bosch, W. et al., “Key Legal Issues,” in L. Raleigh & R. Roginsky (Eds.), Hotel Investments: Issues & Perspectives, 5th Ed (Lansing, Mich: American Hotel & Lodging Educational Institute, 2012). 10. Md. Stat. § 23-101 et seq. 11. A seminal case discussing the owner/operator relationship is Woolley v. Embassy Suites, Inc., 227 Cal. App. 3d 1520 (Cal. App. 1991). Embassy Suites operated hotels for the plaintiff owners, who sought to terminate their management agreements with Embassy Suites for nine hotels. Embassy Suites obtained a court order enjoining the terminations, but the appellate court reversed the order. The California First District Court of Appeal explained that “a principal who employs an agent always retains the power to revoke the agency” and held that Embassy Suites was an agent of the owners. According to the court, “it should always be within the power of the principal to manage his own business and that includes the power of the principal to reassume the control over his own business which he has but delegated to his agent.” Consistent with the Woolley decision, other courts, including the United States District Court for the District of Delaware in Woodley Rd. Joint Venture v. ITT Sheraton Corp, have found that the hotel management agreements create agency relationships that are terminable at will. See Woodley Rd., 1998 WL 1469541, at *6 (D. Del. Feb. 4, 1998); see also Pac. Landmark Hotel, Ltd. v. Marriott Hotels, Inc., 23 Cal. Rptr.2d. 555 (Cal. Ct. App. 1994.); Gov’t Guar. Fund v. Hyatt Corp., 95 F.3d 291, 297 (3d Cir. 1996) (recognizing the trial court’s holding that a hotel management agreement “created a revocable agency that ended once [the owner] gave notice of its termination” (citation and quotations omitted). 12. First Amended Verified Complaint, Eden Roc, LLLP v. Marriott Int’l, Inc., Index No. 651027/2012 (N.Y. Sup. June 29, 2012). 13. Id. at 11 n.2.

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14. Id. at 4. 15. Id. at 6. 16. Order, at 1-2, Marriott Int’l, Inc. v. Eden Roc, LLLP, Index No. 653590/2012 (N.Y. App. Div. March 26, 2013). 17. Id. at 2. 18. Hearing Transcript on Order to Show Cause, at 8, Marriott Int’l, Inc. v. Eden Roc, LLLP, Index No. 653590/2012 (N.Y. Sup. May 21, 2013); see also Declaratory Judgment and Order, Marriott Int’l, Inc. v. Eden Roc, LLLP, Index No. 653590/2012 (N.Y. Sup. May 21, 2013). 19. Id. at 6-7. 20. Order on Plaintiff’s Motion for Partial Summary Judgment Regarding the Power to Terminate, at 7-8, RC/PB, Inc. 21. Id. (quoting Woolley v. Embassy Suites, Inc., 227 Cal. App. 3d 1520, 1534 [Cal. Ct. App. 1991]). 22. Turnberry Isle, No. 11-23115-CIV-Graham/Goodman, 2011 U.S. Dist. LEXIS 155742, at *5 (Sept. 26, 2011). 23. Id. at *8. 24. Id. at *78 (internal citations omitted). 25. Id. at 86 (internal citations omitted). 26. M Waikiki LLC v. Marriott Hotel Servs., No. 651457/2011, slip op., (N.Y. Sup. Ct.N.Y. Cty. Aug. 30, 2011). 27. The day after the court ordered that Marriott be reinstalled as operator, the owner of the Waikiki Edition Hotel filed for bankruptcy. In that proceeding, Marriott claimed that it was owed damages for the owner’s wrongful termination of the management agreement. As a part of the bankruptcy proceedings, the owner and Marriott entered into a confidential settlement agreement. 28. In re M Waikiki LLC, Case No. 11-02371. 29. These fiduciary duties include loyalty, care, and diligence and competence in actions taken pursuant to the agency relationship. In the hotel context, if the operating agreement vests broad discretion in the operator, fiduciary duties require that the operator competently exercise such discretion in good faith and with due care for the benefit of the owner. 30. The Restatement (Third) of Agency (2006) notes that “[a] principal’s right to control the agent is a constant across relationships of agency, but the content or specific meaning of the right varies.” Id. § 1.01 cmt. c. “Thus, a person may be an agent although the principal lacks the right to control the full range of the agent’s activities, how the agent uses time, or the agent’s exercise of professional judgment.” Id. 31. “The power to give interim instructions distinguishes principals in agency relationships from those who contract to receive services provided by persons who are not agents.” Restatement (Third) § 1.01 cmt. f(1).

414 Chapter 14 32. Federal Trade Commission v. Wyndham Worldwide Corp., et al., No. 14-3514 (3rd Cir. 2014) Appellant’s Opening Brief. 33. Id. 34. Id. 35. Federal Trade Commission v. Wyndham Worldwide Corp., et al., No. 14-3514 (3rd Cir. 2014) Appeals Court Docket. 36. http://www.fcc.gov/document/marriott-pay-600k-resolve-wifi-blocking-investigation 37. Id. 38. Id. 39. See http://money.cnn.com/2014/12/25/technology/marriott-wifi/