The hotels sector has suffered in the recession and as an asset class, hotels are capital intensive operations. They are also susceptible to volatile economic conditions, as consumer and corporate expenditure on hotels is generally viewed as a discretionary expense.
There are various ways in which the corporate ownership of a hotel can be structured. This note will concentrate on one of the most common structures in the hotel industry – the hotel management agreement (“HMA”).
It has become increasingly common for a hotel property to be owned, not by the chain that runs the hotel (the “Hotel Operator”), but by a separate third party investor or developer (the “Hotel Owner”). Typically, the Hotel Owner will finance part of the acquisition or investment/development cost with bank debt. To provide operational expertise and obtain for the Hotel the benefits of being part of a larger operating platform or brand, the Hotel Owner enters into an HMA with the Hotel Operator. The HMA governs the way in which the Hotel Operator will run the business as part of its group/brand.
Under the HMA, the Hotel Operator will usually have exclusive control of and responsibility for day to day operations including matters such as bookings, staff, supplies and maintenance, for which it receives fees, while the Hotel Owner will bear the risk of the business, and provide working capital. The Hotel Operator will generally act as an agent to the Hotel Owner, and be entitled to enter into contracts with third parties, and to access the Owner’s bank accounts to make payments in the course of running the hotel. The HMA will contain strict requirements for the Hotel to be maintained and operated in accordance with the standards of the Hotel Operator’s system and brand.
The HMA is often accompanied by a non-disturbance agreement (“NDA”) between the Hotel Operator and the Hotel Owner’s lender. Typically, the lender agrees not to terminate the management agreement, or to procure or consent to its termination, on default by the Hotel Owner under the financing documents, or upon the insolvency of the Hotel Owner, and the Hotel Operator agrees to stay and operate the hotel for the lender should it enforce its security. This means that the Hotel Operator can be secure in keeping the value of the HMA, and the lender knows the Hotel Operator cannot walk away immediately on an insolvency or enforcement, which is potentially extremely disruptive to the business.
In addition, a restriction can be registered against the title of the Hotel Owner at the Land Registry – in the event that the hotel is sold by the Hotel Owner or lender (in the case of repossession), the restriction will prevent a transfer of the title to the Hotel from being registered without the HMA being transferred alongside the Hotel. In practical terms this prevents a sale of the hotel asset with vacant possession.
The documentation typically used for this structure briefly comprises:
- Loan facility agreement between Hotel Owner and lender.
- Debenture from Hotel Owner in favour of lender containing fixed and floating charges, including a first fixed charge over the hotel property.
- Security over any intercompany loans, to facilitate a share sale if necessary.
- The lender should also take security over the Hotel Operator’s fixtures, fittings and equipment – if the hotel ultimately fails, the lender will need to retain the fixtures, fittings and equipment in order to trade/sell the business as a going concern.
- Assignment of the Hotel Owner’s interest in all major contracts entered into by the Owner, including the HMA, and NDA, development and contractor agreements (if not contained in the debenture).
- The HMA may also be secured by second ranking security, so an intercreditor deed may also be needed.
Pre-enforcement options which may be available where the Hotel Owner is in financial difficulties include:
- amend and restate the loan to extend its term, or long stop dates;
- increase the amount borrowed;
- debt for equity swap;
- relaxation of financial covenants;
- renegotiation of HMA;
in exchange for:
- a charged cash deposit;
- an equity injection;
- additional security from other members of the borrowing group
Before considering enforcement, a lender must ensure it has a thorough understanding of market values, the security documents, what enforcement (and pre-enforcement) options are available, and a strategy for how the asset will be developed/traded/marketed and sold. The prime aim will be to maximise value.
On insolvency of the Hotel Owner, the lender will usually be entitled to appoint an administrator/receiver under the powers in the debenture/fixed charge. The lender should bear in mind that it will have less control over an administrator than a receiver, as an administrator is an officer of the court with a general duty to all creditors. However, it is also important to note that a receiver will not have control over floating charge assets. There may also be different tax consequences to the appointment of a receiver or administrator.
The office holder to be appointed will need experience in the hotels sector, and there must be a clear strategy. The office holder must be familiar with the terms of the HMA and any NDA, including any required capital expenditure needed to preserve or maximise value – is there funding available for this? If the HMA has been terminated, there may also be a requirement for funding to continue to trade.
Any NDA will usually contain wording prohibiting the termination of the HMA by the Hotel Operator in the event of appointment of an office holder over the Owner provided that breaches of the HMA on the part of the Owner (including potentially arrears of fees) are dealt with. This means that the Hotel Operator will remain in place to run the business while the office holder carries out his planned course of action, and the office holder will not have full control of running the hotel. A good relationship between the office holder and the Hotel Operator will be essential. Having the Hotel Operator in support of the proposed strategy will assist the office holder in retaining control of the hotel, and prevent employee departures which would stop smooth running of the business. Also, the Hotel Operator’s brand and booking system are often critical drivers of new bookings to hotels and very important to maintaining the business.
The office holder may find it difficult to terminate the HMA in any event, even if he wishes to, and he will therefore have to act in accordance with its terms. These terms will include the exclusive right to run the hotel on a day to day basis free from Hotel Owner (or other) interference, and can lead to difficulties. This can be an issue where the office holder is reluctant to allow the Hotel Operator to continue without supervision, but interference from the office holder may amount to a breach of the Owner’s obligations under the HMA, and could leave the office holder’s actions open to challenge by the Operator and give the Hotel Operator the right to terminate the HMA.
Generally, a trading hotel will be more valuable than an empty, non-trading hotel. However, in some cases, the existence of an HMA can mean that the value of the property is compromised, rather than enhanced, and the office holder may want to sell the hotel quickly with vacant possession, while the Hotel Operator may want to remain in occupation. This could arise if, for example, a competitor operator was interested in purchasing the business or if third party purchasers perceived there to be value in rebranding or repositioning the Hotel or converting it to alternative use, or if a 4* hotel was built in a location more suited to a budget hotel. The office holder, whether an administrator or a receiver, has an obligation to obtain best the price for the hotel on a sale, and he will need to consider whether the cost of any liability arising from a breach of the HMA or NDA, or from a termination of the HMA or NDA without proper grounds, would outweigh the benefit of selling with vacant possession.
In these circumstances, it can be very difficult to see a way to remove the HMA from the picture, and release the value of the property, without incurring significant time and expense.
If there is no option but to sell the hotel, the office holder should also:
- check whether the Hotel Operator has any rights of first offer or last refusal. This must be dealt with, as other potential purchasers may not want to be involved while this right remains outstanding.
- check whether the Hotel Operator has any other rights, such as maintenance of brand standards, confidentiality clauses, is there any prohibition on sale to a competitor? These may impact on timing and sale price.
- depending on the nature of the assets, and in so far as is possible, locate relevant regulatory compliance documents, for example, fire risk assessments, asbestos reports/logs, and check that they are up to date. If the office holder is able to assign the benefit of these documents, or hand them over on a sale, this will increase the speed at which a sale may be completed, and may increase the value of the assets (or avoid a potential price chip).
The office holder will need to consider funding as soon as he is appointed. Is there funding to trade the hotel in administration/receivership (including potentially arising arrears of fees not paid to the Hotel Operator)? Is there any planned capital expenditure that must be met? Does the hotel make enough money to cover immediate costs? Is the office holder able to honour all bookings and deposits received before appointment?
The Hotel Operator will of course want to continue to cover all of these costs, but the office holder may not want the Owner’s assets to be used to cover these payments. Any new obligations entered into by the Operator may also give rise to payments which must be made as expenses in an administration, and an office holder will want to have control over these obligations. As outlined above, this could lead to conflict with the Operator.
Regulatory requirements – licensing, permits, consents and related matters
The operation of a particular hotel may require a number of different permissions to be in place in order to allow the facilities offered to guests to be lawfully provided.
By way of example these might often include:
- a premises licence granted under the Licensing Act 2003 (potentially authorising all or any of the following; alcohol sales, entertainment and late night refreshment);
- where spa facilities are offered, a special treatments licence;
- a “wedding” licence;
- a premises licence and operating licence or other form of permission granted under the Gambling Act 2005 (some hotels have casino licences associated with them by way of example or may offer gaming machines); and
- a tables and chairs licence in respect of the use of public highway space.
These are important permissions for two main reasons. First, any extant permissions will be required to allow the hotel to continue to trade lawfully. Trading without such a permission is backed by criminal sanction. Second, they may be valuable assets in their own right. Premises Licences, in particular, can add significant value to property values.
It is important to be aware of the effect of insolvency on those permissions. Many of the permissions will lapse upon certain insolvency events, with premises licences and gambling licences falling into that category. There is then a limited window available to the office holder within which to reinstate the licence (by transferring it to an appropriate solvent vehicle).
Where a licence is lost it may not be possible to obtain a new licence on the same terms (or in some cases at all). Thus, it is vital to be aware of this.
So administrators need to be aware of their responsibilities. Preparation is vital, as some of the time periods available for reinstatement of a licence are short. In a hotel group situation, each separate premises will have separate licences, so this may be a time consuming process, but it must be done carefully.
If trading the premises, the administrators should ensure there are licences in place and what the requirements of the licences and legislative scheme are. For example, many licences will have detailed conditions attached to them and failure to comply with them may amount to a criminal offence. In addition, where sales of alcohol are concerned each licence will have an individual named on the licence fulfilling the role of “designated premises supervisor”. Without a named “dps” who is responsible for particular premises then alcohol sales are unlawful. In addition, if the terms of licences are not being adhered to then this may put the licences in jeopardy of enforcement action, possibly with a view to revocation in the case of serious breaches. An office holder is unlikely to obtain proper recovery in monetary terms for an hotel site with potential enforcement issues hanging over it.
There may also be other regulatory requirements which the office holder should ensure that he or she is aware of and able to comply with as failure to do so may result in criminal liability. Again by way of example, there is a wealth of regulation around food safety which includes requirements to keep certain records in relation to food handling.
Similarly, there may be agreements in place for maintaining or servicing particular plant, machinery or equipment which are vital to the hotel’s operations. Again, a failure to keep these arrangements in place may have significant adverse consequences.
On appointment, an office holder will need to also give consideration to issues such as staffing, and whether any redundancies will be needed, or whether jobs can be preserved via a sale of the business as a going concern.
The office holder should also check all supplier contracts: is there provision for termination by suppliers on the appointment of an insolvency officeholder? There may be an immediate need for cash, as suppliers may demand payment of arrears before they will supply further. Is there a source of cash funding?