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Mr. Courtnell

Hospitality Law

The Performance Test: Time for a Change?

By Paul Courtnell, Director, Leisure & Resorts Group, Gunster LLP

Introduction

Most hotel management agreements contain a "performance test" that gives the Owner of the hotel an option to terminate the management agreement if the Operator fails to achieve one or more financial benchmarks in the operation of the hotel. Many of these performance tests were negotiated under very different economic conditions than prevail today. Given the new reality that prevails in the hotel industry, Owners, Asset Managers and Operators should be reviewing the performance tests in their existing management agreements to determine if it is time for renegotiation. With respect to new management agreements, the parties should approach the performance test by keeping in mind the mistakes made and lessons learned from the past. This article explains the components of a typical performance test in a management agreement and recommends areas for examination and negotiation.

Components of a Typical Performance Test

A typical performance test negotiated in better economic times probably contains the following elements -

  • Delayed Start Date: Typically, the performance test may not commence until the fourth or fifth full year of management by the Operator. Particularly in the case of a newly constructed hotel, the purpose of the delayed start date was to allow the hotel to reach stabilization.

  • More Than One Year of Failure: The language usually provides that the test must be failed either for two consecutive years or two out of three years for the Owner's termination option to be activated.

  • Performance Against Budget Test ("GOP Test"): The language usually provides that the test is failed if the Operator fails to achieve a certain percentage of budgeted Gross Operating Profit (or some other benchmark) for a particular year. Those percentages range anywhere from 80% to 95%, depending upon the relative negotiating strength of the parties.

  • Performance Against Competitive Set Test ("RevPAR Test"): This test usually measures the RevPAR of the subject hotel against a negotiated competitive set of comparable hotels (typically about five). Again, the test is failed if the Operator does not achieve a certain percentage of the average of the RevPAR of the hotels in the competitive set. The range of percentages is the same as for the GOP Test.

  • "And" vs. "Or": Some performance tests require both the GOP Test and the RevPAR Test to be failed in order for the Owner's termination right to be triggered. The operative word is "and". Others require only one of the two tests to be failed. The operative word is "or".

  • The "Force Majeure" Clause: The performance test usually excuses the Operator's failure if a "force majeure" event has occurred in the test year. Depending upon how "force majeure" is defined in the management agreement, the Operator may be in a strong position. For example, if the definition of "force majeure" includes "general economic conditions", it may be extremely difficult for an Owner to enforce a performance test failure based on financial results of the hotel during the last several years.

  • Operator's Cure Right: The language often allows the Operator to cure the failure by paying to the Owner the amount that the Owner would have received had the test been minimally satisfied. For example, if the test were 85% of budgeted Gross Operating Profit, and the Operator achieved 80% of budgeted GOP, the cure amount to be paid by the Operator would be 5% of budgeted GOP, not 20%.

How Today's Environment is Different

Many of the performance tests in existing hotel management agreements were put in place while the hotel was still in the planning stages or in construction. The performance test was a "check the box" item for the parties, in that standard clauses were often used and not a lot of examination or negotiation went into the language. Probably as a result of this lack of attention to the details in the beginning, very few hotel management agreements have been terminated recently due to failure of the performance test by the Operator.

The environment today is very different. There is hardly any new construction. Ownership of hotels is changing hands, in many cases involuntarily. Existing management agreements are being renegotiated as new owners take title and in many cases new management agreements are being negotiated with new Operators.

As this process unfolds, the components of a typical performance test of the past should be examined with consideration being given to the following points.

Start Date for First Test Year

Since the subject of the renegotiated or new management agreement is probably an existing hotel, not new construction, the typical delayed start date of four or five years is probably no longer applicable. Since the Owner will be expecting the Operator to reach stabilization more quickly, it may be appropriate that the first test year be the second or third year of full operation.

The GOP Test

In good times, Owners (particularly those without experienced in-house or third party Asset Managers) probably did not pay enough attention to the annual plan and budget process. If the GOP Test is to be meaningful, the budgeted GOP must be realistic. For example, a performance test of 85% of budgeted GOP in a situation where the budget may have been "low balled" by the Operator and not challenged by the Owner makes the possibility of a test failure very remote.

A test of 90% or 95% of budgeted GOP, combined with a realistic budget, results in a performance test that is fair for the Operator and gives an Owners a realistic chance to terminate an underperforming Operator.

The RevPAR Test

In order for the RevPAR Test to be meaningful, the competitive set must truly be competitive. Too often in the past, the competitive set was agreed upon when the management agreement was initially negotiated, and then never changed to keep up with changing circumstances. This resulted in a RevPAR Test that became difficult to apply as conditions at the hotels in the competitive set changed over time.

The language in the hotel management agreement should allow either party to raise the competitive set issue during the annual plan and budgeting process. If the parties cannot agree on the hotels to be included in an up-to-date competitive set, the disagreement should be resolved by a simplified expert resolution process. The result should be a competitive set that provides an accurate measure of the hotel's performance against it's peers in a test year.

The "Force Majeure" Trap

In many management agreements, the definition of "force majeure" is set out in the "Definitions" section and is referenced in various unrelated sections of the agreement, including in the language excusing the Operator from failure of the performance test. This results in over broad language that can be used by the Operator in claiming a "force majeure" excuse for failure of the performance test.

This problem is solved by having a separate distinct definition of "force majeure" for purposes of a performance test. It should be narrower than the general definition, and should eliminate language like "general economic conditions" as an element of "force majeure".

What Is the Purpose of the Operator's Cure Right?

Most performance test clauses in the past gave the Operator the right to cure the failure on one or more occasions by paying the difference between the achieved amount and the minimum amount required to pass the test. This greatly reduces the ability of an Owner to terminate an under performing Operator. If an Operator has expansive cure rights, it may choose to simply buy its way out of trouble each time the test is failed.

The Owner is best served by limiting the cure right to only once during the term of the management agreement or eliminating it all together.

Can The Test Be Failed?

The typical components of a performance test negotiated in better economic times, as set forth above, have favored Operators. When a test requires more than one year of failure, is based on unrealistic budgets and competitive sets, requires failure of both a GOP Test and a RevPAR Test, contains a broad definition of "force majeure" to excuse failure, and grants the Operator expansive cure rights, the chances of termination for failure of the performance test are minimal to non-existent.

The key question to ask during the negotiation process is whether the language creates a true possibility of failure of the performance test. If not, the parties may have engaged in an exercise with no lasting value.

Conclusion

With ownership of many hotels changing hands during these turbulent economic times, many hotel management agreements are being renegotiated or new agreements are being entered into. This is the proper time for Owners, Asset Managers and Operators to take a hard look at the performance test and to negotiate language that is meaningful on a going forward basis.

Paul Courtnell Jr. is a senior partner at Gunster, Attorneys at Law with eight offices in Florida. He developed The Leisure and Resorts Group and serves as Director. The Group provides specialized legal and consulting services to the hospitality, recreational and resort development industries. Mr. Courtnell earned his undergraduate degree from Ohio State University in 1965 and his Juris Doctor degree from the University of Florida School of Law in 1973, both with honors. Mr. Courtnell can be contacted at 561-650.0517 or pcourtnell@gunster.com Extended Bio...

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