By Joshua Bernstein, Kathleen Prystowsky and Kristen Niven

Law360 (March 30, 2021, 5:10 PM EDT) --

Joshua Bernstein

Kathleen Prystowsky

Kristen Niven

The curtailing of travel and leisure activities in response to the ongoing COVID-19 pandemic has had an undeniably devastating impact on the hospitality industry.

In spring 2020, with the onset of the COVID-19 pandemic, hotels across the U.S. and internationally saw an unprecedented, immediate and catastrophic decline in occupancy unlike anything seen before in prior recessions. This has, inevitably, resulted in depressed revenues over a protracted period.

Estimates on when the industry will recover vary significantly, with many suggesting it could be two to five years for most hotels to recover to 2019 occupancy and revenue levels. The disruption to the industry was significant and the impact of the crisis has yet to be fully understood.

Hotel operators have been forced to cut expenses significantly, including laying off loyal employees, deferring maintenance and closing valuable amenities, resulting in a significant decrease to their management fees.

Likewise, hotel owners have been forced to fund ongoing debt service, real estate taxes and working capital during long periods of virtually no occupancy and revenue. In short, the entire business model has been upended.

It is in difficult times, such as these, that the tensions between hotel operators and hotel owners can reach a breaking point. Often, hotel owners decide that the best business solution is to terminate the management agreement with their hotel operator, recognizing that a wrongful termination of the management agreement entitles the hotel operator to damages.

Typically, the damages for which an owner may be liable are generally calculated based upon the lost management fees during the remaining term of the management agreement, discounted to translate to present-day dollars.

And, as management fees are typically a percentage of the gross revenues of a hotel, a calculation of such future, lost management fees necessarily requires a projection of the current and future stream of revenues the hotel will generate during what would have been the remaining term of the agreement.

Because hotel revenue projections have plummeted during the last year and given that experts are projecting that it will take years before the hospitality industry will again reach prepandemic levels, the damages for the wrongful termination of a hotel management agreement by an owner at this particular time will inevitably be much lower than in an average year.

This presents an unusual opportunity for owners and risk for hotel operators, as the damages are likely to be significantly discounted.

Terminating a Hotel Management Agreement

Hotel owners wishing to terminate their hotel operator and hotel operators facing the threat of termination of their hotel management agreements should evaluate their respective rights and obligations under all applicable agreements, as well as potential exposure.

As a matter of common law, hotel owners have the right to terminate their hotel operator at any time, even without cause, subject to a claim for damages.

This is because a hotel management agreement is generally characterized as an agency agreement or a personal services contract, or some combination thereof, both of which are generally terminable at will under common law, even if termination by the owner is wrongful and entitles the manager to damages.

Additionally, the general rule is that hotel management agreements, as agency and personal services contracts, cannot be enforced by specific performance or injunctive relief.

While hotel operators have attempted to alter the common law rule in recent years through supporting legislation and by contract, hotel management agreements are often still unenforceable by injunctive relief or specific performance.

Accordingly, hotel management agreements are often terminable at will and unenforceable by injunction or specific performance, such that hotel owners wishing to break their contracts and terminate the hotel manager generally have the power to do so, subject to a potential damages award.

Calculating Damages for the Wrongful Termination of a Hotel Management Agreement

So, how much in damages are we talking about? The calculation of damages that a hotel operator may obtain for breach of a hotel management agreement depends on a number of factors, including the specific terms of the contract, the parties' relationship, the length of time the agreement has been in place and the financial position of the hotel.

Generally, where a hotel operator prevails on a claim for breach of a hotel management agreement based on a claim of wrongful termination, a hotel operator is able to recover the present-day value of the management fees that it would have expected to earn for the remaining duration of the agreement, had it not been terminated.

Hotel management agreements tend to provide that management fees are calculated as a percentage of the hotel's gross revenue. This provides the hotel operator with an incentive to generate increasing revenues over the term of the agreement.

Accordingly, on a claim for breach of contract, hotel operators generally claim damages for their lost profits, i.e., the loss of their future stream of management fees for the remaining duration of the hotel management agreement.

One common method of calculating the damages attributable to the lost profits from lost management fees is to: (1) take a projection of fees based on the most recent year's total management fees, (2) apply a growth rate over the remaining agreement term, (3) then apply a discount rate to account for present-day value.[1]

Each of these factors has been affected by the ongoing COVID-19 pandemic and could have a significant impact on reducing damages awards to hotel operators for the wrongful termination of a hotel management agreement.

The Impact of the COVID-19 Pandemic on Damages for Terminating Hotel Management Agreements

Because the damages from the termination of a hotel management agreement are so closely tied to the hotel's projected revenue — and the manager's projected fees — the impact of the COVID-19 pandemic on current revenue projections and the anticipated slow recovery of the industry will likely affect all three damages calculation factors in the near term: management fee projections, growth rate and the discount rate.

Two of these factors, in particular, could have a significant impact on the size of any damages award that a hotel owner may face in the coming months and years for the wrongful termination of a hotel management agreement.

First, the baseline for lost profits projection is the most recent full year's management fees, which are tied to the hotel's gross revenue. Thus, a steep decline in the hotel's revenue could significantly lower this baseline for a damages calculation.

Second, the discount rate that is applied is generally meant to reflect the level of risk that a particular hotel presents — the more volatile the hotel's projected performance, the higher the discount rate that experts and a court will apply.

The current volatility in the market and the prediction from industry experts that it will take years to recover will likely result in a higher discount rate being applied to wrongful termination damages, which will lower the present-day value of the projected damages.[2]

Applying these two factors, the potential damages for the wrongful termination of a hotel management agreement will almost certainly be far lower than at this time last year. The onset of the COVID-19 pandemic and ensuing global shutdowns over the past year have wreaked havoc on the performance and revenues of hotels worldwide.

While this is devastating to the hospitality industry generally, these circumstances may provide a compelling financial incentive for hotel owners to terminate their hotel management agreements and present a significant risk for hotel operators that are faced with the possibility of termination.

The extremely low revenues and precarious situation faced by most hotels due to the pandemic is likely to result in much lower damages awards for the wrongful termination of hotel management agreements by owners.

Hotels in most markets will by now be showing revenues reflecting nearly a full year of reservation cancellations, globally restricted travel, temporary complete shutdowns, occupancy limits, additional operational costs for safety and sanitation measures, and exposure to additional government regulations and penalties.

Any damages assessment for terminating a hotel management agreement that is based, in whole or in part, on a hotel's 2020 financial performance, will reflect these depressed revenues and will, therefore, likely show a much smaller damages award for projected revenue-based fees.

Moreover, the uncertainty the next few years will bring, including to the travel and hospitality industry, is likely to affect the discount rate applied to lost profits projections for hotel managers.

Since these two issues account for a significant part of the method courts and arbitrators commonly use to calculate a hotel manager's lost profits damages from its lost future management fees, the calculation of those damages is likely to be much lower now and over the next several months than it would have been in years past.

Accordingly, these uncertain times could also provide an incentive for hotel owners to consider the termination of their hotel management agreements and present hotel operators with the risk that financial recovery from any wrongful termination could be significantly lower than it was at this time last year.

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Joshua D. Bernstein is a partner and co-chair of the hospitality sector team at Akerman LLP. 

Kathleen M. Prystowsky is a partner at the firm. 

Kristen Niven is an associate at the firm. 

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] See, e.g., In re MSR Resort Golf Course, LLC, Case No. 11-10372 (SHL), 12, 17-22 (Bankr. S.D.N.Y. Aug. 10, 2012); In re M Waikiki, LLC, Case No. 11-02371, 11 (Bankr. D. Haw. Jun. 7, 2012).

[2] See In re M Waikiki, LLC, Case No. 11-02371 at 11 (applying a higher discount rate because the management fee income is substantially more uncertain after a contractual performance test comes into effect).

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