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Hotel lawsuit cases up in economic downturn

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Hotel lawsuit cases up in economic downturn

Though conditions in the U.S. hospitality market have shown signs of improvement in the past year, hotel attorneys and insurers say the sluggish pace of broader economic recovery has led to a rising tide of litigation between hotel owners and their management companies.

During and after sustained economic downturns, independent hotel owners and management companies often are painted into a financial corner by the multiyear management contracts common to the industry, putting both sides at greater risk of being taken to court over an alleged breach of contract, experts said.

Even as hospitality revenues slowly find their way back to pre-recession levels, experts say they expected the upward trend in lawsuits between ownership and property management firms to be a long-tail effect of the recession.

“I think you're likely going to see more of these cases, either for nonpayment of fees or for termination or violation of a management agreement,” said Richard Barrett-Cuetara, partner and chair of Shannon Gracey Ratliff & Miller L.L.P.'s hospitality group in Dallas.

Independent hotel owners, facing depressed revenues and looming mortgage debts, tend to apply greater pressure to the management companies running the day-to-day operations of their properties, scrutinizing every decision and spent dollar, experts said.

That level of scrutiny often can expose potential breaches of a management company's contractual duties to the property owner, which are the most common cause of legal disputes between small and middle-market hotel owners and operators, experts said.

“In good times, you're not as likely to see these kinds of disputes percolate,” Mr. Barrett-Cuetara said, noting that disputes between hotelier partners often are settled in private during periods of robust economic performance.

“But when the market drops, all of a sudden you've got an owner that's seen gross revenue significantly decline with an operator that's charging the same fees that they were at the beginning of the contract, which might have been signed several years prior to the downturn,” he said.

Similarly, hotel management companies also are more likely to pursue breach-of-contract action against a property owner if he or she struggles to keep up with service fees, operational costs and payroll allocations during times of sustained economic hardship.

Increasingly, disputes over breach of contract are being distilled down to a question of fiduciary duty, and whether it attaches to a contract between an owner and a management company. Many experts, like Jim Butler, a founding partner at Jeffer Mangels Butler & Mitchell L.L.P. in Los Angeles, contend that prior case law has established that hotel management companies are legally considered “agents” of the property owner.

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That agent relationship—by way of English common law, Mr. Butler said—dictates that the operator owes a duty of loyalty, noncompetition and full disclosure to the property owner, and that its actions must be in deference to the owner's interests.

“We believe that virtually every hotel management agreement creates an agency relationship, making the operator the fiduciary of the owner,” Mr. Butler said. “Whether the contract itself addresses it or not, the law imposes those duties.”

Alternatively, some attorneys contend that sufficient case law does not yet exist to assign fiduciary duties automatically.

“It's an interesting concept, but there's a lot of litigation out there right now challenging it,” said David Bender, a Los Angeles-based insurance recovery attorney at Anderson Kill. “I don't know of any courts that have ruled one way or the other on it.”

In the meantime, Mr. Bender said, many operating firms have attempted to reduce their potential fiduciary liabilities through waivers included in their management agreements.

Because hotel management can encompass so many different and distinct business operations, the specific circumstances under which legal discord can manifest between hotel owners and management firms can vary greatly depending on a property's actual programming, experts said.

“The ways people frustrate one another in this industry are as infinite as the ingenuity of mankind,” Mr. Butler said.

For instance, when owners begin examining their management company's workforce, they could find that the operator has maintained staffing levels far higher than the hotel's economic reality would necessitate. An owner might also discover that a general manager has hired an inordinate number of his or her own relatives to staff the hotel, regardless of their qualifications, or that some workers are being periodically diverted to jobs unrelated to the owner's interests.

In times of economic stress, owners frequently accuse their management company of shirking their responsibility to effectively market the property to customers, experts say. Operators also have been accused of selling hotel guest lists to timeshare marketers and other solicitors, or altering their accounting methods to artificially improve their revenue returns.

“There's only one reason to do something like that, and that's not to help the owner,” Mr. Butler said, noting that management companies are just as prone to pressure during economic slumps as property owners.

Aside from the standard contractual requirements of hotel management, experts said owners and operators should pay especially close attention to language denoting the property's long-term intended uses. During an economic slump, a management company may be tempted to change certain aspects of the hotel's activities, amenities and other services, including operating hours and thematic programming of attached restaurants, bars and nightclubs.

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“That can be a big disconnect between the owner and the management company,” said Lance Ewing, Chartis Inc.'s industry practice leader for hospitality and leisure in Memphis, Tenn. “The operator is obviously trying to generate revenue, and they could be doing something that the owner hadn't originally intended to do. The risks can change dramatically if, for instance, the operator is suddenly targeting a spring break crowd instead of retirees.”

Another way in which owners and management companies can reduce the likelihood of a dispute escalating to litigation, experts said, is to include in the management contract periodic opportunities for adjustment of fees, revenue quotas and other financial requirements.

Provisions in the management agreement pertaining to the hotel's risk management program can be just as troublesome as the operational elements of the contract if not properly examined, experts said. Defense costs for many variations of breach-of-contract claims would likely be covered under a combination of executive and professional liability insurance policies, but some allegations and activities could be excluded from coverage, depending on the terms of the management agreement and an entity's risk history.

Owners and operating firms need to be sure they and their partners carry the necessary insurance to respond to internal contractual disputes and externally generated litigation, as well as delineate to the extent possible whose insurance will respond in the event of a claim, experts said.

“Sometimes that's not thought out very well, or contemplated at all,” Mr. Bender said, “particularly at the smaller properties, where they maybe have less experience or less access to risk management or legal advice.”

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