Published September 2017
A much-publicized on-going dispute in Dubai between a hotel developer and an international hotel operator has brought to the fore some of the challenges Dubai hotel owners and developers would face in seeking to terminate hotel management agreements.
The dispute in this case puts Five Holdings (formerly SKAI Holdings) against international hotel operator Viceroy Hotel Group, which operates hotels under the “Viceroy” brand. Five Holdings is the developer of what was to be known as the Viceroy Palm Jumeirah hotel and residences, located on the iconic Palm Jumeirah in Dubai. Five Holdings had entered into a long-term hotel management agreement in 2013 with Viceroy under which Viceroy was to operate and manage the hotel.
Five Holdings underwent a group restructuring as part of which the group’s strategy appears to have changed from developing and contracting out hotels to third party operators to setting up its own hotel operating arm to operate hotels and residences developed by the group. As a result, Five Holdings sought to terminate the management contract with Viceroy and to appoint an affiliate of Five Holdings as the new operator of the hotel and a dispute over the termination ensued. Although tension between owners and operators is nothing new, what has caught the interest of commentators in this particular case has been the rather public nature of this dispute, with either side having issued a series of press statements addressing the dispute. It is often the case that management agreements provide for arbitration or other alternative dispute resolution mechanisms as opposed to referring disputes to courts, for purposes of ensuring the confidentiality of the dispute process and outcome.
From the available press reporting, it does not appear that there is any assertion of breach of contract being made by the developer against the operator, and this appears to be a case of what is known in legal parlance as “termination for convenience”. As far as we are aware, the dispute is ongoing and there has been no final court ruling in this dispute which would give guidance as to how similar disputes in Dubai might be approached in the future. Nevertheless, there are a number of issues which, in view of this dispute, hotel developers and owners in Dubai should bear in mind when entering into management contracts with hotel operators.
Long term contracts:
The traditional model under which hotels were owned and operated was an “owner-operator” model. However, the capital costs involved in developing and owning hotels was unattractive to hotel brands, and an operating model separating the ownership from operation of hotels evolved. This “asset light” approach enabled hotel brands to expand at a much faster rate and at lower cost and is now the prevalent model in the market internationally.
Whereas under an “asset-heavy” model the hotel company’s value was predominantly in its real estate holdings, under an “asset light” model, the value of these companies is now to be found in the management contracts the hotel operator has entered into with various hotel owners/developers. Given this scenario, it is to be expected that hotel operators will often seek long tenures, typically 20-30 years (or even much longer for “iconic” properties). The long tenures will also often be coupled with renewal rights in favour of the operator. For the same considerations, operators will often resist the inclusion in the management contract of termination rights in favour of the hotel owners, and it is often the case that even if these are included, the grounds upon which a hotel management contract may be terminated by an owner will be very limited and tightly circumscribed. So much so that HMAs have been described in certain quarters as ‘virtual annuities’ for the hotel operator companies.
Nature of the owner/operator relationship:
Under the “asset-light” model, the real estate costs and all property maintenance costs are borne by the hotel owner and not the hotel operator. In addition, hotel operators will typically seek to be paid “off-the-top” (based on % of operating revenues) and thus operators will earn fees whether or not the owner has realized a profit during the relevant period. Although this position could be adjusted by negotiation (for instance through owner priority return mechanisms and profit-based incentive fee arrangements), the default position remains that the investment risk is solely for the owner and this risk not shared by the operator.
Another crucial point to note is that hotel operators are not agents of the hotel owner as a matter of law, but independent contractors providing agreed services to the hotel owner. This distinction is an important one, particularly where the HMA is governed by English law or other common law based regime. This is because an agent ordinarily bears fiduciary (good faith) obligations to its principal (whether or not expressly stated in the contract), unlike in an ordinary independent contractor arrangement where only those contractual obligations expressly specified in contract will be taken into account. Secondly, a principal has the power to terminate its agent without cause. In an independent contractor arrangement, there is no such automatic power to terminate without cause and the express terms of contract would dictate the termination rights of the parties. In light of these considerations, operators will often incorporate in the HMA provisions expressly disclaiming any agency relationship. For HMAs that are governed by UAE law, the UAE civil code provisions on good faith in contractual relations would apply, as discussed later in this article.
Termination for convenience:
As highlighted above, it is unusual for operators to agree to provisions for termination without cause in favour of the hotel owner. Indeed, the converse is often true, that the operator will seek to recover liquidated damages for any termination of the HMA on grounds other than the operator’s breach. Liquidated damages will typically be based on the operator's anticipated lost profits for the operating term of the agreement. Given the long-term nature of these contracts, the liquidated damages amount could be quite substantial. From the operator’s perspective, a liquidated damages provision is useful to provide certainty as to the amount recoverable in the event of a wrongful termination, without the time, cost and uncertainty that would otherwise be involved in proving the operator's entitlement to, and value of, its claim for lost profits. It should be borne in mind however that in certain jurisdictions, especially civil law jurisdictions such as the UAE, courts may insist on actual loss being proved by the operator, notwithstanding the liquidated damages provision. The court would also have discretion to adjust the damages amount if in the court’s view it does not reflect actual loss suffered.
From the owner’s perspective, whilst liquidated damages provide an element of certainty for both parties as to the amount of damages payable, it may be in the owner’s interest to seek to ensure that damages are only payable for losses actually proven by the operator, and that even where a measure of lost profits compensation to the operator is agreed to in principle, this is limited to say one or two years of the balance of the term, and not the entire remainder of the term in a long-term contract.
Another key point to note from a UAE law perspective is that unlike the case in English common law-based contracts, the UAE civil code imposes a statutory duty of good faith to the effect that a contract “must be performed in accordance with its contents, and in a manner consistent with the requirements of good faith”. Failure to act in good faith, including in the termination of a contract, would in itself give rise to an actionable claim. Furthermore, the general position under UAE law is that contracts can only be terminated in one of three ways: by consent, by operation of law or by court order. Doubt remains as to whether an express contractual provision allowing for unilateral termination without court order would be enforceable. It is therefore quite important for an owner under a UAE law HMA to carefully consider its position and the applicable provisions of the UAE civil code before seeking to terminate the HMA for convenience.
Termination for breach/non-performance:
The owner’s right to terminate the HMA will often only be available in the event of performance failure by the operator. Owners should note that the typical performance test most operators will offer in the HMA is notoriously difficult, if not impossible, for the owner to successfully enforce, unless in the case of an egregious failure by the operator. The typical test will be framed as a two-pronged test: firstly, measuring the operator’s achieved GOP (gross operating profit) against an agreed threshold GOP (typically 80% of budgeted GOP), and secondly, measuring the operator’s RevPAR (revenue per available room) performance against the average RevPAR of an agreed competitive set of similar hotels (like the GOP test, it is common for a 20% tolerance to be built into the RevPAR test). Both tests must have been failed typically within a two-year testing period for the operator to be said to have underperformed. It is also common for various additional qualifications to be built in by the operator (such as, for example, to allow for revenue stabilization for new or repositioned properties, to provide exceptions for “force majeure” events affecting hotel performance etc).
Given the typical performance test structure outlined above, owners should note the difficulty this structure presents to an owner and ensure that a bespoke, well thought through performance test structure is negotiated, which gives the owner real contractual “bite” and not merely “bark” in the event of underperformance. There are a variety of ways the owner’s risk in this respect can be mitigated through re-negotiation of these clauses to ensure the owner’s position is improved. We will address performance tests and how to negotiate these from an owner’s perspective in a future article.
The Viceroy dispute has further highlighted certain jurisdictional challenges that have been the subject of debate in Dubai over the last twelve months or so. By way of background, there are two judicial systems in Dubai, the first being the local courts system which is civil law based (with proceedings conducted in Arabic language), and the other being the Dubai International Financial Centre (DIFC) courts, based on English common law (with proceedings conducted in English). Each system also has its own arbitration institutions.
The perceived advantages and disadvantages of each system are beyond the scope of this article, but suffice it to say that the practice has evolved over the last few years of parties to disputes approaching the DIFC courts as a so-called “conduit jurisdiction” (regardless of whether the award debtor has a presence or assets in the DIFC itself) for the enforcement of both foreign and domestic arbitral awards in the local UAE courts. The dual court system and the reliance on the “conduit jurisdiction” mechanism has given rise to a variety of jurisdictional challenges and the legislative response to these challenges has been by way of the formation of the Judicial Tribunal for the Dubai Courts and the DIFC Courts, created by Decree No.19/2016. The Decree provides for the establishment of a Judicial Committee whose primary role is to consider conflicts of jurisdiction between the DIFC Court and the local court. The Judicial Committee is relatively new and untested however one of its initial determinations has called into question the continued reliance on the DIFC conduit jurisdiction mechanism.
Whilst the agreed governing law and disputes forum under the Viceroy HMA is not clear from the press reporting, it would appear that Viceroy sought and obtained injunctive orders from the DIFC Courts and in response, the owner would seem to have approached the Judicial Committee, presumably to challenge the jurisdiction of the DIFC courts in this matter. It will be interesting to see how the courts and the Judicial Committee will address this matter.
In conclusion, hotel owners should be aware that termination of HMAs for convenience could be a risky and expensive proposition. The owner should also be aware that HMAs typically offer very limited grounds for termination for operator breach or for underperformance. It is therefore in an owner’s interest to take suitable professional advice and carefully consider the relevant provisions of the HMA at the time of negotiation and to ensure that the performance test mechanisms are drafted in a way that gives the owner real and practicable termination rights. The Owner should also ensure that any termination damages provisions are suitably qualified to minimize or at least cap the owner’s financial exposure. Lastly, where the HMA is governed by UAE, the owner should bear in mind the good faith provisions of the UAE Civil Code and potential claims in relation to their breach.
Ian Gaitta, Partner, firstname.lastname@example.org
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