M Waikiki’s Edition lawsuit against Marriott International and Ian Schrager
This is an interesting lawsuit, so first let’s look at the background facts and then let’s see what the claims and the implications are.
The owner acquired the hotel in 2006 for US$112 million and then spent an additional US$138 million in renovation, including those required to be an Edition-branded hotel. It thus has a total investment in the hotel of US$250 million.
After the acquisition, the owner sought to evaluate whether to brand the hotel or operate it as an independent unbranded hotel.
In June 2007, Marriott announced its arrangement with Ian Schrager to create a new boutique hotel brand — Edition. Extensive plans were announced, including that 22 gateway cities would be the first locations for Edition hotels. Marriott announced that it expected to have five Edition hotel deals by the end of the year and 100 Edition hotels within 10 years.
The complaint then alleges that Bill Marriott and his team launched an aggressive campaign to convert the owner’s hotel to an Edition, promising that Marriott would devote its considerable resources to make the hotel a success from the day it opened its doors. Marriott presented rosy projections, showing that in its first year of operation the hotel would earn more than US$14 million in profit on US$53 million of gross revenue, and that the hotel would have an occupancy rate of 68% with an average daily rate of US$400.
The complaint also alleges that Ian Schrager promised he would be personally involved in the design and operational development of the hotel. The owner says that Schrager promised his personal involvement in key design meetings would ensure that the hotel had the style elements necessary for the hotel to be a success.
The owner claims that the hotel, which had recently been completely renovated, is performing at only 37% of its competitive set. The hotel is branded with Marriott’s new Edition flag — a brand with few other properties and little name recognition.
What went wrong?
The facts in the complaint show that just about everything that could go wrong did go wrong, including Marriott’s failure to develop and support the brand, Ian Schrager turning a cold shoulder on his promises of personal involvement and, ultimately, the apparent abandonment of the brand by Schrager and Marriott.
On top of that, the operating results at the hotel were abysmal. Marriott should have been ashamed to operate a hotel with these numbers. The complaint says that the hotel, which had a major US$138 million renovation, performed at only 37% of its competitive set.
Starting in August 2009, Marriott began reducing its projections of profit for the first year from more than US$14 million in profit on US$53 million of gross revenue to a net operating profit of US$6.5 million on gross revenues of US$37.5 million, with an occupancy of 62% and ADR of US$319. A month later revised projections continued to project less, and so it continued.
Needless to say, the owner has suffered millions of dollars of operating losses under Marriott’s management, and has received no return on its US$250 million investment in the Edition Waikiki.
There are two main prongs to this complaint:
1. The first prong goes to the manager’s failure to drive the gross income or gross revenue (bring in paying guests who spend money for rooms, food and beverage or other accommodations) and reduce or hold down expenses when the hotel is operating at a greatly reduced capacity. The essence of this claim is the one we have talked about at length: Less than 30% occupancy, the failure to generate enough income and the reduction of expenses caused US$6 million of operating losses (negative cash flow) instead of an operating profit of US$14 million as originally projected. That is before mortgage payments or other debt service.
2. The second prong goes to the Edition brand. The complaint suggests that there were representations that the hotel owner would be joining an existing chain of at least nine hotels, commitments to build the brand rapidly and other promises of making the owner’s hotel profitable. There are also references in the HMA to the hotel being operated as part of the “chain” of Edition hotels. The essence of this claim is that there is no chain of hotels and the brand was not developed as promised.
The tension between hotel operators and owners
When hotels operate at a loss for a sustained time, the tensions between operator and owner increase greatly. Operators are virtually in complete control of the hotel. They have complete control over all the activities that might generate income from the talents and skill sets of the people they hire at the property and corporate level, what marketing programs they develop and how they tap into corporate or other resources to develop business at the hotel. They also control (or fail to control) the expense side of things, determining what restaurants to keep open, hours of concierge service, the prices or charges for everything at the hotel and staffing levels.
Under these circumstances, owners feel helpless and often seek cooperation from operators to change the way they are operating to reduce losses and create a profit or breakeven. When the operator is in control of everything, who is to blame for sustained bad results? Often owners do not feel that operators are doing enough and may want to force some kind of change in operations or even a termination of the relationship, feeling that almost anything has to be better than what they have.
Operators tend to feel that they are doing the best they can under difficult circumstances. They have their own profit situation to monitor and their own shareholders to satisfy. But they also feel that they have to maintain the integrity of their brand, and compromises for short-term profit management may cause long-term damage to the value of their brand. They often say that they made a deal with owners, and owners should live by the agreement and provide whatever capital it takes to ride out the downturn or other difficulty.
How common are these situations, claims and suits?
The tension between owner and operator is ever-present, but it is exacerbated in difficult financial situations. The wrestling over approving budgets and forcing compliance is the same, and often depends upon the terms of the HMA. Some HMAs give owners no right to approve any budgets, while others give limited rights but usually leave the operator in control while disputed line items are arbitrated. Too often there is no standard for how the arbitrator is to decide whether to allow the disputed budget item except for the operator’s “brand standards.” And who is likely to win when the branded operator says the budget item is necessary to maintain its standards?
While the arguments are common over budgets, revenue generation and expense control, a relatively small proportion of these arguments result in lawsuits or arbitration. There are few lawsuits because most HMAs require the disputes to be solved by binding arbitration. And a relatively small proportion of arguments are arbitrated because operators make them a war of attrition — very expensive and difficult to win. Plus, if the owner loses, he is stuck with the operator, which is still in complete control of the hotel, and the operator may now carry a grudge. Those monthly review meetings may have a very chilly or even hostile feeling.
What happens in the lawsuits? What do the cases say?
Trial court proceedings are not “reported” cases, so the decision may be brief and difficult to find. Only cases that are appealed and decided by appellate courts result in “reported” decisions that become part of our case law and precedent for other cases.
Arbitrations are “private.” There are no court reporters. They are often subject to confidentiality provisions. And arbitrator decisions, where they are to be found, often tend to be informal and sketchy.
That said, the reported case decisions on owner terminations of operator management agreements are virtually all favorable to owners on why the HMA creates an “agency relationship,” why the agency is not “coupled with an interest,” why there is an absolute right of the owner to terminate such contracts (though the owner may be subject to damages) and that this agency creates fiduciary duties imposed on the operator.
None of the decided cases have specifically focused on whether the acts of the operator were sufficient breaches of contract to justify the termination without liability, although the Embassy Suites vs. Robert E Woolley originated with the owner’s claims that the operator’s problems with the budget were grounds for termination.
There is no way to know how many unreported lawsuits or arbitrations may exist on this matter. From our own experience, I would say the claims are not uncommon, though most are resolved or settled prior to decision.
What is really special, then, about the Edition Waikiki lawsuit?
The complaint’s claim for the defendants’ misrepresentations about and failure to develop the “brand” and the “chain” are NOT the typical type of claim we have been discussing and are less common because a new brand is involved in fewer situations. There have certainly been similar claims made by owners over the years involving brands such as RockResorts, Amfac, Red Lion, Wyndham, Doubletree, Le Meridien and others as the brands changed direction overnight and disappointed owners. Some were successful in terminating the HMA. Others were not. Several involved the claim that the operator was no longer a “chain” and/or was incapable of providing chain services. Others were based upon other factors. In all cases, the very specific language of the HMA, and the skill of the advocate developing the case, are critical to the success of the claim.
Other issues raised
Terminating a bad operator is a little like worrying about the barn doors after all the horses are out of the barn. Sometimes you get your horses back. Sometimes you don’t. But it is always easier to make sure the barn doors are closed first.
With HMAs, the first thing to check is that you have the right brand for your hotel, and then that you have a great operator with a fair HMA that protects your critical interests. If you have to wait 50 years until the contract expires or sue your operator, you have already lost.
Selecting the right operator
Selecting the right operator for its hotel is one of the most important decisions a hotel owner will make. It is a decision that will affect the profitability and value of the hotel for a very long time. The selection process must be intentional and disciplined and should take into account the owner’s needs, the operator’s capabilities and the terms of their agreement.
No matter how strongly a brand may court an owner, or how strongly an owner feels about the “perfect” brand for its property, a disciplined approach to selecting an operator is always the best approach.
Performance standards: The Owner’s Return test
An owner — especially an owner with a new brand on its hotel — will want assurances from the operator that reasonable performance standards will be met. Hotel owners expect to receive an adequate return on their hotel investment. Owners need the return because they are expected to pay debt service, provide working capital, fund capital expenditures and provide a return to their investors. If they don’t get that return, owners should have certain rights. There are a variety of tests, but we believe the most effective, meaningful and fair test is an Owner’s Return performance test.
The Owner’s Return performance clause is included in the HMA and is rather simple: Unless the operator can manage the hotel to generate sufficient profit and distributable cash to provide the owner with a specified return on investment, the performance clause has not been satisfied, and certain consequences follow.