| As we described in our Winter 2000 issue, a Delaware
jury recently found Sheraton liable to the owners of the former Sheraton
Washington hotel for $50 million, including $37.5 million in punitive damages,
based on Sheraton’s alleged failure “to act as owners agent,” including
its receipt of alleged “kickbacks” from vendors at the owners’ expense.1
Tuttle & Taylor’s Hospitality Practice Group has examined various pleadings
and transcripts obtained from the court record and has interviewed some
of the experts and attorneys involved. Based on that research, we describe
below what happened in the Sheraton case, why operators and owners alike
should care, and what each can do to identify and address the potential
problems underscored by the Sheraton verdict.
Q - Most owner/operator
disputes have some history. What’s the history to this dispute?
In 1979, a partnership between John Hancock and
the Washington Sheraton was formed “to expand and improve the then existing
Sheraton Park Hotel.” John Hancock took a 51% interest, and the Washington
Sheraton retained a 49% interest. John Hancock executed a long-term, 20-year
management agreement with Sheraton (a typical term at the time), with three
10-year renewals at Sheraton’s option. In 1985, Sheraton sold all but 1%
of its interest to Hancock, giving Hancock a 99% stake in the partnership.
In 1990, Hancock sold 48% of its 99% interest to Sumitomo, retaining a
51% interest; Sheraton retained its 1% interest. Thereafter, against the
backdrop of the sharp downturn in the economy, the disputes between the
owners and Sheraton took shape. The owners balked at commencing scheduled
renovations, and sought to renegotiate the management agreement, which
they viewed as above-market. Sheraton agreed to renegotiate, but only if
the owners completed the renovations, which were estimated to cost $70
million. Hancock, in turn, asked Sheraton to contribute to the renovations.
Q - Were the parties
able to break the impasse?
No. Things deteriorated from there. In 1995,
Hancock commissioned a “forensic audit.” The audit allegedly uncovered
evidence of operator misconduct. Citing the audit, Hancock gave notice
of breach of contract, and claimed damages of $80 million. Sheraton, in
turn, demanded Hancock’s removal as general partner – a demand Hancock
rejected. Negotiations continued into 1997, when Hancock finally sued in
federal court.
Q - What did Hancock allege
in its suit?
Hancock had a long list of complaints. Among
other things, Hancock alleged that Sheraton obtained “undisclosed cash
kickbacks or barter exchanges from national vendors” in its purchasing
program; required participation in “‘mandatory’ ITT Sheraton programs”
as part of a “deliberate plan to convert its own overhead costs into vendor
charges and ‘chain costs’”; “inequitably and disproportionately allocated
an excessive proportion of the premiums for the pooled insurance to the
Hotel . . . to subsidize the insurance of ITT Sheraton hotels and other
affiliated hotels”; charged the owners for Sheraton’s national marketing
costs and overhead through “chain cost allocations and regional office
charges” on programs that didn’t benefit the hotel, such as “Co-op marketing
costs which do not market the hotel specifically” or which mentioned the
hotel “in small print” with “little or no benefit to the hotel”; imposed
the Sheraton “frequent traveler” program on the hotel to “benefit its affiliated
hotels”; imposed on the property excessive training costs, employee benefits,
and costs for tracking guest complaints and service levels; offered free
use of hotel facilities and services by ITT Sheraton employees without
the owners’ permission; engaged in improper “usable denials” practices;
and “liberally granted complimentary rooms and services to employees and
affiliates of ITT Sheraton having no business connection with the hotel.”
Q - What were the owners
looking to get from the lawsuit?
The owners sought money for their claimed damages
under a variety of legal theories, including breach of contract, breach
of fiduciary duty, misrepresentation, fraud, violation of federal antitrust
law, commercial bribery, and RICO. The owners claimed damages totaling
more than $250 million.
Q - Most of these legal
theories are familiar enough, such as breach of contract and fraud, but
what about the antitrust claim, commercial bribery, and RICO? Are these
claims common in owner/operator disputes?
No, they’re not. The antitrust claim is particularly
unusual. The owners alleged that Sheraton’s purchasing program violated
the Robinson-Patman Act’s ban on price discrimination, although the particulars
of that claim were not clearly laid out for the jury. The theory was apparently
that vendors unwilling to pay “kickbacks” were competitively harmed, and
that the owners were deprived of an opportunity to obtain advantageous
prices from non-participating vendors. The RICO claim is also unusual.
The “Racketeer-Influenced and Corrupt Organizations Act” was enacted by
Congress as a tool to fight organized crime and, as such, was written very
broadly. A plaintiff can state a RICO claim by alleging that a defendant
engaged in a “pattern of racketeering activity”—that is, at least two criminal
law violations, such as mail or wire fraud. Although many judges disfavor
it, RICO is a popular plaintiff’s tool because it provides for automatic
treble damages. The commercial bribery claim, brought under a state criminal
statute, is also unusual. It was plaintiff’s novel twist on the rebate
programs, and was asserted as one of the bases for the RICO claim.
Q - What sort of defenses
did Sheraton rely on?
Among other things, Sheraton claimed that its
practices were consistent with long-standing industry practice; in fact,
Sheraton derided Hancock’s “forensic auditors” as “woefully ignorant of
the economics and practices of the hospitality industry.” Sheraton also
defended its purchasing practices by citing the broad authorization granted
it by the management agreement to collect a fee for the program. Sheraton
also argued that many of the practices condemned by the owners had been
disclosed by Sheraton, and that the owners expressly or impliedly approved
of them. (As a general litigation matter, disclosure, as evidenced by correspondence,
minutes of owners’ meetings, and the like, generally will be a strong defense
to a suit premised on long-standing practices of which the owners have
been aware.) Sheraton also argued that many of the owners’ complaints were
time barred under the statute of limitation. Finally, Sheraton asserted
a counterclaim against the owners for wrongful termination of the management
agreement.
Q - So what did the jury
do?
We know from the verdict what the jury found,
but not why. In fact, some of the findings are puzzling. At bottom, it
looks like the owners convinced the jury at a gut level that Sheraton had
not treated the owners fairly. Looking first at the contract claim, the
jury found that Sheraton’s purchasing practices and workers compensation
program breached the management agreement, but that Sheraton’s frequent
traveler program, reservations system, “usable denials” practices, and
complimentary rooms practices did not. While the jury found that Sheraton
did not breach “any other contractual duty,” it found that Sheraton failed
“to act as owners agent,” a finding so broad and undefined as to mean almost
anything. This finding leads to one of the biggest puzzles of all.
Notwithstanding the owners’ intense focus on Sheraton’s alleged “kickback”
scheme—which formed the basis for the owners claims for fraud, commercial
bribery and RICO—the jury found damages in connection with the purchasing
program in the relatively modest amount of $250,000. The jury also found
damages relating to the workers compensation program in the same order
of magnitude, $222,000. At the same time, the jury assessed damages in
the amount of $10.26 million for Sheraton’s “failure to act as owners agent.”
It’s not at all clear what the jury based that figure on, but, as a matter
of pure conjecture, it’s certainly possible that the jury picked a number
large enough to register its sense of generalized disapproval of Sheraton’s
conduct.
Q - What did the jury
do with the other claims?
The jury rejected the fraud and RICO claims,
but found Sheraton liable for $750,000 in damages on the Robinson-Patman
price discrimination claim, and for an additional $1.1 million in damages
for breach of fiduciary duty, breach of the implied duty of good faith
and fair dealing, and “intentional or negligent misrepresentation.” On
top of these damages, the jury assessed an additional $37.5 million in
punitive damages. The jury rejected Sheraton’s counterclaim, and awarded
it no damages.
Q - Does the jury’s verdict
change the law that applies to disputes between owners and operators?
No. The jury’s verdict was based on existing
law, and the court did not announce any new legal principles. The verdict
itself therefore does not change the law. Having said that, the issues
presented in the Sheraton case are sure to surface again, and while future
cases will be decided on their own facts, other juries might come to the
same conclusions that the Sheraton jury did. The verdict here is therefore
instructive because it gives us an opportunity to see how these jurors
viewed and decided the issues in the context of this case.
Q - How do these kinds
of problems arise, and how can they be avoided?
A management agreement typically provides for
certain fees: a base fee, an incentive fee and miscellaneous other fees.
The owner expects the operator to pay for its overhead out of those fees.
The risk to an operator arises when a property is assessed charges that
are not disclosed on the face of the P&L, or where the charges, even
if disclosed, are not authorized by the management agreement. In short,
there is a potential problem for any charges not covered by base fees,
incentive fees, or other fees explicitly authorized by the management agreement
and disclosed to the owner.
Q - Can you give us some
examples?
Let’s start with purchasing programs. Whenever
an operator requires a property to use a particular vendor, the owner will
always want to know why - and whether rebates or other accommodations played
a role. Owners and operators often disagree about which of them should
benefit from the payment of rebates. Generally, owners believe that rebates
and volume discounts should be credited to the property. Otherwise, they
say, the rebates effectively come out of the owners’ own pockets, as unauthorized
fees, in the form of higher prices paid for goods supplied to the hotels.
Some operators take the opposite view, arguing that the rebate amounts
should help cover the costs of their national purchasing programs which,
they point out, yield substantial benefits to the owners in the form of
lower unit prices.
Q - Sticking with vendor
selection, is there a special problem with related party transactions?
Yes. The issue comes up when the operator obtains
services for the property (insurance, supplies, etc.) from a related entity,
such as a subsidiary, parent, or an entity in which there is some other
kind of relationship between the vendor and the operator or its principals.
In the litigation context, an owner who discovers an undisclosed relationship
of this kind—especially where there’s been no competitive bidding—can easily
exploit it before a jury, casting the relationship as evidence of dishonesty
and greed.
Q - If owners benefit
from nationwide purchasing economies, why are such programs so often the
source of friction between owner and operator?
For one thing, there is a difference in the mind
set of owners and operators. In general, owners focus on the benefit to
their property, while operators tend to focus on the benefits to the system
as a whole. Friction develops when a particular program or practice benefits
one but not the other. For example, in the purchasing context, an owner
might be perfectly happy to get some items through the operator’s system
wide purchasing program, but might protest if it can’t buy some items available
for less down the street. This comes up outside of purchasing as well.
In the Sheraton case, for example, the owners complained about various
charges for services whose value to the property was not obvious, such
as being charged for co-op marketing costs where the owners’ property was
mentioned only in small print. This can also arise in connection with most
other services provided by the operator, such as chain services (e.g.,
advertising and promotion, regional sales offices); central reservations;
and other system wide programs, including relationship management expenditures.
Q - Is there anything
an operator should do now to determine whether it has a problem like that
faced by Sheraton?
We recommend performing a “legal audit” to identify
these kinds of problems before they surface in a dispute or a lawsuit.
The purpose of the audit is to identify the goods and services for which
properties are being charged, directly or indirectly, and whether those
charges are authorized by the management agreement and disclosed.
Q - Can Tuttle & Taylor
help?
Absolutely. Tuttle & Taylor’s Hospitality
Practice Group has extensive experience with these issues, and can design
and perform a legal audit that will identify your particular problem areas
efficiently and effectively. For more information, call one of the Litigation
Principals in our Hospitality Practice Group:
1 2660 Woodley Road
Joint Venture v. ITT Sheraton Corp., Civil Action No. 97-450 -JJF (D.Del.)
© 2000 Tuttle & Taylor, A Law Corporation
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