by Mitch Miller, Miller Law Group, P.C.

Introduction

When acquiring a hotel, a franchise agreement is one of the most important agreements that will affect the long term success of the hotel investment. Which brand? There is no standard answer. The unique factors of your project (location, facility, competition, market dynamics, costs of operation, etc.) must be matched to the brand(s) that best satisfies the criteria. Usually, all other factors being comparable, I will recommend the brand that will deliver the best rate. If fair share of market can be realized, then the brand delivering the highest average rate will maximize both revenue and value. Caveat: the brand selected should not unnecessarily require costs of operation that diminish profitability, thereby reducing the value of the hotel.

In 2013, hotel franchisees face difficult challenges as the most established franchisors become ever more powerful and their legal teams construct agreements that are ever more one-sided. In recent years I have observed some franchisors making significant power grabs through the language in franchise agreements. I have also experienced, in a number of situations, achieving dispute resolutions on favorable terms for my clients, the franchisees. These successes have occurred in different ways: through negotiation, administrative processes, and court decisions.

Prior to litigation, successes can be achieved when we present our case, based on a thorough investigation and presentation of the facts and the documentary evidence, founded in law, not hopes and desires, and asserted confidently yet reasonably. Wherever you may be operating your business, make sure that your professional advisors understand your business and this area of the law so they will be able to provide the best counsel.

Tip: investigate the franchisor's record in dealing with franchisee's during the term of the agreement. The contracts provide minimal protection. The good will and attitudes of the franchisor are critical in determining how well the franchisee will fare during the course of the relationship.

LEGAL ISSUES AND PRACTICAL TIPS

The following discussion highlights some important legal issues. In no way, is it intended as an exhaustive treatment of the subject matter. Further, you should always consult your counsel regarding the applicability of any legal opinions or strategies to your specific situation.

Issues When Negotiating A Franchise Agreement For A Hotel To Be Built

  • Number of Rooms - You may wish to build the hotel in phases. Make sure that the agreement allows you to add rooms. Consider two situations:

1) If the initial plan is for a certain number of rooms but you want to build in phases then this needs to be expressly addressed in the franchise agreement, otherwise, the franchisee will be in default for not opening with the contracted number of rooms.

2) If you think you may want to add rooms at a later date, negotiate the right to do this up front. The major benefit is that you will probably be able to avoid a fee for adding some increased percentage for the rooms to be added.

  • Timing - Development and construction are uncertain and unpredictable processes. Governmental processes and related administrative agencies move at their own pace, over which you have little or no control. These uncertainties need to be expressly considered in the franchise agreement to avoid certain negative consequences:

1) Breach - all agreements will have a schedule which will include some benchmarks and an opening date. Failure to meet the schedule will cause you to be in breach. You could lose the license. Build extra time and the right to extend into the agreement. The proposed agreement may give you the right to extend but it is usually never enough.

2) Extension Fees - Typically, a franchise agreement for a new development will have stated fees to extend the schedule. These are negotiable. Often, we can negotiate a first extension for no fee, and then a second extension for a reduced fee.

REMEMBER, IF YOU DON'T NEGOTIATE THIS AND YOU ARE DELAYED YOU HAVE PROBLEMS THAT ARE USUALLY 100% AVOIDABLE.

  • Specify What Is To Be Built - We have been involved with projects in which the franchisor changes brand standards during construction and mandated that the franchisee had to modify the project before opening. Result: substantial delays and change orders all of which cost the franchisee considerable sums.

Tip: the franchisor and franchisee should agree that a certain set of plans and specifications as of a definitive date, will be the controlling requirements and the franchisee will not be required to make changes after that date and before opening.

  • Minimize Post-Opening Capital Expenditures - The franchisee has just spent millions of dollars to construct a beautiful new hotel. As we know, all franchise agreements allow for the franchisor to mandate upgraded brand standards and systems modifications, including property management systems. For some period of time following the opening of the hotel it is perfectly reasonable for the franchisee to know that it will not have to make substantial expenditures to replace or modify a brand new building, equipment, etc. The dollar limitations and the time limitations must be negotiated.
  • Liquidated Damages - If the project never gets built or cannot be developed in the time schedule required by the franchise agreement, the franchisee will likely lose the license. Minimize or eliminate liquidated damages in these situations. This must be negotiated up front to avoid a very negative position in which the franchisee has little, if any, leverage.
  • Define Gross Revenues - If there will be food and beverage operations, including possibly meeting and banquet revenues, try to exclude these revenues from the definition of gross revenues. If these operations will be leased, definitely try to exclude the lease revenue from the definition.
  • Royalty Ramp-Up - try to get the franchisor to reduce royalties during the first 12-36 months of operations. This will help to reduce cash outflows, while you are building the business.

Early Termination (Windows)

Early termination provisions are a two-edged sword. These provisions give either party the right to terminate at various points during the term of the franchise agreement, frequently at 5, 10 and 15 years (for a 20-year term). I have been involved in situations, where a franchisor exercised its rights because it had the opportunity to add a franchisee in that market for a newly developed hotel. The franchisor did offer the franchisee the opportunity to accept a different flag in the system, albeit a lower priced brand. Windows may well be advisable but one must negotiate the terms and be aware of unintended consequences.

Sometimes, the early termination provision will be voided by the terms of the agreement, which states that the franchisee must not have been in default, during the term of the agreement. More commonly, the agreements require that the franchisee be in good standing when delivering the required notice and on the effective date of termination.

Tip: the failure of franchisees to deliver timely notice of intention to terminate pursuant to the early termination right, is one of the most frequent mistakes I hear about. Beware.

Liquidated Damages and Breach Provisions

Liquidated damages can frequently be negotiated and should be.

Certain franchise policies allow franchisors the right to terminate a franchisee if they receive a second unsatisfactory QA score within 12 months of having received the first failing score. Problem: we have encountered numerous situations in which the noncomplying conditions cited in the second inspection had nothing to do with the first set of issues, and the franchisee then had no notice to be able to affect the right to cure. Case Law: many courts have held that a franchise cannot be terminated unless the franchisee has adequate notice and the right to remedy the cited default. Some courts have found this to be true, even when there has been a history of repeated defaults.

Tip: Don't wait to receive a notice of termination to notify your counsel. Certain Systems, have a review committee that will allow you to challenge a notice of termination. Other franchisors have administrative procedures by which you can seek relief from certain mandates. Further, putting the franchisor on notice that you are represented by counsel, and by using your counsel to present your situation, before you end up being terminated or sued is likely to result in a far more favorable resolution for the franchisee. Yes, it will have a cost attached but that cost is likely to be far less than the costs resulting from the alternative path.

Area of Impact/Encroachment/Cross Brand Protection

Like many of the other issues governing the relationship between a franchisor and a franchisee, this issue is a function of the contractual agreement between the parties. The best protection will only be obtained during the negotiation of the contract. The franchisee e needs to understand what is possible. Keep in mind that the more established and powerful franchisors will be less willing to give extensive, if any, area of protection (AOP). If the best franchisors only produce 25% to 30% reservation contribution, you need to ask yourself, AIs it worth it? Should I go to another franchisor who may be more accommodating?@ Also, when negotiating AOP provisions you should think about other flags licensed by the franchisor, as well as future acquired or developed flags by the same franchisor. With an up and coming flag you can often negotiate more favorable terms as compared to a mature franchisor.

Tip: my esteemed professional colleague, Nelson Migdal, recently pointed out in the August 2013 edition of "Lodging" Magazine that the AOP may be negotiated in phases, whereby the initial AOP encompasses a larger area than an AOP that becomes effective in subsequent years. I agree with Nelson.

Tip: consider the franchisor's impact policies as a substitute for a defined AOP. For example, if the defined AOP is a one mile radius from the hotel, the franchisor may put a flag on a property, one mile and one foot from your hotel. The franchisor is within its rights. If the impact policy has teeth, then that same hotel may be precluded.

Vendor Exclusivity

This can be frequently be negotiated to allow the franchisee to optimize competition in the marketplace, so long as quality standards are satisfied.

Maintaining Relationships With Franchisees - The Implied Covenant of Good Faith

The implied covenant of good faith and fair dealing may provide a semblance of protection. However, recent contracts issued by major franchisors seek to have the

franchisee waive the implied covenant=s application to the specific contract. Although generally such a provision is void as against public policy, the franchisor lawyers are now inserting language that eliminates any reasonable expectations regarding such matters. Since the implied covenant is a function of the expectations of the parties when signing the contract, if you cannot have a reasonable expectation on a certain issue, or any issue, then you have no protection from the implied covenant of good faith and fair dealing.

Recently, California adopted legislation requiring franchise agreements to include a good faith and fair dealing requirement, that good faith being defined as honesty in fact and following commercial standards of fair dealing. This will help California franchisees, to what extent, remains to be seen. The new law may also be a model for other states in the future.

Guarantees

From a practical standpoint there is not much you can do. However, to the extent you are an experienced hotelier, you may be able to persuade the franchisor to accept a corporation as the franchisee. To that extent you will insulate your personal assets from exposure to potential damages.

CONCLUSION

Not all franchisors are equal or have the same policies regarding negotiation of agreement provisions. Some franchisors are more aggressive and hungry for market share. They will be more amenable to negotiating the terms of the agreement. Before selecting a franchisor consider various franchisors and compare what they offer both economically and legally.

There is no clear path to success in dealing with franchisors. The stakes are substantial. Often you will pay well over a million dollars to a franchisor during the term of the license. The technical legal aspects of these agreements are complex requiring the experience and expertise of attorneys who work in this area.. Without professional counsel you cannot evaluate the full risk of the relationship. Even if you determine to assume the risk, you are well advised to do everything you can to optimize the little leverage you have in the relationship. It can make a huge difference, but only if you are proactive, educated and well advised.

About The Miller Law Group, P.C.

The Miller Law Group, P.C., is a full-service hospitality law firm representing hotel owners and management companies throughout the United States. Allied Memberships: AHLA, CHLA, CLIA, AAHOA, NABHOOD, ICSC and AAFD. For further information contact Mitch Miller, at mmiller@MillerLG.com or 650-566-2290.

Contact: Mitch Miller

mmiller@MillerLG.com / 650-566-2290

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