Termination clauses in hotel management agreements (“HMAs”) are keenly negotiated by owners to ensure the liquidity of their investment. These usually include a termination provision in the event the operator underperforms, generally known as a performance test clause. How are these clauses challenged before the courts in France?

The performance test clause as negotiated in France, allows the owner to terminate the HMA early if the operator proves inept or if it fails to properly fulfil its managerial role by achieving satisfactory results and profitability, especially when weighed against the owner’s financial investment (hotel acquisition, construction and/or renovation costs). The parties are free to choose the metric used to determine the performance required of the operator. While EBITDA, GOP or even Adjusted GOP are often used, the performance test may also be based on the hotel’s RevPAR or guaranteed return on investment for the owner.

If pertinent and agreed in the HMA, performance may be compared against that of other similar hotels in a specific geographical area. Any shortfall is assessed at the end of each financial year or at the end of two consecutive testing years (hotel operators have a lively imagination when it comes to performance testing). It all comes down to negotiation at the contract signing stage. The performance test clause has to be worded in such a way that it cannot be open to interpretation at a later date, either by the parties themselves, or by a judge or arbitration tribunal in the event of dispute.

Operators usually negotiate the performance test clause with a “right to cure”, i.e., the faculty to prevent the contract from being terminated. In the event of a failed performance test, the operator makes a compensation payment to the owner, equal to the difference between the performance expected by the owner and the performance achieved by the operator. Operators generally prefer to take a hit in terms of management fees and results, rather than lose the contract and its expected future benefits completely.

Indeed, the stakes are dependent on the term of the agreement, and for long contracts, which is generally the case of HMAs, the stakes are all the higher. If the performance test clause is badly worded, it could devalue the HMA for the owner if the hotel is potentially sold with the existing agreement in place.

The performance test clause in litigation is more than a termination clause. In the case of dispute, the owner will have to demonstrate that the performance test clause, together with the operator’s cure right, is in reality understood as a simple guarantee of performance offered by the operator. Indeed, the performance test and cure right should constitute a form of contractual minimum guarantee for the benefit of the owner, which must stand up to legal scrutiny in court.

The fact that performance testing is standard practice in the French hotel industry should not be relied upon in court, where French judges are often unfamiliar with such methods. French commercial court judges are generalists, not hotel industry experts, and judicial uncertainty can never be ruled out. If necessary, it may be advisable to present a report produced by a legal expert specialising in performance test mechanisms to “enlighten” the judge.

As with any guarantee, the defaulting operator must make the cure payment promptly. Exercising the cure right does not, in practice, raise any major difficulty if the operator is part of a major hotel group, since a chain will tend to pay out rapidly to make sure it retains the management of the hotel in its portfolio. However, the situation can be more challenging if the operator is part of a small organisation without the wherewithal to guarantee cure payment. In this case, the operator may persist in managing the hotel, despite failing the performance test, without providing any compensation to the owner. To protect themselves, some owners require that the operator provide a deposit guaranteeing cure payment should it become due.

The flipside of the owner’s duty of non-interference is operator performance. Yet the owner’s financing structure and cashflow requirements are based on the forecast budget presented by the operator prior to the HMA being signed by the operator and accepted by the owner (who is not considered “informed”). If the owner is an investment fund, it will seek to secure its investment against performance failure and the operator’s insolvency risk. The same applies to investors who have borrowed from a bank, and who wish to protect themselves in this respect.

The owner will thus have secured cure payment, or failing that, early termination of the HMA (without having to pay compensation to the operator). The owner can then resume control of the hotel once the accounts have been rendered and the brand removed from the hotel, as provided for in the HMA.

In practice, there are very few examples in France of litigation involving performance tests coupled with cure rights. Indeed, some operators even waive their cure right, dependent on circumstances, and simply stop managing the hotel. Those legal disputes that can be identified are more likely to be part of a broader, acrimonious dispute with operators acting in bad faith, often having been found in breach of contract, and who are engaged in a process that destroys the value of the hotel, while seeking to wrest a termination fee from the owner.

But that’s a story for another day….

This article has been published in the online magazine Hospitalitynet.org