Australia – The Impact Of Debt On Hotel Management Agreement Negotiations – A Marriage With Three Parties.

8 August, 2019

 

It is a curiosity of hotel management agreement negotiations that aspects of the owner's financing arrangements can be fundamentally impacted at a time when the owner may not even know who its lender will be – let alone the terms and conditions upon which such financing will be provided.
 
It is a longstanding tradition that operators wish to place controls and requirements with respect to the owner's arrangements with its lender. These controls and requirements need to be considered carefully as failure to do so may result in the owner being required to pay more for its financing than otherwise would be the case or even blocked from borrowing from a lender who is offering the best deal.
 
An owner and its lawyers and other advisers always need to pay close attention to the operator's requirements in relation to the owner's borrowings. This has never been more apt than now when the sources of available finance are ever diversifying bringing about an ever expanding range of differing attitudes to operator demands.

 

The Issue	Background	Commentary
When should an owner first seek to identify an operator's requirements in relation to an owner's preferred lender?	Operators usually impose borrowing restrictions on owners. These restrictions can be adversely and materially significant.	An owner should identify at the earliest opportunity what an operator's key financing requirements are. If the owner has instituted an operator selection programme then key  information (including key financing requirements) should form part of each operator's expression of interest. An operator's key requirements (or lack thereof) may improve or impede its chances of being selected as the preferred operator.
What are some typical requirements imposed by operators in respect of an owner's financing?	Each operator has its own specific requirements which differ from operator to operator. These need to be understood thoroughly and considered in the context of the specific circumstances.	Set out below are some examples of requirements we have seen imposed by operators: Imposing an absolute obligation to obtain a non disturbance deed from the lender. A general right to pre-approve the lender and the mortgage. Restricting the borrowing solely to the construction and operation of the hotel. Restricting the mortgage from being cross-defaulted with any other debt financing. Imposing a maximum loan to valuation ratio on the amount borrowed. Limiting the maximum interest payable by the owner as borrower. Imposing a requirement to approve/sight all financing documents. Specifying the class of lenders from whom the owner can borrow.
What approach should an owner take to identify: (a) a lender's receptiveness to operator demands; (b) a lender's requirements regarding the operator; (c) how conflicting requirements can be harmonised	Typically the negotiations with an operator are finalised before the owner has settled on a lender.	Ideally, the following steps should be taken before executing a hotel management agreement: the operator is requested to identify and provide details of all of its financing requirements (including a template non disturbance deed); all prospective lenders should be made aware of the operator's requirements, requested to indicate willingness to comply with the operator's requirements and to provide its own requirements; negotiations should be undertaken primarily with the operator (and also with prospective lender(s) if feasible to do so) to reach agreement on any contentious issues.
What issues arise in relation to  non disturbance deeds?	A  non disturbance deed is a tri-partite agreement between the lender, the owner and the operator to establish direct contractual relationships between the lender and the operator. In the absence of a non disturbance deed the operator would usually be entitled to terminate the hotel management agreement on the owner's insolvency and leave the lender with a hotel and no operator. A non disturbance deed also serves to ensure that the lender will "honour" the hotel management agreement in the event the lender takes possession of the hotel.	Usually the operator wants the lender to execute a non disturbance deed and the lender wants the operator to do so as well but each may have different requirements which may be contradictory. The operator should be requested to provide their required form of non disturbance deed for the lender's review. Difficulties may arise if the owner has not selected its lender yet which may make it difficult to persuade prospective lender(s) to take the review seriously and incur the cost of providing qualified and reliable legal input which the owner can rely on. It is therefore important that there is flexibility embedded within the hotel management agreement as to the form of the non disturbance deed and the requirement to procure the lender to enter into such a deed (see item 7 below where we elaborate on this).
What issues arise in relation to borrowing limits?	The borrowing limit will usually be expressed as a percentage of the value of the hotel (usually referred to as the loan to value ratio ("LVR"))	When determining the LVR limit, it is important to ensure that there is a buffer above the LVR that lenders usually advance in the market (e.g. if the usual advance is around 55% LVR then the borrowing limit should be, for example, 65% LVR or higher.) When setting the LVR limit, owners will need to consider not only  the first ranking lender but also existing or potential lesser ranking lenders, as the LVR will be in respect of the aggregate of all indebtedness against the hotel. A prudent owner should also seek to exclude the borrowing limit during the construction period particularly if the proposed hotel is part of a mixed use development with the potential for the overall loan to exceed the LVR limit.
What issues arise from having a contractual obligation to disclose or seek approval from an operator in respect of   financing documents?	Certain operators require that all legal documentation in relation to the financing for the hotel between an owner and their lender be disclosed to the operator prior to finalisation of those documents.   Other operators require that such legal documentation be approved prior to finalisation.	Any disclosure or pre-approval obligations need to take into consideration any relevant confidentiality requirements that the lender may have. Preferably such obligations should be subject to any relevant or anticipated confidentiality requirements that an existing or proposed lender may have. If operator approval is required, then care needs to be taken to ensure that an appropriate procedure is put in place to ensure that such approval process does not adversely impact on the course of dealing between the owner and the lender.
Avoid "absolute" obligations	Tensions may arise in hotel management agreement negotiations if an operator seeks to impose absolute obligations with respect to financing requirements (e.g. the owner must obtain a non disturbance agreement before it is entitled to borrow from a lender).	As the lender is not a party to the hotel management agreement, it is not contractually obliged to comply with the operator's absolute requirements and if the lender elects not to do so, then the owner may be contractually prevented from being able to borrow from that lender. Consideration should be given to discussing with the operator a less stringent requirement. Common examples are to " use best efforts", to " use reasonable efforts", to " use reasonable endeavours" or to " use commercially reasonable efforts/endeavours". The relaxation of the obligation can also be accompanied by a step by step procedure which codifies what the owner needs to do to satisfy the relaxed obligation.
Can a potential impasse be resolved by the use of a side letter?	If an owner is seeking to negotiate a concession with an operator (e.g. relaxing the obligation to obtain an non disturbance deed or other financing requirements), then the operator may prefer to make the concession personal to that owner rather than agreeing to the concession for the life of the hotel management agreement.  This provides the operator some comfort that the concession will not be available to future (then unknown) owners.	A side letter is the traditional way to allow the owner and operator to agree to a concession on the basis that it is available solely to the original owner. The side letter overrides the provisions of the hotel management agreement while the original owner owns the hotel. The side letter should be drafted so as to ensure that it does not cease to apply should the owner wish to sell the hotel (and assign the hotel management agreement) to a related entity.
Why should owners involve lawyers early in the process?	Negotiations can become protracted in respect of the financing restrictions set out in a hotel management agreement due to the critical role that financing plays for the owner's project.  Sometimes this can be managed by involving lawyers early in the project and particularly during term sheet negotiations.	During term sheet negotiations with an operator, it would be prudent to include the operator's financing requirements so that any key requirements are agreed upfront which may reduce the time spent negotiating these provisions during contractual negotiations.  By involving lawyers at this stage, the owner's commercial requirements can be properly reflected in the term sheet. Term sheet negotiations should also include a review of the operator's template legal documents to ensure there are no red flag provisions which should be agreed upfront and reflected in the term sheet.
What are the key take outs?	Very few parties are able to contemplate hotel ownership in the absence of debt financing.   For the vast majority of hotel owners, it will be self evident that the availability of debt on the best possible terms is a key factor to hotel profitability if not viability.   Issues surrounding the relationship between lenders and operators can be subtle and nuanced. Great care needs to be taken to ensure that harmony prevails.	Some take outs that come to mind: The relationship between operators and lenders can be symbiotic and this needs to be recognised by both parties. While operators have legitimate requirements with respect to the owner's financing, those requirements cannot stifle the owner's ability to secure finance on the best possible terms. Hotel management agreements are usually long term agreements and this needs to be taken into consideration in considering an operator's requirements in respect of the owner's financing. The identity of hotel debt providers will never be a stagnant proposition and the requirements of such providers will remain fluid. Hotel management agreements need to  be drafted to comprehensively deal with this dynamic

 

 

For further information, please contact:

 

Graeme Dickson, Partner, Baker & McKenzie

graeme.dickson@bakermckenzie.com