Key money is often a part of hotel new build and conversion transactions; it is more likely to appear in upscale and larger projects. Most basically, key money represents a kind of “entry fee” where the brand or the operator makes a financial contribution to the project as something of a hybrid between a loan and an equity contribution. Key money is usually the last money in, often not being paid until the hotel is open or is on the very eve of opening. It often bears a curious resemblance to certain pre-opening fees and expenses.
In most cases, the terms of the key money contribution and repayment are found within the many pages of the hotel management agreement. Among the frequently found provisions is the “burn off.” The burn off contemplates that the obligation to repay key money by the owner is forgiven on a pro rata basis, often over all or a substantial part (generally the first 10-15 years) of the initial term of the hotel management agreement. It is also very common to find that in the event that the hotel management agreement is terminated for any reason, the balance of the key money must be immediately repaid to the operator.
Sound simple? Well, as one owner and its principals found out, sometimes it’s not.
A recent case1 shed some light on just what can happen when an agreement does not clearly provide for the repayment of key money upon early termination of the hotel management agreement. The case involved a key money arrangement where a full set of loan documents, including a promissory note, were prepared and executed. In typical fashion, the loan documents provided provisions for burn off and repayment in the event the management agreement was terminated for any reason.
Ultimately, the hotel failed and the operator terminated the management agreement. The operator then filed suit to recover the unamortized balance of the key money loan. The owner’s defense was that the operator had breached the hotel management agreement, resulting in the failure of the hotel, and therefore, any obligation on the part of the owner or the guarantors to pay the key money loan should be discharged. The court concluded that the documents
did not provide for that result, and that the hotel management agreement and the key money loan documents, despite being part of a single transaction, were separate contracts.
The owner did try to tie the hotel management agreement and the operator’s alleged default under the hotel management agreement to the loan documents and have them treated as a single contract. The court did not agree, based on contract law principles beyond the scope of this article. The owner was not permitted to try to prove it was damaged by the operator to an extent that would discharge or offset the key money obligation.
As an aside, there were a number of unusual things about this transaction. The documents provided for personal guarantees by the principals of the owner entity, who signed the note as co-makers. Additionally, the key money loan was documented separately from the hotel management agreement.
Another sidelight, but one of interest within the industry, is that the management agreement dispute resolution provision contemplated mediation only with respect to claims related to the operating accounts, operating budget and the annual operating plan. This meant that any other claim – including termination or breach of contract damages – would be litigated in court, rather than submitted to binding arbitration. This is sufficiently unusual in industry practice to be fairly described as an anomaly and explains how the parties wound up in court.
Ultimately, the note had two provisions that doomed the owner: (i) “. the outstanding principal balance of this Note shall be payable . if the [hotel management agreement] terminates for any reason”; and (ii) “. [the obligation] to pay this Note shall be absolute and unconditional, and all payments shall be made without setoff, deduction, offset, recoupment, or counterclaim.”
The co-makers have appealed. Perhaps the appellate court will see things differently. Stay tuned.
Was this result inevitable? Absolutely not.
If the parties had so intended, the documents could have been drafted to specifically provide that the key money loan would not have to be repaid if the hotel management agreement was terminated as the result of a default by the operator, thereby entitling the owner to terminate for cause.
Suppose, instead of the two provisions above, the note provided (i) “. the outstanding principal balance of this Note shall be payable . if the [hotel management agreement] terminates for any reason other than a termination by the owner for cause resulting from a breach by operator”; and (ii) “. [the obligation] to pay this Note shall be absolute and unconditional, and all payments shall be made without setoff, deduction, offset, recoupment, or counterclaim, except as otherwise provided herein.” Perhaps by just including these 20 words in the hotel management agreement or the key money loan documents, the result of the case could have been dramatically different.
There really was no legal requirement for two separate documents. Brief language could have effectively tied them together, in which case the court could, and likely would have treated the two documents as one. Since the documents did not clearly state how they should be interpreted in relation to each other, the court applied the contract law of the jurisdiction selected by the parties in deciding the outcome of the case. One may ask whether the end result was really one that the operator intended, or whether it was simply the result of the court’s interpretation of the documents that were prepared in this specific instance. It’s a fair question and points to the real lesson that should be learned from this and similar cases.
The importance of clearly-drafted hospitality industry agreements cannot be overstated.
Whether preparing a letter of intent at the very beginning of a deal or finalizing the definitive transaction documents for a transaction that may be effective for half a century or more, everything that is important to either party should be clearly and completely spelled out in the hotel management agreement and any related documents. This is not to say that anticipating every single
potential eventuality is an easy or even necessary task. However, items of particular importance – and certainly those involving things like significant sums of money, material obligations of the parties and termination – must be spelled out in what non-lawyers may consider excruciating detail. It is one of those situations where the dispute you save may be your own.
The take away here can be expressed in two phrases: “Write what you mean” and “Mean what you write.”