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When considering the purchase of an operational branded hotel, apart from research and financial due diligence, a potential buyer should undertake certain steps before making a final decision. The scope of legal due diligence is highly important to reveal, not only existing and potential legal risks, but also any historical risks related to the seller’s title to the hotel and land plot, the selling company’s corporate history, the history of labour relations and contractual relations with suppliers, service providers and lenders, including the status of loan repayments, and the history of compliance of the hotel’s operation with local laws. This is important to ensure that the buyer is clear on his potential exposure due to any risks, the extent of which will depend on the structure of the deal (either share transfer or asset transfer).
The parties should assess whether any risks revealed can be mitigated or eliminated by the seller prior to closing the deal. If the latter is possible, such actions should constitute conditions precedent to closing. Alternatively, the buyer should consider the seller providing an indemnity (and the seller’s financial strength should the indemnity be called upon) against any claims, damage, loss, cost or expense that may be incurred by the buyer in the future, if same relates to the period preceding the closing of the transaction.
Analysis of the HMA
As part of the legal due diligence it is highly important for a buyer to assess the hotel owner’s rights and obligations under the hotel management agreement (HMA) with the operator, since in a vast majority of cases the buyer is obliged to assume all the seller’s rights and obligations under the existing HMA as the new hotel owner. Therefore, the buyer should analyse whether the HMA provides for at least basic protection to the owner, such as in terms of the annual budget approval process and the owner’s veto rights, supervision of spending of funds and obligations to provide additional working capital, monthly and annual reporting by the operator, owner’s control over capital expenditure and spending of funds in the furniture, fixtures and equipment (FF&E) reserve, and the possibility to trigger the performance test or terminate the HMA without cause.
In case the HMA does not provide for such protections, the buyer should thoroughly consider whether the transaction should be consummated, since in most cases, the buyer will not have the option to require vacant possession of the hotel due to the terms of the HMA and, thus, should either take the hotel with all obligations and commitments of the owner, or leave the deal if he cannot get comfortable on these.
The procedure for a hotel sale is heavily regulated in most HMAs. As such, the operator usually has a right of first refusal with respect to any sale of the hotel, which should be respected by the seller and the buyer to prevent any litigation or arbitration in the future. Particularly, the seller should disclose to the operator, the buyer’s offer and the identity before any binding sale and purchase agreement is signed between the parties. Under most HMAs, the operator usually has a particular timeframe to either exercise its right of first refusal or approve the buyer and assignment of the HMA thereto. In this respect, it is important to analyse whether the HMA provides for a clear approval procedure and criteria for the operator’s rejection. If there is no such robust mechanism, the buyer should assume the associated risks since if the operator is entitled to reject the buyer for no objective reason predetermined in the HMA, the buyer’s time and money may be wasted.
On the other hand, if the HMA provides for the possibility for the seller to terminate the HMA on sale by paying the operator an amount of liquidated damages, the buyer should thoroughly consider whether or not it may require such vacant possession and if it does, which party will ultimately pay the liquidated damages. The buyer may wish to terminate the operator for several reasons: performance issues, a strategic change in the hotel’s positioning or the buyer has a strategic relationship with another operator.
The buyer should, however, keep in mind that payment of liquidated damages to the operator would not be the only price for termination
of the HMA, since all operating supplies and equipment (OS&E) and FF&E, which associate the hotel with such operator, will have to be removed, together with change of branding and potential refurbishment/renovation of the hotel to comply with the new brand standards.
Each option of transaction structuring, e.g. through an asset or share acquisition, has its own advantages and disadvantages. In case of a
share acquisition, the buyer is exposed to the risks related to the holding company’s corporate history and previous business activity, including previous credit history etc, and liabilities. However, at the same time a share acquisition may be more efficient since all personnel, permits and licences necessary for the hotel operation, contractual arrangements with suppliers, etc., are already in place in the seller’s name and no additional actions or formalities are generally required from the buyer (unless there is a change of control provision in any contract, which entitles the other party to terminate the agreement with the seller).
Vice versa, if a hotel is sold by way of an asset deal, the buyer is protected in terms of historical risks and liabilities of the seller’s business activity and corporate history, but all personnel, licences and permits, and third-party contracts have to be assigned or re-executed in the name of the buyer.
Considering the pros and cons of each option, the buyer’s legal advisors should advise whether it is preferable to proceed with a share or asset transaction, and which particular conditions precedent, if any, should be provided for in the sales documentation to ensure maximum protection.
Source: Lada Shelkovnikova, Special to Property Weekly