The Top Ten Issues Facing Hotel Counsel

By Robert Zarco, Esq.

Franchise Law Update

1. Encroachment/Protected Territory/Cross-Brand Protection

Significance of the Franchise Agreement's Language- The precise language in the franchise agreement will indicate whether a franchisee has the right to a protected territory, or even whether the franchisor must consider an existing franchisee's interests at all when evaluating where to locate a new hotel property.  Courts tend to interpret these clauses very narrowly, and usually leave the franchisor with a great deal of discretion in its decision.  A major focus of franchisee litigation over the past several years has been disputes over the interpretation of these clauses.  It is important to remember that in most circumstances, only the franchise agreement will define the franchisee's right to area protection.  While some courts will consider the UFOC's statement on this issue, the franchisor's oral promises in determining what the parties originally intended will almost never be considered.

Formulation and Use of Impact Studies - Assuming that a franchisee has some right to be protected from the negative impacts of encroachment, certain hotel franchisors have employed "impact studies," or estimated projections as to how a new property might impact the existing franchisee's operating in the area.  In many cases, the franchisor will require the potentially affected franchisee to pay for the cost of the study - not an insignificant expense.   The impact of a competing property may depress the existing hotel's occupancy rates, increase its marketing expenditures, result in lost food and beverage revenues, and decrease the hotel's resale value.  Both franchisors and franchisees voice concerns that the methodology for these impact studies often varies from one case to another, and that the results may be subject to manipulation based on the study methodology employed.  Even professional valuation associations have not yet devised specific, objective criteria to determine impact, as they have done for assessing property standard criteria to be used industry-wide.  In addition, the study should be performed by an expert who is "neutral."

2. Remodeling/Renovations

Determination of What Type of Renovations and Remodeling are Necessary - A franchisor may determine, as a result of a quality inspection, that a hotel property is in need of PIP, or a "property improvement plan."  These renovations may be necessary because of normal wear and tear to the property, inadequate maintenance by the previous hotel owner, or the effects of a natural disaster such as a hurricane. Alternatively, the franchisor may decide to impose a chain-wide remodeling program to enhance the brand's image.  In either situation, the franchisee hotel will be responsible for paying the cost of the improvements.

One type of situation arises when the franchisee disputes the need for the remodeling.  The franchisee may think that the franchisor is requiring Hyatt-level renovations in a Days Inn, for example.  Some franchisee groups have called for the franchisee to be afforded the right to an independent quality inspection in these situations.

Another problem arises when, for one reason or another, the franchisee is unable to make the repairs as quickly as the franchisor has demanded.  Many times, the franchisor will grant reasonable extensions of time for these matters if the franchisee follows the protocol for extensions.  Franchisees encounter serious difficulties, including default and termination, when they do not follow the required procedure, or fail to do so in a timely manner.  Counsel for both franchisors and franchisees recommend that the parties remain in communication about the status of the work in progress and document those conversations carefully to avoid any misunderstandings.

3. Co-Branding Arrangements

Impact of the Franchise Agreement on a Franchisee's Freedom to Co-Brand - The idea of co-branding with a restaurant franchise may sound like a natural alliance, but there are some, potentially thorny legal issues to be resolved before embarking on such a venture.  A hotel franchise agreement may impose certain restrictions on the types of business and/or products and services with which the hotel franchisee may share its property.  For example, if the hotel offers food and beverage service, would a cafe´ be in violation of the franchise agreement because it may compete with the hotel's service?

The hotel franchise agreement may - depending upon the precise language of the contract - reserve the franchisor's right to approve of the guest concept's equipment and dcor, before it begins operations.  The franchisor may also have the prerogative, under the franchise agreement, to determine the guest concept's hours of operation and even to perform QSC (quality, service and cleanliness) inspections.  These are just a few of the many legal questions which may arise in contemplating a co-brand relationship. It is not a simple decision for any of the parties involved, and a careful analysis of all applicable agreements by counsel is critical.

4. Reservations Systems

Use of Hotel Brand's Confidential Database - Franchisees voice several concerns regarding participation in a national brand's reservations system.  In some systems, the franchisee pays additional fees to the franchisor in return for its participation in the nationwide system.  As part of the process, the franchisee may provide occupation, pricing, and other proprietary information to the reservations system.  The franchisees expect to receive confidential, technologically efficient and a fair distribution of customers from that reservation system.

Occasionally, franchisees fear that the franchisor is using confidential or competitively sensitive information from the reservations system to the advantage of company-owned hotels or for other improper purposes.  Therefor, it is critical to the franchise relationship that franchisors maintain the confidentiality of the information supplied to its reservations database.

Other franchisee concerns pertain to reservation system employees recommending company-owned hotels rather than franchised hotels located in the same vicinity.  The parent company should have a policy affording fair treatment to all of the hotels it represents, regardless of ownership status.

Franchisees have also experienced operational difficulties when the national reservations system's computer malfunctions.  If a franchisee has signed a franchise agreement requiring it to participate in a computerized reservations system, the agreement may also contain a waiver clause absolving the franchisor of liability for computer difficulties with the system.  This waiver clause will usually preclude the franchisee from suing to obtain damages for reservations revenue lost as a result of the malfunction.

In any event, all parties should work cooperatively to ensure that their information technology operates efficiently, as it will affect directly the hotel brand's financial results.           

5. Vendor Exclusivity/Supplier Control

Impact of the Franchise Agreement on Franchisor's Control of Vendors and Suppliers - Frequently, the franchise agreement will provide the franchisor with complete discretion in choosing third-party suppliers and vendors.  Franchisees complain that these arrangements limit their ability to find the most cost-efficient suppliers and deprive them of the opportunity to forge their own network of business contacts.  Franchisors, on the other hand, find that designating vendors and supplies helps to maintain quality control and consistency within the concept.

Some franchise agreements leave the franchisees with an option to use their own suppliers if the products meet with franchisor approval for quality and uniformity; however, that option requires the franchisor to have a system in place for evaluating alternative suppliers.  Should the franchisor fail to allow alternative vendors to be considered, it may be violating antitrust laws and other statutes protecting competition in the market.  Franchisors must be prepared to justify the necessity of requiring franchisees to use a particular vendor or supplier based on the quality control, consistency or uniformity requirements of the franchise system.  Such requirements must also be clearly disclosed in the UFOC.         

6. Advertising/Marketing

Franchisor's Obligations Under the Franchise Agreement - A franchisor's obligation to provide advertising and other promotional services may be framed in terms of a discretionary requirement - the franchisor will provide advertising, for example, as it deems necessary.  If the contract allows the franchisor to decide how much and what type of advertising the system needs, it does not matter that the franchisees believe that the advertising program is insufficient.  Even if the requirement is set forth more objectively, it is often difficult to measure either party's expectations precisely whenever a certain amount of discretion is necessarily written into the contract.  If the requirement does afford the franchisor discretion, there is still a required level of marketing and advertising assistance.   Otherwise, the franchisee may have a viable claim for breach of contract, or breach of the implied covenant of good faith and fair dealing.

Franchisor's Accountability for Marketing and Advertising Fees - Franchisees contribute a significant percentage of their revenue to franchisor-maintained marketing and advertising programs.  The franchisors use those funds for promotional efforts on behalf of the hotel brand.  Particularly where the parent franchisor owns a multibrand portfolio of hotels, franchisees raise concerns that their contributions are not being used for their designated purpose. As a way to alleviate some of these concerns, franchisees often seek some method of franchisor accountability or reporting of their financial contributions.  If a multibrand hotel owner intends to "pool" the advertising funds among its several brands, the franchisor and the UFOC.  Otherwise, the franchisor may subject the company to a viable franchisee lawsuit pertaining to advertising claims.

National vs. Regional and Local Advertising and Promotional Requirements - Franchisees in smaller markets are often concerned about not sharing the benefit of national franchisor advertising, and smaller city hotels would prefer that the franchisor use their contributions to support regional and local advertising.  Franchisors, on the other hand, find that national advertising is the most effective for promoting the system and enhancing the brand's image.  Some franchise systems have attempted to resolve this dispute by forming advertising cooperatives, which allocate part of the advertising contribution for national advertising, and use the rest for local advertising programs.  Regardless of the franchisor's approach, the franchise agreement and the UFOC should disclose what will be done with the advertising fund, and how the contributions will be allocated.

7. Sale/Transfer/Assignment of the Franchise License

Restrictions on Sale or Transfer of the Franchise - Most franchise agreements allow the franchisor to withhold its consent to a proposed transfer or assignment unless and until the transferee meets certain, unspecified criteria.  There are certainly legitimate reasons for requiring franchisor approval of a new operator.  Nevertheless, franchisees fear that this grant of discretion will work to their disadvantage, and may interfere with their ability to sell their franchise for a fair price and leave the system.  It is critical that franchisors and franchisees alike be able to rely on the transfer criteria set forth in their counterparts in the major cities. It is inappropriate for the franchisor to rely upon criteria outside of those set forth in the franchise agreement.

Imposition of Fees on Sale/Transfer of Franchise License - Franchisees raise concerns about franchisors charging excessive fees in connection with the sale or transfer of the franchise license, fearing that they will lose a large part of their investment or be trapped within a system in which they no longer wish to participate.  Franchisors, on the other hand seek a way to recoup the administrative costs of transferring the license to the new owner.  Either the transfer fee or a predetermined formula for calculating the fee should be stated clearly in the franchise agreement.

Impact of Franchisor's Assignment or Transfer of its Own Contractual Rights and Duties - As part of the franchise agreement, franchisors may retain the freedom to assign or transfer their responsibility for furnishing various services to the franchise system to third parties; in so delegating, the franchisors are no longer responsible for providing those services.  A major fear of franchisees is that the third party will not perform those services at the same level the franchisor was performing, due to lack of operational experience or financial resources.  In the event they are dissatisfied, franchisees will be forced to deal directly with the third party, instead of with their franchisor.  This, of course, concerns franchisees because of the fears that the third party will not have the same incentive as would the franchisor to furnish services at the highest caliber.  Nevertheless, if the franchisor sells or transfers the franchise system to an unqualified purchaser, the system's franchisees may have a cause of action based on contract or even on business tort claims.  For this reason, the franchisor must pick its successors prudently.

8. Mechanisms for Dispute Resolution

Mediation as a preferred alternative to litigation or arbitration, is a trend in dispute resolution.  Mediation assumes that the parties will meet at the earliest possible opportunity to discuss their differences, under the guidance of a trained neutral mediator to seek solutions which all parties can live with.

In contrast to the other alternatives, mediation encourages, rather than discourages communication between the parties and seeks to preserve their relationship.  Mediation is far less structured than the other avenues.  It is remedy after-the-fact in that its goal is to assess the conflict and negotiate damages, but it also affords a prospective remedy in that the parties may agree to their mutual expectations for future conduct.

Implicit in this list of positive attributes, however, is that there is a remedy that can fix the situation, that a compromise is possible, and that there are advantages to both parties to continue the relationship.  Mediation is not suitable for all conflicts, and it is arguably the most effective when it is chosen, rather than forced upon parties as the only alternative available.

Nor is arbitration the preferable alternative that some believe it to be.  First, it is very expensive.  Arbitrators, unlike judges, are paid by the hour for all of their work, including attending hearings and reviewing all legal briefs and documentary evidence.  Second, in arbitration, parties forfeit the right to extensive discovery and a jury trial.  The normal rules of evidence and procedure do not usually apply in the same way as they would in state or federal court, unless specifically set forth in the franchise agreement's arbitration clause.  Instead, the law affords the arbitration panel a great deal of flexibility and discretion in conducting the arbitration hearing, and a reviewing court will rarely, if ever, reverse the panel's decision.  For these reasons, the parties should think carefully about signing an agreement which mandates arbitration and thereby waives their right to access the courts.

Although most parties do not wish to consider the prospect of litigation with their business partners, there are situations where litigation provides the best legal protection for all involved.  For this reason, it may be a serious disadvantage to foreclose the alternatives at the contracting state.

9. Impact of Liquidated Damages Clauses on a Franchisee's Alternatives

Liquidated damages clauses are frequently cited as the most egregious of contract clauses.  Liquidated damages provisions serve as a predetermined formula to compute monetary damages in the event of one party's breach (usually, the franchisee).  The significance of this term is that it prevents a judge or jury from awarding damages, leaving the jury with only the determination of liability.  Courts tend to uphold liquidated damages clauses, unless they would serve as a "penalty," or are truly "unconscionable" - and legally, these are both very high standards to meet.  In addition, the court's decision as to whether a liquidated damage clause constitutes a penalty must consider the circumstances as they were at the time the parties entered the contract, not at the time of the dispute.  As a practical matter, liquidated damages clauses deter franchisees from leaving one franchise system to join another system, and franchisors view liquidated damages as a remedy for the lost revenue in the market which the franchisee left prematurely.

In the lodging sector, liquidated damages are often based on the franchisee's royalty payments for a period of months -- at 60 months, for example.  For a large property, this can be a severe penalty.  In a recent effort to improve relations with its franchisee, at least one hotel franchisor has reduced its liquidated damages formula, and offers a 15% discount on damages due if the terminated franchisee complies with certain conditions, including de-identifying within 30 days of termination.  These incentives promote fair franchising practices and provide incentives to the franchisee to comply expeditiously with the termination requirements.

No Effect If the Franchisor Breaches First - If the franchisor commits a material breach of the contract, then the liquidated damages clause will not apply at all.  Nevertheless, the issue of which party breached first is not always easy to determine.  For this reason, the threat of liquidated damages often casts a dark cloud over the franchise relationship.

No Effect if the Franchisor Replaces the Franchisee Immediately - Other issues arise when the franchisor replaces the terminated franchisee in the same market immediately, and therefor, does not suffer a loss of grand representation and royalty revenue in that market.  In certain cases, the franchisor may be prohibited from collecting the liquidated damages from the franchisee because, if the projected financial losses do not actually occur, the liquidated damages would constitute a "double recovery."

10. Construction/Development/Site-Selection Issues

Franchisor's Obligations Regarding Site Selection - Does the franchise agreement require the franchisor to recommend or actually to chose a location or a site?  A location decision means that the franchisor will decide to expand into a certain area.  Once the location is chosen, who is responsible for choosing the actual site?  What are the franchisor's established criteria for making that decision, and thus, reducing the risk of financial loss to the franchisee?  This is a critical decision and it is important that the parties know well in advance which of them is responsible for selecting the actual property site.  If the franchisor fails to adhere to its own site selection criteria when it selects or approves the franchisee's site, the injured franchisee may possess viable claims as a result of the franchisor's failure to follow its own guidelines.

The construction of a hotel necessarily involves significant costs.  The evaluation process ordinarily begins with a feasibility study, of which the project's financing arrangements are a major focus.  The feasibility study also considers the total project cost, the financial structure of the undertaking, and the projected tax consequences of the venture.

A feasibility study for a hotel will consider a much larger area than would a new restaurant business.  The hotel study will likely consider the entire city, or community, as a market, and differs from market studies for restaurants in that the demand comes from outside the local area, rather than from within it.  A thorough feasibility study will contain a site review and area evaluation, a market demand analysis, a review of economics and demographic indicators, a competitive analysis, facilities and concept recommendations, a forecast of revenue and expenses, an estimate of total project cost, and a return on investment analysis.  To be prepared properly, the study will involve considerable time and expense for the responsible party.

Franchisee's Responsibility to Remain Current with Development Schedule - If the franchisee is a multi-unit operation, the franchisee will be responsible for staying current with the development schedule set forth in the franchise agreement. Failure to do so, without the franchisor's written approval, will result in the franchisee's default and the potential termination of the franchise agreement.  It is in the interest of both parties to consider whether the development schedule is realistic - given all of the relevant factors - before it actually becomes part of the parties' contract.  If, however, the franchisor impedes, or in any way interferes with the franchisee's ability to comply with the development schedule for real or pretextual reasons - i.e., to promote the development of the company-owned outfits at the expense of franchised units - the franchisor will not be permitted to default or terminate the franchise on this basis, and may subject itself to liability for its actions.

Conclusion

Franchisees and franchisors are partners in this business relationship.  For this reason, franchisees and franchisors alike must be acutely aware of their respective rights and responsibilities under the franchise agreement.  Both parties should also stay current as to the state of the law will affect the interpretation, construction and performance of the franchise contract.  If either party is unsure of how to proceed in a given situation, the best advice is to consult with an experienced franchise attorney at the earliest possible opportunity.

Bibliography

"AAHOA Survey Finds Franchisees Are Unhappy," Hotel & Motel Management, Information Access Company and Advanstar Communications, Inc., February 15, 1999.

Cannon, Charles B., "A Checklist for Co-Branding Franchised Hotel Properties," Leader's Franchising Business & Law Alert, Leader Publications, January 1999.

"Choice Hotels Lowers Cap on Liquidated Damages," Hotel & Motel Management, Information Access Company and Advanstar Communication, Inc., April 5, 1999.

"Liquidated Damages, Impact Take on Added Importance," Hotel & Motel Management, Information Access Company and Advanstar Communications, Inc., May 3, 1999.

Nozar, Robert A., "Choice Franchisees Gain Area Protection," Hotel & Motel Management, Vol. 214, Issue 13, Information Access Company and Advanstar Communications, Inc., July 19, 1999.

"Officials Hope to Avoid Further Rancor; Industry Executives Question Tactics," Hotel & Motel Management, Information Access Company and Advanstar Communications, Inc., April 19, 1999.

Power, Tom, Marketing Hospitality, John Wiley & Sons, Inc., (2d ed.), 1997.

Rushmore, Stephen, "Franchisors Starting to Clean Up Their Act," Lodging Hospitality, Vol. 55, Issue 2, UMI Company and Penton Publishing and Marketing, February 1, 1999.

"U.S. Franchise Systems," Hotel & Motel Management, Vol. 214, Issue 14, Information Access Company and Advanstar Communications, Inc., August 9, 1999.

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