The hospitality sector has been deeply shaken by the 2019 Novel Coronavirus (COVID-19) which continues to spread across the globe. This has directly affected hotel occupancy rates and revenues that the hotels are able to achieve per available room (RevPAR), as countries around the world are imposing travel bans, quarantining citizens and isolating the infected in an attempt to stop the spread of the new virus.
With operators closing entire floors of hotel rooms, restaurants, as well as renegotiating contract terms with suppliers of goods and placing employees on unpaid leave, the reality of the virus is hitting home.
The legal agreement and force majeure (FM)
The hotel management agreement (HMA) (which is the most common form of agreement governing the relationship between the owner and the operator) addresses the concept of FM in a number of places and gives rise to a number of consequences.
The concept of FM derives from the French civil law system and is frequently incorporated into commercial contracts that are governed by common law systems.
Operators will argue that the definition of a FM event in a HMA should be wide enough to cover global epidemics, pandemics, disease related events and travel disruption. Owners will often argue that these events should be limited to the country within which the hotel is located.
Under which laws will the HMA be considered?
It is important to consider the governing law clause in the HMA as this will have an impact on whether COVID-19 can be classified as a FM event.
About half the HMAs in the Gulf region are governed by English common law. Under common law, what constitutes a FM event and the precise objective test depends on the specific wording of the clause within the agreement. If the agreement provides that a FM event must "prevent" performance, the operator must generally demonstrate that its performance has become legally or physically impossible and not merely more difficult or more expensive. By contrast, if the provision refers to the event "hindering or delaying" performance, then the threshold will generally be lower and FM may be satisfied if performance remains possible but has become substantially more onerous.
English courts tend to take a dim view of claims that market circumstances affecting the profitability of an agreement may be a FM event.
UAE law recognises and differentiates between partial and total impossibility of performing a contractual obligation in terms of a FM event. In such event, the impossible part of the obligation shall cease to exist. The affected party still has the option to terminate the contract and inform the other party of such termination. The same principle applies to temporary impossibility.
Saudi Arabian Law
The position in Saudi Arabia, under shariah law, is that FM can generally be claimed irrespective of whether the contract explicitly provides for it. However, the threshold is high and the burden of proof rests on the claimant. The court would consider several factors in making its determination. An event that lasts or is likely to last for a few months may not be deemed sufficient by the court to excuse a party of its contractual obligations. The court may also consider other factors, such as the possibility that the claimant could have tried to negotiate different contractual terms.
What should we be thinking about?
During these challenging times, it is important for hotel owners and operators to review their agreements with particular regard to the following:
Performance tests - the performance test will include an obligation on the operator to ensure that:
(a) the RevPAR meets the pre-agreed percentage of the average RevPAR of a group of competitive hotels within a certain distance of the hotel (often known as the competitive set); and
(b) the operating profit of the hotel is no less than a pre-agreed percentage of the forecasted gross operating profit set out in the budget.
However, a 'carve out' is typically included by the operator, so that they are not required to achieve the requirements of the performance test in the event of FM.
Enduring Periods of FM - some HMAs afford both parties the right to terminate if an event of FM persists for an extended period of time. This right of termination may become important where closure of the hotel is warranted and the timeframe for its reopening is unclear or unlikely.
Working capital - the impact of COVID-19 on the hotel industry has highlighted the importance of working capital reserves. While the trend has been to reduce these reserves to the minimum amount possible, the current circumstances prove the need for sufficient working capital reserves to be maintained for periods long enough to either (i) allow a FM event to subside and business to resume or (ii) allow the hotel owner sufficient time to make a claim under its business interruption policy and receive the proceeds of insurance.
Insurance - the owner's property all risk insurance policy, and in particular, the business interruption component of that policy, need to be carefully considered. The policy wording needs to respond in circumstances that go beyond physical damage to the hotel, so as to capture pandemic type circumstances where the hotel remains physically intact but the hotel business collapses for an extended period of time.
Employee relations - hotel employees are at the heart of the guest experience and are the cornerstone of the hospitality industry. The mass layoff, furlough or leave without pay arrangements that are being implemented across the industry are placing this core element of the hotel at risk. Better strategies need to be adopted to address the issue of staff retention in circumstances like the present, where business activity suddenly comes to an end.
Debt financing - while central banks are looking to provide relief to affected industries and business owners, hotel owners need to begin talks with their lenders to agree the rescheduling of debt and alternative security packages, as hotel valuations decline triggering loan to value ratio recalculations. Complex and disruptive outcomes can arise if the lenders are not on board and actively engaged in the process.
About the authors
Bilal Ambikapathy is a partner at Baker McKenzie and heads the hotels practice in Saudi Arabia and Bahrain. Bilal is an Australian qualified lawyer who has been working in the Middle East since November 2005 and has extensive experience in the hospitality and real estate sector, having advised hotel owners, banks, real estate funds and developers on all aspects of the hotel and real estate industry. Bilal has a particular focus on shariah compliant hotels.
Keri Watkins is a senior associate lawyer in the Dubai office of Baker McKenzie Habib Al Mulla. Keri is a UK qualified lawyer who has been working in the Middle East since November 2007 and has extensive experience in the hospitality sector, having advised both hotel owners and operators on their agreements and operational issues. Keri provides advice to clients across the Middle East and has also worked on a number of matters in Africa.