HMA Bites: Damage and Casualty Clauses

Though they may intersect and overlap with force majeure clauses, it is unsurprising that HMAs contain standalone "damage and casualty" clauses as standard.  After all, the hotel is the physical asset that underlies the entire HMA (and a very expensive one at that) – and so Owners and Operators will both want to legislate for what happens if it is damaged or destroyed.

There are clear and valid commercial rationales for doing so:

• in the short term, the Owner will want to avoid a continuing obligation to pay fixed fees to the Operator if the hotel is not operational (and no revenue can be generated);

   

• in the longer term, the Owner will want to establish an exit route from the HMA if the damage/destruction is extensive and reinstating the hotel would be impossible or disproportionately expensive;

• the Operator will want the Owner to be obliged to reinstate the hotel as quickly as possible so that operations can be restored and the Operator can continue earning its fees;

   

• conversely, the Operator will also want to establish an exit route from the HMA if reinstatement is likely to be slow or impossible, so that it can walk away and pursue other opportunities.

It is therefore common for HMAs to stipulate that if the damage exceeds a certain materiality threshold (see further below), then either party may terminate – but if neither party terminates,  the Owner must reinstate the hotel so that the parties can continue performing the HMA.  Reinstatement is paid for using the proceeds of the property insurance required to be maintained under the HMA, with any excess not covered by such insurance to be shouldered by the Owner (on its own account, and not as an operating expense of the hotel).

In terms of standard to which the hotel must be reinstated, the Owner is ordinarily required to restore the hotel to the condition it was in immediately prior to the damage or destruction.  In principle this seems logical and uncontroversial – but disagreements could arise if, prior to the damage or destruction, the Owner had under-invested in the hotel such that it fell short of the Operator's brand standards.  The Operator may see reinstatement as a fair opportunity to "reset" this position and bring the hotel back up to the agreed standard – whilst the Owner may view this as a cynical attempt by the Operator to accelerate or increase the scope of a refurbishment obligation at a particularly painful moment.

The "materiality threshold" – i.e. the level of damage/destruction which triggers the termination right – can also be an area of much negotiation.  There are various ways of setting this threshold, including:

• a percentage of overall guestrooms rendered unusable due to the damage or destruction;

   

• the cost to repair the damage or destruction as a percentage of the cost that would be necessary to reinstate the whole hotel if it were completely destroyed (often set in the 60%-80% range);

   

• the length of time that would be required to reinstate the hotel;

   

• whether the undamaged/undestroyed part of the hotel can still reasonably be used as a hotel of similar type and class.

Clearly there are competing interests to be balanced in making this decision.

Another area of negotiation will be the Operator's right to recover lost fees during the period in which the hotel is non-operational.  Rather than seeking to compete for a share of the proceeds of the property insurance, an Operator will likely push for the hotel's business interruption insurance to include provision for payment of loss of fees for the Operator – ideally (from the Operator's perspective!) for a period of 2-3 years.  The Operator will likely also request to be a co-insured on the policy so that it can claim these lost fees directly.

S0 - the parties have agreed a termination right, agreed the materiality threshold, agreed the reinstatement process if the termination right is not exercised, and agreed the insurance cover for the Operator's lost fees.  Are the negotiations of the damage and casualty clause now complete?

Not necessarily.

Many HMAs go further than this, and address (at the Operator's behest, as we will see below) what might happen in the period after a damage-based termination.

An Owner might reasonably conclude that the cost of reinstating the hotel after it is damaged or destroyed is not a financially or commercially advisable use of the insurance proceeds.  But what if the Owner terminates, only then to build a new hotel in place of the old one – and then chooses to operate that hotel itself, or to appoint a new Operator?

It is for this reason that Operators may seek to include a "reinstatement of agreement" clause as the final piece of the damage and casualty puzzle.  This clause states that if, within a certain period (often 3-5 years) after termination of the HMA, the Owner decides to open a new hotel at the site of the damaged/destroyed hotel, the Owner must execute a new HMA with the original Operator, on the same terms and conditions as the original HMA and for a term equal to the unexpired term of the original HMA plus the length of time between termination of the original HMA and execution of the new HMA.

Though these clauses may make the Owner feel like Michael Corleone in the Godfather Part 3 ("Just when I thought I was out, they pull me back in…"), the Operator will argue that this is provides legitimate protection against the risk of the Owner using damage or destruction of the hotel as an opportunity to oust the Operator without cause.