Cash Control Tug-of-War

Negotiating Control of Operating Accounts and Working Capital in Hotel Management Agreements

by Bob Lannan

A frequent point of contention between owners of real estate assets and management companies that operate them is control over operating accounts and working capital.  These disputes arise in negotiation of contracts for management of hospitality assets (e.g. hotels, spas and golf courses), office buildings and other commercial properties, as well as multi-unit residential buildings.  The focus of this article is on cash control issues within hotel management agreements (HMAs).

Under an HMA, the hotel owner hands over to a management company control of day-to-day operation of the hotel.  In the United States it is usually (though not always) the management company that employs all of the employees who operate the hotel.  The management company orders supplies, arranges for utility services and hires outside contractors when needed.  It is usually the management company that receives payments from individual guests and organizational customers and pursues collection actions against debtors.  The hotel’s receipts and outlays usually go in and out of an operating account.  Although this account belongs to the owner, it is the management company that uses it every day.

Control of the Operating Account

This raises the first issue related to operating funds, which is who has what control over the operating account.  A management company’s preferred position on this issue is simple:  It is the management company, and only the management company.  This means the owner cannot make withdrawals of its own funds from this account, even to make hotel-related payments (e.g. for capital expenses).  For some owners new to the hotel industry, this is difficult to accept.  This money does, after all, belong to them.  However, in my experience, very few hotel management companies—and absolutely no brand-affiliated ones—relent on this issue.  They will not accept the risk of an owner withdrawing too much from an operating account and leaving the management company with too little money to operate the hotel properly.  For a brand-affiliated management company, a cash-starved hotel jeopardizes the image of the brand.  For any management company, an inability to pay a hotel’s trade creditors can jeopardize the company’s relationships and reputation.

The one group of creditors that a management company absolutely must be able to pay on time is its own employees who work at the hotel.  Even if the company acts as the owner’s agent in everything else it does for a hotel, in most instances it will have its own employment relationship with these employees, and will be liable to them if it cannot make payroll.  (As noted above, in most hotels in the United States it is the management company, and not the owner, that is the employer.  I have seen management companies try to make this ambiguous, with language suggesting that the “hotel” is the employer.  Such ambiguity should be avoided.)  When pressed, some independent management companies will concede to allow an owner access to all operating funds except those in a separate payroll account, which must be under the management company’s exclusive control.  The owner might also be required to have real-time access to all of the same account data that the bank makes available to the management company.

Controlling the Working Capital Balance

A related issue pertaining to operating funds is the amount of working capital that must be kept in the operating account at any given time.  Here, again, brand-affiliated management companies take stricter positions than non-branded ones.  A hotel management agreement with a major brand for a full-service hotel is likely to give the management company broad discretion to require the owner, upon request by the manager and within a specified timeframe, to deposit into the operating account as much additional working capital as the management company believes is reasonably necessary to operate the hotel in accordance with brand standards.  The management agreement will not identify a dollar figure as the minimum working capital balance.  If the owner fails to forward the working capital demanded, the management company may be given a right to withhold the deficiency from subsequent distributions to the owner, or to lend the management company’s own funds to cover the deficiency at a high interest rate.

At the opposite end of a spectrum of management agreements, an owner with sufficient bargaining power may demand an approach under which the hotel management agreement does not give the management company any right to require the owner to deposit working capital.  (The hotel will hold some amount of working capital when the term of the HMA commences, and this amount and any subsequent adjustments should be acknowledged by the parties.  However, the HMA will not require the owner to maintain any minimum balance.)  The HMA will require the management company, after paying all of the hotel’s operating expenses (including the base management fee) for each month, to forward all of the hotel’s net operating income to the owner.  Absent extraordinary circumstances, it becomes the management company’s responsibility to spread expenses as needed to make these income distributions and retain a sufficient amount of working capital, even if this requires the management company to delay payments to some trade creditors.  Additional infusions of working capital are at the owner’s discretion.  This requires a management company to provide the owner a thorough explanation for any request for additional capital, and the owner must be convinced.

Between these two ends of the spectrum, an approach I have seen used by several independent management companies is for the HMA to require a specified minimum working capital balance (a dollar amount subject to adjustment for inflation).  At the end of each month, the management company forwards to the owner any amount in the operating account in excess of the applicable working capital balance.  If the account falls below that amount, the owner is required to deposit funds sufficient to maintain the balance.  This compromise approach adopts a cash method of accounting that is more rudimentary than the accrual method based on generally accepted accounting principles (GAAP).  It is beyond the scope of this article to discuss the differences between cash and accrual accounting.  However, I will note that it saves time and frustration in HMA negotiations (in addition to later conflict) if the parties agree early on the method of accounting to be used in operation of a hotel and clearly document this in the HMA.

Negotiate Carefully

In any scenario in which a hotel (or any other real estate asset) is owned by one party and operated by another, when negotiating the management agreement, both the owner and the management company should pay particular attention to these and other provisions that govern control of cash management, and be mindful of the parties’ objectives and relative bargaining power.