DARK CLOUDS ON THE HORIZON

, Is the Hotel Franchising Industry Headed for Litigation? ,

By John R. Dent

While the early part of this decade saw one of the worst periods in the hotel industry since the Great Depression, the last several years have been among the most profitable in its history. Unfortunately, this growth has not stemmed the tide of discontent that often simmers between hotel franchisors and the franchisees that pay them a fee to use their name. The combination of widespread industry consolidation and a recent hotel building boom have exacerbated old tensions and created new ones, leading one to wonder , if and when the economy ends its current cycle, will a new tide of lawsuits be far behind?

Years ago, a typical hotel franchise was a roadside motel owned and run by a single proprietor. There were only a few major franchisors, such as Holiday Inn, Ramada Inn and Howard Johnson. Today, there are dozens of hotel brands, many of which did not exist a decade ago, even as consolidation has left several dominant companies with many different brands under the same corporate umbrella.

At the same time, franchisees have become much more knowledgeable. A typical hotel franchise is no longer a family business or other sole proprietorship, but a real estate investment. Some franchisees operate dozens, or even hundreds, of properties. Even franchisees who operate only a single property have capitalized on their numbers by organizing into powerful franchisee associations.

While this has resulted in a far more sophisticated and balanced relationship between hotel franchisors and franchisees, recent events associated with the industry's growth have created a number of new challenges that are putting a strain on many relationships:

& #711; Encroachment. Most franchise agreements include territorial restrictions that prevent a franchisor from awarding another franchise within a certain geographic radius. Suppose the franchisor awards two franchises, under different brands, to two hotels located across the street from each other. Has the franchisor breached the territorial restriction in the franchise agreement? The franchisor will argue that the two brands target different customers, and that the hotels therefore don't compete against each other. Each franchisee, however, believes that its hotel would be more successful if the other was not there.

Or take the same scenario and assume that the two hotels directly compete against each other but the brands are owned by different companies. Subsequently, one company buys the other so that the competing hotels are now franchised by the same company. Can either franchisee claim that its territorial restrictions have been violated?

& #711; Competition by the franchisor. In addition to using the hotel's brand name, a franchisee also gets other benefits including national advertising, central reservations services and established operating standards. Under certain circumstances, this can create a problem. For example, in addition to franchising their brands, many franchisors themselves own or operate other hotels under the same brand. Suppose a franchisor owns and operates a hotel in the same market under the same name as one of its franchisee's hotels. Because the franchisor provides central reservations services and has access to each franchisee's operating results, it could theoretically use its franchisees' confidential information to compete against them. Did the franchisor violate its franchise agreement by opening the competing hotel?

These are new questions that hotel franchisees are facing in today's environment. In addition, a number of old questions remain, such as:

& #711; Liquidated damages. Under most franchise agreements, if the franchisee terminates the agreement early, it must pay "liquidated damages" (usually based on the fees that the franchisor would have received over the life of the agreement). Franchisees have long complained about these provisions, arguing that the reason a franchisee usually terminates the agreement is because the business fails. If a franchisee in that position had the money to pay liquidated damages, they say, it would simply put those funds into saving the hotel.

Approved vendors. To ensure consistency and quality, many franchisors require franchisees to purchase certain supplies from approved vendors. Franchisees often protest that these requirements prevent them from saving money if they can buy the same quality of supplies from another vendor at a lower cost.

Fortunately for us here in Los Angeles, some of these problems are less serious than in other parts of the country. The hotel industry recession was so severe here that developers were less eager to build new hotels, and we therefore did not see the unbridled hotel development that took place in other parts of the nation. As a result, some of these problems described above , particularly encroachment , are not as serious here.

Nonetheless, these and other issues have led to increasing tension between hotel franchisors and franchisees. One of the largest franchisors in the country, for example, recently withdrew its funding support from one of the major franchisee associations after the group issued a list of 12 points it believed should be included in hotel franchise agreements. Legislation was introduced in Congress last term that would have codified several of those provisions into law, and imposed fiduciary duties on franchisors for some purposes. It died in committee, and has not yet been reintroduced.

Several franchisors responded to these proposals by modifying their standard franchise programs themselves. For example, some now permit a franchisee to terminate the agreement if all requirements have been honored but the hotel still is unable to achieve a minimum occupancy. Others will allow franchisees to purchase supplies from non-approved vendors, so long as the supplies meet the franchisor's quality standards.

If the economy continues to expand and competition for franchisees remains intense, franchisors will more and more often include these "franchisee-friendly" options in their agreements. As that happens, many of the issues described above will become moot. If the economy takes a turn for the worse, though, and franchisees with older, less "friendly" agreements begin to fail, these issues may well end up in court.

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John R. Dent is a litigation attorney in the law firm of Tuttle & Taylor and a member of its Hospitality Practice Group, which specializes in legal issues affecting the hotel industry.

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