The benefits and drawbacks of liquidated damages clauses-Interesting read

The benefits and drawbacks of liquidated damages clauses

Clyde & Co LLP

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Singapore December 1 2016

General Ingredients of a Loss of Profits Claim
In general, if there is no liquidated damages clause in a hotel management agreement, then in order to prove a loss of profits claim for wrongful termination, the operator will need to prove the following elements:

1. that the agreement was wrongfully terminated;
2. that it is entitled to its loss of profits for the wrongful termination under the governing law of the agreement;
3. the value of its loss of profits claim.

The method of proving each of the above is usually as follows:

1. the wrongful termination is proved through documents and other evidence (including witness evidence). Usually, the operator must prove that any breaches alleged against it by the owner to justify the termination are not proved;
2. the entitlement to loss of profits must be proved as a question of law;
3. the value of the loss of profits claim is usually proved by a third-party expert report, valuing the operator's estimated profits from the hotel.

Liquidated Damages Clauses
The benefit of a liquidated damages clause is that, in any wrongful termination claim, the operator does not need to prove either its entitlement to loss of profits, or the value of its loss of profits claim. The entitlement to and value of the operator's compensation (points 2 and 3 above) are crystallized, and the parties, therefore, do not need to invest significant time and money arguing about these issues.
Whether or not the operator needs to prove that it was wrongfully terminated (point 1 above) will depend on the wording in the liquidated damages clause. If wrongful termination is a prerequisite to the clause being engaged, then issue 1 above must still be proved.
Examples of Liquidated Damages Clauses
Some examples of liquidated damages clauses in management agreements are:

1. In the event that owner seeks to improperly terminate or is deemed to have improperly terminated this agreement, then the owner must pay to the operator immediately upon demand, by way of liquidated damages, in compensation for loss of future management fees, a "termination fee" in an amount equal to (the number of remaining months in the operating term) times (the total management fees earned by the operator in the last 12 calendar months divided by 12).
2. If this agreement is terminated without proper cause by the owner, the owner shall pay to the operator in full and final settlement of all future obligations a fee equal to the amount earned by the manager in the last 24 months (or if 24 months has not elapsed then based on approved annual budget for that current year times two) or the number of months remaining in the then current term, whichever is less.
3. Upon termination due to the owner's breach, the owner shall pay to the operator the sum of USD $500,000 which shall be liquidated damages and not a penalty.
4. Reasonable Estimate of Damages: The parties recognize the difficulty in ascertaining damages resulting from premature termination of this agreement, and agree to liquidated damages which represent their reasonable estimate of the damage from the loss of revenue which will result from premature termination. The owner shall pay to the operator as liquidated damages (and not as a penalty) an amount equal to the operator's monthly fee due and payable under this agreement for the last full 12 calendar months of the hotel's operation, multiplied by 12.

Most liquidated damages clauses provide that the clause will apply where the agreement is wrongfully (or "prematurely" terminated), and therefore the wrongful termination will need to be proved.

How can Liquidated Damages Clauses Benefit Owners?
Liquidated damages clauses may benefit owners as well as operators. By curtailing the amount of damages that an operator may claim, such clauses enable owners to delineate their risks and avoid the time, costs and risk of litigating issues relating to the operator's entitlement to, and value of, its claim for lost profits. Owners can use their bargaining power to limit the amount of damages payable to the operator to one or more years of lost profits.

Disadvantages of Liquidated Damages Clauses

The principal challenges with liquidated damages clauses are that, in many instances, unless the clause seeks to compensate the operator for its lost profits for the remainder of the operating term of the agreement, the operator will be limiting the damages to which it is entitled.
The most common clauses provide for liquidated damages which are equivalent to two or three years' lost profits (based on previous profits, or including a formula for estimating future profits, such as relying on the annual budget). A clause providing for two to three years' lost profits will be providing a far lower amount of compensation to an operator than a successful claim for lost profits for a 15 to 25 year operating term of an agreement.

In some jurisdictions, particularly civil law jurisdictions, actual loss must be proved to the satisfaction of a court. Therefore, it must be proved to the court that any penalty pre-agreed by the parties in a liquidated damages clause is a reasonable amount. The court will have discretion to adjust the amount of compensation downwards if they consider the amount of liquidated damages to be excessive. Examples of jurisdictions where we have seen this approach broadly adopted are China, Thailand and the UAE.

The approach in common law jurisdictions tends to be that a liquidated damages clause will be enforced where the amount of damages represents a genuine attempt to work out what the loss would be in the event of a breach. If the amount is not a genuine pre-estimate of the loss that would be suffered, but is intended instead to penalize a party, then it will be considered a penalty clause, which is not valid, and the award of damages will then need to be determined by the ordinary principles of contract law. Courts are generally reluctant to find that agreed damages amount to a penalty clause in a commercial contract where the parties have equal bargaining power. Clauses 3 and 4 in the examples above are drafted to minimize the risk of those clauses being deemed to be "penalty clauses".

The approach varies from jurisdiction to jurisdiction, but in our experience, liquidated damages clauses are less likely to be upheld in civil law jurisdictions.
Should Operators Include Liquidated Damages Clauses in their Agreements?
Some key factors when considering a liquidated damages clause are:

1. Will the clause be enforceable under the governing law of the hotel management agreement? If yes, then:
2. Will it be possible to persuade the owner to agree to a clause awarding as liquidated damages the operator's profits for the remainder of the operating term (whether based on past performance, or a draft annual budget)? An operator may be able to gauge this when agreeing to the "Term Sheet" with the owner. If yes, then the clause is likely worth including; if no, then:
3. When balancing the value of limiting the operator's potential damages (eg. to two to three years' lost profits, or a specific sum), and the risks, time and costs of having to prove a claim for lost profits, is it worth including a liquidated damages clause?

An assessment of the value of the hotel project to the operator (both financially and in terms of its prestige) will likely need to be carried out to assist in answering the above question.
In each case, enforcing a liquidated damages clause and factors specific to the project may lead to nuances in the drafting of the liquidated damages clause. We are often asked to advise on these drafting nuances, bearing in mind that a liquidated damages clause will not necessarily be a "one size fits all" boilerplate clause.
Points to consider in addition to those outlined above include:

• When will the clause be engaged? If it will be engaged upon the wrongful termination of the agreement by the owner, how will this be proved?
• What should the amount or value set out in the liquidated damages clause be? Is it a reasonable pre-estimate of the loss to be suffered?

Conclusion

Liquidated damages clauses provide an element of certainty for both parties, but that certainty can come at a cost. Make sure you take advice when looking to include a liquidated damages clause in your hotel management agreement, particularly to check whether it is enforceable under the governing law of the agreement.

Clyde & Co LLP - Sapna Jhangiani

This article was first published in Hotel Management on 5 October 2016
If a management agreement is wrongfully terminated by a property owner—an event which occurs with increasing frequency in developing jurisdictions—the operator's usual remedy will be to sue the owner for wrongful termination. The compensation claimed for the wrongful termination will be the operator's lost profits for the operating term of the agreement, in addition to any sums outstanding to the operator.
However, a number of operators include in their management agreements a clause providing for liquidated damages in the event of termination of the agreement, in an effort to remove the uncertainties in proving a loss-of-profits claim. Why do some operators include liquidated damages clauses in their agreements, and others prefer not to? Are liquidated damages clauses always to the benefit of operators, or can owners also benefit from them? This article by Sapna Jhangiani, an attorney with Clyde & Co, provides an analysis of liquidated damages clauses, seeking to address these issues, and includes points to consider based on our experience of drafting such clauses.