Hospitality Performance Tests In the Real World

Hotel management agreements often contain language permitting a hotel owner to terminate if the hotel’s performance fails to meet certain financial metrics. This provision, colloquially referred to as the “performance test,” is touted as a form of protection for owners by providing a right to terminate (or to receive a “cure payment”) if the hotel underperforms.
But the reality is performance tests are generally structured to make them difficult, if not impossible, to fail, leaving hotel owners without the financial protection they thought they bargained for — or worse.
In fact, some hotel operators have attempted to use the existence of a performance test as a defense to a claimed breach, arguing that a hotel owner cannot claim a breach by the operator if the performance test has not been triggered.
In this article, we discuss how performance tests function in the real world, recent case law interpreting performance tests, and the manners in which performance tests can and cannot provide additional protection to hotel owners.

What Is a Performance Test?

Hotel management agreements generally grant hotel operators significant discretion in performing their management duties. This grant of discretion may leave hotel owners with limited recourse if they become unsatisfied with the hotel operator, which can be problematic given that these types of agreements often run for decades.
In one effort to address this issue, hotel management agreements often contain a “performance test” permitting an early termination by the owner if, under the operator’s stewardship, certain financial metrics are not met.
While performance tests vary, they generally contain two prongs, each tied to a different metric. Most often, this will include the hotel’s comparative performance against its competitors on revenue per available room (RevPAR). Another prong is generally tied to the hotel’s actual profitability, as measured by gross operating profit (GOP), compared to its annual budget.
When a hotel underperforms on a prong of the test — often defined as performance less than 90% of the competitors’ average RevPAR (with 100% being average) or the budgeted GOP, as the case may be — then the prong is considered “failed.” If the hotel fails both prongs — depending on the test, in any single year or in consecutive years — the performance test is failed, and a termination right may be triggered.
Most hotel management agreements provide the hotel operator a right to “cure” — and thereby avoid a performance test-based termination — by paying the hotel owner a sum of money designed to put the hotel financially in the same position it would have been had the test been satisfied. Generally, hotel operators may only cure a limited number of times during the term of the agreement.
Performance tests typically also contain limitations on their use or applicability, such that the test cannot be triggered if circumstances outside the hotel operator’s control impact the hotel’s performance. This can include force majeure events, major capital improvement projects, or the hotel owner’s failure to meet its contractual obligations (such as by failing to provide working capital). Similarly, in recognition that opening a new hotel or a transition to a new operator involves a ramp-up period before performance stabilizes, performance tests usually only become effective after several years.