John's Thoughts on Attrition and Cancellation
From John Foster, Esq., CHME
The wording of attrition and cancellation clauses continues to be a major sticking point in hotel contract negotiations. The purpose of these clauses is to establish the level of performance required from one or both parties and the compensation due the injured if the performance level isn’t met. These terms must be prepared strategically because they represent potentially large sums of money and must be acceptable to both sides. The must also be prepared correctly in order to be legally enforceable.
Contract law provides that if one side breaches a contract, or under-performs, the other side is entitled to damages, but not penalties. The purpose of this rule is to put the injured party in approximately the same financial position as possible as if the contract had been performed. This is called giving the injured party the “benefit of the bargain”.
The general rules for breach or under-performance of a contract are well established, as follows:
• The injured party is entitled to damages (but not penalties)
•Penalties are not allowed in contracts. A penalty exists if the injured party would benefit more by enforcing the liquidated damage clause than if the contract had been performed as written. If a liquidated damage clause if determined to be a penalty, courts will strike it and the injured party must prove its actual damages.
• Generally, damages are defined as lost profits, not 100% of lost revenue.
• “Lost profit” is defined as gross revenue, minus variable expenses. (Hotels track this by revenue producing departments, i.e. guest rooms, catering food and beverage, etc.)
• Damages are collectible to the extent they are foreseeable, certain, and contemplated by the parties.
•Parties may provide in the contract for “actual” damages or for “liquidated” damages.
•“Actual Damages”: the amount owed to the injured party for losses caused or gains prevented as a direct result of the breach. Actual damages can be ascertained only after the time for performance of the contract has passed. As a matter of social policy and law, the injured party may not sit idly by and let actual damages accumulate. The law does not permit the injured party to recover from the other party those damages that were reasonably foreseeable and could have been avoided by the injured party with reasonable effort. This is generally referred to as the “rule of avoidable damages”, or the “duty to mitigate”.
In the meetings industry, when a meeting sponsor fails to perform its obligations under a contract with a Hotel, either in whole or in part, the Hotel has an affirmative duty to take all reasonable steps to resell the cancelled or unused guest rooms, cancelled food and beverage functions, and cancelled meeting space to other meeting sponsors. This affirmative duty must be met and proved before it can legally force the meeting sponsor to pay damages to the Hotel. The exception to the duty to mitigate damages is when the parties negotiate and agree in advance of any breach to a reasonable and properly worded liquidated damage clause.
• “Liquidated Damages”: parties may agree to specific damages at the time of contract formation, before any breach occurs, as reasonable compensation if the contract is breached or under-performed. To be enforceable, actual damages must be difficult or impossible to calculate, and the liquidated damage amount must be a close approximation of the actual damages, and not a penalty. Additionally, liquidated damages must be tied to a specific breach, not just any breach.
•Injured party has a duty to mitigate its damages (doctrine of avoidable damages), unless the parties agree to reasonable liquidated damages. (A liquidated damage clause must factor in mitigation of damages in order to be “reasonable”.)
Liquidated Damages, Estimated Lost Profit, and the Credit for Resold Rooms Issue
The preferred method of providing for contract damages in the meetings industry is a provision for liquidated damages. Liquidated damages may be expressed as either a: flat fee, sliding scale, or formula. Liquidated damages in hotel contracts are usually based on either a minimum revenue guarantee or a minimum guarantee for roomnights and for catering. There is a strategic difference between the two. A minimum revenue guarantee is more favorable to hotels. This is because the Hotel is the final arbiter of what rate a guest pays when they check-in. Every time a hotel offers a range of rates that is below the Group rate, the meeting sponsor is most assuredly going to be required to make up the difference. A minimum guarantee of roomnights and catering revenue is more favorable to meeting sponsors. In both cases, the guarantees must ultimately be based on estimated lost profit to be enforceable.
Attrition damages (i.e. under-performance damage) occur in three instances: when a meeting sponsor’s attendees fail to reserve all of the rooms the Hotel has blocked (i.e. guest room attrition), when a meeting sponsor’s actual food functions fail to generate all of the revenue specified in the contract (i.e. catering food and beverage attrition) and when the Hotel fails to deliver all of the rooms before the cut-off date for which the meeting sponsor contracted (i.e. reverse guestroom attrition or blind-cutting).
When it comes to calculating damages, hotels understandably prefer simplicity and certainty from the beginning. This approach doesn’t always benefit meeting sponsors. Many hotels that are looking for the easiest method, and usually the most profitable for the Hotel, simply state that the Group is liable for picking up a certain percentage of the room block (80% is typical) and if their pick-up falls below that percent they will owe the Hotel the difference. This simple formula is not a reasonable approximation of the Hotel’s damages unless a strategic formula for calculating the difference is stated in the contract. The formula should first calculate attrition on a per night basis. This allows resold rooms to be factored in the total as a credit on a sell-last basis. The deficient rooms each night are compared to the number of rooms left to sell in the Hotel that night. The meeting sponsor is responsible for the lesser of these two numbers. The totals each night are added on a cumulative basis then multiplied by the Group rate and by a percentage amount to represent estimated lost profit. The resulting revenue amount is what the meeting sponsor owes for attrition. This formula is efficient and fair to both parties because it gives credit for resold rooms on a last-sell basis and guarantees the Hotel its estimated lost profit on unsold rooms.
Note, in the above formula, when calculating the number of rooms the Hotel has left to sell each night “sold” rooms in the Hotel must include rooms occupied and paid for, comp rooms, and rooms billed to other groups or individuals for cancellation, attrition or no-show.
Additionally, to be enforceable, all liquidated damage clauses must be based on estimated lost profit, not 100% of lost revenue. Since hotels calculate their profit margins by revenue department, the formula should include estimated profit margins based on well-accepted industry averages. (The industry profit margin for guest rooms is 70 percent to 80 percent. The remaining 20 percent to 30 percent is the variable expenses the Hotel doesn’t incur if a room sits empty, such as: heating and cooling, light and power, mints on the pillow, soap, shampoo, wash cloth and towels. For catered food, the industry average profit margin is 25 percent to 35 percent. The remaining 65 percent to 75 percent is the cost of the food the Hotel doesn’t incur [before the final guarantee]. The industry average profit margin in alcoholic beverage functions is 80 percent to 85 percent. The remaining 15 percent to 20 percent is the cost of a shot of alcohol. Because these are industry averages, some hotels may have higher averages, some lower.
Cancellation damages occur in two instances: when the meeting sponsor decides not to use the Hotel it has contracted with, and the decision isn’t due to an act of God or other force majeure occurrence, and when a hotel decides not to honor its contract with a specific meeting sponsor due to a double booking or for the purpose of booking a different meeting sponsor, usually at a higher rate.
There is no one right damages clause that is perfect in every situation. Lisa’s analysis of liquidated damage clauses for a Group’s cancellation assumes that the parties always agree to a sliding scale. This isn’t always the case. With a sliding scale, the percentage of damages owed starts small and increase in stages the closer the cancellation occurs to the meeting dates. (Sliding scales cannot go up to 100% of the anticipated revenue as that would be a penalty.) Hotels usually present sliding scales in their proposals as liquidated damages with no credit for rooms the Hotel resells. These sliding scales only make sense to a meeting sponsor if the economy is slow and there is little likelihood that the Hotel will resell enough guest rooms to offset the Group’s damages. In today’s seller’s market and booming economy, it makes no sense for a meeting sponsor to agree to this type of clause unless it gives the Group credit for resold rooms. To be fair to hotels, credit for resold rooms should be in the same percentage as the Group owes under the sliding scale.
The best alternative to using an arbitrary sliding scale is to use a formula that calculates “actual” damages as close as possible. Following is a sample formula:
• Total rooms available to sell in the Hotel each night
• Minus Out of order rooms or rooms being renovated
• Minus Sell-last rooms
• Minus “Sold” rooms (including rooms billed to others for cancellation, attrition or no-show=Unsold Rooms
• Compare “Unsold Rooms” each night to the number of cancelled rooms in the Group’s block each night. Group is responsible for the lesser of these two numbers. (For instance, if the Group cancelled 100 rooms the first night but the Hotel only had 30 rooms to sell, the Group is only responsible for 30 rooms)
• Add the resulting totals for each night to reach a cumulative total. Multiply the cumulative total of roomnights times the Group’s negotiated rate times an amount to represent estimated lost profit in guestrooms (70 percent to 80 percent).=Cancellation damages Group owes the Hotel.
The Ancillary Revenue Issue
Ancillary revenue is the revenue hotels receive when guests spend money on room service, in-room movies, business centers, health clubs, phone service, shops and salons, restaurant outlets and other miscellaneous revenue centers. Hotels track this revenue and forecast it in their budgets. This revenue is tracked by dividing the revenue generated in the Hotel’s revenue centers by the number of rooms occupied in the Hotel during a given period. Hotels divide the revenue amount by the number of guests in the Hotel. The resulting figure is called RevPAC or Revenue Per Available Customer. Another management tool used by hotels is Revenue Per Available Room, (RevPAR). This is calculated by taking the total ancillary revenue and dividing by the number of occupied rooms.
A reoccurring issue between hotels and meeting sponsors is whether meeting sponsors should be contractually liable for potential losses to the Hotel for ancillary revenue when attrition or cancellation occurs. Many hotels are now insisting that damages for ancillary revenue be included in contracts as additional compensation.
While revenue per available customer can be historically tracked with accuracy, it cannot be predicted with accuracy. Herein lies the controversy. While ancillary revenue is foreseeable and contemplated by the Hotel, the rationale and responsibility for the payment of these damages is not always foreseeable, contemplated, or agreeable to meeting sponsors. (The foreseeability requirement is met if responsibility for ancillary revenue is specifically included in the contract.
Of primary concern to meeting sponsors is whether they should be responsible for the eating, drinking, movie watching, etc. discretionary activities of their attendees outside of the planned Group functions. The outcome of this debate is subject to individual negotiations, however; I have never advised a meeting sponsor to guarantee to pay for their attendees’ unspent, discretionary spending. The reality is that most meeting sponsors can’t budget for this additional risk. Some associations and corporations would consider not planning meetings at all if they are required to be responsible for this additional expense. Both of these grim alternatives would hurt meeting sponsors and hotels alike if the net affect is less people attending meetings.
When is the Money Owed?
of the type of liquidated damage clause the parties agree on, there is the issue of when the meeting sponsor must pay the money to the Hotel when a cancellation occurs. Hotels prefer to state that the damages must be paid immediately with no credit for resold rooms. Hotels have tried to “sell” planners on agreeing to these terms on the premise that it gives the company or association certainty as to what their damages are and it close the matter immediately. Except for corporate meeting sponsors that book meetings on short notice and cancel on short notice, this arrangement makes no sense to a meeting sponsor. If a meeting is cancelled a year or more in advance, the meeting sponsor knows exactly what its maximum damages are based on the formula used. It can make a sound business decision whether to cancel based on the maximum amount. There is no problem waiting until the actual dates come and go to see if the Hotel reduces its losses by reselling rooms and therefore reduces what the meeting sponsor owes in damages. There is no reason the Hotel should hold the potential damages in its bank account and have use of the money since if the contract was performed as contemplated the Hotel wouldn’t get the money until the meeting dates anyway.
Lost Profit vs. 100% of Gross Revenue
Since lost profit is a subset of gross revenue, I agree with Lisa that it doesn’t matter if the contract refers to “revenue” as long as the amounts or percentages do not exceed estimated lost profit based on industry averages.
Damages Applied to a Future Event
It has become customary with many hotels to apply a portion of the Group’s cancellation damages paid as a credit toward a future meeting. I agree with Lisa that this isn’t required, but it is a good business practice for the Hotel. First, it keeps their customer happy. Second, it guarantees that the Hotel gets the Group back as a repeat customer that they didn’t have to go look for and develop.
Reciprocal Damage Clauses
I agree with Lisa that reciprocal damage clause frequently don’t make sense. The amount of damages suffered by each party when the Hotel cancels the Group is not necessarily equal. Sometimes a group that has been cancelled by a hotel can pick-up the phone and easily rebook the meeting across the street. With other meetings that are cancelled by the Hotel the Group isn’t able to find availability at another acceptable hotel over the same dates. If the Group can’t hold the meeting at all, the meeting sponsor’s damages may be substantially higher.
The APEX Contract Initiative
I also agree with Lisa that the APEX Contract Initiative will not solve all of the industry’s contract problems and that it is not appropriate to prepare a “standard” contract that fits all situations. In reality “standard” contracts don’t stay standard for very long in this industry, even inside the same hotel chain. As soon as the “standard” contract is reviewed by different directors of sales or different meeting planners and their legal counsel, those individuals will determine that the standard terms might be good for others but they don’t fit “our” needs and circumstances.
I’ve been involved in the final edit of the APEX Contract Initiative and endorse it as a start, but not necessarily and end result.
As Lisa alluded to, contracts in our industry have gotten complex and complicated. If the terms aren’t clear, precise and legally sufficient, the parties haven’t accomplished much except to set themselves up for potential disputes in the future. If contract law isn’t your specialty, the best advice that Lisa and I can both agree on is that you should an attorney that is familiar with this business to assist you. Remember, it’s easier to stay out of trouble than to get out of trouble.