Noteworthy M&A legal risks in the hotel industry

By Li Yanshan, Yang Li, East & Concord Partners in Hangzhou
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The growing clientele are driving mid-to-high-end, chained and limited-service hotels in China to upgrade their brand and services. Meanwhile, major hotel brands are losing no time in building their presence at core locations of most visited cities through quick M&A transactions. Except for legal risks customarily associated with M&A transactions, points summarized below need extra attention in the process of performing due diligence and drafting transaction documents:

李燕山 LI YANSHAN 天达共和律师事务所合伙人 Partner East & Concord Partners
李燕山
LI YANSHAN
天达共和律师事务所合伙人
Partner
East & Concord Partners

PROPERTIES LEASED BY TARGETS

Generally, properties at core locations of most visited cities that meet the lists of requirements of acquirers can be labelled non-renewable. When conducting a review on a property leased by a target, access to all documents relating to the lease of the property is needed, including the land use right certificate, property ownership certificate, lease agreement and sub-lease agreement provided by the owner or original tenant. The review should focus on the following factors:

Ownership of the leased property. Urban buildings may be held in varied ownerships due to historical issues, local policies or various other factors during the construction of specific buildings. When carrying out due diligence to control risks of an M&A transaction, the counsel should ensure that at least the land use right certificate and property ownership certificate are available, screening out any property that does not have both certificates. Moreover, if any special property owner is involved, such as a military or government agency or a research institute, relevant policies should also be reviewed to minimize policy risks of hotel operations following the M&A transaction.

Term of the lease. It is not uncommon that a target is operated at a loss in the first rental periods following the closing of the acquisition, because the acquirer needs to take time to renovate the property and get familiar with the local circumstances. In order to earn handsome returns from hotel operations, generally the hotel operator needs to ensure that the property is leased for at least 10 years. However, according to the Contract Law, the term of a lease must not exceed 20 years, and any period beyond 20 years is not legally binding. Therefore, the remaining term of lease is a crucial consideration for hotel M&As. As a possible solution, the M&A agreement between the acquirer and owners of the target may specify that the owners of the target are obliged to ensure, advisably as a precondition to the effectiveness of the M&A agreement, that the legal lessor signs a new contract conforming to requirements on the term of lease with the target.

Liability for breach clause. A premium hotel increases the overall value of the property housing the hotel, driving drastic rise in rental rates of surrounding properties, especially when the term of lease of the hotel property is long. In such cases, the lessor may have a strong motivation to breach the lease agreement. Therefore, the liability for breach provisions should be designed with such changes fully taken into account.

杨力 YANG LI 天达共和律师事务所律师 Associate East & Concord Partners
杨力
YANG LI
天达共和律师事务所律师
Associate
East & Concord Partners

MIXED OPERATIONS BY HOTELS

Mid-to-high-end chained hotels are usually limited-service hotels providing mixed operations ranging from restaurants, gymnasiums, chess rooms to billiard rooms. Before proceeding with its acquisition, an acquirer needs to conduct analyses on the legal relationships, profitability and brand of the mixed operations.

Analysis on legal relationships. In addition to services provided by the hotel on its own, there may be services provided through any outsourcing service provider. In such cases the acquirer should request a copy of the agreement between the target and the outsourcing service provider to understand the rights and obligations of the parties. If the acquirer wants to stop the outsourcing upon closing of the M&A transaction, it should ask the target to terminate cooperation with the outsourcing service provider before being acquired.

Profitability analysis. The analysis should cover the impact of each business on the revenue, cost and profit of the target. Where the price of the M&A transaction is based on the valuation, future earnings are a crucial factor for determining the valuation, given the asset-light nature of hotel operations. Any business to be disposed of in the future may have an immediate impact on the future earnings of the target. If the hotel runs any restaurants to help maintain steady profitability, a list of main suppliers should be made available upon the M&A transaction.

Brand analysis. The target may be operated under a known local brand with its trademark or trade name registered in the name of the target or of its actual controller, controlling shareholder or any other related party of the target. The acquirer should take care to ensure that it will still be able to use the relevant trademark or trade name upon closing of the M&A transaction.

EMPLOYMENT

Integration of labour forces is one of the highlights for post-acquisition integration. Handling employment-related issues could be a tough challenge requiring that the acquirer gains an in-depth and holistic understanding of the target’s employment policy.

Incentive polices. As an effective tool for motivating employees, equity-based incentives are commonly used by companies, especially to incentivize their officers. While incentive programmes that directly grant shares to employees can be easily identified in due diligence, those based on options or virtual shares may be ignored due to their covert nature. In the hotel industry, there are also incentive policies linked to performance indicators, such as the number of stays and catering revenue. Before acquiring the target, it is important that the acquirer communicates with the target’s actual controller and officers to get informed about the above-mentioned issues. If there is any incentive policy not consistent with the acquirer’s business policies, the acquirer should terminate the policy in advance and calculate the estimated impact of the termination on the hotel’s operations.

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Operation under internal contract. To reduce operating costs and motivate employees, the hotel owner may outsource a line of business (such as guest rooms or catering) or a work procedure internally to its employees. Depending on its business policies or strategies, the acquirer may request that the internal contractor agreement be terminated before it proceeds with the M&A transaction.

Dealing with staff for the business to be disposed of. Where the acquirer intends to dispose of any proprietary business of the target, terminating employment with some employees may be inevitable. The acquirer should be fully prepared for this issue.

Li Yanshan is a partner and Yang Li is an associate at East & Concord Partners in Hangzhou

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