Unforeseen dangers where management contracts take the place of leases

Almost every day brings news of another major UK hotel portfolio sale. Hotel operators, which for many years have owned the bricks and mortar of their hotels as well as the hotel businesses, are selling their hotels. Whilst a few unwanted hotels and the businesses operating from them are no doubt being disposed of, generally the selling companies wish to retain management of the hotels. They want to concentrate on what they do best, namely running hotels, and not having huge assets tied up in the bricks and mortar. By disposing of their assets, they can utilise the proceeds in developing their brands and returning money to shareholders.

In the past such disposals would probably have been by way of sale and leaseback. But leases are increasingly unattractive to operators, particularly where it is intended the arrangement should last for a long period. Stamp Duty Land Tax (SDLT) on leases is a significant disincentive. So too are the accounting changes which require the future rental burden to be shown as a balance sheet liability.

As a result, in many cases the sale and lease back has been replaced by the sale and manage back, where the seller/operator enters into a management contract rather than a lease. With the tried and tested traditional management contract, the owner of the freehold also owns the hotel business (and takes the risk in it), with the hotel operator managing that business and receiving a management fee. In legal terms the manager is a licensee, with limited rights of occupation, and not a tenant with a full right of possession. The distinction is important because a management contract is not subject to SDLT and is not registrable at the Land Registry. The manager has no protection under the Landlord and Tenant Act 1954, (which gives a tenant the right to renew a tenancy when it expires), nor the statutory right to relief against forfeiture which a tenant has under the Law of Property Act 1925.

However in many of the current deals, the boundaries of the traditional management contract are being moved, with the manager taking part or all of the risk in the business and guaranteeing income to the hotel owner from the business. But this carries a considerable risk, as demonstrated by the case of Bon Apettito v Michael Poon, decided earlier this year. Though it is a restaurant case the issues it dealt with apply equally to hotels. In the case, the Court held that an arrangement which was described as a management contract was in law a tenancy. The case made it clear the Court looks at the essence of an arrangement, not the title on the document cover; if the occupier is given sufficient rights of possession under a so-called management contract, the arrangement may well be a tenancy rather than a licence.

The distinction is of huge significance. If a hotel sale and manage back steps the wrong side of the legal dividing line, and the management contract is in effect a tenancy, the hotel operator will commit a criminal offence if it fails to pay SDLT on the arrangement. Also the new hotel owner may find that the operator has an unintended right to protection under the Landlord and Tenant Act 1954. In addition both parties may find that the treatment for accounting and tax purposes is different from that which they originally intended.

Each arrangement will have to be judged on its merits. However, if under the arrangement the operator has entrenched rights as a result of which it is difficult to dislodge him from running the business, this may imply possession (and a tenancy) as opposed to occupation (and a licence). Similarly if the operator guarantees a certain level of income to the hotel owner, this may imply a rent and therefore a tenancy. Where the operator takes a material share of the risk in the business operated from the premises, this may also tend to indicate the existence of a tenancy.

If the reports of some of the current deals are accurate, there must be a danger that one or more of the so-called "manage backs" stray into lease or tenancy territory. As mentioned above, if that were to happen the ramifications would be significant. Those negotiating these deals may be walking a very thin line!