Antitrust Law Daily Wrap Up, FRANCHISING & DISTRIBUTION—S.D.N.Y.: Franchisor of Hampton Inns validly terminated hotel, (Jan 30, 2014)

By Peter Reap, J.D., LL.M.

HLT Existing Franchise Holding LLC and its parent Hilton Worldwide, Inc. (collectively, “Hilton”) validly terminated Worcester Hospitality Group LLC (“WHG”) the franchisee of a Hampton Inn hotel in Worcester, Massachusetts, for repeatedly failing Hilton’s in-person evaluations and guest surveys, the federal district court in New York City has decided (HLT Existing Franchise Holding LLC v. Worcester Hospitality Group LLC, January 28, 2014, Engelmayer, P.). In addition, Hilton was entitled to damages of $29,702.09 in past due fees and $672,653.26 in liquidated damages, for a total of$702,355.35.

Background. Between 2004 and 2012, pursuant to a franchise agreement with Hilton, WHG operated its Worcester hotel as a Hampton Inn. Consistent with that agreement, Hilton evaluated the Hotel twice a year, using both in-person inspections and guest surveys. In 2012, Hilton terminated the agreement on the grounds that the hotel had repeatedly failed its evaluations.

Hilton brought suit against WHG for past-due fees and liquidated damages under the agreement. WHG counterclaimed for costs it incurred in renovating the hotel and in re-identifying the hotel with a new brand after Hilton terminated the agreement.

Guest surveys. WHG moved to strike the guest surveys utilized by Hilton as hearsay. However, the SALT surveys were non-hearsay, the court held. Hilton did not ask the court to consider them for the truth of the matters asserted, e.g., whether the Hotel’s rooms were in fact clean, but rather to establish the views that guests reported to it about those matters, e.g., whether guests reported to Hilton that the Hotel’s rooms 23 were clean.

Relevant here, the franchise agreement contemplated a quality assurance process that takes into account guests’ views, irrespective of whether reasonable minds could differ with those views. That was perfectly understandable: A responsible hotel chain logically should care about what their guests think, even if officials of the chain or a franchise might take issue with the guests’ views. Therefore, the court considered the guest surveys solely for the purpose of determining what guests reported they thought about the hotel. WHG’s motion to strike the surveys as hearsay was denied.

Termination. Hilton moved for summary judgment on the grounds that it was within its rights under the agreement to terminate its contract with WHG, because the hotel repeatedly failed its evaluations.

WHG argued that Hilton was required to evaluate the Hotel’s performance reasonably and in good faith, but did not do so, because (1) its evaluations were inconsistent, arbitrary, and lacked an objective scoring scale, and (2) it acted in bad faith, and was subjectively motivated by a desire to get rid of the hotel to make way for a new one. Hilton denied that its evaluations were arbitrary and inconsistent. As for bad faith, Hilton argued that, because it acted within its legal rights in terminating the franchise, its subjective motivations were legally irrelevant.

Hilton was obliged to conduct its evaluations consistent with the covenant of good faith and fair dealing, which is implied in all contracts under New York law, according to the court. Hilton’s implied promise to exercise good faith included any promises which a reasonable person in WHG’s position would be justified in understanding were included. Thus, Hilton was under an obligation to conduct its evaluations in good faith and not arbitrarily or irrationally. The covenant of good faith did not, however, justify an inquiry into Hilton’s subjective motives for terminating the contract, the court explained.

The decisive factual question, then, was whether Hilton conducted the evaluations of the Hotel consistent with the covenant of good faith and fair dealing. If it did so, then, as WHG did not contest, the evaluations would have provided Hilton with a valid legal basis for terminating the franchise, and it was legally irrelevant whether Hilton was motivated to terminate the agreement because of the hotel’s failure to pass the evaluations, for an independent reason, or for a combination of these reasons.

WHG had the burden of proving that Hilton acted inconsistently with the covenant of good faith and fair dealing. However, WHG failed to establish a genuine issue of material fact as to whether Hilton’s conduct in performing the evaluations violated the covenant of good faith and fair dealing, the court determined. Indeed, WHG did not adduce any evidence that the long line of failed evaluations of the Hotel were performed in bad faith.

WHG pointed to a number of emails indicating that Hilton managers wished for “the QA [Quality Assurance] process to terminate the hotel.” But, despite the opportunity to take full document and deposition discovery, WHG did not identify any evidence that this hope on the part of Hilton’s managers was communicated to, let alone affected, the inspectors who actually conducted the evaluations. Further, the emails on which WHG relied reveal that the Hilton managers’ hope that the Hotel would be terminated was itself a product of the Hotel’s track record of failure, as overwhelmingly chronicled in years of negative evaluations, according to the court.

This was not evidence of bad faith. Instead, it was evidence that Hilton’s managers, on the merits, had concluded that the Hotel was a bad asset and hoped that the Quality Assurance process would validate that, thereby contractually allowing Hilton to terminate the Hotel. WHG’s contrary allegation of bad faith was wholly conclusory, reliant on mere speculation or conjecture as to the true nature of Hilton’s inspectors motives in conducting the evaluations.

Nor did WHG show that an issue of material fact existed as to whether the evaluations were sufficiently arbitrary or irrational as to constitute a breach of Hilton’s duty of good faith and fair dealing. The evidence showed that the evaluation process that Hilton used for the Hotel is the same process it uses for its entire Hampton Inn chain of 1,800 hotels, including those it franchises and those it owns.

WHG attempted to excuse the Hotel’s poor performance on the evaluations by pointing to its age; its stated inability to conform to the Hampton Inn prototype and “evolving brand standards,” including that of having a breakfast room on the first floor; and its receipt of waivers as to certain Hampton Inn requirements. These arguments failed for a number of independent reasons. Most importantly, there was no contractual basis for these arguments, the court ruled.

WHG’s counterclaim. WHG counterclaimed for costs it incurred in renovating the Hotel and in re-identifying the Hotel with a new brand after Hilton terminated the franchise agreement. However, as WHG acknowledged, its counterclaim had force only if Hilton’s termination of the agreement was a wrongful breach. In light of the court’s holding that Hilton validly terminated the agreement consistent with its provisions, and that Hilton did not violate the covenant of good faith and fair dealing in doing so, Hilton was granted summary judgment on WHG’s counterclaim.

Damages. Hilton sought, and WHG admitted that it owed Hilton, $29,702.09 in past-due fees. In addition, Hilton moved for summary judgment on its liquidated damages claim of $672,653.26.

Under New York law, a liquidated damages provision would be sustained if the amount liquidated bears a reasonable proportion to the probable loss and the amount of actual loss is incapable or difficult of precise estimation. If, however, the amount fixed is plainly or grossly disproportionate to the probable loss, the provision calls for a penalty and will not be enforced. WHG must demonstrate either that damages flowing from a prospective early termination were readily ascertainable at the time the parties signed the agreement, or that the early termination fee was conspicuously disproportionate to these foreseeable losses, the court explained.

WHG failed to meet its burden of proving either that damages were readily ascertainable at the time the agreement was signed or that the three years’ worth of fees in the liquidated damages provision was plainly or grossly disproportionate to the probable loss, the court held.

WHG merely showed that, in the franchise hotel context, courts have upheld liquidated damages clauses providing for two years’ worth of fees. The legality of a two-year provision did not prove the illegality of a three-year provision, the court noted. There was no record basis on which the court could conclude that a three-year provision was “beyond the pale.” Thus, WHG failed to meet its burden as the party opposing enforcement of the contractual provision.

The case is No. 12 Civ. 8295 (PAE).

Attorneys: Benjamin B. Reed (Plave Koch PLC) for HLT Existing Franchise Holding LLC. Raymond Peter Raiche (Larkin, Axelrod, Ingrassia & Tetenbaum, LLP) for Worcester Hospitality Group, LLC.

Companies: HLT Existing Franchise Holding LLC; Worcester Hospitality Group, LLC

Cases: FranchisingDistribution NewYorkNews