The Lessons of Sheraton v. Castillo Grand

The Lessons of Sheraton v. Castillo Grand

By Irvin W. Sandman, and Russell C. Savrann
January 17, 2012

Castillo Grand developed a 5 diamond ocean-front resort and residences project in Fort Lauderdale and sought to flag it as a St. Regis.  Castillo entered into the usual package of branded management agreements with Starwood’s management subsidiary, Sheraton Operating Corporation.  On November 18, 2011, after 5 years of litigation between Castillo and Sheraton, the New York state court in Westchester County entered its 83 page decision.  The result:  the court ordered judgment for Castillo and against Sheraton for over $30 million.

What happened in the case and what lessons can be learned?

The Litigation and the Rulings

It’s important to note, at the outset, that a trial is its own, separate event—it isn’t the same as the underlying events. The hope of our legal system is that the trial presentation will allow the trier of fact to glean a relatively accurate picture of what occurred. But that can’t be guaranteed. We don’t know what actually happened in this case, either at trial or when the underlying events took place. We can only look at the decision as if it is an accurate reflection of what took place. Then we can use the decision to gain lessons—whether or not one party or the other ultimately prevails in post trial motions or on appeal. That’s what we will do here.

The state court’s lengthy decision (Decision) lays out a vivid story about a seven-year relationship between Starwood and Castillo Grand, LLC (Castillo) and the development of what was to be the St. Regis, Fort Lauderdale and associated residences (Hotel). The Decision’s detailed fact statements include a complete cast of characters and several plot twists.

Ultimately, however, the Decision deals primarily with two main issues: whether Sheraton caused a two-year delay in construction, and whether Sheraton improperly terminated its hotel management agreement. The context of the case and the resolution of these two issues are summarized below.

The Context

Castillo entered into a hotel management agreement (HMA) with Sheraton Operating Corporation (Sheraton) in January 2001. Under it, the Hotel was to be built and run as a St. Regis under Starwood’s then-fledgling St. Regis brand. The HMA included a technical and preopening services exhibit (TSA) and a license agreement for the sale of the residences.

Castillo scheduled August 2005 as the Hotel’s opening date. However, the project suffered delays of almost two years. The Hotel ultimately opened under the St. Regis flag in May 2007, just as the Great Recession’s storm clouds were gathering.

The parties’ five-year litigation journey began when Castillo filed suit against Sheraton in federal court in July 2006, claiming breach of contract and delay damages. That suit was later dismissed for lack of federal jurisdiction. Presumably because Sheraton preferred to litigate in its local state court, Sheraton filed suit in New York state court for Westchester County (the Court) in August 2009. That suit went to trial and resulted in the Decision in November 2011.

In February 2008, while the federal suit was still pending, Sheraton sent Castillo a notice demanding payment of a “Project License Fee.” Castillo disputed this fee. In what the Decision calls a “high pressure tactic” to collect the fee, Sheraton issued a termination notice. In the end, “neither side blinked.” In July 2008, Castillo signed a new management agreement with Ritz-Carlton, and Ritz-Carlton took over management the next month. Thus, Castillo and Sheraton were left with only their litigation to resolve their relationship.

Breach of Contract and Delay Damages: Failure to Provide a Design Guide and to Properly Exercise Approval Rights.

The TSA included a provision that Castillo had to construct, furnish and equip the Hotel “in accordance with final plans and specifications approved by [Sheraton] and in conformity with the Design Guide.” The term “Design Guide” was defined to include “the multi-volume Design Guide, setting forth mandatory requirements” for hotels in the United States that are managed under the “St. Regis” name.

The Court found, however, that because the St. Regis brand initiative was so new, Sheraton in fact “did not have such a Design Guide.” The Guide “was never furnished through the several years that the Hotel was being designed and constructed.” As a consequence “Castillo had no established parameters from which to guide its preparation of interior designs.” Also, the absence of established parameters “resulted in Sheraton’s review of Castillo’s submissions being conducted solely on the basis of the subjective opinions of the reviewers.” This situation was “compounded by the repeated changes in Sheraton personnel responsible for design review and approval.” The court detailed the comings and goings of several Sheraton design review teams, each finding that the prior team’s work or direction was deficient. Choices made “had little to do with their own merits and more to do with the whims of the changing cast of characters.” The Decision’s details include the effects of changes at the CEO level of Starwood.

The Court concluded that Sheraton breached the HMA by failing to provide the Design Guide. Sheraton also “exceeded its contract rights,” was “arbitrary and capricious,” and failed “to use good faith” in exercising its review and approval rights. Sheraton did so when it:

• compelled Castillo to terminate its interior designer “for no better reason” than the then-incoming Sheraton design reviewers “wanted to bring in their own favored designer;”
• revisited “approvals already granted” and “improperly retreated on prior approvals”;
• “deliberately strung Castillo along” on finalizing a spa lease, using the lease “as leverage to try to get Castillo to pay” fees of a designer that Sheraton had engaged; and
• instructed Castillo essentially “to put the design for the public spaces on indefinite hold.”

The Court then analyzed critical path evidence and found it “blindingly obvious” that construction of the Hotel’s interior space could not proceed unless there were approved interior design plans. The Court found that, “because there was no Design Guide and because neither Sternlicht nor Heyer gave clear direction in advance to any interior design team, and because Sheraton insisted upon switching design teams, the lack of a focal point on interior design is attributable entirely to Sheraton.” The Court further found that Sheraton’s breaches were “a substantial factor in delaying the construction and opening of the Hotel” from August 5, 2005 to May 1, 2007.

Applying contract law principles, the Court concluded that Castillo was entitled to judgment for breach of contract and an award of damages. These damages included:

• Interest on Castillo’s construction loan during the delay period, totaling about $13 million.
• Construction loan extension fees and related attorneys fees totaling about $3.8 million.
• A return of about $3.3 million in pre-opening fees and expenses that the Court found Sheraton had improperly imposed on Castillo.
• The permanent lender’s inspection fees during the delay period.
• Construction insurance costs and fees during the delay period, totaling about $2.8 million.

Breach of Contract for Sheraton’s Improper Termination of the HMA

The HMA included a “Project License Fee” under which Sheraton was to receive a $3 million fee relating to the planned sale of fractional units. The fee would become “due and payable” if certain loans were refinanced. But the language of the agreement also appeared to defer payment “if funds are not immediately available.”

In February 2008, Castillo closed a loan transaction. A few days after the loan closed, Sheraton gave Castillo a notice claiming that the closing triggered the obligation to pay the Project License Fee. Castillo wrote back to Sheraton and denied that the fee was owed.

We can all remember that the first quarter of 2008 was a time of turmoil and tight cash in the hotel industry. Castillo at that time was trying to sell the Hotel, which by then was already open and operating. In May, it appeared to Sheraton that the sale efforts had attracted a capable buyer. Although almost three months had passed since Sheraton had demanded payment of the Project License Fee, Sheraton “abruptly” transmitted a five-day notice of termination.

The Court found that “Sheraton was looking to use the prospect of a pending sale” in order to “leverage” Castillo into paying the Project License Fee. The Court examined internal Sheraton emails and found that Sheraton believed “no sale could occur if Sheraton walked off the property and the lawsuits intensified.” Even though Sheraton understood it would “lose millions of dollars of management fees” if it terminated the HMA,” the nonpayment of the Project License Fee “loomed more important” to Sheraton. The Court found it “manifestly clear” that Sheraton was using “a high-pressure tactic” to collect the fee. In the end, however, “neither side blinked.” Sheraton terminated the HMA and Castillo engaged Ritz-Carlton to take over management.

After carefully analyzing the language of the HMA, the Court concluded that the Project License Fee was not, in fact, presently due and payable as Sheraton had claimed. Thus, the Court held that Sheraton’s termination of the HMA was an anticipatory breach of the HMA. The Court further concluded that Sheraton did not did not comply with the implied covenants of good faith and fair dealing when it used its high pressure tactic to collect a fee to which Sheraton “was not then entitled.” The Court also held that Sheraton waived the right to terminate the HMA by “intentionally lulling Castillo into a false sense of security and timing its notice of termination for the purpose of trying to take advantage of a possible sale of the Hotel in order to unfairly leverage its demand.”

The Court awarded Castillo the following damages for wrongful termination:

• Approximately $4.7 million in pre-opening expenses that Castillo had to pay Ritz-Carlton to change flags from St. Regis to Ritz-Carlton.
• Loss of about $9.1 million in the Hotel’s value. This loss in value resulted from the fact that the Ritz-Carlton management agreement’s term was 30 years longer than the HMA’s term. Castillo was forced to give Ritz-Carlton this concession because Castillo was negotiating “under the duress of the abrupt departure of Sheraton.” The Court offset the loss in value by $5 million in “key money” that Castillo received from Ritz-Carlton under the management agreement.

What We Can Learn From the Case—Four Lessons

1. Contractual Language Matters.

One can speculate that Sheraton, in creating the St. Regis brand, cloned the management agreement from one of its other brands. Thus, the HMA contained references to a Design Guide that, according to the Court, didn’t yet exist. This fact was fundamental to the Decision’s outcome on breach of contract and the imposition of delay damages. Also, the Court’s careful analysis of the Project License Fee shows the respect that courts afford contractual language and the care courts use to interpret the words. The Court showed similar care and respect in enforcing the HMA’s indemnification language in favor of Sheraton on one of the peripheral claims the Court resolved. Thus:

• Make your contracts easy to read and understand by both your business people and the trier of fact alike. If your contracts are filled with passive language, half-page sentences, and superfluous terms, then important clauses that really matter can get lost in the mix. Invest in well-drafted agreements and respect their value.
• Cloning agreements without understanding how they apply to a new situation is dangerous.
• Include, as part of your business team, lawyers who understand the industry and your business. Let them work with you to make sure the contractual language fits the deal.

2. How You Operate Internally is on Display in Trial—Internal Teamwork and Cooperation Matter.

Internal emails are discoverable in trial. As a result, the way your company operates internally will be on display, and the trier of fact will see how your decisions are made. The Court spent much time describing the decision-making process, concluding at one point that “Sheraton’s corporate structure hindered effective practical decision-making.” It noted how Sheraton’s middle management tried to work on a “consensus approach,” while, incongruously, the CEOs actually retained and exercised the ultimate control. The Court described how the relationship with Castillo “was handled by a large and ever-shifting cast of characters and, as the corporate shifts occurred, each new wind blew in new views as to how the Hotel should be designed and constructed.” There seems little doubt that this perceived dysfunction impacted the Court’s determinations about who was responsible. Thus:

• Work hard to build teamwork and a respectful, stable work environment. This will improve your chances in any business litigation you confront. Many business consultants will say, of course, that doing so will also improve your business.
• Understand that all of your emails are discoverable. How you behave and make decisions internally will be shown in court if litigation develops.

3. Good Faith and Fair Dealing Matter.

Today’s fast-moving business environment can be highly-pressured. Sometimes it seems that dog-eat-dog is how the game is played. Contract law doesn’t support this view, and in court neither will a trial judge. The Decision is a good example of how legal principles are applied to business tactics and how the “good faith and fair dealing” of a party will affect or even determine the outcome of a dispute. The law doesn’t favor a party who is “determined to exercise its prerogatives without regard to the interests” of the other contracting party or who exercises unfair, “high-pressure” tactics. Further, the Decision illustrates the extreme costs that can be associated with seemingly sharp tactics. In this case, the tactics resulted in the loss of a lucrative, thirty-year contract, an order granting $30+ million in damages, and the costs of five years of distracting and very expensive litigation. Thus:

• Consider the possibility that the Golden Rule still has a place in business dealings—it definitely still has a place in court.
• Again, your internal emails are discoverable. If you are, in fact, engaged in “high-pressure tactics,” especially while litigation is pending, you can expect that these tactics will come to light in court.
• If you want to protect communication while litigation is pending, involve counsel in the decision-making, put in place mechanisms to help insure the communication is protected by the attorney-client privilege, and keep email traffic to a minimum.  Be aware that if your in-house counsel is acting as a business person, and not as your lawyer in the case, then communications with your in-house counsel may be discoverable—consult with your outside counsel to make sure this pitfall is avoided.

4. Arbitration Provisions Can Keep Your Disputes Private.

Dispute resolution can be made private and confidential by contractually opting for confidential arbitration. The Decision is interesting and instructive to people in our industry. Presumably, the winning law firm likes the publicity of the Decision (although the Decision does include several “wins” and “losses” for both litigation teams and plenty of opportunity for second guessing their strategies). However, one would think that neither company particularly likes the fact that the details of the case are now a matter of public record. Some people (especially litigators) enjoy the courtroom, and it’s true that arbitration can be expensive. However, consider the cost to your business of airing your disputes in public. Thus:

• Review the dispute resolution provisions of your contract forms.
• Consider incorporating a mediation/arbitration dispute resolution process, especially if you’d like your disputes to be resolved confidentially.

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About Sandman Savrann—How We Can Help

Sandman Savrann PLLC is devoted to providing comprehensive, first-choice legal counsel to the hospitality industry. Our highly regarded industry counselors lead an interdisciplinary team of professionals to deliver cost-effective, industry-informed counsel for local, regional, national, and international hotel companies.

Sandman Savrann’s industry counselors are distinguished by their extensive knowledge, experience, contacts in the hospitality industry and their reputations built on trust, loyalty and integrity. These strengths allow us to guide you through all aspects of your business. We help hotel companies to create clear, readily-understandable contracts and forms, to establish and follow well-reasoned and supportable strategies in their business dealings, and to prevent or effectively resolve disputes that do occur.

Sandman Savrann works with some of the best hoteliers and hotel companies in the industry. We look forward to the opportunity to help you reach your goals.

For a complete copy of the Decision, please email us at info@sandsav.com.  To contact the authors, please email either Irv Sandman at isandman@sandsav.com or Russ Savrann at rsavrann@sandsav.com.