INTERNAL AUDIT REPORT LIMITED CONTRACT COMPLIANCE HOST INTERNATIONAL, INC. JANUARY 2015 - DECEMBER 2016 ISSUE DATE: MARCH 9, 2018 REPORT NO. 2017-26 Host International January 2015 - December 2016 INTERNAL AUDIT TABLE OF CONTENTS EXECUTIVE SUMMARY ................................................................................................................................................. 3 BACKGROUND .............................................................................................................................................................. 4 AUDIT SCOPE AND METHODOLOGY ........................................................................................................................... 5 SCHEDULE OF FINDINGS AND RECOMMENDATIONS............................................................................................... 6 APPENDIX A: RISK RATINGS ........................................................................................................................................ 7 2 Host International January 2015 - December 2016 EXECUTIVE SUMMARY Internal Audit (IA) completed an audit of the Lease and Concession Agreement (Agreement) between Host International, Inc. (Host or Lessee) and the Port of Seattle (Port) for the period January 1, 2015 - December 31, 2016. The audit was performed to verify compliance with key terms in the Agreement, including the completeness and accuracy of concession fees paid to the Port. The original Agreement (000439) between Host and the Port was executed June 6, 2003, for the right to operate certain food and beverage concessions at the Airport. The Agreement required the Lessee to pay the Port a Minimum Annual Guarantee (MAG) equal to ninety percent (90%) of the total amount paid by the Lessee for the previous year. An amendment to the original lease, allowed for a reduced concession rate applied to Branded Food and Beverages, if a franchise fee was paid by the franchisee or licensee, to the franchisor or licensor. The fee was established at a minimum of three percent (3%) of gross sales per year and gives the franchisee or licensee the right to use the licensor's and franchisor's trademark and/or trade name. We concluded that concession fees paid to the Port, by Host and its subtenants, were complete and accurate (see page five for testing procedures performed). However, we determined that Disadvantaged Business Enterprise (DBE) participation goals were not achieved. This issue is discussed in more detail on page six. 1) For the period, October 2015 to November 2016, Host reported a DBE participation of 24.29%. Host also reported a DBE participation of 17.15% under the Lease and Concession Agreement with Seattle Restaurant Associates, a partnership of Host and Uwajimaya. The targeted DBE participation goal in both Agreements was 25%. We extend our appreciation to Port management and staff of the Aviation Commercial Management Department for their assistance and cooperation during the audit. Glenn Fernandes, CPA Director, Internal Audit RESPONSIBLE MANAGEMENT TEAM Lance Lyttle, Managing Director Aviation Jim Schone, Director, Aviation Commercial Management Dawn Hunter, Senior Manager, Airport Dining and Retail Scott Van Horn, Senior Business Manager, Airport Dining and Retail Khalia Moore, Senior Business Manager, Airport Dining and Retail 3 Host International January 2015 - December 2016 BACKGROUND The original Agreement between Host and the Port was executed June 6, 2003, for the right to operate certain food and beverage concessions at the Airport. The Agreement required the Lessee to pay the Port a MAG equal to ninety percent (90%) of the total amount paid by the Lessee for the previous year. In March 2016, the MAG was adjusted downward to approximately $5.2 million, because seven stores/units were deleted from the Agreement; nonetheless, the concession revenues from Host have consistently exceeded the MAG. The table below reflects the total concession revenue earned by the Port through the Host agreement. HOST CONCESSION REVENUE BY CATEGORY* Category 2015 2016 Food and Beverage (Includes branded and non-branded) Alcohol, Beer, Wine Retail TOTAL $5,563,032 1,835,889 280,397 $7,679,318 $5,129,985 1,803,435 244,252 $7,177,672 * Data Source: PeopleSoft for Agreement 000435 In addition to the original Agreement, the Port and Host executed four amendments dated December 22, 2005, July 29, 2009, January 21, 2010, and March 30, 2016. Most notably, the first amendment lowered the concession fee for Branded Food and Beverage, if a franchise fee of at least 3% of gross sales per year was paid by the franchisee or licensee to the franchisor or licensor. Payment of the fee gives the franchisee the right to use the franchisor's trademark and/or trade name. Rates paid to the Port by subtenant operated units are slightly lower than rates paid by Host operated units. Seventeen Host and seven subtenant stores/locations are operated under this Agreement. The table below reflects the aggregate percentage of gross receipts, paid to the Port, from these locations: PERCENTAGE OF GROSS RECEIPTS PAID TO THE PORT* Concession Category Host Operated 2006 - 2016 Subtenant Operated 2006 - 2007 2008 - 2010 2011 - 2016 Non-Branded Food and Beverage 14% 12% 13% 13.5% Branded Food and Beverage 12 10 11 11.5 Alcohol, Beer, Wine Souvenir Merchandise 18 27 16 25 17 26 17.5 26.5 Advertising and All Others 15 13 14 14.5 Duty Free and Tax Paid 16 n/a n/a n/a * Data Source: Lease and Concession Agreement 000435 and first amendment 4 Host International January 2015 - December 2016 AUDIT SCOPE AND METHODOLOGY We conducted this audit in accordance with Generally Accepted Government Auditing Standards and the International Standards for the Professional Practice of Internal Auditing. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives. The period audited was January 2015 - December 2016. After identifying significant provisions in the Agreement, we performed the following audit procedures: Disadvantaged Business Enterprises • Compared the DBE participation goal in each contract (000435) and (000439) to the participation calculation prepared by Host. Revenue Completeness and Accuracy • Agreed daily sales detail (z-tapes) to monthly sales and profit and loss reports and to the general ledger. • Agreed calculated concession fees by category, to amounts reported to the Port. • Verified the accuracy of the concession fee by agreeing the percentage rate applied to the revenue category and agreeing to the fees invoiced. Franchise Fees • Obtained certification from the Chief Financial Officer of Host for the following:  Royalty payments paid as a percentage of 2015 and 2016 gross revenue.  Royalty percentages as reflected in the Franchise Agreements. • Recalculated franchise fees to verify mathematical accuracy. • Reviewed a sample of invoices and check details from Host to validate franchise fees that were paid. • Validated that at least three percent (3%) of gross receipts was paid in franchise or license fees for Host and a sample of Host subtenants, per the agreement. 5 Host International January 2015 - December 2016 SCHEDULE OF FINDINGS AND RECOMMENDATIONS 1) RATING: MEDIUM The Port established a Disadvantaged Business Enterprises (DBE) participation goal of 25% for the Lease and Concession Agreements with Host International, Inc. (Agreement 000435) and Seattle Restaurant Associates (Agreement 000439). Both Agreements state that the Lessee shall make every reasonable effort to meet the Port DBE goal of at least twenty-five percent (25%) participation, measured in gross receipts. The Agreements also state that failure to meet the participation levels shall be deemed a material default and 90 days will be provided to satisfy the participation levels or the Port may issue a notice of default. For the period October 2015 - November 2016, Host reported the following DBE participation: • • 24.29% - Host International, Inc. (Agreement 000435) 17.15% - Seattle Restaurant Associates, a partnership of Host International, Inc. and Uwajimaya, Inc. (Agreement 000439)* *This agreement was not included in the original audit scope. Recommendation: Internal Audit recognizes that under agreement 000435, Host materially complied with the requirement. However, under agreement 000439, the DBE percentage achieved was significantly under the participation goal. We recommend, Port management inquire with Host as to what steps they have taken or plan to take to meet participation goals. We also recommend assessing alternative penalties, if permitted by FAA regulation, into future Lease and Concession Agreements, as opposed to issuing a notice of default. With over 15 stores operating under Agreement 000435 and 9 stores operating under Agreement 000439 1, terminating the contract is not realistic or beneficial to the Port, Host, or DBE subtenants. Management Response/Action: Host contractually agreed to 25% ACDBE participation. The federal regulation requires Host to make good faith efforts to maintain the 25%. Port staff has asked Host to present documentation on their good faith efforts to achieve the ACDBE participation goal for the period of the audit as well as for the time subsequent to that covered by the audit by the end of March 2018. Also, Port staff recognizes the need for additional mechanisms in the lease, short of default, for holding tenants accountable for noncompliance with lease provisions including ACDBE good faith efforts. Port staff will develop recommendations towards this goal for incorporation into future leases by the end of September 2018. 1 As of 2016 6 Host International January 2015 - December 2016 APPENDIX A: RISK RATINGS Findings identified during the course of the audit are assigned a risk rating, as outlined in the table below. The risk rating is based on the financial, operational, compliance or reputational impact the issue identified has on the Port. Items deemed "Low Risk" will be considered "Exit Items" and will not be brought to the final report. Rating Financial Internal Controls Compliance Missing, or inadequate key internal controls Noncompliance with applicable Federal, State, and Local Laws, or Port Policies Large financial impact HIGH Remiss in responsibilities of being a custodian of public trust Partial controls MEDIUM LOW/ Exit Items Efficiency Opportunity Moderate financial impact Not adequate to identify noncompliance or misappropriation timely Inconsistent compliance with Federal, State, and Local Laws, or Port Policies Public High probability for external audit issues and/or negative public perception Potential for external audit issues and/or negative public perception Port Commission/ Management Important Requires immediate attention Relatively important May or may not require immediate attention Generally Low probability complies with for external audit Federal, State and Lower significance Low financial issues and/or Local Laws or Port impact negative public Policies, but some May not require perception Implementing/enhancing minor immediate attention controls could prevent discrepancies future problems exist An efficiency opportunity is where controls are functioning as intended; however, a modification would make the process more efficient Internal controls in place but not consistently efficient or effective 7