Pitfalls when drafting Real Estate joint venture agreements

Pitfalls when drafting Real Estate joint venture agreements

ARTICLE SUMMARY

Following the global economic crisis of 2008, many commercial lenders began imposing requirements such as 60-70% loan-to-value ratios that gave rise to the need for real estate investors to come up with creative ways to raise an equity gap of as much as 40% of the purchase price in order to acquire real estate assets. Since there are not that many single investors willing to be the sole source of such a large equity investment in a single asset, the vehicle of the real estate joint venture has become increasingly popular in allowing multiple parties to participate in the equity, spreading the risk and reward among themselves.

A real estate joint venture, like any other joint venture, is a vehicle for co-investment by two or more parties, and what makes it a real estate joint venture is that the parties intend to invest in a real estate property or interest. They are typically structured as a limited liability company (or, occasionally, a limited or general partnership), and typically the real estate joint venture raises the equity capital needed to complete a purchase or investment. However, the same structure can be used in the case of a development or redevelopment project, in which case the joint venture is likely to include a party or parties contributing capital and other parties who prefer to receive an ownership interest, including for tax reasons, rather than payment for their nonmonetary contribution to the venture, mainly services.

The law provides the parties with great flexibility in structuring such a relationship. This article is for the practitioner drafting such agreements and points out the five pitfalls to avoid when drafting real estate joint venture agreements. Those are (a) obligations of the parties to the joint venture, (b) distribution of rewards of the joint venture, (c) governing structure of the joint venture, (d) dissolution of the joint venture, and (e) dispute resolution mechanisms. Of course there are thousands of drafting issues in agreements which can run dozens of pages in length, and those of you about to enter a joint venture agreement are advised to seek competent counsel, such as the attorneys at A.Y. Strauss LLC, when undertaking actual legal work and negotiations of such a complex contract. This article is intended to highlight the broadest issues.

BACKGROUND

State laws governing the formation and operation of LLCs and partnerships provide co-owners with great flexibility in creating structure and setting terms and conditions to meet the goals and objectives of co-owners. Thus, for example, Delaware Code Annotated title 6, sections 17-1101(c), 18-1101(b) provide that the policy of the Delaware Revised Uniform Limited Partnership Act and the Delaware Limited Liability Company Act is to give maximum effect to the principle of freedom of contract.

Joint ventures offer advantages for raising equity capital—as opposed to a market-priced subordinated second mortgage loan or a mezzanine loan—primarily because of the lower cost of capital. The joint venture agreement must meet the risk/reward expectations of each investor, but joint venture capital only becomes expensive if the project is financially successful. Then the venture can afford to make premium distribution. More importantly, joint ventures are more likely than second mortgages or mezzanine loans to satisfy the equity requirement of the first mortgage lender.
What this means is that the co-owner (or whoever is drafting the proposed agreement) has tremendous flexibility in defining, for example, how the joint venture is to be taxed (such as a partnership, or an entity taxed at the entity level), the types of contributions, the types of governance, distributions, dissolution, and dispute resolution. The only confines are those of the law, and there are very few contract terms that face a risk of being unenforced due to illegality. Tax law is, of course, a prime consideration.

The main disadvantage to a joint venture is the added complexity and expense of structuring and documenting a joint venture agreement that will give the new funding resources the position approximating a junior lender.

PITFALL #1: CONTRIBUTION

In the case of a joint venture whose sole purpose is to pool equity capital from similar investors and purchase a stabilized, income-producing commercial real estate property that will continue under third-party management, the clauses setting forth contribution should be rather straightforward. Generally speaking, the parties will be required to put up a specified amount by a date certain and deposit it in an escrow account.

However, a joint venture can also involve a development company sponsor that is aggregating the required equity from other investors while it and perhaps other entities will contribute to the enterprise each company’s expertise, contract rights, project entitlements, services, and perhaps a small amount of capital. A joint venture can also be formed for a portion of a real estate development project, such as demolition or design phases of construction.

The drafting lawyer needs to sit down with his client and review carefully the following issues:

  • The nature of each member’s anticipated contributions to the capital or operations of the enterprise
  • When and how each contribution will be received and used by the joint venture and the consequences of failure to timely and/or competently provide the promised contribution
  • How the property will be valued for transferor’s investment in the venture if a contribution of capital by one party consists of the transfer of property to the joint venture
  • Legal requirements, formalities, and costs associated with transfer of the asset, including property, to the joint venture
    The joint venture’s responsibility for any liabilities associated with the assets contributed
  • Tax consequences of the contribution to the venture, such as built-in tax gains or losses, that could be problematic
  • How members are to be recognized or compensated for financial support when they contribute something intangible, such as a limited or unlimited guarantee supporting a letter of credit, which makes the members’ balance sheet strength available for the benefit of the joint venture
  • How services—such as real estate brokerage services, design, demolition, consulting services for obtaining permits, construction management, or leasing services—are to be described, measured, and rewarded
  • Difficult federal income tax issues that could arise from the receipt of an economic interest in a real estate joint venture in exchange for services. Consultation with a tax attorney is a must in forming real estate joint ventures, and typically a tax opinion is required at closing.

PITFALL #2: DISTRIBUTION

The point of a real estate joint venture is to achieve one or more payments, or a stream of payments, to the members of the joint venture. In advance of entering the joint venture, considerable thought must be put into how the members will split the profits of the venture, including how the venture will compensate those who contributed their time and labor, such as contractors, or those who offered the venture other intangibles, such as financial guarantees. This process requires the parties to reach a mutual understanding of the degree of risk of financial failure associated with the joint venture at each stage, such as acquisition, development, and operations.

This requires a fact-specific and project-specific set of inquiries. A venture distributes money upon numerous events, such as the sale of property and lease rentals, and incurs expenses such as interest payments to lenders, compensation to contractors, and compensation to the venture’s employees. Possible issues that could arise surrounding the splitting of profits among the members include money invested, time and labor spent on improvements to the assets, intangible contributions, and time spent in management. Managing owners can claim substantial salaries and benefits, but absent mandatory distributions, passive owners might get no return on their investment. Therefore, be sure to pay attention to costs, especially salaries or contracts with related entities, such as a parent or fellow subsidiary. The concern is that too much predistribution income might be pulled from the venture. A solution might be to structure management.

One example is a joint venture where a subsidiary of a large company holds a 60% interest and you represent one of two junior partners who each have a 20% interest. In this example, the joint venture is for the design of a construction project, and there is another joint venture for the construction phase. The second venture is much bigger, and another subsidiary of the same large company holds an 80% interest in the second venture with other third parties. This creates a conflict of interest in that the large company will want to “rob Peter to pay Paul.” In other words, the large company would be willing to price the design at zero profit and take its profit out of the second project. One work around would be to give the junior partners in the joint venture the ability to veto decisions regarding purchase price, and/or to take the dispute through a hopefully cost-effective, informal dispute-resolution process.

The members of the joint venture have to set formulas for periodic or special cash distributions to some or all of the joint venturers out of cash proceeds realized from operations, partial sales, leasing activity, refinancing, condemnation, and casualty losses. Again, in devising these formulas, the members can be very creative, bound only by federal partnership tax laws. In practice, these formulas can become quite complex. On the whole, this is a business matter.

PITFALL #3: MANAGEMENT

In all but perhaps the simplest two-person joint ventures, there is a need to form some kind of management committee that is responsible for the day-to-day operations of the joint venture. As mentioned above, you need to decide the form of legal organization of the joint venture entity, mainly LLCs or corporations. Alternatively, a general partnership is formed, by default if no entity is created. This includes all the ancillary fiduciary duties attached and consideration of other liabilities that may arise. A partnership is generally disfavored because all partners become liable for the partnership’s debts.

The management of any real estate joint venture should be structured to achieve the following objectives:

  • Allocate authority and responsibility for the project in a clearly defined and most profitable manner to the appropriate members of the joint venture, managers, and perhaps other key employees
  • Protect the interests of minority partners (or any partner, for that matter), by placing checks on the majority, such as veto rights discussed below
  • Anticipate surprise events or potential conflict among management
  • Set benchmarks for the joint venture and standards to be met by management, with the power to remove underperforming management
  • Resolve conflicts among the members and managers in a manner—such as the expedient process discussed below in pitfall No. 5—that minimizes the economic harm to the joint venture

Once the structure is settled, the parties need to resolve issues of control, primarily in terms of voting and veto rights. A management committee will typically meet at least once a month or can be called by any one party to make a major decision based on the votes of the members. In a corporation, this is the board of directors. An LLC is similar, except that member votes, not director votes, are counted. LLCs can also have managers who are given varying degrees of operational responsibilities. Centralizing management authority can help avoid confusion regarding who is responsible and accountable for achieving key joint venture objectives, an area which should be spelled out as specifically as possible in the joint venture agreement. Indeed, some joint ventures, instead of a board or committee, concentrate all management authority in a single designated manager, usually the sponsor or a related entity, and the agreement itself will limit or circumscribe the duties of that individual. Committees are more prevalent in stable multifamily assets with a reputable property manager. A single manager is more prevalent in commercial development projects because management needs to be more flexible.

The assignment of managers is critical to insure that the joint venture can act rapidly to address problems before they become crises or to take advantage of opportunities while they are available. Managers should be assigned functions such as day-to-day property management or leasing, for example, and these people could be independent contractors or employees of one of the members of the joint venture. This should be spelled out in advance, and any conflicts of interest should be resolved in the case of employees of a member serving the joint venture.

For voting rights, you will want to consider if all members equal. One possibility—if you have a venture with a 50% partner, a 35% partner, and a 15% partner—is to form a six-person management committee, where the 50% partner appoints three members, the 35% partner appoints two members, and the 15% partner appoints one member. Think through who will be on the board/management committee and how those participants will get along and ultimately line up in voting coalitions.

Alternatively, as mentioned above, for certain operating decisions (price of the final bid in the above example), the management committee will have to reach a super-majority of members, such as 75% or even unanimity. Decisions requiring these forms of veto rights may include:

  • Amending the joint venture’s organizational documents
  • Additional capital calls from the members
  • Purchase or sale of assets, such as real property
  • Taking on debt above an approved level
  • Entering into nonstandard leases
  • Approval of annual budgets or deviations from annual budgets in excess of a certain percent
  • Approval of contractors and authorization of contracts, such as management, leasing, or franchise agreements
  • Approval of major expenses, including salaries and bonuses
  • Deciding to file lawsuits
  • Resolving any potential conflict of interest, such as transactions with affiliated entities
  • Expansion of the venture to add partners
  • Dissolution of the joint venture, filing for bankruptcy, appointing a receiver, or confessing a judgment against the joint venture
  • Distributions
  • Financial transactions above a certain value
  • Changing the joint venture’s tax reporting and accounting practices
  • Changing insurance policies and/or carriers
  • Ratifying defaults under key agreements
  • Establishing or modifying cash reserves except as provided in the budget

The list is limitless. Of course, veto rights are for the benefit of minority owners, who can create a deadlock on the board. It follows, though, as minorities, they have less bargaining power to demand veto rights before the deal is made, but this is the time to gather what can be gathered. Including these kinds of voting requirements in a joint venture agreement limits management’s range of activities and should therefore be carefully evaluated for the specific project at hand. Sometimes the degree of restraint on management depends on how much the parties trust and control the manager. Where the principle investor controls the manager, the minority investors would want a long list of such items, while the majority partner will want to limit super majority approval to only the most critical decisions. This is a matter for the parties to negotiate under the circumstances.

As shown a few times throughout the list above, a careful budget, along with agreement as to the range of deviation left to management’s sole discretion without a board vote is a way to avoid surprise and conflicts during the daily operations of the joint venture. Generally, in the case of real estate joint ventures, the parties—perhaps with the assistance of an accountant—should be able to project annual costs for the joint venture and annual revenues, the latter tending to be less accurate. The more detailed the budget, the fewer the surprises and conflicts. Typically, the agreement specifies that the management committee has to meet once a year or perhaps quarterly to approve an annual or quarterly budget process.

PITFALL #4: DISSOLUTION

From the beginning, it is important to figure out how your client will exit a business venture. The structure must permit an amicable economic divorce from or among the members of the joint venture. The main goal should be that exiting members should receive their fair share of the venture. No one should be able to take advantage of anybody else. This is easy when the joint venture ends successfully as planned (such as with the sale of a real estate asset after the redevelopment program was completed).

While everybody is optimistic and the principals are eyeing their eventual return on investment, the lawyer is present to consider “trigger events,” namely those events that are bad and lead to termination of the joint venture or expulsion/divorce of one of the members. Examples of bad events can include death or insolvency of one of the members, the need to expel one of the members, such as for violations of the law or just because that member does not get along well with the others, or irreconcilable disputes among the members, such as the failure to reach a super majority even after undertaking dispute resolution efforts, as discussed below.

Dissolution is naturally followed by liquidation, or cashing out the partners to the joint venture. In the case of most real estate joint ventures, that would be the fair market value of the property. Real estate joint ventures do not have high values for good will, in comparison to other industries. The subject property is generally held for a short period of time to be sold for profit as soon as possible. In most cases, if the members cannot get along, it is very easy to liquidate the venture’s assets, distribute the profits to the members, and dissolve the partnership.

Depending on the complexity of the structure and number of participants, it may not be desirable to dissolve the partnership fully, but to replace certain partners, say a partner who is contributing construction management services that is underperforming and falling far behind schedule. Your client may also want to get rid of a partner who is making life difficult for everybody. Indeed, first mortgage lenders may demand this possibility. Thus your client should consider the possibility of the need in the future to buy out individual members. Your client may become the one who is bought out as well.

There is a commonly used solution for problems that arise in situations where a two-member 50-50 partnership just does not get along. One resolution is to have one party offer to buy the other out. The other party can either accept the offer and cash out or buy out the first party at the price offered by the first party. Either way, one of those two fighting parties leaves. In short, the creativity is limitless.

How the joint venture deals with each situation should have a tailor-made solution. Thus the joint venture will certainly want to deal with the freeloader differently than the widow of a dead partner. In any event, the joint venture needs to plan in advance for the orderly and fair removal of members and provision of a fair buy-out package. Consider whether the departing person should simply retain an equity position in the property until the project is completed and final distributions are made. Also consider whether the contributing investors in the buy-out should enjoy added measures such as a preferred return on that investment. Finally, the issue will arise of what sanctions should apply and under what circumstances when a noncontributing member is unable or unwilling to contribute to a capital shortfall.

Especially since your client does not know whether it will be the party buying out another or being bought out, it is emphatic that the buy-out price be fair—neither too low nor too high. Of course the parties could select a neutral appraiser in advance. Then of course, the problem is paying that buy-out price. If the property is not going to be sold in a final dissolution/liquidation, such as a situation where the buy-out price is the net equity value of the member’s interest in the joint venture, the other members could take out financing to buy out that interest. Another party could be substituted and buy in by paying the buy-out price. In the case of death, the joint venture could use a life insurance policy to fund a buy-out. There are many flexible options, but they should be considered in advance.

Finally, pay attention if your party is providing financial guarantees to the joint venture. Not only must these be compensated for, but the party should be protected against claims that may survive the dissolution. In general, the post-dissolution liability situation, such as post-sale construction defect liability claims, should be considered and covered, with insurance if necessary.

PITFALL #5: DISPUTE RESOLUTION

It almost goes without saying that all joint venture agreements should include a dispute resolution clause. Without such provisions, the joint venture is in danger, because one of the members can seek judicial dissolution of the joint venture on the basis that it is not practicable for the partners to continue the joint venture’s business in accordance with the agreement. See, for example, Del. Code Ann. tit. 6, §§ 17-802, 18-802. Dispute resolution can and should be an integral part of the joint venture operational structure. The careful practitioner should not treat dispute resolution as a simple one-size-fits-all arbitration provision. Serious consideration should be given to setting up a more informal process for resolving disputes while the venture is intent on rapidly pursuing its objectives, versus a more formal dispute resolution regime once the joint venture ceases operations or is dissolved.

For example, in the event of a deadlock on the management committee, the committee may be required to refer to some sort of counsel of CEOs of the involved companies, who can try and resolve the dispute rapidly so the parties can move on. Then a rapid mediation could follow, along with a shortened single arbitrator final stage, if necessary. The objective during the first stage is simply speed and the reaching of some interim resolution that will not hold up progress on the project. This sort of rapid informal resolution process is ideal for resolving things, such as budget conflicts, which may be significant but should not stop the project.

However, if the parties are hopelessly deadlocked, or there is a buyout or dissolution, then the joint venture agreement should probably specify a more conventional three-person arbitration panel under standard rules of procedure, such as AAA. Of course, as in all the agreements, the usual considerations apply, protecting against one party being a repeat player with a given arbitrator, the scope of the arbitration clause, spreading of costs and attorneys’ fees, all of which apply to dispute resolution clauses generally.

In conclusion, these are just a few of the more prevalent complex issues that can arise when drafting a real estate joint venture agreement. One could literally write a book on the subject. More importantly, if you are considering a joint venture, the professionals at A.Y. Strauss LLC would be delighted to guide you through the legal complexities.

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.

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