THE DELICATE DANCE: NEGOTIATING THE RIGHT TO REMOVE THE MANAGING MEMBER IN A REAL ESTATE JOINT VENTURE

By Lloyd G. Kepple[1]

A.Introduction

In the wake of the economic recession and downturn of 2007-2009 (“Downturn”), real estate developers, owners and operators (“Sponsors”) have been challenged in meeting capital requirements to continue and maintain their respective businesses and investments. A primary reason for this challenge is the more restrictive debt financing policies and guidelines from lenders. Although loan-to-value ratios of between 70 and 90 percent within various market sectors were common prior to the Downturn, loan-to-value ratios were tightened tobetween 50 and 70 percent during the Downturn in those market sectors where lenders remained willing to provide financing at all. While lending requirements have moderated slightly in the near term, the net result for many Sponsors continues to be an inability to proceed with desired development and acquisition opportunities, because the increased equity requirements of lenders are consuming available Sponsor capital.

Under these circumstances, as has been the case in past economic downturns, many Sponsors seek additional capital through joint venture arrangements. Through the joint venture vehicle, Sponsors can partner with a sophisticated real estate investor with available capital (“Equity Investor”) both to (i) share the economic risk with respect to a particular project, and (ii) permit Sponsors to allocate their scarce capital resources more broadly across a greater number of available projects.

Under a typical joint venture arrangement, the Sponsor provides day-to-day management of the joint venture with the Equity Investor providing the lion’s share of the capital. Given its significant capital investment in the venture, the Equity Investor maintains the right to remove the Sponsor as managing member upon the occurrence of certain defined events. Following an overview of joint ventures generally, this article will focus on the right of the Equity Investor to remove the Sponsor as managing member and the consequences of such removal.

B.Structure of a Joint Venture

Once a Sponsor and an Equity Investor have agreed to combine their capital resources to proceed with a project, a joint venture entity is formed.[2] The joint venture vehicle may be one of several entities. The limited liability company (“LLC”) is by far the most common entity utilized by Sponsors and Equity Investors for joint ventures today. In certain limited circumstances, limited partnerships and general partnerships are also utilized, although given the increasing uniformity of limited liability company state laws and the increasingly stable federal and state tax landscape for LLCs, LLCs have become the clear joint venture vehicle of choice. Corporate structures are rarely utilized, given that they do not offer the tax-efficient pass-through status of the LLC—even a corporation qualifying for and making a Subchapter S election is for other reasons not a preferred entity for joint venture purposes.

C.The Joint Venture Agreement

Joint venture agreements vary in length and format, depending upon the level of sophistication of the joint venture members, the structural complexity of the subject real estate project, the level of detail desired by the members and the allocation of legal resources by the members to the negotiation and preparation of the agreement. Irrespective of length or detail, however, each joint venture agreement must include certain key provisions. These key provisions relate to four critical issues as follows:

(i)Capital Contributions (i.e., who puts the money in and when?);

(ii)Distributions (i.e., who gets the money out and when?);

(iii)Termination of the Joint Venture (i.e., when is the show over?); and,

(iv)Management and Control (i.e., who runs the show?).

1.Capital Contributions – Who Puts the Money in and When?

The Members will negotiate several key components with respect to capital contributions, including the following:

a.Initial Capital Contribution Percentages. The capital contribution percentage of the Sponsor varies depending upon the negotiation of the members, their respective levels of available capital and their respective targeted returns on investment. The contribution of the Sponsor is typically between 5% and 25% of the required capital with the remainder of the capital (i.e., 75% to 95%) contributed by the Equity Investor The relative contribution percentages of the members are sometimes referred to as the “Contribution Percentages.”

b.Additional Capital Contributions. The joint venture agreement should also address additional capital contributionobligations of the members. In some cases the additional capital contributions of the members will be entirely voluntary. In other circumstances, the agreement will require one or both members to make additional capital contributions. Following the Downturn, it has been increasingly common for Equity Investors to require Sponsors to make additional capital contributions to coverdevelopment cost overruns in their entirety (or beyond some designated amount). Though less common, in some circumstances Equity Investors require Sponsors to cover post-completion carrying costs if lease-up is slower than anticipated. Once the project achieves break-even, it is rare for a Sponsor to be expected to be required to make additional capital contributions to cover operating deficits except in unique circumstances.

c.Failure to Make Capital Contributions. The joint venture agreement should specify the consequences of the failure of a member to make required capital contributions. In some cases, the non-defaulting member is permitted to make member loans upon pre-agreed terms to the venture, with the defaulting member’s cash distribution rights abated until the member loan has been repaid. In other cases, the non-defaulting member may make a capital contribution in lieu of the capital contribution of the defaulting member, in which case the distribution rights of the defaulting member are reduced.[3] In addition to economic consequences to a member for the failure to make a capital contribution, management, voting and other governance rights of the defaulting member are frequently impacted as well.

2.Distributions – Who Gets the Money Out and When?

Distributions of available cash from the joint venture typically follow a series of sequential steps set forth in the joint venture agreement known as the “Waterfall”.[4] The first tranche of distributions generally results in a return to the members of their capital contributions together with payment of a preferred return thereon.[5] In most cases, this distribution among the members is pari passu, although in some circumstances the return to the Equity Investor is preferred (i.e., the Equity Investor receives return of its capital and payment of preferred return first, with the same being returned and paid to the Sponsor followingsuch distributions to the Equity Investor).

Following the return of capital contributions and payment of preferred return to the members, the Waterfall will typically allocate remaining available cash between the members in sequential tranches based on one or more “internal rate of return hurdles”, with the percentage of distribution to the Sponsor increasing at each tranche level. An example of a typical approach would be as follows in a joint venture where the Contribution Percentages of the Sponsor and Equity Investor are 10% and 90%, respectively:

  • Next, 80% to the Equity Investor and 20% to the Sponsor until the Equity Investor has achieved an internal rate of return of 20%;
  • Next, 70% to the Equity Investor and 30% to the Sponsor until the Equity Investor has achieved an internal rate of return of 30%; and
  • Thereafter, 60% to the Equity Investor and 40% to the Sponsor.

The difference between the Contribution Percentage of the Sponsor and the percentage level of distribution to the Sponsor in each of the foregoing tranches is known as the “Promote”, and such distributions are sometimes referred to as the “Promote Distributions”. Accordingly, in the foregoing example, the Promote of the Sponsor is 10% in the first tranche, 20% in the second tranche, and 30% in the third tranche.

The negotiation of the Waterfall and the determination of the Sponsor’s Promote are two of the key business discussion points between the joint venture members when the basic business deal is being cut. For the lawyer, it is critical to have a clear understanding of the business deal when drafting the Waterfall and Promote provisions and it is equally important to be sure that the client has thoroughly reviewed the same prior to joint venture agreement execution.[6]

3.Termination Rights – When is the Show Over?

By the timethe members have fully negotiated and agreed on the terms of a joint venture agreement, they have also typically agreed on a detailed business plan which is often referenced in general terms in the joint venture agreement itself. The business plan will typically include a pro forma which contemplates the sale of the project at some point in the future. Although it is a wonderful circumstance when a project meets or exceeds pro forma with the resulting mutually happy exit by the members from the joint venture on or near thetargeted sale date set forth in the business plan, it is also possible that the economic performance of the project will not achieve anticipated results. When this occurs, the respective economic interests of the members, which were so well aligned at the time of the joint venture formation, may diverge going forward. Accordingly, it is critical that the joint venture agreement provide for termination and exit rights of the members in circumstances where the continuing investment horizons of the members are on different paths. While it is sometimes difficult for the business clients and counsel to focus on the the need to plan in this regard, it is critical to do so. The members will likely never be more aligned than they are on the day they sign the joint venture agreement, and so it is incumbent upon the drafting attorneys to work with the business clients to properly address termination rights and to create a blueprint for the ultimate exit by the parties from the venture under varying economic circumstances.

The parties may look to a number of mechanisms to provide termination and exit rights, including the following[7]:

a.Buy-Sell. Under a typical buy-sell arrangement, following the occurrence of some triggering event (e.g., a key business decision disagreement between the members) or after a designated period of time (which period is often tied to the projected investment exit date under the business plan), either member may give notice to the other member of its desire to exit the joint venture together with a statement of valuation of the project (the “Designated Value”). Under the typical approach, the responding member must then elect either to acquire the membership interest of the initiating member for a price that the initiating member would receive if the project were sold at the Designated Value or agree to have its membership interests purchased by the initiating member for the amount the responding member would have received had the project been sold at the Designated Value.

b.Right to Market. This right, also sometimes known as a right of first offer, gives the initiating member the right to advise the responding member of its desire to market the project for sale at a specified valuation. The responding member then has the option to acquire the membership interest of the initiating member for the amount the initiating member would receive under the joint venture agreement if the project were sold at the specified valuation. If the responding member does not agree to so acquire the membership interest of the initiating member, then the initiating member has the right to market the project for a specified period of time and for a price not below the specified valuation amount or a high percentage thereof (i.e., 90%).

c.Right to Sell Membership Interest. In some limited circumstances, an additional exit approach involves the right of the initiating member to sell its membership interest in the joint venture to a third party if the initiating member has first offered to sell its membership interest to the responding member (and the responding member has declined to proceed with such a purchase).[8]

4.Management and Governance – Who Runs the Show?

Most Equity Investors do not desire to be involved in the day-to-day operations of the joint venture. Accordingly, they are typically willing to cede day-to-day management control of the joint venture to the Sponsor by designating the Sponsor as managing member, subject to certain major decisions (“Major Decisions”) set forth in the joint venture agreement requiring Equity Investor approval. Depending upon the respective business models and the respective bargaining positions of the members, the list of Major Decisions may be relatively lengthy or may be rather short. In any event, Major Decisions almost always include the adoption, amendment or modification of the business plan for the venture, the terms of financing and refinancing of the project,[9]the acquisition of assets beyond a specified dollar amount not set forth in the Business Plan, the call for additional capital contributions, and the filing of a voluntary bankruptcy petition by the joint venture.

Beyond the Major Decisions, an equally critical matter to be addressed in the joint venture agreement is under what circumstances the Equity Investor may remove the Sponsor as the managing member of the joint venture. The Equity Investor will want the right either to take over management control itself or designate another manager in certain specified circumstances. The Sponsor will want the joint venture agreement to be clear as to theimpact of its removal as managing member upon its economic and voting rights in the venture going forward. The remainder of this article will focus in detail upon the right of the Equity Investor to remove the Sponsor as managing member of the venture and the consequences of such removal.

D.Right to Remove Sponsor as Managing Member

1.Removal Events: Determining Removal Triggers.

The Equity Investor typically contributes the bulk of the capital to the joint venture and is at the same timewilling to place day-to-day management control of the venture in the hands of the Sponsor to effectuate the business plan. Under these circumstances,the Equity Investor will want the opportunity to consider appointing itself or a replacement manager to manage the venture upon the occurrence of certain specified events or occurrences (“Removal Events”). Although these Removal Events are always a matter of some negotiation in the joint ventureagreement,[10]Removal Events typically include the following categories:

a.Bad Acts. The occurrence of any of the following by Sponsor, a key principal of Sponsor or designated Sponsor affiliates:

i.a criminal act;

ii.misapplication of funds derived from the project (including misapplication of condemnation proceeds and insurance proceeds);

iii.fraud, misrepresentation, gross negligence or willful misconduct;

iv.intentional damage or destruction to the project; or

v.other material breaches of the joint venture agreement (including, by way of example, proceeding with a Major Decision without the prior written consent of the Equity Investor or transferring the membership interest of Sponsor in violation of the transfer approval requirements of Equity Investor set forth in the joint venture agreement).

The foregoing provisions are often grouped together and listed as “Bad Acts” given that they parallel, to some extent, the “bad acts” that triggercarve-out liability on a non-recourse loan.

b.Failure of Sponsor to Make Capital Contributions. As described in paragraph C.1 above, the joint ventureagreement sets forth the requirements of the members to make initial capital contributions and additional capital contributions to the venture in connection with the project. To the extent the Sponsor fails to make its required capital contributions, it is subject to removal as managing member.

c.Performance Defaults. Particularly since the Downturn, Equity Investors have been frequently including the failure of the venture to achieve certain pre-defined performance hurdles as a Removal Event. By way of example, if the project fails to achieve 80% of projected net revenues per the business plan, the Sponsor is subject to removal as managing member. The performance defaults typically utilize the business plan as a performance metric.

d.Bankruptcy of the Company. Bankruptcy of the joint venture typically constitutes a Removal Event under the joint ventureagreement.

e.Bankruptcy of Sponsor. The bankruptcy of the Sponsor (and oftentimes the bankruptcy of one or more key Principals of the Sponsor) is typically included as a Removal Event. Bankruptcy is most often defined in the joint ventureagreement to include not only the filing of a bankruptcy petition, but also the appointment of a receiver, a determination of insolvency, and an assignment for the benefit of creditors. If the triggering bankruptcy event is the filing of an involuntary petition, there is often a period of time, usually not exceeding 90 days, during which the Sponsor may avoid Removal Event status by obtaining dismissal of the involuntary petition. Note that the enforceability of the consequences of a Removal Event arising from the Bankruptcy of the Sponsor is subject to bankruptcy court scrutiny as will be discussed in Paragraph D.3.c below.

f.Liquidation or Dissolution of Sponsor. The liquidation or dissolution of the Sponsor typically constitutes a Removal Event.

g.Non-Participation of Management by Key Sponsor Personnel. In addition to the general expertise and reputation of the Sponsor, the Equity Investor is often relying on the proven expertise of one or two key principals of the Sponsor to guide the management of the venture to economic success consistent with the business plan. In these circumstances, the Removal Events will typically include non-participation or exit from the Sponsor of one or more of the key principals.[11]

h.Default under Venture Loan. To the extent the Sponsor, in its role as managing member, triggers a carve-out default under the non-recourse financing documents of the venture (which defaults typically are akin to the Bad Acts described above and permit the lender to obtain carve-out liability of the venture and guarantors beyond the non-recourse provisions of the loan documents), such action by Sponsor will typically constitute a Removal Event.