Real Estate Joint Ventures: and Legal Risksmedia.straffordpub.com/products/real-estate-joint-ventures... · REAL ESTATE JOINT VENTUREREAL ESTATE JOINT VENTURE Sppyqponsor and Investor

Presenting a live 90‐minute webinar with interactive Q&A

Real Estate Joint Ventures: Real Estate Joint Ventures: Opportunities and Legal RisksStrategies to Negotiate and Structure the JV Operating Agreement

T d ’ f l f

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

TUESDAY, OCTOBER 4, 2011

Today’s faculty features:

Daniel B. Guggenheim, Pircher Nichols & Meeks, Los Angeles

Michael D. Soejoto, Pircher Nichols & Meeks, Los Angeles

Carey W. Smith, Partner, Arnold & Porter, Washington, D.C.

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R l E t t JVReal Estate JVs__________________________________________________________

C t ib ti Di t ib tiContributions, Distributions,Affiliate Agreements & Exits

St ff d W biStrafford Webinar:“Real Estate Joint Ventures: Opportunities and Legal Risks”

October 4, 2011

D i l B G h i E d h i @ i h 310 201 8914Daniel B. Guggenheim, Esq., [email protected], 310.201.8914Michael D. Soejoto, Esq., [email protected], 310.201.8944

© 2011 Nothing herein is to be construed as legal, tax, investment, business or insurance advice.

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TYPICAL CIRCUMSTANCES OFREAL ESTATE JOINT VENTUREREAL ESTATE JOINT VENTURE

Sponsor and Investor form entity to acquire or recapitalize a real p y q pproperty interest.

Sponsor handles day-to-day operations and project management, and i i d i t t ( “ t ”) freceives a carried interest (or “promote”) or fees.

Investor provides most or all of the capital, either pari passu or as preferred equity (or debt).p q y ( )

Delaware is the preferred state of formation for many capital partners.

LLCs are the most common form of venture entity (absent state or international tax concerns).

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PRE-FORMATION ISSUES: LETTERS OF INTENTLETTERS OF INTENT

How much detail is too much detail?

What is the duration of Investor’s exclusivity, and what is the remedy for breach?

Is there an agreement regarding pursuit and diligence expenses (e g Is there an agreement regarding pursuit and diligence expenses (e.g., cost capitalization at closing and dead deal costs)?

3

INITIAL CONTRIBUTIONS: GENERALLYGENERALLY

Various forms: cash, contract rights, real property, debt., g , p p y,

Timing: seed money or deposit vs. closing equity (affects funding conditions).

Failure to fund closing contribution may result in additional Failure to fund closing contribution may result in additional remedies.

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INITIAL CONTRIBUTIONS: TAX CONSIDERATIONSTAX CONSIDERATIONS

Disguised Sales – is there a combination of non-cash contributions, g ,distributions and assumption or relief of liabilities that could trigger taxable gain or loss to the contributing partner?

Capital Shifts – are there any deemed contributions or contribution credits that will cause a party to recognize income?p y g

Basis – is there agreement regarding the value of non-cash contributions, and an understanding of “inside basis” vs. “outside basis”?

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ADDITIONAL CONTRIBUTIONS

How great is the expected need for future fundings (e.g., stabilized How great is the expected need for future fundings (e.g., stabilized

asset vs. development project)?

Do contribution percentages depend on circumstances (e.g., cost Do contribution percentages depend on circumstances (e.g., cost

overruns, contributions in excess of a cap or contributions after

promote distributions)?p )

Tax Consideration: variable contribution percentages may affect the

allocation of profits and losses and may also create “Fractions Rule” p y

issues.

6

REAL PROPERTY CONTRIBUTIONS

Consider a separate Contribution Agreement.p g

Are closing conditions necessary?

Consult local tax counsel regarding potential transfer taxes or real property tax reassessmentproperty tax reassessment.

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CAPITAL CALL LOGISTICS

Sponsor typically monitors finances, with responsibility for p yp y , p yrequesting additional capital.

Often, Investor can also call for capital (e.g., if Sponsor fails to do so or in an emergency).

Cash management: requesting capital for payment of accrued expenses vs. replenishment of working capital.

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COMMON CONTRIBUTION DEFAULT REMEDIES GENERALLYREMEDIES: GENERALLY

Damages/Indemnification.g

Priority loans or contributions.

Dilution.

Change in management rights?

Specific performance?

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COMMON CONTRIBUTION DEFAULT REMEDIES TAX CONSIDERATIONSREMEDIES: TAX CONSIDERATIONS

Priority contributions may violate the “Fractions Rule”.y y

Priority loans may be problematic if a REIT has an interest in the venture.

For dilution special tax allocations may be necessary to achieve the For dilution, special tax allocations may be necessary to achieve the intended result depending on what is being recalculated – e.g., future distributions, capital account balances, etc.

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DISTRIBUTION HURDLES

Preferred returns vs. IRRs.

Equity multiples (aka “whole dollar” hurdles).

Tracking both members, or just Investor?

Any exclusions (e.g., promote distributions, and default contributions or loans)?)

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DISTRIBUTION STRUCTURES

Pari passu?p

Preferred equity or debt?

Tax advances?

Are there multiple projects?

Clawback?

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TAX ALLOCATIONS

Target accounts vs. allocation waterfalls – what are they and when g yare they used?

Liquidating distributions – are they made in accordance with the cash distribution waterfall or in accordance with positive capital account balances?

Managing “Fractions Rule” issues.

13

RELATED PARTY AGREEMENTS

Cross-default/cross-termination with JV Agreement?g

Enforcement, termination and certain other matters should be handled by the unaffiliated member.

Consider consolidation with the JV operating agreement Consider consolidation with the JV operating agreement.

Consult with insurance expert to confirm parties’ expectations.p p p

Tax Consideration: incentive fee in lieu of promote?

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EXIT STRATEGIES: BIG PICTURE ISSUESBIG PICTURE ISSUES

What’s the point: liquidation or divorce? (The answer may depend p q ( y pon the circumstances.)

What’s feasible? (Consider transfer restrictions and guarantor l t i l d t it l t i t d i ilreplacement in loan documents, capital constraints and similar

limitations such as Investor’s fund documents).

Timing may be everything (e.g., status of project, market conditions, g y y g ( g p jaccrued but unpaid preferred return, tax treatment).

“The best laid schemes of mice and men oft go awry…” (Have the ti i d j di i l di l ti titi d i hi ?)parties waived judicial dissolution, partition and receivership?)

15

COMMON TRIGGERS FOR AN EXIT

Deadlock.

Default.

Failure of a performance standard.

Change in ownership or control of other party.

Expiration of lock-out period.

16

TYPICAL EXIT MECHANISMS(MORE THAN ONE MAY BE USED)(MORE THAN ONE MAY BE USED)

Buy-Sell.y

Unilateral marketing/sale right, which may be subject to preemptive right (ROFO or ROFR) in favor of other member.

Put Call (or just put or call) Put-Call (or just put or call).

Tag-Along/Drag-Along (less common).g g g g ( )

17

VALUATION ISSUES:GENERALLYGENERALLY

Parameters for proposals of value (duty to be reasonable or make p p ( ygood faith estimate of value?).

Determination of (and adjustments to) purchase price for property or other party’s interest in the JV. (What’s being sold?)

Methodology for fair market valuation (if applicable).

18

VALUATION ISSUES:TAX CONSIDERATIONSTAX CONSIDERATIONS

Disproportionate exposure to capital gains on sale (e.g., if a party p p p p g ( g , p ycontributed an asset)?

Whether liquidation is in accordance with capital accounts may be relevant to determination of purchase price.

Character of gain may depend upon sale structure (e.g., sale of JV interest vs. sale of asset; sales to related parties).

19

OTHER OVERLOOKED ISSUES WITH EXITS

Disparate access to information. Disparate access to information.

Opportunity to test the market.

How will offers be compared? How will offers be compared?

Potential pricing gamesmanship if there is preferred equity.

M t d ti ft it h d Management and operations after exit process has commenced.

For additional information about Danny Guggenheim or Mike Soejoto or aboutFor additional information about Danny Guggenheim or Mike Soejoto, or about Pircher, Nichols & Meeks, please visit http://www.pircher.com.

20

Real Estate Joint Ventures:Real Estate Joint Ventures:Opportunities and Legal Risks

Carey W. SmithArnold & Porter LLP

October 4 2011October 4, 2011

[email protected]

Governance & Control Issues

Overall Structure of JV Managementg– Non-member manager– Managing member; operating member; administrative member;

general partnergeneral partner– Board of Directors– Officers

M b / t t– Member/partner consents– Consultation rights

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Governance & Control Issues (cont.)

Types of decisions are typically broken down into 2 or yp yp ymore categories– Day to day management decisions; generally the catch-all

category for all decisions that are not specifically identified incategory for all decisions that are not specifically identified in another category

– Major DecisionsOther categories such as “Fundamental Decisions ”– Other categories such as Fundamental Decisions, “Extraordinary Decisions” or “Unanimous Decisions.” The usual reason for a separate category is the desire to have different dispute resolution Examples:dispute resolution. Examples:

• Arbitration for “major decisions” but status quo prevails for “fundamental decisions”

• Buy/sell, forced sale, or put/call may apply only if disagreement on

27

Buy/sell, forced sale, or put/call may apply only if disagreement on certain disagreements such as whether to sell or refinance


Examples of Major Decisionsp j– Approval of budgets and business plans; defining the “box” in

which the manager has freedom to maneuver– Obtaining indebtedness on a non-recourse basisObtaining indebtedness on a non recourse basis– Additional capital calls (or, additional discretionary capital calls)– Major leases

Examples of Fundamental Decisions– Admitting new members– Mergers, consolidationsg ,– Changing the purpose of the JV– Actions that create liability under springing guaranties (e.g.

voluntary bankruptcy filing)

28

voluntary bankruptcy filing)

See Sample Major Decision Provisions, Section 3.2


Process for Major Decisionsj– Who has the right to propose major decisions? Often any

partner may propose; sometimes only the manager may propose.p p

– Timeliness of response. Manager is often concerned about delay in obtaining approval for major decisions. May have deemed approval if no timely responsepp y p

– Standard for approval or rejection of proposed major decision. Partners may be required to be reasonable, may have sole discretion, etc. Standard may vary for different types of , y y ypdecisions.

– See Sample Major Decision Provisions, Section 3.3

29


Dispute Resolution for Major Decisionsp j– One partner has right to force its position– Required negotiation period (“time out”)

Non binding mediation– Non-binding mediation– Binding arbitration– Right to force sale or liquidation– Buy/sell or put/call– Status quo prevails– No dispute resolution mechanismp– See Sample Major Decision Provisions, Section 3.4

30

Allocating Financial & Legal Liabilities

Liability Between/Among Partnersy g– Waivers of fiduciary duties are common; parties will often choose

to define scope of these liabilities by contract rather than by reference to statutory or common law. y

• Duty of good faith and fair dealing generally cannot be waived– Another approach is to incorporate standards from corporate law– Standard of care imposed upon manager or managing member;– Standard of care imposed upon manager or managing member;

often will break down liabilities into two or more categories• Ordinary negligence or breach of obligations under JV agreement

that are not specifically covered elsewherethat are not specifically covered elsewhere• Gross negligence• Willful misconduct or fraud• Failure to fund mandatory capital or member loans

31

Failure to fund mandatory capital or member loans– Noncompetition covenants; radius restrictions

Allocating Financial & Legal Liabilities (cont.)

Liability Between/Among Partners (cont.)y g ( )– Recourse for breaches/defaults by manager or other members

• Cure period?• Liability for damagesLiability for damages

– often limited to actual direct damages and excluding lost profits, indirect, consequential, punitive or exemplary damages)

– will there be any recourse outside of the partner’s interest in t e e be a y ecou se outs de o t e pa t e s te estthis particular JV?

– consider requirements for errors and omissions insurance that could provide a source of payment

• Right to remove manager• Right to terminate affiliate contracts with manager’s affiliates

(consider the fees paid or payable as source of funds to pay d )

32

damages)• Reduction in voting/consent/approval rights


Implementing the Business Deal on Allocation of p gLiabilities to Third Parties– Scope of liabilities

• Recourse carveout guaranties• Recourse carveout guaranties– Bad boy actions– Springing guaranties especially for voluntary bankruptcy or equivalent– Environmental indemnities

• Completion guaranties• Payment guaranties

– Allocation of liabilities between partners and their affiliatesAllocation of liabilities between partners and their affiliates– Indemnification by joint venture

• Harmonize with the provisions discussed above governing liability between and among partners

33

between and among partners • Relationship to provisions governing capital calls


Implementing the Business Deal on Allocation of p gLiabilities to Third Parties (cont.)– How to implement cross-indemnification/contribution when

lenders or others are not willing to accept several liabilitylenders or others are not willing to accept several liability– Impact of third party liabilities on control/management of JV

when things aren’t going well• Example Completion guarantor desires flexibility to take action to• Example – Completion guarantor desires flexibility to take action to

limit exposure• Example – See next slide re springing liability for voluntary

bankruptcyp y– Impact of these third party liabilities on ability of a partner to exit

the JV, through a buy/sell or otherwise– Similar issues arise with ground leases major tenant space

34

Similar issues arise with ground leases, major tenant space leases, possibly other third parties


Significant issue in recent downturn has been the gexistence of springing guaranties, where recourse carveout guarantor may have springing liability for entire loan upon a voluntary or collusive bankruptcyloan upon a voluntary or collusive bankruptcy– Assume that manager’s affiliate has provided springing guaranty– Partner that is not affiliated with guarantor could cause a

l t b k t d t i th li bilitvoluntary bankruptcy and trigger the liability– Partner that is not affiliated with guarantor could argue that

manager must pursue voluntary bankruptcy based on manager’s d t t th JV d it tduty to the JV and its partners

– Mezz lender could foreclose on equity and institute a voluntary bankruptcy, exposing the guarantor to springing liability

35


How can manager/guarantor protect against these risks?g g p g– JV Agreement

• Use Delaware entities to assure enforceability of waivers of fiduciary duties.• Provide in JV operating agreement that non-managing members waive the p g g g g

managing member’s fiduciary duty generally.• In addition to specific waiver of the managing member’s fiduciary duty,

provide in JV operating agreement that non-managing members waive any fiduciary duty or other claim based on managing member’s failure to file afiduciary duty or other claim based on managing member s failure to file a bankruptcy, or take any other action, which could give rise to a claim under any springing guaranty.

• Provide in JV operating agreement that the managing member has unilateral decision making authority on all decisions (including bankruptcy filings)decision-making authority on all decisions (including bankruptcy filings) which, in the judgment of the managing member, could give rise to liability under any springing guaranty.

• Provide in JV operating agreement (or in a separate indemnity agreement) th t h i b ( it t ) i d ifi th i

36

that each non-managing member (or its parents) indemnifies the managing member (and guarantors) from any liability arising under a springing guaranty as a result of any action taken by such non-managing member.


How can manager/guarantor protect against these risks?g g p g– Loan Documents

• Provide in springing guaranty that guarantor has no liability for bad boy acts undertaken by any party other than guarantor and its affiliates after completion of foreclosure of any mezzanine loan.

• Provide in loan agreement that lender will (i) accept a substitute springing guarantor and (ii) release original springing guarantor on a going-forward basis, in connection with any permitted transfer of the property or direct or , y p p p yindirect interests in the Borrower (including pursuant to any buy/sell or other transfer rights among members).

• “Notwithstanding any other provision of this Guaranty, if Lender converts any portion of the Debt to subordinate financing (including B-converts any portion of the Debt to subordinate financing (including Bnotes, junior participation interests and one or more tranches of mezzanine debt), Guarantor shall have no liability under this Guaranty caused solely by actions taken by the holder of such subordinate financing (and any subsector thereof) following foreclosure on the

37

financing (and any subsector thereof) following foreclosure on the subordinate financing by such respective holder of such subordinate financing.”

Carey W. SmithPartner – Real Estate & Tax

[email protected]

IRS Circular 230 Disclaimer

Any U.S. federal tax advice included in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding U.S. federal tax-related penalties or (ii) promoting, marketing or recommending to another party any tax-related matter addressed herein.