When real estate assets undergo financial stress, property owners naturally focus on the relationship with the lender. What many owners in a joint venture fail to focus on at the earliest stages, however, is an equally important and complex set of relationships among the owners themselves.
Failure to sort out the internal issues inherent in these situations at the outset may lead to disaster. Putting one’s own house in order first, by contrast, will maximize the chance of a successful workout.
Most real estate assets are held in some form by a collective of members, often in the form of a limited liability company, a limited partnership, a general partnership or a corporation. Regardless of the form, the members have significantly different interests.
A developer will likely have a management role and possess the most knowledge about the project. One or more investment parties will put up most of the capital and control major decisions. Sometimes a former landowner will contribute land for the development in exchange for an equity stake and certain approval rights.
Further complicating the picture, the developer will likely execute some form of guarantee to the lender, and have thin capitalization, a subordinated profit participation, the right to receive management and leasing fees and a low tax basis in his interest.
The investors have the most capital invested, first call on any proceeds, fewer tax issues, little day-to-day control of the asset or detailed knowledge of the asset, and generally no exposure on guarantees. They do, however, exercise at least two critical functions: They must approve major decisions and they may remove the manager upon certain events.
How does all of this work in the context of a distressed workout situation? All too frequently, the short answer is not very well. In one recent example, a regional shopping center owned by a limited liability company lost the property in a foreclosure proceeding initiated by the CMBS special servicer. The parties could not work together to create a common plan that would satisfy the special servicer’s requirements.
If the issues between the members of the joint venture are not addressed until the workout proposal stage, the parties will likely find themselves engaging in a multi-party negotiation, at a time when the lender, particularly a special servicer, has only limited time to focus on this project. In effect, the parties are playing three-dimensional chess.
Art of capital calls
A frequent requirement of lenders considering a workout is that additional capital be put into the project. If members of the joint venture are not of the same mind or ability, a united front may not be achievable voluntarily. Whether the issue can be forced by one of the members depends on the governing document, usually a limited liability company agreement or partnership agreement.
Some agreements require unanimous consent for additional capital calls. Other agreements require super-majority or majority consent, and still others permit one party or the other to initiate a call based on some standard, perhaps tied to an approved budget. Here the devil truly lies in the details. Definitions, notice provisions and boilerplate provisions may well carry the day.
In those situations where one party can ostensibly make the capital call, the other parties may find various defenses in the governing document. Defenses may include failure of the managing party to live up to its obligations under the agreement, including mismanagement of the asset, failure to have followed procedures for adoption of budgets and the lack of a proper foundation for making the capital call.
Many times a defense rests on matters that could have been avoided had procedures been followed. In other cases, seemingly innocuous boilerplate provisions give rise to defenses. A carelessly worded force majeure clause may doom any chance at making a mandatory capital call during an economic crisis.
The capital call or alleged basis for it may also trigger buy-sell rights or removal rights, which can serve as a potent counter-offensive by the reluctant member.
So sue me
Even in the unusual case where the right to make the capital call is clear, the remedies for that failure provided in the governing document are often inadequate, particularly when the property may be “underwater.”
For instance, a preferred return on additional capital will likely not be sufficient to entice additional investment, without some significant “back-end” participation.
Other remedies may include a “squeeze-down” of the non-contributing party’s interest and perhaps of its capital, subordination of returns, loss of voting rights and a right to sue for damages or specific performance.
None of these options may be sufficient in a distressed market to incentivize a non-contributing member, but a well-crafted governing document can provide as strong a complement of remedies as can practically be obtained.
Economic crises teach valuable lessons. One of these is that a well-crafted operating agreement can help avert disaster. Another is that once the agreement is in place, and a crisis hits, counsel must read every word of it.
Most importantly, if a negotiation or action needs to ensue among the partners, it should happen before the workout negotiations with the lender begin.
James C. Camp is a partner in the Los Angeles office of McKenna, Long & Aldridge, where his practice focuses on structuring complex real estate financings, equity investments and public/private partnerships. He can be reached at email@example.com.