Kenneth M. Jacobson Katten Muchin Zavis Rosenman 525 West Monroe Street Chicago, Illinois

Transcription

1 Sweating the Details: Issue and Negotiation Point Checklist for Limited Liability Company Operating Agreement Matters Pertaining to Capital Contributions, Management Structures and Decision-Making, Distributions, Exit Strategies and Indemnification Kenneth M. Jacobson Katten Muchin Zavis Rosenman 525 West Monroe Street Chicago, Illinois

2 Sweating the Details: Issue and Negotiation Point Checklist for Limited Liability Company Operating Agreement Matters Pertaining to Capital Contributions, Management Structures and Decision-Making, Distributions, Exit Strategies and Indemnification Kenneth M. Jacobson Katten Muchin Zavis Rosenman January 2004 This paper considers the following issues in connection with the negotiation of a limited liability company operating agreement: 1. Capital contribution and capital contribution defaults; 2. Management issues where management is vested in a board of directors-like body; 3. Distributions; 4. Exit strategies; and 5. Indemnification. Many attorneys utilize checklists in connection with formation and organization of limited liability companies. A few checklists have been published or otherwise made available. 1/ Reference to such a checklist is an invaluable tool that should not be overlooked. The purpose of this paper is to provide some ideas for the real estate law practitioner and focuses on issues from the perspective of a real estate transaction. Consideration must, among other things, be given to the goals of the parties in connection with the transaction, the identification of the client 2/ and advancing those interests, the size of the transaction, the relative bargaining strength of the parties, the degree of trust among the parties, the sensitivity of the parties to payment of legal fees and expenses and the timing of the transaction. Several substantive areas of the law may be relevant to the transaction and the LLC in question. For example, federal, state and local tax issues, licensing issues, securities laws issues and pension benefits law issues may all be relevant to the LLC s formation, capitalization and business plan and counsel needs to give consideration to all of those areas where relevant. In that regard, counsel may be required to work with other professionals retained by the client. 1/ 2/ Mark D. Anderson, Thomas M. Staunton and Derek L. Cottier. The Operating Agreement. Limited Liability Companies and S Corporations. (Ill Inst. for CLE, 2000), pp Larry E. Ribstein and Robert R. Keatinge. LLC Formation Checklist. Ribstein & Keatinge on Limited Liability Companies (Thompson West 2000), Appendix A-7, pp Lewis R. Kaster and Noel W. Nellis. Checklist of Issues in Negotiating a Real Estate Joint Venture Agreement. Realty Joint Ventures 1986: Structuring, Deal Points and Legal Analysis. Lewis R. Kaster, ed., Vol. I, pp , PLI While a discussion of professional responsibility issues is beyond the scope of these materials, consideration should be given to the proper identification of the client, use of an engagement letter and obtaining proper conflict waiver letters. Consider a situation where the counsel is asked to prepare an operating agreement for the purpose of owning and operating a commercial real estate project in a situation where an LLC is acquiring a property, obtaining mortgage and mezzanine loan financing in connection with such acquisition and at the same time wants to provide some interests in the LLC to the sponsor s employees. Does counsel represent the sponsor, the LLC or the employees? Would applicable rules of professional conduct preclude counsel from representing the members in a dispute with each other where the counsel had represented the venture in its mortgage financing? -1-

3 The parties must first determine that the LLC is the preferred form of entity. This is not necessarily the case. 3/ Assuming that the parties have determined that an LLC is the desired form of ownership entity, the parties will need to choose the jurisdiction of formation for their entity. In that regard, they need to pay attention to the organic act for that jurisdiction in order to address whether the statute provides the flexibility that they may require. A thorough understanding of the chosen LLC statute is essential. Inasmuch as the statute provides the default for matters that are not addressed in the agreement of the parties, the draftspersons must recognize those default rules. Indeed, the draftspersons may realize that the statute itself is acceptable with respect to certain matters and accordingly an issue need not be addressed by the parties in the agreement itself. Certain statutory provisions may not be varied by agreement of the parties and the draftsperson must understand what those non-waivable provisions are. 4/ The following checklist identifies, in outline form, a limited set of negotiation and drafting issues pertaining to capitalization of the LLC, management of the LLC, distributions by the LLC, exit strategies relevant to the LLC and its members and indemnification, and to some extent, a limited set of alternatives in some of the categories. 5/ The outline is, by no means, exhaustive. The paradigm for the following checklist is an LLC that owns a single real estate property and consideration of issues that arise where the LLC owns multiple properties is beyond the scope of this paper. As with any checklist, the following is only a tool and not a substitute for focusing on the requirements for a particular transaction. Furthermore, the checklist should be looked at as something akin to a menu in that its not intended to be exhaustive and does not purport to argue the merits of particular points. First, the checklist addresses issues regarding capitalization of the entity by its members and their affiliates. Such capitalization could be in the form of a loan or a capital contribution. The checklist considers issues that apply to the initial capitalization as well as issues that may arise in connection with capital needs that may arise following the closing of the initial capitalization. Consideration should also be given to the possibility that one or more of the members or their affiliates may provide credit support for the benefit of the limited liability company. The practitioner using the checklist as a guide should be cognizant that choices made in connection with capitalization of the entity will have consequences that will require attention in connection with other aspects of the limited liability company s operating agreement. 3/ 4/ 5/ See John E. Blyth, Gary E. Fluhrer, Kenneth M. Jacobson, Robert R. Nix II, Elliot M. Surkin and James A. Winkler The LLC Vehicle Is There Ever a Reason Not to Use It. The ACREL Papers. Spring 2000, Tab 17. See, for example, 805 ILCS 180/5-15 (b)(7) (operating agreement may not eliminate or reduce the obligations of good faith and fair dealing under Section 15-3 of the Illinois Limited Liability Company Act). Often, the parties will negotiate a term sheet, letter of intent or analogous document. While the list that follows is most appropriate as a drafting tool for an operating agreement, reference might be made to the checklist to identify salient points that merit attention in a term sheet, letter of intent or analogous document. -2-

4 Second, the outline addresses management issues. A few alternative management structures are presented. For those transactions that utilize a major decisions approach or an approach that does not require unanimous member approval for all limited liability company business, the outline provides a representative sample of decisions that the members may wish to have a voice in. Other issues that may arise in connection with limited liability company management are the resolution and management of disputes. Third, the outline addresses distribution issues by, among other things, identifying concerns as to the genesis of the proposed distribution (e.g., cash from operations as opposed to cash from capital events). The outline also notes some distribution alternatives and identifies some considerations with respect to mandatory and optional distributions by the limited liability company. Fourth, the outline considers exit strategies. An exit strategy is the mechanism by which one or more members may dispose of their interest in the project and exit the deal whether through a sale of the underlying asset or otherwise. The ability to exit is of critical importance to any member. Indeed, institutional investors will typically insist on very strong exit rights. Of course, the other members may wish to avoid premature exits. The outline identifies a few different exit strategies and some considerations that apply to such exits. Finally, the outline addresses indemnification matters. Members, managers and limited liability company representatives desire protection when they act on behalf of the limited liability company. The outline sets out some considerations that the parties may wish to address in connection with the LLC in question. I. Capitalization 6/ A. Threshold Questions 7/ 1. How much capital will be needed? 2. The parties to identify capital providers 3. Allocation of capitalization responsibility among the parties 4. Form of capitalization (will capital be in the form of debt or equity) 6/ 7/ The primary focus of the capitalization component of this outline is capitalization to be provided by the members or their affiliates. Of course, capitalization is often provided by third parties that are not affiliated with the members. Analysis of issues that pertain to the interplay between the concerns of the third-party capitalization provider, on the one hand, and the concerns of the LLC s members and the LLC itself, on the other hand, is beyond the scope of this paper. Yet, one must understand that the rights and obligations of an LLC s members under the operating agreement are not negotiated, drafted or exercised in a vacuum. For example, the ability to utilize an exit strategy may depend upon the assumability of third-party mortgage financing, the ability to transfer membership interests without the consent of the third-party lender or the ability to prepay or defease such financing. An invaluable tool is a so-called Sources and Uses statement. This statement identifies the anticipated costs of the project and anticipated capitalization sources. -3-

5 B. Initial Capitalization 1. Debt provided by members or members affiliates a. How much money will be funded in connection with the initial funding b. Who will be the lender i. What is the allocation of lending responsibility among the lenders ii. Control issues may arise if there are multiple lenders c. Who is the borrower (will it be the LLC or one or more of its members) d. Security (if any) for repayment of debt? e. What are the terms of the debt? f. Is the debt convertible to equity? g. Have fiduciary duty and good faith concerns been addressed? 8/ 2. Equity a. How much of the capitalization will be in the form of equity b. Who will provide the equity capital as between or among the members i. How will the capital contribution obligations be allocated among the members a) Allocation of Contribution Obligations (i) Will capital be contributed in proportion to percentage interests? (ii) Will capital be contributed in proportion to capital interests (if these vary from percentage interests) 9/ (iii) Are other methods of allocation appropriate? c. Form (What form will the equity capital contribution take?) i. Will capital be contributed to the deal in the form of non-cash property a) Should a separate Contribution Agreement be utilized pursuant to which a member contributes the asset to the LLC, is it appropriate to utilize a separate purchase and sale agreement pursuant to which the asset will be sold to the LLC by a person that will become a member (or such member s affiliate) or is it appropriate instead to address closing matters, conveyance issues and other asset 8/ 9/ There may be an inherent conflict between the interest of an LLC creditor and the LLC itself. The LLC member will seek to act in its own best interests. The parties will need to determine if participation in profits, losses and distributors are to be shared in the same proportion as capital contribution obligations. This paper generally refers to percentage interests in the context of participation percentages in losses, profits and distributions, and to capital interests as participation percentages with respect to capitalization responsibilities. -4-

6 transfer issues within the body of the operating agreement itself? 10/ b) Valuation of the asset must be addressed. ii. Services might be provided in exchange for an interest 11/ 3. Cash may be contributed 4. Consequences of Failure to Contribute (see discussion under I.C, below) 5. Use of Funds 12/ a. Acquisition, Financing and Closing Costs 13/ b. Make-up dead-deal costs 14/ c. Other i. Will operating agreement negotiation costs be included as an LLC expense? ii. LLC formation expenses (e.g., filing fees) 6. Conditions to Funding and Closing of Initial Capitalization 15/ 7. Closing Matters Regarding the initial capitalization must be considered. a. Representations and Warranties may be appropriate 16/ b. Indemnification 17/ 10/ 11/ 12/ 13/ 14/ 15/ 16/ 17/ The parties that are putting cash into the deal will often seek assurances regarding the asset in question. Contributions of property may have different tax consequences than contributions of cash. For example, to address the treatment of gain inherent in booked-up property, the parties will need to address I.R.C. 704(c) and the relevant Treasury Regulations. There may be tax consequences associated with receipt of an LLC interest in this regard. See, for example, Kenneth M. Jacobson, Howard M. Richard and Sheldon I. Banoff. Illinois Limited Liability Company: Forms and Practice Manual (1999, Supplemented 2002), p Obviously, issues such as use of funds apply to initial debt capitalization and additional (post-closing) capitalization as well. To maintain brevity, this paper will generally not enumerate points that logically might apply in more than one category of this outline. This would include the cost of acquiring the property (e.g., purchase price), due diligence expenses in connection with the acquisition, closing costs associated with the acquisition as well as closing and other costs associated with any financing utilized in connection with the acquisition. In addition, the parties may want to establish reserves for working capital, payment of real estate taxes and other anticipated expenses (although, to some extent some of the reserves may be funded through utilization of loan proceeds from a third-party lender and, in effect, some of the reserves may be funded through closing prorations). Occasionally, parties that have formed investment relationships may negotiate a recapture of pursuit costs for deals that, for one reason or another, did not close. The parties should consider what conditions, if any, are appropriate and the appropriate documentation to specify such conditions. See I.B.2.c.i. To the extent representations and warranties pertain to contributed property, the non-contributing parties may want assurances regarding such property that might typically be found in an asset sale agreement. Even if property is not being contributed, representations and warranties regarding organization, existence, good standing, power and authority, securities laws exemptions, due authorization, non-contravention and third-party and internal consents may be appropriate for the usual reasons. If property were contributed, the non-contributing members might have expectations regarding responsibility for pre-contribution matters. -5-

7 c. Expenses/Prorations d. Assignment of Asset Matters 18/ e. Third-Party consents and estoppel certificates f. Closing Deliveries g. Licensing and Permitting Issues 19/ h. Transfer Tax and Real Estate Tax Reassessment Issues 8. Consequences of Breach of Representation, Warranty or Covenant discovered after closing and indemnification for Pre-Closing Matters a. Lawsuit b. Set-off against Distributions c. Other C. Additional Capitalization (How are the parties going to address the capital requirements of the LLC following the initial capitalization of the LLC) 1. General a. How much b. Who provides c. Allocation between Debt and Equity d. Optional v. Mandatory 20/ 2. Debt (See I.B.1, above) 3. Equity (see I.B.2, above) 4. When required (the following focuses on mandatory equity contributions, but these concerns might also apply to debt infusions or optional fundings agreed to after formation in accordance with the operating agreement) a. Agreed-Upon Schedule/Budget 21/ b. Capital Call 22/ i. When Required/Purpose of call ii. Who May Initiate a Capital Call and What Is the Required Degree of Authorization for the Capital Call a) Managing Member may unilaterally call (i) Any amount 18/ 19/ 20/ 21/ 22/ Deeds, assignments of leases, bills of sale, etc. Furthermore, if one of the members (or, its affiliate) has signed a purchase agreement for the property the LLC is acquiring, the purchase agreement should be assigned to the LLC. The parties may need to address how licenses will be held. For example, in many jurisdictions, liquor licenses require satisfaction of a variety of conditions, including finger-printing of officers, etc. Optional refers to situations where the parties are not obligated to contribute capital in excess of their initial capital contribution, but may choose to do so in accordance with procedures outlined in the operating agreement. Mandatory contributions are agreements by a party to make a contribution. This contemplates that the parties will automatically make specified contributions on specified dates in accordance with an agreed-upon funding schedule. This contemplates that the members are obligated to contribute capital, but not on an agreed-upon funding schedule. This also contemplates optional contributions that become mandatory with the requisite approvals. -6-

8 (ii) Any amount up to specified maximum without approval of members, managers, board of managers (see discussion below) (a) Per Advance (b) Aggregate b) Members/Board of Managers/Managers (i) Majority (ii) Super-Majority (iii) Unanimous iii. Form of Call 23/ iv. Dollar Limitations 24/ a) Aggregate b) Per Member v. Limitations on Purpose of the call 25/ vi. Time Limitations 26/ vii. Clawback of Previously Distributed Funds 27/ viii. Refunds of Contributions if Premature Call 28/ a) Investment of Funds Pending Use b) Return of Capital Contribution If Not Expended Within Specified Period c) Clawback If Refunded Within Specified Period ix. Time Period to Meet Call a) Time specified in notice b) Time specified in agreement x. Mandate Attempt to Use Other Funding sources? 23/ 24/ 25/ 26/ 27/ 28/ Sometimes the parties may specify the form of notice for the capital call. The parties may choose to impose a maximum amount for mandatory capital contributions. The parties may choose to specify purpose-limits on mandatory contributions. Perhaps, they may choose to tie-it to the agreed-upon budget. The parties may choose to limit the time period in which capital may be called. Presumably, this period may be derived through pro forma budgets. Obviously, this begs the question of what to do about unanticipated events. A clawback, in this context, would obligate a member, having received distributions, to re-contribute all or a portion of distributed amount. What happens when a capital call is issued, but, all of the contributed funds are not needed? For example, suppose a capital call is issued to provide funds with which to acquire adjacent real estate and the closing of such acquisition does not occur as intended at the time of the call. Should the funds be returned? If there is an overall limitation on the capital that may be called, should the funding of the returned capital be counted against such limitation. -7-

9 5. Other Situations a. Emergency Capital 29/ i. Defining Emergency a) Natural disaster b) Unanticipated Budget Shortfall c) Critical Expenditures d) Significant or Material Adverse Legal Consequences May Result e) Other ii. Procedures a) Managing Member (or another Member) may advance subject to reimbursement b) Managing Member (or another Member) must advance subject to reimbursement c) Expedited call procedure d) Other b. Dead-Lock Capital 30/ c. Exit Strategy Executory Period 31/ 6. Security for Funding Obligations to Assure the LLC and the Other Members 32/ a. Guaranty b. Letter of Credit c. Lien on Membership Interest d. Lien on other Assets e. Other 7. Failure to Fund 33/ a. Grace Period/ Last Clear Chance b. Excused Failure to Fund 34/ 29/ 30/ 31/ 32/ 33/ Emergency capital issues are, to some extent, subsumed within the above discussions regarding mandatory and optional contributions. The parties may disagree as to a decision of the LLC that would require a capital contribution. Dead-lock capital permits capital to be advanced under such circumstances. Once an exit strategy is initiated, a member whose interest is being acquired may have little interest in continuing to make capital contributions. For example, in a buy-sell situation, with the pricing determined, the seller may not want to contribute additional capital unless the pricing adjusts to reflect the added capital. Of course, the seller may have a concern about maintaining the viability of the LLC during the preclosing period in the event the closing does not occur. The credit of the contributing parties may be relevant as the other members may have an expectation as to the availability of funds. The parties may consider securing the future funding obligations of one or more members. Such security might take a variety of forms. What happens when needed capital is not contributed? There are a variety of mechanisms to deal with the shortfall. Some of the following items may be considered as a menu options. The operating agreement may include more than one menu item. It might also provide for enhanced remedies as the degree of noncontribution increases. -8-

10 c. Funding Members can withdraw their funding and terminate their obligations to fund d. Funding Members Can Contribute Shortfall i. Procedure for Allocation of Shortfall ii. Funding Time Period e. Default 35/ f. Loss of Voting, Management and Other Rights i. Loss of Voting Rights a) All rights or just some rights b) Shift in Size or Composition of Managers or Management Committee ii. iii. Loss of Right to Initiate Buy-Sell and Other Exit Strategies Can these rights be reinstated and, if so, under what circumstances? g. Preferential Return of and/or Return on Capital 36/ i. Specify Priority of Return ii. Specify rate of return, if applicable, and whether simple or compounded h. Squeeze-Down 37/ i. Variations 38/ a) Dollar Formula Translates into Percentage Interest Shift b) Percentage Formula Based on Capital Contributed c) Percentage Formula based on Valuation d) Haircuts 39/ 34/ 35/ 36/ 37/ 38/ 39/ Should a member be entitled to withhold additional contributions? If a contribution is optional, how should a non-contributor be treated. A threshold question is whether the failure to meet a capital call is a default that entitles the LLC or the other member to institute specified remedial provisions of the agreement. Some LLC agreements differentiate between remedies that supply capital to the LLC (often at some cost to the non-contributing member), but refuse to treat the non-contributing member as a bad-guy who should be punished beyond loss of specified economic benefits of the transaction. At some level, repeated failure to meet capital calls might be treated in the agreement as a default. This allows the contributing members to receive their capital and a return on such capital ahead of other capital returns. Presumably, this could include the capital contributed on behalf of the non-contributing member and/or the capital that the contributing member would otherwise have provided. This is intended to provide a remedy choice that may result in an adjustment of distributions. It helps to utilize examples (even if not reflected in the text). In this regard, the parties should endeavor to work through their examples utilizing the precise words utilized in the documentation. Some squeeze-down formulas adjust capital and/or rights to profits, losses and distributions on a straight-up basis. Other arrangements seek to penalize, to some degree, the non-contributing member. See Stevens A. Carey. Squeeze-down Formulas: Do They Work the Way You Think They Work. The Real Estate Finance Journal. Fall 1997, p

11 ii. Adjustments Not to Affect Future capital funding obligations 40/ iii. Timing of Squeeze-down 41/ a) Immediate b) Opportunity Period to Raise Capital c) Loan Conversion (see below) iv. Liquidated Damages/Not a Penalty Savings Clause v. Blow-Out Membership Interest When Reduced to Specified Percentage 42/ a) Compensated b) Uncompensated vi. Adjusted Capital i. Loans i. To Whom a) Loan to LLC 43/ b) Loan to Defaulting Member ii. By Whom iii. iv. a) Contributing Members (i) Allocation of Loan among Contributing Members b) LLC Security a) Unsecured b) Secured by Membership Interest c) Secured by Other Collateral d) Perfection Repayment Source a) Limited to Distributions b) Other v. Maturity vi. Prepayable a) Mandatory Prepayment out of Distributions 44/ 40/ 41/ 42/ 43/ 44/ Presumably, adjustments in rights to profits, losses and distributions should not decrease the noncontributing member s future obligations to contribute capital or increase the contributing member s obligations to make future capital contributions. The timing question attempts to ameliorate the concerns of the impecunious member that it will be blown away without an adequate opportunity to find the necessary funds to meet its obligations. Under this scenario, the non-contributing member is given a period of time to repay the capital that was advanced, either as capital or as a loan, before reduction in its rights to share in the profits, losses and distributions of the LLC. This permits a member whose rights to profits, losses and distributions have been diluted to a relatively small amount to be eliminated as a member. Because the loan is to the LLC it has the effect of making the lending member pay for a portion of the interest cost of the loan. The lender will often insist that distributions to the non-contributor be applied to the debt until paid in full. -10-

12 b) Voluntary Prepayment 45/ c) Mandatory Prepayment in connection with Exits vii. Interest Rate a) Simple Interest or Compounded (i) Frequency of Compounding b) Actual/360, Actual/ , or 360 days/30-day months c) Usury Issues and Usury Savings Clause viii. Conversion to Capital 46/ j. Cross-default with Other Agreements i. Penalize Other Arrangements with the non-contributing member or its affiliate ii. Cross-Default with Loans to Member iii. Set-off Against Other Arrangement (e.g., management fees, development fees, asset management fees and/or debt service payable to the non-contributing member or its affiliate) 47/ k. Personal Liability for Damages for non-contributing member l. Dissolution m. Buy-Sell, Put, Call or other Exit Strategy Procedure (see below) i. Haircut 48/ ii. Valuation 8. Other Capitalization Issues; Credit Support a. Credit Support. 49/ i. What form will the credit support take? There are a variety of forms, such as letters of credit, guaranties, set-aside agreements, carveout guaranties, environmental indemnities, etc. ii. Who will provide the support? What issues must be addressed if the credit support is provided not by a member but by an affiliate of a member. iii. Treat as contribution for purpose of return? 45/ 46/ 47/ 48/ 49/ Presumably, voluntary prepayment will be permitted. Occasionally, the parties will negotiate a procedure whereby a loan may be converted to capital after expiration of a specified period of time. To some extent this may be counterproductive. To the extent that fees are intended to subsidize the cost of services (e.g. asset administration expenses), deprivation of funds may reduce the quality of the services in question. In this context, haircut refers to a downward adjustment in the price that would otherwise be payable. To what extent will the credit of a member be utilized for the benefit of the LLC? In this regard, consideration must be given to the identity of persons that will provide the credit support, the circumstances under which the credit support will be provided, maintained or withdrawn and the consequences of being forced to make a payment on account of such credit support obligations. -11-

13 iv. Count against Maximum Commitment of Member Until Drawn v. Obligation to Maintain vi. Fee for Providing Credit Support vii. Reimbursement of Expenses for providing credit support viii. ix. Reserving for consequences of credit support draw Contribution and Indemnification 1) Proportionate Sharing of Exposure or Disproportionate Sharing 2) Responsible Party to Provide 100% of Payment (e.g., non-recourse carveout liability due to fault of indemnifying party)? 3) Indemnifying Party (i) Company (ii) Members (iii) Others (Deep-Pocket) x. Consequences of credit support draw xi. Security for Reimbursement of Draw on credit support xii. Right to Call Capital In connection with Draw on Credit Support xiii. Return/Releases of Credit Support in Connection with Exit (see below) a) Is indemnification sufficient? b. Developer-Member Guaranty 50/ i. Completion ii. Cash Flows iii. Development Cost Overruns iv. Other 9. Capital Accounts II. Management Structures and Issues 51/ A. Structures 1. Member-Managed 2. Manager-Managed 3. Statutory Limitations 52/ 50/ 51/ 52/ While a developer might provide a guaranty to a third-party as to these issues, it is also possible that the other members will want direct assurances from the developer as well. The parties must address how the LLC will be managed. There are a variety of structures that are commonly employed to govern an entity. Statutory regimes typically provide that an LLC will be either member-managed or manager-managed. The operating agreement might also provide for a corporate-type structure by management through a board or executive committee. Section of the Delaware Limited Liability Company Act contemplates the ability of members or managers to delegate management rights. The applicable LLC act should be consulted to determine if particular levels of authority are mandated (e.g., unanimous approval of members) and whether the statutory default rules must be overridden in the -12-

14 4. Public Document Limitations 53/ 5. Fiduciary Duty and Good Faith Implications. Fiduciary duties will affect what members may do with regard to their management structures and other matters 54/ B. Structural Alternatives 1. Member-Managed a. Czar-like Management Structure i. Unlimited Authority 55/ ii. Any Limitations? 56/ b. Managing Member (or Administrative Member and/or Operating Member) Structure Subject to Specified Approval Procedure for Major Decisions c. All Members Must Approve (or specific number or percentage) 2. Manager-Managed a. Czar-Like Manager b. Managing Manager (Administrative Manager) Manager Subject to Major Decisions c. All Managers to Agree (or Specific Number or Percentages d. Member approval as to Certain Matters 3. Executive Committee/Board of Directors/Board of Managers/Management Committee a. Approvals for Certain Matters by Members as Members 57/ b. Selection, Resignation and Replacement i. Who picks ii. Resignation/Member Exit a) Voting b) One Member One Vote c) Weighted-Vote iii. Decision-making a) Voting b) One Member One Vote public documents of the LLC (e.g., filed certificate of formation) or may be addressed in the operating agreement only. 53/ 54/ 55/ 56/ 57/ The parties should consider whether authority restrictions should be included in the LLC s public documents. See Kenneth M. Jacobson. Fiduciary Duty Considerations in Choosing Between Limited Partnerships and Limited Liability Companies. Real Property, Probate and Trust Journal. (Spring 2001), pp Obviously, there may be fiduciary duty and good faith obligations that may provide limitations. The members might insist on limitations pertaining to very important issues such as entering a business outside of the originally intended business, etc. The usual situation finds that the members select representatives to the board to represent the interests of the member that appointed them. However, the statute might require approval of certain matters by the members or not all members may be represented on the board. -13-

15 c) Weighted-Vote C. Decisions (Major Decisions, etc.). 58/ 1. Sale, Exchange or Disposition of Assets 59/ a. All Dispositions b. Dispositions In Excess of Threshold (e.g., condominium, corporate and residential subdivision deals) i. Specify Parameters c. All Cash v. Purchase Money Loans 2. Acquisition of Assets a. Real Estate b. Personal Property (Tangible) i. FF& E programs c. Intangible Assets (e.g., assets that are not tangible assets such as derivatives) d. Equipment Leasing 3. Borrowing a. Any Borrowing b. Borrowing Outside of Specified Parameters c. Borrowing with Recourse to Members or their affiliates 4. Guaranty by LLC a. Any Guaranty or Only Guaranties Outside of Specified Parameters? b. Other Contingent Obligations c. Exclusions (certain contingent obligations might logically be excluded from this; for example, check endorsements in the ordinary course of business) 5. Budget and Business Plan a. Managing Member (a/k/a Operating Member, Administrative Member, etc.) to Manage Per Budget and Business Plan 60/ b. Deviations Permitted for Specified Maximum Tolerances c. Emergency Deviations d. Amendments to Budget and Business Plan e. Annual or Quarterly Business Plan and Budget Review (Formal) 6. Compensation of Employees, Officers, etc. /Other Employment Matters 7. Amendments to LLC Agreement a. All amendments b. Specified amendments only c. Matters that Affect Member in Question 58/ 59/ 60/ Many decisions will require the attention of the LLC s governing body or members, as applicable. A representative sample of such decisions is set forth in this part II.C. Note that this may be something that will have to be overridden in connection with specified exit strategies. See outline components pertaining to deadlock and dispute resolution. -14-

16 8. Leases (new leases, lease amendments, lease administration, lease enforcement, lease termination, etc.) a. All Leases b. Leasing Parameters 9. Legal Entitlements (e.g., zoning, subdivision, etc.) 10. Contracting (to the extent not otherwise addressed in II.C.) a. Contracting Parameters 11. Litigation including tax assessment contests and arbitration a. Initiation b. Major decisions c. Settlement d. Appeal e. Bonding 12. Confession of Judgment 13. Lending by the LLC 14. Collateralization of LLC obligations a. Mortgage b. Other collateral 15. Transfers of LLC Interests (see IV below) a. Economic Interests of Members b. Admission of Transferees (see IV below) 16. Admission of Members a. Membership Interest Transfer b. Remedial Exercise or Transfers in Lieu of Remedial Exercise c. Additional Capitalization i. Anti-Dilution Protection ii. Preemptive Rights iii. Securities Laws Considerations d. Other 17. Capital Calls (see I above) 18. Compromise of Capital Contribution Obligation. 19. Easements/CCRs 20. Reserves 61/ a. Establishment b. Adjustment c. Expenditure 21. Tax Matters a. Tax Matters Member b. Tax Returns c. Tax Audits and Settlements 22. Construction Matters a. Projects b. Contractors 23. Retention of Professionals 61/ The project lenders will often impose these requirements in any event. -15-

17 24. Banking a. Financial Institution Selection b. Check Signing Authority c. Investment Alternatives 25. Establishing and Administering Subsidiaries 26. Mergers, consolidations, conversions and reorganizations 27. Bankruptcy and State Insolvency Law Protection 62/ a. Bankruptcy b. Receivership c. Assignment for Benefit of Creditors d. Other 28. Affiliate Transactions a. Pre-Approved Transaction(s) b. Mechanism for Approval c. Control of Administration and Enforcement 63/ 29. Distributions (see below) 30. Dissolution 31. Insurance and Condemnation Matters a. Insurance Program b. Settlement and Adjustment of Claims 32. Ground Leases D. Specify Degree of Required Approvals (and By Whom) 1. Unanimous 2. Majority Vote a. By Number b. By Interest 3. Super-Majority a. By Number b. By Interest c. Designated Member/Manager/Board Member Must Approve (Veto Power) d. Designated Member/Manager/Board Member Breaks Ties (Makes Decision After Consultation) e. Classes of Membership Interests 4. Disqualification a. Interested Party b. Default-Failure to Fund c. Default or Other Significant Event-Other (e.g. bad act, bankruptcy, death, etc.) 62/ 63/ The insertion of independent managers or members in connection with securitized lending arrangements is a topic beyond the scope of this paper. For example, if Member X s affiliate is the property-manager, it may not be appropriate for Member X to vote on exercise of remedies and, indeed, it may not be appropriate for Member X to participate in or attend, meetings where consideration of such remedial matters are discussed by other members. -16-

18 5. Shift Member Rights, Manager Rights, Board Size or Board Composition upon Happening of Specified Events (e.g. failure to fund, failure to satisfy performance targets, buy-sell executory period, etc.) 6. Are there circumstances where a member that has resigned or withdrawn should continue to have a say in LLC matters that may affect it? E. Meetings/Voting 1. Formal Meetings 64/ a. Annual b. Quarterly c. Other 2. Notices of Meeting a. Who May Call b. Form of Notice c. Advance Notice d. Waiver of Notice Procedure 3. Consent without Meeting 4. Telephonic/Teleconference Meetings 5. Place of Meeting 6. Quorum 7. Expenses of Meeting Attendance 8. Who May Attend: Consultation and observation rights (but no approval rights) a. Attorneys and other professionals b. Non-voting members and/or their representatives 9. Voting: Proxies F. Records 1. Responsible Party 2. Minute Book G. Officers 1. Specification of Officers and Responsibilities 2. Generic Authority for Future Officers H. Resignation of Managers, Officers and Board Members I. Indemnification of Managers, Officers and Directors (see V below) J. Disputes 1. Deadlock: what happens when the operating agreement governing procedures result in a disagreement as to the proper course of action for the LLC? a. Defined 2. Resolving Deadlock a. Negotiation b. One or More Members, Managers or Directors has tie-breaking authority (see above) c. Mediation i. Invoking Mediation 64/ Member meetings? Manager meetings? Other Meetings? -17-

19 ii. Selection of Mediators iii. Procedures iv. Time Period v. Expenses d. Arbitration i. Arbitrable Matters ii. Procedures a) Invoking Arbitration b) Rules to Be Followed (i) Decision-Making: How is the decision to be made (e.g., Baseball-style ) (ii) Procedural Matters c) Selection of Arbitrators d) Forum for Arbitration e) Expenses of Arbitration f) Time Period(s) 65/ iii. Binding or Non-Binding iv. Appeals v. Expenses e. Exit Strategy (see below) 66/ i. Single Unresolvable Dispute ii. Multiple Unresolvable Disputes iii. Cooling-Off Period f. Accountants 3. Interim Solutions Pending Dispute Resolution a. Budget/Expenses i. Prior Year Budget ii. Non-Discretionary (to a degree) Costs 67/ a) Real Estate and Personal Property Taxes b) Debt Service c) Insurance d) Legal Requirements iii. Tolerances iv. Emergency Expenditures v. Emergency Capital (see above) b. Deadlock Capital (see above) 65/ 66/ 67/ Consider that the party that initiates arbitration may have selected its arbitrator and gone a long way toward preparing its case. This may put the other party at a disadvantage if response periods are too short. The operating agreement might provide that the existence of a deadlock will entitle one member to initiate an exit strategy. As a practical matter, some items must be paid as non-payment might have significant adverse consequences. -18-

20 K. Administrative Member/Operating Member 1. Duties a. Specification of Duties b. Restrictions on Authority (see above) c. Public Record of Restrictions 2. Specified Compensation (if any) 3. Standard of Performance a. Specify Standard b. Force Majeure c. Time Periods d. Consequences of Nonperformance 4. Defaults and Failure to Contribute Capital (see above) a. Replacement of Defaulting Administrative Member b. Reallocation of fees to replacements L. Fiduciary Duty and Good Faith Concerns M. Access to Information 68/ N. Confidentiality 69/ III. Distributions 70/ A. Differentiate Among Types of Cash Flows 1. Cash is Cash? 2. Operating Cash Flow a. Defined b. Reserves c. Allocation and Distribution Scheme Differs from Capital Proceeds Distributions? 3. Capital Proceeds a. Defined i. Net financing proceeds ii. Net sale proceeds iii. Net condemnation proceeds iv. Other v. Will a member or its affiliate be entitled to a fee by virtue of an event that generates capital proceeds? b. Reserves c. Treatment of Purchase Money Debt Payments 68/ 69/ 70/ The operating agreement might specify the information which will be distributed to the members or allow the members to inspect records. Access may also be important to a member, board member or officer that has exited. The parties may wish to impose limitations on disclosure of information to actual or potential competitors, etc. While seemingly an obvious choice, the use of examples, especially with complicated distribution schemes, is suggested, even if such examples do not become part of the documentation. It is important that the examples utilize the precise words of the documentation. -19-

21 d. Allocation and Distribution Scheme Differs from Operating Cash Flow Distributions? 4. Who Decides Whether Cash is Operating or Capital B. Non-Cash Distributions C. Allocation of Cash 71/ 1. New Money before Old Money 2. Straight-Up (distribute in accordance with percentage interests) 3. Return on Capital Contributions a. Specify Rate of Return b. Simple v. Compounded c. Frequency of Compound d. Priority of Return on Capital e. Allocation of Return on Capital 4. Return of Capital a. Priority of Return of Capital b. Allocation of Return on Capital 5. Other Distributions a. Promote b. Straight-Up c. IRR-based hurdles d. Final Splits e. Treatment of Member Loans D. Tax Matters 72/ 1. Capital Accounts 2. Target Capital Accounts 3. Allocations/Track Cash 4. Curative Allocations 5. Tax Credits 6. Phantom Income Issues? 7. Deficit Restoration Issues Addressed 8. Other E. Manner and Timing of Distributions 1. Operating Cash v. Capital Proceeds 2. Forcing Distributions a. Mandatory or Optional b. Optional with distribution as determined by Management Provisions (see above) c. Tax Distributions or Loan from LLC i. Annual ii. Estimated Payments iii. True-Up 73/ 71/ 72/ To the extent that a portion of capitalization is in the form of a loan from a member or its affiliate, the parties will also need to address the priority of payments to that creditor. The parties may want their respective tax counsel and tax accountants to confirm that the tax allocations are satisfactory and consistent with the business objectives of the parties. -20-

22 d. Frequency and Timing of Distributions (if mandatory) F. Distributions on Liquidation 74/ 1. Capital Accounts 2. Other 3. Deficit Capital Restoration IV. Exit Strategies 75/ A. Identification of Exit Strategies (General) 76/ 1. Asset Sales v. Membership Interest Sales 2. Will Exit Strategy Be Hard-Wired Into Documentation? 3. Transfer Tax and Tax Reassessment Issues 4. Securities Law Issues 5. Third Party Issues 6. Tax Issues B. Dispositions 1. Puts and Calls a. Puts and Calls Distinguished 77/ b. Circumstance that permits exercise of put or call right i. Demand following passage of time or satisfaction of specified conditions ii. Default iii. Refusal to Arbitrate 78/ iv. Other c. Pricing i. Pre-Set Price ii. Price Set by Appraisal iii. Price Set by Net Income or Net Cash Flow Multiple d. Transferee i. LLC ii. Other Member 73 74/ 75/ 76/ 77/ 78/ Consider whether the true-up obligation should be guaranteed. See III.D., above. See Elliott M. Surkin. How Do I Get Out of Here? Exit Strategies in Closely-Held Real Estate LLCs. 18 No. 3 Prac. Real Est. Law. 27 (2002). If the operating agreement includes more than one exit strategy, the agreement may need to specify the priority of one strategy over another. A put is commonly thought of as a right of a member to elect to require another member to acquire its interest or to require the LLC to redeem its interest. A call is commonly thought of as a right of a member to elect to acquire the interest of another member or to have the LLC redeem the interest of such other member See Metro Riverboat Associates, Inc. v. Bally s Louisiana, Inc., 817 So. 2d 1275 (La. App. 4 Cir. 2002) (court refused to enforce remedy in operating agreement that allowed member having elected to arbitrate to choose between put and call if the other member refused to arbitrate). -21-

23 e. Disqualification i. Initiating Party in default ii. Other f. Structuring i. Asset Sale ii. Membership Interest Sale g. Mechanics of Closing i. Closing Date ii. Closing Location iii. Payment of Price iv. Document Deliveries v. Third-Party Matters a) Financing b) Releases of Credit Support (e.g., letters of credit, guaranties, indemnification agreements, etc.) (i) Will indemnification do? (ii) Security for indemnification? vi. Licensing Issues vii. Resignation of Board Member/Managers/Officers (see above) viii. Documents Required To Transfer h. Management During Executory Period i. Capital Needs ii. Decision-Making i. Statutory Filings and Notices j. Affiliate Agreements k. Indemnification to Survive l. Access to Information and Confidentiality i. Reports/Tax Returns ii. Tax Matters a) Approval of tax returns for current and prior years? iii. Other m. Waiver of Statutory Payments on Withdrawal 2. Mandatory Sale Process 79/ a. Defined b. Circumstance that permits exercise of such right i. Mandatory a) Passage of Time b) Default c) Hurdles d) Other ii. Discretionary a) Who May Initiate b) Circumstances that Permit 79/ This contemplates that the project or all of the ownership interests in the LLC will be sold as an entirety. -22-

24 (i) Any Time (ii) Passage of Time (iii) Specified Hurdle (iv) Default Hurdle (v) Default (vi) Other c. Asset to be sold i. Company Assets ii. Membership Interests 80/ d. Pricing i. Parties to Agree ii. Pre-Set Minimum iii. Valuation Process Determined Minimum a) Appraisal Value Determination Procedures b) Other Valuation Methods e. Control of Sale Process i. Retention of Brokers ii. Control Over Process (Contract Negotiation/Contract Details) f. Affiliate Agreements 81/ g. Right of First Refusal or Right of First Offer (see below) h. Statutory Filings and Notices i. Indemnification j. Access to Information and Confidentiality i. Reports/Tax Returns ii. Tax Matters a) Approval of tax returns for current and prior years? iii. Other 3. Right of First Refusal 82/ a. Asset to Be Disposed Of i. Membership Interests ii. Real Estate b. Trigger for Exercise of Right i. Signed Contract ii. Letter of Intent or Term Sheet iii. Expression of Interest 80/ 81/ 82/ See Tag-Along and Drag-Along discussion below. Will these agreements be terminated or satisfied in connection with the disposition? A right of first refusal (ROFR) is commonly thought of as a pre-emptive right given to a member to match the terms of a negotiated (often, fully documented, transaction). The ROFR might be utilized by one member to protect its interests in connection with an exit strategy initiated by another member. A typical objection to use of a ROFR is that it has a chilling effect on the negotiation of the deal that triggers the ROFR. Some third-party buyers might object to the time and expense of negotiating an agreement if all of its efforts may be undone by the exercise of a ROFR. Of course, one could argue that the third-party has established, almost by definition, a market price for the asset. -23-

25 iv. Negotiated Final Contract v. Other c. Who Has Right to Initiate d. Who Has Right to Consider i. Members ii. Disqualification iii. Company e. Price 83/ f. Documentation to Be Provided to Initiate g. Time to Consider ROFR h. Method for Accepting ROFR i. Excluded Transactions i. Portfolio sale in connection with disposition of membership interests ii. Affiliate Transfer in connection with disposition of membership interest iii. Financing Transactions iv. Other j. Mechanics of Closing k. Waiving Purchase i. Deemed Waiver v. Express Waiver ii. Survival of Waiver a) Time Period b) Other iii. Ability to Modify terms following Waiver of the Right to Purchase 84/ a) Price b) Timing c) Financing Terms d) Other Terms l. Representations and Warranties 85 m. Third Party Arrangements n. Affiliate Arrangements o. Consequences of Failure to Close i. Haircut ii. Earnest Money iii. Other 83/ 84/ 85 What is the price that needs to be matched? This might be trickier than one thinks. Suppose the property in question is bundled together with other properties. Must the party entitled to the benefit of the ROFR purchase all of the assets that have been bundled together. What happens when, at the end of a contractual due diligence period, the third-party purchaser requests a purchase price adjustment? Will the representations and warranties in the triggering documentation be appropriate for the ROFR sale and purchase? -24-

26 p. Management during Executory Period i. Capital Needs ii. Decision-making q. Access to Information By the Member Having Disposed of its Interest r. Brokerage Issues 86/ 4. Right of First Offer (see IV.B.2, above) 87/ a. Defined b. When May It Be Initiated c. Who May Initiate d. Notice of ROFO and Required Information e. Price 88/ f. Period to Consider g. Who Has Right to Consider i. Members ii. Disqualification iii. Company h. Documentation to Be Provided to Initiate i. Time to Consider ROFO j. Method for Accepting ROFO k. Mechanics of Closing l. Waiving Purchase i. Deemed Waiver v. Express Waiver ii. Survival of Waiver a) Time Period b) Other iii. Ability to Modify terms 89/ a) Price b) Financing Terms c) Other m. Representations and Warranties n. Third Party Arrangements o. Affiliate Arrangements 86/ 87/ 88/ 89/ If a broker was retained in connection with the transaction that is being matched, will exercise of the ROFR excuse payment of a brokerage commission? A right of first offer (ROFO) is commonly thought of as a pre-emptive right in which a member ( Member A ) notifies another member ( Member B ) of the terms that Member A desires in connection with the disposition of an asset. The recipient member (Member B) has the opportunity to acquire the asset on the terms proposed by the initiating member (Member A). As noted previously, this might also be tricky if more than one asset has been bundled together by the party initiating the ROFO. Furthermore, the pricing offered might be grossed-up to reflect payment of a brokerage commission. However, if a broker has not been retained at the point in time, matching the offered price might result in a windfall to the offeror. What happens when the offeror goes to market and discovers that it has misread what the market is willing to pay? -25-