A Real Estate Lawyer's Guide to Equity Investment. Scott A. Lindquist Eric M. Schiller Sonnenschein Nath & Rosenthal LLP Chicago, Illinois

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1 365 ALI-ABA Course of Study Commercial Real Estate Financing: Strategies for Changing Markets and Uncertain Times January 15-17, 2009 Coral Gables (Miami), Florida A Real Estate Lawyer's Guide to Equity Investment By Scott A. Lindquist Eric M. Schiller Sonnenschein Nath & Rosenthal LLP Chicago, Illinois 2009 Sonnenschein Nath & Rosenthal. All Rights Reserved.

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3 367 A REAL ESTATE LAWYER S GUIDE TO EQUITY INVESTMENT By: Scott A. Lindquist Eric M. Schiller Sonnenschein Nath & Rosenthal Introduction As first mortgage financing has become increasingly standardized, so that it now often covers no more than about 65% of the value of a property, other sources of funding have arisen to fill the gap between the first mortgage amount and the amount of equity that an owner or developer is prepared to bring to a deal. A substantial number of institutional investors and private equity funds are now active in a well-established market for such capital. As a result, (1) such transactions are becoming increasingly common, and (2) the structure and documentation for such transactions have become quite well developed. The goal of this paper is to provide a guide to lawyers whose clients are involved, or would like to be involved, in either obtaining or providing equity capital, and to familiarize them with the more significant business and legal issues that such structures and documents present. One established method of funding such capital is a mezzanine finance structure, in which a subordinate loan is made, either to the ownership entity or its investors. Such loans are most often secured by a pledge of the equity interests in the ownership entity (because the first mortgagee usually will not permit second mortgage financing). Where the principal security is a pledge of equity interests, mezzanine financing subjects the lender to many of the same economic risks as a direct equity investment, often without the same level of returns or the same amount of control. 1 Consequently, many different types of investors, including life insurance companies, Wall Street investment banking firms, and private equity investment advisors, have developed direct equity investment programs. The focus of this paper will be on direct equity investment, rather than mezzanine financing, although some comparisons with mezzanine financing are useful in understanding why an investor might choose one over the other. Probably the most common investment situation is one in which a developer does not have the liquid capital needed for a new development, redevelopment, or acquisition opportunity, and therefore brings a money partner to the deal. Most of the discussion below will be based on this type of situation. It should be noted that an important element in attracting equity capital is the potential for significant upside returns. Investors in this market are generally looking for investment opportunities that will provide more than just a preferred return, so new developments and renovations with good turn-around potential are the ones most likely to attract such capital. 1 The control that a mezzanine lender exercises will ultimately be limited by concerns about lender liability, and the level of such a lender s financial participation will be constrained by the concern that its loan could be recharacterized as equity, at least for income tax purposes.

4 368 I. Organization of the Investment Vehicle A. Selecting the Investment Vehicle. In the typical structure for such an equity investment, the investor acquires either a membership interest in a limited liability company ( LLC ) in which the developer is the managing member, or a limited partnership interest in a limited partnership ( LP ) in which the developer is the general partner. General partnerships can also be used, but in most cases the equity investor is not looking for either the level of participation in management or the potential liability that a general partnership interest entails, nor is the developer usually interested in giving such an interest to the equity investor. For a number of reasons, LLC s are probably now the predominant form of investment in these transactions: (1) LP s (at least those not governed by more liberalized versions of 303 of the Revised Uniform Limited Partnership Act ( RULPA )) still pose some risk that extensive involvement by a limited partner in the management of the affairs of the partnership could render the investor a general partner. As discussed further below, because the equity investors in these transactions are putting in most of the equity, they demand a substantial degree of control. Consequently, this can be of significant concern, at least where the investor partner does not want to use a different, single purpose subsidiary for every investment (which can impose significant administrative burdens and costs). (2) LLC s offer somewhat more flexibility in structuring their governing mechanisms, although most equity investment deals involve a fairly simple two-party structure that can easily be done either as an LLC or an LP. (3) Partnerships require at least two partners, while at least most LLC statutes now recognize single-member LLC s. In such states, the use of an LLC can avoid the complications that arise from situations that could result in there being only one partner, such as a buy-sell or the insolvency or dissolution of a partner (particularly a sole general partner). (4) Partners have a number of implied duties to one another, including fiduciary duties, duties of fairness and loyalty, and even duties of care, as well as certain inherent powers (such as the power to dissolve the partnership), which the parties may want to limit or avoid. However, as discussed below, in many states, LLC statutes share many provisions with the partnership acts in those states and impose duties similar to those applicable to partnerships. From this perspective, the choice of where to organize can be more important than whether to organize as an LLC or an LP. There are a few jurisdictions (Texas, Pennsylvania) that impose significant entity-level taxes on LLC s but not on partnerships. In those jurisdictions, LP s are generally used to avoid the application of such taxes. For purposes of the discussion below, it will generally be assumed that an LLC is being used, although unless otherwise indicated, the issues and points discussed will also be applicable to an LP structure. B. Issues Affecting Selection of the Place of Formation. While every state now authorizes LLC s, different state statutes create different rules governing their organization and management, and the differences in those rules can affect where the parties elect to organize their LLC. Some statutes reflect the approach that an LLC is a kind of corporation that happens to get partnership tax treatment, while other LLC statutes take the opposite approach that an LLC is a - 2 -

5 369 partnership in which the partners are shielded from personal liability. The latter kinds of statutes are modeled more closely after partnership acts and expressly create the same types of rights, powers, and duties as apply to partners. These differences can have important effects on the relationship between the members and can create some unexpected issues. For example, LLC statutes may grant members the power to withdraw or dissociate from the LLC, just as a general partner has the power to withdraw from a partnership (and in contrast to a corporation, where no such power is granted to shareholders). 2 Like a partnership, such withdrawal or dissociation may cause the acting party to incur liability for damages if its actions violate the terms of the agreement between the members, but this may not be a practical deterrent to a wrongful withdrawal or dissociation. Such damages may be speculative or difficult to prove, so that in most cases, if damages can be shown at all, it will only be through protracted and expensive litigation. Furthermore, where the partners or members have invested through singlepurpose entities, damages will effectively be limited to whatever distributions such party may be entitled to receive. 3 In addition, some statutes may obligate the LLC to buy out a withdrawing or dissociating member s interest and prescribe judicial procedures for valuing that interest, although the members may be permitted to eliminate such rights by agreement. 4 As noted above and discussed in more detail below, most operating agreements or partnership agreements used in these investment structures contain detailed buy-sell provisions that carefully set out mechanisms for valuing and buying out a member s or partner s interest. However, these agreements are not always clear that such provisions are intended to supersede any other rights granted by statute or that such statutory rights are otherwise denied by the agreement. Finally, some LLC statutes may also create rights to force a dissolution, which the parties would need to expressly limit or negate in their agreement. 5 Because LLC statutes are very new, there is virtually no case law construing any of their provisions, and in fact there is relatively little case law construing comparable provisions of the partnership acts. What case authority exists in the partnership area seems to indicate that courts are willing to enforce carefully drafted provisions of partnership agreements, but such cases tend to deal with whether general principles of fiduciary duty and duties of loyalty and care will override specific provisions in the agreement and may not provide much guidance on other, more 2 See, e.g., Section of the Illinois Limited Liability Company Act, 805 ILCS 180/35-50 and 602 of the Uniform Limited Liability Company Act ( ULLCA ) on the power of a member to dissociate from the LLC, which closely parallel 602 of the Revised Uniform Limited Partnership Act ( RULPA ) regarding a general partner s power to withdraw. 3 See, e.g., Section 602(d) of the ULLCA, providing for a right of offset for damages caused by a wrongful dissociation. 4 See, e.g., Section of the Illinois Limited Liability Company Act, 805 ILCS 180/35-60, and compare 604 of RULPA. 5 See, e.g., Section 35-1 of the Illinois Limited Liability Company Act, which provides that a transferee of a member s interest (e.g., a judgment creditor of a member that executes upon such member s membership interest) may be entitled to apply to a court to force a dissolution, and in such event the company will be dissolved upon a judicial determination that it is equitable to wind up the company s business. 805 ILCS 180/35-1(5)