Opportunities and Legal Risks Strategies to Negotiate and Structure the JV Operating Agreement

Transcription

1 Presenting a live 90 minute webinar with interactive Q&A Real Estate Joint Ventures: Opportunities and Legal Risks Strategies to Negotiate and Structure the JV Operating Agreement TUESDAY, OCTOBER 4, pm Eastern 12pm Central 11am Mountain 10am Pacific Td 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. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

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5 Real Estate t JVs Contributions, ti Distributions, ib ti Affiliate Agreements & Exits Strafford Webinar: Real Estate Joint Ventures: Opportunities and Legal Risks October 4, 2011 Daniel B. Guggenheim, Esq., dguggenheim@pircher.com, i h Michael D. Soejoto, Esq., msoejoto@pircher.com, Nothing herein is to be construed as legal, tax, investment, business or insurance advice. 1

6 TYPICAL CIRCUMSTANCES OF REAL ESTATE JOINT VENTURE Sponsor and Investor form entity to acquire or recapitalize a real property interest. Sponsor handles day-to-day operations and project management, and receives a carried dinterest t( (or promote ) or fees. Investor provides most or all of the capital, either pari passu or as preferred equity y( (or debt). 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). 2

7 PRE-FORMATION ISSUES: LETTERS 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., cost capitalization at closing and dead deal costs)? 3

8 INITIAL CONTRIBUTIONS: GENERALLY Various forms: cash, contract rights, real property, p debt. Timing: seed money or deposit vs. closing equity (affects funding conditions). Failure to fund closing contribution may result in additional remedies. 4

9 INITIAL CONTRIBUTIONS: TAX CONSIDERATIONS Disguised Sales is there a combination of non-cash contributions, 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? Basis is there agreement regarding the value of non-cash contributions, and an understanding of inside basis vs. outside basis? 5

10 ADDITIONAL CONTRIBUTIONS 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 overruns, contributions in excess of a cap or contributions after promote distributions)? Tax Consideration: variable contribution percentages may affect the allocation of profits and losses and may also create Fractions Rule issues. 6

11 REAL PROPERTY CONTRIBUTIONS Consider a separate Contribution Agreement. Are closing conditions necessary? Consult local tax counsel regarding potential transfer taxes or real property tax reassessment. 7

12 CAPITAL CALL LOGISTICS Sponsor typically y monitors finances, with responsibility for requesting 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. 8

13 COMMON CONTRIBUTION DEFAULT REMEDIES: GENERALLY Damages/Indemnification. Priority loans or contributions. Dilution. Change in management rights? Specific performance? 9

14 COMMON CONTRIBUTION DEFAULT REMEDIES: TAX CONSIDERATIONS Priority contributions may violate the Fractions Rule. 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 intended result depending on what is being recalculated e.g., future distributions, capital account balances, etc. 10

15 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)? 11

16 DISTRIBUTION STRUCTURES Pari passu? Preferred equity or debt? Tax advances? Are there multiple projects? Clawback? 12

17 TAX ALLOCATIONS Target accounts vs. allocation waterfalls what are they and when are 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

18 RELATED PARTY AGREEMENTS Cross-default/cross-termination with JV Agreement? Enforcement, termination and certain other matters should be handled by the unaffiliated member. Consider consolidation with the JV operating agreement. Consult with insurance expert to confirm parties expectations. Tax Consideration: incentive fee in lieu of promote? 14

19 EXIT STRATEGIES: BIG PICTURE ISSUES What s the point: liquidation or divorce? (The answer may depend on the circumstances.) What s feasible? (Consider transfer restrictions and guarantor replacement in loan documents, capital constraints t and similar il limitations such as Investor s fund documents). Timing may be everything g( (e.g., status of project, market conditions, accrued but unpaid preferred return, tax treatment). The best laid schemes of mice and men oft go awry (Have the parties waived judicial i dissolution, partition and receivership?) 15

20 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

21 TYPICAL EXIT MECHANISMS (MORE THAN ONE MAY BE USED) Buy-Sell. 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). Tag-Along/Drag-Along g g g( (less common). 17

22 VALUATION ISSUES: GENERALLY Parameters for proposals p of value (duty to be reasonable or make good 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

23 VALUATION ISSUES: TAX CONSIDERATIONS Disproportionate p exposure to capital gains on sale (e.g., if a party contributed 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

24 OTHER OVERLOOKED ISSUES WITH EXITS Disparate access to information. Opportunity to test the market. How will offers be compared? Potential pricing gamesmanship if there is preferred equity. Management and operations after exit process has commenced. For additional information about Danny Guggenheim or Mike Soejoto, or about Pircher, Nichols & Meeks, please visit 20

25 Real Estate Joint Ventures: Opportunities and Legal Risks Carey W. Smith Arnold & Porter LLP October 4,

26 Governance & Control Issues Overall Structure of JV Management Non-member manager Managing member; operating member; administrative member; general partner Board of Directors Officers Member/partner consents Consultation rights 26

27 Governance & Control Issues (cont.) Types of decisions are typically y broken down into 2 or more categories Day to day management decisions; generally the catch-all category for all decisions that are not specifically identified in another category Major 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: Arbitration for major decisions but status quo prevails for fundamental decisions Buy/sell, forced sale, or put/call may apply only if disagreement on certain disagreements such as whether to sell or refinance 27

28 Governance & Control Issues (cont.) Examples of Major Decisions Approval of budgets and business plans; defining the box in which the manager has freedom to maneuver Obtaining indebtedness on a non-recourse basis Additional capital calls (or, additional discretionary capital calls) Major leases Examples of Fundamental Decisions Admitting new members Mergers, consolidations Changing the purpose of the JV Actions that create liability under springing guaranties (e.g. voluntary bankruptcy filing) See Sample Major Decision Provisions, Section

29 Governance & Control Issues (cont.) Process for Major Decisions Who has the right to propose major decisions? Often any partner may propose; sometimes only the manager may propose. p Timeliness of response. Manager is often concerned about delay in obtaining approval for major decisions. May have deemed approval if no timely response 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 decisions. See Sample Major Decision Provisions, Section

30 Governance & Control Issues (cont.) Dispute Resolution for Major Decisions 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 mechanism See Sample Major Decision Provisions, Section

31 Allocating Financial & Legal Liabilities Liability Between/Among Partners 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. 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; often will break down liabilities into two or more categories Ordinary negligence or breach of obligations under JV agreement that are not specifically covered elsewhere Gross negligence Willful misconduct or fraud Failure to fund mandatory capital or member loans Noncompetition covenants; radius restrictions 31

32 Allocating Financial & Legal Liabilities (cont.) Liability Between/Among Partners (cont.) Recourse for breaches/defaults by manager or other members Cure period? Liability for damages often limited to actual direct damages and excluding lost profits, indirect, consequential, punitive or exemplary damages) will there e be any recourse outsde outside of the partner s interest est in this 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 damages) Reduction in voting/consent/approval rights 32

33 Allocating Financial & Legal Liabilities (cont.) Implementing the Business Deal on Allocation of Liabilities to Third Parties Scope of liabilities 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 affiliates Indemnification by joint venture Harmonize with the provisions discussed above governing liability between and among partners Relationship to provisions governing capital calls 33

34 Allocating Financial & Legal Liabilities (cont.) Implementing the Business Deal on Allocation of Liabilities to Third Parties (cont.) How to implement cross-indemnification/contribution when lenders 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 limit exposure Example See next slide re springing liability for voluntary bankruptcy 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 leases, possibly other third parties 34

35 Allocating Financial & Legal Liabilities (cont.) Significant issue in recent downturn has been the existence of springing guaranties, where recourse carveout guarantor may have springing liability for entire loan 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 voluntary bankruptcy and trigger the liability Partner that is not affiliated with guarantor could argue that manager must pursue voluntary bankruptcy based on manager s duty to the JV and its partners Mezz lender could foreclose on equity and institute a voluntary bankruptcy, exposing the guarantor to springing liability 35

36 Allocating Financial & Legal Liabilities (cont.) How can manager/guarantor g protect against these risks? JV Agreement Use Delaware entities to assure enforceability of waivers of fiduciary duties. Provide in JV operating agreement that non-managing g members waive the 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 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) 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) that t each non-managing member (or its parents) indemnifies ifi 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. 36

37 Allocating Financial & Legal Liabilities (cont.) How can manager/guarantor g protect against these risks? 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 p or direct or indirect 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- notes, 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 subordinate financing by such respective holder of such subordinate financing. 37

38 Carey W. Smith Partner Real Estate & Tax 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.