Real Estate Joint Ventures: Stress-Testing New Challenges

Clients often say that the best joint venture agreements are the ones that go in a drawer at closing and stay there until it is time to divvy up the spoils from a profitable sale.[1]

However, even when partners have a great relationship, and feel that they can count on each other to do the right thing if faced with unexpected circumstances, it is nonetheless a good idea to dust off that JV-turned-paperweight every once in a while for a reminder about the details of the partnership parameters.

Now as much as ever, in the face of recent reports assessing the risk of a recession, and related news and trends indicating potential economic headwinds such as inflation, rising interest rates, labor shortages, supply chain constraints, capital markets uncertainty and geopolitical risks, it will be helpful for sponsors and capital partners to understand their protections and exposures under their existing real estate JV agreements.

This article will address capital contributions and control, which are two of the most important concepts to consider revisiting in existing real estate JV agreements between a sponsor and a capital partner, in light of recent events and current market conditions.[2]

Before reviewing the issues, it is important to keep in mind that the relevance of any particular topic to an actual JV will depend largely upon whether the business plan for the JV contemplated any development or significant construction, and how far along the JV has progressed toward achieving its business plan.

On one hand, the partners in a JV that have undertaken a major construction project may be focused on potential cost overruns, achieving stabilization, or challenges with eventually refinancing the construction loan, or some combination of the foregoing.

And on the other hand, the partners in a JV with a stabilized project may be focused on whether to sell or hold, and refinance, and on how the capital call and clawback provisions work.

Capital Contributions

In nearly all scenarios, it is critical to understand each partner's rights and obligations in connection with capital contributions.

In what circumstances can each partner make a capital call without the other partner's approval?

Often, the sponsor's responsibilities include making capital calls, subject to the investor's approval. And sometimes an investor may have certain rights to make unilateral capital calls.

Each partner may be interested in reviewing whether either partner can make a capital call without the other partner's approval, in particular to pay nondiscretionary expenses including overruns, to make a loan balancing payment, to cover a shortfall in or lack of refinancing proceeds, or to reimburse or otherwise indemnify a partner or its affiliate that has provided a loan guaranty.

What are the consequences for a partner failing to contribute its share of a capital call?

It is common for a noncontributing partner to be subject to remedies such as subordination (e.g., by reason of a loan or a priority contribution by the contributing partner), dilution, being bought out at a discount, and, in certain circumstances, reduction or loss of promote, voting rights and management authority, and termination of collateral agreements (e.g., development management agreements, construction management agreements or property management agreements).

Each partner should understand what is at stake, including whether the potential consequences might vary based on the reason for the capital call, as part of the cost-benefit analysis in connection with any capital call.

Is there any exposure to a lender beyond the equity capital that has already been invested?

Nearly every JV utilizes financing that will require creditworthy affiliates of either or both of the partners to provide the lender with a nonrecourse carveout, also known as "bad boy," guaranty, an environmental indemnity, and, for construction loans, a completion guaranty and potentially a repayment guaranty.

Each partner should confirm the scope of each guarantor's potential liabilities to the lender under the loan documents, as well as any requirements to maintain a minimum net worth or liquidity, any rights to provide a supplemental or replacement guarantor and otherwise cure loan defaults arising from a guarantor's breach, and any restrictions on partner buyouts, exercise of removal and replacement rights, or other direct or indirect transfers, which might include dilution.

Is there any exposure to the JV or the other partner beyond the equity capital that has already been invested?

Nearly every JV is composed of single-purpose entities as the partners, which results in each partner's liability to the JV and to the other partner generally being limited to the value of its equity interest, unless otherwise agreed upon.

Many JVs include a guaranty by a sponsor affiliate in favor of the investor or the JV, which may be structured as a short-form joinder to the JV agreement, typically covering risks and liabilities arising from cost overruns, loan balancing requirements, bad conduct, prohibited competition, and clawbacks.

Less frequently, JVs may include a guaranty by an investor affiliate in favor of the sponsor or the JV, which might be structured as a contribution and indemnity agreement, typically with respect to post-closing capital commitments of the investor partner, or liabilities incurred by a sponsor affiliate as loan guarantor in excess of the sponsor's ownership percentage of such liabilities or arising from the investor's bad acts.

Each partner may wish to refresh its understanding of all loan guaranties, partnership guaranties and reimbursement and indemnification obligations, and the circumstances in which there may be exposure to any partner, including the scope of each partner's obligations to indemnify the other partner and the JV, the scope of the JV's obligations to indemnify the partners and their affiliates, and whether a capital call can be made to satisfy the JV's indemnification obligations.

Control

The general understanding is usually that the sponsor is responsible for day-to-day implementation of an approved business plan within an approved budget, subject to the investor's right to approve major decisions. But variations on that theme are common, and it is important to understand the details of the JV's governance provisions.

Whose decision prevails if the partners do not agree on a major decision, and can either partner propose a major decision?

In some instances, the investor's rights are limited to a veto power, with the sponsor controlling the proposals, and not subject to being overridden by the investor.

In other instances, though, the investor has ultimate control of the JV, including the right to propose and unilaterally approve and implement major decisions, subject to limited protections for the sponsor, such as approval over a limited subset of major decisions, protections against self-dealing or disproportionate treatment of the sponsor's economic rights by the investor, and perhaps a right to require dispute resolution or initiate an exit process in the event of certain fundamental disagreements.

Each partner should be familiar with the technicalities of who may, and who must, approve what, and when, as well as any potential consequences for failing to reach agreement.

What if the partners disagree on whether to sell or to hold and refinance a completed project?

The sponsor may wish to realize on its profits and promote, before the market cools, and reinvest its time and money in a new project with opportunistic potential upside. However, the investor may wish to hold the asset for its cash flow, and if necessary refinance into a new loan.

In practice, it is common to see some combination of an exit right and a preemptive right for each partner, for example a right to force a sale of the property after a lockout period, subject to a right of first offer or a call right in favor of the other partner, a right to elect to be bought out after a lockout period, subject to the other partner's right to elect to sell the property, or a right of first offer or a call right if the other partner elects to force an exit.

Less common, but still prevalent, a JV agreement may provide a buy-sell procedure.

Often the exit and preemptive rights will include detailed provisions in the JV agreement regarding the following, potentially with further limitations under the loan documents: an appraisal or other process to determine the value of the property or a partner's interest for purposes of a buyout; replacing, releasing or ratifying loan guaranties, and related indemnifications from creditworthy affiliates when lender releases are not obtained; and earnest money deposits, escrow closing, and closing documentation and calculations.

Regardless of whether one partner can control the decision, if there might be misalignment around whether to sell or hold, the best approach may for the partners be to work toward a negotiated resolution that takes into account the actual considerations at the time, with a mutual understanding of each partner's specific rights under the applicable provisions of the JV agreement to frame the discussion.

What if the partners are not getting along, and there is a dispute regarding implementation of a decision that was contentious or contested?

It is generally understood that the sponsor has the authority to act for the JV, in order to implement decisions that do not require or have already received the investor's approval.

It is also generally understood that the investor typically has the right to remove and replace the sponsor as day-to-day manager in certain circumstances, subject to any conditions under the loan documents, often including the need to provide a replacement guarantor, but there may be a significant period of time between when that process is initiated and when it becomes effectives, which should be taken into account if it might be relevant.

In some instances, the investor may also have the authority to act for the JV, prior to having assumed responsibility for day-to-day management, if it has the right to do so. For example many capital partners learned this lesson after the last downturn and updated their JV forms to include the ability to unilaterally deal with third parties on behalf of the JV in some or all events (e.g., by the investor being designated as a general partner or a managing member in the JV agreement).

If the partners are not agreeing on a major decision or there is otherwise an issue with implementing a decision, each partner should consider the circumstances in which it is required and permitted to act for the JV, and be aware of the potential challenges relating to organizational formalities that may be lurking in the JV agreement, such as noticed meetings, certified resolutions, multiple signatories, or notice and cure periods before self-help rights may be exercised.

Despite the potential for upcoming challenges, we hope that partners in real estate JVs are able to communicate effectively with an understanding of their JV agreements in order to achieve the best possible outcomes for their projects.

This blog was originally published on Law360.

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