Joint Venture and Partner Capital Obligations in the Time of COVID-19
In the wake of COVID-19, many real estate companies are facing decreased cash flow, cost overruns, and other unanticipated delays and expenses. In this new reality, parties who own real estate through a joint venture (JV) will need to reacquaint themselves with the operating agreements that govern the same (JV Agreements). As they begin to re-evaluate their budgets, operating plans, and their partners, the individuals undertaking such evaluations will want to understand salient provisions that govern the (i) ongoing financial obligations of the parties, (ii) sponsor removal rights and (iii) exit mechanisms included in the JV Agreement. Although the four corners of the JV Agreement generally govern the rights and obligations of partners with respect to each other and the JV in general, there are various strategic and practical considerations to consider before implementing a particular course of action. As a result, a seasoned JV attorney should be consulted before any such action is implemented to avoid unintended consequences. This alert focuses on the onging financial obligations of the parties.
Capital call provisions included in JV Agreements vary widely. Some provide one partner with the unilateral right to deliver or veto a capital call, while others provide that both partners must agree upon issuing a call for additional capital.
Once a capital call is made, partners are often required to contribute such capital to the JV on a pro rata basis in accordance with their respective ownership interests. However, some JV Agreements modify such pro rata funding. For instance, some JV Agreements cap the capital exposure of certain partners, disproportionately allocate certain types of obligations on less than all of the partners (e.g., cost overruns) and if promote hurdles have been achieved, may require a reverse waterfall contribution (with or without credit in the cash waterfall).
After determining who may issue a call for additional capital and allocating responsibility for the contribution of the same, it must be determined if all partners are able and willing to make their respective required contributions and the consequences that may be imposed upon a partner that fails to satisfy its funding obligation.
CONSEQUENCES FOR FAILURE TO FUND
JV Agreements typically include one or more of the following specific remedies to encourage each partner to fund its additional capital obligations:
- Partner Loan to the JV or Non-Funding Partner – The funding partner provides debt financing to the JV, which takes priority over distributions to the partners, and the funding partner becomes a lender to the JV. This is sometimes structured as a loan to the non-funding partner, often secured by the non-funding partner's JV interest.
- Preferred Equity Contribution – Similar to a Partner Loan, the funding partner contributes the required capital, often at rate higher than the rate that accrues on common equity. Such contributions, together with any return thereon, also receives priority over other distributions. Although this is not an actual dilution of the non-funding partner's interest, if the interest rate is higher than that which accrues on common equity, this structure will have a dilutive effect.
- Dilution – The funding partner provides equity to the JV, which dilutes any non-funding partner’s ownership interest (sometimes up to 2.5x dilution). In some JV Agreements, the capital accounts and unreturned capital contributions of the non-funding partner are also diluted, which results in an immediate economic loss to the non-funding partner.
- Removal and Promote Loss – Some JV Agreements provide that a sponsor's failure to fund additional capital is a default event for which such sponsor may be removed as the operator, and may also result in a loss or a portion of its promote.
- Clawback on Fees – The JV Agreement may allow the funding partner to clawback fees previously paid to the non-funding partner or its affiliates.
- Personal Guarantees – A credit-worthy affiliate may have provided a personal guaranty backstopping certain funding obligations of a partner. This can trigger personal liability to such affiliate.
- All Other Rights and Remedies – Some JV Agreements specifically waive a funding partner's general rights and remedies available to such partner at law and in equity, and limit a partner's ability to sue a non-funding partner for damages. If these rights and remedies are not specifically waived, the funding partner may elect to bring an action against the non-funding partner for a breach of contract claim.
Both funding partners and non-funding partners should consult their attorneys to determine the consequences and penalties related to fulfilling and/or not fulling their funding obligations. A non-funding partner should understand its cure rights, arguments for force majeure or other equitable arguments under general law and other repercussions. Funding partners should be calculated in enforcing their rights during this time, and consider the long-term effects of their election.
Notwithstanding the four corners of the JV Agreement, there are other outside factors that should be taken into account in connection with the decision whether or not to contribute capital, how such additional contributions should be structured and the remedies that should be pursued against non-funding partners. These include:
- Loan Requirements – Does any course of action permitted under the JV Agreement require lender approval? For example, does a "change in control" require lender consent?
- Taxes – Are there any unintended tax consequences? Dilution that changes ownership percentages or causes a "capital shift" may cause adverse state and federal income tax, property tax and documentary transfer tax consequences.
- Fiduciary Duties – Does the election of any of the remedies discussed above violate a partner's fiduciary duties to the other partner?
- Is Another Structure More Favorable – For instance, if the project is underwater, a partner loan or infusion of preferred equity may be preferable to contributing common equity and diluting the non-contributing partner. In addition, it may be advantageous to the JV and its partners to seek third-party debt and/or equity financing to avoid the risk associated with making further contributions to the JV.
- Other Factors – The JV and its partners must also be mindful of any reputational concerns, dis-incentivizing partners, and disrupting the management and development of their projects.