The Breakdown of a Real Estate Joint Venture: Negotiating Divorce During Courtship

New York Law Journal | June.26.2017

One of the toughest discussions that any couple can have is what will happen upon a breakdown of their relationship. Likewise, negotiations concerning the collapse of real estate joint ventures are among the most vexing, contentious and emotional—particularly in connection with the removal of the real estate operator from its role as the manager of the JV by the investor member(s) in the event of non-performance or "bad boy" acts.

Though difficult, recent events and common sense militate for clear language in the JV agreement concerning the right of the investor member to remove the manager in such circumstances.

This isn't just abstract legal mumbo jumbo. As a recently reported episode in the New York real estate community illustrates, getting the operator removal provisions right is critical. In early 2017, it was reported that prominent developer Michael Shvo no longer had any control over the direction of the development of 125 Greenwich Street and that, while he would retain his (less than 10 percent) equity stake, at the end of the day he would get a check and that's all. This came a short time after Shvo was indicted for allegedly scheming to evade the payment of more than $1 million in taxes and it was reported that the indictment had been a source of concern for lenders on the project. This column has no firsthand insight into these reported facts. But it seems plausible that as a result of Shvo's indictment and perhaps the consequent difficulty in obtaining financing and other adverse consequences to the project, he was removed from the management of the project by the investor(s), resulting in a loss of what is known as the "Promote," a key factor in investment return (discussed below). Though it may have actually played out differently, one can assume that the investor(s) would have at least wanted to have the right to remove Shvo as a means to safeguard its investment.

Real estate joint ventures with operators skilled in the local market or property type serve as the primary method through which institutional capital invests in real estate. Institutional capital invests in the JV through a non-managing investor that typically provides the majority of equity. The operator identifies the investment opportunity, prepares and executes the business plan and has day-to-day responsibility over the real estate (for which it is compensated with an investment return greater than its pro rata share of profits based on the performance of the investment (the Promote) and, often, an additional income stream from service contracts with affiliates).

In the event that the operator defaults under the JV agreement or otherwise commits a "bad boy" act, the investor will want the right to act swiftly to protect its investment, which protection may include (1) removal of the operator as manager and (2) minimizing or extinguishing the operator's right to the Promote and other income. Conversely, the operator will want to protect its right to the Promote and other income (as well as its reputation) by (x) seeking notice and cure rights, (y) restricting the definition of removal events (i.e., making sure no accidental mishap could lead to a removal event) and (z) strongly arguing against any Promote loss.

To show how this tension plays out in a real world joint venture negotiation, below are certain typical removal events and arguments related to their application:

Operating Agreement Default. Parties recognize that the investor is entitled to remove the operator in the event of a default under the JV Agreement (and often under any affiliate agreement). However, because of the severity of removal, for most defaults the investor will agree to substantial cure periods. Operator defaults for which there are no cure periods may include (1) the occurrence of an event of default under loan documents triggered by a bad act of the operator (since the investor may be in a race against time to prevent lender's exercise of remedies) and (2) failure by the Operator to make consecutive required capital contributions.

Significant Removal Events. In most JV agreements, the investor will insist upon including a set of "bad boy" acts that are so egregious that (1) they are typically not subject to any notice and cure period prior to investor's exercise of its rights and (2) the economic penalties may be more severe. These defaults include typical "non-recourse carve out" type defaults as well as unrelated acts which could cause reputational or actual damage to the investor (through its association with the operator) or the real property. These may include:

- Criminal Activity. The investor will want the right to remove the operator for certain criminal activity. Some investors will insist upon the removal right vesting upon the arrest of certain principals of the operator while others will have an indictment or conviction standard. This leads to what I refer to as the "What if" discussion—with operators seeking clarification about what would happen if they were arrested/indicted for criminal activity unrelated to their business operation such as DUI or crimes of passion. Depending on their sensitivities, certain investors are willing to mitigate the blanket prohibition by adding language like: "arrest or indictment on felony charges or any criminal charges involving fraud, dishonesty or moral turpitude …" or "conviction of a felony that involves dishonesty, breach of trust or a crime involving grave infringement of the moral sentiment of the community … ."

- Fraud, Theft, Misappropriation. Investors will often concede removal rights for such bad acts if caused by non-management employees provided that (1) the employee was not working upon the authorization of management, (2) full restitution is made to the venture and (3) the employee is removed from any involvement in the project.

- Others. Other events that can trigger a Significant Removal Event can include (1) a "Key Man" event (with possible replacement/cure rights), (2) voluntary and involuntary bankruptcy events, (3) taking certain material actions without obtaining the investor's "major decision" approval, (4) prohibited transfer and (5) gross negligence or intentional misconduct which has a material adverse effect.

In the event that the investor elects to remove the operator as the manager, then some of the following may result:

Managing Member. Investor may become the managing member or appoint a new manager of the JV.

Control. Typically, the former operator becomes a non-managing member with no control or major decision rights. However, investors are typically willing to provide operator with some limited consent rights to protect its investment or any lingering guarantees provided by the operator (including bankruptcy, affiliate transactions and modifications to corporate documents).

Promote Loss. Since the operator is no longer managing the project, the investor's position may be that the operator shall no longer be entitled to any Promote (particularly since investor may need to incentivize a replacement manager with a Promote). The operator's position will be that it created the investment opportunity and created value through the date of its termination and is therefore entitled to all or a portion of the Promote. A common compromise is for the operator (1) in the case of an Operating Agreement Default, to remain entitled to the Promote that it would have received had the real estate been sold as of the date of the occurrence of the default, and (2) in the case of a Significant Removal Event, to lose any right to any Promote whatsoever. Notwithstanding the foregoing, the operator retains its right to a pari passu return based on its equity investment.

Affiliate Contracts. Investor will typically terminate the service contracts with operator's affiliates, having the effect of cutting off additional fee income to operator as well as day to day engagement in the project through it service provider role.

Other Rights. Operator may lose other rights under the JV agreement including with respect to exit mechanisms (buy/sell, forced sale, etc.).

As the Shvo situation above demonstrates, while it is certainly difficult to discuss divorce during the courtship, JV partners are well advised to develop a clear understanding of what happens when the operator's behavior endangers the real estate project and the investor's investment therein.

Marshall Brozost is head of Orrick, Herrington & Sutcliffe's New York real estate practice.

Reprinted with permission from the June 26, 2017 issue of New York Law Journal © 2017 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.