By Douglas J. Lubelchek, Partner at Neal, Gerber & Eisenberg LLP
Often, a local real estate developer or operator identifies a great piece of property that can be developed and/or operated for a use that is sorely needed in the area, but doesn’t have the funds or borrowing capacity to undertake the project alone. On the other hand, real estate funds and real estate investment trusts often have plenty of cash to invest and are seeking a real estate investment providing a target return, but often do not have the appetite to take on the entire risk of the project or do not have the infrastructure needed in the local area to deal with the project on a daily basis.
The previous scenario can be a perfect situation for the parties to form a joint venture to acquire, finance, develop and operate the project. A joint venture is typically formed as a limited liability company, or in certain circumstances, a limited partnership, between the parties to jointly own, develop, finance and operate the project.
Each party makes a contribution of equity to the joint venture, but the expectation is that the “money partner” will contribute a majority of the equity while the other party will undertake (in return for additional compensation above and beyond its percentage share of the profits based on relative equity contributed) the daily responsibilities related to the project.
Although all parties hope for a great relationship, what happens if the developer does not properly perform its duties under the joint venture agreement? Most joint venture agreements address this very realistic possibility by including provisions which give the non-managing member a right to remove the managing member from such role and provide for certain negative ramifications to the managing member if removal occurs.
This article discusses some of the events which should entitle a non-managing member to remove the managing member from such role and potential ramifications to the members that can be included in the joint venture agreement as a result of a removal.
There are a number of events that can be included in a joint venture agreement that trigger a right of the non-managing member to remove the managing member for cause due to the acts or omissions of the managing member.
(A) The occurrence of certain defaults by the managing member under the joint venture agreement.
A default can consist of something as broad as failing to generally comply with the duties imposed on the managing member under the joint venture agreement or something as narrow as failing to provide a particular financial report on a timely basis.
In negotiating which defaults should trigger a removal right, the parties will need to determine if there should be a materiality standard, any notice and cure period or any specific defaults which do not rise to the level of justifying a removal.
Joint venture agreements often contain arbitration provisions if the managing member disputes the existence of a default claimed by the non-managing member (pending which either the managing member can be given the right to continue in such role, or a third party can be designated to serve such function pending resolution of the dispute.)
(B) Fraud, negligence, misappropriation of funds, willful misconduct or criminal misconduct by the managing member.
Many managing members resist being removed if the bad act is undertaken by an employee of the managing member that is not a senior employee or principal member of the managing member (such as an on-site property manager or in house bookkeeper). Accordingly, many joint venture agreements provide that this type of act can be cured, and not result in a removal right, if the managing member makes the joint venture whole in connection with any loss suffered as a result of the bad act and/or the offending employee is removed from any involvement in the project or venture.
Other events that can trigger the removal of a managing member include when certain insolvency events affecting the managing member occur, or if certain key personnel or principals of the managing member, whose expertise and experience the non-managing member has relied on, no longer serve an active role on behalf of the managing member for any reason.
In the event that a removal event occurs and the non-managing member elects to remove the managing member from its role, then some or all of the following may be included in the joint venture agreement to automatically occur upon removal:
• The managing member no longer has the right or obligation to perform the duties of the managing member under the joint venture agreement and also may (or may not) lose the right going forward to participate in any decisions of the joint venture otherwise requiring such member’s consent.
• Any right to promote distributions (i.e. preferential distributions in excess of a pro rata share based on the members’ percentage interests in the venture) to which the managing member may be entitled is eliminated on a going forward basis.
• Any right of the managing member or an affiliate to compensation such as asset management fees and property management fees (whether pursuant to the joint venture agreement or a separate agreement) is terminated and any agreements between the joint venture and the managing member are terminated (with the non-managing member having the right to engage a replacement on behalf of the joint venture.)
• The managing member’s percentage interest in cash flow and capital proceed distributions is diluted.
• Any restriction on the non-managing member’s right to compete with the joint venture is terminated.
• The non-managing member may lose other rights, such as the right to initiate a buy/sell or other exit mechanisms.
• Distributions which otherwise would be due to the non-managing member may be used to offset any losses to the joint venture caused by the managing member.
• A call right in favor of the non-managing member to acquire the managing member’s membership interest (which can be based on an appraisal and may include a discount factor or some other formula agreed upon in advance) is triggered.
Entering into a joint venture can be a very useful mechanism for investors and developers to undertake projects that they cannot or do not wish to undertake alone. However, it is crucial to understand up front what will happen if the managing member fails to perform its required duties. The parties should carefully consider and negotiate under which circumstances a managing member can be removed from such role and what happens after removal. These provisions are often the most hotly negotiated provisions in a joint venture agreement since the non-managing member’s achievement of its desired return is largely reliant on the managing member’s operation of the project, and the managing member’s reason for undertaking the project is largely induced by the compensation it expects to receive for serving in such role. Douglas J. Lubelchek is a partner at Neal, Gerber & Eisenberg LLP (Chicago). He practices in the firm’s Real Estate practice where he represents clients involved in complex real estate and finance transactions, including developers, real estate investment trusts and banks. Lubelchek can be reached at firstname.lastname@example.org.