by David Lewis
In the first article of this five-part series on investing in property in the United States, David Lewis, a Los Angeles attorney, provided an overview of the US market for the British investor. In the second article he looked at some of the key legal concepts that buyers and sellers should be aware of. In this article he answers some of the complex questions that can arise in real estate joint ventures between UK and US investors, with emphasis on situations where the money partner is a British investor and the “hands-on” or “sweat equity” partner is a US developer.
There is a saying that a joint venture is where the man with the money and the man with the experience trade places. While a well-drafted partnership agreement is by no means a guarantee that this unhappy outcome will not eventuate, the absence of a properly drafted agreement is always a recipe for disaster.
General partners v limited partners
A joint venture vehicle commonly used in the US is the limited partnership. Almost unheard of in the UK, limited partnerhsips do exist under English law, but having been introduced at the same time as privately held, limited companies, they never stood much chance of being widely used.
In the US limited partnerships gained prominence in the 1960s and, despite numerous changes in tax law, they are likely to remain a permanent part of the investment scene unless the double taxation of dividends (at the corporate level and in the hands of shareholders) is changed. So far there seems little likelihood that this will happen in the foreseeable future.
Simply put, in the US a limited partnership is one in which there is at least one general partner and at least one limited partner. Limited partners are so called because their liability is limited in two respects: first, liability is limited to the amount of capital invested in the partnership, contributed in full or in instalments. Second, the rights of limited partners to manage and control the partnership are severely restricted and, in many ways, are comparable to the rights of shareholders in a company. A limited partner who exceeds his or her boundary of authority runs the risk of losing limited liability status vis-a-vis third parties.
So, right from the outset, the British investor has to decide whether to be a general partner or a limited partner in the investment vehicle. For a relatively passive British partner the limited partner status may be the better choice. In less clear-cut situations, the best of both worlds can generally be obtained by structuring the partnership as a general partnership. Such an arrangement maximises the British investor’s rights of control, while a corporate subsidiary can be formed to play the role of the British general partner to obtain the benefits of limited liability. Properly structured, the disadvantages of double taxation inherent in most corporate structures can be avoided, so giving the British investor the best of all worlds.
Pre-empting disputes over control
Despite what a partnership agreement may stitpulate, a US developer may be tempted to treat his British partner merely as a lender or as a limited partner, even when the British partner is, in fact, a general partner. This situation arises because the US partner begins running the project as though it were his alone, obtaining the British partner’s approval on decisions only when thought necessary.
In a sense this is inevitable. Indeed, to a certain extent it may even be an advantage. Clearly, the day-to-day operations of a partnership cannot possibly be carried out by someone 3,000 to 6,000 miles away unless he also has a substantial US presence. On the other hand, it is understandable that the British general partner may object to the lack of discussion, consultation and general involvement.
One way to resolve this difficulty is to define “major decisions” and to require that both partners agree to the decisions as defined. Examples are sale or refinancing of the project; appointment of an architect; approval of plans; execution of significant leases; and the initiation or conduct of litigation or settlement. It should be pointed out that many of these functions may legitimately be performed by a limited partner.
Provision for the resolution of deadlocks is a must. A well-thought-out partnership agreement will include provisions for resolving them according to the stage the project has reached at the time. For example, a deadlock occurring after the project has been completed can be reasonably settled with a buy-sell agreement, discussed in more detail later. This may be advantageous for the British investor who, presumably, has access to greater funds than his American counterpart. Conversely, this type of solution is impractical until the project has been completed, owing mainly to the difficulty of valuation.
Questions of valuation aside, a British investor will seldom have the ability to step in and run the project. One solution is to require the parties to reach agreement on all major decisions which normally go into the development of a project before the parties actually purchase the land. These decisions may include preliminary and final approval of site plans, plans and specifications, and financing.
Pre-development agreements
A good way of structuring a development project is for the developer to enter into a pre-development agreement with the partnership, which sets out all the pre-development conditions which must be satisfied before the venture is funded. Such conditions may comprise completion of the permit process, approval by both sides of what is to be built, by whom and for how much and, possibly, pre-leasing requirements.
While the pre-approval period is running, the US developer should either have the site under option or otherwise tied up in a satisfactory manner. Once the partnership, acting solely through the British partner at this stage, has approved all the contingencies set out in the pre-development agreement, the partnership can then proceed with the development with, it is to be hoped, agreement on all the fundamentals.
Financing and cost overruns
Investors should beware of falling into the trap of making open-ended commitments to provide whatever finance is needed to complete a project. The British investor should limit his obligation to the provision of a specific dollar amount for the project. It is advisable from the outset to have an agreement in place to cover whatever additional construction funds need to be borrowed. Again, the parties may have very different ideas as to what is, or is not, acceptable. A useful resolution is the “beat it or eat it” principle, whereby the partner who does not like the financing package proposed by the other must accept it unless, within a given period of time, he comes up with a better deal.
Then there is the important question of cost overruns — a key item in partnership agreements. As far as a British investor is concerned, this should always be settled by requiring overruns to be paid by the developer partner, except in specified and, one hopes, unusual situations.
Cash distribution and partnership costs
Central to any partnership agreement is the manner in which profits and losses are to be allocated. Usually, although by no means universally, partnership deals are structured on a 50/50 basis. In addition, the British investor will often seek to obtain a preferred rate of return, say 10% pa, on his investment, allowing it to accumulate until available for distribution either out of operating funds, or on the refinancing or sale of the project.
However, if the British investor requires a preferred return, his American partner is bound to want his pound of flesh, too, in the form of a fee. It could be a developer’s fee, management fee, leasing fee, or some other fee that the developer’s fertile imagination can conjure up. In all fairness, however, it is not unreasonable for a developer to require a fee for his time and effort and to help cover overheads.
Provisions for cash distributions should be specified clearly. At the heart of any good partnership agreement is a detailed order of priority for distributions, with respect to both continuing operations and capital transactions, including the sale of the project. Another key issue to settle at this point is which expenses will be deemed expenses for each partner’s own account as distinct from expenses of the partnership. It is important to distinguish, for example, between the developer’s on-site expenses, which are generally charged to the venture, and his off-site expenses, including general overheads, which should be excluded from the cost of the project.
Another area often in dispute is the legal cost of preparing partnership documents. It is my view that, where the parties jointly retain one lawyer to represent the venture, legal costs are properly borne by the partnership. Where negotiations are more adversarial, each party should bear his/her own costs. Professional fees are obviously a legitimate partnership expense, so long as the beneficiary is the partnership itself.
Selling your interest
It is generally not permissible for a partner in a joint venture to sell his interest to a third party, or to do so by some back-door manoeuvre such as selling stock (if a partner is in a corporate form). The partnership agreement should also state whether either partner is to be prohibited from assigning his right to receive distributions from the partnership, as distinct from his interest in the partnership itself.
Sometimes a partner will be permitted to dispose of his interest in the partnership once the project has been completed and all the partners’ obligations have been discharged, although even here it is wise for the parties to require a right of first refusal. A properly drafted partnership agreement will also define the manner in which, if at all, additional partners may be admitted to the partnership.
The buy-sell solution
The buy-sell agreement is invariably one of the most crucial aspects of any partnership agreement. It is the ultimate recourse of the parties should they find that they are unable to continue to live with each other for any reason. The agreement commonly provides that partner A may offer his partnership interest to partner B for a price at which partner B may either (a) buy partner A’s interest, or (b) sell his own interest to partner A.
Another important question to consider is whether the partners are to have this right at any time, or only after certain events have occurred, such as completion of the project or deadlock over a major issue.
Partners often assume that value will have increased by the time the buy-sell rights are exercised. Unfortunately this is not always the case. A clear, professional buy-sell provision should cover the possibility of a negative valuation. In this situation, the buying partner will receive a payment from the selling partner, not vice versa. In return, the selling partner will be relieved of his partnership obligations to third parties, primarily the lender. Alternatively, the selling partner will receive an indemnification from his partner if the lender is unwilling to give such a release.
Defaults, rights and remedies
What happens if either party fails to live up to its obligations under the partnership agreement? Space does not permit an exploration of all possible defaults, rights and remedies which should be addressed or redressed, but one basic question in this area must be raised. If one partner fails to discharge his obligations, particularly an obligation to contribute money, is the other partner’s recourse limited to the defaulting partner’s interest in the partnership? Or is it unlimited and therefore subject to legal action? Any agreement should be clear on this point.
These examples of areas of possible dispute and how they can be resolved illustrate the importance of drawing up comprehensive partnership agreements. While what you sign is not nearly as important as who you sign it with, even those fortunate enough to be dealing with the most honest and fair-minded of partners may come to grief if they have not sat down beforehand and thought through every one of the major issues.
David Lewis is a Los Angeles-based specialist in property law and a partner in the law firm of Pircher, Nichols & Meeks.