During challenging economic times, investors in real estate joint ventures need to be creative and flexible when considering strategies to preserve the viability of the venture and its projects. This is especially true when it comes to deciding if and how additional capital should be raised, if that becomes necessary to see the venture through difficulty.
Typically, a real estate joint venture raises capital through equity contributions by the venture members, debt financing provided by third-party lenders, or some combination of equity and debt. In a capital-constrained environment, obtaining additional third-party financing for a struggling real estate joint venture may be difficult, if not impossible. As a result, the joint venture members themselves may be the only feasible source of additional capital. However, the ability or willingness of the venture members to place additional capital at risk may vary. For example, it is not uncommon for the members to agree that additional capital is both necessary and desirable but for one of the members to be unable to contribute its share. In those instances, to induce the financially capable member to provide all of the needed capital, the members must agree upon the manner by which that member is sufficiently compensated to induce it to take on the entirety of the economic risk associated with the new investment.
There are any number of possible approaches, depending on the particular circumstances of the joint venture and its members. These approaches tend to fall into several broad categories, including preferred equity, where the financially capable member provides a new class of equity to the joint venture that enjoys a priority return over the existing equity or adjustments to the members' relative interests based on the amount of the new capital in comparison to the existing capital. Note that some joint venture agreements describe 'company loans' or 'member loans,' which can be made by the contributing member to cover both its capital contribution and that of its non-contributing partner. Commonly, attributes of traditional third-party loans are not attributed to these 'loans' because they typically do not include collateral and often are not separately documented using loan documents. Such 'loans' have the attributes of preferred equity and are not the subject of this article.
Another possible approach is for the financially capable member to provide the additional capital in the form of a loan to, rather than an equity investment in, the joint venture. The potential lending member may perceive the advantages of priority and additional remedies typically afforded to debt over equity to be sufficient motivation to induce it to make the loan. However, an investor considering acting as a lender to a joint venture of which it is also a member should be aware that there are risks associated with that type of loan that do not attach to third-party loans.
For example, if notwithstanding the injection of the new capital, the joint venture continues to have problems, there is the risk that the venture may eventually be forced into bankruptcy. Once a joint venture is in bankruptcy, a lender that is also a member of the venture runs two primary risks. The first is recharacterisation, where the court determines that the debt should be treated as if it were equity. The second is equitable subordination, where the court allows the claim to be treated as debt but requires that the debt be subordinated to the claims of unaffiliated third-party creditors.
If a bankruptcy court recharacterises a lending member's claim of debt and instead treats it as equity, the lending member's claim will be treated on a par with the equity in the joint venture. That result would be highly detrimental to the lending member because equity contributions are typically repaid only after satisfaction of all other obligations, which in most cases means the equity is wiped out.
In making a determination whether or not to recharacterise debt into equity, the court will examine a number of factors, among them whether the purported loan was made at arm's length, and the formality of the loan documents. Factors that would be considered include whether there is a promissory note and other standard documentation; whether standard loan terms apply such as a fixed maturity date, a fixed payment obligation and a stated rate of interest; whether there is security for the loan; whether the debtor was adequately capitalised for its foreseeable obligations at the time the loan was made; whether a reasonable third-party lender would have made the same loan; whether the loan by its terms is subordinated to other claims against the venture; and the exact nature of the relationship between the lending member and the joint venture, particularly the amount of control the lending member has over the venture.
Even if the bankruptcy court determines that the lending member's claim should retain its character as debt, there is still a danger that the lending member's claim will be subordinated to the claims of other creditors through the doctrine of equitable subordination. A creditor seeking equitable subordination of another creditor's claim typically must show inequitable conduct by the second creditor that resulted in injury to the first creditor or an unfair advantage to the second creditor. Although egregious conduct such as fraud or misrepresentation is usually required for a finding of inequitable conduct, courts have applied a stricter standard to an insider who owes a fiduciary duty to the debtor.
As a participant in the joint venture, a lending member is likely to be deemed an insider. Thus, the application of the more rigorous standard should be expected. Under the insider standard, a breach of fiduciary duty, the undercapitalisation of the debtor or control of the debtor by the lending member has, in certain circumstances, been considered enough to warrant causing the lending member's loan to be equitably subordinated to other creditors' claims.
Finally, there is the general risk that an investor making a loan to a joint venture in which it is also a member will be found to have violated a fiduciary duty, the lending member may have to the venture or its other members. Such a finding could be relevant not only in a bankruptcy equitable subordination analysis as noted above but also could arise independent of bankruptcy. As an example, a lending member may be found to have fiduciary duties to the venture and the other members if the lending member is involved with the day-to-day operations of the venture, or is found to be in control of the venture. As a member of the venture, the lending member may also have a fiduciary duty to not take unfair advantage of the venture or its members. Thus, an investor contemplating making a loan to a joint venture of which it is also a member should take care not to violate its fiduciary duties, regardless of how likely it is that the venture will declare bankruptcy.
There are things an investor contemplating making a loan to a joint venture in which it is a member can do to attempt to minimise the risks associated with doing so. Some of these precautionary steps include:
- Amending the joint venture's governing agreement to the extent necessary to confirm the power of the lending member to deal at arm's length with the venture.
- Amending the joint venture's governing agreement to the extent necessary to limit any fiduciary duty that the lending member may have to the venture or the other members with respect to the loan transaction.
- Arranging for an independent underwriting analysis to ensure that the proposed lending transaction meets prudent third-party lending criteria.
- Obtaining security for the loan, preferably in the form of a first priority lien upon the assets of the joint venture or, alternatively, identifying a solid source of repayment.
- Obtaining a loan policy of title insurance with special protection covering the lender's status as a member of the venture.
- Utilising standard and customary third-party loan documents.
- Ensuring that the loan terms and documents are negotiated and approved on behalf of the joint venture exclusively by the non-lending member of the venture.
- Throughout the life of the loan, the lending member should not participate in any decisions or control any action of the joint venture with regard to the loan.
In conclusion, a member considering lending money to a joint venture in which it participates should consider the potential risks. Each individual circumstance will be unique and there is no 'one size fits all' approach. This article serves only as a cautionary note and does not address all of the potential risks. Nor does this article suggest all of the mitigating measures that could potentially result in a member loan being a viable alternative to address a joint venture's additional capital needs. Each individual situation should be carefully analysed in light of its own special circumstances and compared to other potential alternatives, such as preferred equity or adjustments of the members' relative interests, to determine if a member loan is the best alternative.
John Kuhl and Amy Wells are partners in the Century City, California, office of Cox Castle & Nicholson LLP. Both specialise in advising institutional investors.
This article first appeared in The Institutional Real Estate Letter – North America (October 2010, Volume 22, Number 9, Pages 49-50). For more information, please visit www.irei.com