Perhaps the most visceral concept in real estate joint venture (REJV) sponsorship is to contemplate ‘for cause removal’ – the guillotine of REJVs. These provisions, embedded in a joint venture operating agreement, warrant your team’s focused attention, as they can significantly impact the control and success of the venture. A thorough understanding of these provisions is crucial, as they set the framework for actions when issues arise.
‘Bad Acts’ as Grounds for Removal
REJVs are typically overseen by the sponsor, who acts as the operating or managing member of the JV LLC. However, if the sponsor commits ‘bad acts’, the capital investing member holds the power to remove the sponsor from this position for cause. What exactly are these ‘bad acts’? They are broadly similar to those identified in a mortgage loan’s recourse carve-out guaranty. In the JV context, they expand and vary based on deal size, relative bargaining leverage, market niche, and other factors. Generally, ‘bad acts’ can be grouped into three categories, depending on the market’s complexity.
Lower Market
At the shallow end of the market, where it shifts from JVs to syndications, the ‘LPs’ may have few, if any, grounds to remove the sponsor from day-to-day control of the venture. The reasons for removal may be limited to fraud, felonies, and material willful misconduct. These terms may be left undefined or narrowly defined, while relevant procedural provisions may favor the sponsor. For example, the JV operating agreement may state that a ‘bad act’ cannot result in removal until it is conclusively determined by a court, giving the sponsor a credible threat to delay or escalate a dispute for leverage.
Middle Market
Further upmarket, in middle-market JVs, the list of ‘bad acts’ typically expands to include gross negligence and garden-variety defaults that materially harm the investor. Procedurally, provisions such as notice and cure rights, dispute resolution protocols, and other relevant procedures are more detailed and tailored to the specific facts and asset class involved.
Upper Market
At the upper end of the market, institutional investors’ JVAs are often comprehensive, with extensive provisions exhaustively defining bad acts and their consequences in detail. These can include removal and sometimes forfeiture of promote or membership interest. The list of ‘bad acts’ typically extends into double digits, covering defaults in affiliate agreements, debt documents, and even performance tests. As the venture progresses toward a redemption date, the JV increasingly resembles ‘hard’ preferred equity in its structure and pricing.
Conclusion
In certain situations, a respected vertically integrated sponsor and an institutional capital partner may agree on a nuanced approach to ‘bad acts’ based on the roles of different actors within the sponsor’s organization and affiliates. An example of this is actions by sponsor principals or key people that may trigger immediate and unconditional removal, while acts by executive-level employees are potentially curable by terminating the employee and making the investor whole.
Context is critical, as development and programmatic JVs have their own sets of ‘bad acts’ to consider. Further, co-GP deals introduce another level of complexity. At A.Y. Strauss, we handle them all as part of our regular practice, and we’re always ready to assist in navigating the nuances of any joint venture with expertise.