LSI 2010 Real Estate Joint Ventures conference materials.pdf
LSI 2010 Real Estate Joint Ventures conference materials.pdf
LSI 2010 Real Estate Joint Ventures conference materials.pdf
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L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong><br />
and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Copyright <strong>2010</strong> by Law Seminars International
Featuring Speakers From:<br />
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Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong><br />
<strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Webcasting<br />
now available!<br />
-Attend from anywhere-<br />
Current challenges, strategies and opportunities<br />
February 8 & 9, <strong>2010</strong><br />
Seattle, Washington<br />
Renaissance Seattle Hotel<br />
Credits: <br />
Quick when/where: <br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds Conference<br />
February 8 & 9, <strong>2010</strong> | Seattle, Washington<br />
Renaissance Seattle Hotel<br />
Yes!<br />
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800 Fifth Avenue, Suite 101, Seattle, WA 98104<br />
tel (206)567-4490 or (800)854-8009<br />
fax (206)567-5058 | www.lawseminars.com<br />
10REJVWA WS
Monday, February 08, <strong>2010</strong><br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds Conference<br />
8:00 Registration and Continental Breakfast<br />
8:30 Introduction and Overview<br />
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8:45 State of <strong>Real</strong> <strong>Estate</strong> and Mortgage Markets<br />
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9:30 Economics of <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong><br />
10:45 Break<br />
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11:00 Key Business Terms in <strong>Joint</strong> Venture Operating<br />
Agreements<br />
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12:00 Lunch (on your own)<br />
1:15 Mock Negotiation of a <strong>Joint</strong> Venture Agreement<br />
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2:15 Partnership Taxation<br />
3:15 Break<br />
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3:30 Large-scale Residential Development in Public/<br />
Private Partnership<br />
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5:00 Adjourn Day 1<br />
About the Conference<br />
LAW SEMINARS<br />
INTERNATIONAL<br />
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www.lawseminars.com
Tuesday, February 09, <strong>2010</strong><br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds Conference<br />
8:00 Continental Breakfast<br />
8:30 State of Equity Capital Markets<br />
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9:15 Key Economic Terms in a <strong>Real</strong> <strong>Estate</strong> Fund<br />
10:15 Break<br />
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10:30 Key Legal Issues in <strong>Real</strong> <strong>Estate</strong> Fund Formation<br />
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11:00 Taxation of Carried Interests<br />
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11:45 Securities Law Issues in Fund Formation and<br />
Sponsorship<br />
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12:30 Lunch (on your own)<br />
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1:45 Dealing with an Established <strong>Real</strong> <strong>Estate</strong> Fund<br />
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3:00 Exit Strategies from Funds and <strong>Joint</strong> <strong>Ventures</strong><br />
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4:00 Evaluations and Adjourn<br />
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Upcoming Related Seminars:<br />
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See more at lawseminars.com<br />
Registration & Other Conference Information<br />
To Register:<br />
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Tuition: <br />
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Substitution & Cancellation:<br />
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Seminar Location: <br />
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Continuing Education Credits:<br />
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If You Cannot Attend:
John W. Hanley, Jr.,<br />
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Steven L. Wood, <br />
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Rodney A. Bench, <br />
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Tracy B. Edgers, <br />
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Hal Ferris, <br />
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Gregory K. Johnson, <br />
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Quentin Kuhrau,<br />
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Faculty: <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds Conference February 8 & 9, <strong>2010</strong><br />
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Stephen P. Latimer, <br />
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Erin Joyce Letey, <br />
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Joseph P. McCarthy, <br />
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David E. Myre, Jr.,<br />
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Jane Rakay Nelson, <br />
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John Orehek,<br />
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Matthew G. Paddock, <br />
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John M. Parker, <br />
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Thomas J. Parkes, <br />
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Donald E. Percival, <br />
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Preston R. Sargent, <br />
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Tom Tierney,<br />
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Brian Todd,<br />
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James E. Wreggelsworth,<br />
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Gary A. Young <br />
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Andrew H. Zuccotti, <br />
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Seattle, Washington<br />
Renaissance Seattle Hotel<br />
515 Madison St.<br />
(206) 583-0300<br />
Who Should Attend:<br />
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You Will Learn About:<br />
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To Register:<br />
Mail<br />
800 Fifth Ave., Suite 101<br />
Seattle, WA 98104<br />
Phone<br />
(206) 567-4490<br />
or (800) 854-8009<br />
Fax<br />
(206) 567-5058<br />
Email<br />
registrar@lawseminars.com<br />
www.lawseminars.com
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong>, in Seattle, WA<br />
Table of Contents<br />
Topic Speaker #<br />
Introduction and Overview<br />
John W. Hanley, Jr. 1<br />
State of <strong>Real</strong> <strong>Estate</strong> and Mortgage Markets<br />
Steven L. Wood 2<br />
Tracy B. Edgers 3<br />
Economics of <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong><br />
Steven L. Wood 4<br />
Gregory K. Johnson 5<br />
Key Business Terms in <strong>Joint</strong> Venture Operating Agreements<br />
Preston R. Sargent 6<br />
Joseph P. McCarthy 7<br />
Mock Negotiation of a <strong>Joint</strong> Venture Agreement<br />
Thomas J. Parkes 8<br />
David E. Myre, Jr. 9<br />
Partnership Taxation<br />
Jane Rakay Nelson 10<br />
Brian Todd 11<br />
Large-scale Residential Development in Public/Private Partnership<br />
Andrew H. Zuccotti 12<br />
John W. Hanley, Jr. 13<br />
Tom Tierney 14<br />
Gary A. Young 15<br />
Page 1 of 2<br />
800 Fifth Avenue, Suite 101, Seattle, WA 98104 | 206 567 4490 | 800 854 8009 | fax 206 567 5058<br />
www.lawseminars.com
Table of Contents<br />
Topic Speaker #<br />
Large-scale Residential Development in Public/Private Partnership<br />
Hal Ferris 16<br />
State of Equity Capital Markets<br />
John M. Parker 17<br />
Key Economic Terms in a <strong>Real</strong> <strong>Estate</strong> Fund<br />
Quentin Kuhrau 18<br />
Key Legal Issues in <strong>Real</strong> <strong>Estate</strong> Fund Formation<br />
Taxation of Carried Interests<br />
Securities Law Issues in Fund Formation and Sponsorship<br />
Dealing with an Established <strong>Real</strong> <strong>Estate</strong> Fund<br />
Rodney A. Bench 19<br />
John W. Hanley, Jr. 20<br />
James E. Wreggelsworth 21<br />
Erin Joyce Letey 22<br />
John Orehek 23<br />
Matthew G. Paddock 24<br />
Exit Strategies from Funds and <strong>Joint</strong> <strong>Ventures</strong><br />
Stephen P. Latimer 25<br />
John W. Hanley, Jr. 26<br />
Donald E. Percival 27<br />
Page 2 of 2
Faculty<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Mr. Rodney A. Bench<br />
RA Bench, Inc.<br />
1301 Fifth Avenue<br />
35th Floor<br />
Seattle, WA 98101<br />
T: (206) 682-7803 F: (206) 682-6526<br />
Email: rbench@rabench.com<br />
Mr. Hal Ferris<br />
Spectrum Development Solutions LLC<br />
1191 Second Avenue<br />
Suite 1500<br />
Seattle, WA 98101<br />
T: (206) 399-4302 F:<br />
Email: hal@spectrumdevsolutions.com<br />
Mr. Gregory K. Johnson<br />
Wright Runstad & Company<br />
1201 Third Avenue<br />
Suite 2700<br />
Seattle, WA 98101-3221<br />
T: (206) 447-9000 F: (206) 223-8791<br />
Email: gjohnson@wrightrunstad.com<br />
Mr. Stephen P. Latimer<br />
ING Clarion Partners<br />
1420 Fifth Avenue<br />
Suite 2020<br />
Seattle, WA 98101<br />
T: (206) 622-9200 F:<br />
Email: steve.latimer@ingclarion.com<br />
Mr. Tracy B. Edgers<br />
Wells Fargo Bank<br />
999 Third Avenue, 14th Floor<br />
MAC P6540-146<br />
Seattle, WA 98104<br />
T: (206) 292-3431 F: (206) 292-3883<br />
Email: tracy.b.edgers@wellsfargo.com<br />
Mr. John W. Hanley, Jr.<br />
Davis Wright Tremaine LLP<br />
1201 Third Avenue<br />
Suite 2200<br />
Seattle, WA 98101-3045<br />
T: (206) 757-8262 F: (206) 447-0849<br />
Email: JohnHanley@dwt.com<br />
Mr. Quentin Kuhrau<br />
Unico Properties LLC<br />
1215 Fourth Avenue<br />
Suite 600<br />
Seattle, WA 98161<br />
T: (206) 628-5050 F: (206) 628-5067<br />
Email: quentink@unicoprop.com<br />
Ms. Erin Joyce Letey<br />
Riddell Williams P.S.<br />
1001 Fourth Avenue<br />
Suite 4500<br />
Seattle, WA 98154<br />
T: (206) 389-1585 F: (206) 389-1708<br />
Email: eletey@riddellwilliams.com<br />
800 Fifth Avenue, Suite 101, Seattle, WA 98104 | 206 567 4490 | 800 854 8009 | fax 206 567 5058<br />
www.lawseminars.com
Faculty for <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds (con't)<br />
Mr. Joseph P. McCarthy<br />
Stoel Rives LLP<br />
600 University Street<br />
Suite 3600<br />
Seattle, WA 98101<br />
T: (206) 386-7534 F: (206) 386-7500<br />
Email: jpmccarthy@stoel.com<br />
Ms. Jane Rakay Nelson<br />
Lane Powell PC<br />
1420 Fifth Avenue<br />
Suite 4100<br />
Seattle, WA 98101-2375<br />
T: (206) 223-6249 F:<br />
Email: nelsonj@lanepowell.com<br />
Mr. Matthew G. Paddock<br />
Metzler North America<br />
700 Fifth Avenue<br />
Suite 6175<br />
Seattle, WA 98104-5071<br />
T: (206) 623-2700 F: (206) 623-4864<br />
Email: mpaddock@metzlerna.com<br />
Mr. Thomas J. Parkes<br />
Foster Pepper PLLC<br />
1111 Third Ave<br />
Suite 3400<br />
Seattle, WA 98101-3264<br />
T: (206) 447-8984 F:<br />
Email: parkt@foster.com<br />
Mr. Preston R. Sargent<br />
Kennedy Associates <strong>Real</strong> <strong>Estate</strong><br />
Counsel, LP<br />
1215 Fourth Avenue<br />
Suite 2400<br />
Seattle, WA 98161-1085<br />
T: (206) 623-4739 F: (206) 682-4769<br />
Email: PrestonS@kennedyusa.com<br />
Mr. David E. Myre, Jr.<br />
Hillis Clark Martin & Peterson, P.S.<br />
1221 Second Avenue<br />
Suite 500<br />
Seattle, WA 98101-2989<br />
T: (206) 623-7789 F:<br />
Email: dem@hcmp.com<br />
Mr. John Orehek<br />
Security Properties<br />
1201 Third Ave<br />
Sutie 5400<br />
Seattle, WA 98101-3031<br />
T: (206) 628-8053 F:<br />
Email: johno@secprop.com<br />
Mr. John M. Parker<br />
Kennedy Associates <strong>Real</strong> <strong>Estate</strong><br />
Counsel, LP<br />
1215 Fourth Avenue<br />
Suite 2400<br />
Seattle, WA 98161-1085<br />
T: (206) 623-4739 F: (206) 682-4769<br />
Email: JohnP@kennedyusa.com<br />
Mr. Donald E. Percival<br />
Davis Wright Tremaine LLP<br />
1201 Third Avenue<br />
Suite 2200<br />
Seattle, WA 98101-3045<br />
T: (206) 757-8264 F:<br />
Email: donaldpercival@dwt.com<br />
Mr. Tom Tierney<br />
Seattle Housing Authority<br />
PO Box 19028<br />
Seattle, WA 98109-1028<br />
T: (206) 615-3500 F: (206) 615-3504<br />
Email: ttierney@seattlehousing.org<br />
Faculty Page 2 of 3
Faculty for <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds (con't)<br />
Mr. Brian Todd<br />
Davis Wright Tremaine LLP<br />
1201 Third Avenue<br />
Suite 2200<br />
Seattle, WA 98101-3045<br />
T: (206) 757-8157 F: (206) 757-7157<br />
Email: briantodd@dwt.com<br />
Mr. James E. Wreggelsworth<br />
Davis Wright Tremaine LLP<br />
1201 Third Avenue<br />
Suite 2200<br />
Seattle, WA 98101-3045<br />
T: (206) 757-8174 F: (206) 757-7174<br />
Email: jimwreggelsworth@dwt.com<br />
Mr. Steven L. Wood<br />
Century Pacific, LP<br />
1201 Third Avenue<br />
Suite 1680<br />
Seattle, WA 98101<br />
T: (206) 757-8891 F: (206) 689-7210<br />
Email: stevenwood@dwt.com<br />
Mr. Gary A. Young<br />
Polygon Northwest Company<br />
11624 SE Fifth Street<br />
Suite 200<br />
Bellevue, WA 98005-3590<br />
T: (425) 586-7700 F:<br />
Email: gary.young@polygonhomes.com<br />
Mr. Andrew H. Zuccotti<br />
K&L Gates LLP<br />
925 Fourth Avenue<br />
Suite 2900<br />
Seattle, WA 98104-1158<br />
T: (206) 370-6680 F: (206) 623-7022<br />
Email: andrew.zuccotti@klgates.com<br />
Faculty Page 3 of 3
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Introduction and Overview<br />
John W. Hanley, Jr., Esq.<br />
Davis Wright Tremaine LLP<br />
Seattle, WA<br />
Steven L. Wood, Esq.<br />
Century Pacific, LP<br />
Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 1: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 1: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Steven L. Wood of Century Pacific, LP Speaker 2: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Steven L. Wood of Century Pacific, LP Speaker 2: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
State of <strong>Real</strong> <strong>Estate</strong> and Mortgage Markets<br />
Tracy B. Edgers<br />
Wells Fargo Bank<br />
Seattle, WA<br />
Steven L. Wood, Esq.<br />
Century Pacific, LP<br />
Seattle, WA
Tracy B. Edgers of Wells Fargo Bank Speaker 3: 1<br />
<strong>Real</strong> estate joint ventures and funds<br />
State of real estate and<br />
mortgage markets<br />
Presented by:<br />
Tracy B. Edgers<br />
Senior Vice President<br />
Wells Fargo Bank<br />
Law Seminars International<br />
January <strong>2010</strong><br />
© <strong>2010</strong> Wells Fargo Bank, N.A. All rights reserved. For public use.<br />
Overview<br />
Market Observations<br />
Loan Underwriting Trends<br />
Strategies<br />
Lender<br />
Borrower<br />
Opportunist<br />
1<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Tracy B. Edgers of Wells Fargo Bank Speaker 3: 2<br />
Market observations<br />
Pricing is down to 35%-45% +/- from peak valuations<br />
Cap rates have increased 200 bp +/- while rents have<br />
declined 10% - 30% depending on the market<br />
Loans in special servicing are growing $2-3 Billion per<br />
month; currently $50 billion<br />
Massive need for de-leveraging<br />
Vast majority of deals done in past 12 months had<br />
assumable debt, seller financing, or lender willing to<br />
facilitate a sale<br />
Some traditional transactions are getting done<br />
2<br />
Underwriting trends<br />
Banks represent 58% of market but have limited capacity<br />
with a good portion of that capacity being used for REITs<br />
and extensions<br />
Life Companies represent only 11% of market > Targeting<br />
$15 billion net new originations<br />
Quality, well-leased (85%+) properties in good markets with<br />
moderate leverage (50-60%; 13-15% debt yield) and<br />
moderate size (< $150mm) can get done<br />
Biggest Issues:<br />
Change in property values combined with new underwriting<br />
standards<br />
Large loans<br />
Need for additional capital to stabilize deals<br />
Looming maturities outstrips new origination capacity<br />
3<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Tracy B. Edgers of Wells Fargo Bank Speaker 3: 3<br />
Annual sales volume<br />
Greater than $25 million<br />
$400<br />
$367<br />
$350<br />
$300<br />
$250<br />
$236<br />
$ billions<br />
$200<br />
$150<br />
$133<br />
$198<br />
$100<br />
$50<br />
$0<br />
$75<br />
$81<br />
$62<br />
$45<br />
$12<br />
2001 2002 2003 2004 2005 2006 2007 2008 YTD 2009<br />
4<br />
Loan statistics<br />
An approaching bottom to the slump in bank loans has yet extend to<br />
commercial real estate<br />
24<br />
18<br />
12<br />
6<br />
Commercial <strong>Real</strong><br />
<strong>Estate</strong> Loans<br />
0<br />
-6<br />
-12<br />
Total Loans & Leases<br />
12/23/09<br />
Wk.<br />
-18<br />
12/26/07 3/26/08 6/25/08 9/24/08 12/24/08 3/25/09 6/24/09 9/23/09 12/23/09<br />
Source: Federal Reserve Board<br />
All Banks In The U.S.; Percent Change From 13 Weeks Ago, Seasonally Adjusted Annual Rate*<br />
5<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Tracy B. Edgers of Wells Fargo Bank Speaker 3: 4<br />
Impact on commercial real estate debt<br />
markets<br />
Finding a New Equilibrium<br />
New real estate loan activity continues to be very light<br />
<strong>Real</strong> estate fundamentals continue to deteriorate and values<br />
continue to decline as vacancies and rents are expected to<br />
reflect a weak economy<br />
Loan Market Considerations<br />
Banks very selective and focused on best clients<br />
Lender credit approval process has lengthened significantly<br />
Pricing and fees higher across the board with LIBOR floors<br />
being required in most instances<br />
6<br />
Social commentary<br />
Fat<br />
Cat<br />
7<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Tracy B. Edgers of Wells Fargo Bank Speaker 3: 5<br />
30+ day & 60+ day delinquency<br />
(1996-2008 Vintage)<br />
10.00%<br />
9.00%<br />
8.00%<br />
7.00%<br />
6.00%<br />
5.00%<br />
4.00%<br />
3.00%<br />
2.00%<br />
1.00%<br />
0.00%<br />
30+Days Dlq or Specially Serviced %<br />
Nov-00<br />
Mar-01<br />
Jul-01<br />
Nov-01<br />
Mar-02<br />
Jul-02<br />
Nov-02<br />
Mar-03<br />
Jul-03<br />
Nov-03<br />
Mar-04<br />
Jul-04<br />
Nov-04<br />
Mar-05<br />
Jul-05<br />
Nov-05<br />
Mar-06<br />
Jul-06<br />
Nov-06<br />
Mar-07<br />
Jul-07<br />
Nov-07<br />
Mar-08<br />
Jul-08<br />
Nov-08<br />
Mar-09<br />
60+Days Dlq%<br />
Jul-09<br />
Nov-09<br />
8<br />
2009 CMBS recap<br />
The total delinquency rate (incl. 30+ day delinquency and<br />
performing specially serviced loans) increased from 2.2% to<br />
8.9%, a rise of over 650 bps<br />
CMBS ratings went through a major downgrade cycle. In all,<br />
nearly 6,000 classes were downgraded this year, included<br />
192 super-senior classes.<br />
TALF and PPIP programs introduced mid-year in an effort to<br />
spur investment in legacy CMBS and aid the demand for new<br />
issue<br />
At the tail-end of 2009, three new single-borrower CMBS<br />
transactions totaling $1.4 billion came to market and priced<br />
with strong investor demand<br />
9<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Tracy B. Edgers of Wells Fargo Bank Speaker 3: 6<br />
U.S. CRE debt maturities<br />
900,000<br />
800,000<br />
700,000<br />
Fixed Rate CMBS<br />
Floating Rate CMBS<br />
Commercial Banks & Savings Inst.<br />
Insurance Companies<br />
GSEs & FED-Related Mtg. Pools<br />
Other<br />
600,000<br />
$ (Billion)<br />
500,000<br />
400,000<br />
300,000<br />
200,000<br />
100,000<br />
-<br />
2009 <strong>2010</strong> 2011 2012 2013 2014 2015 2016 2017<br />
Maturity Year<br />
Sources: Federal Reserve and Intex Solutions, Inc.<br />
10<br />
Near-term CMBS maturities<br />
70.0<br />
60.0<br />
0.13<br />
50.0<br />
$ (in Billions)<br />
40.0<br />
30.0<br />
20.0<br />
18.34<br />
14.96<br />
33.76<br />
0.12<br />
43.51<br />
58.05<br />
0<br />
41.9<br />
10.0<br />
13.57<br />
0.0<br />
2009 <strong>2010</strong> 2011 2012 2013<br />
Year<br />
Fixed-Rate CMBS<br />
Floating-Rate CMBS<br />
Existing CMBS maturities show $32 billion in refinance debt-capital needs<br />
with an additional $49 billion scheduled to mature in <strong>2010</strong>.<br />
Approximately 30% of CMBS loans that were slated to mature in 2009 have<br />
failed to be refinanced.<br />
Property types have exhibited mixed performance as retail properties<br />
experience the most stress at only a 52% refinance rate. Multifamily loans,<br />
meanwhile, have experienced a nearly 90% refinance rate.<br />
Sources: Wells Fargo Securities, LLC, Citi Investm ent Research and Analysis, Intex Solutions, Inc., Trepp, LLC.<br />
.<br />
11<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Tracy B. Edgers of Wells Fargo Bank Speaker 3: 7<br />
Need for deleveraging<br />
$650 billion worth of commercial real estate mortgages will come<br />
due by the end of 2011<br />
Investors and developers will have trouble selling and/or<br />
refinancing many loans due to falling rents and declining property<br />
values<br />
Deleveraging Example<br />
Cap NOI NOI < 5% NOI < 10%<br />
Rate<br />
NOI $1.50M $1.425M $1.35M<br />
Value @ 6% $25.00M<br />
Loan @ 75% $18.75M $18.75M $18.75M<br />
Debt Yield 8.0% 7.6% 7.2%<br />
New Value @ 8% $18.75M $17.81M $16.88M<br />
New LTV 100% 105% 111%<br />
Req.<br />
$4.69M $5.39M $6.09M<br />
Remargin<br />
New Loan @ 75% $14.06MM $13.36MM $12.66MM<br />
New Debt<br />
Yield<br />
10.7% 10.7% 10.7%<br />
Remargin % of Value<br />
19% 22% 24%<br />
12<br />
Lending strategies<br />
Lend to borrowers with cash equity and access to capital<br />
Provide incentives for borrowers to support transactions<br />
Warm body guarantors<br />
Non-recourse carve-outs such as bankruptcy<br />
Level of analysis depends on level of recourse<br />
Get paid for taking risk<br />
13<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Tracy B. Edgers of Wells Fargo Bank Speaker 3: 8<br />
Borrower strategies<br />
Substantial upfront cash equity still required<br />
Expect impounds and leasing reserves<br />
Covenant parameters must allow for restructure while equity<br />
still at risk<br />
Emphasis on:<br />
Tenant financials<br />
Tenant rollover<br />
Lease analysis<br />
Historic operations<br />
14<br />
Utilization of TALF<br />
TALF will be utilized most by large sponsors and upstart the<br />
CMBS market with single borrower transactions done on a<br />
“best-efforts” basis<br />
While TALF may help revive the securitization market,<br />
aggressive underwriting found in short term loans originated<br />
since 2005 will likely preclude them from refinance risk<br />
without significant equity infusions<br />
Investor confidence in the CMBS market necessitates<br />
participation by the originator (retention of the B-piece) and<br />
more stringent risk-assessment<br />
15<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Tracy B. Edgers of Wells Fargo Bank Speaker 3: 9<br />
Opportunist strategies<br />
Have Plenty of CA$H<br />
Know the Status of the Asset<br />
Review:<br />
“Policy Statement on Prudent Commercial <strong>Real</strong> <strong>Estate</strong> Loan<br />
Workouts”<br />
http://www.federalreserve.gov/boarddocs/srletters/2009/SR<br />
0907.htm<br />
Wells Fargo REO Assets:<br />
https://www.wellsfargo.com/com/cgi/properties.jhtml<br />
16<br />
What will CMBS 2.0 look like?<br />
Minimal issuance that will be predominantly single-borrower and<br />
large loan transactions<br />
Conduit pools will be significantly smaller than 2006 – 2007<br />
transactions<br />
Underwriting will be ‘back to basics’; true 70% LTV and 11% debt<br />
yield loans will be the standard<br />
New issue CMBS will be viewed in a different light due to structural<br />
improvements and tighter underwriting standards<br />
Mandatory cash management<br />
Full impounds<br />
Limited to no additional leverage<br />
Higher subordination levels; although ratings shopping may still<br />
continue<br />
Heightened regulatory environment may cause bumps in the road<br />
for new issuance<br />
17<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Tracy B. Edgers of Wells Fargo Bank Speaker 3: 10<br />
Sample financing<br />
Multi-borrower pooled transaction<br />
Rating Class Size Subordination Spread Bond Yield<br />
AAA $400,000,000 20.0% 2.00% 5.93%<br />
AA $40,000,000 12.0% 3.57% 7.50%<br />
A $10,000,000 10.0% 4.57% 8.50%<br />
BBB $10,000,000 8.0% 6.07% 10.00%<br />
BBB- $10,000,000 6.0% 8.07% 12.00%<br />
Pooled transactions of<br />
50+ loans offer more AAA<br />
/ lower credit<br />
enhancement.<br />
Breakeven WA coupon is<br />
~6.85%<br />
UR $30,000,000 0.0% 11.07% 15.00%<br />
IO $500,000,000 0.34% 4.23%<br />
$500,000,000 2.92% 6.80%<br />
Assumptions:<br />
Diverse pool of 50+ loans with 10/30 structure<br />
Leverage: 75%<br />
Debt Yield: 11%<br />
10 year Swap Rate: 3.96%<br />
18<br />
Questions<br />
Tracy B. Edgers<br />
Senior Vice President<br />
<strong>Real</strong> <strong>Estate</strong> Banking Group<br />
Wells Fargo Bank<br />
tracy.b.edgers@wellsfargo.com<br />
(206)-292-3431<br />
© <strong>2010</strong> Wells Fargo Bank, N.A. All rights reserved. For public use.<br />
19<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Steven L. Wood of Century Pacific, LP Speaker 4: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Steven L. Wood of Century Pacific, LP Speaker 4: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Economics of <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong><br />
Preston R. Sargent<br />
Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Seattle, WA<br />
Gregory K. Johnson<br />
Wright Runstad & Company<br />
Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 1<br />
Speaker 6: 1<br />
The Economics of <strong>Real</strong> <strong>Estate</strong><br />
<strong>Joint</strong> <strong>Ventures</strong><br />
February 8, <strong>2010</strong><br />
Gregory K. Johnson<br />
President<br />
Wright Runstad & Company<br />
Preston R. Sargent<br />
Executive Vice President<br />
Kennedy Associates<br />
1<br />
The Economics of <strong>Real</strong> <strong>Estate</strong><br />
<strong>Joint</strong> <strong>Ventures</strong><br />
• Investment Advisory<br />
• Capital Consolidation<br />
• Debt and Equity in <strong>Joint</strong> <strong>Ventures</strong><br />
• Top 10 “Do’s and Don’ts” List<br />
– From Institutional Investor’s Perspective<br />
– From Deal Sponsor’s Perspective<br />
• Questions<br />
2<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 2<br />
Speaker 6: 2<br />
Kennedy’s Investment Advisory Activities:<br />
• Separate Accounts – Kennedy manages separate accounts for<br />
a limited number of institutional clients pursuing specific<br />
investment strategies, individual properties, and/or targeted<br />
locations.<br />
• Commingled Funds – We are the founder and investment<br />
advisor to the Multi-Employer Property Trust (MEPT), one of<br />
the country’s largest and most successful open-ended<br />
commingled funds. MEPT offers the opportunity to invest in a<br />
broadly diversified portfolio of newly constructed and<br />
redeveloped core properties (office, industrial, retail, multifamily,<br />
and hotel) in major markets throughout the country.<br />
• Closed-End Funds – Kennedy has successfully sponsored<br />
closed-end funds which take advantage of market opportunities<br />
i.e., the Multi-Employer Development Partners (MEDP), a $530<br />
million fully invested partnership formed in 1999, and the Multi-<br />
Employer Hotel Partners (MEHP), formed in 2001, to acquire<br />
$350 million in hospitality properties for redevelopment.<br />
3<br />
MEDP Management Fee<br />
Section 3.04 of the MEDP agreement states:<br />
“… the Partnership shall pay a fee for each calendar quarter<br />
for management services as follows: (a) during the<br />
Commitment Period, in an amount equal to 0.30% of total<br />
Capital Commitments, and (b) after the termination of the<br />
Commitment Period, an amount equal to 0.30% of the<br />
average aggregate unreturned Capital Contributions during a<br />
calendar quarter commencing with the calendar quarter<br />
immediately following the termination of the Commitment<br />
Period.”<br />
4<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 3<br />
Speaker 6: 3<br />
MEHP Management Fee<br />
Section 3.04 of the MEHP agreement states:<br />
• “… the Partnership shall pay to the General Partner a fee for<br />
each calendar quarter for management services (a) during the<br />
Commitment Period, in an amount equal to .3% of total Capital<br />
Commitments and (b) after the Commitment Period … in<br />
amount equal to .3% of the sum of (i) the average aggregate<br />
Invested Capital of all Partners plus (ii) the average aggregate<br />
Remaining Capital Commitments that may be called to fund<br />
amounts committed to Investments on or prior to the end of the<br />
Commitment Period…”<br />
• Invested Capital is defined as Capital Contributions plus<br />
Unallocated Contributions less amounts distributed.<br />
5<br />
Typical JV Development Structure<br />
Property Type:<br />
Office or Industrial Development<br />
Ownership Equity Structure: Kennedy Client 90% to 97%<br />
Developer 3% to 10%<br />
Debt:<br />
Zero to 60% max<br />
Completion & Cost Guaranty: Developer guaranties on time completion subject to late penalties.<br />
Developer guaranties cost overruns.<br />
Development Fee:<br />
2% to 3.5% of controllable cost depending on project size.<br />
Sometimes a fixed dollar amount.<br />
Completion:<br />
Promote/Earnout to Developer:<br />
Promote payout:<br />
Developer Management Fee:<br />
Major Decisions:<br />
Fee is earned based on a completion schedule with some level of holdback<br />
to secure completion and cost guaranty.<br />
Sometimes includes incentives for on-time completion and for cost savings.<br />
Definition varies with project objective. On short holds, completion is sale<br />
of the property. Longer term holds, completion can be 90% occupancy<br />
within say 18 – 24 months and obtaining Certificate of Occupancy.<br />
Pro-rata distributions to Kennedy Client and Developer up to a<br />
hurdle rate (8 – 9%) then a waterfall.<br />
Example:<br />
1) 90/10 pro-rata to an 8% IRR to Kennedy<br />
2) 75/25 to a 13% IRR<br />
3) 65/35 above a 16% IRR<br />
Paid on sale or based on appraisal after stabilization<br />
At market rate<br />
Sale or financing must be controlled by Kennedy<br />
6<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 4<br />
Speaker 6: 4<br />
CAPITAL<br />
TIME<br />
LAND<br />
USERS<br />
7<br />
Developer Equity in <strong>Real</strong> <strong>Estate</strong><br />
• First maximize debt<br />
– Construction Loan<br />
• The rest is your own money!<br />
• ….unless you raise equity (OPM)<br />
– Give up control<br />
– Management issues<br />
– Reporting requirements<br />
– Legal compliance (ERISA – REIT)<br />
– Suffer dilution/share risk<br />
– Complicate your life<br />
8<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 5<br />
Speaker 6: 5<br />
Construction Loan<br />
• Up to 70-85% LTC<br />
• Floating rate<br />
• Developer looks for:<br />
– As much as possible<br />
– As cheap as possible<br />
– No recourse/guarantees<br />
9<br />
Construction Loan<br />
• Lender looks for:<br />
– Getting paid back<br />
• Enough $ to do the job<br />
• Preleasing<br />
• Take out<br />
– Risk Management<br />
– Senior position<br />
– Recourse<br />
– Guarantees<br />
10<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 6<br />
Speaker 6: 6<br />
Equity Investment Underwriting<br />
• Sponsor<br />
– Organization<br />
– Track Record<br />
– Principals<br />
• Strategy<br />
– The Play<br />
– Location/Configuration<br />
– National/Regional/Local Market<br />
– Exit - How do I get my money back?<br />
– Risk<br />
• How is Risk Mitigated?<br />
• Structure<br />
– Cost/Projected Cash Flow<br />
– Projected Returns<br />
– Capital Structure<br />
11<br />
JV or Operating Agreements<br />
• Formation<br />
• Purpose<br />
• GP/Manager Duties and Rights<br />
• Control/Major Decisions<br />
• Liability/Indemnities<br />
• Recourse to third parties<br />
• Reps and Warranties<br />
• Capital Contributions<br />
• Allocation of Profits/Losses<br />
• Allocation of Cash – Operating and Capital<br />
• Failure to Contribute $<br />
• Accounting and Tax issues<br />
• Exit provisions<br />
• Sale of interests (ROFR, ROFO, Tag along, etc.)<br />
• Options<br />
• Buy/Sell rights<br />
• Dispute Resolution<br />
• Independent activities of Members<br />
• Agreements with related parties<br />
• Exhibits<br />
12<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 7<br />
Speaker 6: 7<br />
<strong>Real</strong>ly Great Deal<br />
Total Cost = $100<br />
Land $15<br />
A&E $7<br />
Const $55<br />
Mktg $3<br />
Interest $6<br />
Net Carry $5<br />
Dev Fee $4<br />
Contingency $5<br />
Annual Rents = $15<br />
Annual Expenses = $5<br />
Annual NOI = $10 10% Return on Cost<br />
Like Properties Sell @ 8% Cap Rates<br />
Developed Value = $125<br />
13<br />
$35 Equity<br />
$100<br />
$65<br />
Leased at<br />
$15/yr<br />
Expenses of<br />
$5/yr<br />
NOI = $10/yr<br />
Cap NOI at<br />
8%<br />
Value=$125<br />
<strong>Real</strong>ly Great Deal<br />
Total Cost = $100<br />
Construction Loan<br />
65% LTC<br />
14<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 8<br />
Speaker 6: 8<br />
$35 Equity<br />
$125<br />
$100<br />
$65<br />
Leased at<br />
$15/yr<br />
Expenses of<br />
$5/yr<br />
NOI = $10/yr<br />
Cap NOI at<br />
8%<br />
Value=$125<br />
$60 Equity<br />
<strong>Real</strong>ly Great Deal<br />
Total Cost = $100<br />
Construction Loan<br />
65% LTC<br />
Sell<br />
Return Original Investment<br />
Profit of $25<br />
15<br />
$35 Equity<br />
95% Investor = $33.25<br />
5% Developer = $1.75<br />
70/30 Split after<br />
Return of Original Investment<br />
$100<br />
$98.25<br />
$65<br />
Leased at<br />
$15/yr<br />
Expenses of<br />
$5/yr<br />
NOI = $10/yr<br />
Cap NOI at<br />
8%<br />
Value=$125<br />
<strong>Real</strong>ly Great Deal<br />
Total Cost = $100<br />
Construction Loan<br />
65% LTC<br />
16<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 9<br />
Speaker 6: 9<br />
$35 Equity<br />
95% Investor = $33.25<br />
5% Developer = $1.75<br />
70/30 Split after<br />
Return of Original Investment<br />
$100<br />
$98.25<br />
$65<br />
Leased at<br />
$15/yr<br />
Expenses of<br />
$5/yr<br />
NOI = $10/yr<br />
$125<br />
$60 Equity<br />
Cap NOI at<br />
8%<br />
Value=$125<br />
<strong>Real</strong>ly Great Deal<br />
Total Cost = $100<br />
Construction Loan<br />
65% LTC<br />
Sell<br />
Return Original Investment<br />
Profit of $25 Split 70/30<br />
Investor $33.25 + $17.5 = $50.75<br />
Developer $1.75 +$7.5 = $9.25<br />
17<br />
$35 Equity<br />
95% Investor = $33.25<br />
5% Developer = $1.75<br />
70/30 Split after<br />
Return of Original Investment<br />
$100<br />
$98.25<br />
$65<br />
Leased at<br />
$15/yr<br />
Expenses of<br />
$5/yr<br />
NOI = $10/yr<br />
Cap NOI at<br />
8%<br />
Value=$125<br />
$125<br />
$60 Equity<br />
Permanent Loan<br />
80% LTV = $100<br />
10 yrs @ 6% I/O<br />
DS=$6/yr<br />
$125<br />
$117.5<br />
$100<br />
<strong>Real</strong>ly Great Deal<br />
Total Cost = $100<br />
Construction Loan<br />
65% LTC<br />
Sell<br />
Return Original Investment<br />
Profit of $25 Split 70/30<br />
Investor $33.25 + $17.5 = $50.75<br />
Developer $1.75 +$7.5 = $9.25<br />
Refinance<br />
Return Original Investment<br />
NOI $10/yr DS=$6/yr<br />
CF =$4/yr Split 70/30<br />
Investor $2.8/yr<br />
Developer $1.2/yr<br />
18<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 10<br />
Speaker 6: 10<br />
TOP TEN “DO’s and DON’Ts”<br />
(From an Active Institutional Investor’s Perspective)<br />
19<br />
10. Do Create Deal Summary/Abstract<br />
• During or immediately after closing by deal person<br />
9. Don’t Waste Time/Words/Money on 1% Probability Stuff<br />
• Simple straight-forward resolutions<br />
8. Do Take Time to Run Through “What Ifs”<br />
• Be expansive/out of the box<br />
• Market conditions change<br />
• JV partner can be very “creative”<br />
7. Don’t Partner with Someone for Whom This Deal is “Their Life”<br />
• Even slight divergence of interests can be enormously painful<br />
• Having all the $’s/power doesn't necessarily avoid problems<br />
6. Do Insist on Appropriate “Shoot Out” Provision<br />
• Ultimate dispute resolution tool<br />
• Makes “divorce” less cumbersome/costly<br />
20<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 11<br />
Speaker 6: 11<br />
5. Don’t Limit to Arbitration/Mediation in Development Deals<br />
• Limited discovery rights<br />
• Too many parties… cumbersome<br />
4. Do Retain Right to be “Arbitrary and Capricious”<br />
• Having the prerogative doesn’t require its exercise<br />
• Circumstances evolve… conflicts arise<br />
3. Don’t Constrain the Exit<br />
• Avoid lock-out periods<br />
• ROFR’s never… ROFO’s maybe (if carefully crafted)<br />
2. Do Choose a Jurisdiction for Disputes<br />
• Saves time and money<br />
• Important for drafting purposes<br />
1. Don’t “Marry” Someone You Don’t Love/Trust<br />
• No such thing as a “good deal with a bad partner”<br />
• With good partner you don’t need any JV Agreement<br />
• With bad partner the best JV Agreement won’t save you<br />
21<br />
TOP TEN “DO’s and DON’Ts”<br />
(From the Deal Sponsor’s Perspective)<br />
22<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 12<br />
Speaker 6: 12<br />
10. Do Create Deal Summary/Abstract<br />
• During or immediately after closing by deal person<br />
9. Don’t Waste Time/Words/Money on 1% Probability Stuff<br />
• Simple straight-forward resolutions<br />
8. Do Take Time to Run Through “What Ifs”<br />
• Be expansive/out of the box<br />
• Market conditions change<br />
• Institutional investor will not view new factors your way<br />
7. Find an Investor who is Committed to Your Type of Deal<br />
• More prone to work things out or see them through<br />
• Deal needs investors attention<br />
6. Do Insist on Appropriate “Shoot Out” Provision<br />
• Ultimate dispute resolution tool<br />
• Makes “divorce” less cumbersome/costly<br />
• Protect yourself with adequate notice and process beforehand<br />
23<br />
5. Don’t Limit to Arbitration/Mediation in Development Deals<br />
• Limited discovery rights<br />
• Too many parties… cumbersome<br />
4. Do Insist in a Reasonable Judgment Standard<br />
• Circumstances evolve… conflicts arise<br />
• Limits arbitrary actions<br />
3. Don’t Limit your Control at the Exit<br />
• Look for lock-out periods<br />
• ROFR’s preferred… ROFO’s always<br />
2. Do Choose a Jurisdiction for Disputes<br />
• Make sure its your own<br />
1. Don’t “Marry” Someone You Don’t Love/Trust<br />
• No such thing as a “good deal with a bad investor”<br />
• With good investor you don’t need any JV Agreement<br />
• With bad investor you’ll have to fight to get what’s in the JV Agreement<br />
24<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Gregory K. Johnson of Wright Runstad & Company<br />
Preston R. Sargent of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Speaker 5: 13<br />
Speaker 6: 13<br />
The Economics of <strong>Real</strong> <strong>Estate</strong><br />
<strong>Joint</strong> <strong>Ventures</strong><br />
February 8, <strong>2010</strong><br />
Gregory K. Johnson<br />
President<br />
Wright Runstad & Company<br />
Preston R. Sargent<br />
Executive Vice President<br />
Kennedy Associates<br />
25<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Key Business Terms in <strong>Joint</strong> Venture Operating<br />
Agreements<br />
Joseph P. McCarthy, Esq.<br />
Stoel Rives LLP<br />
Seattle, WA<br />
Thomas J. Parkes, Esq.<br />
Foster Pepper PLLC<br />
Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 1<br />
Speaker 8: 1<br />
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<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 2<br />
Speaker 8: 2<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 3<br />
Speaker 8: 3<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 4<br />
Speaker 8: 4<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 5<br />
Speaker 8: 5<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 6<br />
Speaker 8: 6<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 7<br />
Speaker 8: 7<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 8<br />
Speaker 8: 8<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 9<br />
Speaker 8: 9<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 10<br />
Speaker 8: 10<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Joseph P. McCarthy of Stoel Rives LLP<br />
Thomas J. Parkes of Foster Pepper PLLC<br />
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Speaker 7: 11<br />
Speaker 8: 11<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Mock Negotiation of a <strong>Joint</strong> Venture Agreement<br />
David E. Myre, Jr., Esq.<br />
Hillis Clark Martin & Peterson, P.S.<br />
Seattle, WA<br />
Jane Rakay Nelson, Esq.<br />
Lane Powell PC<br />
Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
Excerpts from Term Sheet<br />
Speaker 9a: 1<br />
Speaker 10a: 1<br />
Magnificent Tower LLC,<br />
a Delaware limited liability company<br />
Confidential Term Sheet<br />
This Confidential Term Sheet is a nonbinding expression of interest by Institutional<br />
Investment Fund LLC (herein “Investor”) to form a joint venture with Local Development<br />
Partners LLC (herein “Developer”), an affiliate of Local Development Company, for the purpose<br />
of acquiring a certain site at 1234 Fifth Avenue, Gotham, WA (the “Site”) at which the joint<br />
venture will develop, design, construct, mortgage, own and operate the Project hereinbelow<br />
described.<br />
1. The Project. The “Project” will consist of a Class A mixed-use tower<br />
encompassing approximately 300,000 square feet and consisting of underground parking<br />
facilities for approximately 120 vehicles, a ground floor and two additional floors of rental retail<br />
space, three (3) floors of office/commercial space, and twenty-five (25) residential floors<br />
containing approximately 220 luxury rental apartment units.<br />
2. Sources and Uses of Funds. The parties currently anticipate that the joint venture<br />
will acquire the Site and develop, design, construct and lease the Project to the milestone of<br />
Project Stabilization (as hereinafter defined) using the following Sources and Uses of Funds.<br />
Sources of Funds<br />
First Mortgage Loan $ 65,000,000<br />
Cash Capital Contributions<br />
Investor<br />
Developer<br />
Total Sources<br />
$ 31,500,000<br />
3,500,000<br />
$100,000,000<br />
Uses of Funds<br />
Site Purchase Price $ 10,000,000<br />
Construction Period Soft Costs $ 12,000,000<br />
GMC Construction Contract $ 78,000,000<br />
Total Uses $100,000,000<br />
3. Form and Name of <strong>Joint</strong> Venture. The joint venture will be in the form of a<br />
limited liability company organized under Delaware’s Limited Liability Company Act and<br />
governed by a limited liability company agreement (the “Operating Agreement”) to be<br />
negotiated containing terms and conditions substantially consistent with those set forth herein<br />
and such other terms and conditions as shall be mutually agreeable. The joint venture (the<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
“Company”) shall be named “Magnificent Tower LLC” or such other name as is hereafter<br />
mutually approved by Investor and Developer (collectively, the “Members”).<br />
4. Management. Developer shall serve as initial Manager of the Company. As such,<br />
Developer shall have the management duties and authorities set forth below and shall be subject<br />
to removal from management by Investor for any of the reasons hereinbelow described.<br />
5. Initial Capital Contributions. At the Equity Closing (as hereinafter defined), and<br />
subject to satisfaction of the funding conditions hereinafter described, the Members shall make<br />
initial capital contributions to the Company by wire transfer of cash in the following amounts<br />
and shall receive the following percentage ownership interests in the Company:<br />
Developer: $ 3,500,000 10%<br />
Investor: $31,500,000 90%<br />
At the Equity Closing, Developer shall also contribute, for no additional consideration,<br />
by assignment to the Company (subject to assumption of all related prospective obligations) the<br />
following:<br />
(i) the existing real estate purchase and sale agreement with Fifth Avenue<br />
Associates LLC (the “Site Owner”), together with all earnest money deposits, title insurance<br />
commitments and due diligence reports and studies obtained or prepared by Developer in<br />
connection with the pending purchase of the Site;<br />
(ii) the existing architectural services contract with XYZ Architects LLP (the<br />
“Architect”), together with all studies, schematics, designs, drawings, models, plans and<br />
specifications prepared by the Architect in connection with the Project;<br />
(iii) the existing development phase services contract with ABC Construction<br />
Company, Inc. (the “General Contractor”), together with all cost estimates, analyses, studies,<br />
bids and proposals prepared by the General Contractor in connection with the Project;<br />
(iv) all construction, building, street use, sidewalk use, and other permits and<br />
licenses obtained by Developer from the City in connection with the Project and all applications<br />
submitted by Developer for any such licenses not yet issued (collectively, the “Permits”); and<br />
(v) the loan commitment dated February 9, 2009, issued by Optimism Bank,<br />
N.A. (“Construction Lender”) for a construction loan in the amount of $65,000,000 in<br />
connection with the Project, and all deposits posted and payments made by Developer pursuant<br />
thereto.<br />
At the Loan Closing (as hereinafter defined), Developer shall also provide to or for the<br />
benefit of the Company, for no additional consideration, the following:<br />
(i) a guaranty to Construction Lender of payment of all non-recourse carveout<br />
liabilities to which the Company will be subject under the governing documents for the<br />
Speaker 9a: 2<br />
Speaker 10a: 2<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
Construction Loan, in form and substance reasonably satisfactory to the Construction Lender;<br />
and<br />
(ii) an environmental indemnity agreement for the benefit of the Construction<br />
Lender, to which the Company will also be liable with respect to the ongoing environmental<br />
condition of the Site and the Project, in form and substance reasonably satisfactory to the<br />
Construction Lender.<br />
6. Equity Closing Funding Conditions. Each Member’s obligation to complete its<br />
initial capital contribution shall be subject to fulfillment (or waiver by Investor in its sole<br />
discretion) of the following conditions precedent:<br />
….<br />
* * *<br />
Speaker 9a: 3<br />
Speaker 10a: 3<br />
9. Additional Capital Contributions: Construction Phase. During the Construction<br />
Phase, if Investor reasonably determines that the proceeds of the initial capital contributions and<br />
the Construction Loan will not be sufficient to complete development, design and construction of<br />
the Project and achieve Project Stabilization, Investor may issue a mandatory capital call notice<br />
for additional capital contributions that, in the aggregate, will eliminate such deficit. Such<br />
notice, when issued, shall require each Member to complete an additional contribution of cash to<br />
the Company, in proportion to its percentage interest, not later than thirty (30) days after such<br />
notice. Such additional capital contribution proceeds shall be delivered to the Construction<br />
Lender (if required by the Construction Loan documents) for disbursement or otherwise applied<br />
by the Company as described in the capital call notice. If either Member fails to complete an<br />
additional capital contribution when due, the other Member shall have the right to advance the<br />
shortfall as a loan or substituted or additional capital contribution, with applicable interest rate or<br />
preferred return, according to Investor’s customary operating agreement provisions.<br />
Developer’s failure to make an additional capital contribution when due shall also be a<br />
grounds for removal as Manager of the Company (as hereinafter described) and also constitute a<br />
“Default” (as hereinafter defined). If Developer commits a breach of its duties as Manager of<br />
the Company and such actions are the cause of a capital deficit during the Construction Phase,<br />
Investor may (but is not obligated to) issue a mandatory capital call notice without waiving the<br />
Company’s, or Investor’s, claims against Developer for such breach.<br />
10. Additional Capital Contributions – Operating Phase. After Project Stabilization,<br />
if each Member reasonably determines that, for the current year, revenues from operation of the<br />
Project, plus any remaining proceeds from capital contributions and the Construction Loan or the<br />
Term Loan (as hereinafter described), will be insufficient to meet all of the Company’s operating<br />
expenses and debt service obligations and maintain a reasonable level of working capital in such<br />
year, such Member may issue a capital call notice for voluntary additional capital contributions<br />
in the aggregate amount of the projected capital deficit. If either Member chooses not to make<br />
the requested additional capital contribution, the other Member may make a loan to the Company<br />
(if then permitted by the terms of the Construction Loan or Term Loan), in the amount of the<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
shortfall, bearing a commercially reasonable rate of interest and having other loan terms<br />
according to Investor’s customary operating agreement provisions.<br />
* * *<br />
13. Major Decisions. All of the following actions (the “Major Decisions”) shall<br />
require the express prior written approval of Investor before the Manager is authorized to act on<br />
behalf of the Company:<br />
(1) Any modification to the contracts assigned to the Company on the Equity<br />
Closing Date, with the Site Seller, the Architect and the General Contractor;<br />
(2) The Design Development phase and Construction Documents phase plans<br />
and specifications for the Project prepared by the Architect (or any replacement<br />
architect);<br />
(3) A Construction budget;<br />
(4) Any modification of the Permits assigned to the Company, and any new<br />
permits of a material nature;<br />
(5) Form and content of any agreement with the General Contractor for<br />
construction of the Project, and any amendments, extensions or assignments thereof;<br />
(6) Any modification to the loan commitment from the Construction Lender,<br />
the definitive Construction Loan documents, and all modification thereto;<br />
(7) The incurring of other material indebtedness for or on behalf of the<br />
Company;<br />
(8) All Construction Loan draw requests and other material communications<br />
to the Construction Lender during construction of the Project;<br />
(9) Any agreement for the acquisition of real property (other than the Site) or<br />
material tangible personal property to be acquired by the Company, and any amendments<br />
or modifications thereto;<br />
(10) Any service contract for the Site or the Project that is not cancelable by the<br />
Company upon thirty (30) days’ notice;<br />
(11) The sale, assignment, transfer, conveyance, ground lease, easement, lease<br />
or other disposition of any portion of the Site or the Project;<br />
(12) Any parking agreement or arrangement concerning the parking spaces<br />
constructed as part of the Project;<br />
Speaker 9a: 4<br />
Speaker 10a: 4<br />
DWT 12263743v1 0000099-071219<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
(13) Any engagement of a leasing agent to lease any portion of the Project<br />
(other than the Property Management Agreement with Developer’s Affiliate approved<br />
pursuant to the Operating Agreement);<br />
(14) Any engagement of a property management company to manage any part<br />
of the Project (other than the Property Management Agreement);<br />
(15) All annual operating budgets, which budgets shall include parameters for<br />
minimum rental rates and maximum tenant improvement allowances, and all annual<br />
business plans;<br />
(16) The investment of Company funds in any asset other than the Site or the<br />
Project, or any transaction that is not in the ordinary course of business of the Company<br />
or that is not directly related to the acquisition of the Site and development, construction,<br />
leasing and operation of the Project;<br />
(17) Any agreed-upon condemnation (or any conveyance in lieu of<br />
condemnation) of all or part of the Project;<br />
(18) Selection of insurance carriers, determination of insurance coverages to be<br />
obtained by the Company, and settlement of insurance claims in excess of an agreed<br />
amount;<br />
(19) Institution or settlement of any lawsuit, arbitration or other legal<br />
proceeding or confession of any judgment against the Company;<br />
(20) Any press release or other public dissemination of non-public information<br />
with respect to the Company or the Project;<br />
(21) Granting of all approvals, waivers and consents on behalf of the Company<br />
under the Property Management Agreement (and Developer as Manager shall have no<br />
discretion or authority in such matters);<br />
(22) Enforcement of the terms and conditions of the Property Management<br />
Agreement on behalf of the Company (and Developer as Manager shall have no<br />
discretion or authority on such matters);<br />
Speaker 9a: 5<br />
Speaker 10a: 5<br />
(23) Adoption by the Company of the “Leasing Guidelines” referred to in the<br />
Property Management Agreement, all subsequent modifications thereto, adoption of<br />
forms of retail, office/commercial and residential leases to be used at the Project, and all<br />
modifications to any of the foregoing;<br />
(24) Execution of any lease in the Project for retail or office/commercial space<br />
not in conformity with the Leasing Guidelines, the economic terms set forth in the<br />
applicable annual operating budget and annual business plan, or the applicable approved<br />
form of lease;<br />
DWT 12263743v1 0000099-071219<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
(25) Any action by the Company or Manager constituting or effecting a<br />
bankruptcy of the Company;<br />
(26) Any business or activity by the Company other than the business(es) or<br />
activity(ies) contemplated by this Term Sheet, or any action by the Company not in the<br />
ordinary course of the Company’s business; and<br />
(27) Entering into any agreement to do any of the foregoing.<br />
Speaker 9a: 6<br />
Speaker 10a: 6<br />
Exhibit A:<br />
Sections 18-502 and 18-1101 of Delaware Limited Liability Company Act<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
Exhibit A<br />
Speaker 9a: 7<br />
Speaker 10a: 7<br />
Excerpts from Delaware Limited Liability Company Act (6 Del. Code Ch. 18)<br />
§ 18-502. Liability for contribution.<br />
(a) Except as provided in a limited liability company agreement, a member is obligated to a<br />
limited liability company to perform any promise to contribute cash or property or to perform<br />
services, even if the member is unable to perform because of death, disability or any other<br />
reason. If a member does not make the required contribution of property or services, the member<br />
is obligated at the option of the limited liability company to contribute cash equal to that portion<br />
of the agreed value (as stated in the records of the limited liability company) of the contribution<br />
that has not been made. The foregoing option shall be in addition to, and not in lieu of, any other<br />
rights, including the right to specific performance, that the limited liability company may have<br />
against such member under the limited liability company agreement or applicable law.<br />
(b) Unless otherwise provided in a limited liability company agreement, the obligation of a<br />
member to make a contribution or return money or other property paid or distributed in violation<br />
of this chapter may be compromised only by consent of all the members. Notwithstanding the<br />
compromise, a creditor of a limited liability company who extends credit, after the entering into<br />
of a limited liability company agreement or an amendment thereto which, in either case, reflects<br />
the obligation, and before the amendment thereof to reflect the compromise, may enforce the<br />
original obligation to the extent that, in extending credit, the creditor reasonably relied on the<br />
obligation of a member to make a contribution or return. A conditional obligation of a member to<br />
make a contribution or return money or other property to a limited liability company may not be<br />
enforced unless the conditions of the obligation have been satisfied or waived as to or by such<br />
member. Conditional obligations include contributions payable upon a discretionary call of a<br />
limited liability company prior to the time the call occurs.<br />
(c) A limited liability company agreement may provide that the interest of any member who fails<br />
to make any contribution that the member is obligated to make shall be subject to specified<br />
penalties for, or specified consequences of, such failure. Such penalty or consequence may take<br />
the form of reducing or eliminating the defaulting member's proportionate interest in a limited<br />
liability company, subordinating the member's limited liability company interest to that of<br />
nondefaulting members, a forced sale of that limited liability company interest, forfeiture of the<br />
defaulting member's limited liability company interest, the lending by other members of the<br />
amount necessary to meet the defaulting member's commitment, a fixing of the value of the<br />
defaulting member's limited liability company interest by appraisal or by formula and<br />
redemption or sale of the limited liability company interest at such value, or other penalty or<br />
consequence. (68 Del. Laws, c. 434, § 1; 70 Del. Laws, c. 186, § 1.)<br />
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Exhibit A – Page 1<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
§ 18-1101. Construction and application of chapter and limited liability company<br />
agreement.<br />
Speaker 9a: 8<br />
Speaker 10a: 8<br />
(a) The rule that statutes in derogation of the common law are to be strictly construed shall have<br />
no application to this chapter.<br />
(b) It is the policy of this chapter to give the maximum effect to the principle of freedom of<br />
contract and to the enforceability of limited liability company agreements.<br />
(c) To the extent that, at law or in equity, a member or manager or other person has duties<br />
(including fiduciary duties) to a limited liability company or to another member or manager or to<br />
another person that is a party to or is otherwise bound by a limited liability company agreement,<br />
the member's or manager's or other person's duties may be expanded or restricted or eliminated<br />
by provisions in the limited liability company agreement; provided, that the limited liability<br />
company agreement may not eliminate the implied contractual covenant of good faith and fair<br />
dealing.<br />
(d) Unless otherwise provided in a limited liability company agreement, a member or manager or<br />
other person shall not be liable to a limited liability company or to another member or manager<br />
or to another person that is a party to or is otherwise bound by a limited liability company<br />
agreement for breach of fiduciary duty for the member's or manager's or other person's good faith<br />
reliance on the provisions of the limited liability company agreement.<br />
(e) A limited liability company agreement may provide for the limitation or elimination of any<br />
and all liabilities for breach of contract and breach of duties (including fiduciary duties) of a<br />
member, manager or other person to a limited liability company or to another member or<br />
manager or to another person that is a party to or is otherwise bound by a limited liability<br />
company agreement; provided, that a limited liability company agreement may not limit or<br />
eliminate liability for any act or omission that constitutes a bad faith violation of the implied<br />
contractual covenant of good faith and fair dealing.<br />
(f) Unless the context otherwise requires, as used herein, the singular shall include the plural and<br />
the plural may refer to only the singular. The use of any gender shall be applicable to all genders.<br />
The captions contained herein are for purposes of convenience only and shall not control or<br />
affect the construction of this chapter.<br />
(g) Sections 9-406 and 9-408 of this title do not apply to any interest in a limited liability<br />
company, including all rights, powers and interests arising under a limited liability company<br />
agreement or this chapter. This provision prevails over §§ 9-406 and 9-408 of this title. (68 Del.<br />
Laws, c. 434, § 1; 69 Del. Laws, c. 260, § 35; 72 Del. Laws, c. 389, § 26; 73 Del. Laws, c. 221,<br />
§ 1; 74 Del. Laws, c. 275, §§ 13, 14.)<br />
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Exhibit A – Page 2<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
Developer-Investor Remarks re<br />
Confidential Term Sheet<br />
For Magnificent Tower LLC<br />
_____________________________________________________________<br />
Additional Capital Contributions<br />
Developer: No need for this provision. Project has been carefully planned with<br />
very conservative cost estimates. General reserves and ample construction<br />
period contingencies in proposed construction budget. I have secured best<br />
possible general contractor, and JV can expect favorable GMC-type<br />
construction contract. I have secured construction loan commitment from best<br />
possible local bank. With proposed initial capital contributions, this project will<br />
be fully funded. No risk of funding shortfall or cost overruns. Therefore no<br />
real risk of capital shortfall, once initial capital contributions are made and<br />
Construction Loan closed.<br />
Investor: Not comfortable. At least during Construction Phase, must have<br />
mandatory additional capital calls if Project gets into trouble. Many<br />
uncertainties during this phase<br />
a) construction contract not yet negotiated<br />
b) loan documents not yet negotiated, lender due diligence continuing<br />
c) City permits not yet issued<br />
d) risk of Architect and General Contractor malfeasance or negligence<br />
e) substantial lease-up risk<br />
Developer: If we experience construction cost overruns, I can persuade<br />
Construction Lender to release reserves or contingencies, or increase loan<br />
amount. No need for this provision. It only gives Construction Lender a reason<br />
to say “no” to my request.<br />
Investor: Still not comfortable. Construction Lenders are very tight.<br />
Developer: Okay, let’s provide that the members in the JV will meet, examine<br />
problem and possible solutions to an unexpected funding shortfall, and, if no<br />
other solution, we will agree at that point to make further capital contributions<br />
per our respective Percentage Interests.<br />
Speaker 9b: 1<br />
Speaker 10b: 1<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
Investor: Agreement to agree is unenforceable, unacceptable. Once initial capital<br />
contributions are made, Investor will have almost all equity capital at risk.<br />
Developer should not have veto. Too much danger of deadlock (or a retrade) at<br />
very crucial moment.<br />
Developer: Investor should not be able to unilaterally issue additional capital call<br />
notice whenever nervous. Investor has much deeper pockets, could take<br />
advantage by precipitating Developer default when Developer short of cash.<br />
Investor: First, Investor is a blind pool investment fund, which is now closed.<br />
Fund may be fully invested at time problem arises. Raising additional capital<br />
would be difficult and painful. Do not assume that Investor has deep pockets<br />
and is a free spender without limits.<br />
Second, any additional capital contributions will be per Percentage Interests.<br />
Investor will contribute 90% of the amount needed by the Company. That’s a<br />
great deterrence to issuing additional capital calls wily-nily.<br />
Third, the Term Sheet says Investor must “reasonably determine” the need<br />
for an additional capital call.<br />
Developer: “Reasonably” means what? Not comfortable. Must have a trigger on<br />
additional capital calls that is objective and neutral.<br />
Investor: Okay. Suggestions:<br />
(1) After we form joint venture and take down Site, JV will finish design<br />
and permitting, and negotiate construction contract and construction loan<br />
documents, based on commitment from Optimism Bank. Then a “Construction<br />
Loan Closing.” One pre-condition: submission and approval of final<br />
construction budget. If that agreed-upon budget shows shortfall in equity<br />
capital, there will be mandatory additional capital contributions at that time.<br />
(2) After Loan Closing, JV will submit Monthly Draw Reports showing<br />
financial results to date. Will be prepared by JV’s accountants, submitted by<br />
you, and approved by Lender. If approved Monthly Draw Request shows<br />
actual or prospective equity capital shortfall, there will be mandatory capital<br />
calls.<br />
Speaker 9b: 2<br />
Speaker 10b: 2<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
(3) Otherwise, additional capital calls during Construction Phase only by<br />
mutual agreement.<br />
Developer: Nervous about giving this power to Construction Lender. Can accept<br />
only if some stated cap in JV agreement on maximum aggregate additional<br />
capital contributions.<br />
Investor: Depends on size of cap in relation to Project budget.<br />
Developer: What consequences if Member just cannot meet call? What does<br />
Term Sheet mean by “customary operating agreement provisions”?<br />
Investor: Quite simple. Other Member (“Performing Member”) can choose to<br />
advance the missing capital to the JV. And if it does, it can do so in either of<br />
two ways:<br />
First, Performing Member can make another capital contribution directly to JV,<br />
in exchange for preferred return. Second, alternatively, Performing Member<br />
can advance “missing funds” to JV and treat that as a loan by the Performing<br />
Member to the Defaulting Member, and a capital contribution by the Defaulting<br />
Member to the JV. Naturally, this loan by one Member to the other Member<br />
will bear interest and have other commercially reasonable loan terms.<br />
Developer: Doesn’t sound simple to me. Why can’t the Performing Member just<br />
loan the missing capital directly to the JV? Earn a reasonable rate of interest<br />
and get repaid before equity distributions?<br />
Investor: Couple of reasons. Simplest is that Construction Lender will not permit<br />
subordinate debt financing for Project but will permit additional equity<br />
contributions to the Company’s capital base.<br />
Developer: Okay. Tell me more about the first funding alternative you proposed.<br />
Investor: Performing Member makes voluntary additional capital contribution in<br />
amount of missing funds. After that, capital will no longer be 90-10. As<br />
reward for covering this unexpected equity gap, this voluntary capital<br />
contribution should command priority return. That is, whenever JV begins<br />
accumulating cash, JV distributions to Members will go first to return this<br />
capital plus an annual return of, say, 8%.<br />
Speaker 9b: 3<br />
Speaker 10b: 3<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
And, for reasons too complicated to explain here, this preferred return formula<br />
– that is, first priority return of capital plus 8% per annum – should also apply<br />
to the mandatory additional capital contribution made by Performing Member<br />
in response to the capital call notice and in accordance with its own percentage<br />
interest.<br />
Developer: Wow, that sounds too rich. Let’s hear about the second alternative.<br />
Performing Member makes a loan to the Defaulting Member, in the amount of<br />
the missing capital, but never actually sees the cash; it goes right to the JV’s<br />
bank account?<br />
Investor: That’s right; or possibly into a deposit account for the benefit of the JV<br />
controlled by the Construction Lender.<br />
As a result of that funding, the Defaulting Member is deemed to have complied<br />
with the additional capital call, and total capital contributions on the books of<br />
the JV remain in balance at 90-10.<br />
Meanwhile, Developer is considered to have borrowed the funds used to make<br />
this past-due additional capital contribution from Investor. This loan is<br />
repayable whenever Developer can and wants to retire it. Meanwhile, it will<br />
bear interest at a reasonable rate – say 8% per annum – and will have<br />
commercially reasonable loan terms. For example, a maturity date tied to the<br />
anticipated date for Project Stabilization. And security, in the form of a pledge,<br />
by the borrower Member, of its membership interest in the JV. Plus an<br />
assignment of all distributions by the JV with respect to that membership<br />
interest until this loan is fully repaid.<br />
Developer: And these two alternatives for dealing with a missed capital<br />
contribution will be available to either Member? That is, if Investor does not<br />
make an additional capital call when due, then our company, Developer, can<br />
use one of these mechanisms to cover the capital shortfall?<br />
Investor: Of course. What could be more fair than that?<br />
Speaker 9b: 4<br />
Speaker 10b: 4<br />
Developer: The Term Sheet has some additional penalties that are only applicable<br />
to our company, Developer, if we fail to make an additional capital<br />
contribution. Those terms aren’t fair – they are unfair and unacceptable. What<br />
gives?<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
Investor: You’re referring to the “removal” and “Default” provisions in paragraph<br />
9 of the Term Sheet. Keep in mind that Developer is in an absolutely critical<br />
position. Your company is Manager and exercising day-to-day control over<br />
completion of the Project. Our investment fund is relying on your company.<br />
We will have placed great trust in you.<br />
If Developer fails to make a proportionate additional capital contribution when<br />
required to save the Project, that will tell us that our trust was misplaced. And,<br />
if our fund steps up and saves the Project by providing the missing capital, to<br />
cover the capital deficit, your company will no longer has a meaningful<br />
economic interest in the Project. Developer will lose interest and begin to take<br />
its eye off the ball. We need to be in a position to act---to seize control of the<br />
Company and the Project.<br />
Developer: That’s ridiculous. First, Developer will have invested at least $3.5<br />
million – our initial capital contribution – in this Project. We will have that at<br />
risk. Plus the substantial development fee that we think the JV should pay<br />
Developer at Project Stabilization. Plus the leasing commissions and property<br />
management fees that our affiliated asset management company can earn at the<br />
Project in the future. Not to mention our reputation in this community, which is<br />
our home, not yours. In fact, I think that Developer will have more at risk<br />
during the Construction Phase than Investor will – even if Developer happens to<br />
miss an additional capital call notice.<br />
Second, you are joint venturing with us because of our real estate development<br />
and construction management expertise – not because we are an inexhaustible<br />
source of equity capital. Providing capital is basically your job – not ours.<br />
We understand that there will be stated grounds in the Operating Agreement for<br />
removal and replacement of Developer as Manager of the JV, but these should<br />
be grounds tied to performance of our special skills and functions – real estate<br />
development and construction management. If Developer is fully performing as<br />
Manager, it is irrelevant that Developer as a small minority owner of the JV was<br />
unable to meet an unexpected additional capital call.<br />
These additional punitive measures in the Term Sheet concerning removal of<br />
Developer as Manager and exercise of Default remedies are unfair—and they<br />
are probably not enforceable anyway. They are a penalty provision, a<br />
forfeiture. They must be deleted!<br />
Speaker 9b: 5<br />
Speaker 10b: 5<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
Speaker 9b: 6<br />
Speaker 10b: 6<br />
Investor: I seem to have touched a nerve. Well, as to the enforceability, these<br />
terms are quite typical and are specifically authorized by Delaware law. It’s a<br />
little unusual, but you may have noticed that I attached a copy of the pertinent<br />
section of the Delaware statute---section 18-502(c)---to the Term Sheet as an<br />
exhibit. Take a look.<br />
Tell you what. Let’s postpone further discussion of this last topic until we<br />
come back to the “removal” and “Default” provisions later in the Term Sheet.<br />
Investor is concerned about the scenarios of the Project running into serious<br />
trouble, Developer deciding to “give up” on the Project, and intentionally<br />
refusing to honor a series of additional capital calls. And Investor not being<br />
able to dislodge Developer and take control of the mess. But let’s try to address<br />
that concern when we get to the subject of Manager removal and Member<br />
default.<br />
Developer: Okay. One last question. I gather from the Term Sheet that Investor<br />
proposes a different, much simpler approach to the subject of additional capital<br />
contributions after the JV achieves Project Stabilization. Why is that?<br />
Investor: Three reasons. First, once it hits Project Stabilization, the JV has passed<br />
through a phase of relatively high risk and into a period of much lower risk.<br />
Almost all of the development, construction and lease-up risks will be behind<br />
us. The most likely scenario leading to an equity capital shortfall after Project<br />
Stabilization would probably be an uninsured casualty, or a design or<br />
construction defect not covered by the warranties, or a major lease rollover<br />
requiring substantial, unanticipated tenant improvements. So, generally<br />
speaking, Investor feels there will be much less likelihood of needing to make<br />
unforeseen additional capital contributions after Project Stabilization.<br />
Second, soon after Project Stabilization the JV will refinance the Construction<br />
Loan with the Term Loan described in the Term Sheet. Investor anticipates<br />
that, unlike the Construction Loan, the Term Loan will permit subordinate<br />
financing for the Project, at least if it is an unsecured loan to the Company. So<br />
we will be able to use a simpler structure to deal with the scenario if a Member<br />
decides not to make an additional capital contribution – namely, a direct loan by<br />
the other Member to the JV.<br />
Third, as mentioned in the Term Sheet, the JV agreement will provide that, after<br />
Project Stabilization, the Members will go through an annual process of<br />
mutually approving an annual budget and annual business plan for the<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
Company. That process should be useful to identify any unforeseeable equity<br />
capital shortfall, and permit the Members to discuss possible solutions in a<br />
deliberate, informed manner before the problem is on top of us. That’s why<br />
Investor has proposed a simpler approach to additional capital calls after the JV<br />
achieves Project Stabilization.<br />
Developer: Okay, let’s move on.<br />
Speaker 9b: 7<br />
Speaker 10b: 7<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
Developer-Investor Remarks re<br />
Confidential Term Sheet<br />
For Magnificent Tower LLC<br />
_____________________________________________________________<br />
Speaker 9c: 1<br />
Speaker 10c: 1<br />
Major Decisions Approval Rights<br />
Developer: “Major Decisions” approval requirement will be a major intrusion into<br />
discretion and authority of Developer. Unworkable and inconsistent with<br />
customary functions and authority of “Manager” of a real estate joint venture.<br />
Investor: Can modify list of Major Decisions, but many concepts are essential to<br />
protect Investor’s substantial investment.<br />
Developer: During Construction Phase, Investor can attend weekly meetings with<br />
General Contractor and Architect (for information), but no approval or veto<br />
rights once final Construction Budget and final Plans and Specs have been<br />
approved by Investor. There will be multiple small change orders.<br />
Investor: Must have approval rights as to “material” change orders and “material”<br />
amendments to Construction Budget and Construction Contract. Standards to<br />
be negotiated.<br />
Developer: Similarly, after Project Stabilization, Investor approval rights should<br />
be limited to annual budget, annual business plan, Leasing Guidelines – and<br />
major divergences from any of these documents during course of the ensuing<br />
year.<br />
Investor: Certain exceptions to your suggested approach are necessary. One is<br />
mandatory Investor approval of all “interested transactions” and “self-dealing<br />
contracts” between the Company and any affiliate of Developer or related party.<br />
Developer: The major contract will be the Property Management Agreement with<br />
Developer’s property management affiliate. That will be negotiated and signed<br />
with JV Agreement.<br />
Investor: All subsequent amendments of the Property Management Agreement<br />
must be approved by Investor, no matter how small.<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
David E. Myre, Jr. of Hillis Clark Martin & Peterson, P.S.<br />
Jane Rakay Nelson of Lane Powell PC<br />
And all actions taken by the Company under the Property Management<br />
Agreement – including any lawsuit to enforce the contract – will be taken<br />
solely by Investor on behalf of Company. Developer as “Manager” will have<br />
no authority or role whatsoever.<br />
Developer: Any other interested transaction contract should be authorized,<br />
without specific Investor approval, if on market terms and conditions.<br />
Investor: Negotiable point, depending.<br />
Developer: With respect to any remaining items on the Major Decisions list, there<br />
should be a penalty if Investor fails to respond quickly to a request from<br />
Developer for an approval.<br />
Investor: No, but will discuss approval procedures and customary decisionmaking<br />
timeline. May agree to certain exceptions.<br />
Developer: Also need mechanism for breaking deadlock if Developer approves<br />
but Investor disapproves a proposed budget, contract amendment or other<br />
action.<br />
Investor: Depends on subject matter of impasse. In some areas, negotiable.<br />
Speaker 9c: 2<br />
Speaker 10c: 2<br />
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L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Partnership Taxation<br />
Andrew H. Zuccotti, Esq.<br />
K&L Gates LLP<br />
Seattle, WA<br />
Brian Todd, Esq.<br />
Davis Wright Tremaine LLP<br />
Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
Speaker 11: 1<br />
Speaker 12: 1<br />
PARTNERSHIP TAX CONSIDERATIONS<br />
February 8, <strong>2010</strong><br />
Andrew H. Zuccotti<br />
K & L Gates, LLP<br />
Brian J. Todd<br />
Davis Wright Tremaine LLP<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
I. The Basics -- The Substantial Economic Effect Safe Harbor.<br />
Speaker 11: 2<br />
Speaker 12: 2<br />
The Treasury Regulations promulgated under Code Section 704(b) provide that<br />
allocations of items of partnership (or LLC) income, gain, loss and deduction will be<br />
respected if they either (i) satisfy the “substantial economic effect” safe-harbor or (ii) are<br />
consistent with the partners’ interests in the partnership. The latter test involves a facts<br />
and circumstances analysis; the former requires that an allocation must have “economic<br />
effect” and that such economic effect must be “substantial.”<br />
A. Economic Effect, in General. The regulations prescribe three<br />
requirements for an allocation to have economic effect. All three must be provided for in<br />
the partnership or LLC agreement throughout the full term of the LLC or partnership.<br />
The requirements are designed to assure that the organization’s profit and loss allocations<br />
are consistent with the underlying economic arrangement of the members. The<br />
requirements are:<br />
1. That a capital account be maintained for each member in<br />
accordance with the rules set out in the regulations;<br />
2. That liquidating distributions be made in accordance with the<br />
members’ positive capital account balances; and<br />
3. That if a member has a deficit balance in his or her capital account<br />
following the liquidation of his or her interest in the entity, he or she is obligated to<br />
restore the amount of the deficit balance to the LLC or partnership. Treas. Reg. § 1.704-<br />
1(b)(2)(ii)(b).<br />
Each of these requirements is discussed in more detail below.<br />
B. Capital Account Maintenance. Each member’s capital account is<br />
increased by the amount of money and the fair market value of property (net of liabilities<br />
assumed by the LLC or partnership or to which the property is subject) contributed to the<br />
LLC or partnership by the member and by profits allocated to the member. Each<br />
member’s capital account is decreased by the amount of money and the fair market value<br />
of property (net of liabilities assumed by the member or to which the property is subject)<br />
distributed to the member and by allocations of loss to the member. Treas. Reg. § 1.704-<br />
1(b)(2)(iv).<br />
In addition, the regulations permit the capital accounts of the members to be<br />
adjusted to reflect unrealized appreciation or depreciation in the value of the LLC’s or<br />
partnership’s assets upon the occurrence of certain events. These are:<br />
• A contribution to the LLC or partnership by a new or existing member in<br />
exchange for an interest in the LLC or partnership;<br />
• Liquidation of the LLC or partnership or of the member’s interest in the<br />
LLC or partnership;<br />
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Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
• In connection with the grant of an interest in the LLC or partnership (other<br />
than a de minimis interest) as consideration for the provision of services to<br />
or for the benefit of the LLC or partnership by an existing member acting<br />
in a member capacity, or by a new member acting in a member capacity or<br />
in anticipation of being a member;<br />
• A distribution by the LLC or partnership to a retiring or a continuing<br />
member in consideration for an LLC or partnership interest; or<br />
• If substantially all the assets of the LLC or partnership consist of stock,<br />
securities, commodities, options, warrants or futures that are regularly<br />
traded on an established securities exchange, then adjustments may be<br />
made in accordance with generally accepted accounting principles<br />
(GAAP). Treas. Reg. § 1.704-1(b)(2)(iv)(f).<br />
This rule permits the capital accounts to be “booked up,” or “marked to market,”<br />
in order that unrealized appreciation or depreciation in LLC or partnership property will<br />
be allocated to the members who owned interests in the entity during the period in which<br />
the appreciation or depreciation occurred. The rule further requires that subsequent<br />
allocations of depreciation, depletion, amortization, gain and loss, as computed for tax<br />
(not book or capital account maintenance) purposes, be determined so as to take into<br />
account the variation between the adjusted basis of the property for tax purposes (which<br />
is not adjusted) and the book value of the property (which is adjusted). This requirement<br />
is imposed so that the tax burden associated with gain in partnership or LLC property, or<br />
the tax benefit associated with depreciation or other loss deductions, follow their<br />
correlative economic benefits and burdens.<br />
C. Liquidating Distributions. The regulations require that liquidating<br />
distributions be made in accordance with the members’ positive capital account balances.<br />
For this purpose, a liquidation means either a liquidation of the entire LLC or partnership,<br />
or a liquidation of the member’s entire interest in the LLC or partnership. In either case,<br />
however, the members’ positive capital account balances are determined after taking into<br />
account all capital account adjustments for the taxable year in which the liquidation<br />
occurs.<br />
D. Deficit Restoration Obligation.<br />
1. In General. The third requirement necessary to satisfy the<br />
economic effect prong of the substantial economic effect safe harbor is that each member<br />
with a deficit in his or her capital account at the time of the liquidation be unconditionally<br />
obligated to restore the deficit by the end of the LLC’s or partnership’s taxable year, or, if<br />
later, within 90 days after the liquidation. However, requiring that each member be<br />
obligated to restore his or her capital account deficit may eliminate the protection from<br />
personal liability afforded LLC members and LLP partners under state law. Limited<br />
liability company agreements and partnership agreements for LLPs therefore typically<br />
provide that the members of the LLC do not have an obligation to restore any capital<br />
account deficit.<br />
Speaker 11: 3<br />
Speaker 12: 3<br />
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Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
2. Alternate Economic Effect Test. To permit the members of an<br />
LLC (or the limited partners of a limited partnership or the partners of an LLP) to<br />
preserve their limited liability while at the same time matching tax and economic<br />
consequences of profit and loss allocations, the regulations provide an alternative test for<br />
economic effect. This test requires that the first two prongs of the regular economic<br />
effect test (maintenance of capital accounts and liquidating distributions in accordance<br />
with capital account balances) be satisfied. Additionally, instead of requiring members to<br />
have a deficit make up obligation, if the partnership or limited liability company<br />
agreement contains a “qualified income offset provision,” the regulations will deem an<br />
allocation to have economic effect to the extent it does not cause, or increase, a deficit<br />
balance in a partner’s or member’s capital account as of the end of the year in which the<br />
allocation occurs in excess of any limited amount that the partner or member is by<br />
contract obligated to restore.<br />
3. Adjustments for Reasonably Expected Events. In making the<br />
determination whether an allocation will create (or increase) a deficit in a member’s<br />
capital account in excess of any amount the member is obligated to restore, the<br />
regulations require not only that all allocations for the year be taken into account, but, in<br />
addition, that certain allocations or events reasonably anticipated to occur in future years<br />
be taken into account. The most relevant of these events typically relates to future<br />
distributions. This rule requires that the partner’s or member’s capital account be<br />
reduced by any distributions expected to be made in future years, to the extent such<br />
distributions exceed offsetting increases to the member’s capital account that reasonably<br />
are expected to occur during (or prior to) the years in which the distributions are expected<br />
to be made. The purpose of this rule is to prevent a loss allocation from being made to a<br />
partner or member in one year, which drops his capital account balance to (or close to)<br />
zero when it is expected that a distribution will be made in a subsequent year without any<br />
offsetting profit allocation, which distribution would create a deficit in the member’s<br />
capital account. Absent this requirement, since the member has no obligation to make a<br />
contribution to the LLC to restore his capital account deficit, and consequently would not<br />
bear the economic burden associated with the loss earlier allocated to him, the goal of<br />
matching economic and tax consequences would fail.<br />
4. Qualified Income Offset. Notwithstanding that an allocation will<br />
have economic effect under the alternate test only to the extent it does not create (or<br />
increase) a deficit in a partner’s or member’s capital account, after taking into account<br />
reasonably expected distributions to the partner or member, a partner’s or member’s<br />
capital account nonetheless may become negative as a result of unexpected events or<br />
distributions. Since the partner or member has no obligation to restore the deficit, and<br />
cannot in that way bear the economic burden associated with the loss contributing to the<br />
deficit, the regulations employ a gross income allocation mechanism as a substitute for<br />
the deficit restoration obligation. In other words, a partner or member whose capital<br />
account unexpectedly drops below zero is required to bear the economic burden of the<br />
loss creating the deficit by receiving a subsequent allocation of gross income to restore<br />
his or her capital account to zero as quickly as possible. The regulations denominate this<br />
gross income allocation a “qualified income offset,” and require that a partnership or<br />
LLC agreement contain a qualified income offset provision in order to satisfy the<br />
Speaker 11: 4<br />
Speaker 12: 4<br />
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Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
alternate test for economic effect.<br />
Speaker 11: 5<br />
Speaker 12: 5<br />
E. Substantiality. The second prong of the substantial economic effect safe<br />
harbor requires that the economic effect of an allocation be “substantial.” Under the<br />
regulations, the economic effect of an allocation of profit or loss will be substantial, and<br />
be respected, if there is a reasonable possibility that the allocation will affect substantially<br />
the dollar amounts to be received by the partners or members from the partnership or<br />
LLC, independent of tax consequences. The focus here is on whether the after-tax<br />
consequences of at least one partner or member will (in present value terms) be enhanced<br />
by receiving the allocations in the partnership or LLC agreement without a concomitant<br />
effect on the after-tax economic consequences of any other partner or member. If so,<br />
then the allocation may not be substantial.<br />
F. Failure to Satisfy the Substantial Economic Effect Test – the “No Harm,<br />
No Foul” Rule. Even if allocations made to a member or partner do not have “substantial<br />
economic effect” because the partnership or LLC agreement does not contain the<br />
provisions required to satisfy the economic effect test, the regulations nonetheless will<br />
deem the allocations to have economic effect if, as of the end of each partnership or LLC<br />
taxable year a liquidation of the partnership or LLC at the end of such year or at the end<br />
of any future year would produce the same economic results to the partners or members<br />
as would occurs if the economic effect requirements were satisfied. It is this provision<br />
that drafters of LLC and partnership agreements using the targeted capital account<br />
approach, discussed below, rely upon for comfort that allocations made under the<br />
agreement will be respected.<br />
G. Failure to Satisfy the Substantial Economic Effect Test – the Partners’<br />
Interest in the Partnership Test. If a partnership or LLC agreement provides for an<br />
allocation of profits or losses that does not satisfy the substantial economic effect safe<br />
harbor, and the “no harm, no foul rule” cannot be said to apply, the IRS may reallocate<br />
profits and losses in accordance with the partners’ or members’ interests in the<br />
partnership or LLC—that is, in accordance with the manner in which the partners or<br />
members have agreed to share the economic benefit or burden (if any) corresponding to<br />
the profit or loss allocation that does not have substantial economic effect. A partner’s or<br />
member’s interest in the partnership or LLC will be determined based upon all of the<br />
facts and circumstances, including the partners’ or members’ relative contributions to the<br />
partnership or LLC, the interests of the partners or members in economic profits and<br />
losses (if different than their interests in taxable income or loss), the interests of the<br />
partners or members in cash flow and other non-liquidating distributions and the rights of<br />
the partners or members to distributions of capital on liquidation.<br />
II.<br />
Drafting Financial Provisions of a Partnership or LLC Agreement.<br />
A. Overview. In general there are currently two primary methods of drafting<br />
the financial provisions of a partnership agreement or an LLC operating agreement.<br />
These typically are referred to as: (i) liquidation by capital account balances and (ii)<br />
liquidation by specified tiers with target allocations. The draftsman using the liquidationby-capital-accounts<br />
method uses allocations of profit and loss to construct capital<br />
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Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
accounts that will support the distribution scheme which the businessmen have<br />
negotiated. This methodology follows the requirements set forth in the Section 704(b)<br />
regulations for “economic effect” (or, more accurately in the context of an LLC, the<br />
requirements for the so-called “alternate test for economic effect”), described above.<br />
Draftsmen who use the liquidation-by-tiers-with-target-allocations method prefer not to<br />
rely on capital account balances for liquidating distributions. Why? They are concerned<br />
that the balances may be wrong, or if not wrong there is often a suspicion that the<br />
accounting judgments or the technical minutia in the allocation of profit and loss are<br />
sufficiently judgmental that the draftsmen cannot be comfortable that the LLC operating<br />
agreement reflects the economic deal. The liquidation-by-tiers-with-target-allocations<br />
method involves (i) liquidation by specified tiers or percentages (without regard to capital<br />
account balances); and (ii) “target allocation” provisions which allocate profit and loss in<br />
a manner so that capital accounts will follow the specified tiers or percentages. In other<br />
words, with the liquidation-by-capital-accounts-balance method, cash distributions on<br />
liquidation follow allocations of profit and loss; with the liquidation-by-tiers-with-targetallocations<br />
method allocations of profit and loss follow the described cash distributions.<br />
B. Advantages/Disadvantages. Which method is better? Frankly, it is hard<br />
to say. The liquidation-by-capital-accounts method has the advantage, indeed it is<br />
probably its greatest benefit, of being more clearly compliant with the substantial<br />
economic effect safe-harbor. It is debatable 1 whether the liquidation-by-tiers-with-targetallocations<br />
method satisfies the alternate test for economic effect 2 .<br />
Furthermore, there is considerable doubt whether target allocations will satisfy the<br />
so-called “fractions rule” of Code Section 514(c)(9)(E), discussed further below.<br />
Accordingly, liquidation-by-tiers-with-target-allocations method is particularly<br />
disadvantageous if the LLC or partnership will have as members charities or qualified<br />
plans which wish to avoid debt-financed unrelated business income tax. Similarly, the<br />
liquidation-by-tiers-with-target allocations method likely does not satisfy the tax-exempt<br />
use property rules of Code Section 168(h)(6) and, therefore, it may be a problem for<br />
LLCs (and other partnerships) with tax-exempt members.<br />
Finally, it can be extremely tricky to draft a liquidation-by-tiers-with target<br />
allocations partnership or operating agreement in which a pure “profits interest” is<br />
granted to a service partner or member. It is all too easy for a taxable capital shift to<br />
occur under such an agreement.<br />
The liquidation-by-tiers-with-target-allocations is clearly becoming more<br />
common. Presumably this is due to the draftsman’s concern to provide for cash<br />
distributions which reflect the businessmen’s deal. It is more crucial to get the right cash<br />
allocations than to be comfortable that the tax allocations will be respected by the IRS.<br />
The other advantage of the liquidation-by-tiers-with-target-allocations method is<br />
Speaker 11: 6<br />
Speaker 12: 6<br />
1 See Cuff, Some Basic Issues in Drafting <strong>Real</strong> <strong>Estate</strong> Partnership and Limited Liability Company<br />
Agreements, 65 N.Y.U. Inst. § 18.84 [7] (2007).<br />
2 It seems clear that an agreement which provides for liquidation by tiers or percentages without target<br />
allocations does not meet the alternate test for economic effect.<br />
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Andrew H. Zuccotti of K&L Gates LLP<br />
its (some would say “illusion of” 3 ) simplicity. A draftsman can insert the target<br />
allocation provision into any operating agreement he drafts. He can exclude tax lawyers<br />
completely from the drafting process. He can save the client money and (some would<br />
say) headaches. The liquidation-by-tiers-with-target-allocations method is, in our view,<br />
more likely than the liquidation-by-capital-account method to give rise to capital shifts<br />
among the members of an LLC or the partners of a partnership, particularly in situations<br />
involving preferred returns. By its nature the liquidation-by-tiers method directs<br />
available cash be distributed in tiers. This may move one member’s capital contribution<br />
to another, senior member. (The federal income tax consequences of internal capital<br />
shifts in an LLC are not well understood by practitioners.)<br />
But this (apparent) simplicity comes at a cost, i.e., it is difficult to predict how<br />
profit and losses will be allocated. This may be a reason why accountants typically prefer<br />
the liquidation-by-capital-accounts method. And, given new Code Section 6694, which<br />
imposes penalties on “return preparers” who take a position on a return and do not have<br />
“a reasonable belief that the position would more likely than not be sustained on the<br />
merits,” it seems likely that the accountants’ preference for greater predictability will<br />
only increase. Furthermore, this lack of predictability probably makes it even more<br />
appropriate to include in the operating agreement a provision for distributions to pay tax<br />
on allocations of income.<br />
The best answer we can give to the question of which method to use in drafting<br />
LLC and partnership agreements is that it depends on the circumstances. If one of the<br />
members is a tax exempt plan or a charity, the liquidation-by-capital-accounts method<br />
seems clearly preferable because of Sections 168(h) and 514(c)(9)(E). If the business<br />
deal includes a flip-flop as a function of an internal rate of return calculation, the<br />
liquidation-by-tiers-with-target-allocations method is preferable because it is difficult to<br />
draft a flip-flop which is a function of an IRR – a cash return concept – using the<br />
liquidation-by-capital-accounts method.<br />
C. Potential Pitfalls: Drafting Issues to Watch For.<br />
Two recent cases illustrate the dangers of trying to draft an LLC agreement<br />
without input from tax counsel.<br />
1. Imprimis Investors, LLC. v. U.S., ___F.3d___ (Cl. Ct. 2008); 102<br />
AFTR2d 2008 5727.<br />
The LLC Agreement provided for a “waterfall” of allocations of net profits and<br />
net losses and then, after such waterfall, 20% of net profits and net losses would be<br />
allocated to one member, Insight. If the net profits consisted of “items of ordinary<br />
income,” then Insight was to receive a special gross income allocation of such “ordinary<br />
income” items equal to the amount Insight would otherwise receive with the remainder to<br />
be allocated to the other members. If the amount of ordinary income allocated to Insight<br />
Speaker 11: 7<br />
Speaker 12: 7<br />
3 Cuff, “Working with Target Allocation Provisions: Idiot-Proof or Drafting for Idiots?” (Pre-publication<br />
draft) (2008). Mr. Cuff sets forth a series of examples arguing that “the perceived simplicity of the target<br />
allocation provision is considerably overstated.<br />
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Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
was less than what Insight would otherwise receive, then the LLC was to allocate other<br />
income, such as capital gain, to make up the difference. The term “ordinary income” was<br />
not defined. Insight argued that the term “ordinary income” excluded capital gain and<br />
moved for summary judgment. The LLC argued that the plan meaning of “ordinary<br />
income” is income taxed at ordinary income tax rates and that the term includes,<br />
therefore, short term capital gain. The court held that the term “ordinary income”<br />
unambiguously excluded short-term capital gain.<br />
Speaker 11: 8<br />
Speaker 12: 8<br />
2004WL.<br />
2. Interactive Corp v. Vivendi Universal, S.A. (Del. Ch. 2004)<br />
In this case, an LLLP was formed and its agreement provided for a profits<br />
allocation waterfall in which preferred units received a priority profits allocation in a<br />
specified annual percentage (the “Preferred Return”) and after such allocation residual<br />
profits were allocated based on percentage interests. Tax distributions were to be made<br />
annually in an amount “[e]qual to the product of (a) the amount of taxable income<br />
allocated to such partner for such taxable year pursuant to Section 7.02 [the entire<br />
waterfall] and (b) the highest aggregate marginal statutory federal, state, local and foreign<br />
income tax rate . . ..” Thus, the LLLP Agreement in effect made the preferred return an<br />
after-tax amount. Vivendi contended that the LLLP was not required to make tax<br />
distributions to the preferred interest holder, the tax distribution having already been<br />
satisfied by the distribution of the Preferred Return. In addition, Vivendi argued the<br />
doctrines of waiver, estoppel, unclean hands, mutual mistake and unilateral mistake, all<br />
of which it claimed supported reformation of the contract. The count rejected each of<br />
these arguments and followed the “plain meaning” of the agreement.<br />
III.<br />
Examples.<br />
A. “Liquidation-By-Capital-Accounts” Allocation Provisions.<br />
8.4 Capital Accounts.<br />
8.4.1 Maintenance. A capital account (“Capital<br />
Account”) shall be determined and maintained for each Member in<br />
accordance with the principles of Regulation Section 1.704-1(b) at all<br />
times throughout the full term of the Company. In the event of a<br />
permitted sale or assignment of all or any part of an Interest, the Capital<br />
Account of the transferor shall become the Capital Account of the<br />
transferee to the extent it relates to the transferred Interest.<br />
8.4.2 Capital Account Adjustments, in General. The<br />
book value of all Company properties shall, upon Board Approval, be<br />
adjusted to equal their respective gross fair market values (as reasonably<br />
determined by the Board) as of the following times: (a) in connection with<br />
the acquisition of an Interest in the Company by a new or existing<br />
Member for more than a de minimis Capital Contribution; (b) in<br />
connection with the liquidation of the Company as defined in Regulation<br />
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Andrew H. Zuccotti of K&L Gates LLP<br />
Section 1.704-(1)(b)(2)(ii)(g); or (c) in connection with a more than de<br />
minimis distribution to a retiring or a continuing Member as consideration<br />
for all or a portion of its Interest. In the event of a revaluation of any<br />
Company assets hereunder, the Capital Accounts of the Members shall be<br />
adjusted, including continuing adjustments for depreciation, to the extent<br />
provided in Regulation Section 1.704-(1)(b)(2)(iv)(f). The Board shall<br />
determine such values.<br />
Speaker 11: 9<br />
Speaker 12: 9<br />
8.4.3 Profits Interest. Member D is receiving his interest<br />
in the Company in consideration of services to be rendered to the<br />
Company in his capacity as a Member of the Company. Member D’s<br />
interest in the Company is a profits interest only, and not a capital interest<br />
of any kind, and his initial Capital Account balance in the Company shall<br />
be zero (0).<br />
8.5 No Interest or Right to Withdraw Capital. No interest shall<br />
be paid on Capital Contributions and no Member shall have the right to<br />
withdraw its Capital Contribution. A Member, irrespective of the nature<br />
of its Capital Contribution, has only the right to demand and receive cash<br />
in return for its Capital Contribution.<br />
ARTICLE 9 -- ALLOCATIONS<br />
9.1 Allocation of Net Profit and Loss – In General.<br />
9.1.1 Allocation of Net Profit. After giving effect to the<br />
special allocations set forth in Sections 9.2 and 9.3, the net profit for any<br />
fiscal year of the Company shall be allocated among the Members in the<br />
following order of priority:<br />
(a) First, to the Members in the reverse<br />
chronological order in which net losses were allocated to the Members<br />
pursuant to Sections 9.1.2(e), 9.1.2(d), 9.1.2(c) and 9.1.2(b), respectively,<br />
until each Member has received aggregate allocations of net profit under<br />
this Section 9.1.1(a) in an amount equal to, but not in excess of, the<br />
aggregate allocations of net loss to such Member pursuant to<br />
Sections 9.1.2(b) through 9.1.2.(e) for all prior fiscal years;<br />
(b) Second, to the Members in proportion to and<br />
to the extent of their respective accrued Preferred Returns until the<br />
aggregate Profits allocated pursuant to this Section 9.1.1(b) is equal to, but<br />
not in excess of, each Member’s accrued Preferred Return; and<br />
(c) Thereafter, to the Members in proportion to<br />
their respective Percentage Interests.<br />
9.1.2 Allocation of Net Loss. After giving effect to the<br />
special allocations set forth in Sections 9.2 and 9.3, the net loss for any<br />
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Andrew H. Zuccotti of K&L Gates LLP<br />
fiscal year of the Company shall be allocated among the Members as<br />
follows:<br />
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Speaker 12: 10<br />
(a) First, in proportion to the amount of net<br />
profits allocated to the Members pursuant to Section 9.1.1(c) in an amount<br />
equal to the excess, if any, of (a) the cumulative net profits allocated to the<br />
Members pursuant to Section 9.1.1(c) for all prior fiscal years, over (b) the<br />
cumulative net losses allocated to the Members pursuant to this<br />
Section 9.1.2(a) for all prior fiscal years;<br />
(b) Second, in proportion to the amount of net<br />
profits allocated to the Members pursuant to Section 9.1.1(b) in an amount<br />
equal to the excess, if any, of (a) the cumulative net profits allocated to the<br />
Members pursuant to Section 9.1.1(b) for all prior fiscal years, over (b) the<br />
cumulative net losses allocated to the Members pursuant to this<br />
Section 9.1.2(b) for all prior fiscal years;<br />
(c) Third, to the Members in proportion to their<br />
respective Percentage Interests; provided, however, that net losses shall<br />
not be allocated to any Member pursuant to this Section 9.1.2(c) to the<br />
extent such allocation would cause such Member to have a Deficit Capital<br />
Account at the end of any fiscal year (which excess net loss shall, instead,<br />
be allocated in accordance with Section 9.1.2(d);<br />
(d) Fourth, the remaining net loss, if any, shall<br />
be allocated among the Members who do not have Deficit Capital<br />
Accounts in proportion to their respective Percentage Interests; provided,<br />
however, that no allocation under this Section 9.1.2(d) shall cause any<br />
Member to have a Deficit Capital Account; and<br />
(e) Thereafter, any remaining net loss shall be<br />
allocated among the Members in proportion to their respective Percentage<br />
Interests.<br />
9.2 Special Allocations. The following special allocations shall<br />
be made for any fiscal year of the Company in the following order:<br />
9.2.1 Minimum Gain Chargeback. If there is a decrease<br />
in the Company’s “partnership minimum gain,” as defined in and<br />
determined under Regulation Sections 1.704-2(b)(2) and 1.704-2(d), the<br />
minimum gain chargeback provisions of Regulation Section 1.704-2(f),<br />
which are hereby incorporated into this Agreement by this reference, shall<br />
be applied.<br />
9.2.2 Member Minimum Gain Chargeback. If there is a<br />
decrease in any Member’s share of “partner nonrecourse debt minimum<br />
gain,” as defined in and determined under Regulation Section 1.704-2(i),<br />
the partner nonrecourse debt minimum gain chargeback provisions of<br />
DWT 12372832v1 0053770-000001<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
Regulation Section 1.704-2(i)(4), which are hereby incorporated into this<br />
Agreement by this reference, shall be applied.<br />
Speaker 11: 11<br />
Speaker 12: 11<br />
9.2.3 Qualified Income Offset. In the event that any<br />
Member unexpectedly receives any adjustments, allocations, or<br />
distributions described in Regulation Sections 1.704-1(b)(2)(ii)(d)(4), (5)<br />
or (6), items of Company income and gain shall be specially allocated to<br />
such Member in accordance with Regulation Section 1.704-<br />
(1)(b)(2)(ii)(d).<br />
9.2.4 Nonrecourse Deductions. “Nonrecourse<br />
deductions,” as defined in and determined under Regulation Sections<br />
1.704-2(b)(1) and (c), shall be allocated among the Members in<br />
accordance with their respective Percentage Interests.<br />
9.2.5 Member Nonrecourse Deductions. “Partner<br />
nonrecourse deductions,” as defined in and determined under Regulation<br />
Sections 1.704-2(i)(1) and (2), shall be specially allocated among the<br />
Members in accordance with Regulation Section 1.704-2(i).<br />
9.3 Corrective Allocations. The allocations set forth in<br />
Section 9.2 are intended to comply with certain regulatory requirements<br />
under Code Section 704(b). The parties hereto intend that, to the extent<br />
possible, all allocations made pursuant to such Sections will, over the term<br />
of the Company, be offset either with other allocations pursuant to<br />
Section 9.2 or with special allocations of other items of Company income,<br />
gain, loss, or deduction pursuant to this Section 9.3. Accordingly, the<br />
Board is hereby authorized and directed to make offsetting allocations of<br />
Company income, gain, loss or deduction under this Section 9.3 in<br />
whatever manner it determines is appropriate so that, after such offsetting<br />
special allocations are made (and taking into account the reasonably<br />
anticipated future allocations of income and gain pursuant to<br />
Sections 9.2.1 and 9.2.2), the Capital Accounts of the Members are, to the<br />
extent possible, equal to the Capital Accounts each would have if the<br />
provisions of Section 9.2 were not contained in this Agreement and all<br />
income, gain, loss and deduction of the Company were instead allocated<br />
pursuant to Section 9.1.<br />
9.4 Other Allocation Rules.<br />
9.4.1 General. Except as otherwise provided in this<br />
Agreement, all items of Company income, gain, loss, deduction, credit,<br />
and any other allocations not otherwise provided for shall be divided<br />
among the Members in accordance with their respective Percentage<br />
Interests, or as otherwise may be required under the Code and the<br />
Regulations thereunder.<br />
DWT 12372832v1 0053770-000001<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
9.4.2 Allocation of Excess Nonrecourse Liabilities.<br />
Solely for purposes of determining a Member’s proportionate share of the<br />
“excess nonrecourse liabilities” of the Company within the meaning of<br />
Regulation Section 1.752-3(a)(3), the Members’ interests in the<br />
Company’s profits shall be in accordance with the allocation set forth in<br />
Section 9.1.1(b).<br />
Speaker 11: 12<br />
Speaker 12: 12<br />
9.4.3 Allocations in Connection with Varying Interests.<br />
If, during a Company fiscal year, there is (a) a permitted transfer of all or a<br />
part of a Member’s Interest or (b) the admission or withdrawal of a<br />
Member, net profit, net loss, each item thereof, and all other tax items of<br />
the Company for such fiscal year shall be divided and allocated among the<br />
Members by taking into account their varying interests during such fiscal<br />
year in accordance with Code Section 706(d) and using any conventions<br />
permitted by law and selected by the Board.<br />
9.5 Determination of Net Profit or Loss. The net profit or net<br />
loss of the Company, for each fiscal year or other period, shall be an<br />
amount equal to the Company’s taxable income or loss for such period,<br />
determined in accordance with Code Section 703(a), with the following<br />
adjustments:<br />
(a) all items of income, gain, loss or deduction<br />
required to be stated separately pursuant to Code Section 703(a)(1),<br />
including income and gain exempt from federal income tax, shall be<br />
included in taxable income or loss;<br />
(b) expenditures described in Code<br />
Section 705(a)(2)(B) or treated as Code Section 705(a)(2)(B) expenditures<br />
pursuant to Regulation Section 1.704-1(b)(2)(iv)(i) and not otherwise<br />
taken into account in computing net profit or loss shall be subtracted from<br />
such taxable income or loss;<br />
(c) any adjustment to the book value of the<br />
assets of the Company pursuant to Section 8.4.2 shall be treated as an item<br />
of gain or loss, as the case may be;<br />
(d) for purposes of computing taxable income or<br />
loss on the disposition of an item of Company property or for purposes of<br />
determining the cost recovery, depreciation, or amortization deduction<br />
with respect to such property, the Company shall use such property’s book<br />
value computed in accordance with Regulation Section 1.704-1(b); and<br />
(e) any items that are specially allocated<br />
pursuant to Sections 9.2 and 9.3 shall not be taken into account in<br />
computing the Company’s net profit or loss., including income and gain<br />
exempt from federal income tax, shall be included in taxable income or<br />
DWT 12372832v1 0053770-000001<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
loss.<br />
Speaker 11: 13<br />
Speaker 12: 13<br />
9.6. Mandatory Tax Allocations Under Code Section 704(c). In<br />
accordance with Code Section 704(c) and Regulation Section 1.704-3,<br />
income, gain, loss and deduction with respect to any property contributed<br />
to the capital of the Company shall, solely for tax purposes, be allocated<br />
among the Members so as to take account of any variation between the<br />
adjusted basis of such property to the Company for federal income tax<br />
purposes and its initial book value computed in accordance with<br />
Section 9.5.2. Prior to the contribution of any property to the Company<br />
that has a fair market value that differs from its adjusted tax basis in the<br />
hands of the contributing Member on the date of contribution, all<br />
Members shall agree upon the allocation method to be applied with<br />
respect to that property under Regulation Section 1.704-3, which<br />
allocation method shall be set forth on attached Schedule 2, as amended<br />
from time to time. The same procedure shall apply to any revaluation of<br />
Company property as permitted under Regulation Section 1.704-<br />
1(b)(2)(iv)(f). Allocations pursuant to this Section 9.6 are solely for<br />
purposes of federal, state, and local taxes and shall not affect, or in any<br />
way be taken into account in computing, any Member’s Capital Account<br />
or share of net profit, net loss, or other items as computed for book<br />
purposes, or distributions pursuant to any provision of this Agreement.<br />
ARTICLE 10 -- DISTRIBUTIONS<br />
10.1 Operating Distributions. Upon Board Approval, the<br />
Company shall make distributions of Distributable Cash to the Members<br />
in the following order of priority:<br />
10.1.1 Tax Distributions. On April 15, June 15, and<br />
September 15 of each fiscal year, and on January 15 of the following year,<br />
the Company shall make a distribution to the Members (a “Tax<br />
Distribution”) in proportion to their respective Percentage Interests in the<br />
aggregate amount determined under this Section 10.1.1. The total amount<br />
of each Tax Distribution shall be the product of multiplying (a) the highest<br />
combined marginal Federal and state income tax rate applicable to any<br />
Member, or, if any Member is not itself subject to such tax, to any of its<br />
owners, for the fiscal year in question, by (b) the Company’s best estimate<br />
of its net profit allocable to the Members pursuant to Section 9.1.1 for the<br />
fiscal year through the end of the tax quarter in question (each of the<br />
periods ending March 31, May 31, August 31, and December 31 each<br />
year). The amount determined under the previous sentence shall be<br />
reduced by the amount of any Tax Distribution previously made by the<br />
Company to the Members during the fiscal year in question (other than<br />
Tax Distribution made during that fiscal year that are required to be made<br />
under the provisions of this Section 10,.1.1 with respect to a prior fiscal<br />
year);<br />
DWT 12372832v1 0053770-000001<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
10.1.2 Preferred Return. Second, to the Members in<br />
proportion to and to the extent of the accrued but unpaid Preferred Return<br />
of each Member on the date of such distribution;<br />
Speaker 11: 14<br />
Speaker 12: 14<br />
10.1.3 Return of Invested Capital. Third, to the Members<br />
in proportion to their respective Adjusted Capital Contributions until each<br />
Member’s Adjusted Capital Contribution is zero; and<br />
10.1.4 Residual Distribution. Thereafter, to the Members<br />
in proportion to their respective Percentage Interests.<br />
10.2 Liquidating Distributions. Notwithstanding Section 10.1,<br />
distributions in liquidation of the Company shall be made to the Members<br />
in proportion to the positive balances of their respective Capital Accounts,<br />
as determined after taking into account all Capital Account adjustments<br />
for the taxable year during which the liquidation occurs.<br />
B. “Liquidation-By-Tiers-With Target Allocations” Provisions.<br />
DEFINITIONS<br />
“Carrying Value” means (a) with respect to any property<br />
contributed to the Company by a Member, the fair market value of such<br />
property, as determined in good faith by the Managing Member, reduced<br />
(but not below zero) by all Depreciation with respect to such property<br />
charged to the Members’ Capital Accounts and (b) with respect to any<br />
other asset of the Company, the adjusted basis of such property for federal<br />
income tax purposes, all as of the time of determination. The Carrying<br />
Value of any property shall be adjusted in accordance with the second<br />
paragraph of Section 3.9 to reflect changes, additions or other adjustments<br />
to the Carrying Value of Company properties, as deemed appropriate by<br />
the Managing Member.<br />
“Deficit Capital Account” means, with respect to any Member, the<br />
deficit balance, if any, in such Member’s Capital Account as of the end of<br />
the taxable year, after giving effect to the following adjustments:<br />
(a) credit to such Capital Account any amount that such<br />
Member is obligated to restore to the Company under Regulation Section<br />
1.704-1(b)(2)(ii)(c), as well as any addition thereto pursuant to the next to<br />
last sentences of Regulation Sections 1.704-2(g)(1) and (i)(5); and<br />
(b) debit to such Capital Account the items described in<br />
Regulation Section 1.704-1(b)(2)(ii)(d)(4), (5) and (6).<br />
This definition is intended to comply with the provisions of Regulation<br />
Sections 1.704-1(b)(2)(ii)(d) and 1.704-2, and shall be interpreted<br />
consistently with those provisions.<br />
DWT 12372832v1 0053770-000001<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
“Depreciation” means, for each fiscal year, an amount equal to the<br />
depreciation, amortization or other cost recovery deduction allowable with<br />
respect to an asset for such year or other period for federal income tax<br />
purposes; provided, that if the Carrying Value of an asset differs from its<br />
adjusted basis for federal income tax purposes at the beginning of any such<br />
year or other period, Depreciation shall be an amount that bears the same<br />
relationship to the Carrying Value of such asset as the depreciation,<br />
amortization, or other cost recovery deduction computed for federal income<br />
tax purposes with respect to such asset for the applicable period bears to the<br />
adjusted tax basis of such asset at the beginning of such period, or if such<br />
asset has a zero adjusted tax basis, Depreciation shall be an amount<br />
determined under any reasonable method selected by the Managing Member.<br />
Speaker 11: 15<br />
Speaker 12: 15<br />
“Mandatory Tax Distribution” means, with respect to a Member<br />
for a fiscal year, a Distribution in cash in an amount equal to the product<br />
of (a) the net amount of all taxable income, gain, loss and deduction of the<br />
Company allocated to such Member with respect to such year pursuant to<br />
Article 7, excluding (i) any income allocated to such Member pursuant to<br />
Code Section 704(c) in accordance with Section 7.6 and (ii) any<br />
depreciation or amortization deductions attributable to basis adjustments<br />
under Code Section 743(b) for the benefit of such Member and (b) the<br />
highest marginal Federal income tax rate applicable to individuals for such<br />
fiscal year.<br />
“Modified Adjusted Capital Account” means, with respect to any<br />
Member, an amount equal to such Member’s Capital Account, increased<br />
by the sum of such Member’s share of “partnership minimum gain,” as<br />
defined in and determined under Regulation Sections 1.704-2(b)(2) and<br />
1.704-2(d) and such Member’s share of “partner nonrecourse debt<br />
minimum gain,” as defined and determined under Regulation Section<br />
1.704-2(i).<br />
“Target Capital Account” means an amount, determined with<br />
respect to each Member for any fiscal year, equal to the hypothetical<br />
Distribution such Member would receive if each Company asset (other<br />
than cash) were sold for an amount of cash equal to such asset’s Carrying<br />
Value as of the end of such fiscal year, each liability of the Company were<br />
satisfied in cash in accordance with its terms (limited, with respect to each<br />
Nonrecourse Liability, to the Carrying Value of the asset or assets<br />
securing such Nonrecourse Liability), and all remaining cash of the<br />
Company (including the net proceeds of such hypothetical transactions<br />
and all cash otherwise available after the hypothetical satisfaction of all<br />
Company liabilities) were distributed in full to the Members pursuant to<br />
Section 7.8; provided that if upon such hypothetical liquidation instead of<br />
receiving a Distribution such Member would be obligated to make a<br />
capital contribution to the Company, such Member’s Target Capital<br />
Account shall be a negative amount equal to such contribution obligation.<br />
DWT 12372832v1 0053770-000001<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
Speaker 11: 16<br />
Speaker 12: 16<br />
ARTICLE 7 -- ALLOCATIONS AND DISTRIBUTIONS<br />
7.1 Allocation of Income and Loss . After giving effect to the<br />
special allocations set forth in Sections 7.2 and 7.3, and subject to Section<br />
7.8, the net profit or loss for any fiscal year of the Company and, if<br />
necessary, items of income, gain, loss and deduction included in the<br />
determination of net profit or loss, shall be allocated among the Members<br />
so as to reduce, proportionately, the differences between their respective<br />
Modified Adjusted Capital Account balances and their respective Target<br />
Capital Accounts for such fiscal year.<br />
7.2 Special Allocations. The following special allocations shall<br />
be made for any fiscal year of the Company in the following order:<br />
7.2.1 Minimum Gain Chargeback. If there is a decrease<br />
in the Company’s “Company minimum gain,” as defined in and<br />
determined under Regulation Sections 1.704-2(b)(2) and 1.704-2(d), the<br />
minimum gain chargeback provisions of Regulation Section 1.704-2(f),<br />
which are hereby incorporated into this Agreement by this reference, shall<br />
be applied.<br />
7.2.2 Member Minimum Gain Chargeback. If there is a<br />
decrease in any Member’s share of “Member nonrecourse debt minimum<br />
gain,” as defined in and determined under Regulation Section 1.704-2(i),<br />
the Member nonrecourse debt minimum gain chargeback provisions of<br />
Regulation Section 1.704-2(i)(4), which are hereby incorporated into this<br />
Agreement by this reference, shall be applied.<br />
7.2.3 Qualified Income Offset. In the event that any<br />
Member unexpectedly receives any adjustments, allocations, or<br />
distributions described in Regulation Sections 1.704-1(b)(2)(ii)(d)(4), (5)<br />
or (6), items of Company income and gain shall be specially allocated to<br />
such Member in accordance with Regulation Section 1.704-<br />
(1)(b)(2)(ii)(d); provided that an allocation pursuant to this Section 7.2.3<br />
shall be made only if and to the extent that such Member would have a<br />
Deficit Capital Account after all other allocations provided for in this<br />
Article 7 have been tentatively made as if this Section 7.2.3 were not in<br />
this Agreement.<br />
7.2.4 Gross Income Allocation. In the event any Member<br />
has a deficit Capital Account at the end of any fiscal year or other period<br />
which is in excess of the sum of (i) the amount such Member is obligated<br />
to restore pursuant to any provision of this Agreement, and (ii) the amount<br />
such Member is deemed to be obligated to restore pursuant to the next-tolast<br />
sentence of Regulation Sections 1.704-2(g)(1) and 1.704-2(i)(5), each<br />
DWT 12372832v1 0053770-000001<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
such Member shall be specially allocated items of Company income and<br />
gain in the amount of such excess as quickly as possible, provided that an<br />
allocation pursuant to this Section 7.2.4 shall be made only if and to the<br />
extent that such Member would have a Deficit Capital Account in excess<br />
of such sum after all other allocations provided for in this Article 7 have<br />
been made as if Section 7.2.3 and this Section 7.2.4 were not in this<br />
Agreement.<br />
Speaker 11: 17<br />
Speaker 12: 17<br />
7.2.5 Nonrecourse Deductions. “Nonrecourse<br />
deductions,” as defined in and determined under Regulation<br />
Sections 1.704-2(b)(1) and (c), shall be allocated among the Members in<br />
accordance with their respective Percentage Interests.<br />
7.2.6 Member Nonrecourse Deductions. “Member<br />
nonrecourse deductions,” as defined in and determined under Regulation<br />
Sections 1.704-2(i)(1) and (2), shall be specially allocated among the<br />
Members in accordance with Regulation Section 1.704-2(i).<br />
7.3 Corrective Allocations. The allocations set forth in<br />
Section 7.2 are intended to comply with certain regulatory requirements<br />
under Code Section 704(b). The Members intend that, to the extent<br />
possible, all allocations made pursuant to such Sections will, over the term<br />
of the Company, be offset either with other allocations pursuant to<br />
Section 7.2 or with special allocations of other items of Company income,<br />
gain, loss, or deduction pursuant to this Section 7.3. Accordingly, the<br />
Managing Member is hereby authorized and directed to make offsetting<br />
allocations of Company income, gain, loss or deduction under this<br />
Section 7.3 in whatever manner the Managing Member determines is<br />
appropriate so that, after such offsetting special allocations are made (and<br />
taking into account the reasonably anticipated future allocations of income<br />
and gain pursuant to Sections 7.2.1 and 7.2.2), the Capital Accounts of the<br />
Members are, to the extent possible, equal to the Capital Accounts each<br />
would have if the provisions of Section 7.2 were not contained in this<br />
Agreement and all income, gain, loss and deduction of the Company were<br />
instead allocated pursuant to Section 7.1.1 and Section 7.1.2.<br />
7.4 Other Allocation Rules.<br />
7.4.1 General. Except as otherwise provided in this<br />
Agreement, all items of Company income, gain, loss, deduction, credit,<br />
and any other allocations not otherwise provided for shall be divided<br />
among the Members in accordance with their Percentage Interests, or as<br />
otherwise may be required under the Code and the Regulations thereunder.<br />
7.4.2 Allocation of Excess Nonrecourse Liabilities.<br />
Solely for purposes of determining a Member’s proportionate share of<br />
“excess nonrecourse liabilities” of the Company within the meaning of<br />
DWT 12372832v1 0053770-000001<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
Regulation Section 1.752-3(a)(3), the Member’s interests in the<br />
Company’s profits shall be their respective Percentage Interests.<br />
Speaker 11: 18<br />
Speaker 12: 18<br />
7.4.3 Allocations in Connection with Varying Interests.<br />
If, during a Company fiscal year, there is (i) a permitted transfer of all or a<br />
part of a Member’s interest in the Company, or (ii) the admission or<br />
withdrawal of a Member, net profit, net loss, each item thereof, and all<br />
other tax items of the Company for such fiscal year shall be divided and<br />
allocated among the Members by taking into account their varying<br />
interests during such fiscal year in accordance with Code Section 706(d)<br />
and using any conventions permitted by law and selected by the Managing<br />
Member.<br />
7.5 Determination of Net Profit or Loss. The net profit or net<br />
loss of the Company, for each fiscal year or other period, shall be an<br />
amount equal to the Company’s taxable income or loss for such period,<br />
determined in accordance with Code Section 703(a), with the following<br />
adjustments:<br />
(a) all items of income, gain, loss or deduction required<br />
to be stated separately pursuant to Code Section 703(a)(1), including<br />
income and gain exempt from federal income tax, shall be included in<br />
taxable income or loss;<br />
(b) expenditures described in Code Section<br />
705(a)(2)(B) or treated as Code Section 705(a)(2)(B) expenditures<br />
pursuant to Regulation Section 1.704-1(b)(2)(iv)(i) and not otherwise<br />
taken into account in computing net profit or loss shall be subtracted from<br />
such taxable income or loss;<br />
(c) any adjustment to the Carrying Value of the assets<br />
of the Company shall be treated as an item of gain or loss, as the case may<br />
be;<br />
(d) for purposes of computing taxable income or loss<br />
on the disposition of an item of Company property or for purposes of<br />
determining the cost recovery, depreciation, or amortization deduction<br />
with respect to such property, the Company shall use such property’s book<br />
value determined in accordance with Regulation Section 1.704-1(b); and<br />
(e) any items that are specially allocated pursuant to<br />
Section 7.2 or Section 7.3 shall not be taken into account in computing the<br />
Company’s net profit or loss., including income and gain exempt from<br />
federal income tax, shall be included in taxable income or loss.<br />
7.6 Mandatory Tax Allocations Under Code Section 704(c). In<br />
accordance with Code Section 704(c) and Regulation Section 1.704-3,<br />
income, gain, loss and deduction with respect to any property contributed<br />
DWT 12372832v1 0053770-000001<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
to the capital of the Company shall, solely for tax purposes, be allocated<br />
among the Members so as to take account of any variation between the<br />
adjusted basis of such property to the Company for federal income tax<br />
purposes and its initial Carrying Value. Prior to the contribution of any<br />
property to the Company that has a fair market value that differs from its<br />
adjusted tax basis in the hands of the contributing Member on the date of<br />
contribution, the contributing Member and the Managing Member shall<br />
agree upon the allocation method to be applied with respect to that<br />
property under Regulation Section 1.704-3, which allocation method shall<br />
be set forth on a Schedule attached to this Agreement, as amended from<br />
time to time. The same procedure shall apply to any revaluation of<br />
Company property as permitted under Regulation Section 1.704-<br />
2(b)(iv)(f); provided, however, that all decisions regarding allocation<br />
methods under Regulation Section 1.704-3 shall be made by the Managing<br />
Member.<br />
Speaker 11: 19<br />
Speaker 12: 19<br />
Allocations pursuant to this Section 7.6 are solely for purposes of<br />
federal, state, and local taxes and shall not affect, or in any way be taken<br />
into account in computing, any Member’s Capital Account or share of net<br />
profit, net loss, or other items as computed for book purposes, or<br />
distributions pursuant to any provision of this Agreement.<br />
7.7 Distributions.<br />
(a) Subject to the restrictions set forth in<br />
Section 7.9, the Members authorize the Managing Member, acting without<br />
the further approval of the Members, to make Distributions when and if<br />
the Managing Member deems appropriate in its absolute discretion;<br />
provided that (i) after the third anniversary of the Closing Date, the<br />
Managing Member shall make a Distribution of cash held by the Company<br />
in excess of: the greater of (x) $___________ or (y) the amount of<br />
reserves established by the Managing Member to meet the anticipated cash<br />
needs of the Company; and (ii) the Managing Member shall make the<br />
Mandatory Tax Distribution with respect to a Company fiscal year within<br />
ninety (90) days after the end of such fiscal year, to the extent of cash held<br />
by the Company in excess of the amount of reserves established by the<br />
Managing Member to meet the anticipated cash needs of the Company;<br />
provided, however, that both clauses (i) and (ii) above shall be.<br />
(b) Distributions to the Members, other than<br />
Mandatory Tax Distributions, shall be calculated and distributed as<br />
follows:<br />
(i) Distributions shall first be made to<br />
the Class A Members, in proportion to their respective Percentage<br />
Interests, until each Class A Member has received aggregate Distributions<br />
pursuant to this Section 7.7(b)(i) equal to such Class A Member’s Invested<br />
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Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
Capital;<br />
Speaker 11: 20<br />
Speaker 12: 20<br />
(ii) Distributions shall then be made to<br />
the Class A Members, in proportion to their respective Percentage<br />
Interests, until each Class A Member has received aggregate Distributions<br />
pursuant to Section 7.7(b)(i) and this Section 7.7(b)(ii) resulting in a ____<br />
percent (___%) IRR on such Class A Member’s Invested Capital<br />
calculated through the date of the Distribution;<br />
(iii) Distributions shall then be made to the<br />
Class B Members until each Class B Member has received in aggregate an<br />
amount equal to a ______ percent (___%) per year cumulative, noncompounded<br />
return on the total amount of Invested Capital contributed by<br />
the Class A Members;<br />
(iv) Distributions shall then be made<br />
____________ percent (___%) to the Class A Members, in proportion to<br />
their respective Percentage Interests, and ____________ percent (___%)<br />
to the Class B Members, until each Class A Member has received<br />
aggregate Distributions pursuant to Section 7.7(b)(i), Section 7.7(b)(ii)<br />
and this Section 7.7(b)(iv) resulting in an __________ percent (___%)<br />
IRR on such Class A Member’s Invested Capital calculated through the<br />
date of the Distribution; and<br />
(v) The balance of funds available for<br />
Distribution, if any, shall be distributed _________ percent (___%) to the<br />
Class A Members, in proportion to their respective Percentage Interests,<br />
and ________ percent (___%) to the Class B Members.<br />
Mandatory Tax Distributions shall be treated as advances against the<br />
Distributions payable to the Members pursuant to Sections 7.7(b)(i)<br />
through (v). Distributions to Class B Members as a group shall be made<br />
in accordance with Section 7.4.3.<br />
7.8 Liquidating Distributions. Distributions in liquidation of the Company<br />
shall be made in the order of priority described in Section 7.7. It is intended that the<br />
allocation provisions of this Article 7 will produce final Capital Account balances of the<br />
Members that would permit liquidating distributions, if such distributions were made in<br />
accordance with final Capital Account balances (instead of being made in the order of<br />
priorities set forth in Section 7.7) to be made (after unpaid loans and interest thereon,<br />
including amounts owed to Members have been paid) in a manner identical to the order<br />
of priorities set forth in Section 7.7. To the extent that such allocation provisions of this<br />
Article 7 would fail to produce such final Capital Account balances, net profits and losses<br />
(including items of gross income, loss and deduction if required to fulfill the intent of this<br />
Section 7.8) will be reallocated among the Members for the fiscal year of the liquidation<br />
(and, if necessary, prior fiscal years) so as to cause the balances in the Capital Accounts<br />
to be in the correct amounts. Notwithstanding anything herein to the contrary, in the<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
event the Company is liquidated within the meaning of Regulation Section 1.704-<br />
1(b)(2)(ii)(g), liquidating distributions shall be made by the end of the taxable year in<br />
which the Company liquidates or, if later, within 90 days of the date of such liquidation.<br />
V. Allocations in LLCs and Partnerships with Exempt Entity Partners or Members.<br />
A. Unrelated Business Taxable Income – General Rule. Under Code Section<br />
511, a retirement plan or other entity otherwise exempt from federal income tax<br />
nonetheless will be subject to tax on its “unrelated business taxable income” (“UBTI”)<br />
which, generally speaking is the net income the tax-exempt entity derives from the<br />
conduct of any trade or business not substantially related to its exempt function. Included<br />
in the computation of UBTI is the tax-exempt entity’s allocable share of net income of a<br />
partnership (or limited liability company treated as a partnership for federal tax purposes)<br />
in which the entity is a partner or member (as the case may be), except to the extent the<br />
income is derived from activities of the partnership that are substantially related to the<br />
exempt function of the tax-exempt entity. This latter rule applies regardless of whether<br />
the income is distributed and regardless of whether the entity holds the interest as a<br />
general partner, a limited partner or a member in an LLC. Rev. Rul. 79-222, 1979-2 C.B.<br />
236; Service Bolt & Nut Co. Profit Sharing Trust v. Comm'r, 78 T.C. 812 (1982).<br />
B. General Exclusions from UBTI. Subject to limitations, UBTI does not<br />
include certain enumerated types of investment income – such as dividends, interest,<br />
rents and royalties – or gain from the sale of property other than inventory and property<br />
held for sale to customers in the ordinary course of business. I.R.C. § 512(b)(1), (2), (3)<br />
and (5).<br />
C. Debt Financed Property. In addition to income derived from activities not<br />
substantially related to a tax-exempt entity’s exempt purpose, UBTI includes “unrelated<br />
debt financed income,” which is a portion of the income (including gain from a sale or<br />
exchange) derived from property held to produce income with respect to which there is<br />
“acquisition indebtedness.” I.R.C. §§ 512(b)(4); 514. The percentage of the income<br />
generated by an item of property that is unrelated debt financed income depends upon the<br />
extent to which the cost of acquisition or improvement of the property was financed<br />
through borrowing. I.R.C. § 514(a).<br />
“Acquisition indebtedness” is indebtedness incurred directly or indirectly in<br />
connection with the acquisition or improvement of property. Acquisition indebtedness<br />
does not, however, include indebtedness incurred by certain defined categories of taxexempt<br />
entities (“qualified organizations”), or by a partnership or LLC in which such an<br />
entity is a partner or member, to acquire or improve real property if certain conditions are<br />
satisfied. I.R.C. § 514(c)(9). These conditions are:<br />
• The price for the acquisition or improvement must be a fixed amount,<br />
determined as of the date of the acquisition or completion of the<br />
improvement;<br />
Speaker 11: 21<br />
Speaker 12: 21<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
• The amount of indebtedness or any other amount payable with respect to<br />
such indebtedness, or the time for making any payment of such amount,<br />
may not depend, in whole or in part, on the revenue, income or profits<br />
derived from the real property;<br />
• The real property may not be leased back to the seller or to a person<br />
related to the seller;<br />
• The real property may not be acquired from, or at any time after such<br />
acquisition be leased to, a related person;<br />
• Neither the seller nor any person related to either the seller or the qualified<br />
organization acquiring the real property may provide financing in<br />
connection with the acquisition or improvement.<br />
I.R.C. § 514(c)(9)(B).<br />
“Qualified organizations” are limited to the following:<br />
• Certain educational institutions and their affiliated support organizations;<br />
• Trusts that are qualified pension plans under Code Section 401; and<br />
• <strong>Real</strong> property holding corporations exempt from tax under Code Section<br />
501(c)(25).<br />
I.R.C. § 514(c)(9)(C). IRAs are not qualified organizations.<br />
In order for this exception to the definition of acquisition indebtedness to apply to<br />
a qualified organization when the real property is held in a partnership in which the<br />
qualified organization is a partner or in an LLC in which the qualified organization is a<br />
member, one of the following three conditions must also be satisfied:<br />
• All of the partners or members must be qualified organizations; or<br />
• Each allocation to a partner or member that is a qualified organization is a<br />
“qualified allocation” within the meaning of Code Section 168(h)(6), that<br />
is, an allocation that both (i) has “substantial economic effect” and (ii) is<br />
consistent with the qualified organization being allocated the same<br />
distributive share of each item of income, gain, loss, deduction, credit, and<br />
basis and such share remains the same during the entire period the<br />
organization is a partner in the partnership or a member in the LLC 4 ; or<br />
Speaker 11: 22<br />
Speaker 12: 22<br />
4 It is not entirely clear whether allocations that reverse prior disproportionate allocations that were made<br />
because proportionate allocations would have caused one or more members to have a deficit capital account<br />
are qualified allocations within the meaning of Code Section 168(h)(6). Since such allocations are<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
Brian Todd of Davis Wright Tremaine LLP<br />
Andrew H. Zuccotti of K&L Gates LLP<br />
• The partnership agreement or LLC operating agreement complies with the<br />
“substantial economic effect” safe-harbor under the Treasury Regulations<br />
and also satisfies the so-called “fractions rule.” I.R.C. § 514(c)(9)(E).<br />
The fractions rule requires that the allocation of items to a partner or<br />
member that is a qualified organization cannot result in the partner or<br />
member having a percentage share of overall partnership or LLC income<br />
for any taxable year that is greater than the partner’s or member’s<br />
“fraction rule percentage,” which is the partner’s or member’s percentage<br />
of overall partnership or LLC loss for the taxable year for which the<br />
partner’s or member’s percentage share of overall partnership or LLC loss<br />
will be the smallest. Overall partnership or LLC income and loss are the<br />
respective amounts by which the aggregate items of partnership or LLC<br />
income and gain for a taxable year exceed, or are less than, (as the case<br />
may be) the aggregate items of partnership or LLC loss and deduction for<br />
the year. For purposes of applying the fractions rule, a reasonable<br />
preferred return or guaranteed payment for capital may be disregarded.<br />
Additionally, allocations that reverse prior disproportionate allocations<br />
that were made because proportionate allocations would have caused one<br />
or more non-qualifying organization members to have a deficit capital<br />
account are disregarded for purposes of the fractions rule.<br />
Speaker 11: 23<br />
Speaker 12: 23<br />
disregarded for purposes of the fractions rule (discussed in the following paragraph), a solid argument can<br />
be made by analogy that such allocations should not be treated as other than qualified allocations.<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Large-scale Residential Development in<br />
Public/Private Partnership<br />
John W. Hanley, Jr., Esq.<br />
Davis Wright Tremaine LLP<br />
Seattle, WA<br />
Tom Tierney<br />
Seattle Housing Authority<br />
Seattle, WA<br />
Gary A. Young<br />
Polygon Northwest Company<br />
Bellevue, WA<br />
Hal Ferris<br />
Spectrum Development Solutions LLC<br />
Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Tom Tierney of Seattle Housing Authority<br />
Gary A. Young of Polygon Northwest Company<br />
Hal Ferris of Spectrum Development Solutions LLC<br />
Speaker 13: 1<br />
Speaker 14: 1<br />
Speaker 15: 1<br />
Speaker 16: 1<br />
Large-scale Residential Development in Public-Private Partnership<br />
Meeting the goals of both the public and private sectors<br />
Tom Tierney, Executive Director, Seattle Housing Authority<br />
Gary Young, Sr. Vice President and Co-Owner, Polygon Northwest Co.<br />
Hal Ferris, Principal, Spectrum Development Solutions<br />
Moderated by John Hanley, Partner, Davis Wright Tremaine LLP<br />
The public or private sector: which one “does it better?”<br />
From the volume at which partisans argue the question, one might think there could<br />
actually be an answer. But increasingly, the people who have to move large capital<br />
projects forward understand that a partnership between the public and private sectors<br />
provides benefits that neither sector can achieve alone. For the implementation of a wide<br />
variety of large capital projects, from water supply facilities to transportation<br />
improvements, from schools to housing, the public sector is turning to joint ventures<br />
with the private sector through public-private partnerships.<br />
A public-private partnership is “a contractual agreement between a public agency<br />
(federal, state, or local) and a private sector entity. Through this agreement the skills and<br />
assets of each sector (public and private) are shared in delivering a service or facility for<br />
the use of the public. In addition to the sharing of resources, each party shares in the risks<br />
and rewards potential in the delivery of the service and/or facility.” (Source:<br />
www.ncppp.org.)<br />
To be successful, such a partnership must build on the special strengths of each of the<br />
parties, it must fulfill the unique needs of the parties, and it must balance the distribution<br />
of risks and rewards between the parties. In the February 8 <strong>LSI</strong> session on Large-Scale<br />
Residential Development in Public-Private Partnership, we examine what two parties –<br />
Seattle Housing Authority (SHA) and Polygon Homes – were seeking through a<br />
partnership in SHA’s award-winning High Point development, and we explore what<br />
potential partners may desire in the distribution of the risks and rewards in a much<br />
denser urban development being planned for Yesler Terrace.<br />
Even though these case studies are focused on public-private residential development,<br />
many of the ideas are transferable to other potential partnerships. The advantages we seek<br />
through partnership in these residential settings are similar to the advantages sought<br />
whenever the public sector reaches to a private partner to deliver a project. The National<br />
Council for Public-Private Partnerships lists some of these advantages as follows:<br />
maximize the use of each sector’s strength, reduce development risk, reduce public capital<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Tom Tierney of Seattle Housing Authority<br />
Gary A. Young of Polygon Northwest Company<br />
Hal Ferris of Spectrum Development Solutions LLC<br />
Large-scale Residential Development in Public-Private Partnership<br />
Page 2 of 8<br />
Speaker 13: 2<br />
Speaker 14: 2<br />
Speaker 15: 2<br />
Speaker 16: 2<br />
investment, improve efficiencies and result in more timely completion, foster better<br />
environmental outcomes, improve service to the community, and bring the parties<br />
mutual rewards through an allocation of resources and risks. (www.ncppp.org)<br />
Most of these advantages are present in the case of the development of High Point. They<br />
will need to be stretched and enhanced if we are to find success in the development of a<br />
new urban neighborhood at Yesler Terrace. The following sections provide background<br />
on the two projects and examine the partnerships that have been demonstrably effective<br />
at High Point and may yield significant benefits at Yesler Terrace.<br />
HIGH POINT<br />
At the end of the last century, High Point residents, community leaders, and Housing<br />
Authority employees started to dream about a new neighborhood for 4,000 residents on a<br />
beautiful hilltop site in West Seattle.<br />
Now, with all of the rental housing and about half of the for-sale homes completed, more<br />
than 3,000 people already live in this new neighborhood. What was once an isolated area,<br />
home only to those with very low incomes, has become an award-winning, mixed-income<br />
community that is a national model for sustainable development.<br />
The new neighborhood is characterized by pride of ownership among all residents,<br />
whether they rent or own. High Point now features well-designed homes that work for a<br />
wide range of people, from elderly singles to large families. It is a richly diverse place<br />
where people of many cultures, backgrounds and incomes live together as good<br />
neighbors.<br />
High Point’s streets are purposely narrow, to help slow cars and increase pedestrian<br />
safety. Wide sidewalks encourage walking. To help bring neighbors together, homes<br />
feature porches close to the street, and parks, playgrounds, and gardens are found<br />
throughout the community.<br />
New neighborhood amenities serve both the residents of High Point and the surrounding<br />
neighborhood. The Seattle Public Library has opened a new High Point branch, and<br />
Neighborcare Health has created a spacious new facility next to the library for its High<br />
Point Medical & Dental Clinic, which serves area residents in 24 languages.<br />
Neighborhood House recently opened a state-of-the-art neighborhood center, home to a<br />
Head Start program, on-site job training, offices for social service workers, and an afterschool<br />
gathering place for area teenagers.<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Tom Tierney of Seattle Housing Authority<br />
Gary A. Young of Polygon Northwest Company<br />
Hal Ferris of Spectrum Development Solutions LLC<br />
Large-scale Residential Development in Public-Private Partnership<br />
Page 3 of 8<br />
Speaker 13: 3<br />
Speaker 14: 3<br />
Speaker 15: 3<br />
Speaker 16: 3<br />
High Point redevelopment has also benefited the environment. Because the<br />
neighborhood’s 120 acres occupy ten percent of the watershed of Seattle’s most<br />
significant salmon stream, Longfellow Creek, it was built with a natural drainage system<br />
beneath it. Water entering the stream is now filtered by the system and is as clean as water<br />
from a natural meadow.<br />
In addition, new homes all qualify for three-star BuiltGreen TM and Energy-Star<br />
certification. During construction 110 mature trees were preserved and still grace the<br />
community.<br />
As High Point nears completion, it is becoming a more integral part of West Seattle. New<br />
streets have reconnected it with the surrounding community and barriers between High<br />
Point residents and the rest of West Seattle – real or imagined – have diminished.<br />
By the time it is completed, a total of $550 million will be invested in the redevelopment<br />
of High Point. The uses of this money includethe construction of energy-efficient public<br />
and private housing, the development of infrastructure-including High Point’s innovative<br />
natural drainage system-and the creation of parks, community gardens, open spaces, the<br />
library, the neighborhood center, and more.<br />
Summary of investment at High Point<br />
$285 million - Private investment<br />
$106 million - Other public funding<br />
$68 million - Tax-exempt borrowing<br />
$56 million - Tax credit partnership equity<br />
$35 million - HOPE VI grant<br />
When the High Point neighborhood is completed it will include housing units for<br />
residents with very low incomes (50 percent of area median income or below) and lowincomes<br />
(80 percent or below) in addition to market-rate rental and for-sale housing:<br />
Housing Type Income Category Units<br />
For-sale housing Any income level 790<br />
Public housing Very low income 350<br />
Affordable rental housing Low income 250<br />
Senior housing Any income level 160<br />
Senior housing Very low income 75<br />
Affordable for-sale housing Low income 56<br />
Units of on-site housing 1,681<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA<br />
3
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Tom Tierney of Seattle Housing Authority<br />
Gary A. Young of Polygon Northwest Company<br />
Hal Ferris of Spectrum Development Solutions LLC<br />
Large-scale Residential Development in Public-Private Partnership<br />
Page 4 of 8<br />
Speaker 13: 4<br />
Speaker 14: 4<br />
Speaker 15: 4<br />
Speaker 16: 4<br />
Redevelopment at High Point will also result in the creation of 291 additional units of offsite<br />
housing for extremely low income residents. In addition, 397 housing assistance<br />
vouchers were added to Seattle Housing Authority’s voucher portfolio because of the<br />
redevelopment.<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA<br />
4
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Tom Tierney of Seattle Housing Authority<br />
Gary A. Young of Polygon Northwest Company<br />
Hal Ferris of Spectrum Development Solutions LLC<br />
Large-scale Residential Development in Public-Private Partnership<br />
Page 5 of 8<br />
Speaker 13: 5<br />
Speaker 14: 5<br />
Speaker 15: 5<br />
Speaker 16: 5<br />
The goals of a partnership at High Point<br />
Public Sector Goals<br />
The first and most significant goal of the Housing Authority in redeveloping its old<br />
public housing “projects” is to create new, more healthful and safer living environments<br />
for low-income people. The agency seeks to create ‘neighborhoods of choice and<br />
connection” that people of all income levels will choose as a neighborhood and where<br />
people will be connected to other neighbors in a single community and in ways that may<br />
provide more educational and economic opportunity than the segregated, isolated<br />
neighborhoods of the past.<br />
After the first phase of its earliest large-scale, mixed-income redevelopment, at NewHolly<br />
in the mid-1990s, the Housing Authority recognized it could not be an efficient or<br />
effective developer of private homes for sale. The agency had built the 142 private homes<br />
in that phase at NewHolly, and indeed it may have been the only entity at the time that<br />
would have taken the risk of building for-sale homes in the midst of an old public<br />
housing development. But Seattle Housing managers learned that they had little expertise<br />
at pricing, marketing, or efficient delivery of a for-sale product. Beginning with the<br />
second phase at NewHolly, the Housing Authority has turned to the private sector to<br />
build and market private homes in its mixed-income communities.<br />
The agency acts as the master-plan-developer of all the land in its redevelopments,<br />
constructing all of the infrastructure, including parks, streets and sidewalks, and<br />
environmental requirements such as water supply and stormwater management. In one<br />
respect, when the agency interacts with a private home builder, it is simply selling<br />
developed lots.<br />
However, the Housing Authority needs, and requires, more than a mere lot-sale in its<br />
partnership with private builders. The agency seeks to control the design and<br />
environmental attributes of the homes. It relies on the private builder’s marketing but<br />
also requires participation in the joint marketing of the neighborhood itself.It seeks<br />
timely development of multiple lots and expects multiple builders to coordinate and<br />
cooperate in the build-out. It also requires different price points of different builders, in<br />
order to obtain a mix of properties to serve people with a mix of incomes. Finally, the<br />
Housing Authority seeks to protect the public trust through a profit-sharing<br />
arrangement, so all of the “up-side” (if any) does not accrue to the private sector alone.<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Tom Tierney of Seattle Housing Authority<br />
Gary A. Young of Polygon Northwest Company<br />
Hal Ferris of Spectrum Development Solutions LLC<br />
Large-scale Residential Development in Public-Private Partnership<br />
Page 6 of 8<br />
Speaker 13: 6<br />
Speaker 14: 6<br />
Speaker 15: 6<br />
Speaker 16: 6<br />
Private Sector Goals<br />
The large-scale redevelopment of SHA property provides the private home builder with<br />
some advantages that are nearly unique in Seattle, where in-fill small-scale development<br />
predominates. Instead of in-fill, the private developer can production-build scores of<br />
homes at a time, mobilizing for efficiencies that may elude them in smaller in-city sites.<br />
Against that advantage, however, the private builder faces large risks: First, can I expect to<br />
be able to sell homes in a neighborhood that has been “branded” for decades as isolated,<br />
segregated, high-crime enclaves of public housing? Will the Housing Authority deliver<br />
the infrastructure in a timely manner, and will that infrastructure perform as promised?<br />
Will the agency and its other private partners create a neighborhood in which my homes<br />
will sell? Will the joint neighborhood marketing efforts prove effective, or would I be<br />
better off marketing my own product alone? What is the basis for “profit-sharing,” when<br />
I will need and deserve maximum returns for taking all this risk?<br />
Both the Housing Authority and the private home builder seek to achieve what they need<br />
– a balanced distribution of risks and rewards – through a contract that effects a purchase<br />
and sale, but also directs the two parties’ relationships on the variety of “goals” described<br />
above. At the February 8 <strong>LSI</strong> session, Tom Tierney, the Housing Authority’s Executive<br />
Director, and Gary Young, the Sr. Vice President and co-owner of Polygon Northwest<br />
Company will describe how these two parties approached the creation of a partnership.<br />
YESLER TERRACE<br />
Yesler Terrace is currently a 28-acre publicly-subsidized housing community, owned and<br />
operated by Seattle Housing Authority. With 561 housing units, it houses about 1,200<br />
residents.<br />
The new Yesler Terrace neighborhood is envisioned as a dynamic and welcoming urban,<br />
mixed-use neighborhood with convenient connections to neighboring communities.<br />
It will be a great place to live and work, and will increase the number of units of<br />
affordable and workforce housing near the urban core. The neighborhood will include a<br />
mix of market-rate housing, office and retail uses, as well as parks and open space,<br />
enhanced landscaping, improved streets and a system of pedestrian and bike trails. Yesler<br />
Terrace is conceived as a model community—safe, healthy and sustainable—<br />
incorporating green design practices, enhanced transportation alternatives and economic<br />
opportunity for its residents.<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA<br />
6
John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Tom Tierney of Seattle Housing Authority<br />
Gary A. Young of Polygon Northwest Company<br />
Hal Ferris of Spectrum Development Solutions LLC<br />
Large-scale Residential Development in Public-Private Partnership<br />
Page 7 of 8<br />
Speaker 13: 7<br />
Speaker 14: 7<br />
Speaker 15: 7<br />
Speaker 16: 7<br />
Presuming economic recovery and a return to “normal” real estate markets, the new<br />
community is being planned as significantly larger than today's Yesler community.<br />
Preliminary planning concepts suggest the following:<br />
• 3,000 to 5,000 residential units<br />
• 800,000 to 1.5 million square feet of medical office or institutional space<br />
• 25,000 to 100,000 square feet of retail space<br />
• 5 to 8 acres of parks and open space<br />
This dynamic mix allows Seattle Housing to reduce the demand for external funding for<br />
the project and to use proceeds from the sale of market-rate housing and commercial<br />
properties to fund additional low-income, workforce and affordable housing—not just at<br />
Yesler Terrace, but also elsewhere throughout Seattle.<br />
Yesler Terrace sits on the southern slope of First Hill, adjacent to downtown, Harborview<br />
Medical Center, the International District and Seattle University. Built in 1939, it is<br />
among the most diverse and one of the most economically challenged neighborhoods in<br />
Seattle. Many of its residents are families with children, seniors, people with disabilities,<br />
and immigrants who speak scores of different languages and come from a rich array of<br />
cultural experiences. Yesler Terrace residents earn less than 30 percent of the city's<br />
median income. Today, the deteriorating structures at Yesler Terrace and its underlying<br />
infrastructure are more than 70 years old, and need to be replaced.<br />
Yesler Terrace is envisioned as a connected community, linked to adjacent communities<br />
and downtown Seattle. As the economy rebounds and the markets return to “normal”<br />
levels over the next 10 to 15 years, Seattle will see a rebirth of Yesler Terrace as a place<br />
where people from across society can come together to enjoy cultural diversity, high<br />
quality homes and access to nearby parks, shops and offices. As it is completed, the new<br />
Yesler Terrace will provide opportunities for new life and prosperity for the<br />
neighborhood.<br />
The goals of a partnership at Yesler Terrace<br />
Although the Housing Authority has developed land for an aggregate of well over 4,000<br />
apartments and for-sale homes in its several large neighborhood redevelopments over the<br />
past 15 years, the agency recognizes the creation of a new urban neighborhood of 3,000-<br />
5,000 residential units on 30 acres adjacent to downtown offers risks and rewards that are<br />
significantly different from the earlier developments, for both the public and private<br />
sectors. Confounding the balance of risks and rewards right now are the current<br />
economic and market climates whose rebounds are a prerequisite for any successful<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP<br />
Tom Tierney of Seattle Housing Authority<br />
Gary A. Young of Polygon Northwest Company<br />
Hal Ferris of Spectrum Development Solutions LLC<br />
Large-scale Residential Development in Public-Private Partnership<br />
Page 8 of 8<br />
Speaker 13: 8<br />
Speaker 14: 8<br />
Speaker 15: 8<br />
Speaker 16: 8<br />
development on the Yesler Hill. Still, both the public and private sectors have reason to<br />
look positively to the redevelopment of Yesler Terrace<br />
Public Sector Goals<br />
As with its other redevelopments, the Housing Authority’s primary goal in the<br />
redevelopment of Yesler Terrace is the replacement of aging and unhealthy living<br />
environments for its current and future residents. But it is also clear to the agency, and to<br />
many in the broader community and in City government, that a new mixed-income<br />
neighborhood at Yesler’s prime location could meet a number of other community goals<br />
as well.<br />
The Housing Authority seeks development in partnership with others for a variety of very<br />
specific reasons:<br />
• to lower the agency’s capital requirements on the site<br />
• to spread the development risk<br />
• possibly to take advantage of site-wide infrastructure innovations such as district<br />
energy, state of the art water, waste, and stormwater technology<br />
• to bring higher-income residents to the site, avoiding a concentration of lowincome<br />
housing<br />
• to bring expertise the agency does not possess, in the construction of denser urban<br />
neighborhoods.<br />
Seattle Housing will also expect its partners to help promote the community benefits of<br />
social equity, environmental stewardship, and economic opportunity that are imbedded<br />
in the Guiding Principles for the site.<br />
Private Sector Goals<br />
Even thought the Housing Authority may play a role of master planner for this<br />
development, the agency may actually develop a smaller share of the housing than in its<br />
previous projects. Therefore, there will be questions for private partners relating to how<br />
contractual agreements can help enforce promises about the overall development of the<br />
site when full build-out may happen over a relatively long period of time because of<br />
considerations like market absorption. This will be especially true for “early movers” from<br />
the private sector.<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/08/10 in Seattle, WA<br />
8
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
State of Equity Capital Markets<br />
John M. Parker<br />
Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP<br />
Seattle, WA
John M. Parker of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP Speaker 17: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John M. Parker of Kennedy Associates <strong>Real</strong> <strong>Estate</strong> Counsel, LP Speaker 17: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Key Economic Terms in a <strong>Real</strong> <strong>Estate</strong> Fund<br />
Quentin Kuhrau<br />
Unico Properties LLC<br />
Seattle, WA<br />
Rodney A. Bench<br />
RA Bench, Inc.<br />
Seattle, WA
Quentin Kuhrau of Unico Properties LLC Speaker 18: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Quentin Kuhrau of Unico Properties LLC Speaker 18: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Rodney A. Bench of RA Bench, Inc. Speaker 19: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Rodney A. Bench of RA Bench, Inc. Speaker 19: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Key Legal Issues in <strong>Real</strong> <strong>Estate</strong> Fund Formation<br />
John W. Hanley, Jr., Esq.<br />
Davis Wright Tremaine LLP<br />
Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 1<br />
KEY LEGAL ISSUES IN<br />
REAL ESTATE FUND FORMATION<br />
John W. Hanley, Jr.<br />
Davis Wright Tremaine LLP<br />
1201 Third Avenue, Suite 2200<br />
Seattle, WA 98101<br />
(206) 622-3150 – Telephone<br />
(206) 757-7700 – Fax<br />
JohnHanley@dwt.com<br />
January 15, <strong>2010</strong><br />
© John W. Hanley, Jr., <strong>2010</strong><br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 2<br />
KEY LEGAL ISSUES IN REAL ESTATE FUND FORMATION<br />
John W. Hanley, Jr.<br />
Davis Wright Tremaine LLP<br />
January 15, <strong>2010</strong><br />
1. Introduction.<br />
The last decade saw an explosion in the use of private equity funds to pool global capital<br />
for investment in U.S. real estate. Indirect investment in real estate assets through large, private,<br />
co-owned vehicles became commonplace for many institutional investors. In a short six-year<br />
period (2002 through 2007), at least 850 high-yield real estate funds were formed, which raised<br />
approximately $400 billion for investment in commercial real estate on behalf of public and<br />
private pension funds, endowments, insurance companies and other investors. 1 However, this<br />
ever-growing use of “blind pools” to aggregate capital for investment in U.S. properties came to<br />
a crashing halt at the commencement of the current recession, in the fall of 2008.<br />
The year <strong>2010</strong> may not appear to be an auspicious time to raise a new real estate<br />
investment fund. However, the commercial real estate markets face a massive deleveraging<br />
challenge during the years <strong>2010</strong>-2013, when an enormous volume of first mortgage loans on<br />
highly leveraged commercial properties will mature, and it is apparent that new mortgage debt at<br />
recent lending levels will not be available. There will be a widespread need to replace mortgage<br />
debt with equity, and one of the principal tools for accomplishing that will be the real estate blind<br />
pool. Despite the lack of transaction volume in the current markets, this may be exactly the right<br />
time to focus on the process of structuring and capitalizing a new real estate investment fund.<br />
The object of the real estate fund is to aggregate investment capital and make it available<br />
to a local real estate developer or operator for use in completing equity investments in target<br />
asset classes under a set of rewards and requirements that incents the local manager to produce<br />
high profits for the investors. When creating a real estate fund, it is important to align the<br />
interests and objectives of the fund manager, charged with placing the capital and managing the<br />
fund’s assets, with those of the passive investors in the fund. The structure typically used for a<br />
real estate fund will provide tax-advantaged financial incentives to the manager that will not be<br />
fully realized unless the fund achieves exceptional economic performance. Fund documentation<br />
can also impose requirements and limitations on the manager to protect the investors from abuse<br />
and to reinforce the investment objectives.<br />
Naturally, both the prospective fund investor and the local real estate operator should<br />
consider alternative arrangements before casually embarking on creation of a real estate fund to<br />
invest in multiple real estate assets. One possibility is the classic real estate joint venture, by<br />
which the investor directly invests its capital in a real estate asset specifically identified by the<br />
operator, or a series of related joint ventures. Historically, the mix of duties, rights and potential<br />
rewards for the capital source, and for the local developer/operator, in the real estate joint<br />
venture have been different from those in the private equity fund for investment in real estate<br />
1 B. Gale and S. Hason, A Principled Approach to a Commingled Fund Documentation, PREA Quarterly, Fall 2007.<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 3<br />
assets. Typically, in the real estate joint venture, the investor approves the selection of the target<br />
asset in advance, and it has a greater voice in development, management, financing and sale of<br />
the property than does an investor in a real estate fund. For the investor, use of a series of singleasset<br />
joint ventures, even if they are all with the same operator, may be more time-consuming<br />
and expensive than a single bulk investment in a multi-asset fund, and that strategy may lead to<br />
less diversification than would be the case if the investor deployed its capital through a largescale<br />
blind pool. For the local operator, the joint venture may provide more attractive economic<br />
terms than those typically found in a fund. <strong>Real</strong> estate joint ventures can vary widely in<br />
economics, but historically the typical joint venture offered the investor only a preferred return<br />
of 6%-8% (as contrasted with a typical fund’s preferred return of 8%-10%), and the split of<br />
residual profits between developer and investors was as rich as “50-50”(in contrast to a 20%-<br />
25% residual interest for the manager of a fund). However, for the developer, the tradeoff for<br />
better economics in the real estate joint venture was typically greater restrictions on authority and<br />
discretion (e.g., investor voting rights) than in a fund structure.<br />
Another possible alternative for the investor is to invest through a public or private real<br />
estate investment trust, which, like the typical real estate fund and typical joint venture, is a taxadvantaged<br />
form of investment (i.e., no federal income taxation at the asset level). However,<br />
with this alternative the investor will typically have less control than in either a private real estate<br />
fund or joint venture structure. The principal distinguishing benefits to the prospective investor<br />
from use of a public REIT to place its capital in real estate are greater liquidity and more assured<br />
diversification, but at the cost of greater volatility.<br />
<strong>Real</strong> estate and capital market conditions in the United States have dramatically changed<br />
from those seen between 2001 and late 2008. During those heady times, capital from all corners<br />
rushed into U.S. commercial real estate, and fund sponsors enjoyed the upper hand in setting the<br />
terms for each successive fund. Investors motivated by potential eye-popping investment returns<br />
had little interest in, or little bargaining power to require, protections in governance,<br />
transparency, disclosure, and other measures to limit excess risk or operator abuse. Then the<br />
bubble burst.<br />
Today, real estate investment capital remains relatively scarce, and the dynamics of<br />
negotiating a fund structure may be quite different. <strong>Real</strong> estate fund terms will be affected by<br />
many considerations, including the prevailing conditions in the capital and real estate markets,<br />
the track record and demonstrated capabilities of the fund sponsor, the stated objectives of the<br />
proposed fund, and the sponsor’s proposed investment guidelines. However, all of the legal<br />
issues implicit in fund formation remain, but perhaps now with different emphases. This paper<br />
will identify and briefly discuss the most important of those legal issues. 2<br />
2 A private equity fund may solicit investments from foreign or domestic entities which have specialized federal and<br />
state tax and reporting requirements. There are at least three categories to be considered:<br />
(a) foreign investors, that is to say, non-U.S. persons. The presence of such investors will trigger<br />
requirements on the fund manager under OFAC, RAFC and, in connection with distributions, “effectively connected<br />
income” and federal tax withholding laws;<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 4<br />
2. Economic Terms of <strong>Real</strong> <strong>Estate</strong> Investment Fund.<br />
Preliminary Comments. An investment in commercial real estate will typically produce<br />
two forms of return, if the asset is managed in a profitable manner. First, during the fund’s<br />
ownership, the property should generate net cash flow from operations, that is, rents and/or other<br />
forms of revenue above and beyond the receipts required to pay current period operating<br />
expenses, taxes, insurance, and mortgage debt service. Second, upon sale of the asset, the fund<br />
may expect to realize net sale proceeds in excess of the amounts required to retire the asset’s<br />
mortgage debt and pay transactions costs. 3 Thus, the real estate fund formed to take ownership<br />
positions in a range of commercial real estate properties will normally expect a recurring stream<br />
of earnings of both types during its projected life. Distributions of such proceeds by the fund to<br />
its investors will be governed by the fund documents and made according to the formula(s) for<br />
splitting profits contained in those documents. The fund manager will typically have some<br />
discretion in determining the timing and gross amounts of cash distributions, 4 but, when the<br />
manager is ready to send cash to the fund participants, he will be required to comply with the<br />
distribution formulas in the governing fund documents (the “waterfall” discussed below).<br />
The real estate investment fund will be structured as a “pass-through” entity for purposes<br />
of federal income taxation, usually either a limited liability company or a limited partnership.<br />
Use of a limited partnership is more common if foreign investors will be solicited, because of the<br />
terms of double taxation treaties in certain foreign countries. Profits realized by the fund from its<br />
investments in real estate assets will not be taxed by the federal government at the fund level.<br />
Under Subchapter K of the Internal Revenue Code (partnership taxation), profits and losses<br />
realized by the fund will be allocated to its owners, for reporting on the tax returns of those<br />
members or partners, according to the allocations provisions found in the fund documents<br />
(subject to certain requirements and limitations in IRC Subchapter K). Thus, the prospective<br />
fund investor must consider the impact of future tax allocations in order to calculate the potential<br />
net after-tax return from a proposed fund investment. (The “preferred return” promised in the<br />
fund documents will be stated on a pre-tax basis.) The investor must also consider the possibility<br />
that, in one or more years, the fund will allocate taxable income or gain to the investor, creating a<br />
tax liability, without making any cash distributions to it before that federal income tax on that<br />
(b) tax-exempt investors, who are subject to a special regime of taxation with respect to unrelated<br />
business taxable income (UBTI), which can be problematic with respect to debt-financed income; and<br />
(c) ERISA-regulated investors, also known as benefit plan investors, whose presence in a fund above<br />
a certain percentage (normally 25%) would trigger almost unbearable regulatory requirements on the plan sponsor<br />
unless the plan sponsor limits the fund’s investments to REOC’s and VCOC’s.<br />
This paper will not discuss the legal requirements or issues unique to these types of potential investors in a real<br />
estate fund.<br />
3 Of course, another form of “capital event” which can yield net cash proceeds to the owner is a refinancing of the<br />
current mortgage debt.<br />
4 Typically the manager will be subject to certain other requirements in the fund documents related to tax<br />
distributions, the use of cash to establish reserves, and distributions upon sold amount or liquidation of the fund.<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 5<br />
allocated income must be paid (the “phantom income” problem). Federal income tax planning is<br />
an essential part of real estate fund investing.<br />
Capital Contributions and Defaults. The investor in a private equity real estate fund will<br />
commit to make a certain investment in the fund, a commitment usually expressed in a signed<br />
fund document (the subscription agreement). Frequently the investor will further agree that the<br />
committed capital may be drawn down by the fund, at the discretion of the manager, over a<br />
stated period of months or years. The informed investor will want assurances that its capital will<br />
be collected and used by the fund only for investment in target real estate assets according to the<br />
investment program described in the fund’s offering <strong>materials</strong>.<br />
Thus, the investor will look for several limitations on the ability of the fund manager to<br />
draw on the investor’s capital commitment. First, what is the period of time during which fund<br />
may draw down committed capital, by the issuance of one or more capital calls, and how does<br />
that period relate to the fund’s plan for acquisition of real estate assets or investments? Do the<br />
fund documents permit the sponsor to draw down capital commitments after the stated<br />
acquisition period has closed, and, if so, for what purposes? Second, what are the permitted uses<br />
of drawn capital? Purchase of real estate assets? Reduction or retirement of mortgage debt on<br />
an existing fund property? Payment of property-level capital expenses or operating expenses?<br />
Use in an acquisition in lieu of promised or anticipated leverage? The investor may be<br />
particularly concerned that the fund sponsor will draw down investment capital and use it,<br />
instead of projected mortgage financing, to complete early acquisitions or to keep on a promised<br />
acquisition timetable. (Leverage can be a necessary ingredient to realize promised economic<br />
returns.) Finally, the investor will be concerned about the mechanics by which capital calls will<br />
be issued and, in particular, the amount of advance notice the sponsor will be required to give<br />
before committed funds are due.<br />
The fund sponsor will want remedies, in the fund documents, regarding the consequences<br />
of a failure by a committed investor to make a capital contribution in response to a proper capital<br />
call. There are several possible remedies, including any and all of the following: forfeiture of a<br />
portion (perhaps 25%-40%) of the defaulting investor’s existing capital account; a right for the<br />
fund manager to terminate the defaulting investor’s percentage interest (and other rights)<br />
associated with the defaulted payment obligation and to solicit a replacement investment from<br />
another existing member or a new capital source; sale, by the fund, of a portion of the defaulting<br />
investor’s membership interest at a discount; loss of the right of the defaulting member to receive<br />
distributions; and legal action by the fund or its manager for specific performance or damages.<br />
As a practical matter, the burden of a default by one investor may, for the most part, fall on the<br />
shoulders of the other investors already committed to the fund.<br />
Finally, the fund documentation should address the possibility that there will be an<br />
unexpected early termination of the fund, and the effect on that event on any outstanding capital<br />
calls and on unfunded capital commitments.<br />
Returnable Capital. The investment capital raised by a fund and deployed into real estate<br />
assets will normally be recaptured by some combination of profitable operations (yielding<br />
periodic net cash flow) and asset sales and refinancings (yielding net capital proceeds).<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 6<br />
Foreclosures, deeds-in-lieu and distressed sales are of course the painful exceptions. The<br />
prospective investor will want to know whether the fund sponsor will have discretion to reinvest<br />
recovered investment capital, instead of distributing capital proceeds back to the investors, and,<br />
if so, under what circumstances. Such discretion is uncommon but possible. By contrast, it is<br />
quite customary for the fund manager to have broad authority to establish a certain levels of cash<br />
reserves, for certain purposes, at the fund level. Prospective investors should focus on the<br />
purposes, circumstances and amounts of such reserves, since reserves will reduce “net” cash<br />
flow and “net” capital proceeds available for distributions to fund investors.<br />
Distributions – The Waterfall and Other Issues. The stated formula for distribution of net<br />
proceeds realized from operations, or from a capital event, will be of real interest to the<br />
prospective investor. Such formulas are typically referred to as “the waterfall,” and they are not<br />
unlike those found in real estate joint venture agreements, although the economic results may be<br />
considerably different (depending on a host of considerations). Most commonly (and<br />
generalizing somewhat), the distribution formula will promise three levels of distributions:<br />
(a) first, distributions to the investors until they have realized a stated “preferred<br />
return” on the investors’ capital (either limited to the investors’ capital in the capital asset giving<br />
rise to the distributable proceeds, or on total invested capital);<br />
(b) distributions to the investors until they have received a return of their invested<br />
capital (again, measured either with respect to the capital in the subject capital asset, or a<br />
cumulative basis); and<br />
(c) distributions to the investor and the fund manager effecting a final division of<br />
remaining distributable proceeds between the investors (as a group) and the fund manager, in<br />
proportions having little to do with the amount of invested capital, in order to give to the fund<br />
manager a “carried interest” in the profits of the enterprise as a reward for his services.<br />
Typically, the fund manager will also commit to invest a certain amount of his own<br />
capital in the fund (usually in the range of 1%-5% of total commitments to the fund), because<br />
prospective investors usually expect (or require) the fund manager to have some of his own skin<br />
in the game. For purposes of the waterfall, the fund manager as capital investor may be treated<br />
in a manner indistinguishable from all other investors (i.e., as part of the “investor group”), or the<br />
distributions with respect to his capital investment may, at each of the first two tiers, be expressly<br />
subordinated to the distributions at that tier to all other fund investors.<br />
There are important details to be addressed at all tiers in the waterfall, but, frequently, the<br />
carried interest tier commands greatest attention and is the source of greatest controversy. The<br />
amount of the carried, or “promoted,” interest received by the manager is of course a key<br />
consideration. During the boom years, the classic formulation in the world of hedge funds and<br />
private corporate equity funds was the “80/20 after an 8”, meaning that the preferred return at<br />
tier two of the waterfall was set at 8% per annum and the third tier featured a 20% promoted<br />
interest for the fund manager. As market conditions became more heated, there were reports of<br />
funds offering smaller preferred returns and requiring a larger percentage promote (perhaps 25%-<br />
30%) for the fund sponsor.<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 7<br />
It is not unusual for a prospective lead investor in a new fund, who is prepared to make<br />
an early and disproportionately large capital commitment, to ask for a share of the fund<br />
manager’s promoted interest, as the reward for this investor’s lead commitment to the fund (a<br />
form of early market validation). This sharing of the sponsor’s promoted interest may be<br />
addressed expressly in the fund documents, or it may be covered in a side letter between the fund<br />
manager and the lead investor, making the sharing relatively invisible to later investors. The<br />
effect of sharing the promoted interest will be to diminish the overall return to the fund’s<br />
sponsor. The possibility of extra benefits flowing to an early fund investor, by means of a side<br />
letter agreement, may prompt later investors to ask for a “most favored nations” clause in their<br />
subscription agreements.<br />
In the case of a fund designed for multiple assets, an important question is whether net<br />
cash flow and net capital proceeds from each asset will be tracked and distributed (according to<br />
the waterfall) separately, or whether all proceeds from all assets will be considered fungible,<br />
pooled, and distributed periodically over time on an aggregate and cumulative basis. Under the<br />
former approach, the fund sponsor may begin to receive distributions on account of its promoted<br />
interest quite early in the life of the venture, perhaps even when the first capital transaction<br />
occurs if the harvested asset has been exceptionally profitable. Under the latter approach, the<br />
third tier of distributions is not reached until much later in the life of the fund, even if the fund is<br />
quite successful.<br />
In the case of a fund with multiple assets, if the manager’s promoted interest return is to<br />
be calculated on a cumulative basis, the investors must protect themselves against the possibility<br />
that the most profitable assets will be harvested first. The result of that scenario might be the<br />
fund manager will receive one or more “third tier” distributions in recognition of his promoted<br />
interest in the sold assets, and the fund’s less profitable (or unprofitable) assets will not be sold<br />
until the end of the fund’s life. The effect of that sequence may be that, on a cumulative basis,<br />
the fund manager received a greater distribution that he is strictly entitled to collect, because of<br />
the early year promote-level distributions based only on the most profitable assets. The<br />
customary protection against this form of abuse is the clawback provision, an explicit promise by<br />
the fund manager to return to the fund (for distribution to the investors) the amount of excess<br />
distribution to him. There are many significant details to be addressed in an effective clawback<br />
provision, including the time period during which the investors may trigger the provision<br />
following liquidation of the fund, the mechanics for using it, the actual scope of the clawback<br />
obligation (e.g., whether it calculates the clawed-back amount on a before-tax or after tax basis),<br />
and the credit strength standing behind the obligation.<br />
The importance of the promoted interest as an element of the economics of a real estate<br />
fund (and a driver of the incentives of the manager) cannot be overstated. Under current federal<br />
tax laws, if appropriately structured and documented, promoted interest distributions will be<br />
taxable to the manager only as capital gains, even though arguably earned in consideration of the<br />
services rendered by the fund manager. As this paper is being written, the taxation of promoted<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 8<br />
interests in all forms of investment funds has become the subject of controversy and a potential<br />
target for tax reform. 5<br />
Finally, the fund documents will speak to other, secondary issues related to distributions<br />
to perspective investors, including the establishment of reserves, the requirement of mandatory<br />
tax distributions, the timing of such distributions, the circumstances (if any) under which a<br />
distribution becomes mandatory because of the occurrence of a particular capital event, and<br />
whether distributions in kind (that is, non-cash distributions) will ever be permitted.<br />
Fees. There is an additional dimension to the economics of a fund for the fund manager.<br />
Typically, the fund manager, or its affiliates, will also collect from the fund, directly or<br />
indirectly, one or more of a host of transaction and management fees. (The fund documents may<br />
also provide that the manager is entitled to certain kinds of expense reimbursements, although it<br />
is relatively unusual for the fund to be obligated to reimburse the manager’s general<br />
administrative and overhead expenses.) These can include the following:<br />
(a) Asset Management Fee. This fee may vary in amount depending on the stage of<br />
life of the fund or other considerations (e.g., a higher asset management fee during the<br />
investment period, when the manager is expected to be more active; a lower asset management<br />
fee after the investment period is closed; and an even lower fee after the fund has entered the<br />
liquidation phase). Typically, the asset management fee is expressed as a percentage of the<br />
capital invested in the venture; during the 2002-2008 era, it was often set in the range of 1% to<br />
2% of total capital commitments during the investment period and 0.75%-1.25% of invested<br />
capital thereafter. Its stated purpose is to (partially) compensate the fund manager for the<br />
administrative burdens taken on by the manager in deploying the fund’s capital and managing<br />
the resulting investments for the fund’s investors. In turn, the fund manager may use some or all<br />
of the fee to create incentive compensation arrangements for individuals within the fund<br />
management company whose performances are judged critical to the success of the fund.<br />
Finally, the fund documents may provide that the asset management fee will be reduced, in<br />
amount, if certain other forms of compensation come to the manager, such as the manager’s<br />
receipt of a share of the placement fees paid by fund investors to their own advisors.<br />
(b) Capital Market Fees. This fee is associated with services provided by the<br />
manager to or for the benefit of the fund in any capital market transaction (in lieu of the fund<br />
using a third party broker or advisor). A capital market fee may be payable in connection with<br />
(i) purchase of a real estate asset, (ii) completion of financing or refinancing of real estate asset,<br />
and/or (iii) sale of a real estate asset by the fund.<br />
(c) Property Management and Leasing Fees. Typically, the fund manager will<br />
bargain for the right to have an affiliate provide both leasing services at each rental property<br />
owned or controlled by the fund (typically compensable by a commission) and property<br />
management services at the property (usually a percentage fee based on gross receipts from the<br />
property).<br />
5 See, generally, “Lawmakers Push to Raise Taxes on Carried Interest,” New York Times, October 14, 2009.<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 9<br />
(d) Construction and Development Management Fees. Sometimes a proposed fund<br />
will target development opportunities, and the fund sponsor may propose that an affiliate provide<br />
construction management or real estate development services, usually pursuant to a separate<br />
agreement, in exchange for the fee stated therein (perhaps a percentage of the construction or<br />
development phase budget).<br />
(e) Sponsor Overhead Fees. Occasionally a private equity fund will allow the<br />
sponsor to recoup a small portion of its general administration and overhead by means of an<br />
additional services fee, such as an annual accounting/reporting fee.<br />
(f) Placement Fees. Finally, a fund sponsor may be able to persuade a prospective<br />
investor that the placement fee typically paid by the investor to its own family wealth office,<br />
advisor or other representative should be split, with a portion of that fee going to the fund<br />
sponsor, in consideration of the fund manager’s willingness to present this fund investment<br />
opportunity.<br />
3. Structure and Governance of Fund.<br />
Basic Structure and Documentation. A fund is a separate legal entity, typically formed as<br />
a limited liability company or a limited partnership. Delaware is frequently chosen as the<br />
jurisdiction of formation, although, in an earlier era, Maryland was a favored jurisdiction for the<br />
formation of limited partnerships.<br />
The sponsor of the fund may choose to serve as the manager (in the case of an LLC) or<br />
general partner (in the case of an LP) of the fund entity, or the sponsor may have an existing<br />
affiliated management company ready to serve that function, or the sponsor may form a new<br />
special purpose entity to play that role only for a particular fund. Investors will participate in the<br />
fund either as members (of the LLC) or limited partners (of the LP). Regardless of the form of<br />
entity, the entity formation laws of the organization’s jurisdiction will typically permit the<br />
entity’s founder to create multiple classes of ownership interests, so the capital structure of a<br />
fund may be as complex as the aspirations and imagination of the founder allows.<br />
In the balance of this paper, to simplify the discussion, we will assume that the typical<br />
real estate fund is a limited liability company, and all investors in it are members of a single<br />
class. The fund will be governed by a limited liability company agreement (sometimes called an<br />
“operating agreement”), a contract to which the fund manager and all members are parties. The<br />
fund will also be governed by the formation law of the state of organization, which may impose<br />
absolute requirements concerning governance or operation of the fund, or “default rules” that<br />
will be applicable in the absence of contrary rules specifically stated in the limited liability<br />
company agreement. One reason Delaware is a favorite jurisdiction, among lawyers, for<br />
formation of real estate funds (and joint ventures) is that state’s expressed policy (stated in its<br />
statute) to maximize freedom of contract. The Delaware Limited Liability Company Act<br />
imposes very few absolute rules of operation on the limited liability company formed in that<br />
jurisdiction; it creates most no default rules that will govern if the framers of the fund’s operating<br />
agreement forget to set a different rule in the document; and it expressly authorizes the founders<br />
of the limited liability company to use the operating agreement to modify – or eliminate –certain<br />
common law rules of conduct that Delaware courts would otherwise impose on the fund or its<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 10<br />
manager. In short, for at least the real estate fund formed under Delaware’s law, the limited<br />
liability company agreement rules.<br />
Standard of Conduct. The limited liability company agreement for a private equity real<br />
estate fund will frequently specify the standard of care, and level of effort, expected from the<br />
manager by the investors. Absent a contractual standard of conduct, the manager of the LLC<br />
will probably have common law fiduciary duties of loyalty and care to the members analogous to<br />
those owed by each general partner in a general partnership, or to those owed by a director to the<br />
stockholders of a Delaware corporation. 6 These common law duties of due care and loyalty are<br />
subject to interpretation – and reinterpretation – by courts, so they are of uncertain impact on the<br />
fund and its management, if this subject is not explicitly addressed in the contract. 7 Therefore,<br />
the fund sponsor typically seeks to circumscribe the manager’s standard of conduct and scope of<br />
duties in order to provide certainty and limit exposure. In this regard, Delaware’s Limited<br />
Liability Company Act is extremely flexible, and it expressly authorizes the use of a limited<br />
liability company agreement to completely eliminate the possible application of fiduciary duties<br />
to a manager. 8<br />
Key Personnel Provisions. There is a second issue of concern to prospective investors<br />
very closely related to the scope of the manager’s duties: which of the manager’s key executives<br />
will participate in finding investment opportunities for this fund, make investment decisions, and<br />
otherwise manage the fund and operate its assets? Historically, this focus on the sponsor’s key<br />
personnel was much more common in the worlds of hedge funds and “corporate” private equity<br />
funds, but it is not completely unknown among private equity real estate investment funds. The<br />
investors’ focus on key personnel is driven by two related concerns. First, which senior<br />
executives or other key personnel will be dedicated to pursuit of the fund’s objectives, and what<br />
is the time commitment of each such individual? Second, what will be the consequences if one<br />
or more of the identified key executives leaves (or is removed from) the sponsor’s company<br />
during the life of the fund? As to the latter point, in the hedge fund/private equity world of<br />
“superstars,” there is a range of alternative remedies, including a right to terminate the fund or<br />
the fund’s investment period (triggering a partial refund of drawn capital). Key personnel<br />
provisions in the fund’s operating agreement can become quite elaborate, particularly when the<br />
fund sponsor wishes to mitigate their potential impact by reserving to itself a right to hire and<br />
substitute qualified replacement personnel.<br />
Indemnification. Related to these questions of sponsor duty and key personnel<br />
commitment is the question of indemnification of the manager and its team. The basic view of<br />
the fund sponsor is, of course, that liabilities and exposures incurred in a good faith, legitimate<br />
pursuit of fund opportunities or management of fund business are an enterprise cost which<br />
6 See, e.g., Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, Delaware Chancery Court No. 3658-VCS,<br />
April 20, 2009, 2009 WL 1124451 (Del. Ch.) at fn. 33.<br />
7<br />
See J.J. Cunningham, “Reforming LLC Fiduciary Law,” Business Law Today (American Bar Association)<br />
November/December 2009 at 51-54.<br />
8 Delaware Limited Liability Company Act § 18-1101(c), authorizing elimination of all such duties other than the<br />
implied contractual duties of good faith and fair dealing.<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 11<br />
should be borne by the fund, not by the manager. In the fund sponsor’s view, the appropriate<br />
mechanism to effect this allocation of responsibility is indemnification of the manager (and,<br />
typically, his affiliates, directors, officers, personnel, employees and agents) by the fund itself.<br />
The scope of this indemnification frequently shields against claims and liabilities arising out of,<br />
or related to, almost any conduct under the fund charter or in pursuit of fund objectives.<br />
Frequently the only stated exceptions to this general indemnity umbrella relate to circumstances<br />
where there has been a demonstrated (and usually egregious) failure by the management team to<br />
conform to the stated or expected standard of conduct – most notably, self-dealing by the fund<br />
manager. There has also typically been an exception from indemnification for “gross<br />
negligence” by the manager. Some investors have pushed to expand that exception to include<br />
conduct which amounts to “mere” negligence by the manager, but fund sponsors have resisted<br />
and, at least before the market crashed, this was not a market standard term.<br />
A related issue concerns the strength of the indemnity commitment made by the fund to<br />
the manager. During its life, the fund will (presumably) have the financial strength (i.e., its<br />
portfolio of assets) to make the indemnity meaningful. However, the fund sponsor may also be<br />
concerned about the possibility of a claim against him after the fund has been liquidated. It is<br />
relatively unusual, but a fund charter may contain a clawback provision pursuant to which, for a<br />
limited period of months or years following fund termination, the investors will be obligated to<br />
return to the fund such monies, from their respective distributions, as are needed to meet the<br />
fund’s continuing tail obligation to indemnify the manager for fund-related claims and liabilities.<br />
Removal of Manager. Investors usually expect to have the right to remove the fund<br />
manager from his position of control in a variety of circumstances that threaten the fund’s<br />
survival or profitability. Frequently, this removal power will be exercisable only upon the<br />
occurrence of a “for cause” circumstance, which may be described in the limited liability<br />
company agreement as conviction of a crime, willful malfeasance or other forms of egregious<br />
conduct. The investors may press for the right to remove the manager without having to prove<br />
“cause,” but fund sponsors typically resist. Such a right is usually provided, at all, only if upon<br />
the occurrence of a specific sign of significant financial distress and only if exercised by a super<br />
majority of members.<br />
The fund charter should specify the mechanics for exercise of the members’ removal<br />
power, if any; in particular, whether a formal vote of (or consent by) the non-managing members<br />
will be required (if so, and at what level). The fund’s operating agreement should also address<br />
the consequences of removal, which may vary depending upon the grounds for removal. In the<br />
instance of removal for cause, the fund manager might forfeit his promoted interest and also<br />
suffer some form of dilution or loss with respect his own invested capital in the enterprise. In<br />
other forms of removal, there might be a less draconian consequence, such as a forfeiture of<br />
projected economic return but payment of some compensatory or reimbursement amount to<br />
mitigate the loss. Finally, the investors should consider the impact of removal of the fund<br />
manager on (i) any rights the manager or an affiliate may hold as a member by virtue of having<br />
made its own capital investment in the fund, (ii) ongoing contract relationships with the fund<br />
held by affiliates of the manager, such as a property management contract, and (iii) the impact of<br />
the change in fund management on the fund’s important third party contracts – especially the<br />
mortgage financing for its portfolio assets.<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 12<br />
Investment Discretion Limitations. One of the manager’s greatest responsibilities, and<br />
most important authorities, is selection of the real estate assets into which to invest the “blind<br />
pool” fund’s capital. Frequently, the fund charter will grant broad investment authority to the<br />
manager but subject that authority to several different investment power limitations, sometimes<br />
called “investment objectives” or “investment guidelines.” These limitations should be driven<br />
by (and consistent with!) the investment plan described to the prospective investors in the fund’s<br />
offering <strong>materials</strong>. Among the types of limitations frequently found in real estate fund charter<br />
documents are the following:<br />
(a)<br />
geographic limitations;<br />
(b) limitations by product type (e.g., office properties, multifamily properties,<br />
industrial properties);<br />
(c) descriptive prohibitions (e.g., no hotels, no property requiring new construction,<br />
no environmentally-impaired property);<br />
(d) concentration limitations, which limit the amount (usually by percentage) that the<br />
fund’s capital that may be invested in a single asset, thereby promoting diversity; and<br />
(e) minimum and maximum amounts of leverage that may be drawn down to support<br />
any asset acquisition.<br />
As a failsafe to protect the ability of the fund to respond to changing market conditions,<br />
the fund sponsor may also include, in the fund charter, a provision authorizing an investment<br />
advisory committee to approve transactions outside of the stated investment guidelines.<br />
The Advisory Committee. Frequently, a real estate fund will create an advisory<br />
committee composed of a specified number of representatives designated by investors selected<br />
by the fund sponsor (normally those investors with the largest capital commitments to the<br />
enterprise). Sometimes the committee will be composed of representatives selected by all<br />
investors in the fund, using a weighted voting process. This advisory committee will be given its<br />
own “charter,” inside the limited liability company agreement, and that charter may give the<br />
committee any or all of the following responsibilities:<br />
(a)<br />
(b)<br />
authorize divergences from the investment limitations;<br />
approve or disapprove transactions in which the manager has a conflict of interest;<br />
(c) authorize or require early termination or extension of investment period in light of<br />
unexpected market conditions;<br />
(d)<br />
(e)<br />
(f)<br />
approve the fund’s auditor;<br />
approve the fund’s appraiser (if one is needed); and<br />
initiate or approve an early termination of fund, or extension of fund’s term.<br />
11<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 13<br />
The fund’s charter will typically sketch out the procedures by which this committee can<br />
act, including the appropriate voting standard, appointment or replacement of designated<br />
participants, and protection of the advisory committee representatives by an explicit exoneration<br />
from any personal liability based on common law fiduciary duties and by an indemnification<br />
provision.<br />
Exclusivity. Another issue important to investors will be the extent to which the fund<br />
manager (and/or the larger organization of which he is a part) will be obligated to guide and<br />
support the fund’s activities to the exclusion of all other potentially-competitive or distracting<br />
activities. This concern will have at least two elements. First, to what extent will the fund<br />
sponsor be precluded from forming other similar real estate investment funds during the offering<br />
period, or after this fund has been formed but while the fund is still within its asset investment<br />
period? Typically, investors want to see a complete prohibition on fundraising activities for<br />
similar real estate investment funds, since their expectation is normally that the fund sponsor will<br />
have a single-minded dedication to the placement of their capital in the best available real estate<br />
investment opportunities, as described in the offering documents. However, in the case of a<br />
multi-faceted fund sponsor with several types of investment discipline programs, the fund<br />
sponsor will often insist on drawing distinctions (by type of investment, product type, geographic<br />
focus, and so forth) in order to continue to create and manage other funds that can credibly be<br />
described as noncompetitive.<br />
Second, to what extent will the fund manager or sponsor be required to make available to<br />
the fund, during the fund’s investment period, all potential investment opportunities that come to<br />
the manager’s or sponsor’s attention? Typically, investors will want to see this form of<br />
exclusivity stated in the fund documents, since their expectation is a single-minded dedication to<br />
the placement of their capital in the best available investment opportunities, in order to achieve<br />
the best available investment return. Investors are concerned not only about a possible lack of<br />
focus or dedication, but also the risk of adverse selection of investment opportunities, that is, the<br />
possibility that a fund sponsor will stockpile the best investment opportunities for a subsequent<br />
fund or for its own account. Again, however, when dealing with a multi-faceted fund sponsor<br />
organization, there can be complexities which lead to qualifications and exceptions to this<br />
commitment of exclusivity.<br />
As a general rule, a real estate fund sponsor will usually agree to the principle of<br />
exclusivity in the presentation of investment opportunities, but it will want to reserve to itself<br />
(and its other funds and affiliates) one or more of the following exceptions (or others):<br />
(a) investment opportunities that fall out of stated investment parameters; (b) investment<br />
opportunities rejected by the advisory committee; (c) investment opportunities in (or related to)<br />
assets already owned by other parts of the fund sponsorship organization (e.g., another fund);<br />
and (d) investment opportunities that are in size in excess of that in which the fund should<br />
prudently invest.<br />
Related Party Transactions. A fund manager with very broad powers may cause the fund<br />
to engage in transactions with parties related to the fund sponsor, a circumstance in which the<br />
fund sponsor has conflict of interest, and the best interests of the fund may not be well served by<br />
such deals. Two related concerns arise from this possibility. Is the related party truly qualified<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20a: 14<br />
to provide the required service to the fund or in support of the fund’s assets? Is the<br />
compensation to be paid by the fund to the related party fair market value? In the real estate<br />
world, these concerns often arise because the fund manager proposes to use an affiliate to<br />
provide property management or leasing services, capital market transaction services, or other<br />
services like construction management. Frequently, fund’s charter document will address these<br />
concerns by (a) expressly authorizing certain service contracts with a fund manager affiliate that<br />
can be anticipated, “pre-negotiated” (as to terms) and fully disclosed and justified to prospective<br />
investors at the time of the offering (such as an initial property management agreement);<br />
(b) imposing a “market-rate compensation” requirement with respect to all future contracts with<br />
related parties, and/or (c) subjecting all related party controlled transactions to a requirement of<br />
prior approval by the advisory committee.<br />
Transparency and Accountability. Investors typically want maximum transparency (to<br />
them, not the public) in all aspects of operation of the fund, and regular and convenient<br />
disclosure by the fund manager of pertinent information to the investors. This concern will<br />
manifest itself in several provisions of the fund charter. The operating agreement will call for<br />
various forms of periodic financial reporting, as well as tax filings and communications, often<br />
with considerable detail. (Normally, the fund manager will be designated as the “tax matters<br />
partner” for tax purposes.) Second, investors may ask for the right to audit fund financial<br />
statements or expense records, which is an unusual but not unheard of right. (More typically,<br />
prospective investors will specifically bargain for the right to audit all calculations of waterfall<br />
distributions.) Third, investors may seek exceptional disclosure and reporting of any transaction<br />
in which the fund sponsor has a conflict of interest or where there is a potential for a conflict of<br />
interest, such as the selection of future service providers.<br />
4. Other Terms.<br />
Exit Rights for Investors. In Europe and, in particular, in Germany, it is common to find<br />
open-ended real estate investment funds that grant each investor a periodic right of redemption,<br />
even while the fund continues. During the recent economic downturn, this feature caused<br />
considerable difficulty for those funds. Typically, the U.S. real estate fund is a closed-end fund<br />
with no such exit right, although this, of course, is subject to potential negotiation. In unusual<br />
circumstances, the fund sponsor may grant a special redemption right to a favored investor or<br />
possibly agree to a provision by which the investors collectively (by a high supermajority vote)<br />
can precipitate an early termination of the fund in certain circumstances, but such provisions are<br />
out of the ordinary.<br />
Membership Interest Transfer Rights. The fund charter will typically address the right of<br />
a member (and, in rare circumstances, the fund manager) to transfer its membership interest prior<br />
to the termination and liquidation of the fund. For the passive investor, transferability is usually<br />
severely restricted with a few customary exceptions related to transfers to affiliates and corporate<br />
reorganizations. For the manager, transferability is frequently even more severely restricted<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20b: 1<br />
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John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20b: 14<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20b: 15<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20b: 16<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20b: 17<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20b: 18<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20b: 19<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20b: 20<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20b: 21<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 20b: 22<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Taxation of Carried Interests<br />
James E. Wreggelsworth, Esq.<br />
Davis Wright Tremaine LLP<br />
Seattle, WA
James E. Wreggelsworth of Davis Wright Tremaine LLP Speaker 21: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
James E. Wreggelsworth of Davis Wright Tremaine LLP Speaker 21: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Securities Law Issues in Fund Formation and<br />
Sponsorship<br />
Erin Joyce Letey, Esq.<br />
Riddell Williams P.S.<br />
Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 1<br />
Securities Issues in <strong>Real</strong> <strong>Estate</strong><br />
Investments<br />
February <strong>2010</strong><br />
Presented by:<br />
Erin Joyce Letey<br />
4810-6298-0357<br />
Overview<br />
Sources of securities law<br />
What is a security?<br />
How might a real estate transaction involve a security?<br />
If a real estate transaction involves a security, what are the<br />
regulatory requirements?<br />
What are some of the exemptions from securities registration<br />
that might apply in a real estate transaction?<br />
What are some of the common mistakes made by companies<br />
raising funds?<br />
What are some of the recent problems / unique issues<br />
presented by real estate related offerings?<br />
Riddell Williams P.S. 2<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 2<br />
Sources of Securities Law – Both Federal and State<br />
Federal<br />
Statutes<br />
Securities Act of 1933<br />
Securities Exchange Act of 1934<br />
Rules and Regulations of the SEC<br />
Policy and interpretative releases, no-action letters<br />
State<br />
RCW 21.20 – Securities Act of WA<br />
WAC 460-44A<br />
Each state has separate set of securities<br />
regulations<br />
State where your investor resides is the relevant<br />
state for state securities law purposes<br />
Riddell Williams P.S. 3<br />
“Security” Defined<br />
“Security” is defined as “any note, stock, treasury stock, security<br />
future, bond, debenture, evidence of indebtedness, certificate of<br />
interest or participation in any profit-sharing agreement, collateral-trust<br />
certificate, preorganization certificate or subscription, transferable<br />
share, investment contract, voting-trust certificate, certificate of<br />
deposit for a security, fractional undivided interest in oil, gas, or other<br />
mineral rights, any put, call, straddle, option, or privilege on any<br />
security, certificate of deposit, or group or index of securities (including<br />
any interest therein or based on the value thereof), or any put, call,<br />
straddle, option, or privilege entered into on a national securities<br />
exchange relating to foreign currency, or, in general, any interest or<br />
instrument commonly known as a “security,” or any certificate of<br />
interest or participation in, temporary or interim certificate for, receipt<br />
for, guarantee of, or warrant or right to subscribe to or purchase, any of<br />
the foregoing.” RCW 21.20.005(12)(a).<br />
Federal definition nearly identical. Section 2(a)(1) of 1933 Act.<br />
Riddell Williams P.S. 4<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 3<br />
“Note”: Presume it is a security<br />
A “note” (including promissory notes, debentures, convertible<br />
debt, etc.) is presumed to be a security under the family<br />
resemblance test established in Reves v. Ernst & Young<br />
A note may be excepted from the definition of “security” where<br />
the note strongly resembles one of the listed types of notes<br />
that are not considered securities<br />
Notes that are not considered securities include:<br />
Note delivered in consumer financing<br />
Note secured by a mortgage on a home<br />
Short-term note secured by a lien on a small business or some of<br />
its assets<br />
Note evidencing a “character” loan to a bank customer<br />
Short-term notes secured by an assignment of accounts<br />
receivable, or<br />
Note that simply formalizes an open-account debt incurred in the<br />
ordinary course of business (particularly if, as in the case of the<br />
customer of a broker, it is collateralized)<br />
Riddell Williams P.S. 5<br />
“Note”<br />
Other factors considered in question of whether a<br />
note is a security:<br />
Motivation of parties<br />
Reasonable expectations of the investing public<br />
Plan of distribution<br />
Presence of another regulation regime<br />
Riddell Williams P.S. 6<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 4<br />
“Investment Contract”<br />
Serves as a catch-all to embrace all arrangements that look<br />
like a security<br />
Four elements of an “investment contract”:<br />
An investment of money<br />
In a common enterprise<br />
With an expectation of profits<br />
Solely from the efforts of others<br />
E.g. investment in real estate coupled with management<br />
agreement<br />
Form disregarded for substance, and emphasis is placed on<br />
economic reality<br />
SEC v. W. J. Howey Co., 328 U.S. 293 (1946)<br />
Riddell Williams P.S. 7<br />
Basics of Securities Regulation<br />
Securities laws regulate both the<br />
offer and sale of a security<br />
Every offer and sale of securities<br />
must either be registered or<br />
exempt from registration<br />
Other areas of regulation:<br />
registration or exemption of every<br />
broker-dealer, securities<br />
salesperson, investment adviser<br />
or investment adviser<br />
representative<br />
Prohibition on fraudulent conduct,<br />
i.e., misrepresentations or failure<br />
to disclose material information<br />
Riddell Williams P.S. 8<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 5<br />
Private Offerings: Exemptions available<br />
Section 4(2) and RCW 21.20.320(1):<br />
Sales not involving a public offering -<br />
Very limited application<br />
Regulation D – Primary exemption<br />
used for private offerings<br />
Rule 504<br />
Rule 505<br />
Rule 506<br />
Rule 147 – Intrastate offering<br />
Riddell Williams P.S. 9<br />
Rule 504<br />
Maximum Offering amount: $1,000,000<br />
<br />
<br />
<br />
<br />
<br />
<br />
<br />
<br />
Number of non-accredited investors: 20 in WA<br />
Investor qualification: In WA, sophistication or suitability<br />
General solicitation or advertising: No<br />
Sales commissions: No<br />
Limitations on resale: Yes<br />
Issuer disqualifications: Yes<br />
Prior securities violations, fraud convictions, etc. by issuer, director,<br />
officer, GP, promoter, or 10% owner<br />
Filing (SEC) – within 15 days after first sale (unless relying on<br />
Rule 147)<br />
File Form D electronically on SEC Edgar system<br />
Filing (WA) – at least 10 business days prior to first sale in WA:<br />
Copy of electronic Form D (or Notification of Claim Exemption)<br />
Representation that sales have yet to occur in WA, and<br />
$50 filing fee<br />
Riddell Williams P.S. 10<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 6<br />
Rule 505 – Rarely Used<br />
Maximum Offering amount: $5,000,000<br />
Number of non-accredited investors: Up to 35 (but information<br />
requirements for non-accredited investors make this impractical for a typical private<br />
offering)<br />
Investor qualification: In WA, sophistication or suitability<br />
General solicitation or advertising: No<br />
Sales commissions: OK, if sales to accredited investors<br />
or by registered broker-dealers<br />
Limitations on resale: Yes<br />
Issuer disqualifications: Yes<br />
Filing (SEC) - within 15 days after first sale<br />
File Form D electronically<br />
Filing – within 15 days after first sale in Washington:<br />
Copy of electronic Form D<br />
Date of first sale in Washington (cover letter), and<br />
$300 filing fee<br />
Riddell Williams P.S. 11<br />
Rule 506 – Most Common Exemption<br />
Offering amount: Unlimited<br />
Number of non-accredited investors: Up to 35 (but<br />
information requirements for non-accredited investors make this<br />
impractical for a typical private offering)<br />
Investor qualification: Sophistication if non-accredited<br />
General solicitation or advertising: No<br />
Sales commissions: Permitted<br />
Limitations on resale: Yes<br />
Issuer disqualifications: No<br />
Filing (SEC) - within 15 days after first sale<br />
File Form D electronically<br />
Filing – within 15 days after first sale in Washington:<br />
Copy of electronic Form D<br />
Date of first sale in Washington (cover letter), and<br />
$300 filing fee<br />
Riddell Williams P.S. 12<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 7<br />
Form D Filing Process – Practical Considerations<br />
Form D must be filed electronically with the SEC, on paper with states<br />
For a 506 offering, due 15 days after first sale – first sale is the date on<br />
which the first investor is irrevocably contractually committed to invest<br />
(deposit of funds into escrow = sale, even if the offering closes at a later<br />
date)<br />
GIVE YOURSELF ENOUGH TIME:<br />
Need to obtain Edgar Access Codes for issuer<br />
(the entity issuing the securities) with the SEC first<br />
Electronically submit Form ID to SEC, together with notarized authentication<br />
document (www.filermanagement.edgarfiling.sec.gov/)<br />
Upon acceptance of Form ID by SEC (1-2 business days), issuer receives a “CIK”<br />
code via e-mail – issuer must return to website and use CIK to generate EDGAR<br />
access codes<br />
Form D filed electronically at www.onlineforms.edgarfiling.sec.gov/<br />
Washington requires copy of electronically filed Form D;<br />
some other states still require manually signed Form D (print<br />
Form D prior to submission for signature)<br />
Riddell Williams P.S. 13<br />
Other Washington Exemptions<br />
“Whole Mortgage” Exemption<br />
RCW 21.20.320(5) exempts:<br />
Any transaction in a bond or other evidence of indebtedness<br />
secured by a real or chattel mortgage or deed of trust, or by an<br />
agreement for the sale of real estate or chattels, if the entire<br />
mortgage, deed of trust, or agreement, together with all the<br />
bonds or other evidences of indebtedness secured thereby, is<br />
offered and sold as a unit<br />
Not available where:<br />
Transaction involves partial interest<br />
There is more than one purchaser, or<br />
Transaction does not involve debt<br />
Isolated Transaction (Limited Offering Exemption)<br />
Limited to 3 sales during the prior 24 months<br />
Riddell Williams P.S. 14<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 8<br />
Common Mistakes – Issues in Raising Funds<br />
GENERAL SOLICITATION<br />
Prohibited activities:<br />
Advertising<br />
Website posting<br />
Purchasing a list of accredited investors<br />
Offering by mass email to a certain group or club, even if you are<br />
a member and even if you are confident they are accredited<br />
e.g., all of the members of your country club, or all the attendees of<br />
this <strong>conference</strong><br />
Asking any third party, such as a finder or business broker, to do<br />
these prohibited activities on your behalf.<br />
Key: Investors must have pre-existing personal or business<br />
relationship with you, your company or your management<br />
Relationship must be of sufficient length and duration that you can<br />
evaluate their financial position and suitability<br />
Riddell Williams P.S. 15<br />
Common Mistakes, Cont.<br />
DISCLOSURE ISSUES<br />
Need to disclose to your investors all material facts about the<br />
investment<br />
Cannot omit to state any material facts necessary in order to<br />
make the statements made not misleading<br />
At a minimum, include:<br />
Description and details regarding the property<br />
Bios of management<br />
Use of proceeds<br />
Risks<br />
Industry / market information (including a discussion of<br />
competitors, if relevant)<br />
Description of terms of securities<br />
Limitations on transfer<br />
Material agreements (and any agreement with related parties)<br />
Financial statements<br />
If you don’t want to disclose something because you believe it<br />
will make your investor less likely to invest, it is material<br />
Riddell Williams P.S. 16<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 9<br />
Common Mistakes, Cont.<br />
Common items that may be seen as misrepresentations or<br />
material omissions:<br />
“Guaranteed” return<br />
Secured investment<br />
Fee disclosures<br />
Bankruptcy / defaults by management<br />
BROKER DEALER ISSUES<br />
Payment of commissions to non-registered broker/dealer<br />
Any person engaged in the business of effecting transactions in<br />
securities for the account of others is a broker<br />
Hiring “finders” or business brokers that are not registered as<br />
broker/dealers is risky, and depending on exemption, not permitted<br />
Employees of issuer with job of finding investors, who are paid<br />
commission for such sales, may be considered brokers<br />
NON-COMPLIANCE<br />
Failure to file or late Form D<br />
Note: Some practitioners believe WA exemption is arguably lost if<br />
Form D is not filed timely<br />
Riddell Williams P.S. 17<br />
TIC Developments<br />
SEC “No Assurance” letter to Omni Brokerage, Inc.,<br />
Argus <strong>Real</strong>ty Investors, L.P., and PASSCO Companies, LLC,<br />
issued January 14, 2009<br />
Involved “sponsor” entity purchasing income-producing real property<br />
Sponsor sold undivided tenant-in-common interests to up to 35<br />
individuals in return for cash and assumption of debt on property<br />
Investors purchased TIC interests subject to 20-year Lease with Master<br />
Tenant, a property management agreement, and asset management<br />
agreement.<br />
Attorneys for TIC sponsor argued TIC interest was not an “investment<br />
contract” under federal securities law – SEC rejected.<br />
If TIC interest is a security, it may be a disqualified property for<br />
purposes of a tax-deferred exchange under IRC §1031, investors<br />
have rescission rights, sponsor and brokers subject to civil and<br />
criminal liability.<br />
Riddell Williams P.S. 18<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 10<br />
Condo / Hotel<br />
Depending on how structured, securities laws may apply<br />
Sale of condo, no intent to occupy or restricted use of unit,<br />
coupled with mandatory management/rental agreement,<br />
turns purchase of real estate into investment contract<br />
Investment of money in a business enterprise where profit<br />
(rental income) comes solely from the efforts of the<br />
developer’s management of the property = investment<br />
contract = security<br />
If securities laws apply:<br />
Disclosure obligations<br />
Exemption needed<br />
Accredited investors<br />
Limitations on manner of offering – no advertising!<br />
If no exemption, purchasers have rescission rights<br />
Riddell Williams P.S. 19<br />
Condo/Hotel: How to Avoid Application of Securities Laws<br />
Intrawest No-Action Letter, 2002<br />
Keep rental management program completely separate from sales program –<br />
real estate sales personnel cannot promote the investment nature of the<br />
condo<br />
Sales <strong>materials</strong> cannot discuss the economic or tax benefits from entry into a<br />
rental arrangement or provide rental information<br />
Can mention program but limited to the following statement: “Ownership may<br />
include the opportunity to place your home in a rental arrangement”<br />
Entry into real estate purchase and sale completely independent from<br />
decision to enter into rental management agreement, and real estate<br />
purchase must be binding first<br />
Rental program is voluntary<br />
Condo owners free to use any rental management company<br />
No pooling of rents<br />
Rental program cannot provide projections of rental income or occupancy<br />
rates – can provide historical raw data only<br />
Do not compensate real estate sales personnel for rental agreements entered<br />
into by condo purchasers<br />
Riddell Williams P.S. 20<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Erin Joyce Letey of Riddell Williams P.S. Speaker 22: 11<br />
Vail Resorts No-Action Letter, April 25, 2007<br />
SEC denied no action relief to Vail Resorts<br />
Program structured similarly to Intrawest except Vail offered<br />
dues reductions, free furniture and complimentary ski season<br />
passes as participation “incentives” to purchasers who had<br />
already signed a binding contract (not limited to those that<br />
affirmatively inquired about a rental pool)<br />
Riddell Williams P.S. 21<br />
Questions?<br />
Please contact us any time with additional questions.<br />
Erin Joyce Letey<br />
206.389.1585<br />
eletey@riddellwilliams.com<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Dealing with an Established <strong>Real</strong> <strong>Estate</strong> Fund<br />
John Orehek<br />
Security Properties<br />
Seattle, WA<br />
Matthew G. Paddock<br />
Metzler North America<br />
Seattle, WA<br />
Stephen P. Latimer, Esq.<br />
ING Clarion Partners<br />
Seattle, WA
John Orehek of Security Properties Speaker 23: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John Orehek of Security Properties Speaker 23: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Matthew G. Paddock of Metzler North America Speaker 24: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Matthew G. Paddock of Metzler North America Speaker 24: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Stephen P. Latimer of ING Clarion Partners Speaker 25: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Stephen P. Latimer of ING Clarion Partners Speaker 25: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
L A W S E M I N A R S I N T E R N A T I O N A L<br />
Our Second Annual Two-Day Comprehensive Conference on<br />
<strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds<br />
Current challenges, strategies and opportunities<br />
February 8 and 9, <strong>2010</strong><br />
Seattle, WA<br />
Exit Strategies from Funds and <strong>Joint</strong> <strong>Ventures</strong><br />
John W. Hanley, Jr., Esq.<br />
Davis Wright Tremaine LLP<br />
Seattle, WA<br />
Donald E. Percival, Esq.<br />
Davis Wright Tremaine LLP<br />
Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 26: 1<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
John W. Hanley, Jr. of Davis Wright Tremaine LLP Speaker 26: 2<br />
R~ N o t e s ~<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 1<br />
REAL ESTATE JOINT VENTURES AND FUNDS<br />
LAW SEMINARS INTERNATIONAL<br />
February 8-9, <strong>2010</strong><br />
Renaissance Seattle Hotel<br />
Seattle, WA<br />
EXIT STRATEGIES FROM REAL ESTATE FUNDS AND JOINT<br />
VENTURES<br />
DONALD E. PERCIVAL<br />
Davis Wright Tremaine LLP<br />
Suite 2200<br />
1201 Third Avenue<br />
Seattle, WA 98101-3045<br />
Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 2<br />
<strong>Real</strong> estate funds and joint ventures are illiquid, labor-intensive creatures living in<br />
a cyclical market. At the beginning of a venture, it is natural for the prospective partners<br />
to concentrate their discussions on issues relating to the investment purposes of the<br />
venture, the size of their capital commitments, the conditions under which their capital<br />
contributions will be made, the scope of the partner’s rights to participate in major<br />
decisions and the formula by which the participants will share the fruits of their success.<br />
Until recently, prospective partners were not likely to devote as much attention to<br />
defining the future circumstances in which one partner may want to exit the joint venture<br />
or the partners may otherwise want to part company.<br />
Recent events have demonstrated that even the most committed long-term venture<br />
partners must consider the possibility that changing internal or external circumstances<br />
may alter their desire to remain in the venture. As time passes, venture partners may<br />
discover they have different needs for liquidity, different opinions of future market<br />
conditions, different investment priorities and different opportunities. And over time<br />
even the most amicable relationships can cool or turn contentious, particularly where the<br />
venture is unsuccessful and the manager’s or general partner’s right to fees is not tied<br />
solely to the venture’s performance. Prospective partners therefore need to think about<br />
the “endgame” and define the conditions and terms under which partners may exit the<br />
venture in the absence of mutual agreement to dispose of the property and wind up the<br />
venture.<br />
Investors and general partners/managers of property-specific real estate ventures<br />
have traditionally chosen from a wide array of alternative exit strategies with familiar<br />
names and acronyms (ROFO, ROFR, buy-sell, etc.). But there appear to be no common<br />
definitions of many of these terms, no clear consensus concerning the advantages and<br />
disadvantages of different exit strategies and only rarely do new partners fully appreciate<br />
the scope and complexity of the issues posed by each alternative.<br />
Exit devices for fund investors are generally fewer and simpler, but there still is<br />
little consensus concerning what exit strategies are appropriate. Fund investors have<br />
traditionally had little opportunity to require liquidation of all or portion of the fund’s<br />
portfolio, to dissolve the fund or otherwise to demand the return of their capital prior to<br />
expiration of the fund’s life. Although the evaporation of traditional sources of credit and<br />
a dramatic decline in real estate values over the past few years have triggered intense<br />
interest in the creation of new real estate funds and joint ventures to fill a market vacuum<br />
and seize upon pricing opportunities that seemed unlikely only two years ago, large<br />
losses incurred by funds organized by even the most respected and historically successful<br />
fund sponsors have motivated participants to pay greater attention to the ways in which<br />
venture documents can align the interests of investors and managers and give investors<br />
greater say over the liquidation of their interests.<br />
This phenomenon is not limited to real estate. In September 2008, the<br />
Institutional Limited Partners Association (ILPA), a 220-member organization of<br />
institutional investors managing more than $1 trillion of private equity capital, issued a<br />
position paper titled “Private Equity Principles,” in which the ILPA recommended a set<br />
of “best practices” for the private equity industry intended to align the interests of<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 3<br />
investors and managers and reaffirm focus on value creation. The ILPA Private Equity<br />
Principles, which can be obtained by visiting the ILPA website (www.ilpa.org), reflect<br />
the widespread perception among institutional investors that private equity fund terms<br />
had become too manager-friendly during the “boom times” of low cap rates, easy credit<br />
and spiraling valuations, and offer additional evidence that current market conditions are<br />
forcing a shift to more investor-friendly deal terms, including terms describing exit<br />
strategies available to investors. It would be an overstatement to say that all of the ILPA<br />
Principles reflect terms that have become “standard” in today’s fund documents, those<br />
principles have generated considerable attention and garnered formal endorsements from<br />
a wide variety of institution investors, including CalPERS, CalSTRS, Teacher Retirement<br />
System of Texas, the Oregon Investment Council and the Washington State Investment<br />
Board. The pendulum is clearly swinging in the direction of greater flexibility for the<br />
investor.<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 4<br />
I. REAL ESTATE JOINT VENTURE AND FUND EXIT STRATEGIES: OVERVIEW<br />
A. Basic Venture Exit Strategies<br />
1. <strong>Real</strong> <strong>Estate</strong> Funds<br />
(a) Termination of Commitment Period: Investors may, upon<br />
the occurrence of certain events, terminate their obligations<br />
to make future capital contributions even if they have not<br />
yet contributed all of their committed capital<br />
(i) “Key person” event (departure of key manager<br />
personnel)<br />
(ii) Without cause upon majority or super-majority vote<br />
of investor percentage interests<br />
(b) Transfers of Individual Investor Interests<br />
(i) Typically requires consent of general<br />
partner/manager (may be exceptions for transfers to<br />
other investors in same fund)<br />
(ii) Subject to various conditions dictated by tax or<br />
securities laws<br />
(c) Dissolution of Fund: Investors may elect to dissolve fund<br />
without general partner/manager consent:<br />
(i) Trigger events<br />
(A) For cause<br />
(B) Without cause upon super-majority vote<br />
(ii) Consequences<br />
(A) General partner/manager generally may<br />
liquidate fund assets over time following<br />
dissolution (liquidating trust may be used to<br />
terminate the venture without immediately<br />
liquidating its portfolio assets)<br />
(B) Nature of underlying assets may determine<br />
timing of distributions: Investors should<br />
consider whether fund documents should<br />
specify maximum allowable lockup periods<br />
for underlying investments or that<br />
underlying investments be distributable in<br />
kind)<br />
(d) Expiration of Fund Life<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 5<br />
2. Other <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong><br />
(a) Right of First Offer: Before selling entity interests to third<br />
party, initiating partner must first offer to sell those<br />
interests to receiving partner(s) at price specified by<br />
initiating partner; if no receiving partner agrees to purchase<br />
at that price, initiating partner is permitted for limited time<br />
to sell interests to third party on terms no more favorable to<br />
third party than those offered to receiving partner(s).<br />
(b) Right of First Refusal: Initiating partner obtains bona fide<br />
purchase agreement from third party, offers to sell its entity<br />
interest to receiving partner(s) on terms stated in third-party<br />
offer; if no receiving partner agrees to purchase on terms<br />
stated in third-party offer, initiating partner may for limited<br />
time sell interests to third party per terms of third-party<br />
offer.<br />
(c) Forced Property Sale: Initiating partner obtains bona fide<br />
third-party offer to purchase underlying property and<br />
proposes that receiving partners approve sale of property by<br />
entity to third party pursuant to offer; receiving partner(s)<br />
must elect either to (i) approve the sale of the entity<br />
property to the third party or (ii) purchase the initiating<br />
partner’s interest in the entity for a price equivalent to what<br />
initiating partner would have received had the entity sold<br />
its property pursuant to the third-party offer, satisfied its<br />
obligations and made liquidating distributions to the<br />
partners.<br />
(d) Buy-Sell (a/k/a “shootout”): Initiating partner specifies<br />
value for entity property; receiving partner must elect either<br />
to (i) purchase the initiating partner’s interest in the entity<br />
for a price equivalent to what initiating partner would have<br />
received if the entity were to sell its property for the stated<br />
value, satisfy its debts and make liquidating distributions to<br />
the partners, or (ii) sell the receiving partner’s interest in<br />
the entity for a price equivalent to what receiving partner<br />
would receive if the entity were to sell its property for the<br />
stated value, satisfy its debts and make liquidating<br />
distributions to the partners.<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 6<br />
BASIC EXIT STRATEGIES – REAL ESTATE JOINT VENTURES<br />
Price to receiving<br />
partner based on value<br />
of entity interest or<br />
value of underlying<br />
assets owned by<br />
entity?<br />
Pricing established by<br />
initiating partner or by<br />
binding third-party<br />
offer?<br />
Receiving partner<br />
obligated to either buy<br />
or sell?<br />
Following exercise of<br />
option, receiving<br />
partner buys . . .<br />
Following failure of<br />
receiving partner to<br />
exercise, third party<br />
buys . . .<br />
Dissolution<br />
and<br />
Liquidation<br />
of Venture<br />
Underlying<br />
assets<br />
Third-party<br />
sale<br />
Right of<br />
First Offer<br />
(ROFO)<br />
Entity<br />
interest<br />
Initiating<br />
partner<br />
Right of<br />
First Refusal<br />
(for Venture<br />
Interests)<br />
(ROFR)<br />
Entity<br />
interest<br />
Third party<br />
offer<br />
Forced<br />
Property<br />
Sale<br />
Underlying<br />
assets<br />
Thirdparty<br />
offer<br />
Buy-Sell<br />
Underlying<br />
assets<br />
Initiating<br />
partner<br />
N/A No No Yes Yes<br />
N/A<br />
N/A<br />
Entity<br />
interest<br />
Entity<br />
interest<br />
Entity<br />
interest<br />
Entity<br />
interest<br />
Entity<br />
interest<br />
Underlying<br />
assets<br />
Entity<br />
interest<br />
N/A<br />
B. Variations on Basic Venture Exit Strategies<br />
1. Other structures and triggering mechanisms<br />
(a) Right of first negotiation (cooling off period)<br />
(b) Mandatory buyout upon occurrence of certain events<br />
(death, disability, termination of employment, etc.)<br />
(c) Optional buyout (“call”) upon occurrence of certain events<br />
(death, termination of employment for cause, etc.)<br />
(d) Optional buyout (“call”) of a partner’s interest following<br />
default by that partner (typically, developer partner)<br />
(i) Definition of default: Often distinguish between<br />
breach of obligations (e.g., failure to make<br />
contributions, taking actions without obtaining<br />
required investor consent, gross negligence) and<br />
mere poor performance (e.g., failure to pay<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 7<br />
(ii)<br />
guaranteed preferred return or to meet other<br />
performance criteria)<br />
Remedies/pricing:<br />
<br />
<br />
<br />
Removal of defaulting GP/manager<br />
Optional buyout (with or without setoff for<br />
actual damages?)<br />
Forfeiture of right to receive (all or some<br />
portion of) promoter’s interest<br />
(e) Optional or mandatory “put” upon occurrence of other<br />
events (e.g., death, disability, termination of employment)<br />
2. Other pricing methods<br />
(a) Distributions (of portfolio interests) in kind<br />
(b) Re-trading room<br />
(c)<br />
(i)<br />
(ii)<br />
Even if valuation is based on price stated in<br />
initiating partner’s notice (ROFO) or third-party<br />
offer (ROFR or forced sale), if receiving partner<br />
declines to buy, initiating partner may be given<br />
re-trading room to sell its interest (or the underlying<br />
assets) to a third party for price that is within some<br />
modest percentage (say, 2% - 5%) of original price<br />
stated in activating notice<br />
Similarly, in case of ROFR or forced sale, receiving<br />
partner may be given right to elect to purchase<br />
initiating partner’s interest at a modest discount<br />
(say, 2%-5%) from price stated in third-party offer,<br />
on theory that purchaser is likely to re-trade.<br />
Valuation based on appraisal<br />
(i) Appraisal of what?<br />
(ii)<br />
<br />
<br />
Partner’s interest or underlying property?<br />
Working capital adjustment?<br />
Dispute resolution using multiple appraisals<br />
<br />
<br />
<br />
Average of two? Average only if difference<br />
is less than x% of [lower/higher] value?<br />
If two don’t agree, use third appraisal? Use<br />
third only if between the other two<br />
(otherwise use middle appraisal)?<br />
“Baseball” arbitration (i.e., third party picks<br />
between two appraisals)?<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 8<br />
(d)<br />
Valuation based on amount of investment (with or without<br />
imputed return?)<br />
(e) Valuation based on formulas (e.g., multiple of NOI,<br />
revenues, etc.)<br />
3. There are many, many other triggering mechanisms and pricing<br />
methods<br />
II.<br />
VENTURE EXIT STRATEGIES: KEY CONSIDERATIONS<br />
A. Pricing<br />
1. Premium/discount for sale of partial interests? Depends on what<br />
would be sold to third party:<br />
(a)<br />
If price is based on value of entity interests, would reflect<br />
control premium or lack-of-control discount<br />
(b) If price is based on value of underlying assets, does not<br />
reflect premium/discount<br />
2. Is price real or a “trial balloon?” -- Bona fides of the third party<br />
offer price:<br />
(a) Is third party buyer unaffiliated with initiating partner?<br />
(b) All-cash sale vs. barter/exchange<br />
(c)<br />
(d)<br />
(e)<br />
Price as allocated portion of aggregate price for portfolio of<br />
properties<br />
Is sufficient earnest money at risk?<br />
(i) Amount of earnest money (relative to size of<br />
transaction)<br />
(ii) Form of earnest money: Cash or note?<br />
(iii) Is earnest money non-refundable?<br />
(iv) Are seller’s remedies limited to retention of earnest<br />
money if purchaser defaults?<br />
Is buyer’s obligation to close subject to satisfaction of<br />
conditions that are effectively within buyer’s control?<br />
(i) Due diligence<br />
(ii) Financing<br />
(iii) Delivery of “clean” tenant estoppels<br />
(iv) Permitted title exceptions<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 9<br />
(f) What is relationship between buyer conditions in third<br />
party offer and nature of receiving partner’s obligations to<br />
buy upon exercise of purchase rights?<br />
(i) Would receiving partner generally have benefit of<br />
same conditions following exercise of purchase<br />
right?<br />
(ii) Will interpretation of meaning of buyer’s conditions<br />
depend on external circumstances (i.e., parameters<br />
not clearly established in third-party purchase<br />
agreement)<br />
(A) Representations and warranties tied to<br />
contents of document (e.g., rent roll) not<br />
attached to third-party purchase agreement?<br />
(B) Title conditions tied to list of encumbrances<br />
accepted by third party purchaser<br />
(C) Seller’s representations deemed modified by<br />
information known to buyer<br />
3. Purchase price adjustments for actual or imputed costs<br />
(a) Assumption or payoff of liabilities (depends on transaction<br />
structure)<br />
(b) Prepayment penalties/yield maintenance fees<br />
(c) Brokerage commissions<br />
(d) Transfer taxes<br />
(e) Other closing costs<br />
(i) Title premiums<br />
(ii) Escrow fees<br />
(f) Working capital adjustments<br />
4. Breakup fees -- quid pro quo for binding third-party offer<br />
B. Practical obstacles to implementing the partners’ intentions and<br />
understandings<br />
1. Unequal access to information (e.g., initiating partner is property<br />
manager or affiliate of property manager)<br />
2. Unequal ability to perform as buyer<br />
(a) Relative net worth of initiating partner vs. receiving partner<br />
(b) Relative liquidity of initiating partner vs. receiving partner<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 10<br />
(c)<br />
(d)<br />
May address by providing for seller financing of sale to<br />
purchasing partner<br />
Restraints on receiving partner’s ability to exercise<br />
purchase rights because of limitations imposed on receiving<br />
partner by statute, charter documents or board investment<br />
policies<br />
(i)<br />
(ii)<br />
Example: Fund life expiring in near future and<br />
liquidation/payout imminent<br />
Example: Limitations on size of investment in<br />
particular property (in absolute $$ or as a % of<br />
entire portfolio)<br />
(iii) Example: Limitations on size of real estate<br />
portfolio relative to investor’s entire investment<br />
portfolio<br />
3. Purchase would cause taxable termination of entity<br />
4. Purchase may trigger a violation of loan covenants<br />
C. Avoiding monkey business<br />
1. Is sale of partial interest permitted, or must initiating partner<br />
trigger with respect initiating partner’s entire interest?<br />
2. May multiple initiating partners act in concert to capture control<br />
premium by aggregating their interests and including crosspurchase<br />
condition in ROFO/ROFR terms?<br />
3. Affiliated partners should be required to speak with one voice, act<br />
as a single bloc<br />
4. Simultaneous activation of multiple strategies: Which transaction<br />
takes priority?<br />
5. Disguised attempts to require receiving partner to pay breakup fee<br />
6. Disguised attempts to require receiving partner to pay brokerage<br />
commission<br />
7. May want moratorium on activation of all or certain exit strategies<br />
during agreed honeymoon period<br />
D. Other considerations<br />
1. Typically require repayment, at closing, of any outstanding loans<br />
made by selling partner (exception: selling partner has committed<br />
“bad boy” acts)<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 11<br />
2. Treatment of loan guaranties previously given by selling partner<br />
(a) Lender may require purchasing partner to provide<br />
substitute guaranties<br />
(b) May not be possible to obtain releases from third-party<br />
lenders, even with substitute guaranties, so may need to<br />
provide for purchasing partner to indemnify the selling<br />
partner/guarantor<br />
3. Exercise of exit right may constitute a default under existing loan<br />
documents<br />
4. Tax considerations: Buy-sell may enable remaining partner to<br />
avoid recognizing gain that would have to be recognized if venture<br />
were to sell the underlying assets<br />
5. How should initiating partner describe other partners’ ROFR in<br />
conditions precedent to initiating partner’s obligations to perform<br />
under purchase agreement with third party?<br />
(a) Right of first refusal to purchase what (assets or entity<br />
interests)?<br />
(b) “. . . on terms no more favorable than . . . .” or “right to<br />
match”<br />
6. Defining the contract between initiating partner and receiving<br />
partner following exercise of purchase option<br />
(a) Particularly problematic where:<br />
(i) There is no third party purchase contract addressing<br />
reps, warranties, indemnities, closing prorations,<br />
closing costs, remedies (baskets, caps, limitations<br />
period), etc.<br />
(A) ROFO<br />
(B) Buy-sell<br />
(ii) Even when there is third-party purchase contract,<br />
may still be an issue if:<br />
(A) Ambiguity between ROFR provisions in<br />
entity documents<br />
(B) Third-party contract (on which price to<br />
receiving partner is based) relates to sale of<br />
underlying assets and yet receiving members<br />
would be buying entity interests following<br />
exercise of purchase option (e.g., exercise of<br />
partner purchase right in lieu of forced sale<br />
of property)<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
Donald E. Percival of Davis Wright Tremaine LLP Speaker 27: 12<br />
(b) Parameters to address<br />
(i) Reps/warranties/indemnities/remedies<br />
(baskets/caps/claims periods)<br />
(ii) Remedies interwoven with other transactions<br />
7. If there are multiple receiving partners, need to deal with<br />
possibility that some, but not all, of receiving partners may wish to<br />
exercise purchase rights in response to offer from initiating<br />
partner:<br />
(a) Need mechanism for receiving partner to determine how<br />
much of initiating partner’s interest it will be<br />
entitled/obligated to buy<br />
(i) If only single round of exercise notices, receiving<br />
partner electing to purchase may not know how<br />
much of initiating partner’s interest it will become<br />
entitled/obligated to buy<br />
(ii) Round-robin election procedure would ensure that<br />
receiving partners that want to purchase may<br />
maintain their pro rata percentage interests relative<br />
to other purchasing partners<br />
(b) Must specify what happens if less than all of interests<br />
offered by initiating partner are subscribed for<br />
(c) May want to require affiliated receiving partners to act as<br />
one<br />
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Law Seminars International | <strong>Real</strong> <strong>Estate</strong> <strong>Joint</strong> <strong>Ventures</strong> and Funds | 02/09/10 in Seattle, WA
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