GPSOLO March 2010
Real Estate Law
Management and Governance of Real Estate Joint Ventures
The management of any real estate joint venture should be structured to achieve the following goals: empower the appropriate joint venture partners (as used in this article, “partners” refers to the holders of interests in any type of joint venture entity) or managers with the clear-cut authority to manage the joint venture in a way that will achieve its economic goals; place appropriate checks on that authority to protect the interests of the partners, particularly minority partners; avoid bad surprises and conflict in the area of joint venture management; replace management that fails to perform to certain agreed-on standards; and resolve conflicts among the partners and managers in a manner that minimizes the economic harm to the joint venture. This article will discuss structuring joint venture agreements to achieve these objectives.
Granting and limiting management authority. The partners must decide both who will manage and lease the joint venture’s properties on a day-to-day basis and who will make longer-term strategic decisions. The key elements of an effective grant of management authority include the following: the scope of authority granted and limitations on that authority must be clear; management accountability for the achievement of joint venture objectives must be clearly set forth and consistent with the grant of authority; and there must be a mechanism for correcting, and if necessary replacing, management that is off course.
Typically, the easiest way to achieve these objectives is by delegating centralized management control to a manager or a board of managers or directors. Centralizing management authority can help avoid confusion regarding who is responsible and accountable for achieving key joint venture objectives. Key management decisions and actions are less likely to “fall between the cracks” with a centralized management structure that includes well-defined processes and responsibilities, as compared with decentralized management. A centralized management structure also can allow the joint venture to act more rapidly to take advantage of opportunities before they disappear and address problems before they become crises.
The manager of the joint venture can in turn have the authority or obligation to delegate certain functions to independent contractors under management and leasing agreements. With such delegation, the joint venture management must effectively monitor and manage these independent outside management services providers. The joint venture management should remain responsible and accountable for subcontracted management functions unless the other partners have dictated the choice of these management subcontractors.
Regardless of the exact management structure used, at least some management authority checks and balances should ordinarily be incorporated into the joint venture agreement to protect the interests of the partners who do not control management. This often is done by including in the joint venture agreement a list of management actions that require approval of a majority of the partners before they can be taken by the manager.
Avoiding bad surprises and conflicts. The principal way that joint venture partners can avoid bad surprises and conflicts in day-to-day joint venture operations is to adopt a budget that serves as a road map for operating expenses and foreseeable capital expenditures. The budget’s line items should be detailed and narrow enough for the partners to evaluate and establish controls over specific categories of expenses. A carefully prepared and reasonably detailed budget should provide the partners with a good idea of the joint venture’s expenses and projected cash flow for the upcoming years.
Typically there is an annual budget approval process, with the joint venture managers required to propose a budget for review and adoption by the partners. The joint venture agreement can provide that if the partners fail to approve the proposed budget, the prior year’s budget rolls forward, perhaps with a price-index adjustment to the prior year’s budgeted costs or with uncontrollable costs automatically resetting at the prior year’s actual amount for those costs.
The approved budget should generally be binding on the joint venture’s managers. The partners, however, should consider including some flexibility in the budget to ensure that it functions as a road map rather than a straightjacket. For example, the budget could permit percentage variances from budgeted amounts for controllable expenses. Such permitted variances could apply on an aggregate and a line-item basis.
The joint venture will not be able to function without a reasonable level of trust among the partners and the joint venture management. Establishing and maintaining this trust require transparency in joint venture management and compensation, with a satisfactory process for either avoiding or resolving conflicts of interest after full disclosure to the partners.
There should be no hidden or “buried” fees. All fees to managers, partners, or their affiliates should be fully disclosed and approved in writing by the disinterested partners in the initial joint venture agreement or subsequent partner resolutions or joint venture budgets. The joint venture agreement also should set forth in detail any noncompete obligations of the partners or managers.
Replacing nonperforming management. The partners should decide at the outset what events will justify a management change. The partners should certainly have the power to terminate a manager guilty of intentional misconduct, fraud, willful breach, or other sorts of bad acts. What constitutes a reasonable “for cause” basis for replacing a manager can be subject to debate. Because of the potential for disputes regarding whether a manager has committed bad acts or failed to discharge contractual obligations to the joint venture, the partners may want to reserve the right to remove the manager without cause, perhaps on a supermajority vote of the partners. Such termination without cause often is coupled with a liquidated damages termination fee to the manager and a buy-sell option for the manager’s interest in the joint venture. These buy-sell provisions protect the manager from having to continue in the joint venture after its removal as manager and also make available an ownership interest in the joint venture to attract and compensate a replacement manager.
Resolving conflicts. The two principal contractual means of resolving conflict among partners are inclusion in the joint venture agreement of buy-sell provisions allowing buyouts of (or by) warring parties and alternative dispute resolution provisions allowing the partners to resolve conflicts in a reasonable manner. Without such provisions, the partners must recognize the potential for the joint venture to implode if conflict arises. Typically this occurs when one of the partners seeks judicial dissolution of the joint venture on the basis that it is not practicable for the partners to continue the joint venture’s business in accordance with the joint venture agreement.
The most commonly used buy-sell provision for resolving conflict among partners is the “Russian roulette” buy-sell. This provision allows any partner to approach another partner or groups of partners with an offer to buy its joint venture interests. The other partner or group must then either accept the offer and be bought out of the joint venture or buy the initiating partner out of the joint venture on the same proportionate price and terms offered.
Another buy-sell option for resolving conflict among partners is a put-call option as to certain partners. Such an option might be based on a formula price, an appraised value price, or perhaps a price determined under a “baseball-type” arbitration. In “baseball” arbitration, each party presents its proposed price to the arbitrator, who must choose one of the two proposals.