Real Estate Private Equity Choice of Entity Considerations

Selecting the appropriate investment vehicle for a real estate transaction can be crucial to the success of an acquisition, repositioning or development opportunity.  Why? Choosing the wrong form of entity can discourage participation by investors in a transaction or require expensive restructuring of the project entity.

This note briefly summarizes some of the issues a project sponsor and private equity investor may consider when choosing one of the two most frequently used forms of entity in real estate transactions: the limited liability company (“LLC”) and the limited partnership (“LP”).

  1. Number of Participants – Initial and Continuing

Most LLC statutes allow single member LLCs, so an LLC can be formed with one member and continue with one member if necessary through its life.

Limited partnerships generally require at least two members, the general partner (who must be fully liable for the obligations of the business) and at least one limited partner.  At formation, this issue is easy to control.

However, once the business is operating, if either the sole general partner or the sole limited partner withdraws from the limited partnership, the partnership could dissolve as a matter of law.  In California, a general partner can withdraw from a limited partnership at any time, whether rightfully or wrongfully.  A limited partnership agreement cannot eliminate that power.  While a general partner that wrongfully withdraws will likely cause the general partner to incur liability for damages if the withdrawal violates the terms of the limited partnership agreement, damages may not be a practical deterrent.  Damages can be speculative or difficult to prove and, depending on the structure of the deal, damages may be effectively limited to the distributions a party is entitled to receive.

Limited partners generally do not have the right to dissociate as a limited partner before the termination of the partnership.  However, there are exceptions.  For example, if the limited partner entity is terminated as a matter of law, or if there is a conversion or merger of a limited partner entity and the limited partner entity does not survive the merger, the limited partner is dissociated.  At that point, the limited partnership may terminate if a new limited partner is not admitted.  In a troubled deal or a bad economy, finding a replacement limited partner can be difficult.

  1. Extent of Involvement by Investors

A limited partner in a partnership generally has no personal liability for the obligations of the limited partnership.  However, private equity investors typically demand a substantial degree of control over the business decisions of the partnership, because they are contributing most of the capital required for the business’ operations.  If a limited partner intends to be extensively involved in the business, the limited partner could be rendered a general partner of the partnership by operation of law.  As a result, the limited partner could lose the cloak of limited liability, meaning that the limited partner becomes personally liable for the business of the limited partnership.

An LLC has much more flexibility in structuring entity governance.  An LLC operating agreement typically goes into great detail on management, voting rights, and the extent of each member’s participation of the LLC’s decision-making.  Unlike an active limited partner, an LLC member retains the cloak of limited liability despite the LLC member’s active and intense involvement in the operations of the company.

  1. Implied Duties

Partners generally have implied duties to one another, including fiduciary duties, duties of fairness and loyalty, duties of care, and the duty of good faith and fair dealing.  In some states, these duties can be limited or waived in the limited partnership agreement.

State laws may also impose on LLC members implied duties unless limited or waived in the limited liability company’s operating agreement.  Delaware, for example, allows great latitude in permitting the parties to define the scope of implied duties in their limited liability company operating agreement; however, LLC members may not eliminate the implied contractual covenant of good faith and fair dealing.

  1. Tax Matters

A limited partnership offers pass through tax treatment, which means the income, gains, losses, deductions, and credits of the limited partnership will be passed through to the partners for reporting on their personal tax returns.

A limited liability company will be classified as a partnership for income tax purposes, unless the LLC affirmatively elects otherwise.  A limited liability company that elects to be classified as a partnership will enjoy pass through tax treatment.

Some jurisdictions impose heavy entity-level taxes on limited liability companies but not on partnerships.  It is important to review the structuring of your transaction with your tax advisor to avoid tax pitfalls.

Loan guaranty waivers cannot be used to shield a bank from misconduct

A guarantor’s general waiver of defenses cannot be used to shield a lender from the lender’s willful breach of a loan agreement.

A guarantor’s waiver of defenses is limited to legal and statutory defenses expressly set out in the agreement, a California appellate court held in California Bank & Trust v. Thomas Del Ponti.  A waiver of statutory defenses is not deemed to waive all defenses, especially equitable defenses, where to enforce the guaranty would allow the lender to profit from its own wrongful conduct.

The facts of the case were straightforward.  A developer obtained a construction loan from Vineyard Bank to develop a 70-unit townhome project with guaranties from two of the principals.  The developer contracted with a general contractor to build the project in two phases.  The project was on schedule for the first 18 months.  However, when the first phase of the project was nearly complete, the bank stopped funding approved payment applications, preventing completion and sale of the first phase units.  As a result, the developer defaulted under the loan.

The bank eventually reached an agreement with the developer, requiring the general contractor to finish the first phase so the units could be sold at auction.  The bank promised to pay the subcontractors unless they discounted their bills and released any liens.  The general contractor paid the subs out of its own pocket to keep the project lien free so the auction could proceed.  Nevertheless, the bank foreclosed against the developer.  In response, the general contractor filed an unbonded stop notice.  The bank (through its assignee California Bank & Trust) sued the developer and the guarantors under various theories for the deficiency following a trustee’s sale of the property.  The general contractor sued the developer and the bank for restitution and breach of contract.

In a consolidated case, the court found that bank breached the assigned construction contract and found that the bank breached the loan agreement with the developer, exonerating the guarantors.  The bank appealed, claiming that the guarantors had waived all defenses under the guaranty agreements.

The appellate court rejected the bank’s argument.  A pre-default waiver of the Bank’s own misconduct was not expressly waived in the guaranty agreement.  California Civil Code section 2856 permits a guarantor to waive certain legal and statutory defenses.  However, that section does not permit a lender to enforce pre-default waivers beyond those specified where to do so would result in the lender’s unjust enrichment and allow the lender to profit from its own fraudulent conduct.

In all suretyship and guaranty contracts in California, the creditor owes the surety a duty of continuous good faith and fair dealing. The court reasoned that it would be a violation of public policy to enforce the guarantors’ waivers of defenses to payment of the note where the bank willfully breached the loan agreement, causing the default.