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.

Managers of Delaware LLCs Owe Fiduciary Duties to LLC Members by Default

A Delaware court has held that, in the absence of contrary language in an LLC operating agreement, the manager of a Delaware limited liability company owes fiduciary duties to the members of the limited liability company.

The court’s holding is significant because the Delaware Supreme Court has refused to expressly hold that such fiduciary duties apply. In fact, as recently as November 2012, the Delaware Supreme Court found that a lower court’s reference to fiduciary duties applying to LLC managers was “dictum without any precedential value.” Nevertheless, the lower courts in Delaware have not given up on the idea on imposing equitable fiduciary duties on LLC managers or managing members. As a result, until a final, express decision is rendered by the Delaware Supreme Court, real estate developers, operators, and investors should consult with counsel regarding fiduciary duties that may be imposed in the absence of other express language in their operating agreements.

The most recent case is Feely v. NHAOCG LLC (Del. Ch., CA No. 7304-VCL, 11/28/12). In Feely, the court allowed a fiduciary duty claim to move forward in a busted real estate development deal. The plaintiff, a member of the LLC, claimed that the manager “failed miserably” in his management role and his skills as a financier “proved to be illusory.” At the time of formation of the LLC, the manager told the members that he was “extremely well-connected in the world of financing” and that he had an extensive “book of business” that he would be able to employ to seek out and secure sources of debt and equity financing.

The plaintiff further alleged that a development project in Florida failed due to gross negligence, when the manager failed to provide the entire deposit called for by the written purchase agreement for the property and failed to fix the mistake during the cure period, even after the LLC’s counsel flagged the issue. The seller declared a default under the real estate purchase agreement and cancelled the contract. As a result, the LLC forfeited a portion of its deposit, became obligated to reimburse a co-investor for its investment, suffered financing penalties, and lost the fees that would have been earned had the deal closed. Finally, the plaintiff asserted that the manager of the LLC began “negotiating student housing deals for his own account” instead of presenting them to the members of the LLC.

The defendant manager argued that LLCs are creatures of contract and the managing member of the LLC owes only the duties expressly stated in the operating agreement. However, the court disagreed with the defendant manager’s theory. “Numerous Court of Chancery decisions hold that managers of an LLC owe fiduciary duties,” the court stated, “unless those duties are eliminated, restricted, or otherwise displaced by express language in the LLC operating agreement.” While the Delaware Supreme Court has not yet finally determined whether LLC managers owe fiduciary duties — and in fact had found that a lower court’s decision that such fiduciary duties were “dictum without any precedential value” — the court nevertheless reasoned “the long line of Chancery precedents holding that default fiduciary duties apply to the managers of an LLC . . . are appropriately viewed as stare decisis by this Court.” The court thus held: “Like the Delaware General Corporation Law, the LLC Act does not explicitly provide for fiduciary duties of loyalty or care; consequently, the traditional laws of law and equity govern.” The court goes on to say that the managing member of an LLC is vested with discretionary power to manage the business of the LLC and easily fits the definition of a fiduciary.

The court also dismissed an argument that the LLC’s operating agreement spoke to the issue of fiduciary duties, reasoning that an exculpation clause that shielded the manager “against liability for certain types of claims” did not “restrict, modify, or eliminate fiduciary duties.” The plain language of the provision eliminated monetary liability unless, among other things, “the act or omission is attributed to gross negligence [or] willful misconduct or fraud . . . .” As a result, the manager owed fiduciary duties to the other member of the LLC and may be held liable for damages if gross negligence or willful misconduct can be shown in the manager’s dealings in the real estate deal.

Delaware limited liability companies are often used as the entity of choice in real estate transactions in California and elsewhere. If a real estate developer or operator is the managing member of an LLC, it will be important to state in the operating agreement the extent of any fiduciary duties owed to the other members of the LLC when discharging its active responsibilities. The more clear the agreement, the better the understanding among the parties as to each party’s obligations under the LLC’s operating agreement. Without clear drafting, general equitable fiduciary duties under common law will apply, meaning that a body of case law will determine the parties fiduciary rights and responsibilities. Similarly, real estate investors that are “silent members” of an LLC or who typically only get involved in “major decisions” will want to have a very clear understanding of the duties owed in the transaction. Sometimes a fiduciary relationship will make sense for both the “sweat equity” and “money” in a transaction; in other situations fiduciary relationships are not necessary for one or more parties if each party’s rights and obligations are spelled out clearly. In either case, consulting with counsel will help to make sure that the parties are on the same page.

Breach of Commercial Lease Doesn’t Trigger Loan Guaranty, Resulting in $40 Million Loss for Lender

A tenant’s refusal to pay rent and the borrower’s resulting failure to make debt service payments did not trigger a “bad boy” loan guaranty because the lease was never terminated by operation of law, a California Court of Appeal has held. 

In GECCMC 2005-C1 Plummer Street Office Limited Partnership v. NRFC NNN Holdings, LLC (referred to in this Post as the “Plummer decision”), the court’s holding resulted in a heavy loss of more than $40 million for the lender.  The court’s holding demonstrates the necessity of carefully evaluating lending risks and coordinating remedies in lease and loan documents, particularly when a real estate asset has a single tenant.

Facts of the Case

In the Plummer decision, the lender loaned $44 million to a borrower.  With the money, the borrower purchased two commercial projects in Chatsworth, California.  The borrower leased the properties to Washington Mutual Savings and Loan as the sole tenant.  The loan was non-recourse, secured by the properties but not any other assets of the Borrower, subject to exceptions for borrower misconduct.  An affiliate of the borrower, Northstar, executed a loan guaranty that contained triggers that corresponded to the borrower misconduct non-recourse carve outs.

Northstar’s guaranty to the lender provided that “[t]he Loan shall be fully recourse to Guarantor, and Guarantor hereby unconditionally and irrevocably guarantees payment of the entire Loan, if any of the following occurs after the date hereof:  . . . (iv) without the prior written consent of the [Lender, either lease] is terminated or canceled.”

Washington Mutual went out of business and it and its successors stopped paying rent and abandoned the properties.  The borrower ceased making loan payments to the lender.  The lender took title to the properties through a non-judicial foreclosure sale in which it bid approximately $11 million.  The lender then brought suit against Northstar, the guarantor, for the balance due on the loan — approximately $42 million plus attorney fees and costs.

Court’s Decision

The principal legal issue was whether the tenant’s ceasing to pay rent and abandoning the property terminated the leases, triggering the guarantor’s duty to pay the amount owning on the loan if the leases were “terminated” “without the prior consent of Lender.”  The trial court concluded that the leases were terminated without the lender’s consent and the guarantor was liable. 

The Court of Appeal disagreed, holding that the guarantor was not liable under the guaranty.  When the tenant stopped paying rent and abandoned the premises, the leases were not terminated as a matter of law.  Both leases contained provisions, pursuant to California Civil Code section 1951.4, that the leases continued in effect for so long as the landlord did not terminate the tenant’s right of possession, notwithstanding the tenant’s breach of the lease.  The leases expressly provided:  “No act by Lessor other than giving notice of termination to Lessee shall terminate Lessee’s right of possession.”  The borrower never gave notice of termination of the leases.  (Why would the borrower do so under these facts?)

As a result of the lease provisions and operation of California Civil Code section 1951.4, the leases did not terminate and the guaranty was not triggered.  The court reasoned that its interpretation of the guaranty was consistent with the parties’ intent, expressed in the deed of trust and other loan documents, to  carve out exceptions to the loan’s non-recourse provision only in the event that borrower committed certain “bad boy acts” that pose particular risks to the lender’s interests and collateral.  Those same acts could trigger the liability of the guarantor.  But in this case, because none of the express “bad boy” acts occurred, so the lender’s sole recourse was to the collateral. 

The lender tried to argue that although the lease termination provision in the guaranty resembled a “bad boy” guaranty it should operate like an absolute guaranty because full recourse is triggered regardless of whether the lease is terminated by the tenant or the landlord (i.e., the borrower).   However, the court did not accept that argument, stating that the leases were never terminated and only the borrower held the right to terminate the leases, which the borrower did not do.  For the same reasons, the tenant’s repudiation of the leases did not trigger the guaranty.   The leases expressly provided they could not be terminated by an act of the tenant. 


Do you think the lender believed, at the time the loan was made, that the guarantor had no obligation if the borrower stopped making debt payments on the grounds that its sole tenant decided to walk from the lease?  The answer to this question is almost certainly no, but the court’s decision doesn’t provide any facts to help us understand the thinking of the loan officer or loan committee.  Did the lender underwrite this loan believing that Washington Mutual was essentially at no risk of default?

Going forward, lenders and their counsel will want to pay close attention to remedies in leases and loan documents.  Lenders may be tempted to require their borrowers to include lease continuation provisions in order to continue collecting rents from a defaulting, creditworthy tenant.  However, as this case instructs, if a tenant suffers a financial calamity and goes out of business, those lease continuation provisions have little utility and can actually be harmful if a “bad boy” guaranty is not properly structured.

The language of a loan guaranty should also be carefully reviewed so that it reflects the expectations of the parties.  Does the lender expect that the single tenant will provide the sole source of funding for the loan?  Or does the borrower need to back up the loan and have incentive to find a replacement tenant?  If the latter is so, the guaranty could have provided that any abandonment of the premises by its single tenant combined with a failure of the borrower to make debt service payments triggered the guaranty.   The trigger would not be “termination” of the lease, but abandonment of the premises regardless of whether the lease was “terminated.”  If the original tenant goes out of business and abandons the property, the borrower should find a replacement tenant and continue to make debt service payments during the search.  Then, the incentives are properly aligned between the borrower and the lender:  both want a stable rental stream.  Of course, there are circumstances where a lender may be willing to take on the additional risk after extensive underwriting of the single tenant, but the pricing model for the loan would likely have to be adjusted to account for the additional risk.  The Plummer case offers a unique view into decisions that were made during the real estate finance bubble prior to 2008 and their heavy financial consequences.

Limited Liability Companies May Now Hold a Contractor’s License In California

Beginning Jan. 1, 2012, California’s contractor licensing authority must now begin issuing contractor’s licenses to limited liability companies.  Previously, contractor’s licenses were only available to individuals, corporations and partnerships.   

The limited liablity company is the preferred form of entity for most real estate owners, developers and investors.  A limited liability company is a superior form of entity not only because of its limited liability features, but also because of its flexibility and ability to act as a pass-through entity for tax purposes if properly structured.

However, for many years, limited liability companies (or LLCs) could not hold a contractor’s license in California.  As a result, real estate developers often had to form affiliate corporations or limited partnerships with corporate general partners to hold contractor’s licenses issued by California’s Contractor’s State License Board. The formation of these entities and the related flow through accounting and legal issues were an administrative burden for some developers. 

This year the Contractor’s State License Board is required to begin processing applications by LLCs for a contractor’s license.  The law does add some additional requirements for those seeking to license an LLC.  For example, applicants must procure a $100,000 surety bond in addition to the $12,500 contractor bond.  LLC’s wishing to be licensed must also secure liability insurance with a minimum limit of $1 million and an aggregate limit as high as $5 million, depending on the number of employees of record.  Satisfying these additional requirements makes business sense for most sophisticated real estate developers anyway. 

Now that LLCs may hold contractor licenses, real estate developers that typically purchased land or brownfields for development with the LLC form of entity may now consolidate their land ownership and construction activity into the same entity.  It is important to consult with an attorney knowledgeable with your situation to determine whether this consolidation effort is best for you.