November 2015

LEGAL EASE: Compulsory funding in real estate joint ventures

Laurence ApplegateIn many joint ventures, the shareholders’ agreement will remain silent on how the future funding needs of a joint venture will be satisfied. This makes sense in many businesses where it is unclear what the future funding requirements will be or when they might arise. In real estate joint ventures, however, parties are able to be more prescriptive about the circumstances in which future funding must be made to the joint venture company and the consequences of failing to do so. Particularly in joint ventures where one party is financially stronger than the other, the stronger party will want the weaker party to be committed from the outset so that the joint venture is not allowed to stagnate A company would typically only make a cash call to shareholders where it does not have the cash or external finance is unavailable. The following are common examples of compulsory funding events: • funding any costs of the business plan, for example agreed refurbishment costs
• funding any shortfall in capital projects undertaken pursuant to the business plan
• avoiding or reducing the threat of material damage to the relevant property CONSEQUENCES OF A DEFAULT
A failure to provide compulsory funding will frequently give rise to an event of default. The consequences of an event of default may include a compulsory transfer of shares from the defaulting party to the non-defaulting party often at a discount to market value or perhaps a right to sell the non-defaulting party’s shares to the defaulting party at market value.  The non-defaulting party will also need to consider whether to provide the defaulting party’s compulsory funding. If the non-defaulting party is unable or unwilling to fund the defaulting party’s compulsory funding then it may be preferable for it to rely on the event of default provisions.  If the non-defaulting party is willing to provide the additional funding, it can be invested as debt, equity or a combination of the two. It is common in this scenario for some or all of the contributions made by the non-defaulting party to be made in ‘priority’ to all other contributions made by the shareholders to the joint venture. This means that priority funding is repaid ahead of any other shareholder loans or equity contributed to the joint venture and such priority loans or shares carry a higher interest rate or preferential return than any other shareholder loans and equity.  If additional shares are subscribed for with the result that there is a change to the respective percentage shareholdings of the parties, the provisions in the shareholders’ agreement with respect to, among other things, board representation, reserved matters, deadlock and transfer provisions may no longer be appropriate. For this reason, parties will need to consider how to deal with this issue when drafting the shareholders’ agreement and constitutional documents of the joint venture company, for example, by requiring compulsory funding to be made by way of priority loans only or setting out the consequences of any future dilution in the shareholders’ agreement. While bringing a degree of certainty to some of the potential funding requirements of real estate joint ventures, compulsory transfer provisions come with their own challenges. In negotiating these provisions, a party, especially an investor without deep pockets, should try to cap its potential exposure to compulsory funding costs by imposing an upper limit on the amount it is prepared to fund on the occurrence of some or all of the compulsory funding events. Laurence Applegate is a partner at REN Legal ©2015 funds europe

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