Limited liability companies or “LLCs” are used to hold the vast majority of U.S. real estate investments. Outside of REITs and other corporate owned real estate, investments of any significant size typically include a large institutional capital partner and a more entrepreneurial operating partner (or, in the language of LLCs, “member”) with each contributing a share of the equity required for the deal. Operating members often offer a portion of their investment to permit small investments to be made by friendly co-investors. Sometimes that invitation is done as a favor, i.e., to reward an investor’s loyalty on other deals or to return a favor granted by the investor, and sometimes because the operating member needs the money in order to meet the requirements of the institutional investor.
When the invitation to a smaller investor arrives it can be accompanied by a “we’re in a hurry” message with the clear implication that the co-investor won’t be able to negotiate the terms of the agreement governing the LLC. So what should such smaller investors and their lawyers look for in the draft LLC agreement? And what should the operating member instruct its lawyer to include in the agreement so that the small investors are comfortable with the terms of the investment? This column mentions a few and assumes the small investor has no or minimal negotiating leverage.
Perhaps the primary issue to review is whether the operating member has disclaimed fiduciary duty. A disclaimer can be made in Delaware LLCs but not New York LLCs since New York does not permit a broad disclaimer. An operating member should think twice before including a broad disclaimer in the proposed Delaware LLC agreement given to investors because of the negative impression it will give small investors. With a fiduciary duty standard, the investor can at least feel that he or she will be treated fairly. Without it, all bets are off.
Next, small investors typically invest because they trust the operating member. If the proposed LLC agreement permits the operating member to transfer all of its interest in the LLC to a third party without the consent of the small investors, the small investors could be stuck with an illiquid investment in an entity managed by a stranger. The easy solution is a “tag-along” clause which lets the small investor sell its interest to the same third party at the same price. While a tag-along clause is a mild drag on the marketability of the operating member’s interest, most agree that it’s only fair to permit the small investor to tag-along on the sale. The clause typically doesn’t apply to transfers by the operating member to affiliates or to partial sales.
Finally, since most small investors are individuals, the right of the small investor to transfer his or her interest for estate planning purposes and on death or disability is key. Failure to include commonly used permitted transfer provisions could lead to a default, a heavily discounted forced sale, or even forfeiture of the interest depending on the terms of the LLC agreement.
In short, small investors should look for, and operating members should consider including in the first draft, a few key protections for the smaller investors to give them comfort that they will be treated fairly.
Thomas Kearns is a partner with Olshan Frome Wolosky LLP’s real estate department, New York, N.Y.