Weathering the “Forced Sale” Storm: Strategies for avoiding Year 15 conflict

9 min read

The formation of tax credit financial partnerships to build affordable housing can be a joyous occasion. Both general and investor limited partners are optimistic. Regrettably, years later, the exit can be mayhem.

Many, if not most, tax credit partnership agreements (or operating agreements if the owner entity is a limited liability company) contain some iteration of a “forced sale” provision – a right exercisable by the investor to compel the general partner to find a buyer for the property on terms acceptable to the investor. The “forced sale” would apply whether or not the general partner wants to sell.

There are three elements that can be at play. The first is an investor’s “forced sale” rights. The second is the partnership agreement’s distribution sections relating to capital transactions, which apply in the event the property is sold. The third is the fact that most tax credit partnership agreements require distributions following a dissolution based on positive capital accounts.

What happens when these three elements coalesce in a single transaction and are read in conjunction with each other? The answer: a perfect storm of confusion, misunderstanding and anger, with general partners and their investors in conflict and wails from owners like “That isn’t what we agreed to,” “What happened to the 80/20 split?” “It can’t mean that,” and “But, I don’t want to sell.”

This storm has blown like a hurricane through partner interest dispositions in the past few years. How has that happened? And what can be done to insure against future storms?

Waiting for the end of the compliance period to address the issue is risky.

Owners and investors start to focus attention on property and/or partnership interest dispositions at or near the end of the tax credit compliance period, when investors have received the full benefit of the tax credits and the property probably needs a “facelift” (if not a complete makeover). Under circumstances in which the fair market value of the housing development has greatly appreciated, once the compliance period has ended, owners usually wish to retain their property and reinvest in its future. Investors however, may want out. But, “out” comes at a price. That price is viewed, by most owners with unfavorable language in their partnership agreements, as both unanticipated and exorbitant. Owners and investors addressing this subject today, in 2015, are operating pursuant to agreements drafted 10 to 20 years ago, and perhaps by different participants than those now involved.

In recent years, when post-compliance period property dispositions are initiated, attention gets focused on:  (a) how to handle “exits” when the underlying agreement contains language that – from an owners’ perspective – is “troublesome,” and (b) how to write agreements going forward that, in the arena of dispositions, result is predictable and economically balanced outcomes. In other words, how to avoid the storm.

Both objectives can be achieved.

Evolution of “Forced sale” Language – and the Distribution Result

What got us into this perfect storm? It was seeded by a progression of seemingly innocuous and standard provisions that were inserted into partnership agreements starting in the early 90s. Then, piece-by-piece, agreements negotiated thereafter broadened what was a narrow “forced sale” provision to provide the investor with a clear path to exit a deal.

Tax credit partnership agreements have evolved over the past two decades. At the inception of the tax credit program, the industry was dominated by a small number of prominent investor groups. Investment documents were almost standardized. There were few secrets – everyone’s documents looked more or less the same.  Then, as changes were made to the tax credit program, new concepts were added to the standard agreement.

In 1989, Subsection (h)(6)(F) was added into Section 42. This provision created the process of “qualified contracts.” Soon thereafter, investor-drafted partnership agreements started to provide that the investor could compel the general partner to request that the housing credit agency find a buyer of the property. In my opinion, the genesis of such provisions was the investor’s desire to control the decision of whether to involve the housing agency in a sale.

What was originally a narrow “forced sale” provision tied to qualified contracts morphed into a general right of the investor to force a sale of the property after the compliance period.

General partners, failing to focus on the effects of the “distribution on dissolution” provisions in their agreements, may have asked their investor if, in lieu of a sale, they could purchase the investor’s partnership interest.  Investors agreed but dictated that purchase price for their interest needed to be what the investor would have received if (a) the property were sold at fair market value and (b) proceeds were divided in accordance with the distribution sections of the agreement. However, the applicable distribution section was not the Capital Transaction waterfall (as many owners and their counsel assumed); but rather, the distribution section related to dissolution.

To most general partners, that the investor may or does control the decision on whether a property is sold is frustrating enough. Adding that the distribution of proceeds between owner and its investor does not follow the so-called “back-end split” makes it heinous.

Why does the result come about? It’s because:

  1. the sale of all, or substantially, all of the (owner) partnerships assets is, by definition, a dissolution;
  2. most capital transaction waterfall provisions start with the words “prior to dissolution,” which means that the words that immediately follow (i.e. the waterfall) do NOT describe how proceeds are split in a sale of the property held in a single asset partnership/LLC; and
  3. elsewhere in the document, in plain English, but without cross-reference, there is almost always an entire section devoted to “distribution upon dissolution” and, in that section, which generally references a sale of the project, the partnerships’ assets are to be distributed in accordance with positive balances in capital accounts.

An example may help illustrate the difference in results. Suppose you have owned a property for 16 years. You have managed the property capably; yearly, after all expenses are paid, the property generates $50,000.00/$100,000.00 in cash flow. Now a sale could occur which could generate $1,000,000.00 in net proceeds. If the split is 80/20, the general partner would garner $800,000 and the investor $200,000. But if the investor has a positive capital account of $1,000,000.00 or more, the general partner would receive – ZILCH!

Was that the intended outcome?  Most owners I know say “no – that was never the deal.” Many investors (at least the ones who negotiated the original investment) would agree. Is it fair? That depends upon whom you ask. Is it avoidable? Yes, thankfully, with careful drafting.

In tax credit partnership agreements, distributions after dissolution (involving positive capital accounts) are not treated the same as distributions following a capital transaction. Tax lawyers and accountants usually insist distribution on dissolution language needs to be in the agreement, and it is that exact language that leads to the storm. But, even if one accepts the tax analysis reasoning for honoring dissolution distributions respecting capital accounts, the fact remains: a sale of partnership interest is not a dissolution. If what is sold is a partnership interest (not the property), there is no dissolution.  What traps the owner is not the Internal Revenue Code but the language of the partnership agreement. What is the solution? Change the language of the agreement.

What can be done now?

  • First, go read all of your agreements. Don’t assume you know what the language says and/or means. Ask yourself these questions as you read them:
  • Can the general partner be forced by its investor to sell the property? If so, when and under what circumstances?
  • If a general partner does not wish to sell, what alternatives are available? Can the interest of the investor be purchased? At what price and with what distribution of net proceeds?
  • Can the property be refinanced (where proceeds will be distributed pursuant to the Capital Transaction waterfall) before an investor can force a sale?

Once you understand your documents, formulate a strategy to engage with your investor. Discuss refinancing options and/or future syndication opportunities, involving the subject property or other properties.  But don’t wait until the compliance period draws to a close.  Since most forced sale provisions commence after the compliance period, engage with the investor in Year 11 or shortly thereafter.

What can General  Partners do in the future?

  1. Don’t agree to “forced sale” provisions at all.
  2.  If the investor insists on a forced sale right, value the investor’s partnership interest at the outset of the negotiation or, at least, don’t agree on a purchase price for the interest based on what the investor would have received if there were a sale (if there isn’t going to be a sale, why pretend?).
  3. Insist on a right of first refusal provision to buy the property or an option to buy investor’s interest.  Options should be exclusive to the general partner and exist for a considerable period.
  4. If an investor initiates a sale process (because the investor wants an exit), insist on an option to buy its partnership interest in lieu of a sale but without triggering a distribution based on positive capital accounts.
  5. Impose a disposition/cooperation fee for a general partner who is forced into a sale.

Working through the pitfalls attendant to the disposition of partnership interest takes time and compromise. The parties’ goals and expectations need to be balanced. Investors need an exit; owners need to be protected from a forced sale of their property in circumstances where the profits will not be returned to them.

One final thought

  • Don’t be afraid of a blank piece of paper.
  • You know the language that has upset you. Avoid it and write down what you want the deal to be.
  • If you can’t get what you want now, negotiate for it in the next deal.
For over 35 years, John has concentrated his practice in the development of real estate projects. While his clients have come from a broad range of diverse industries, most of John’s day-to-day representation involves housing. John’s clients have built, owned and/or managed hundreds of thousands of multi-family housing units, including housing for the men and women who serve in our armed forces. John has extensive experience in complicated financing structures including syndication of State and Federal Low Income Housing Tax Credits, State and Federal Historic Credits, New Market Tax Credits, Brownfields Credits, energy-related credits and other state credits. Working with owners, lenders investors, industry groups, as well as municipal, state, federal, governmental and regulatory agencies to obtain approvals and support for proposed developments, John’s skills and experience have earned him the reputation as a lawyer who “gets the deal done.” John currently serves on the Board of Directors of Preservation Massachusetts and the National Housing & Rehabilitation Association (NH&RA). He assisted in drafting laws and regulations dealing with affordable housing properties to better facilitate the advancement of his clients’ projects, including the preservation law, enacted in 2009, in the Commonwealth of Massachusetts (Chapter 40T – An Act Preserving Publicly-Assisted Affordable Housing). John continues to serve on the advisory committee which provides advice and recommendations relative to the implementation of Chapter 40T. He also serves, or has served, on the boards of a number of local community banks, hospitals and other social organizations.