The collapse of the asset and credit bubble and resulting economic downturn presented both danger and opportunity for low-income housing properties and the affordable housing industry. The flow of capital all but ceased, and financial pressures strained federal and state subsidies and loan programs for housing projects nationwide. At the same time, demand for affordable housing increased tremendously as communities coped with rising unemployment and continued financial stress.
The heightened credit risk of housing projects and the housing portion of loan portfolios also significantly increased the need for vigilant monitoring by investors and effective asset management.
Mismanagement, coupled with poor economic conditions, significantly increases the risk of loan default and gives rise to a number of other opportunities for property managers and developers charged with effectively and lawfully managing these properties to cut corners or otherwise get in trouble.
When these properties become troubled, removal and replacement of management by investors may be the last resort to save the property and the investment. It may be the best, or only, way for investors to implement a new and effective asset management plan, save the property from foreclosure, protect the remaining assets of the project, and establish the first step toward turnaround.
The removal and replacement process is rife with potential pitfalls and must be approached with caution and careful planning, however. After all, the removal and replacement of existing management is tantamount to divesting a manager of potentially years of work developing, leasing, and running the property.
Cause for removal
The first step in the analysis is whether sufficient grounds exist for removal and replacement. Courts often have the inherent power to remove general partners and property managers for bad acts and mismanagement of assets, but partnership and operating agreements typically govern the removal process and should provide the first avenue of recourse for the investor.
Typically, these agreements require substantial cause to justify removal. And while the actual grounds for cause will often be delineated in the agreement, some causes rank higher than others in the pecking order of what constitutes true, effective grounds for removal.
Understandably, imminent loss of the property (to foreclosure or tax sale) and danger to life and limb of the residents rank high on the list. Other worthy causes include improper tapping of the tenant security deposit accounts, misappropriation of company assets, commingling of funds, and otherwise playing fast and loose with the project's coffers, particularly where there is a demonstrable, material effect on the business.
These are the causes that judges most frequently recognize when push comes to shove. Failure to provide periodic reports, while significant, ranks lower on the list as a basis for a removal action.
The terms of the partnership or operating agreement may significantly limit removal rights. In some cases, management will have bargained for an opportunity to cure any major defaults, assuming the default is susceptible to cure, before they can be removed. Further, a partnership or operating agreement may unwittingly permit otherwise odious conduct by managers, thereby limiting the investor's to take effective, or prompt, action.
The nuts and bolts of removal and replacement
Partnership agreements often contain specific procedural requirements in connection with the removal process. These provisions generally require that a notice of removal be delivered to the appropriate party, with a stated opportunity to cure within an allotted time period, and may well require more than one notice to trigger and complete the removal.
Failure to follow this procedure carefully provides ample opportunity for upsetting even the most worthy removal.
Even with detailed agreements, all steps in the removal process may not be obvious to the uninitiated. For example, there may be an internal conflict when removal provisions reference other provisions of the agreement or other agreements with additional or inconsistent requirements. Removal provisions that are triggered by a loan default can quickly be undone where the lender has not satisfied the notice requirements in the loan documents; other problematic situations arise where the project is in jeopardy of meeting its placed-in-service date, but the construction agreement fails to impose any meaningful completion deadlines on the developer or affiliated general contractor.
Subtle nuances in terminology may also have significant implications that must be understood to successfully execute a removal. The operating or partnership agreement may, for example, give members the “option” to remove managers after providing a 10-day notice of intent to remove. Such a provision might grant members the right, but not the obligation, to remove the managers 10 days after providing notice. Removal would therefore not be self-executing after the notice. In these instances, investors may need to exercise their removal rights after the initial notice by sending an additional notice expressing the members' decision to execute the right of removal. Other agreements include self-executing provisions that state the removal is automatic if curing steps are not taken by management. Failure to act immediately within the time period required may result in a waiver.
Plan ahead and proceed cautiously
Failure to understand these agreements and implement a detailed removal plan prior to initiating the process may result in costly and time-consuming missteps or even litigation, further threatening the project's assets.
Removed general partners and managers often contest their removal on the grounds that investors failed to comply with all of the technical requirements of the removal provisions in a governing agreement. Common allegations by removed management are that the investor has failed to comply with the express removal provisions, there are inadequate (or cured) grounds for removal, a failure to provide adequate notice, deficiencies in the notice procedure followed (i.e., not delivered or not delivered to the correct recipient) and “side agreements” or promises between the investor and management that supersede the agreement.
Additionally, where investors have both debt and equity at risk in the project, a common claim to be guarded against is “conflict of interest” between the two investment types, resulting in one improperly acting for the benefit of the other.
In addition to effective and proper notices, investors should take advantage of other provisions in the governing agreements or under applicable state law that give them substantial leverage. Powers of attorney in the operating agreement allowing the investor member or its designee to execute certificates of amendment and file those with the secretary of state's office are just one example. Recognition of these rights can go a long way toward putting the investor in the best possible position to enforce the removal, should claims arise. Proper amendments to the operating agreement reflecting the change in management, and proper notices regarding termination of the property management company are also key.
Understanding where the financial assets of the business are maintained and being able to obtain immediate control over those assets is also paramount to quickly controlling troubled properties. Proper demand for turnover of books and records, and physical assets owned by the business such as security codes and keys, can also smooth out the process.
Effective removal, however, may only be the beginning of rescuing troubled properties.
Valuation issues with respect to the manager's partnership interests can arise, and there may be detailed provisions for how that procedure is to be carried out.
While removal sometimes results in complete divestiture of the manager's economic interests, a more tenable position for investors, particularly when challenged in court, is that whatever rights the manager bargained for under the applicable agreement will continue to be honored. Hopefully, those rights will include appropriate deductions for proven bad acts, but not always. Often, such provisions result in no economic upside for the removed manager, but the existence of a valuation provision and mechanism can give a court embroiled in a partnership dispute comfort that if the removal is affirmed, the disappointed manager may still have protectable economic rights.
Upon removal, physical and financial assets of the business must be properly inventoried (to avoid claims of “missing property”) and cared for. New management, and new property management, are responsible for accounting for the assets of the business, establishing new operating accounts, changing over the billing information for utilities and related services, putting in place effective lease-up programs, providing on-site security where necessary, and ensuring that, from the tenant's standpoint, there is a smooth transition of property management responsibilities and no disruption in expected services. Attention to these details can also stand the investor in good stead in the event of litigation questioning the removal.
While removal of a general partner or managing member and its affiliated property manager should generally be a last resort to protect troubled properties, the process may sometimes be the only way to improve management or prevent a continued downward spiral of the property and the investment, especially during periods of economic turmoil.
Louis E. Dolan Jr. is a Washington, D.C.-based partner at Nixon Peabody, LLP, and a member of the firm's Commercial Litigation practice, which focuses in part on workouts and litigation involving low-income housing. Brian Whittaker, a Washington, D.C.-based associate, assisted in the development of this article.