Delaware Chancery Refuses To Apply Ferengi Principles To Low Income Housing Deals
There have been two important opinions in the Low Income Housing Tax Credit Year 15 struggle so far this month. Both favor not-for-profit (NFP) sponsors. They each deserve their own post, so today we will start with JER Hudson GP XXI LLC which came down May 2 from Vice Chancellor Morgan T. Zurn of the Delaware Court of Chancery. First a little bit of background, which you can skip if you are familiar with the issue.
The Year 15 Problem
The major source of funding for affordable housing in this country is the LIHTC – Section 42 of the Internal Revenue Code. States are apportioned credits based on population. A specified agency in each state then parcels out the credits to projects. NFP sponsors have an edge in the allocation process.
Typically the credit will be allocated to an investor limited partner, often a bank that is getting Community Reinvestment Act good dooby points in addition to the return from the credit. The credit is doled out over ten years and subject to recapture for an additional five years. There is a requirement for the property to remain affordable for an additional 15 years, but that is enforced by the state agencies not the IRS.
Section 42 allows for not for profits sponsors to have a right of first refusal (ROFR) to purchase the property for a bargain price at the end of the 15 year compliance period. Many deals are underwritten on the assumption that the ROFR price will take the investor out after year 15.
Lately investors, some of whom have acquired their interest after the credits have been exhausted are not cooperating with the ROFR process and are looking for an additional return that in the view of the NFP sponsors they are not entitled to. In general NFP sponsors have been doing well in state courts and the court of public opinion. Overall the investor interests, sometimes referred to as aggregators have been winning in federal court.
JER Hudson presents an unusual fact pattern. At issue was Kate’s Trace, a 108 unit project in Newport News, Virginia, owned by Kate’s Trace Limited Partnership (KTLP). Hudson Housing Tax Credit Fund XXI LP (The Fund) held the limited partnership interest in KTLP through a LLC . JER is the general partner of the the Fund. They are the plaintiffs in the case. DLE Investors LP (DLE) is a limited partner in the Fund.
The Fund started in 2002. DLE became a limited partner in the Fund in 2007. Sometime between 2007 and 2020 ownership of DLE changed. When DLE became a partner in 2007, projections indicated that there would be tax credits flowing, but that there would not be much in the way of residuals as the expectation was that NFP sponsors would acquire the properties under the bargain ROFR terms.
The new owners of DLE, Hunt Capital Partners, didn’t see it that way. They tried to convince the GP to buy them out at a premium. When the sponsor of KTLP acquired the Newport News property at the bargain ROFR price, the GP, on advice of counsel, decided to take no action. DLE was not happy with that and sought to remove the GP under the terms of the partnership agreement.
So the GP brought the action to challenge the removal. DLE asserted counterclaims for breach of fiduciary duty, breach of contract and declaratory judgement that the removal was valid.
Enough Is Never Enough
There is little doubt that if Chancellor Zurn were a Ferengi, that DLE would have prevailed in this case in accordance with Rule 97 of the Ferengi Rules of Acquisition – Enough is never enough. The opinion outlines some of the bickering that went on between the JER and DLE including DLE refusing to consent to a refinancing unless some of the proceeds were used to buy them out. It was the NFP sponsor NHT Communities that ended up triggering the litigation even though it was not directly involved in it.
In the spring of 2021, NHT and the KTLP general partner started taking the steps to transfer the property under the terms of the ROFR to an affiliated NFP. I will spare you the details. It was a done deal when they informed JER. JER sought advice from law firm Holland & Knight about whether the transfer was proper and whether they could do anything about it.
Based on the advice of H&K, JER, the Fund GP, decided not to spend any of the Fund’s remaining $200,000 in reserve funds engaging in futile resistance to the ROFR exercise. DLE responded to that easy going approach with “You’re fired”.
The essence of Chancellor Zurn’s opinion was that the purpose of the Fund was to reap tax credits and the GP had no duty to try to squeeze more out of the deal. Chancellor Zurn wrote:
At the risk of straying from my task, I will share that I do not believe that a failure to sue over an improperly exercised ROFR can cause a material adverse effect on the Fund after the Compliance Period. As explained, Fund GP’s duties to safeguard the funds and assets of the Fund encompass the Property Partnership Interests and cash reserves, but not the Property itself. As explained, Fund GP is authorized and charged to protect those interests only as consistent with the purpose of the Fund. And as explained, under that purpose, the Fund’s Property Partnership Interests have always been valued as sunsetting with a ROFR disposition. Because the partners understand and intend the Property Partnership Interests will terminate with a ROFR disposition, it seems to me that an improperly exercised ROFR does not change the value of the Fund’s Property Partnership Interests, and so cannot constitute a material adverse event on the Fund. Consequently, failure to correct or rescind an improperly exercised ROFR would be exculpated due to the absence of a material adverse effect on the Fund.
David Davenport is an attorney who has been involved in numerous ROFR cases. He was not directly involved in this litigation, but rather represented the NFP sponsor. He is quite enthusiastic about the opinion.
The written decision was issued earlier this week and represents a scathing acknowledgment and indictment of Aggregators and their misconduct throughout the LIHTC industry. It is an extremely lengthy, detailed, and thorough decision, with more than 350 supporting citations to various other cases, articles, treatises, and sources. ………………………
The Court found that the Hudson Fund GP’s mission was to preserve the Kate’s Trace property as affordable housing under the LIHTC program through a ROFR execution, and the Fund’s course of conduct through the end of the Property’s Compliance Period was consistent with its stated purpose. That purpose was an exchange of investor dollars for tax credits and the original investors exiting the Fund once the tax credits were distributed. The Court further found significant that, fundamentally, the Fund is a LIHTC partnership and its source of value and reason for formation is to participate in the LIHTC program, and the ROFR is a feature of the program that is meant to extend the property’s viability as affordable housing beyond the Compliance Period.
I understand Mr. Davenport’s enthusiasm, but this situation is pretty limited in its applicability. The lesson to aggregators is probably that they need to get control of the GP interests in funds or find GPs who will play ball with them. On the other hand, the opinion does endorse the views of NFP sponsors. And it endorses an “Enough is enough” view of responsible business behavior.
An industry insider told me that what has created this problem is a long period of low capitalization rates that were not anticipated when the projects were underwritten. I tend to think that this sort of thing is an inevitable byproduct of using the tax code as an instrument of social policy. Capitalism hates the commons as we learn from watching Mr. Potter and George Bailey every Christmas.
Jeff Montgomery has Chancery Nixes Investor Suit To Force Subsidized Apt. Saleon Law 360. The piece is behind a paywall so I don’t know if there is a pun intended referring to Nixon Peabody which represented DEL.
Beth Healy has Courts are handing setbacks to Nixon Peabody clients seeking control of affordable housing on WBUR. This follows coverage in September on the firm’s role in representing aggregators.
Here is a roundup of my coverage of the issue.