Time to Review Your Defaulting Partner Provisions –

Given the past year’s economic troubles, general partners of venture capital funds have received an increasing number of calls from non-institutional limited partners claiming that they are unable to continue to meet their capital commitment obligations. This has forced GPs to carefully look at the heretofore ignored defaulting LP provisions of their partnership – and they are quickly realizing that many existing clauses do not allow enough flexibility and authority to deal appropriately with the varied circumstances of individual LP default.

Defaults by LPs impact not only the fund, but also the non-defaulting LPs. Many LPs’ capital commitments are primarily based upon such factors as fund size and anticipated investment diversification. A reduction in the size of a fund, for example, could inadvertently trigger LP regulatory restrictions, such as those under banking and ERISA laws, which are dependent upon an individual LP’s percentage of total capital commitments. A reduction in a fund’s available capital may also impact the number and size of investments that a fund can make, thus significantly impacting LP returns.

In the past, LP default provisions were generally structured not to be “penalty” provisions, which were expressly permitted by the Delaware Revised Uniform Limited Partnership Act but unenforceable under most states’ contract law. Thus, the remedies included were painful to defaulting LPs, but not harsh enough to ensure that LPs would take their capital commitment obligations seriously. As a result, many funds’ partnership agreements began to contain provisions that, in addition to affording the GP the right to sue the LP and to eliminate voting rights of the defaulting LP, would permit the GP to:

* Impose a high interest rate on the amount owed by the defaulting LP.

* Purchase or offer the fund or other LPs’ the right to purchase the defaulting partner’s interest for the lower of cost or fair market value (or some discount off this amount).

* Reduce the defaulting partner’s capital account or share of profits by 50%.

* Offset the amount in default from future distributions.

These more recently included provisions, while more costly to a defaulting LP, may still not be adequate to convince a cash-poor LP to liquidate its other assets in order to honor its capital commitment to the fund.

A fund’s most aggressive line of defense is to sue the defaulting LP to enforce its required contribution obligation. Most funds, however, generally avoid litigation because of its attendant costs, including potential publicity hazards and risk of counter-claims. This aversion to litigation may also decrease the likelihood of imposing an interest charge during the period of default because the GP would now need to go to court to enforce not only the LP’s initial capital commitment obligation but also to enforce payment of the interest charge.

A repurchase right, while appealing in theory, may be ineffective in practice. Depending on how the repurchase provision is drafted, particularly if the repurchase price is set at fair market value with no applied discount, it may allow the defaulting LP to walk away from the fund with a substantial return on its investment. Given that many funds often suffer losses near the end of their investment term, an early exit by a defaulting LP may actually provide it with a comparative benefit instead of the deserved penalty. In addition, if the provision is drafted such that it requires the defaulting LP’s interest to be offered to all of the fund’s non-defaulting LPs, the GP may be faced with an administrative burden and an investor relations problem.

The reduction of the defaulting partner’s capital account and/or share of profits by 50% is probably the strongest remedy among those listed above. Many partnership agreements already provide that the capital account can continue to be reduced to make the management fee payments that would have otherwise become due absent the default. This solution will largely eliminate the defaulting LP’s capital account by the time the fund is dissolved. Nonetheless, a defaulting LP with even a fraction of its original capital account would still be entitled to receive distributions with respect to such remaining balance, again providing the defaulting LP with some ability to retain value.

In general, GPs would be wise to assume that when they deliver a capital call notice, each LP will make an economic decision as to whether continued participation in the fund has more or less value than other investment alternatives. Thus, to provide proper incentive to the potentially defaulting LP, a GP must make the costs of default greater than the expected benefit defaulting. Moreover, the GP must have an easy, quiet and low-cost method of enforcing its contractual rights.

Delaware law specifically provides for adequate and appropriate defaulting LP provisions that can be included in a limited partnership agreement and will be enforced by the courts. Most venture capital funds are structured as Delaware limited partnerships, whose terms are generally governed by the Delaware Revised Uniform Limited Partnership Act.

Defaulting LPs

In the case of LPs that default on their obligations to the partnership, including default on capital contribution obligations, the act leaves broad discretion to partners as to the terms and consequences that can be included in a limited partnership agreement. Section 17-502(c) of the act clearly states that limited partnerships may impose penalties or consequences for a failure to contribute capital.

Recent amendments to Sections 17-306 and 17-406 of the act have further confirmed the act’s intention to allow such penalties or consequences to be imposed upon defaulting LPs. In addition, Section 17-1101(c) of the act expressly provides that maximum effect will be given to the principles of freedom of contract and to the enforceability of partnership agreements.

Although Delaware courts have yet to set limits on the severity of these penalties, the Delaware Supreme Court recently affirmed an earlier ruling that imposed a complete forfeiture of an interest in a general partnership for failure to fulfill a capital contribution obligation because the language in the partnership agreement was unambiguous. GPs should note, however, that where there is ambiguity Delaware courts typically construe contractual provisions against the drafter of the agreement, especially in the case of provisions that are not heavily negotiated. Thus, so long as the remedies for default are drafted in an unambiguous fashion in the partnership agreement, the GP should have wide latitude to impose as severe a remedy as is appropriate for the situation.

Defaulting LP provisions must not only be strong. They also must be adaptable and varied enough to enable a GP to deal with defaulting LPs in a manner appropriate for the circumstances.

The following provisions, in addition to affording the GP the right to sue defaulting LPs and eliminate their voting rights, are suggested to provide the greatest flexibility to the funds to deal properly with defaulting LPs:

* The accrual of a high, non-usurious interest rate on the amount owed by the defaulting LP, plus the agreement to reimburse collection expenses including reasonable attorneys fees.

* A forced sale of the defaulting partner’s interest to a third party selected by the GP at a price negotiated by the GP.

* The freezing of the defaulting LP’s capital account with respect to allocations of gain coupled with the continued allocation of partnership expenses (including management fees) to the defaulting partner’s remaining capital account.

* The right of GP, the fund or other LPs to purchase the defaulting partner’s interest for the lower of cost or fair market value (or some discount off this amount), which amount may be paid for by the issuance to the defaulting LP of a non-recourse note bearing interest at the applicable federal rate payable at the dissolution of the fund and secured by the interest.

* The elimination or reduction of the defaulting partner’s capital account to any percentage determined by the GP.

* The complete forfeiture of the defaulting partner’s limited partnership interest and forced withdrawal of the defaulting partner without payment of any value for such interest.

* The offset of the amount in default from future distributions.

* The elimination or reduction of the defaulting partner’s right to receive future distributions.

* The reduction of the defaulting partner’s capital commitment to amounts already contributed.

The carefully drafted limited partnership agreement will include a power of attorney or some other mechanism to reduce or eliminate the need for any additional paperwork to be executed by the defaulting LP.

The defaulting LP provisions should explicitly provide that any one or more of these remedies might be implemented at the sole discretion of the GP in order to allow the GP to adapt the provisions to the situation to determine a suitable remedy. GPs should be aware, however, that the flexibility and freedom to contract granted by the Delaware act could contain a few traps for the unwary. For example, the imposition of severe penalties can trigger breach of fiduciary duty claims from defaulting LPs.

The GP can avoid these claims by including a provision in the partnership agreement that states that the GP’s discretion to enforce the defaulting partner remedies supercedes its fiduciary duties to the defaulting LP. Section 17-1101(d) of the act permits this language, but its inclusion would not eliminate a GP’s duty of good faith and fair dealing.

Equal Treatment

These claims generally arise when defaulting LPs in similar situations are treated differently. GPs should note that leniency sets a precedent, and Delaware courts would probably not look kindly upon funds that go easy on some defaulting partners while harshly penalizing others in similar situations.

The determination of what constitutes a similar situation lies within the business judgment rule. It permits the GP, in consultation with counsel, to craft the best solution to fit the situation, while putting LPs on notice that defaulting on their contribution obligation may not make economic sense.

Jay Hachigian is the managing partner of the Boston office of Gunderson, Dettmer Stough Villeneuve Franklin & Hachigian LLP.