Recently I sat down with an active real estate flipper, Freddy, who found success in the Atlanta market. Freddy is currently rehabbing four properties in his corporation. When asked why he was juggling four deals in his corporation versus using separate LLCs for each deal, each of which owned 100% by his corporation, Freddy informed me a local attorney advised him on this strategy and discouraged making his business any more complicated. The attorney thought a separate LLC was not warranted for the following reasons:
- Each LLC will cost $1,500 – an unnecessary expense;
- Each LLC will need a separate bank account – an unnecessary complexity; and
- Each LLC will require separate accounting – an undue burden
What the attorney did not accept is each property has a separate set of liabilities, and one lawsuit could bring Freddy’s investing to an end. However, more troubling for Freddy is the attorney’s failure to understand his investing. Freddy uses private money to finance his deals. His properties have different joint venture partners each of whom, required Freddy to sign a personal guarantee for the money they invested. If Freddy’s business is involved in a lawsuit and his properties are lost to a creditor, each of his joint venture partners could sue Freddy for monies lost. This added threat should be enough for any investor to use separate LLCs for each deal when joint venturing but, I will provide you a few others reasons that quite possibly pose an even greater risk to Freddy.
When entering into a joint venture with another party, you are in a partnership and as such, owe your partners specific duties. In essence, you become an agent for your other partners. A breach of any one of the following duties can result in liability for both Freddy and his business:
Duty of Good Faith and Fair Dealing
The obligation of good faith and fair dealing begins with the offer of the joint venture opportunity and will continue throughout the agreement, i.e., the sale of the property.
Duty of Loyalty
The investor must always place the interest of the joint venture above their own personal or business interests. As part of the duty of loyalty, the investor must refrain from conflicts of interest or self-dealing for personal gain. The conflict of interest is a very real concern for Freddy because he is running several joint ventures in the same company thereby putting each deal in conflict with another. A joint venture partner could allege Freddy did not devote his best efforts to their deal because his joint venture deals were more profitable. Although Freddy assured me, he would never do such a thing I told him it is all about perception. I pointed out he did not share with each joint venture partner his involvement with the other joint venture arrangements. This failure to disclose, by itself, is a breach for not fully disclosing relevant information to the other partners about his other deals.
Duty of Care
Freddy is in charge of the joint venture’s business activities. The duty of care requires Freddy to act reasonably, in good faith, and without any conflict of interest when making business decisions for the joint venture. A clear conflict exists when Freddy has three other joint ventures he is trying to manage. At a minimum, Freddy is required to fully disclose to other joint venture partners any information relating to the joint venture and its business that could affect a partner’s interest. Notably, this could be extended to any other real estate opportunities his corporation might want to engage in the future, contributions made to Freddy’s corporation from other joint venture partners, contracts entered into, and the corporation’s finances and operations.
Freddy is running all of his joint venture contributions, property expenses, and income from the sale of various properties through one bank account. Questions arise as for proper accounting, use of joint venture funds for the benefit of other joint ventures, and personal benefit to Freddy.
As I explained to Freddy, not all lawsuits germinate from issues surrounding the underlying business assets, i.e., real estate. Lawsuits can also grow from how the business was conducted. In Freddy’s situation, he cultivated a potential garden of claims that could be brought by any of his joint venture partners. To make matters worse, the claims mentioned above typically result in personal liability in addition to liability for the business. To minimize Freddy’s duties to his joint venture partners and the general risk posed by real estate in general, Freddy should create the following structure:
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