Real estate financing: the end of the project limited partnership?

In this blog, I discuss a very important Supreme Court ruling. This highest Dutch court held the managing director-shareholder of a project company liable for the damage caused on the seller's side by the fact that that project company ultimately did not take delivery of a property it had purchased (office space in FC Groningen's stadium).

Wrongful dissolution

After the purchase agreement, no transfer took place because the real estate was not delivered. The cause was that the purchasing project company did not take delivery, with the (hidden) argument that it could not get the financing: after all, the costs of the additional work were too high. The project company dissolved the purchase agreement.

The court found that rescission to be unfounded and unlawful. And not only the project company, but also the director of the project company was held liable for the damages suffered by the seller as a result of the termination of the transfer. The court included in its ruling that it is not unusual for a project company to be formed that will act as a buyer and be provided with funds by the shareholder(s) when the real estate is purchased.

Supreme Court: the director/shareholder of the project company is liable

The Supreme Court agrees with that opinion of the Court. The Supreme Court also finds that the director can be seriously blamed. Its judgment implies that the director caused or allowed the project company to fail to fulfill its obligations to the seller, while the director knew or reasonably should have understood that the project company would have no recourse for the seller's damages. Thus, the issue is not only the purchase obligations (of which payment of the purchase price is usually the most important), but also any related or substitute compensation obligations.

A director who uses a project company, in which no other projects or activities take place, to purchase real estate must ensure that the project company is able to fulfill the purchase agreement. But that director must also ensure that, if that purchase agreement is (wrongly) rescinded, there are sufficient financial resources available in the project company to compensate the seller for the damage suffered.

Funding claims?

That, of course, is by no means easy. Purchases of real estate can be financed. After all, that real estate offers security of recovery by establishing a mortgage right on it. Moreover, that real estate will be exploited and the rent can be pledged to the financier.

But an application to finance compensation claims in the event of an unlawful termination of a purchase agreement will - euphemistically - not be received with enthusiasm by an average financier. In my opinion, this means that this will often require falling back on the equity to be contributed by the shareholder(s) of the project company.

Calculation and financing of additional work

Anyway, in this case, of course, it did not go wrong in whether or not to fund compensation. It went wrong in underestimating or calculating the additional work. Had that additional work been better mapped out, it could have already been included in the financing application for the purchase of the property.

Indeed, the performance of the additional work should have resulted in a direct increase in the value of the property, or at least an improved operating model of that property, which at least indirectly improved the value (via the calculation of the DCF).

The director/shareholder could have offset the amount of liability for wrongful rescission of the purchase agreement against necessary additional investment to bring the property up to the desired level by performing the (apparently disappointing) additional work.

If additional work is disappointing, that is the business risk of the project company; even after thorough calculation of it. And that entrepreneurial risk is therefore not only for the empty project company, but also for its director(s) and capital providers/shareholders. This ruling does show that this risk cannot simply be passed on to the (intended) seller of the property.

How does this affect a financing reservation?

This ruling is in line with rulings in other cases in which buyers rescinded purchase agreements because financing did not materialize. The sellers held the buyers liable under the penalty provision included for failure to take possession of the property. The buyers could not reasonably rely on the financing provision because they had not submitted any serious financing applications at all.

As a result of these rulings, it is almost standard practice nowadays to include in purchase agreements that reliance on the financing reservation can only be made if it is based on good documentation of sound financing applications and (for example) three refusals from major banks. After all, the financing reservation is not intended to easily get rid of a purchase agreement. The buyer has a best-efforts obligation to obtain financing.

If the buyer is a project company, this obligation - and the risk of failure - may also lie with the director of that project company on the basis of this judgment!