Do you understand the legal risks in your management rights business?
21 May 2015
We don’t like being negative nellies, but sometimes we do need to talk about the things that go wrong in these newsletters.
Alan Greenspan (the then Federal Reserve Chairman in the USA) coined the famous phrase ‘irrational exuberance’ in relation to the dot-com bubble of the late 1990’s, but it could apply to any boom since (and before - even back to the tulip boom of the 1600’s.)
If you were to Australianise that phrase it would be along the lines of something being ‘too silly for words’.
It is not for a lawyer to talk about risk when it comes to valuations / asset pricing as Greenspan could, but it is certainly within our ambit to talk about legal risk.
Legal risk abounds everywhere. As lawyers, we primarily tend to get asked to help clients when they are about to do a deal or when they get into trouble. Unfortunately, you sometimes don’t know the risks you are running until you are on the edge of – or are falling – into the abyss of the risk you having assumed (whether knowingly or otherwise).
Consider the position where you act as a letting agent without a valid letting appointment. Section 89 of the PoA makes it very clear you cannot charge an owner if you do not have a Form 6.
What are the pros and cons?
|You keep a relationship with the owner||It is not a formal legal relationship|
|You earn income||
The owner can claim it all back – from
|You don’t lose it to an outside agent||Would an outside agent take it anyway
without a Form 6?
|The income adds capital value to
|A proper accounting due diligence will
raise it as an issue for any buyer
|The OFT may prosecute you for acting
without an appointment
You might earn $2,000 (as an example) in income from the lot per annum but you are running all of those risks. Is it worth it? Personally, we think not, but it is not our business. It is yours.
Now for a more complex one.
An interesting barometer for the state of the management rights market in general is off the plan management rights sales. In terms of risk, there is a bit more involved in these because the final nature of the business depends on what happens through the sale and settlement process. What it will look like on registration is obviously not as visible as what an existing management rights business is.
When the property market is booming (as it seems to be now), there are a lot more off the plan matters about. During the GFC we didn’t need to bother sharpening up on our off the plan skills because there was no development. As it sits right now, we have been involved in more off the plan deals in the last six months than we have had for the last few years.
Any purchase (and in fact really any business decision) involves the pricing of risk. You are happy to pay a price of $X if you are going to a return of Y. If there is a risk to that return, you might pay $X minus a factor for that risk.
The returns being sought from management rights businesses are not necessarily just financial ones. What we mean by that is that when you place funds on a term deposit with a bank all that may matter is the interest rate (and perhaps the continued solvency of the bank itself).
In management rights, other factors, particularly around lifestyle and residence, come into the equation which all then go into the purchasing decision.
Factors which affect lifestyle choices are not the subject of this article but legal factors which affect the financial return are.
One of the key legal risks in an off the plan sale is the negotiation of claw back arrangements. There are obviously quite a few more, but the documentation of the claw back / claw forward arrangement is one of the most important things to get right.
In the run up to the GFC in 2007 we were asked to second guess the legal advice a purchaser had received when a deal turned bad. The management rights deal itself was for a relatively small off the plan business. The developer had apparently said they would deliver 35 of the 36 lots in the letting pool (the missing one being the manager’s lot).
An offer to purchase was made which was based on that.
When the claw back arrangement for each lot less than 35 in the letting pool was suggested, the developer apparently pushed back. The essence of the conversation was this:-
Purchaser – ‘Can we have a claw back for each lot less than 35 in the letting pool?’
Developer - ‘I’ve said I will deliver 35 and I will.’
Purchaser – ‘Well why don’t you want to include that in the contract?’
Developer – ‘Because I have made that commitment and I will stick to it’
The developer then threatened to move on to the next buyer – who were allegedly (and in fact probably were) thick on the ground. The purchaser capitulated and the deal ended up being struck on the basis that the purchaser paid a fixed purchase price no matter how many lots ended up in the letting pool.
The risk with any missing letting appointments was in effect shifted wholly the purchaser. Under a claw back arrangement it really rests with the developer (in terms of if a lot does not appear in the letting pool, the developer does not get paid for it).
The lawyers acting for the purchaser had advised their client of that risk and the purchaser charged on regardless.
At the end of the day the commercial call for the purchaser in this off the plan deal was whether they priced the risk of the potential for the letting pool to be smaller than what they had been promised.
Perhaps they didn’t think they needed to document it because they thought the developer would deliver what it had promised given their dealings with it. Maybe the multiplier was so low, or the caretaking remuneration so high, they could lose some letting units and it would not matter as the business still worked. Perhaps the decision to buy that particular business (even with that risk) was irrelevant having regard to the lifestyle considerations that led them to purchase it in the first place.
There are no prizes for guessing what happened on settlement and why we got involved. There were not 35 lots in the letting pool. There were less than 30. Our view of developers is not necessarily jaundiced but you could hardly call us surprised when a developer did not deliver something they had not contracted to deliver. Why would they?
Litigating one of these things for misrepresentation is also a hard road, and given the relative size of the business, it wasn’t worth it.
It is easy to get caught up in the rush to do the deal. Part of the art of buying well is being able to not become emotionally involved and walk away, and any decision to walk away depends at a very macro level on whether the risk in your particular deal has been priced right for you.
Irrational exuberance. Words worth bearing in mind.