On August 27, in Historic Boardwalk Hall, the Third Circuit Court of Appeals decided that a tax credit investor was not a partner because it “lacked a meaningful stake in the success or failure” of the project owner. Consequently, the investor was not entitled to any rehabilitation tax credits. This ruling could have far-reaching implications for various federal tax credit investments.
The case involved the redevelopment of Historic Boardwalk Hall, an “iconic venue” and historic home to the Miss America beauty pageant, by the New Jersey Sports and Exposition Authority (NJSEA), a state agency. To defray project costs, NJSEA solicited bids for federal rehabilitation tax credit investors. Pitney Bowes Inc. (PB) was the winning bidder. Historic Boardwalk Hall, LLC, (HBH) was formed to be the tax owner of the building and to complete the renovation of Historic Boardwalk Hall.
The transaction structure in effect insulated the tax credit investor from the economic performance of HBH. Among the relevant deal terms:
- A construction completion guaranty by NJSEA fully protected PB from construction risk.
- Historic Boardwalk Hall provided PB with a comprehensive tax benefits guaranty, backed by NJSEA, protecting PB from a failure to receive projected tax benefits.
- The project was so highly leveraged that it was unlikely that PB would receive any economic return (other than the 3 percent preferred return on PB’s investment).
- One of PB's two put options was secured by a guaranteed investment contract.
- NJSEA had an option to purchase PB's interest in HBH at a strike price not based on fair market value, but rather based on the present value of projected tax benefits and distributions through the five-year tax credit recapture period.
- NJSEA provided PB with an uncapped operating deficit guaranty that in the court's view eliminated PB's operational risk from the project.
In many respects, however, the structure of the transaction in the Historic Boardwalk Hall case is similar to industry practices in structuring historic tax credit investments, particularly those that use the pass-through lease structure, in which the owner of the project makes a statutory election to pass through the rehabilitation tax credit to a master tenant of the project. Mitigation of construction risk, a tax credit indemnity, an operating deficit guaranty and a preferred return on equity are commonly found in historic tax credit deals. In many of those transactions, however, the investor is subject to the risk of losing all or a portion of its investment based on performance of the real estate. In fact, some tax credit investors in rehabilitation tax credit transactions have suffered losses on deals even where there were broad guaranties of tax benefits and economic performance.
The tax credit industry is only beginning to sort out the implications of the Historic Boardwalk Hall decision. The initial impact most likely will be on historic tax credit transactions, especially those that use the lease pass-through structure. Deal structures and industry practices will have to be reevaluated in light of Historic Boardwalk Hall. The decision will likely have implications for other federal tax credit investments, too, including the low-income housing tax credit and renewable energy tax credits. In the low-income housing tax credit area, we do not expect to see much change in connection with the acquisition of interests in project partnerships that that own the low-income housing projects. But we do anticipate that there may be more scrutiny of some tax credit fund structures, particularly those that involve comprehensive guaranties by credit-worthy entities or otherwise eliminate investor risk.
A guiding principal from the Historic Boardwalk Hall case is that if a tax credit investor has no realistic possibility of upside and is insulated from construction, operational and tax risk, the investor may lose the tax credits it expects. According to the Third Circuit, comprehensive risk mitigation can be inconsistent with a tax credit investor's status as a partner.