Why Capital Partners Need SPE Covenants in the Operating Agreement
November 28, 2025 | Author: David J. Murphy
Special purpose entity covenants occupy an awkward place in real estate joint venture documentation. The covenants themselves typically appear in the loan documents, where they protect the lender’s interest in maintaining a bankruptcy-remote borrower. But the party most vulnerable to SPE violations, after the lender, is often the capital partner, who has no privity with the lender and no direct contractual protection if the operating partner breaches covenants to which the capital partner is not a party.
This structural gap can produce devastating outcomes. A capital partner may watch its equity evaporate despite excellent property performance, simply because the operating partner failed to maintain separate books or guaranteed an affiliate’s debt. A solution is to incorporate SPE covenants directly into the joint venture operating agreement, creating obligations that run to the capital partner and support meaningful remedies when violations occur.
The Disconnect Between Property Performance and Equity Value
Consider a joint venture that acquires an industrial property with a value-add business plan. The operating partner executes the leasing strategy, achieves targeted rents, and delivers the projected returns on a property-level basis. By every operational measure, the investment succeeds.
Meanwhile, the operating partner, facing liquidity pressure elsewhere in its portfolio, has caused the borrower to guarantee an affiliate’s obligation, commingled funds across entities, or failed to maintain the separate books and records that SPE status requires. The lender discovers the breach, declares a default, and accelerates the loan. The capital partner’s equity, which should have been substantial based on property fundamentals, is extinguished in foreclosure.
This outcome has nothing to do with real estate risk. The capital partner underwrote the property correctly and selected an operator who performed capably at the asset level. The equity was destroyed by administrative failures and affiliate entanglements entirely within the operating partner’s control-failures that the capital partner had no contractual right to prevent or remedy because the relevant covenants appeared only in loan documents between the borrower and lender.
Why Loan Document Covenants Are Insufficient
Loan documents protect lenders. The borrower’s representations and covenants regarding SPE status give the lender grounds to declare default and exercise remedies, but those provisions create no rights for the capital partner. When the operating partner causes an SPE violation, the capital partner’s injury is real-its equity is at risk-but its remedies are limited to whatever the operating agreement provides.
If the operating agreement is silent on SPE compliance, the capital partner may have a claim for breach of fiduciary duty or the implied covenant of good faith, but these theories are uncertain, fact-intensive, and slow. By the time litigation resolves the question, the lender may have already foreclosed. The capital partner needs direct contractual protection that allows it to act quickly when violations occur.
Incorporating SPE Covenants into the Operating Agreement
The operating agreement should contain a dedicated section establishing SPE requirements as affirmative obligations of the joint venture entity, with the operating partner responsible for ensuring compliance. These covenants should be at least as comprehensive as the corresponding provisions in the loan documents, and any breach should constitute an event of default under the operating agreement.
The core requirements fall into several categories. Single-purpose limitations ensure the entity exists solely to own and operate the property, holds no unrelated assets, engages in no unrelated business, and does not make loans or acquire securities of its members or affiliates. Separateness covenants require the entity to maintain its own books, records, bank accounts, and financial statements; file its own tax returns; pay its own expenses from its own funds; use its own stationery and invoices; and hold itself out as a separate entity distinct from its members and their affiliates.
Restrictions on affiliate transactions require that any dealings between the entity and its members or their affiliates occur on arm’s-length terms, with advance notice to the capital partner and, for transactions above a specified threshold, the capital partner’s prior consent. Credit restrictions prohibit the entity from guaranteeing the debts of any other person, pledging its assets for the benefit of affiliates, or holding out its credit as available to satisfy others’ obligations. Solvency requirements ensure the entity maintains adequate capital and does not make distributions that would leave it unable to pay its debts as they come due.
Designating any breach of these covenants as an event of default under the operating agreement is essential. This designation triggers the removal rights and other remedies that give the capital partner meaningful recourse.
Monitoring Compliance
SPE covenants in the operating agreement are only effective if the capital partner has visibility into compliance. The agreement should require the operating partner to deliver quarterly certificates affirming compliance with all SPE covenants in both the operating agreement and the loan documents, describing any exceptions, and outlining plans to cure any deficiencies. The operating partner should also be required to provide immediate notice of any breach or potential breach, any communication from the lender regarding SPE status, and any event that could reasonably be expected to result in an SPE-related default.
Audit rights should extend beyond property-level financials to include examination of the borrower’s books, records, bank statements, and documentation of affiliate transactions which are the materials necessary to verify that separateness requirements are being observed. Some capital partners negotiate for direct communication rights with the lender, ensuring they receive copies of any default notices or compliance inquiries simultaneously with the borrower rather than relying on the operating partner to forward them.
Regular monitoring serves a preventive function as well as a detective one. An operating partner who knows the capital partner is watching, who must sign quarterly compliance certificates, is less likely to treat SPE requirements as administrative details that can be deferred or overlooked.
Removal Rights and Direct Lender Negotiation
Monitoring alone is insufficient if the capital partner lacks the ability to act on what it discovers. The operating agreement should provide that any breach of SPE covenants constitutes cause for removing the operating partner as managing member, with removal effective immediately upon notice. Extended cure periods are dangerous in this context. The lender’s remedies may outpace the capital partner’s ability to intervene if removal requires weeks of notice and opportunity to cure.
Upon removal, the capital partner or its designee assumes management authority, including the authority to negotiate directly with the lender. This capability is critical. Lenders generally prefer to avoid foreclosure if a viable path exists to cure defaults and preserve the loan. A capital partner who can demonstrate that it has removed the problem operator, cured the SPE violations, and restored proper borrower governance may find the lender willing to reinstate the loan or negotiate a modification.
The operating agreement should also grant the capital partner the right to cure loan defaults directly, including by making payments or taking corrective action, with amounts expended treated as priority loans to the venture. This cure right allows the capital partner to stop the lender’s remedies from advancing while it addresses the underlying problems.
Indemnification
The operating partner should bear financial responsibility for losses arising from SPE covenant violations within its control. The operating agreement should require the operating partner to indemnify the capital partner against claims, losses, and expenses resulting from SPE breaches caused by the operating partner’s acts or omissions, including losses resulting from loan acceleration or foreclosure attributable to such breaches. This indemnification obligation should survive termination of the agreement and dissolution of the venture.
Indemnification is not a substitute for the structural protections discussed above as an insolvent operating partner’s indemnity is worthless. But it provides an additional layer of accountability and may be backed by guarantees from creditworthy principals.
Structural Protections Beyond the Operating Agreement
Some capital partners pursue additional structural safeguards at the borrower entity level. An independent director or special member, whose consent is required for actions that could breach SPE covenants or result in bankruptcy, provides protection against unauthorized actions by the operating partner. Third-party administration of the borrower’s books and records reduces reliance on the operating partner’s back-office discipline.
These structural elements complement the operating agreement covenants but do not replace them. The operating agreement remains the governing document between the joint venture partners, and the capital partner’s rights must be clearly established there.
Preserving the Investment Thesis
Capital partners underwrite real estate investments based on property fundamentals which include location, tenancy, market dynamics, capital requirements, and projected cash flows. Those underwriting models assume, usually without explicit analysis, that the operating partner will comply with loan covenants and that the capital structure will remain intact through the hold period.
When SPE violations break that assumption, the capital partner faces a scenario its models never contemplated – a performing asset with worthless equity. The remedy is not better real estate underwriting but better structural protection in the operating agreement. Direct SPE covenants, robust monitoring rights, clear removal triggers, and the ability to negotiate with lenders before foreclosure becomes inevitable. These provisions preserve the link between property performance and equity value that the capital partner’s investment thesis depends upon.
We welcome the opportunity to discuss how these protections can be structured in specific transactions.
David J. Murphy is the managing attorney at Murphy PC in Boston, Massachusetts. He regularly represents real estate developers and investors in real estate development projects.