The Operating Agreement as Credit Document: How Major Decision Rights, Removal Language, and Capital Call Mechanics Drive Lender Control

The Operating Agreement as Credit Document: How Major Decision Rights, Removal Language, and Capital Call Mechanics Drive Lender Control

The operating agreement sits in a peculiar zone of real estate finance. It is not the loan agreement. It is not the mortgage. Yet it functions as a credit document in ways that most borrowers and even some lenders underestimate. The reason is structural: once the loan closes, the lender's economic claim is secured by the property and the borrower's cash flow. But the lender's ability to enforce that claim, to prevent value leakage, and to force recapitalization or sponsor replacement depends entirely on what rights are embedded in the operating agreement itself. Those rights are not negotiated at closing. They are negotiated, or imposed, months before the loan is underwritten.

This is a story about path dependence. The operating agreement's governance architecture constrains what the lender can do after closing far more than the mortgage language does. And because most sponsors have already negotiated their OA with their co-investors before the lender appears, the lender's leverage to modify those terms is limited. The result: lenders increasingly use the loan agreement to reference, amend, or effectively override the OA's default governance rules. That creates a two-layer control system, and the friction between those layers is where credit risk lives.

Why the Operating Agreement Is a Credit Document at All

A loan agreement specifies terms: interest rate, amortization, financial covenants, reserve requirements. It is a contract between lender and borrower entity. But the borrower entity itself is a legal fiction. It has no assets except the real property (and cash). It has no decisions to make except which vendor to hire, when to refinance, and how to deploy reserves. Every material decision in the entity's life is governed by the operating agreement, not the loan agreement.

Consider a typical scenario: the sponsor wants to defer CapEx to inflate NOI in year one. Or the sponsor wants to inject additional capital ahead of a refinance to lower leverage. Or the sponsor wants to replace the property manager. Or the sponsor wants to pay a special distribution before the loan matures. Each of these actions requires a vote or consent from the managing member or the members' committee. The voting threshold, the definition of who gets to vote, and the removal provisions for the sponsor are all in the operating agreement. The loan agreement can restrict these actions through negative covenants, but enforcement requires the lender to police the OA, not just the loan agreement.

This is why lenders increasingly demand that operating agreements include specific language that ties major decisions to loan compliance. If the loan agreement says "no distributions unless DSCR is above 1.25x," but the operating agreement says "distributions approved by majority vote of members," the lender faces a governance gap. The sponsor can argue that the operating agreement controls internal decisions, and the loan agreement controls external obligations. The lender wins the argument only if the OA explicitly subordinates member voting rights to loan agreement covenants.

Major Decision Rights and Removal Language as Lender Leverage

The structural constraint here is simple: the lender cannot replace the sponsor without a removal provision in the operating agreement. And most OAs, negotiated among co-sponsors before the loan, do not include easy removal rights for lenders. The typical structure requires "cause" (fraud, criminal conduct, material breach) or a super-majority vote (75% or higher). Some OAs require both.

Lenders have learned to negotiate removal language that ties sponsor continuation to loan compliance. The most common formula: the sponsor can be removed if the property is in material default under the loan agreement for more than 30 days. Some lenders push further and require removal if DSCR falls below a threshold (e.g., 1.0x) for two consecutive quarters. Others demand removal if the sponsor fails to fund capital calls or if the entity violates specific loan covenants (occupancy, debt service coverage, leverage).

The reason this matters: it shifts the sponsor's incentive structure. The sponsor now has a personal, contractual obligation to keep the property performing. If the sponsor cannot or will not recapitalize, the lender can force replacement and install a receiver or substitute sponsor. This is not a covenant in the loan agreement. It is a governance right embedded in the operating agreement. And because it is embedded in the OA, it survives refinancing and transfers with the entity itself.

Capital Call Mechanics as the Lender's Hidden Recapitalization Engine

Capital call provisions in the operating agreement are where structural undersupply meets lender control. Most OAs specify the process by which the sponsor can call additional capital from co-investors: notice period (typically 10-15 days), contribution deadline (typically 15-30 days), and consequences of non-payment (dilution, forced redemption, or removal). The lender is almost never a member and therefore cannot be called upon to fund capital calls. But the lender's loan terms assume the sponsor will have the ability to call capital if the property underperforms.

This creates a structural dependency: the lender's credit thesis rests on the assumption that if the property's cash flow deteriorates, the sponsor can and will inject equity to maintain debt service coverage and stabilize operations. But if the operating agreement's capital call provisions are weak, or if the co-investors lack the financial capacity to respond to a call, the sponsor cannot recapitalize. The property then faces forced disposition or loan default.

Smart lenders now require that the operating agreement include specific language guaranteeing capital call mechanics: mandatory capital calls if DSCR falls below a specified level, shortened notice periods (5-10 days), accelerated contribution deadlines (10 days), and automatic dilution or removal for non-responding members. Some lenders even require that the operating agreement permit the lender to initiate capital calls on behalf of the sponsor if the sponsor fails to do so. This is rare and highly controversial, but it is beginning to appear in more aggressive loan structures, particularly in the bridge and mezzanine markets.

The structural insight: capital call mechanics are not optional governance provisions. They are the lender's third line of defense after debt service coverage and cash flow. If the OA makes capital calls difficult, expensive, or discretionary, the lender's risk increases materially. If the OA makes capital calls automatic and binding, the lender can rely on sponsor recapitalization as a credit mitigant.

The Two-Layer Control System and Where It Breaks

Most modern loan agreements now include a section titled "Operating Agreement Amendments" or "Loan-Driven OA Modifications." This section specifies which operating agreement provisions must be amended as a condition of loan closing. Typical amendments include subordination of member voting rights to loan covenants, restrictions on distributions based on loan compliance, mandatory capital call triggers, and sponsor removal rights.

The tension arises when the sponsor's co-investors resist these amendments. A co-investor who holds, say, 20% of the entity may argue that removal provisions tied to loan default are unfair, or that capital call mechanics tied to DSCR should require the sponsor to give co-investors advance notice and an opportunity to negotiate. The sponsor and lender then face a choice: either negotiate acceptable compromise language, or the loan does not close.

This is where the structural constraint becomes visible. The operating agreement's original governance architecture was designed for a world in which there was no lender, or a much weaker lender. Retrofitting that architecture to accommodate lender control creates friction. That friction typically resolves in one of three ways: the lender wins most of what it wants (and the loan closes with strong control language), the sponsor and co-investors win (and the lender accepts weaker governance provisions and compensates with higher rates or more conservative debt sizing), or the deal breaks.

What I'm watching next:

- How capital call mechanics in OAs will evolve as property performance deteriorates across cycles. Lenders are beginning to demand that capital calls be triggered not just by loan default, but by occupancy declines, lease roll-down risk, or expense inflation. The co-investor resistance to these provisions will intensify.

- Whether lenders will begin to require that operating agreements include specific language subordinating co-investor consent rights to lender direction during workout scenarios. This is a frontier issue in mezzanine and preferred equity structures, where the lender's control over the sponsor's decision-making becomes critical post-default.

- The role of removal language in multi-sponsor deals where there is no single "sponsor" and instead a managing member elected by a members' committee. Lenders are discovering that removal provisions are almost impossible to enforce in these structures, because the committee can simply vote to re-elect the same managing member. This is pushing lenders toward direct governance rights (observer seats, veto rights on major decisions) rather than removal rights.