REIT M&A Transactions - Peculiarities and Complications

Business Lawyer

Volumn 55, Issue 2, 2000, Pages 693-734

  Einhorn, David M ^a   Emmerich, Adam O ^a   Panovka, Robin ^a  

^a NONE

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EID: 0034410940     PISSN: 00076899     EISSN: None     Source Type: Journal    
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References (177)

1. See National Association for Real Estate Investment Trusts (NAREIT), Annual Market Capitalization: Equity Market Capitalization Outstanding (last modified Dec. 31, 1999), available in .
2. See NAREIT, January 1999 NAREIT Summary Performance Numbers, available in .
3. See Isles of Stability: When Dot.com Mania Dies, Property Stocks Will Gain, Says Legendary Investor, Interview by Jonathan R. Laing with Sam Zell (Dec. 27, 1999) .
4. See NAREIT, 1998 INDUSTRY STATISTICS 5 (1998) (including both equity and mortgage interests) (applicable pages on file with The Business Lawyer, University of Maryland School of Law).
5. See, e.g., Mark O. Decker, The Modern Real Estate Investment Trust Industry, in REAL ESTATE INVESTMENT TRUSTS 3, 7 (Richard T. Garrigan & John EC. Parsons eds., 1998).
6. Total U.S. equity market capitalization is approximately $12.5 trillion. See Greg Steinmetz, U.S. Firms, Honed in Huge Home Market, Are Poised to Pounce in the New Europe, WALL ST. J., Jan. 4, 1999, at A5.
7. See Real Estate Investment Trust Act of 1960, Pub. L. No. 86-779, § 10(a), 74 Stat. 998, 1003 (codified as I.R.C. §§ 856-858 (1994 & Supp. III 1997)).
8. See H.R. REP. No. 86-2020, at 3 (1960); Rev. Rul. 89-130, 1989-2 C.B. 117.
9. See I.R.C. § 857(b)(1)(B) (1994). Unless otherwise noted, all references herein to "the Code" are references to the Internal Revenue Code of 1986, as amended, and references to "section" or citations to "I.R.C. §" are references to sections of the Code. References to "Regulation §" or "Reg. §" and citations to "Treas. Reg. §" are to the Treasury Regulations promulgated under the Code.
10. See id. § 856 (1994 & Supp. III 1997).
11. The term "UPREIT" is an acronym for "umbrella partnership REIT."
12. See I.R.C. § 721. See generally John P. Napoli & John F. Smith, Emerging Issues in UPREIT Transactions, 26 J. REAL EST. TAX'N 87 (1999) (exploring some of the tax and business issues involved in an UPREIT's acquisition of real estate in exchange for OP Units).
13. See I.R.C. § 351(a), (e). Acquisitions taking the form of reorganizations within the meaning of § 368(a) are beyond the scope of this paper. See infra note 102 for a brief discussion of structural alternatives for REIT mergers and acquisitions.
14. See infra notes 100-09 and accompanying text.
15. See Glenn L. Carpenter & Gary B. Sabin, DownREITs: Now Everyone Can Do Tax-Free Exchanges, REIT REP., Spring 1996, at 9, 9.
16. See Glenn L. Carpenter, DownREIT Strategy, REIT REP., Spring 1996, at 10, 10.
17. See infra notes 100-09 and accompanying text.
18. See James M. Lowy, REITS: 1999 Strategies for Financing and Growth in a Challenging Market, in REAL ESTATE INVESTMENT TRUSTS, at 87, 103 (PLI Corp. Law & Practice Course Handbook Series No. 1137, 1999).
19. The "5/50 rule" is one of the REIT qualification requirements of § 856(a) of the Code. See I.R.C. § 856(a)(6), (h)(1)(a) (1994 & Supp. III 1997) (excluding from the definition of REIT entities which are closely held pursuant to the stock ownership provisions of I.R.C. § 542(a)(2) (1994)).
20. See Lowy, supra note 18, at 103 ("In some REITs that are created by converting existing partnerships or corporations which have owners that own significant percentages of the outstanding interests, the ownership limitation for other shareholders may be as low as 2%.").
21. The trustee of the excess shares trust is usually required to sell the excess shares and distribute to the purported acquiror the lesser of the net sale proceeds or the acquiror's cost for the shares. Dividends and any increases in value are paid to the designated charity. Through this mechanism, the purported acquiror receives no economic or voting benefit from its purchase. See generally Priv. Ltr. Rul. 96-27-017 (Apr. 5, 1996) (discussing the workings and tax implications of excess shares trusts); Priv. Ltr. Rul. 95-34-022 (May 31, 1995) (same). See also PETER M. FASS ET AL., REAL ESTATE INVESTMENT TRUSTS HANDBOOK § 4.02 [6][b], at 4-13 to -15 (1998) (discussing other issues raised by excess shares trusts).
22. The trustee of the excess shares trust is usually required to sell the excess shares and distribute to the purported acquiror the lesser of the net sale proceeds or the acquiror's cost for the shares. Dividends and any increases in value are paid to the designated charity. Through this mechanism, the purported acquiror receives no economic or voting benefit from its purchase. See generally Priv. Ltr. Rul. 96-27-017 (Apr. 5, 1996) (discussing the workings and tax implications of excess shares trusts); Priv. Ltr. Rul. 95-34-022 (May 31, 1995) (same). See also PETER M. FASS ET AL., REAL ESTATE INVESTMENT TRUSTS HANDBOOK § 4.02 [6][b], at 4-13 to -15 (1998) (discussing other issues raised by excess shares trusts).
23. See infra note 25 and accompanying text for the meaning of "individuals" for this purpose.
24. The "look-through" mechanism is incorporated into the 5/50 rule through the application of § 544(a)(1) of the Code, which provides that "[s]tock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by its shareholders, partners, or beneficiaries." I.R.C. § 544(a)(1) (1994).
25. Indeed, some REITs' ownership restrictions go farther still by applying their ownership limits to "groups" as defined under § 13(d)(3) of the Securities Exchange Act of 1934. See 15 U.S.C. § 75m(d)(3) (1994). Section 13(d)(3) of the Act defines a "group" as "two or more persons act[ing] as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of securities of an issuer." Id. 25. I.R.C. § 542(a)(2).
26. Throughout this Article, we pay special attention to Maryland law, because most REITs are incorporated in Maryland. See Jay L. Bernstein, REIT Merger Issue Online, in REITs USING FINANCIAL AND LEGAL TECHNIQUES TO CAPITALIZE ON THE EXPLODING MARKET, at 281, 286 (PLI Corp. Law & Practice Course Handbook Series No. 1016, 1997).
27. See Realty Acquisition Corp. v. Property Trust of Am., [1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ (95,245, at 96,083 (D. Md. Oct. 27, 1989). The court applied the business judgment rule to uphold the target's reliance on an excess share provision, largely because the offer being deterred was a coercive tender offer, precisely the sort of offer the excess share provision was designed to deter.
28. For a discussion of recent Maryland statutory developments relating to this issue, see infra note 49 and accompanying text.
29. See infra note 50 and accompanying text.
30. See infra notes 32-73 and accompanying text.
31. In 1998 alone, 31 REITs instituted shareholder rights plans. See Barbara Martinez, REIT Interest: Poison Pills Take Precedence at Many Firms, WALL ST. J., Jan. 27, 1999, at B10. Currently, 60 of the 208 REITs have poison pills in place. Email from Danielle Endreny, NAREIT, to David Kahan, Summer Associate, Wachtell, Lipton, Rosen & Katz (Nov. 10, 1999) [hereinafter Poison Pills List] (on file with The Business Lawyer, the University of Maryland School of Law) (attaching a list of REITs with poison pills).
32. See Edward Herlihy et al., Financial Institutions - Mergers and Acquisitions 1996: Another Successful Round of Consolidation and Capital Management, in FINANCIAL INSTITUTIONS MERGERS & ACQUISITIONS, at 251, 360 (PLI Corp. Law & Practice Course Handbook Series No. B4-7179, 1997); Lee Meyerson, Breaking Up an Existing Deal - The Art of "Deal-Jumping," in FINANCIAL INSTITUTIONS MERGERS & ACQUISITIONS, at 639, 673 (PLI Corp. Law & Practice Course Handbook Series No. B4-7179, 1996); Martin Lipton, Poison Pills Update, M&A LAW., July/Aug. 1997, at 3, 3.
33. See Edward Herlihy et al., Financial Institutions - Mergers and Acquisitions 1996: Another Successful Round of Consolidation and Capital Management, in FINANCIAL INSTITUTIONS MERGERS & ACQUISITIONS, at 251, 360 (PLI Corp. Law & Practice Course Handbook Series No. B4- 7179, 1997); Lee Meyerson, Breaking Up an Existing Deal - The Art of "Deal-Jumping," in FINANCIAL INSTITUTIONS MERGERS & ACQUISITIONS, at 639, 673 (PLI Corp. Law & Practice Course Handbook Series No. B4-7179, 1996); Martin Lipton, Poison Pills Update, M&A LAW., July/Aug. 1997, at 3, 3.
34. See Edward Herlihy et al., Financial Institutions - Mergers and Acquisitions 1996: Another Successful Round of Consolidation and Capital Management, in FINANCIAL INSTITUTIONS MERGERS & ACQUISITIONS, at 251, 360 (PLI Corp. Law & Practice Course Handbook Series No. B4- 7179, 1997); Lee Meyerson, Breaking Up an Existing Deal - The Art of "Deal-Jumping," in FINANCIAL INSTITUTIONS MERGERS & ACQUISITIONS, at 639, 673 (PLI Corp. Law & Practice Course Handbook Series No. B4-7179, 1996); Martin Lipton, Poison Pills Update, M&A LAW., July/Aug. 1997, at 3, 3.
35. See Gilbert G. Menna & Michael S. Turner, REIT Mergers, Going Private and DeREITing Activities in the Real Estate Securities Industry, in REITs: 1999 STRATEGIES FOR FINANCING AND GROWTH IN A CHALLENGING MARKET, at 291, 320-231 (PLI Corp. Law & Practice Course Handbook Series No. 1137, 1999) (listing the dates of adoption of all poison pills adopted through May 1999). The Menna and Turner piece in addition to individual research using the Poison Pills List, supra note 31, led to the figure of 47 REITs.
36. See supra notes 18-25 and accompanying text.
37. That is, a would-be acquiror may purchase a quantity of shares in excess of the ownership in hopes of pressuring the REIT's board to waive the provision or of obtaining a favorable judicial decision regarding the provision's enforceability.
38. Note, however, that in Maryland, recent legislation establishes that a board has no duty to "[a]uthorize the corporation to redeem any rights under, modify, or render inapplicable, a stockholders rights plan." MD. CODE ANN., CORPS. & ASS'NS § 2-405-1(d)(2) (1999).
39. REIT boards of directors that have tried to adopt bylaws that provide more restrictive share ownership limitations than contained in their charters have been unsuccessful in enforcing the limitations against hostile acquirors. See infra notes 59-68 and accompanying text.
40. In order to qualify as a REIT for federal income tax purposes, the REIT's shares must be transferable. See I.R.C. § 856(a)(2) (1994); see also infra notes 166-76 and accompanying text (applying the transferability requirement to ownership limits and excess share provisions).
41. See Mark Gerstein, Legal and Other Planning Issues in Assessing and Effecting Exit Strategies for the Privately-Held Company, in ADVANCED DOING DEALS: A STRATEGIC APPROACH TO COMPLETING THE TRANSACTION, at 187, 219 (PLI Corp. Law & Practice Course Handbook Series No. 1055, 1998).
42. See infra notes 167-77 and accompanying text (discussing how limits on transferability of REIT shares can under certain circumstances jeopardize REIT status).
43. See supra notes 18-23 and accompanying text.
44. Conversely, a rights plan may indirectly serve to maintain a REIT's compliance with the 5/50 Rule by deterring persons or affiliated or other groups from acquiring shares in amount beyond the plan's trigger level.
45. See supra notes 22-24 and accompanying text.
46. See I.R.C. § 542(a)(2) (1994); see also supra note 25 and accompanying text.
47. See supra note 25 and accompanying text.
48. The authors faced just this interpretative issue in connection with a REIT that had provided a significant investor with an interpretation of its charter provision that varied from the interpretation given to an earlier investor.
49. For information on the Chateau/ROC transaction, see Complaint, Chateau Properties, Inc. v. Manufactured Home Communities, Inc. (D. Md. 1996) (on file with The Business Lawyer, University of Maryland School of Law); Response including Answer, Verified Counterclaims, and Third Party Complaint, Chateau Properties, Inc. v. Manufactured Home Communities, Inc. (D. Md. 1996) (on file with The Business Lawyer, University of Maryland School of Law); PR Newswire Association, Inc., Chateau Properties Announces Second Quarter Results; Funds from Operations Increased 10 Percent on a Per Share/Op Unit Basis, Aug. 6, 1996, available in LEXIS, News Library, Wire Service Stories File; PR Newswire Association, Inc., MHC Files Suit Against Chateau, Seeks Immediate Hearing, Sept. 25, 1996, available in LEXIS, News Library, Wire Service Stories File; PR Newswire Association, Inc., MHC Proposes Merger with Chateau, Aug. 19, 1996, available in LEXIS, News Library, Wire Service Stories File; PR Newswire Association, Inc., MHC Responds to Chateau/ROC Announcement, Sept. 19, 1996, available in LEXIS, News Library, Wire Service Stories File; PR Newswire Association, Inc., ROC Communities, Inc. (RCI) Announces Board Approval of Amended Merger Agreement with Chateau Properties, Sept. 18, 1996, available in LEXIS, News Library, Wire Service Stories File; Chateau Properties, Inc., Schedule 14D-1 (1996), available in ; Chateau Properties, Inc., Schedule 14D-9 (1996), available in ; CHATEAU PROPERTIES, INC., SCHEDULE 14D-9A (1996), available in ; Chateau Properties, Inc., Form S-4 (1996), available in ; Letter from Manufactured Home Communities, Inc. to John A. Boll, Chairman of the Board, Chateau Properties, Inc. (Aug. 16, 1996) (on file with The Business Lawyer, University of Maryland School of Law); Press Release, MHC Proposes Merger with Chateau (August 19, 1996) (on file with The Business Lawyer, University of Maryland School of Law); ROC Communities, Inc., Notice of Special Meeting of Stockholders and Joint Proxy Statement/Prospectus (1996) (on file with The Business Lawyer, University of Maryland School of Law); ROC Communities, Inc., Schedule 13D/A (1996), available in .
50. Interestingly, Chateau did not argue that MHC's interpretation could render ineffective that provision in its charter designed to insure that it satisfies the 100 shareholder test. Under the tax rules, a REIT must have at least 100 actual shareholders. See I.R.C. § 856(a)(5) (1994 & Supp. III 1997). Chateau's charter voided any transfer that, if effective, would result in its stock being "Beneficially Owned" by fewer than 100 Persons. If, as MHC argued, the definition of "Beneficially Owned" called for a look-through analysis to determine ownership by individuals, the acquisition of all of Chateau's stock by a widely held corporation or partnership would violate neither the charter's Ownership Limitation nor the charter's provision that was designed to insure that Chateau has 100 actual shareholders. This latter violation could jeopardize Chateau's tax status.
51. As discussed below, Maryland law now expressly allows a REIT charter to include transferability and ownership restrictions designed to preserve the REIT's tax status or "for any other purpose." MD. CODE ANN., CORPS. & ASS'NS §§ 2-105(a)(11), 8-203(a)(5) (1999); see infra note 70 and accompanying text. Even if, however, such other purposes are judicially determined to include defense against unsolicited takeover bids, the interpretive issues discussed in this Article will remain, as will issues concerning the circumstances, if any, in which the REIT's board may be required to waive any such restriction.
52. For an example of such a statement, see Boston Properties, Inc., Form S-11/A, S.E.C. File No. 333-41449 (Jan. 23, 1998), available in , which states that the purpose of Boston Properties' ownership limit is to protect the REIT's tax status and "to otherwise protect the Company from the consequences of a concentration of ownership among its stockholders." Id. at 103. The prospectus further discloses that the "Ownership Limit may have the effect of precluding acquisition of control of the Company." Id. at 104. The "Risk Factors" section of the prospectus notes that the ownership limit so operates even with respect to transactions that "involve a premium price for the Common Stock or otherwise be in the best interests of the Company's stockholders." Id. at 6.
53. [1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 95,245, at 96,083 (D. Md. Oct. 27, 1989).
54. See id. at 96,083.
55. See id. at 96,082.
56. See id. at 96,082-83.
57. See id. at 96,083.
58. The so-called "business judgment rule" is shorthand for the deference courts typically show to boards of directors when action taken by the board is challenged in a judicial proceeding. The rule has a number of well developed and well known exceptions, particularly those crafted in the context of judicial review of decisions taken in the context of transformative transactions such as a sale or merger of the company, or as a response to unsolicited takeover offers. Most of these doctrines have been developed in Delaware; while Maryland has adopted certain statutes which render some of this Delaware case law irrelevant in Maryland, the overall contours of Maryland courts' approach to the entire area remains somewhat unknown in light of those courts' relatively small experience in the area.
59. Realty Acquisition Corp., [1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) at 96,083 (citation omitted).
60. 651 P.2d 163 (Or. Ct. App. 1982).
61. See id. at 167.
62. The bylaw restricted ownership to 9.8% on an entity-level basis.
63. See Pacific Realty Trust, 651 P.2d at 167; see also I.R.C. § 856(a)(5) (1994 & Supp. III 1997) (enumerating the requirements for REIT status).
64. Pacific Realty Trust, 651 P.2d at 166 n.4.
65. 701 F.2d 1000 (1st Cir. 1983).
66. See id. at 1005.
67. See id. at 1007.
68. Id. at 1007.
69. Id. at 1007 n.10.
70. See supra note 50 for an example of language typical of contemporary disclosure statements.
71. See 15 U.S.G. § 78m(d) (1994); see also supra note 24.
72. MD. CODE ANN., CORPS. & ASS'NS § 2-105(a)(11) (1999) (emphasis added); see also id. § 8-203(a)(5) (allowing same scope of transferability restrictions in the declarations of trust of Maryland REITs organized as trusts). No judicial decision has yet construed § 2-105 or § 8-203.
73. See 72 Del. Laws 123 (1999) (to be codified at DEL. CODE ANN. tit. 8, § 202(d)(1)(iii)) (expanding the list of reasons that are "conclusively presumed" to demonstrate that the restriction is "reasonable" to include any provision designed to enable a corporation to maintain its REIT status). New § 202(e) also applies the list of permissible restrictions to those on "ownership," as opposed to merely those on "transfer." It should be noted, however, that the new Delaware language does not provide clear guidance to courts as to whether it is presumptively reasonable to draft a provision that, while ostensibly designed to satisfy the statutory goal of REIT qualification, is overinclusive and reaches entities. This lack of guidance illustrates the ambiguities regarding enforcement of excess share provisions.
74. Recognition that a REIT's ownership limitation operates on an entity-level basis is not inconsistent with the argument that it is designed solely to protect REIT status. Because of the difficulty in monitoring ownership by attribution, a REIT that did not intend to use an excess share provision defensively might still adopt an entity-level ownership limit as the most practicable and cost effective means of insuring compliance with the 5/50 Rule. This argument, however, may make it difficult to refuse to grant a waiver in connection with an acquisition that clearly does not jeopardize REIT status.
75. See Realty Acquisition Corp. v. Property Trust of Am., [1990 Transfer Binder] Fed. Sec. L. Rep. CCH) ¶ 95,245, at 96,082-83 (D. Md. Oct. 27, 1989).
76. See, e.g., Unitrin, Inc. v. American Gen. Corp., 651 A.2d 1361, 1378 (Del. 1995) (noting that the adoption of poison pills is appropriate in certain defensive circumstances); Grand Metro. Pub. Ltd. v. Pillsbury Co., 558 A.2d 1049, 1056 (Del. Ch. 1988) (using a detailed test to determine the validity of a poison pill).
77. Issues concerning the consequences of the Rights separation and Distribution are overwhelmingly academic because, despite the popularity of pills and the many waves of takeover activity, Rights have not separated and been Distributed. Given the severe economic consequences to an Acquiror, unsolicited offers are always conditioned on the redemption of the Rights or their neutralization.
78. See Edward D. Herlihy & David A. Katz, Developments in Takeover Tactics and Defense, in CONTESTS FOR CORPORATE CONTROL 1991, at 7, 82-83 (PLI Corp. Law & Practice Course Handbook Series No. 731, 1991) (describing flip-in and flip-over provisions).
79. See id.
80. See id.
81. For example, in a flip-in or flip-over, if Rights had an exercise price of $160 and the poisoned stock had a market value of $40, the holder could purchase eight shares of stock with an aggregate market value of $320 for $160.
82. See Rev. Rul. 90-11, 1990-1 C.B. 10.
83. Id. The Committee on Corporations of the New York State Bar Association's Tax Section, in its Report on the Taxation of Shareholder Rights Plans (Rights Plan Report), offered six different tax characterizations for the adoption of a Rights Plan. COMMITTEE ON CORPORATIONS, NEW YORK STATE BAR ASSOCIATION TAX SECTION, REPORT ON THE TAXATION OF SHAREHOLDER RIGHTS PLANS (July 25, 1988), reprinted in TAX NOTES TODAY, Aug. 1, 1988, available in Westlaw, 88 TNT 157-22. Of the six, only one would have created immediate tax and, given the conclusion in Revenue Ruling 90-11, that taxable characterization can be ruled out as the basis for the ruling. The Rights Plan Report notes: The adoption of a Rights Plan could be characterized in at least six different ways, namely, (1) a non-event because of the contingencies precedent to separation and flip-in, (2) an addition of a new term to the issuer's stock that does not rise to the level of a deemed exchange of "old" stock for "new" stock, (3) a promise on the part of the issuer to pay, or the declaration of a dividend to be paid, in the future, (4) an addition of a term to the issuer's stock that is treated as an exchange of "old" stock (which does not incorporate the Right) for "new" stock (which does), (5) a distribution of the Rights as an item of property separate from the stock and (6) an exchange of old stock for a package consisting of new stock and separate Rights. Id.
84. See Rev. Rul. 90-11, 1990-1 C.B. 10.
85. The model Rights Plan recommended by the New York law firm of Wachtell, Lipton, Rosen & Katz provides for a ten-day window period after the Distribution Date in which the separated Rights may be redeemed for a nominal price. Not all Rights Plans have such a window period. It is uncertain whether a Distribution for federal income tax purposes occurs when the redemption right lapses, the Rights separate, or both. The model plan also permits the board of directors to defer the Distribution unless the Distribution Date occurred by reason of an actual purchase.
86. I.R.C. § 544(a)(3) (1994).
87. See Rev. Rul. 68-601, 1968-2 C.B. 124.
88. A Distribution that occurs because of the commencement of a tender offer that, if completed, would result in an Acquiror owning shares in excess of the target level would be made to all shareholders and thus would be pro rata.
89. This may well be the appropriate method. See Treas. Reg. § 1.544-1(b)(4) (as amended in 1964).
90. Ownership shifts could also cause rent to be disqualified as related tenant income or cause a loss of domestically-controlled REIT status. See infra notes 135-66 and accompanying text.
91. Whether and how the ownership limitations and excess share provisions would apply would depend on the particular provisions.
92. The tax cost to the 9% Shareholders of treating what may be low basis REIT shares as excess must also be considered. In any event, because the board will be charged with interpreting the charter and will therefore consider the charter's purpose, this interpretation is not likely.
93. See Rev. Rul. 68-601, 1968-2 C.B. 124; see also Rev. Rul. 89-64, 1989-1 C.B. 91; IRS Field Service Advice 199915007 (Apr. 16, 1999), available in 1998 FSA LEXIS 29.
94. See supra note 21 and accompanying text (describing the workings of an excess shares trust).
95. See supra notes 18-23 and accompanying text.
96. On this point, a private letter ruling on the related issue of "excess OP units" (i.e., operating partnership units in an UPREIT, which, if exchanged by their holder for REIT shares, would result in a violation of the REIT ownership limitations) may be instructive. The Service has ruled that exchangeable OP units generally would be treated as "options" under § 544(a)(3), but excess OP units would not count as such because, under the terms of the REIT charter there considered, the OP units lose their exchange rights when they become excess. See Priv. Ltr. Rul. 96-27-017 (Apr. 5, 1996). This ruling could be read to support the more general proposition that an option on a REIT's share will not be treated as an "option" under § 544(a)(3) if the REIT's charter operates to deprive the option holder of the economic and voting benefits of the option. On this reading, if the shares to be issued on exercise of a Right will be excessed, the Right would not be a § 544(a)(3) option. See I.R.C. § 544(a)(3) (1994).
97. The fact that a non-exercisable transferable Right provides the holder with some of the economic benefits of share ownership should not cause the Rights to be treated as stock. It is not unusual for options to be transferable.
98. The distribution for federal income tax purposes may occur on termination of the REIT's right to redeem the Rights and not on the date of the Distribution. See supra note 83.
99. See I.R.C. § 562(c).
100. See id. § 857(a)(1)(A)(i). The REIT Modernization Act of 1999, enacted into law on December 17, 1999, as part of the Ticket to Work and Work Incentives Improvement Act of 1999, Pub. L. No. 106-170, § 556, starting with any REIT taxable year beginning after December 31, 2000, reduces a REITs annual distribution requirement from 95% to 90%.
101. See FASS ET AL., supra note 21, § 5.09[3], at 5-56 to -58.
102. See I.R.C. § 857(d)(1).
103. See supra notes 11-17 and accompanying text. For an excellent discussion of federal income tax issues and alternatives in reorganizations involving REITs and UPREITs, see generally Marshall E. Eisenberg, Mergers and Acquisitions in an UPREIT/DownREIT World, 74 TAXES 993 (1996).
104. There are a number of structural alternatives that can be employed in mergers or acquisitions of UPREITs. For example, two UPREITs could merge through the separate mergers of the two corporate general partners (the REITs) and of the two operating partnerships; a REIT or an UPREIT could acquire or merge with an UPREIT without acquiring or merging with the target UPREIT's operating partnership; or the assets of an UPREIT could be contributed to the acquiror UPREIT's operating partnership in exchange for OP Units in a § 721 transaction. See I.R.C. § 721.
105. For the purpose of economy, we will henceforth refer only to UPREITs, but the issues discussed apply equally to DownREITs.
106. See supra notes 47-48 and accompanying text.
107. See Chadwick M. Cornell, Comment, REITs and UPREITs: Pushing the Corporate Law Envelope, 145 U. PA. L. REV. 1565, 1588-91 (1997) (discussing this and other connicts raised in the Chateau/ROC/MHC contest).
108. Different states have adopted different approaches to the question of which constituencies the Board may consider in deciding how to deal with potential acquisitions of the company. While the traditional common-law approah emphasized board loyalty to shareholders, many states have passes "nonshareholder constituency statutes" that allow the Board to consider other groups. See James J. Hanks, Jr., Playing with Fire: Nonshareholder Constituency Statutes in the 1990s, 21 STETSON L. REV. 97 (1991), for an overview and evaluation of such statutes. Recently enacted Maryland legislation allows REITs to adopt charter provisions that empower the Board to "consider the effect of the potential acquisition of control on: (i) [s]hareholders, employees, suppliers, customers, and creditors of the trust; and (ii) [c]ommunities in which offices or other establishments of the trust are located." MD. CODE ANN., CORPS. & ASS'NS § 8-202(b)(2) (1999).
109. 600 A.2d 43 (Del. Ch. 1991).
110. See id. at 49.
111. See id.
112. See, e.g., Weinberger v. UOP, Inc., 457 A.2d 701, 709 & n.7 (Del. 1983) (citations omitted), aff'd, 497 A.2d 792 (Del. 1985).
113. This question, however, should not arise in Maryland, where recent legislation provides that director actions in response to a potential acquisition "may not be subject to a higher duty or greater scrutiny than is applied to any other act of a director." MD. CODE ANN., CORPS. & ASS'NS § 2-405. 1(f)(2).
114. See Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 363 (Del. 1993) (holding that to disqualify a corporate director from the protection of the business judgment rule, there must be evidence of disloyalty, and that a showing of self-interest alone is insufficient), modified, 636 A.2d 956 (Del. 1994).
115. The exchange of OP Units for stock of the REIT will generally be taxable. See I.R.C. § 1001 (1994).
116. See, e.g., Irvine Apartment Communities, Inc., Form 10-K, Exhibit 3.5, § 7.3(E) (filed Mar. 31, 1998) (Second Amended and Restated Agreement of Limited Partnership of Irvine Apartment Communities, L.P., Jan. 20, 1998), available in .
117. I.R.C. § 856 (1994 & Supp. III 1997). Currently, a REIT cannot hold more than 10% of the voting stock of a corporation. See id. § 856(c)(4)(B) (Supp. III 1997). As noted in the text, these restrictions will be relaxed for taxable years beginning after December 31, 2000. See infra note 116 and accompanying text.
118. The REIT Modernization Act is part of the Ticket to Work and Work Incentives Improvement Act of 1999, enacted into law December 17, 1999, Pub. L. No. 106-170, §§ 542, 543, 546.
119. See I.R.C. § 856(c)(2)-(3) (1994 & Supp. III 1997).
120. See Treas. Reg. § 1.451-1(a) (as amended in 1999).
121. See, e.g., Worden v. Commissioner, 2 F.3d 359 (10th Cir. 1993); Tech. Adv. Mem. 96-38-002 (June 3, 1996).
122. See I.R.C. § 856(c)(3)(D).
123. See id. § 1234(a)(1) (1994). Cash settled options are treated in the same manner. See id. § 1234(c)(2).
124. See id. § 857(b)(6)(A).
125. See id. § 1221(1).
126. See id. § 857 (b)(6)(C) (1994 & Supp. III 1997).
127. See id. § 857(b)(6)(C)(i) (1994).
128. See id. § 857(b)(6)(C)(ii).
129. See id. § 857(b)(6)(C)(iii) (1994 & Supp. III 1997). The Service's position on whether § 1031 like-kind exchanges count for this purpose is unclear. See Priv. Ltr. Rul. 91-23-042 (Mar. 12, 1991) (expressing no opinion as to tax consequences of transactions under § 1031).
130. In order to fully appreciate some of the tax and nontax issues that arise in REIT change of control transactions and in connection with the acquisition of REIT shares by a foreign or domestic investor, it is necessary to keep in mind tax requirements for qualification as a REIT. A REIT is purely a creature of the tax law and, generally, a corporation, trust, or association may qualify as a REIT if: (i) it is managed by one or more trustees or directors; (ii) its beneficial ownership is evidenced by transferable shares or transferable certificates of beneficial interest; (iii) it would be taxable as a domestic corporation but for its taxation as a REIT; (iv) it is not a financial institution or insurance company; (v) it is owned by at least 100 persons; (vi) it is not "closely held," i.e., no more than 50% of the value of its stock may be owned by five or fewer "individual" shareholders at any time during the last half of its taxable year; (vii) it elects (or continues in effect a pre-existing election) to be taxed as a REIT; and (viii) it satisfies the detailed asset and income tests contained in § 856(c). See I.R.C. § 856(a). In addition, in order to be taxed as a REIT, an entity must also meet the distribution requirement contained in § 857 and must not have any undistributed earnings or profits accumulated in years in which the entity was not a REIT See id. § 857(a)(2) (Supp. III 1997).
131. See id. § 856(a)(5)-(6) (1994 & Supp. III 1997).
132. See supra notes 18-31 and accompanying text.
133. As used herein, unless otherwise noted, the term "person" means a person as defined in § 7701(a)(1), which includes "an individual, a trust, estate, partnership, association, company or corporation." I.R.C. § 7701(a)(1) (1994).
134. Regulation § 1.856-1(d)(2) states that charter or bylaw provisions that permit the directors to refuse to transfer shares if the directors believe in good faith that the transfer would cause the loss of REIT status do not render the REIT's shares nontransferable in violation of section 856(a)(2). See Treas. Reg. § 1.856-1(d)(2) (as amended in 1981); see also I.R.C. § 856(a)(2). This Regulation has been applied to typical excess share provisions in a number of private letter rulings. See, e.g., Priv. Ltr. Rul. 96-27-017 (Apr. 5, 1996); Priv. Ltr. Rul. 95-52-047 (Sept. 29, 1995); Priv. Ltr. Rul. 95-34-022 (May 31, 1995). The issue of whether the use of very expansive ownership limitations can cause a REIT's shares to be considered nontransferable in violation of § 856(a)(2) is considered infra notes 168-77 and accompanying text. 133. See I.R.C. § 856(b).
135. See, e.g., Priv. Ltr. Rul. 83-42-016 (July 13, 1983). The Internal Revenue Service is apparently no longer issuing rulings that a shareholder whose ownership interest in the REIT is nominal counts as a shareholder for the 100 shareholder requirement. The 100 shareholder requirement, nevertheless, is not difficult to satisfy, and there is no support in the Code or the Regulations for ignoring nominal unrestricted share ownership by a bona fide shareholder.
136. See I.R.C. § 897(h)(4)(B).
137. See id. §§ 897, 6039C.
138. See id. § 897(h)(4)(B).
139. See id. § 897(a).
140. See id. § 871(b) (imposing U.S. income tax liability on nonresident aliens for effectively connected income); id. § 882(a) (same for foreign corporations).
141. See id. § 1445(a). Any tax withheld under § 1445(a) is credited against the amount of income tax due from the foreign transferor. See Treas. Reg. § 1.1445-1(f)(1) (as amended in 1995).
142. See I.R.C. § 897(c)(1)(A)(ii), (c)(2).
143. See id. § 897(h)(2). There are two other important exceptions. Stock of a REIT that is regularly traded on an established securities market is only treated as a USRPI in the hands of an investor that held more than 5% of such class of stock at some time during the preceding 5-year period. See id. § 897(c)(3). In addition, because a USRPI does not include an interest solely as a creditor, a so-called mortgage REIT may not be a USRPHC. See generally id. § 897(c). Accordingly, interests in a mortgage REIT may also escape USRPI status.
144. See id. §§ 897(h)(2), 1445(a); Treas. Reg.§ 1.897-1 (c)(2)(i) (as amended in 1975), id. § 1.1445-2(c)(1) (as amended in 1988).
145. A not insignificant investment clientele: "Approximately 5 to 10 percent of the common shares of the largest institutionally favored U.S. REITs are held by foreign investors . . . ."John F. C. Parsons, REITs and Institutional Investors, in REAL ESTATE INVESTMENT TRUSTS 413, 422 (Richard T Garrigan & John EC. Parsons eds., 1998).
146. Indeed, under certain circumstances a domestic corporation must (upon request from a foreign person owning an interest in it) inform such owner whether the interest constitutes a USRPI. See Treas. Reg. § 1.897-2(h) (as amended in 1987).
147. Section 897(h)(4)(B) refers to shares that are directly and indirectly "held" and not to shares that are directly and indirectly "owned." In this instance the difference does not appear to be substantive. See I.R.C. § 897(h)(4)(B).
148. See id. § 897(h). The attribution rules of § 318 are not made applicable to the determination of whether a REIT is domestically-controlled. Unless the attribution rules of § 318 are expressly made applicable, they do not apply. See id. § 318(a).
149. See Monte A. Jackel & Glenn E. Dance, Indirect Ownership Through A Partnership: What Does It Mean?, 70 TAX NOTES 91, 95-96 (1996) (discussing rulings in which the Service has found indirect ownership by attribution despite the lack of any expressly applicable Constructive ownership provision of the Code).
150. Treas. Reg. § 1.897-1(c)(2)(i) (as amended in 1975).
151. See id. § 1.857-8(b) (as amended in 1981).
152. Professors Bittker and Eustice, in commenting on the terminology of "actual," "direct," and "indirect" ownership in the context of § 318, explain: "Actual stock ownership" is referred to in various provisions of §318 as stock owned "directly or indirectly," i.e., stock titled in the name of the owner (direct ownership) or held by an agent (indirect ownership). "Indirect ownership," therefore, does not mean ownership by attribution . . . otherwise, reattribution would occur by virtue of this phrase in all cases and not by virtue of §318(a)(5), which provides reattribution in most, but not all, cases. BORIS BITTKER & JAMES S. EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS & SHAREHOLDERS ¶ 9.02[1], at 9-11 & n.40 (6th ed. 1996).
153. See Jackel & Dance, supra note 148, at 95-96.
154. While it may be possible for direct and indirect foreign holders to cause the REIT to elect or forgo an election under § 857(b)(3)(C) to treat part of a distribution as capital gain, the ability to control the election concerning the character of the distribution is not likely to be of significant benefit to foreign shareholders under FIRPTA. See I.R.C. § 857(b)(3)(C) (1994). Section 897(h)(1) treats distributions to a REIT's foreign shareholders as gain recognized by the shareholder on the sale or exchange of a USRPI to the extent the distribution is attributable to the REIT's gain on sales or exchanges of USRPIs, apparently without regard to whether the REIT elects to treat the distribution as capital gain dividend. See id. § 897(h)(1). Moreover, as a result of the Taxpayer Relief Act of 1997, a REIT may retain capital gain proceeds but must pay a REIT level tax and pass through a tax credit to its shareholders under the newly enacted § 857(b)(3)(D). See id. § 857(b)(3)(D) (Supp. III 1997). Thus, it does not appear that foreign persons can dispose of USRPIs through a non-domestically-controlled REIT without incurring U.S. income tax liability either directly, upon receipt of distributions attributable to gain on dispositions of USRPIs, or indirectly, by way of a REIT-level capital gains tax. The legislative history of FIRPTA provides litde guidance on this question. In what may be a clue, the U.S. House of Representatives reported its concerns that under prior law a foreign investor actually engaged in a U.S. real estate business could avoid U.S. capital gains taxes by selling property on an installment basis so as to receive income in a later year in which the gain would not be effectively connected with a U.S. trade or business, or through like-kind exchanges of U.S. real property for foreign property. See H.R. REP. No. 96-1167, at 509-10 (1980), reprinted in 1980 U.S.C.C.A.N. 5526, 5872-73. One might speculate that Congress believed these types of manipulations to be less likely in the case of domestically-controlled REITs. The only House or Senate report that expressly mentions the domestically-control REIT, however, exception does not comment on its rationale. See H.R. CONF. REP. No. 96-1479 (1980), reprinted in 1980 U.S.C.C.A.N. 5903.
155. Although the answer should be the same, a "harder" case would involve a 49% foreign owner of a REIT that creates a wholly owned domestic subsidiary exclusively to hold an additional 2% interest in that REIT.
156. Lesser problems with the meaning of direct and indirect ownership arise under § 856(d) in connection with the calculation of "rents from real property." See I.R.C. § 856(d) (1994 & Supp. III 1997). The term "rents from real property" does not include amounts received by the REIT from any person if the REIT owns, "directly or indirectly," ten percent or more of the total combined voting power or of the total number of all shares of all classes of such person. See id. § 856(d)(2)(B) (1994). For this purpose, the constructive ownership rules of § 318 are expressly made applicable, with certain modifications, to determinations of share ownership. See id. § 856(d)(5) (1994 & Supp. III 1997); see also id. § 318. Although the use of language calling for the use of both constructive ownership and indirect ownership suggests that the terms are not coextensive, the Regulations applicable to § 856(d) strongly suggest otherwise. In that
157. Section 269 uses the term "indirectly" in a manner similar to that of § 897(h), but § 269 serves a very special purpose. Compare I.R.C. § 897(h) (1994) with id. § 269. Section 269 generally allows the Service to disallow, inter alia, net operating loss carryovers if a person acquires "directly or indirectly" control of a corporation for the purpose of avoiding tax, where control is the ownership of stock possessing at least 50% of the voting power or value of all classes of stock. See id. § 269(a). The fact that in § 269(a) the term "indirectly" modifies "acquires," a verb, should not make a substantive difference. In 1980, the Service ruled that the attribution rules of § 318 did not apply to § 269, but indicated, without citation of authority, that a corporation that owned 45% of a holding company indirectly owned 45% of each of the holding company's subsidiaries. See Rev. Rul. 80-46, 1980-1 C.B. 62. Based on Rev. Rul. 80-46, the Service, at least for purposes of § 269, views the acquisition of the stock of a parent company as an indirect acquisition of the stock of its direct subsidiaries.
158. See I.R.C. § 856(d)(2)(B).
159. See id. § 856(c) (1994 & Supp. III 1997).
160. See id.
161. A tenant is related to the REIT if the REIT owns, directly or indirectly, either (i) stock of such tenant possessing 10% or more of the total combined voting power of all classes of stock entitled to vote, (ii) 10% or more of the total number of all classes of stock of such tenant, or (iii) if the tenant is not a corporation, an interest of 10% or more in the assets or net profits of such tenant. See id. § 856(d)(2)(B) (1994). Because the determination of the amount of stock owned by the REIT takes into account the constructive ownership rules of § 318, the REIT is treated as owning (among other shares) the stock owned by an owner of 10% or more of the REIT's stock. See id. § 318(a); id. § 856(d)(5) (1994 & Supp. III 1997).
162. See id. § 856(d)(5). Because the constructive ownership rules of § 318 are quite different from those of § 544 that apply for purposes of the 5/50 Rule, an acquiror may accumulate the requisite 10% ownership for purposes of the related tenant rules without exceeding a numerically smaller general share ownership limitation that uses § 544 constructive ownership rules. For example, § 544 does not contain constructive ownership rules that attribute stock owned by individuals to entities, but § 318 does have such rules. Compare id. § 318(a)(3) (1994) with id. § 544.
163. See, e.g., Treas. Reg. § 1.856-4(b)(4) (as amended in 1981).
164. Id. (emphasis added).
165. For example, suppose A owns a 10% interest in REIT tenant B Corp., but no interest in the REIT from January through November. On November 30, the B Corp.'s lease with the REIT terminates and is not renewed. On December 1, A, still owning 10% of B Corp., acquires a 10% interest in the REIT. Because by attribution the REIT owns the specified percentage of B Corp. in December, a literal reading of Treas. Reg. § 1.856-4(b)(4) could result in disqualification of all rent received by the REIT from B Corp. for the year, even though B Corp. is no longer a tenant of the REIT in December.
166. What policy is the Regulation protecting? The Code may reflect the congressional policy that a REIT can only earn income from denned activities and should not be able to indirectly receive income earned by a 10% owned entity engaged in a business that the REIT could not engage in directly. See H.R. REP. No. 86-2020, at 4 (1960). Alternatively, this rule may be a backstop to the requirement that a REIT be a passive investor and the belief that an ownership of 10% or more of a tenant might make the REIT too active. Similarly, it has been suggested that the asset diversification requirement contained in § 856(c)(5)(B) that prohibits a REIT from owning 10% or more of the voting securities of any corporation "may reflect a policy that a REIT cannot carry on indirectly through an affiliate activities in which it could not engage directly." See John A. Corry, Stapled Stock - Time for a New Look, 36 TAX L. REV. 167, 178-79 (1981).
167. See Treas. Reg. § 1.856-4(b)(4).
168. See I.R.C. § 856(a)(2) (1994).
169. See supra note 40 and accompanying text.
170. Prior to the Tax Reform Act of 1976, Pub. L. No. 94-455, 90 Stat. 1520, a REIT could not be organized as a corporation.
171. Because transferability of shares is a condition for qualification as a REIT, REITs frequently seek the protection of a private letter ruling with respect to their share ownership limitations and excess share provisions. Accordingly, a large number of repetitive rulings concerning ownership limitations and "excess shares" provisions have been issued. See, e.g., Priv. Ltr. Rul. 95-52-047 (Sept. 29, 1995) (holding that "[t]he Ownership Restrictions will not cause Company to fail to satisfy the requirement imposed by section 856(a)(2) of the Code that beneficial ownership of a REIT must be evidenced by transferable shares"); Priv. Ltr. Rul. 92-05-030 (Nov. 5, 1991). Priv. Ltr. Rul. 92-05-030 held that [i]f (1) any person attempts to acquire shares in contravention of the restrictions contained in the Articles, (2) those restrictions are set aside by a final court order, and, (3) the Company meets the stock ownership requirement of section 542(a)(2), then the transfer will be considered effective, and the Company will be closely held within the meaning of 856(a)(6). In order to receive such rulings, REITs have been representing to the Service that the charter provisions concerning ownership limits and excess shares are enforceable under applicable state law and that the REIT will enforce the restrictions. While not entirely free from doubt, excess share provisions that limit only individual ownership to that necessary to protect REIT status are generally believed to be enforceable as a matter of corporate law. Charter provisions that impose transfer restrictions beyond those necessary to protect REIT status, however, have not been fully tested in the courts, though there may be some legislative authority for their enforcement under Maryland law. See supra note 70 and accompanying text.
172. Regulation § 1.856-1 (d)(2) provides: Provisions in the trust instrument or corporate charter or bylaws which permit the trustee or directors to redeem shares or to refuse to transfer shares in any case where the trustee or directors, in good faith, believe that a failure to redeem shares or that a transfer of shares would result in the loss of status as a real estate investment trust will not render the shares "nontransferable." Treas. Reg. § 1.856-1(d)(2) (as amended in 1981); see also Priv. Ltr. Rul. 96-27-017 (Apr. 5, 1996) (applying the Regulation); Priv. Ltr. Rul. 95-52-047 (Sept. 29, 1995) (same); Priv. Ltr. Rul. 95-34-022 (May 31, 1995) (same).
173. The Service has ruled that the use of restricted stock as compensation does not cause a REIT's shares to be nontransferable. See Priv. Ltr. Rul. 97-47-034 (Aug. 25, 1997); Priv. Ltr. Rul. 96-31-018 (May 3, 1996); Priv. Ltr. Rul. 95-34-022 (May 31, 1995); Priv. Ltr. Rul. 94-40-026 (July 11, 1994). The Service has also ruled that sale restrictions imposed by the securities laws do not cause a REIT's shares to be nontransferable. See Priv. Ltr. Rul. 96-30-016 (Apr. 26, 1996). In addition, the Service has ruled that restrictions to protect the status of a REIT as "domestically-controlled" (within the meaning of § 897(h)(4)(B)) do not cause the REIT's shares to be non-transferable. See id. 173. See, e.g., Priv. Ltr. Rul. 97-47-034 (Aug. 25, 1997).
174. See id.
175. See id.
176. See Priv. Ltr. Rul. 89-21-067 (Feb. 28, 1989).
177. E.g., "group" level ownership limits. See supra notes 43-73 and accompanying text.