EXCESS SHARE PROVISIONS AS TAKEOVER DEFENSES

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EXCESS SHARE PROVISIONS AS TAKEOVER DEFENSES By Steven Seidman, Michael Schwartz, Henry Chn and Meredith Levy [Messrs. Seidman, Schwartz and Chn are partners, and Ms.

1 EXCESS SHARE PROVISIONS AS TAKEOVER DEFENSES By Steven Seidman, Michael Schwartz, Henry Chn and Meredith Levy [Messrs. Seidman, Schwartz and Chn are partners, and Ms. Levy is an assciate, at Willkie Farr & Gallagher LLP.] Hstile M&A unslicited bids and sharehlder activism has never been as prevalent in the REIT wrld as it has been in the larger public cmpany universe. REITs have lng been viewed as hardened targets fr hstile activity, but that perceptin is changing. Certainly, the successful replacement f CmmnWealth REIT s bard in 2013 was a sbering reminder t REITs that they t, may be vulnerable. Mre recently, in 2015, a number f activist vertures have been made, including ne at American Realty Capital Prperties (ARCP) by Crvex Capital Management, the lead activist in the CmmnWealth REIT drama. In light f a renewed interest in (r cncern ver) activism in the REIT wrld, we tk a lk at the excess share prvisins (ESPs) f 27 publicly traded REITs t get a sense f the landscape. Here are ur bservatins frm that infrmal survey, with sme explanatin and cmmentary. Different Types f Excess Share Prvisins: What are the tax cncerns mtivating ESPs? Limits are designed at a minimum t prevent the REIT frm being clsely held, which means, under Sectin 856(a)(6) and Sectin 856(h) f the Internal Revenue Cde, that 5 r fewer individuals may nt wn mre than 50% f the stck f the REIT (the Clsely Held Ownership Limit ). All the charters we reviewed with ESPs had a Clsely Held Ownership Limit. The ESPs in many REIT charters als prtect the REIT frm related party rent, which arises if, fr example, the same persn (either an individual r an entity) wns 10% r mre f bth the tenant and the REIT (the Related Party Rent Limit ). Related party rent is treated as bad REIT incme under Sectin 856(d)(2)(B). Twenty-fur (89%) f the charters als had ESPs that were bradly designed t include a Related Party Rent Limit, while 15 (63%) cntained an express limitatin n wnership that wuld either cause any related party rent r cause sufficient related party rent t disqualify the REIT. 1

2 All the charters we reviewed defined wnership as direct wnership r wnership thrugh attributin f shares wned by ne individual r entity t anther individual r entity. Attributin rules are relevant fr calculating bth the Related Party Rent Limit and the Clsely Held Ownership Limit, althugh the precise attributin rules differ fr calculating the tw separate limits. What are the wnership limits? Generally, the Clsely Held Ownership Limits and Related Party Rent Limits prvided fr in the charters we reviewed ranged frm 2% t 9.9%. A lwer Clsely Held Ownership Limit will be required where the charter permits a funder r ther investr t exceed the limit. Fr example, if a charter permits a funder s family grup t wn up t 18%, that wuld leave 32% (50% less the 18%) t be shared amng 4 persns, s the Clsely Held Ownership Limit in that charter wuld need t be reduced t under 32/4 = 8. In such as case, there is n necessity t reduce the Related Party Rent Limits, but sme charters nly have ne verall limit. Seventeen (63%) f the REITs we lked at initially implemented an wnership limit f between 9.0% and 9.9%, althugh sme charters with lwer threshlds gave t the bard the ability t increase the threshld t between 9.0% and 9.9% as time passed. T whm d the wnership limits apply? All ESPs we reviewed applied the Clsely Held Ownership Limit and, where applicable, Related Party Rent Limit t individuals and entities alike. Eighteen (67%) f the ESPs applied the Clsely Held Ownership Limit t Schedule 13D filing grups as well. Of the 24 ESPs with Related Party Rent Limits, 16 (67%) als applied the wnership limit t 13D grups. A 13D grup will generally be brader than the grup f entities r individuals t which either f these limits wuld therwise apply. Applicatin f ESP wnership limits t 13D grups is nt required t avid the primary adverse tax cnsequences underlying ESPs and may therefre be viewed simply as a takever defense measure. Under what circumstances can the wnership limits be waived? All ESPs we reviewed allwed sme flexibility fr the Bard t waive the wnership limitatins. In a significant number f the charters we reviewed, the ability t waive the Related Party Rent Limit is limited where the waiver wuld cause either ANY related party rent r a REIT failure. Sme charters required the Bard t receive an pinin r ruling with respect t the tax cnsequences f the waiver. Other charters wuld permit waivers in the Bard s discretin and leave it t the Bard s discretin as t whether t get an pinin r ruling r require representatins frm the excepted hlder. In the event f an wnership limit vilatin, 21 (78%) f the charters we reviewed prvided that the excess shares are autmatically transferred t a trust fr the benefit f a charity, while thers did nt specify the beneficiary f the trust in the charter. The nminal wner f the excess shares des nt receive dividends r vte the shares, and will generally nly receive the lesser f the amunt received by the trust upn sale f the shares, and the amunt paid by the nminal wner. That is, the nminal wner cannt prfit frm wnership f the shares. 2

3 Issues affecting whether the ESPs cnstitute a valid takever defense: General bservatins: Ownership and transfer restrictins n shares generally are permitted by state crprate statutes in rder t preserve certain benefits (such as desired tax treatment) fr the crpratin. Public disclsure (and thus apprval) upn implementatin (such as at an initial public ffering) and subsequently f the effects f an ESP blsters the argument fr validity f a cmpany s ESP. Other aspects f ESPs may cme int questin, as well as determinatins by a bard when a waiver f the prvisins is sught. The validity f using an ESP as a takever defense may depend n the particular threat psed (e.g., bid fr cmpany versus activists). A challenger may argue that if the ESP is nt related t tax benefits (clearly the primary purpse f ESPs), then the ESP wuld be an impermissible takever defense. We nte that the Maryland statute specifically permits ESPs fr purpses ther than the REIT s tax status and therefre can be argued as a basis fr a valid takever defense. Maryland Cde, Crpratins and Assciatins, 8-203, permits a declaratin f trust fr a REIT t allw [f]r any ther preferences, rights, restrictins, including restrictins n transferability r wnership designed t permit the real estate investment trust t qualify under the Internal Revenue Cde r regulatins adpted under the Cde r fr any ther purpse, and qualificatins nt incnsistent with law. Sectin als permits the charter fr any crpratin t prvide any ther preferences, rights, restrictins, including restrictins n transferability, and qualificatins nt incnsistent with law. Sme bservatins frm the review f the charters: Because prhibiting wnership by 13D grups may g beynd what is necessary t prtect against the adverse tax effects frm being clsely held r generating related party rent (thugh pssibly an imprtant radblck fr activists), inclusin f the 13D cncept in an ESP may pen a line f challenge where tax cncerns are nt present. Similar t pisn pill prvisins, the ability f the Bard t waive an ESP at its discretin may als pen the dr fr a line f challenge. In additin t litigatin challenges, the use f an ESP as a takever defense may affect vting recmmendatins, such as thse frm ISS, in cnnectin with any takever battle. Althugh ISS des nt have a frmal plicy that relates t ESPs as a takever defense (unlike its plicies n pisn pills), ISS vting recmmendatins may be influenced by hw a bard uses an ESP, particularly where tax cncerns are nt at play. 3

4 Where there is a separate Related Party Rent Limit, it may be ineffective as a takever defense if, as is ften the case, the limit applies nly if the investr s wnership creates at least sme related party rent, that is, the investr bth exceeds the limit (e.g., 9.8%) and wns 10% r mre f ne r mre tenants. The majrity f REIT charters reviewed d have such a dual requirement, i.e., the limit is applicable nly if the excess wnership creates at least sme related party rent. Given that the Clsely Held Ownership Limit lks nly at wnership by individuals, the applicatin f an wnership limit intended t prevent shares in excess f the Clsely Held Ownership Limit t entities/13d grups may raise scrutiny. On the ther hand, since an entity s wnership f REIT stck and a tenant culd give rise t related party rent, cnstructive wnership limitatins which apply t entities may be easier t justify; we nte, hwever, that attributin rules wuld generally nt attribute wnership t as brad a set f entities as wuld cmprise a 13D grup. Furthermre, as nted in the preceding paragraph, such limitatin may nt be effective if the activist investr des nt wn stck f a tenant f the REIT (directly r via applicable attributin rules). Hw D ESPs Cmpare t a Pisn Pill? Implementatin: ESPs are charter prvisins and are put in place when a REIT is established. Amendments t ESPs require bth bard and sharehlder apprval. Pisn pills may be kept n the shelf and available fr use nly if and when needed. This avids unnecessary crprate gvernance cncerns and allws fr the pill t be tailred t the specific situatin. Pisn pills can be put in place, and amended, withut sharehlder apprval. Validity: The implementatin and use f defensive tactics including bth Pisn Pills and ESPs against substantial accumulatins f stck are limited by the fiduciary duties f bards. Where such defensive tactics are nt prhibited, Pisn Pills are a prven defensive tactic. They are an extremely strng deterrent because they are crafted specifically t prevent all unwanted accumulatins f stck exceeding their triggering threshld and their effects, if triggered, are dracnian. Hwever, t the extent they are slely a takever defense, the use f Pisn Pills is clsely scrutinized by the curts. ESPs may als prvide prtectin against unwanted accumulatins f stck. Hwever, since they are crafted with a view tward preventing adverse tax cnsequences, there may be hles in any given ESP s that nt all situatins are cvered. In particular, ESPs withut 13D language may prvide little prtectin against hstile accumulatins f shares because it may be relatively easy t structure wnership arund the ESP s wnership limits. ESPs with 13D language may prvide prtectin similar in breadth t a Pisn Pill. Given the dual purpse f the ESP, it is pssible that an ESP might withstand judicial scrutiny in circumstances where a pisn pill might nt. With respect t the recent wave f activism generally, and ptentially in the REIT space: 4

5 The 13D grup language will be a cncern fr activists. Given the wnership limitatin threshlds in ur infrmal survey, hwever, activists in many cases may nt be significantly affected. Especially with larger REITs, activists regularly take n cmpanies with smaller stakes. In smaller REITs, the wnership limitatin limits the amunt f an activists investment in the REIT, which may make activism less interesting r less lucrative. Hwever, it is likely that smaller activist funds will still be interested in mst REITs f a size t be publicly traded. ESPs d nt prevent activists frm running a prxy cntest and replacing the bard r a number f directrs. It shuld be nted that, t the extent the wnership limitatins f ESPs with 13D language will nt deter an activist, neither will a Pisn Pill deter an activist. Apart frm Pisn Pills designed t prtect tax net perating lsses (NOLs), the triggering threshlds f Pisn Pills tend t be at r abve the wnership limitatins fund in ESPs. LINK t WILLKIE FARR & GALLAGHER LLP WEBSITE: Individual REIT WRAP subscriptins can nly be ed t an individual's address, n grup distributin addresses. Fr infrmatin n Grup Rates cntact Rick Berg at , rickberg@reitzne.cm, r REIT Wrap, Bx 1188, Nvat, CA Our main fax number is ; ur editrial fax line is ; and ur advertising department fax is Unauthrized cpying r frwarding f REIT Wrap is a vilatin f ur subscriptin terms, as well as U.S. cpyright law Cpyright 2015, REIT ZONE PUBLICATIONS, LLC. All rights reserved. Cpyright 2015 by Willkie Farr & Gallagher LLP This article is prvided by Willkie Farr & Gallagher LLP and its affiliates fr educatinal and infrmatinal purpses nly and is nt intended and shuld nt be cnstrued as legal advice. This article may be cnsidered advertising under applicable state laws. 5

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