REITs and UPREITs: pushing the corporate law envelope.

• Author: Cornell, Chadwick M.

INTRODUCTION

The boom-and-bust real estate market has been a gold mine at times and a minefield at others. The specter of the 1980s, when cavalier lending fueled wild speculation on dubious real estate ventures, still lingers in many investors' minds. As we move through the 1990s, however, many experts feel that real estate is once again on the rise.(1) And, as seems to be true of investing generally, real estate assets are increasingly being held by large conglomerates.(2) One vehicle being used with greater frequency by real estate investors is the Real Estate Investment Trust, or "REIT."(3) REITs are a creation of the Internal Revenue Code that allow investors to pool real estate holdings, resulting in beneficial tax consequences.(4)

REITs, however, are not only growing from the contribution of real estate by property owners. Increasingly, they are looking toward the capital equity markets to finance acquisitions.(5) This influx of capital has helped REITs prosper as they look for further acquisition and merger opportunities. The funds from these equity offerings also bring a new type of investor into the REIT equation: the common stockholder. The addition of common stockholders to a REIT's organizational structure can cause conflicts between the property owners, who contributed their real estate to the REIT to enjoy the effects of diversification and beneficial tax consequences, and the common shareholders in the REIT, who are concerned with dividends and the appreciation of the stock.

Because both REITs and UPREITs,(6) the latest and most popular incarnation of the REIT, are relatively modern inventions, the legal issues they present, particularly in scenarios where UPREITs are merging with or acquiring other UPREITs, are new and untested. In the few instances in which courts have addressed issues involving REITs, they have analyzed the REIT as they would any other corporate entity--usually deferring to the business judgment of the REIT's officers and directors.(7) Though such deference may be appropriate in some situations concerning UPREITs, the UPREIT structure presents many inherent conflicts between shareholders and fiduciaries that a regular corporation does not. Because an UPREIT is more likely to generate conflicts of interest for fiduciaries,(8) a reviewing court's decision to automatically defer to the business judgment of the fiduciaries becomes more suspect.(9)

This Comment explains why courts should not treat UPREITs as they would treat any other corporate entity. This conclusion is based on the inherent conflicts between individuals who became shareholders by contributing property to the UPREIT and those who became shareholders through the stock market. Before granting an UPREIT the type of deference that is usually given to the business judgment,of a corporation's board and officers, courts must understand the reasons why the UPREIT structure makes conflicts of interest so much more likely than in a normal corporation. In litigation concerning UPREITs, courts should be wary of these inherent conflicts and their effect on the decisions of UPREIT fiduciaries. This increased scrutiny is more likely to result in a heightened standard of review than that which is usually given to the decisions of corporations under the business judgment rule. Understanding the complexity of the UPREIT structure is an ambitious task, but it is one that should be undertaken to ensure that courts are protecting the interests of the REIT's common shareholders.

The purpose of this Comment is twofold: first, to show why the decisions of UPREIT fiduciaries merit greater judicial scrutiny than that which is usually given to corporate fiduciaries; and second, to show how this more rigorous scrutiny is consistent with the current majority doctrinal approach to breach of fiduciary duty claims. Part I of this Comment will briefly describe the structure and mechanics of a basic REIT, as well as the advantages a REIT entity has over a partnership or corporate organization. Part 11 will analyze why investors are almost exclusively switching to UPREITs, which are a derivation of the basic REIT, and will focus both on the advantages the UPREIT structure offers and on the types of conflicts the structure engenders among investors in the UPREIT. Part III will discuss the different standards of review a court may apply when dealing with corporate litigation, including business judgment, entire fairness, and Schnell/Blasius review. Parts IV and V will describe why the application of the business judgment rule to UPREITs is difficult, especially in the context of a merger or acquisition scenario) and how courts should analyze an UPREIT involved in breach of fiduciary duty litigation. This Comment will not postulate a new doctrinal approach or standard of review for a court faced with litigation involving UPREITs; rather, it will show how the greater judicial scrutiny merited by the UPREIT structure can be fit within the current doctrinal framework.

1. REITs GENERALLY

   Real Estate Investment Trusts are investment vehicles that allow investors to pool real estate assets with beneficial tax consequences.(10) In 1960, Congress created REITs as a means of encouraging small investors to participate in the type of real estate investments that were traditionally available only to institutions or wealthy individuals.(11) Organizations that operate as REITs do not have to pay federal tax on income or gains and can opt to pass their income through to shareholders.(12) REIT investors also enjoy the advantages of limited liability and transferability of shares (i.e., liquidity) that a corporate structure offers, without incurring the costs of double taxation.(13) Thus, a REIT is essentially a combination of a corporation and a partnership in that it combines the benefits of a corporation with the pass-through nature of a partnership.

   1. Basic REIT Structure

      A REIT is defined as any corporation, trust, or association that meets the requirements of [sections] 856 of the Internal Revenue Code.(14) REIT ownership is shared by two different types of parties. The distinction between these parties is a function of the type of capital each party contributes to the REIT. Those who contribute real estate in exchange for equity are generally called "sponsors" of the REIT. Those who purchase shares in the REIT with cash are called "investors."(15)

      Section 856 of the Tax Code includes four types of requirements that a business must meet to qualify as a REIT: organizational requirements, distributional requirements, income tests, and asset tests.(16) The overall purpose of these tests is to ensure that the REIT operates primarily as a passive real estate investment vehicle.(17)

      1. Organizational Requirements

         Section 856 of the Internal Revenue Code includes six different organizational requirements that a REIT must satisfy. First, the REIT must be managed by one or more trustees or directors for the entire taxable year.(18) Second, beneficial ownership of the REIT must be evidenced by transferable shares.(19) Third, the entity must be one that, but for the REIT election, would be taxable as a domestic corporation or trust.(20) Fourth, the entity can be neither a financial institution, as defined in [sections] 582(c)(5) of the Code, nor an insurance company pursuant to Subchapter L of the Code.(21) Fifth, beneficial ownership of a REIT must be held by 100 or more persons.(22) Sixth, during the last half of each taxable year, not more than fifty percent of a REIT's outstanding stock can be held by five or fewer persons, pursuant to the personal-holding company provisions in [sections] 542.(23)

         These organizational requirements reflect the general policy initiative behind the creation of the REIT structure-giving small investors the opportunity to invest in real estate. The most prominent of these requirements (and the most troubling for REIT organizers) are the five person/fifty percent requirement and the 100 person beneficial ownership requirement.(24) By setting up rigid quantitative ownership requirements, these rules address the concern that REIT ownership will be concentrated in the hands of wealthy individual real estate investors.

      2. Income Tests

         After meeting the six basic organizational requirements, a REIT must satisfy three different income tests. These tests are "complicated, mechanical tests which are intended to limit the investments of a REIT to real estate and certain other types of passive investments."(25) Thus, by limiting the types of investments with which a REIT can involve itself, these tests limit a REIT's earnings to income that is both passive and derived from transactions that are closely connected with real estate activities.(26)

      3. Assets Tests

         A REIT must also meet several requirements based on the nature of the assets it holds. These requirements ensure that a REIT's asset holdings are primarily comprised of real property or assets related to real property ownership. At least seventy-five percent of the value of a REIT's assets must be represented by real estate assets, cash and cash items (for example, receivables), and government securities.(27) In addition, not more than twenty-five percent of a REIT's total assets may be comprised of securities, not more than five percent may be the securities of a single issuer, and the REIT cannot own more than ten percent of the outstanding voting securities of a single non-REIT issuer.(28)

      4. Distribution Requirements

         Section 857 of the Code sets out a number of requirements which dictate the manner in which a REIT is to distribute income to its shareholders.(29) The basic purpose of these requirements is to ensure that a REIT operates as a pass-through entity. The major distribution requirement is that at least ninety-five percent of the REIT's annual income must be distributed to shareholders as dividends.(30) If the REIT meets these requirements, it is allowed to deduct the...