On March 14, 2016, the SEC issued a no-action letter1 permitting holders of shares of common stock of a publicly traded REIT, or REIT shares, received in exchange for privately placed units of the REIT’s operating partnership, or OP units, to tack the holding period of the OP units to the REIT shares for purposes of Rule 144. This new position is a very significant change from the way Rule 144 has been interpreted historically by the SEC, and may lead to the elimination of registration rights in many OP unit transactions as well as to changes in the way OP unit transactions are structured.
Rule 144 and “Tacking”
Rule 144 provides a safe harbor for the public resale of securities that were first issued in a private placement or pursuant to another exemption from the registration requirements of the Securities Act (sometimes referred to as “restricted” securities). The principal requirement of Rule 144 for this purpose is that the securities be held for at least six months before resale.2 Pursuant to Rule 144(d)(3), if the securities issued in an unregistered transaction are convertible into other securities of the same issuer, then one may generally “tack” the holding period of the initial security to that of the second one, so long as the conversion does not require payment. However, if the issuer of the initial security is not the same as the issuer of the underlying security, the SEC has generally not permitted tacking of the holding periods under Rule 144.
OP Units and REIT Shares
OP units and REIT shares are securities that have different issuers but which are substantially identical from an economic perspective. Many publicly traded REITs today use a corporate structure referred to as an umbrella partnership REIT, or UPREIT, where a listed REIT serves as the general partner of an operating partnership (or controls the general partner) and indirectly owns all of its properties and conducts its business through the operating partnership. In a typical UPREIT structure, each OP unit issued by the operating partnership is the economic equivalent of one REIT share and may be redeemed at the holder’s election for cash equal to the current market price of one REIT share; provided that, upon exercise of this redemption right, the REIT may elect to exchange REIT shares for the OP units instead of having the operating partnership redeem the OP units for cash. As a practical matter, REITs typically exercise this exchange right and issue REIT shares in exchange for the tendered OP units. The question addressed in the SEC no-action letter is how soon former OP unitholders can freely sell their new REIT shares under Rule 144.
Previously, in order to immediately sell REIT shares issued in exchange for OP units in the public market, either the issuance of the REIT shares, or their resale, was required to be registered under the Securities Act. While this is generally true for the public sale of any newly issued security, the registration requirement for REIT shares issued in exchange for OP units was particularly vexing because it ignored the fact that the stockholder had been holding the economically equivalent security for many months or even many years prior to the proposed sale of REIT shares. While a holder could have waited a further six months after the issuance of the REIT shares to satisfy a new Rule 144 holding period, a holder was not permitted to “tack” its holding period for the OP units to that of the REIT shares newly issued in connection with the exercise of the redemption right, no matter how long the OP units were previously held.
The position taken in the SEC no-action letter will now generally permit holders of OP units to tack the holding period of their OP units to the holding period of the REIT shares issued in exchange for their OP units. In other words, OP unitholders generally may immediately resell REIT shares issued in exchange for OP units under Rule 144 so long as the OP units and their underlying REIT shares have collectively been held for at least six months.
This no-action letter represents a significant change from the SEC’s historical position and a recognition of the economic equivalency of REIT shares and OP units, inasmuch as holders of OP units effectively assume the economic risks of an investment in both the REIT and the operating partnership as of the date the OP units are acquired.3
Practical Implications of the No-Action Letter
OP Unit Transactions Without Registration Rights. As a result of the SEC no-action letter, registration rights may no longer be required in many OP unit transactions. Registration rights have long been customarily provided to OP unitholders because: (i) the exchange of REIT shares for OP unit causes the recognition of taxable gain to the OP unitholder, including gain that may have been deferred in connection with the original issuance of the OP units, (ii) the REIT’s obligation to provide immediate liquidity for the underlying REIT shares has been part of the bargain in permitting the REIT to satisfy the redemption right through the exchange of REIT shares and (iii) Rule 144 had not previously been available to permit immediate sales into the public market. There still may be good reasons for OP unitholders to seek registration rights in OP unit transactions and it remains to be seen how practice develops, but there is now a very good argument that OP unitholders no longer need any registration rights in most circumstances. Eliminating registration rights in connection with OP unit transactions would benefit REITs by allowing them to avoid the time and expense associated with such rights.
OP Unit Transactions Without 12-Month Holding Period. A direct consequence of the SEC no-action letter may be the upending of the customary 12-month lock out period on the right of OP unitholders to seek redemption of their units. The SEC’s longstanding position is that if a convertible security is convertible within 12 months, an offering of the underlying security is deemed to have taken place at the same time as the offering for the convertible security. Thus, if an OP unit was issued in a private placement (as is generally the case) and is redeemable within less than 12 months, then the underlying REIT shares are also deemed to have been privately placed at the same time. Since one may not go back and register an offer or sale that was initially made on a private/exempt basis, it followed that the issuance of REIT shares in exchange for OP units could not be registered. This left unitholders with the prospect of either having their REIT shares registered for resale, which can be burdensome and comes with the risk of liability, or waiting until the expiration of a new Rule 144 holding period. By imposing a 12-month lock out period on the redemptions of OP units, issuer were successfully able to claim that the REIT shares should not be deemed to have been issued at the time of issuance of the corresponding OP units and could thus be registered for issuance directly. However, now that Rule 144 may be relied upon to obtain immediate liquidity, this 12-month lock out may no longer be beneficial or necessary. We note, nevertheless, that the SEC no-action letter was based on representations including a 12-month lock out for the redemption right. Although this was not one of the particular representations cited by the SEC and, logically, it should not impact the rationale for tacking, parties may want to use caution before eliminating this lock out period given the potential negative consequences of falling outside of the SEC’s no-action position.
Expiration of Existing Registration Rights. For REITs that have already provided registration rights to OP unitholders, the SEC no-action letter may permit these REITs to discontinue existing registrations if they so desire, depending upon the contractual terms of the rights. Registration rights agreements entered into with OP unitholders often provide that the right to registration automatically ceases if/when the underlying securities become eligible for resale under Rule 144. Because the SEC’s position on tacking will now generally permit holders to immediately resell REIT shares issued in exchange for OP units under Rule 144, OP unitholders’ registration rights may have terminated under applicable agreements.
Registration/Exemption Still Needed for Issuance of REIT Shares. It should be noted that, at least for now, the issuance of REIT shares in exchange for OP units does still either need to be registered or completed pursuant to an exemption from registration. This results from the fact that a REIT may not rely on Section 3(a)(9) to exempt the exchange of REIT shares for OP units because the REIT and the OP are different issuers and the SEC has not yet been willing to extend its “no sale” position to this exchange. However, in many situations, especially where the original OP unitholder continues to hold the OP units, REITs may be able to comfortably rely on Section 4(a)(2) for the issuance of REIT shares.
1 Bank of America, N.A., Merrill Lynch, Pierce, Fenner & Smith Incorporated, SEC Staff No-Action Letter (March 14, 2016).
2 The six month holding period applies to issuers that are current in their SEC filings and have been SEC reporting companies for 90 days. For issuers that have not been SEC reporting companies for 90 days, the holding period is one year. The same holding periods apply to affiliates of issuers but affiliates are subject to volume limitation and other requirements under Rule 144.
3 In its no-action letter, the SEC noted that it relied, in particular, on the following representations in reaching its conclusion that the holding periods of the OP units and the REIT shares could be tacked under Rule 144: (1) that the unitholders paid the full purchase price for the OP units at the time they were acquired from the operating partnership, (2) an OP unit is the economic equivalent of a REIT share, representing the same right to the same proportional interest in the same underlying pool of assets, (3) the exchange of REIT shares for OP units is entirely at the discretion of the REIT and (4) no additional consideration is paid by the unitholders for the REIT shares.