On February 10, 2022, the U.S. Securities and Exchange Commission (“SEC”) proposed amendments designed to modernize the rules governing beneficial ownership reporting. Section 13 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and related SEC rules and regulations generally provide that an investor who “beneficially owns” more than 5% of a registered class of voting equity securities must publicly file either a Schedule 13D or a Schedule 13G disclosing such ownership. The filing deadline for Schedule 13D filers is within 10 days after acquiring beneficial ownership of more than 5%, and, for Schedule 13G filers, “qualified institutional investors” who are acquiring passive ownership have until 45 days after the calendar year-end in which beneficial ownership exceeds 5%. The SEC’s proposed new rules would, among other things, shorten these time frames and accelerate the filing deadline for Schedule 13D reports to five calendar days after acquiring beneficial ownership of more than 5% and, for Schedule 13G reports by passive qualified institutional investors, to five business days after the month-end in which beneficial ownership exceeds 5%.
In this REIT Alert, we address two areas of SEC focus in the proposed rules that may have unintended consequences with respect to REITs generally, and to the application of the ownership limitation provisions in REIT charters, specifically:
- The proposed expansion of beneficial ownership under Section 13 to include cash-settled derivative securities; and
- The proposed clarifications by the SEC of the circumstances under which two or more persons will be deemed to have formed a “group” for purposes of Rule 13d-3 under the Exchange Act.
As discussed below, these provisions of the proposed rules, if adopted, would represent fundamental changes to the long-standing Section 13 and Rule 13d-3 framework for identifying beneficial ownership of publicly-traded securities. For REITs and REIT investors, the carryover of any new rules into the ownership limitation provisions in REIT charters may lead to uncertainty and, in some cases, potentially undesirable outcomes.
I. Expanded Definition of “Beneficial Ownership”
While Section 13 of the Exchange Act addresses beneficial ownership of securities, the Exchange Act itself does not define the term “beneficial owner” or “beneficial ownership.” Rule 13d-3 provides in relevant part that a beneficial owner of securities is someone who has or shares voting power and/or investment power with respect to the securities. Rule 13d-3 further provides that contingent interests in securities, e.g., options, warrants or rights, may also be deemed to constitute current “beneficial ownership,” so long as a person has the right to acquire voting power and/or investment power over the underlying securing within 60 days. Conversely, direct or indirect interests in securities that are economic only — e.g., where a holder is entitled to a payment (or liable to make a payment) based on the objective performance of a security over a specified period of time, but never has the right to acquire voting power and/or investment power over the underlying security — do not constitute “beneficial ownership” under current Rule 13d-3.
In the proposed rules, the SEC professes concern that financial product innovation has outpaced the reach of the historical Rule 13d-1 parameters and that holding a cash-settled derivative security today can be tantamount to holding the underlying security:
“Persons who acquire and hold cash-settled derivative securities with the purpose or effect of changing or influencing control of the issuer may seek to use their position to influence the voting, acquisition or disposition of any shares the counterparty may have acquired in a hedge, proprietary investment or otherwise. Moreover, the economic realities of the counterparty relationship mean that, even absent an express right to direct the voting, acquisition or disposition of such shares, the holders of cash-settled derivative securities could be well-positioned to pursue a change in control. The derivative holder’s counterparty may have a business relationship to develop and protect, and thus may ultimately cast votes in accordance with the preference of the derivative holder. Even if any counterparty shares are not voted, the derivative holder’s probability of success in exerting influence or control over the issuer of the reference security may increase given that any voting power the derivative holder held would be magnified by minimizing the number of shares that potentially could be voted against its plans or proposals. Similarly, while the terms of the derivative instrument may only provide for settlement in cash, these types of derivative holders could remain in a position to acquire any reference securities that the counterparty may acquire to hedge the economic risk of that transaction.”
Based on this reasoning and other assertions, the SEC proposes to amend Rule 13d-3 to provide a new paragraph (e), pursuant to which a holder of a cash-settled derivative security will be deemed the “beneficial owner” of the underlying reference securities so long as the derivative security is held for the purpose or effect of changing or influencing the control of the issuer or in connection with, or as a participant in, any transaction having such purpose or effect. As the SEC explains in its proposing release, this test is essentially the same one that distinguishes between Schedule 13D and Schedule 13G eligibility. Accordingly, the upshot of the proposed rule is that all holders of cash-settled derivative securities, other than passive institutional investors, would be deemed to be the beneficial owners of the underlying reference securities — irrespective of the fact that the holders do not have the power to vote and/or dispose of, or to direct the voting and/or disposition of, the underlying securities, nor do they have the right to acquire the underlying securities at any time in the future. Or, to use a concrete example, a holder of, say, 1% of a publicly-traded company’s shares that also has cash-settled derivative securities giving it economic exposure to a notional number of shares of the same class that would constitute a further 4.01%, would be required to become a full-fledged Schedule 13D filer with all accompanying disclosure and update requirements, despite only holding 1% of the class.
In seeking to fashion broad-based regulatory presumptions about over-the-counter derivatives, the SEC acknowledges that it is wading into deep waters. For one, the new rule would exclude from its purview “security-based swaps,” since the SEC does not have sole jurisdictional authority to determine beneficial ownership based on security-based swaps. Second, even with cash-settled derivatives not involving security-based swaps, the over-the-counter market for equity derivatives is rife with myriad structures and formulations that do not always lend themselves to easily quantifying the precise number of underlying reference securities. As the SEC notes, “the value of the derivative security, although based on the value of a reference security, may change at a multiple or fraction to any change in value of the reference security, particularly in the case of a security option.” To address these nuances, the SEC has proposed a rather complicated formula based on the calculated “delta” of the derivative to the underlying reference security. The “delta” is a ratio that indicates the amount by which the value of a derivative security changes as compared to the amount of change in the underlying reference security. If a derivative security does not have a fixed delta, the proposed rule would require that the delta be calculated on a daily basis.
Finally, an additional note to the proposed rules provides that only long positions in derivative securities would be counted for purposes of determining beneficial ownership. Short positions, whether held directly or synthetically through cash-settled derivatives, would not be netted against long positions or otherwise taken into account.
II. Broadening of “Group” under Section 13(d)
As noted above, Section 13(d) of the Exchange Act generally provides that a person who “beneficially owns” more than 5% of a registered class of voting equity securities must publicly file either a Schedule 13D or a Schedule 13G disclosing such ownership. In turn, Section 13(d)(3) (and 13(g)(3)) of the Exchange Act provides that when two or more persons act as a group for the purpose of “acquiring, holding, or disposing” of the relevant securities, such group will be deemed a “person” for Section 13(d) reporting purposes. These provisions seek to prevent creative investors from evading the plain meaning of the Section 13(d) disclosure and reporting requirements by effectively joining them together in a group where no individual investor owns more than 5%.
The Exchange Act itself, however, does not define the term “group.” Rule 13d–5(b) simply provides that a group is formed when “two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer.” The determination of “group” status has thus historically been a highly fact-dependent analysis. Some courts have inferred from Rule 13d-5’s use of the word “agree” that formation of a “group” requires an agreement among group members, even if not a formal written agreement. In its proposing release, the SEC Staff disagrees with this approach and, among other things, proposes to clarify Rule 13d-5(b) to remove any inference that group formation is dependent upon the existence of an express or implied agreement. Instead, the touchstone is whether two or more persons are in fact taking concerted actions in acquiring, holding or disposing of securities; if yes, this action alone is sufficient to deem the actors part of a “group” for Section 13(d) purposes. Accordingly, while determination of “group” status under the proposed rules will still be a case-by-case facts-and-circumstances analysis, the universe of activity that might result in “group” status would seemingly be greatly expanded.
As the proposing release itself acknowledges, the proposed rules are likely to “raise concerns among investors” as to whether even routine communications with other investors will trip the newly-expanded “group” concept. To assuage these concerns, the proposed rules include a number of exemptions to be reflected in amendments to Rule 13d-6, the intent of which is to “avoid chilling communications among shareholders or impeding shareholders’ engagement with issuers,” so long as such actions are not undertaken for the purpose or effect of changing or influencing the control of the relevant issuer and that no person is obligated to take any such actions.
III. Potential Impact on REIT Ownership Limitation Provisions
If the new rules relating to cash-settled derivatives are adopted by the SEC as proposed, the newly-expanded scope of beneficial ownership could materially disrupt the application of the charter ownership limitation and excess share provisions of those few REITs whose charters include the concept of “beneficial ownership” as defined under Section 13(d) of the Exchange Act. Moreover, if the new rules relating to an expanded concept of “group” are adopted as proposed, they could impact a much larger number of REITs whose charters incorporate Section 13(d)’s “group” concept in determining whether ownership of REIT shares by separate persons should nonetheless be aggregated for purposes of the charter, even though “beneficial ownership” is defined otherwise than by reference to the Exchange Act.
Publicly-traded REITs routinely protect their REIT qualification through, among other ways, specific ownership limits in their charters. A typical ownership limit will generally prohibit anyone from owning in excess of 9.8% of the REIT’s outstanding capital stock, though the limit can also be lower in certain circumstances. At its core, the ownership limit is designed to protect the REIT’s ability under applicable federal income tax requirements to meet what is commonly referred to as the 5/50 test — essentially, five or fewer individuals may not own more than 50% of the stock during the second half of any calendar year. A holder whose share ownership surpasses the limit will have its shares automatically converted into “excess stock,” i.e., the shares are effectively confiscated from the shareholder and held in trust for the benefit of a designated charity until they are sold in the marketplace. See, generally, our June 2016 alert, Waivers of Ownership Limitation Provisions in REIT Charters.
Because the focus of the ownership limits is on ownership of a percentage of the outstanding capital stock, questions such as what constitutes ownership and to whom is ownership attributed are critical to the proper operation and interpretation of a charter. In the majority of cases, ownership in REIT charter provisions is characterized as beneficial or constructive ownership as defined under the relevant provisions of the federal tax code, which generally are not thought to include notions of derivative (synthetic) exposure. Nevertheless, as we have previously noted in several of our REIT Alerts, because ownership limitation provisions are designed to protect the REIT’s status as a REIT, they are typically drafted more broadly than to purely mimic the minimum REIT qualification provisions of the tax law. In prior alerts, we explained that the flexibility that might accompany a more surgical application of the tax rules does not lend itself to serving as an effective firewall in the context of a publicly traded REIT, which may have hundreds of thousands and even millions of shares changing hands anonymously each day over the electronic facilities of a stock exchange.
A. Beneficial Ownership and Cash-Settled Derivatives
Some of the earlier publicly-traded REITs incorporated a Section 13(d) concept of “beneficial ownership” directly into their charters (e.g., the charter provided that if an investor would be the deemed the beneficial owner of shares under Section 13(d), then that person would also be deemed to be a holder of the shares for purposes of the charter ownership limitation provisions). For charters of this vintage, adoption of the proposed rules that would expand “beneficial ownership” into the realm of cash-settled derivatives would expand yet further the scope of ownership restricted by the charter. For example, it would be possible that an investor that holds 4% of the outstanding common stock in actual shares but has synthetic exposure via cash-settled derivative securities in an amount equivalent to an additional 6% or more of the outstanding common stock, would suddenly find itself in violation of a 9.8% charter ownership limitation. By the same theory, an investor can own 0% of outstanding shares of common stock in actual shares and still find itself in violation of the charter ownership limitation by virtue of a sizable synthetic position. This result would be problematic not just for the investor, but for the REIT’s board of directors as well. As noted above, the typical remedy available to the board in enforcing the charter’s ownership limitation is to forcibly confiscate the excess shares and transfer them to a trust pending sale into the market. But if the relevant excess “shares” are in the form of deemed beneficial ownership under the new rules due to cash-settled derivative securities, which actual shares can the board move to confiscate? Can the board confiscate shares held as a hedge by the derivatives counterparties? Must the board first move to confiscate actual shares held by the investor, if any? Clearly, REITs that have or are considering including a Section 13(d) concept of “beneficial ownership” into their charter ownership limitation provisions are advised to proceed with extreme caution in situations where the ownership limits may be implicated by synthetic investments.
B. Expansion of “Group” Concept
Few (if any) publicly-traded REITs today directly incorporate a Section 13(d) concept of “beneficial ownership” into their charter ownership limitation provisions. Rather, a majority of REITs today reference Section 13 of the Exchange Act in a slightly different way — by defining the “person” who may not acquire shares in excess of the ownership limit to include all individuals or entities that together form a “group” for purposes of Section 13(d), and treats the aggregate holdings of the group as being held by a single holder for purposes of the charter.
As we have had occasion to note previously, the duty and responsibility of interpreting and enforcing the ownership limitation provisions of a REIT’s charter are exclusively vested in its board of directors. In today’s climate of increased shareholder activism and a more muscular posture from even traditionally passive institutional investors, the board’s interpretation of the “group” prong in the charter ownership limitation provisions is more important than ever. The SEC’s proposed clarification that there need not be any explicit or implicit agreement among actors in order for them to constitute a “group” may make the application of the charter ownership limitation provisions even more challenging.
For example, if two or more otherwise unaffiliated activist funds jointly approach the REIT to propose strategic alternatives or material corporate governance changes, then these investors are clearly acting as a “group” and their collective ownership would be aggregated for purposes of Section 13(d) and thus under the charter ownership limitation provision. As clarified by the proposed rules, no explicit or implicit agreement among the funds to act as a group would be necessary to support this finding. Conversely, if two or more otherwise unaffiliated institutional investors engage with one another or the REIT on, say, corporate governance or executive compensation matters in the ordinary course, where it is clear that the conversations are not for the purpose or effect of influencing control of the issuer, and each party is acting voluntarily and not pursuant to a commitment to the other party, then this type of multi-party engagement will not automatically cause the participants to be treated as a “group.” This is particularly true under the proposed new exemptions to be added to Rule 13d-6, as discussed above.
Everything in between, however, continues to be a subjective and fact-specific analysis that REIT boards will need to undertake, often with the assistance of counsel. As the SEC proposes to clarify in the new rules, (and as many courts have candidly already concluded), in many cases, concerted action by two or more persons with respect to a REIT and its securities will, alone, be sufficient to deem the participants a “group.”
C. Impact on Institutional Asset Managers and Waivers
In the day-to-day life of publicly-traded REITs, the question of “group” status often arises in the context of waiver requests from large institutional asset managers. These investment managers typically sponsor or manage a variety of individual mutual funds and/or other client accounts, any of which may have an investment in the shares of the same publicly-traded REIT. If the aggregate number of shares across all managed funds and client accounts exceeds 5% of the outstanding number of shares, the investment manager is required to file a Schedule 13G disclosing the organization’s aggregate holdings in the applicable REIT. Indeed, a casual perusal of the beneficial ownership tables included in the annual proxy statements that REITs send to their stockholders reveals that many of today’s publicly-traded REITs have one or more 10% or greater stockholders. Vanguard, Fidelity, Cohen & Steers, BlackRock, to name just a few, are among the large asset managers routinely listed as beneficially owning 12, 15 even 18 percent of the outstanding stock of a REIT whose charter ostensibly restricts any person from owning more than 9.8% (or less) of the outstanding stock. As we noted in our June 2016 alert, Waivers of Ownership Limitation Provisions in REIT Charters, there are really only two ways this can occur:
- The asset manager received a waiver from the REIT’s board of directors with respect to the relevant ownership limitations set forth in the charter; or
- The REIT’s board of directors has concluded that no waiver is necessary under the terms of the charter.
And where a single asset manager has disclosed aggregate beneficial ownership of shares in excess of the ownership limit, the only way a waiver would not be necessary under the terms of the charter is if it is determined that the individual funds and client accounts managed by the same investment manager do not constitute a “group” under Section 13(d) and Rule 13d-5. This may be getting harder to conclude given the SEC’s new proposed rules and guidance.
On one hand, merely being the parent company of entities that own similar securities does not, in and of itself, render the entire enterprise a “group” for purposes of Rule 13d-5. The SEC has provided guidance in the context of Section 13 to the effect that beneficial ownership need not be attributed to parent entities when there are substantive policies and procedures in place to ensure that voting and/or investment powers are independently exercised by subsidiaries and/or client funds. But if, as is often the case, the investment manager files a Schedule 13G that concedes its beneficial ownership of all the securities held by its various subsidiaries and client funds, then this would seem to be an acknowledgment by the parent that it ultimately has or shares voting and/or investment power for all the REIT shares held by its subsidiaries and client funds. How then can a REIT board get comfortable that the affiliated shareholder group does not constitute a “group” for purposes of the charter?
There are likely a limited number of circumstances where this does not automatically equate to finding that the organization as a whole constitutes a “group” for purposes of its aggregate holdings of a given REIT’s securities. For example, as noted above, the SEC has carved out organizations that have implemented procedural and informational barriers designed to ensure independent exercise of voting and/or investment powers by individual fund and managed account. In these cases, we have recommended that the REIT also obtain corresponding representations from the investment management company as to the non-group status of its funds and managed accounts for Section 13(d) purposes.
Under the SEC’s proposed rules, however, there are likely to be instances where it may no longer be sufficient for a REIT to simply accept an investment manager’s representation as to non-group status without further corroboration, representations and disclosures. For example, there are a number of common fact patterns applicable to funds managed by the same parent company that suggest the existence of a “group” among managed funds and accounts, irrespective of whether a consolidated Schedule 13G is filed or not, and irrespective of representations of the investment manager to the contrary. These include:
- All shares held by the consolidated group are consistently voted each year on the same day, at the same time and in the same way (for, against, abstain, etc.);
- When the REIT seeks to engage in shareholder outreach, either generally or in connection with a specific proposal, there is a single address, phone number and/or contact person or department to which inquiries for all consolidated group shares are directed; and/or
- The investment management company emphasizes or notes the aggregate holdings of its client funds when communicating with the REIT or when otherwise addressing its consolidated investment in the REIT (e.g., mailing a letter to the REIT advocating for change in the REIT’s internal governance policies).
It may still be true that none of these alone are dispositive in determining whether a “group” exists. It may also be true in many cases that the relevant asset management company has procedures and protocols in place that would permit individual portfolio and account managers to vote independently. Indeed, But the new proposed rules articulate the SEC Staff’s view that “group” status does not hinge on agreements, procedures or protocols, it depends on actions — if two or more persons are in fact regularly taking concerted actions in acquiring, holding or disposing of securities, then they will likely be deemed a “group” for Section 13(d) purposes.
While the REIT’s board has the exclusive right and responsibility for interpreting and enforcing the REIT’s charter provisions, this must generally be done on a consistent and reasonable basis. A history of looking past potential charter violations, say, by passive institutional fund complexes, may be suboptimal for a REIT that then seeks to actively enforce the charter in, say, an activist or other potentially hostile investor scenario.
To be clear, none of this means that the aggregate ownership of traditional asset management organizations necessarily poses concerns regarding a company’s REIT qualification status since, in the majority of cases, the aggregate ownership will not cause an “individual” to own shares in excess of the charter limit. Nor does this mean that REIT boards should be newly reluctant to grant waivers of ownership limit charter provisions to affiliated institutional shareholder groups. It does mean, however, that, in discharging their duty to interpret and enforce the ownership limit charter provisions, REIT boards should appreciate that concentrated ownership among affiliated institutional investment funds that “walk and talk” like a group, may violate the ownership limit absent an appropriate waiver. In light of the SEC’s proposed rules, it may no longer be sufficient to simply rely on representations of the investment manager as to its own non-group status. Similarly, for those REITs that currently have waivers in place that are conditioned on the non-group status of the applicable affiliated funds, it may be prudent to revisit this construct upon any proposed renewal or amendment in the future.
How and to what extent to revise new and existing waivers, if at all, is an exercise each REIT board must undertake independently in light of the facts and circumstances applicable to the particular company. We would strongly recommend consulting with REIT counsel as part of this evaluation. On one hand, preserving the current Section 13(d) “group” concept in the charter ownership limitation provisions would continue to ensure that, absent a waiver, investors acting in concert cannot circumvent the REIT ownership limitation provision if their aggregate ownership exceeds the limit, while, on the other hand, the expanded concept of “group” as contemplated by the proposed rules may make it more challenging for even passive index-tracking funds to avoid getting caught up in inadvertent “groups”. We can understand if not every REIT board ultimately chooses to draft the line in the same spot down the middle.
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The proposed rules have been circulated by the SEC for comment and have not yet been adopted as final rules. The proposed rules may never be adopted by the SEC, either in the form proposed or at all.
Please reach out to your Goodwin contact to discuss any comments or questions relating to this alert.
 Release Nos. 33-11030; 34-94211.
 See Release Nos. 33-11030; 34-94211 at pages 56-57. Readers may recall that the district court in CSX Corporation v. Children’s Inv. Fund Mgmt. (UK) LLP, 562 F. Supp. 2d 511 (S.D.N.Y. 2008) proffered essentially the same conjectures in analyzing the beneficial ownership of CSX securities by the hedge funds in that case. In CSX, however, the facts were that the hedge funds and their counterparties physically settled their derivative transactions, such that the hedge funds in fact did acquire full voting and investment power over these securities. See generally Goodwin’s REIT Alert, Recent Case Raises Questions Affecting Ownership Limits in Publicly Traded REITs, July 2008.
 In separate rulemaking, the SEC has proposed to at least require disclosure of security-based swap positions. See “Prohibition Against Fraud, Manipulation, or Deception in Connection with Security-Based Swaps; Prohibition against Undue Influence over Chief Compliance Officers; Position Reporting of Large Security-Based Swap Positions,” Release No. 34-93784 (Dec. 15, 2021).
 The proposing release provides the following example: If a person holds a derivative security with a notional amount of $100 and a delta equal to one that references a covered class of common stock with a most recent closing market price of $10 per share, then that person would be deemed to beneficially own 10 shares of such covered class. If, however, that same derivative security had a delta equal to two, then such person would be deemed to beneficially own 20 shares of such covered class, calculated as (x) the quotient obtained by dividing the $100 notional amount of the derivative security by the $10 per share most recent closing market price, (y) multiplied by the derivative security’s delta of two.
 The full text of the relevant proposed amendments to Rule 13d-6 reads as follows:
(c) Two or more persons shall not be deemed to have acquired beneficial ownership of, for purposes of section 13(d) of the Act, or otherwise beneficially own, for purposes of section 13(g) of the Act, an issuer’s equity securities as a group under sections 13(d)(3) or 13(g)(3) of the Act solely because of their concerted actions with respect to such issuer’s equity securities, including engagement with one another or the issuer or acquiring, holding, voting or disposing of the issuer’s equity securities; provided, that:
(1) Communications among or between such persons are not undertaken with the purpose or the effect of changing or influencing control of the issuer, and are not made in connection with or as a participant in any transaction having such purpose or effect, including any transaction subject to § 240.13d-3(b); and
(2) Such persons, when taking such concerted actions, are not directly or indirectly obligated to take such actions.
 By prohibiting any one holder from owning more than 9.8%, it is impossible for any five to reach 50%. The ownership limit also protects the REIT from incurring related party tenant income, which can affect the REIT’s ability to satisfy the gross income tests necessary for REIT qualification.
 See, e.g., Goodwin’s REIT Alerts, Waivers of Ownership Limitation Provisions in REIT Charters, June 2016, and Recent Case Raises Questions Affecting Ownership Limits in Publicly Traded REITs, July 2008.
 For example, a typical REIT charter definition of the term “Person” would include any individual, corporation, partnership, limited liability company, estate, trust, association, private foundation, joint stock company or other entity, and also “a group as that term is used for purposes of Rule 13d-5(b) or Section 13(d)(3) of the Exchange Act”.
 See Waivers of Ownership Limitation Provisions in REIT Charters, June 2016
 A waiver would also obviously not be necessary if the relevant charter did not include the “group” concept at all in its relevant ownership limitation provisions.
 As above, the determinations regarding securities-law or tax-law beneficial ownership or any other legal conclusions reached by an investor about its ownership of a REIT’s securities, while informative, is not binding on the REIT’s board of directors, who are charged with independently evaluating all relevant facts and circumstances in interpreting and enforcing the REIT’s own charter.
 SEC Release No. 34-39538 (January 12, 1998).
 The implications of the proposed rules with respect to “group” status of affiliated investment funds has not been lost on the investment management community. See, e.g., comment letters to the SEC with respect to the proposed rules from Investment Company Institute, dated April 7, 2022, and from Managed Funds Association, dated April 11, 2022.
Yoel KranzPartnerCo-Chair of REITs and Real Estate M&A
Ettore A. SantucciPartnerCo-Chair of Debt Capital Markets, Co-Chair of REITs and Real Estate M&A