WAIVERS OF OWNERSHIP LIMITATION PROVISIONS IN REIT CHARTERS 40 1. WHY DO REITS HAVE OWNERSHIP LIMITS IN THE FIRST PLACE? Ownership limitation provisions are designed primarily to protect one of a REIT’s most valuable assets – its status as a REIT under the federal income tax rules. By placing limits on the amount of stock investors can own, the REIT builds in safeguards to ensure that it will satisfy the ownership tests that are a critical part of its qualification as a REIT, including the so-called “5/50 test,” and 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.1 We discuss these ownership limitations, including when or how they may be waived, in further detail below. The REIT’s charter2 will typically include a mechanism pursuant to which a stockholder whose actual and/or constructive share ownership surpasses the stated ownership limits included in the charter will have its shares automatically and effectively confiscated and held in trust for the benefit of a designated charity until the shares are sold in the marketplace.3 A stockholder whose shares are transferred to this trust will not receive the economic benefit of any appreciation in, or distributions paid on, these shares after the date the shares are deemed to be transferred to the trust. 2. THE 5/50 OWNERSHIP LIMITATION The “5/50 test” essentially provides that five or fewer individuals may not own, actually and/or constructively, more than 50% of the value of the REIT’s stock during the second half of a taxable year.4 A typical ownership limitation provision will thus generally prohibit anyone from owning, actually and/or constructively, in excess of 9.8% of the value of the REIT’s outstanding stock — making it impossible for any five holders together to own more than 50%.5 This is often described as a “5/50 ownership limit.” If there is already a single individual (e.g., a founder) owning, actually and/or constructively, more than 9.8% of the outstanding stock, then the 5/50 ownership limit may be set even lower than 9.8% to ensure that any additional four “individuals,” together with the founder, will not exceed 50% in the aggregate.6 A casual glance, however, at the beneficial ownership tables included in the annual proxy statements 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 1 The related party tenant income ownership limitations are discussed in further detail below under “Related Party Tenant Ownership Limitations.” In addition, the ownership limits in a typical REIT charter will restrict a person from holding REIT stock if such ownership would cause the REIT to have fewer than 100 stockholders or otherwise cause the REIT to fail to qualify as a REIT. Some REIT charters also include ownership limits that prevent a person from holding REIT stock if such ownership would cause the REIT to be a “pension-held REIT” under Code Section 856(h)(3)(D) or not be a “domestically controlled qualified investment entity” under Code Section 897(h)(4)(B). 2 While the majority of ownership limitations provisions are included in the articles of incorporation, certificate of formation, declaration of trust or other incorporating document of the REIT, a small minority of REITs include these provisions in their bylaws. In jurisdictions where the bylaws may be amended by the board of directors without stockholder approval, inclusion of the ownership limitations provisions in the bylaws rather than in the charter may permit a limited measure of flexibility to the board to update outdated terms as appropriate in response to changing circumstances, if otherwise permitted by the bylaws. See, e.g., footnote 6 below. 3 Market commentators have contrasted the relatively benign economic effect to the investor of having shares transferred to a trust under the ownership limitation provision to the catastrophic economic effect to an investor whose ownership triggers a shareholder rights plan. See footnote 24 below. 4 Section 856(a)(6) and Section 856(h) of the Internal Revenue Code. See also footnote 8. 5 It is important to note that the 5/50 test is a “value” test — so it is possible that shares of different classes, and sometimes even shares within the same class, have ownership value that is different from their purely mathematical percentage ownership. For example, special rights associated with certain classes or blocks of stock should be taken into account when determining the stock’s value for purposes of applying the ownership limitations. Likewise, when determining the value of stock held by a founder or sponsor (and, therefore, the correct 5/50 ownership limit to include in a REIT’s charter) a REIT should also consider any special rights granted with respect to the founder’s or sponsor’s block of shares, as well as any applicable control premium represented by the founder’s or sponsor’s shares. This might result in percentage ownership for purposes of the 5/50 test that is greater than the founder’s or sponsor’s straight economic ownership based on number of shares. The typical 5/50 ownership limitation will apply to both the number of common shares outstanding as well as the aggregate value of all outstanding shares of capital stock of the REIT. Accordingly, as above, REITs with different classes of shares must also account for the relative values of the various classes when implementing the 5/50 ownership limitation. For purposes of these calculations, the “outstanding” shares of capital stock are those shares that are considered outstanding for tax purposes, and will exclude certain restricted stock and certain other equity interests in the REIT. 6 We note that a number of REITs that adopted a 5/50 ownership limit lower than 9.8% at the time of formation or otherwise to accommodate one or more founders or other large stockholders may no longer need this lower limit. Specifically, if follow-on offerings and other stock issuances in the interim have materially increased the total outstanding shares, or if the original large stockholder has otherwise decreased its percentage ownership, adjusting the 5/50 ownership limit to 9.8% or an otherwise higher limit would forestall the need for waivers based on the original lower limit (though an amendment to the ownership limit will generally require stockholder approval). See footnote 2.