Michael S. Schimmel
Although, historically investors view real estate investment trusts (“REITs”) as relatively constant, the downward trend of the real estate market and the decimation of nearly 50 percent of the value of the stock exchange over the past year has drastically impacted even fundamentally sound companies. The combination of market uncertainty and lack of consumer confidence, coupled with the fact that some believe the United States has officially been in a recession since December of 2007, helps to demonstrate the vulnerability of every aspect of the real estate sector.
This article briefly explores certain basic fiduciary duties that directors and trustees of public REITs owe to the company. While many consider the concept of fiduciary duties straightforward and simple, it is quite the contrary. In fact, this aspect of corporate governance has an extensive body of case law, countless volumes of secondary sources and treatises, and most notably, a highly complex intricate web of both federal and state statutory laws.
Since REITs acquire, manage and/or invest in real estate assets or loans that are secured by real estate and simultaneously issue shares in these investments to shareholders, various duties and responsibilities attach to the individuals managing and overseeing these investments. Unfortunately, due to the significant decline in property values across the country, surge in vacancy rates, tenant defaults and the impact of the credit crisis on all classes of real estate assets, the traditional view of many investors considering real estate a secure long-term investment is now long gone. In response to the poor economic times, the actions of the REIT’s founding and controlling stockholders, directors and trustees, are often scrutinized.
In addition, many REITs are structured as “UPREIT’s” (i.e., umbrella partnership real estate investment) with the REIT acting as the general partner and numerous other investors holding limited partnership interests, which may be converted or exchanged into REIT stock. As a result, it is worth noting that the below referenced fiduciary duties are applicable in this context as well, meaning that directors and trustees owe a fiduciary duty not only the REIT, but also to the limited partners with convertible interests.
There are a variety of nuances in the law that are imposed on directors and trustees of both public and privately held REITs. The most basic principle applicable to both is the requirement that directors and trustees of a REIT protect its shareholders. This principle incorporates the two primary fiduciary duties that all directors and trustees owe: (1) the duty of loyalty; and (2) the duty of care. When these fiduciary duties are fulfilled, the “business judgment rule” applies and the fiduciary is generally shielded against liability. The “business judgment rule” is an ever evolving concept that gives deference to a fiduciary for his or her decisions; irrespective of whether in retrospect it is correct or incorrect. However, this presumption is rebuttable under certain circumstances. If it is determined that a breach in fiduciary duties occurred or the business judgment rule is not applied, the director or officer may be held personally liable and director and trustees insurance could be denied by the insurer.
Simply stated, the duty of loyalty requires a fiduciary to act solely in the best interest of the company and serve the corporation for the shareholder. It is imperative that directors and officers avoid situations that may result in direct or indirect conflicts of interest and avoid selfdealing transactions. If the result of a transaction directly or indirectly benefits the fiduciary personally, the fiduciary is required to fully disclose this matter to the board of directors. The contemplated deal cannot occur, unless and until a vote by disinterested board members occurs approving the transaction.
With respect to the duty of care, directors and trustees are required to be informed and involved in business decisions of the REIT. Specifically, this duty creates an affirmative obligation to act in the manner of a prudent person under similar circumstances. Accordingly, it is essential that a fiduciary take all necessary actions to make fundamentally sound business decisions. A few examples of these obligations include, but are not limited to the review of proformas, evaluation of due diligence materials relating to certain essential acquisitions and dispositions and not knowingly violate REIT reinvestment obligations. In connection with the above referenced obligations, Section 856 of the Revenue Service Code of 1986 and corresponding treasury regulations provides that the management and oversight of certain matters (e.g., rental properties) should be delegated to independent contractors. See IRC §856; Treas. Regs. §1.856.
In today’s world all directors and trustees of REITs must be aware of the basic fiduciary duties that are owed to their corporation. This brief article should serve simply as a reminder of the obligations imposed on individuals entrusted with the responsibility to govern. In light of the complex and often intricate details associated with various types of commercial real estate transactions, it is critical to always bear in mind the consequences that may result from a breach of these fundamental duties.
— Michael S. Schimmel works in the Real Estate and Corporate Practice Group at Gunster Yoakley & Stewart