The New Form 8-K: Interpretive Issues for REITs and REOCs

The New Form 8-K: Interpretive Issues for REITs and REOCs John Newell and Ettore Santucci Recent changes in SEC rules require public companies to make greatly expanded disclosures with signi cantly shorter deadlines. REITs and other real estate operating companies face particular challenges in applying some of the new SEC rules. This article discusses several of the most signi cant practical issues confronting REITs under the new SEC rules. The amendments to Form 8-K adopted earlier this year by the Securities and Exchange Commission became e ective earlier this year. They are summarized, and the compliance challenges they present are discussed, in our article in this issue of the Real Estate Finance Journal entitled Operating Under the New Form 8-K Accelerated and Expanded Reporting Requirements. Public real estate operating companies face several questions that are speci c to their business operations as they apply the new Form 8-K reporting requirements. Among these questions are: E Does Form 8-K require REITs and REOCs to report events involving material real estate purchase and sale agreements made in the ordinary course of business? E How do the new Form 8-K requirements apply to real estate purchase and sale agreements that are subject to satisfaction of due diligence or other conditions? E How does the requirement to report material asset impairments apply to dispositions of real estate assets? The discussion that follows refers speci cally to public REITs, but may apply to REOCs and other John Newell, a senior counsel in the Business Law Department of Goodwin Procter LLP, works on a variety of securities, nancing and corporate matters for nancial institutions and industrial companies. Ettore Santucci, a partner in the rm's Business Law Department and chair of its Securities & Corporate Finance Practice, focuses on public and private securities o erings, mergers and acquisitions, corporate governance, securities law compliance and cross-border transactions. companies engaged in real estate activities if they are subject to SEC reporting requirements. Ordinary Course Real Estate Transactions Item 1.01 of Form 8-K requires companies to report when they enter into or amend a material de nitive agreement not made in the ordinary course of the company's business, and to le a copy of the agreement and/or amendment as an exhibit to that Form 8-K report or the company's next periodic report on Form 10-Q or 10-K. If a REIT enters into a purchase and sale agreement for real estate assets, and if the REIT determines that the agreement is material and binding, does Form 8-K require the REIT to report entering into the agreement? Based on the plain language of Item 1.01, a REIT could conclude that it was required neither to report entering into the agreement nor to le the agreement as an exhibit, relying on the fact that the agreement was made in the ordinary course of its business. 1 Recently, however, members of the sta of the SEC's Division of Corporation Finance have advised that, when interpreting the new disclosure requirements of Item 1.01 (and Item 1.02, which applies to terminations of material de nitive agreements), the sta anticipates extending its existing position that acquisitions of real estate by companies engaged in real estate activities are not considered to be made in the ordinary course of business. The SEC sta has historically applied this position THE REAL ESTATE FINANCE JOURNAL/WINTER 2005 45

The New Form 8-K: Interpretive Issues for REITs and REOCs to require REITs and other companies engaged in real estate activities to le nancial statements for certain probable and completed acquisitions of operating real estate assets under Rule 3-14 of Regulation S-X, even if the acquisition was in the ordinary course of business. The sta has also applied this position to require REITs to le Form 8-Ks to report signi cant completed acquisitions of real estate properties under former Item 2, the requirements of which are substantially carried over into new Item 2.01. Although the sta 's interpretive position was originally applied to the reporting of acquisitions of real estate assets, it would appear to apply equally to agreements relating to dispositions under Items 1.01 and 1.02. Although it is possible that the SEC sta will revisit its position as its experience with the new Form 8-K rules develops, the result of applying that position to Item 1.01 and 1.02 is that, at this time, REITs should report entry into, amendments to, and termination of material de nitive agreements involving acquisitions and dispositions of real estate assets, even if they believe that the agreement or transaction is in the ordinary course of business. Consistent with past practice, REITs should also continue to le nancial statements for probable and completed acquisitions of operating real estate assets that meet the requirements of Rule 3-14 under Item 8.01 (formerly Item 5), and to report completed transactions involving signi cant real estate assets under Items 2.01 and 9.01 (formerly Items 2 and 7, respectively). Closing Conditions And Form 8-K Reporting As noted earlier, Item 1.01 of Form 8-K requires companies to report when they enter into or amend a material de nitive agreement not made in the ordinary course of business, and to le a copy of the agreement and/or amendment as an exhibit to the Form 8-K report or the next Form 10-Q or Form 10-K report. The SEC sta has indicated that it will extend its historical position that real estate purchase and sale agreements are not made in the ordinary course of business to new Items 1.01 and 1.02 of Form 8-K. REITs should therefore le a Form 8-K under Item 1.01 to report entry into a real estate purchase and sale agreement if the agreement contains provisions that are both (1) enforceable by or against the REIT and (2) material to the REIT. However, as NAREIT pointed out in its comment letter on the proposed amendments to Form 8-K, these agreements usually contain due diligence conditions that allow the buyer to terminate the agreement without signi cant liability if it is not satis ed with the results of its due diligence. How should REITs apply the requirements of Item 1.01 to these types of agreements? What Agreements Are Subject to Item 1.01? Form 8-K de nes a material de nitive agreement as an agreement that provides for obligations that are material to and enforceable against the registrant, or rights that are material to the registrant and enforceable by the registrant against one or more other parties to the agreement, in each case whether or not subject to conditions (emphasis added). In the adopting release, the SEC went on to state that...amaterial de nitive agreement which is subject to customary closing conditions, such as the delivery of legal opinions or comfort letters, completion of due diligence or regulatory approval, must be disclosed under Item 1.01 when such agreement is enforceable against or by the company despite the fact that such conditions have not yet been satis ed [emphasis added]. Item 1.01 therefore applies at the time when a public REIT enters into an agreement that contains rights or obligations that are binding and material, even if the agreement is subject to conditions at that time. Conversely, the requirements of Item 1.01 do not extend to non-binding letters of intent, even if they contain binding provisions (such as con dentiality or no-shop provisions), as long as the binding provisions are not material. Under Form 8-K and the SEC statements contained in the adopting release, therefore, whether or not an agreement is subject to Item 1.01 disclosure turns not on whether it is labeled an agreement or a letter of intent but whether it contains material provisions that are enforceable by or against the company. Please note that this analysis is not limited to real estate purchase and sale transactions, but potentially applies under Items 1.01 and 1.02 to any agreement entered into by a public company. When are Real Estate Purchase and Sale Agreements Subject to Item 1.01? The form and historical use of agreements for acquisitions of real property in the real estate industry leads to practical and interpretational issues that are unique to REITs and other real estate operating companies. In a majority of transactions, we believe that these contracts have the following characteristics: E At the time of execution, the buyer has an enforceable right to require the seller to convey the property to the buyer, subject to a due diligence condition that provides for a period during which the buyer can perform its due diligence review of the property before it becomes obligated to purchase the property; E The buyer pays a deposit upon execution of the agreement, which may be refundable if the results of its due diligence review are not satisfactory; and E The obligation of the buyer to purchase the property does not become enforceable by the seller until the due diligence condition has been satis- ed and the deposit has become non-refundable, or gone hard. The agreement provides either that this condition is waived if the buyer does not give written notice to the seller by a speci ed date or, in other cases, that the buyer will give written notice to the seller that it has completed its due 46 THE REAL ESTATE FINANCE JOURNAL/WINTER 2005

diligence and intends to proceed with the acquisition. 2 In light of the de nition of material de nitive agreement in Form 8-K and the statements by the SEC when it adopted the amendments to Form 8-K, an agreement of this nature could be potentially subject to the requirements of Item 1.01 as early as the time when the buyer and seller enter into the agreement because the agreement is usually enforceable by the buyer against the seller starting at that time, even though the buyer may have a right to terminate the agreement if its due diligence review is not satisfactory. The existence of conditions, such as satisfactory completion of due diligence, would not, by itself, a ect the reporting obligations of a public REIT buyer or seller under Item 1.01. To determine whether a REIT is subject to the requirements of Item 1.01 when it enters into a purchase and sale agreement of the type described above, the REIT must rst evaluate the agreement to determine whether its terms are enforceable by or against the REIT. Then, assuming that the agreement is enforceable (as will typically be the case), the REIT must determine whether the agreement provides for rights or obligations that are material to the REIT. This materiality analysis may have several di erent results, due to the peculiar nature of this type of agreement. E As a general matter, if the REIT determines that the agreement is a material de nitive agreement under the Form 8-K de nition because it provides for enforceable rights or obligations that are material to the REIT, Item 1.01 requires the REIT to le a Form 8-K report within four business days after entering into the agreement. E However, if the REIT determines that the enforceable rights or obligations contained in the agreement are not material to the REIT when it rst enters into the agreement, then Item 1.01 would not require a Form 8-K report at that time. E If the REIT determines that no Item 1.01 report is due when it rst enters into the agreement, it should continue to monitor the status of the agreement to determine whether the REIT later becomes subject to reporting obligations under Item 1.01 or Item 1.02, either as a result of actions taken by the buyer or seller, or as a result of other changes in the facts relating to the transaction. When evaluating whether, or when, a real estate purchase and sale agreement (or a subsequent amendment) will be subject to reporting under Item 1.01, REITs must carefully consider the de nition of material de nitive agreement in Form 8-K. Whether an agreement meets the requirements of that de nition turns, in part, on the overall context of a transaction, and that context may be dynamic, not static. Therefore, the Item 1.01 analysis is not necessarily as simple as determining whether the transaction itself would, if consummated, be material to the REIT when the parties rst enter into the agreement. Under the materiality tests developed by the courts, for purposes of Item 1.01 a REIT should balance the probability and the magnitude of its contractual rights and obligations with respect to the potential transaction. In some cases, a REIT may determine that the magnitude of its rights or obligations is not suf- cient to support a conclusion of materiality. We anticipate that many materiality decisions will be made on this basis. However, in other cases a REIT may determine that the probability of the transaction being completed when it rst enters into the agreement is such that its rights and/or obligations under the agreement are not material even if the transaction is of signi cant magnitude. In these latter cases, we note that the result would be similar in e ect to the treatment of the transaction under Rule 3-14, under which real estate acquisitions that would be signi cant if consummated are not reportable until they become probable. For purposes of Rule 3-14, a buyer may determine in some cases that a transaction that was subject to satisfactory conclusion of due diligence was not probable until that condition has been satis ed or waived. Similarly, under Item 1.01, a buyer may be able to determine in some cases that its rights under a purchase and sale agreement were not material until the due diligence condition has been satis ed or waived because the probability that the buyer would exercise its right to acquire the property is not su ciently great to satisfy the probability/ magnitude test of materiality prior to that time. If a REIT concludes, based on this probability/ magnitude analysis, that it is not required to report entering into a purchase and sale agreement under Item 1.01 when it rst enters into the agreement, the REIT should consider whether actions subsequently taken or not taken by either party might be viewed as a constructive amendment of the agreement. In these circumstances, the REIT would need to evaluate whether that event (for example, the buyer giving notice that the due diligence condition had been satis ed, or allowing its right to terminate the agreement to lapse) could be treated as a reportable amendment under Item 1.01. Whether this application of the disclosure requirements of Item 1.01 complies with those requirements as interpreted by the SEC sta will depend largely on the facts and circumstances of the speci c agreement and transaction. The REIT should assess the risk that SEC sta or investors may reach di erent conclusions on materiality with the bene t of hindsight. For example, where probability is a factor in the REIT's analysis, this risk would be greater where the REIT (1) does in fact consummate the transaction contemplated by the agreement in question and (2) has a history of completing similar transactions. In view of the potentially serious consequences of failing to le a required Item 1.01 or 1.02 Form 8-K report, especially where REIT does THE REAL ESTATE FINANCE JOURNAL/WINTER 2005 47

The New Form 8-K: Interpretive Issues for REITs and REOCs not fall within the safe harbor for late Form 8-K lings by including all required disclosure and exhibits in its next periodic report, REITs may in some cases choose to resolve close materiality questions in favor of disclosure. REITs should be aware that the nature of the typical purchase and sale agreement may result in a public buyer and a public seller in the same transaction reaching di erent conclusions about whether, or when, each has a disclosure obligation under Item 1.01. For example, while a buyer may determine that its rights, although enforceable, are not material when it rst enters into the agreement, the seller may determine that its obligations under the agreement are immediately enforceable and material upon entering into the agreement and therefore subject to disclosure under Item 1.01 at that time. Further, rights and transactions that are material to one party may, for a variety of reasons, be immaterial to the other party. REITs should be aware of the potential for divergent disclosure decisions before entering into a purchase and sale agreement with other public REITs. This potential obviously would not arise where the other party is not subject to SEC reporting obligations. Applying Materiality Standards. The foregoing discussion of materiality in the context of the typical real estate purchase and sale agreement underscores the practical challenges that REITs face in applying Item 1.01 in light of the general view of these agreements in the real estate industry. The prevailing industry view is that these agreements are a type of hybrid agreement that includes two distinct phases: (1) an initial period during which the buyer is not fully committed to the transaction because it will not acquire the property unless its ongoing due diligence has been satisfactorily completed, and (2) a post-due diligence period during which both parties are irrevocably committed to close the transaction. Buyers and sellers of real estate often regard these contracts as the functional equivalent of a letter of intent that provides for subsequent execution of a de nitive agreement, as evidenced by the common practice among REITs of not issuing a press release until the deposit has gone hard. However, as discussed above, the typical real estate purchase and sale agreement does not t within the exception for non-binding letters of intent under Item 1.01 because in most cases it is impossible to conclude that the agreement is not enforceable from the date it is rst signed, even though it is subject to conditions. Thus, the principal question for a REIT in these transactions under Item 1.01 is whether its enforceable rights or obligations are material. In particular, applying the probability and magnitude test of materiality to the buyer's contractual rights in the context of real estate industry practice will require REITs to balance, during the life-cycle of an acquisition, the tensions that exist under Item 1.01 between letters of intent and similar documents that contain rights that are enforceable but not material (and are therefore not subject to Item 1.01 disclosure), on the one hand, and de nitive agreements that contain enforceable rights that are material (and are therefore subject to reporting under Item 1.01), on the other hand. The combination of the new Item 1.01 and 1.02 reporting requirements, the structure of typical purchase and sale agreements in the real estate industry, and the SEC sta 's position on ordinary course real estate acquisitions by companies engaged in real estate activities will require REITs to develop thoughtful and consistent policies on materiality determinations. In the absence of speci c SEC sta guidance on how to apply the concept of materiality under Item 1.01, REITs will have to base these policies on the general standards developed by the courts in cases such as Basic v. Levinson, TSC Industries, Inc. v. Northway, Inc., and SEC v. Texas Gulf Sulphur Co. As discussed in our article, Operating Under the New Form 8-K Accelerated and Expanded Reporting Requirements, SEC rules contain a variety of quantitative standards in di erent contexts, but these vary signi cantly. Further, SEC Sta Accounting Bulletin No. 99 states generally that materiality should not be determined solely by reference to quantitative tests. In addition to the timing and probability considerations discussed above, in evaluating whether a transaction is material, REITs should consider all relevant facts and circumstances on a case-by-case basis. These could include, for example, in addition to the size of the transaction, the structure of the transaction and its business and nancial terms, and whether the transaction represents entry into a new geographical market, business sector or property type. Readers are cautioned that the preceding discussion is only a general discussion and cannot be viewed as legal advice with respect to any speci c agreement or transaction. REITs must review the requirements of Form 8-K as interpreted by the SEC on a case-by-case basis with securities counsel in order to determine whether, or when, an agreement will be subject to the requirements of Form 8-K. REITs should be aware that a purchase and sale agreement may include terms that result in reporting obligations under more than one item of Form 8-K, and that additional disclosure requirements may apply under other SEC rules and forms. Potential Item 1.02 Reporting Requirements. REITs should be aware that if a purchase and sale agreement is determined to be a material de nitive agreement subject to Item 1.01 of Form 8-K, it is also likely to be subject to the requirement to report termination of a material de nitive agreement under Item 1.02 if the parties terminate the agreement before closing. This could occur if, for example, the buyer determines that the due diligence condition has not been satis ed. Depending on whether the buyer and/or the seller have determined that the agreement was subject to disclosure under Item 1.01, one or both may have an obligation to report termination of the agreement under Item 1.02 within four business days. 48 THE REAL ESTATE FINANCE JOURNAL/WINTER 2005

Additional Practical Considerations. When REITs le a Form 8-K to report entry into a material de nitive agreement, we expect that in many cases they will choose to le the purchase and sale agreement as an exhibit with the Form 8-K in order to eliminate questions about whether deferring ling the exhibit might have a ected the completeness of the disclosure in the Form 8-K. However, SEC rules permit companies to postpone the exhibit ling until their next periodic report is due. It is currently unclear how the new Form 8-K reporting requirements will a ect the legal documentation of real estate transactions that involve public REITs. At a minimum, one of the practical implications of Item 1.01 is that REITs should carefully consider the scope of con dentiality provisions when negotiating purchase and sale agreements in order to ensure that there will not be a con ict between those provisions and any potential Form 8-K reporting obligations that may apply to the REIT. Losses On Property Sales And Reporting Of Material Impairments Item 2.06 of Form 8-K requires a company to report when a conclusion is reached that a material charge for impairment to one or more of the company's assets is necessary under generally accepted accounting principles. The instructions to Item 2.06 state that companies are not required to le a report under Item 2.06 if the conclusion concerning the material charge is made in connection with the preparation, review or audit of nancial statements at the end of a scal quarter or year and the impairment is disclosed in the company's Form 10-Q or 10-K report for the relevant period. Although one of the SEC's principal concerns in adopting Item 2.06 appears to have been impairments of securities and other nancial instruments, Item 2.06 applies to all assets, including real estate assets. In some cases, a REIT may determine that the value of an asset has been impaired under GAAP as a part of the process of preparing a periodic SEC report, and will therefore not be required to report the impairment separately under Item 2.06. However, in instances where a REIT agrees to sell or otherwise dispose of an asset for an amount that results in a loss, the REIT must determine whether the loss will be material and will give rise to an impairment under FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long- Lived Assets to Be Disposed Of and related accounting requirements. If these conditions are satis ed, the REIT may be required to le a Form 8-K report within four business days after the amount of the impairment has been determined. This would presumably occur not later than the date on which the sale price has been determined. Thus, in some cases, the seller may become obligated to report a material impairment under Item 2.06 at the same time that or in other cases possibly even before the seller and/or buyer become obligated to report entering into the purchase and sale agreement for the property under Item 1.01. Late Filing Of Reports REITs and other companies should remember that although Items 1.01, 1.02 and 2.06 are among the reporting obligations covered by the SEC's safe harbor for late ling, the e ective scope of the safe harbor has a number of signi cant limitations. Many of these are summarized in our article, Operating Under the New Form 8-K Accelerated and Expanded Reporting Requirements. One limitation of the safe harbor is that it ceases to apply on the due date of the rst Form 10-Q or Form 10-K report after the reportable event occurred. The Form 10-Q or Form 10-K report must therefore satisfy all of the disclosure and exhibit ling requirements that would have been required in a Form 8-K report. Failure to catch up with the missed disclosure obligations can result in a variety of serious consequences. Among others, these consequences could include: the REIT would become ineligible to use Form S-3; the REIT could be subject to Rule 10b-5 liability; and the REIT's independent auditors might take adverse positions with respect to the company's internal control over nancial reporting. Conclusion The new Form 8-K rules require continuous monitoring of many di erent aspects of a REIT's business, nances and other matters, as well as rapid evaluation of legal and accounting matters, both internally and with the REIT's outside legal and accounting professionals. This brief overview of interpretational issues involving the expanded reporting of purchases and sales of real estate assets under Form 8-K indicates that REITs should include their real estate acquisitions and dispositions in their monitoring processes. Compliance will be di cult if the REIT has not reviewed the requirements of Form 8-K and taken any steps necessary or appropriate to adopt or modify internal policies and procedures that will facilitate legal compliance. 1 Whether or not a real estate transaction is in the ordinary course of a REIT's business for SEC reporting purposes is not dispositive with respect to the question of whether the REIT is a dealer under applicable provisions of the Internal Revenue Code. 2 These are, of course generalizations. Real estate purchase and sale agreements vary signi cantly with respect to their terms. Each agreement, amendment or termination must be evaluated individually to determine whether and/or at what time it is subject to Form 8-K reporting requirements. THE REAL ESTATE FINANCE JOURNAL/WINTER 2005 49