Reproduced with permission from Real Estate Law & Industry Report, 6 REAL 136, 03/05/2013. Copyright � 2013by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

R E I Ts

Addressing Retail Flowback in Listing Transactions for Unlisted REITs

BY SPENCER JOHNSON, TONY ROTHERMEL, AND

KEITH TOWNSEND

1. Overview - the Flowback Issue

U nlisted real estate investment trusts, or unlistedREITs, have enjoyed tremendous success raisingand deploying capital into real estate investments.

Unlisted REITs raise capital through public offeringsand make filings under both the Securities Act of 1933(the ‘‘Securities Act’’) and the Securities Exchange Actof 1934 (the ‘‘Exchange Act’’) with the Securities andExchange Commission as part of their offering processand ongoing operations. The securities of unlisted RE-ITs are not (at least initially) traded on any securitiesexchange. Investors in unlisted REITs typically consistof retail investors who acquire the securities throughbroker/dealers that market the unlisted REIT’s securi-ties in connection with its offering process. From a li-quidity standpoint, an unlisted REIT will generally indi-cate to investors through its offering process an ex-pected horizon for the vehicle to seek some type ofliquidity event - whether in the form of a sale transac-tion, liquidation or an initial public offering or listingtransaction.

A number of unlisted REITs have recently opted topursue liquidity for their shareholders through initialpublic offering or listing transactions in which the secu-rities of the vehicle are listed on a national securities ex-

change.1 In some cases, the vehicle itself may issue se-curities in connection with a capital raising event. In ad-dition, the shares held by the dispersed, largely retailshareholder base will become freely tradable. Even avery small percentage of these existing shareholdersselling into the market following the transaction canrepresent significant volume and result in downwardpressure on the stock price. Without the implementa-tion of appropriate steps, this scenario can result in in-stitutional investors refusing to participate in the trans-action or, at best, participating at reduced levels and atdecreased prices relative to what could be achievedwith appropriate measures in place to address this is-sue. To further exacerbate the issue, the magnitude ofthe importance placed by institutional investors on theissue is unpredictable and may vary from investor to in-vestor.

2. Alternatives to Address the Flowback IssueA number of potential alternatives exist to combat

the flowback issue and the pitfalls arising from the re-tail overhang on the stock. In general, these potentialalternatives can be grouped into three broad categories:(i) do nothing; (ii) structure a lock-up to control the vol-

1 Piedmont Office Realty Trust, Healthcare Trust ofAmerica, Retail Properties of America, and American RealtyCapital Trust have all closed either initial public offerings orlisting transactions.

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Real Estate Law & Industry Report®

ume of flowback; and (iii) enter the market and absorba portion of the flowback. The following discussion ad-dresses each of these potential categories of alterna-tives and covers specific ideas within each category.

a. Do Nothing. As indicated by the heading, in thisscenario the issuer takes no proactive steps to addressthe retail flowback of shares into the market in connec-tion with the transaction. A review of precedent trans-actions where this option was implemented highlightsthe potential negative implications of the flowback is-sue. DCT Industrial Trust (DCT), a former unlistedREIT, conducted an initial public offering and did notimplement any measures designed to address the flow-back issue. Trading in the stock exerted significantdownward pressure on the share price as retail share-holders attempted to exit the stock - within four weeks,the trading volume in the stock exceeded 30 percent ofthe number of shares outstanding and within 26 weeksthat number had climbed to more than 150 percent. Inaddition, the stock underperformed a peer group ofsimilar companies by 5 percent to 15 percent during itsfirst year of trading. Further, the composition of theownership of the stock trended significantly from retailto institutional holders during the initial trading year ofthe stock indicating that the full demand for the stockfrom institutional investors may not have been capturedin connection with the initial public offering. Followingits listing, approximately 25 percent of the stock washeld by institutional investors —at the end of its firstyear of trading, that figure had increased to approxi-mately 80 percent. Inland Real Estate Corp. (IRC) tooka similar approach in connection with its listing trans-action (i.e., the listing of the stock without any corre-sponding primary offering). Similar to DCT, Inland ex-perienced significant volume. Within four weeks thetrading volume in the stock exceeded 20 percent of thenumber of shares outstanding and within 26 weeks over60 percent of the outstanding shares had changedhands. While Inland outperformed its peer group, itsownership also trended from retail to institutional withjust over 6 percent being held by institutions immedi-ately following the transaction to approximately 35 per-cent within one year of the transaction.

DCT and Inland provide important data points for un-listed REITs considering taking no action to address theflowback issue in connection with a listing transactionor an initial public offering. The trading volumes forthese two companies show significant volume, increas-ing price pressure on the stock during extended timeperiods following the transaction. As an initial consid-eration, investment banks prefer for the trading mar-kets following an initial offering of a security to free ofpricing pressure caused by trading by existing security-holders. Unlisted REITs pursuing listing transactionsmay be unable to find investment banks willing to par-ticipate in an offering in which no action is taken to ad-dress the volume and price pressure associated with theflowback. Further, each of these precedent transactionsshows strong institutional interest in the stock as insti-tutions trade into the security over the initial year of itslisting. Although difficult to quantify, issuers wouldhave to consider how much of that demand could havebeen harnessed to increase price and participation forthe security in connection with the issuer’s primary of-fering. At a minimum, pricing in connection with the of-

fering will be negatively impacted based on institutionalinvestor concerns regarding the flowback issue.

b. Control the Flowback - Implementing Lock-Ups. Theflowback issue has its origins in the scope and charac-ter of the unlisted REIT shareholder base. The unlistedREIT shareholder base is largely dispersed and madeup of retail holders that, individually, do not generallyown any meaningful position in the security. For a moretraditional private company pursuing an initial publicoffering, the clean trading market post-closing in re-spect of existing shareholders (as required by invest-ment bankers) is typically handled through a customarylock-up agreement. The group of potential options toaddress the flowback issue outlined below are intendedto moderate the degree of flowback just as lock-ups areimposed in connection with more traditional initial pub-lic offerings.

i. Traditional Lock-Ups.The idea of implanting a traditional lock-up with ex-

isting shareholders of unlisted REITs would effectivelyrequire the unlisted REIT to solicit each shareholder tosign and return a lock-up agreement in connection withthe listing transaction. While effective from a legal per-spective with respect to any shareholder that returnsthe lock-up, this approach is unlikely to be successfulfor a number of reasons. Most importantly, there is noreal economic incentive for the shareholders to returnthe lock-up. From a more practical perspective, thisprocess would require the issuer to print and mail thou-sands of lock-up agreements to existing shareholders,expend the resources to follow up with those sharehold-ers regarding completing the materials and spendcountless hours inventorying, reviewing and assimilat-ing the lock-ups. We are not aware of any unlisted REITpursuing this approach in connection with an initialpublic offering or listing transaction and do not view itas a viable alternative to addressing the flowback issuegiven the economic and practical considerations in-volved with this approach.

ii. Recapitalization in Connection With a ListingTransaction.

The recapitalization option for installing a lock-upmechanism in connection with a listing transaction hasbecome the preferred answer to the retail flowback is-sue for unlisted REITs. The recapitalization option con-verts existing common shares of the unlisted REIT intoa new class of stock that is not listed as part of thetransaction. The initial public offering or listing trans-action then lists a new, separate class of stock on therelevant exchange. The new shares obtained by the ex-isting holders in connection with the transaction thenconvert into the listed security over a staggered periodof time. Generally, the unlisted security is divided intothree separate tranches that convert to the listed secu-rity in equal installments over the 60-, 120-, and 180-dayperiods following the closing of the transaction. The re-capitalization event is appealing in connection with list-ing transactions as it moderates the amount of flowbackon a wide-spread basis across the entire shareholderbase of the unlisted REIT. Further, by controlling thevolume of flowback, the recapitalization option encour-ages institutional investor participation in the transac-tion by eliminating the element of downward pricepressure on the security immediately following thetransaction from retail flowback.

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While the recapitalization option is attractive givenits effectiveness in addressing the flowback issue, therecapitalization option is not without cost and timingimplications for the overall transaction. As the processto implement the recapitalization requires an amend-ment to the issuer’s charter, the unlisted REIT will berequired to seek and obtain shareholder approval. Thisprocess will require the issuer to prepare and file withthe Securities and Exchange Commission (SEC) proxymaterials in connection with obtaining the shareholdervote. The SEC will have an initial period of 10 calendardays to notify the issuer as to whether it intends to re-view the proxy materials. If no notice is given, the is-suer may proceed with the proxy solicitation. Given themateriality of the recapitalization and the focus on un-listed REITs by regulatory authorities, issuers shouldgenerally expect the SEC to review the proxy filings,which most likely means a minimum of 60 calendardays between the date the initial filing is made and thedate of the shareholders’ meeting to approve the recapi-talization. The requirement for a shareholder vote willneed to be taken into account in connection with struc-turing listing transactions and shaping expectations re-garding timing. The shareholder vote requirement andrelated proxy materials will also increase the cost asso-ciated with the transaction.

c. Absorb the Flowback - Offset Opportunities. In addi-tion to structural mechanisms to control the flowback,there are a number of alternatives available to unlistedREITs to absorb some portion of the flowback in an ef-fort to eliminate the volume of shares entering the mar-ket on a post-transaction basis. While these alternativesmay be sufficient to eliminate some portion of the flow-back, by their nature they are unlikely to be sufficientin size or scope to completely address the issue. Rather,each of these options acts as a mitigant in reducing theamount of pressure on the security from a volume andpricing perspective. In general, this group of alterna-tives can be broken into two general categories—permitting investors to participate in the initial publicoffering and the issuer entering the market on a post-transaction basis to acquire shares of the listed security.

i. Selling Shareholders in the Initial Public Offer-ing.

The unlisted REIT may consider permitting existingmembers of the retail shareholder base to participate inthe offering. This approach addresses the flowback is-sue by redirecting a portion of the flowback directlyinto the public offering and alleviates the overhangcaused by potential post-transaction sales of thoseshares by the existing holders. It is not unusual forsome portion of the existing shareholders of a companyto monetize a percentage of their holdings in connec-tion with an initial listing of a company’s securities.However, this process is not particularly attractive forunlisted REITs primarily for the same reasons that drivethe flowback issue itself. The widespread nature andthe retail character of the typical unlisted REIT share-holder base makes the potential for allowing existingshareholders to participate in the offering impractical.

To participate in the offering, shareholders would berequired to deliver a commitment to participate in theoffering, together with relevant transfer instruments inrespect of their holdings, in advance of the offering.This would mean coordinating a mailing of the docu-mentation to each shareholder and the return of com-

pleted documentation by shareholders wishing to par-ticipate in the offering. Given the relatively small posi-tions held by individual investors, the unlisted REITwould need to expend significant time and energy inconnection with this process for the participation of theshareholders in the offering to provide any meaningfulsolution to the flowback issue. The process for prepar-ing the relevant documentation, distributing it to share-holders, following up with shareholders and coordinat-ing participation in the offering in general may also sig-nificantly add to the cost and time required to close thetransaction.

Trading in the stock exerted significant downward

pressure on the share price as retail shareholders

attempted to exit the stock - within four weeks,

the trading volume in the stock exceeded 30

percent of the number of shares outstanding and

within 26 weeks that number had climbed to more

than 150 percent.

Beyond the logistical limitations, the size and scopeof this potential alternative will be limited by economicconsiderations as well. The book of purchasers in con-nection with the initial public offering are likely to man-date through their interest and pricing levels that a sig-nificant portion of the trade be made up of a primary of-fering by the issuer. As initial public offerings tend to besold on a growth strategy, the growth potential and op-portunities for the issuer diminish as the amount ofcapital from the transaction trends away from the is-suer. In other words, the initial public offering growthstory can be undercut if the selling shareholder partici-pation represents a material portion of the transaction.This potential negative pricing impact should be ex-plored with the issuer’s financial adviser and taken intoaccount when attempting to counterbalance the poten-tial upside from addressing the flowback issue.

ii. Issuer Enters the Market to Address Flowback.Perhaps the most interesting set of alternatives for

the unlisted REIT in addressing flowback issues is en-tering the market as a buyer to purchase some portionof the flowback entering the market. There are a num-ber of considerations relevant to the unlisted REIT inmaking the determination to move forward with thisoption. In general, these considerations can be groupedinto two separate categories: (a) legal and timing con-siderations relative to the repurchasing program to beimplemented and (b) the form of the repurchasing pro-gram to be implemented. As the legal and timing impli-cations are the threshold question regarding when theissuer may enter the market and, in some instances,dictates the size of the program, this article addressesthese considerations first.

Legal Considerations. As a threshold item, RegulationM under the Securities Act governs the activities of dis-tribution participants in a public offering of securities.Specifically, Regulation M precludes manipulative con-

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duct by persons with an interest in the outcome of anoffering. Among other things, Regulation M prohibitsissuers, selling security holders, underwriters, broker-dealers, and other distribution participants from di-rectly or indirectly bidding for, purchasing, or attempt-ing to induce any person to bid for or purchase any se-curity that is the subject of the distribution during theapplicable restricted period. Consequently, the unlistedREIT pursuing a listing transaction should be awarethat it would be prohibited from entering the market forpurposes of absorbing flowback until the distributionassociated with the offering is complete. For these pur-poses, the distribution will be complete once the under-writing syndicate has broken.

In addition, Rule 10b-18 promulgated under the Ex-change Act provides an issuer with a non-exclusive safeharbor from liability under certain market manipulationrules under the Exchange Act as well as Rule 10b-5 un-der the Exchange Act. Rule 10b-18’s safe harbor isavailable when repurchases of the issuer’s commonstock in the market are made in accordance with therule’s manner, timing, price, and volume conditions.Rule 10b-18’s safe harbor is available for purchases ofthe issuer’s stock on any given day. Failure to meet anyone of the four conditions will disqualify all of the issu-er’s repurchases from the safe harbor for that day. Rule10b-18 permits purchases of up to 25 percent of dailyvolume based on average volume for the trailing fourcalendar weeks preceding the week of the purchase. Anissuer cannot rely on 10b-18 for purposes of comingwithin the safe harbor provided by the rule until the is-suer’s security has been publicly traded for at least fourcompleted calendar weeks. Issuers generally will notpurchase in the market until the safe harbor is availableand, as a consequence, remain out of the market for atleast this designated period following the closing of thetransaction.

Finally, the prospectus and related disclosure pack-age in connection with the issuer’s listing or initial pub-lic offering transaction should include detailed disclo-sures regarding the issuer’s intended approach to stockrepurchases. Given that the issuer would be enteringthe market a relatively short period of time followingthe offering, a heightened level of transparency and dis-closure is of critical importance relative to setting ex-pectations of investors in the transaction. In particular,the expectations regarding the sources and uses of pro-ceeds should be disclosed in the prospectus.

Implementing Share Buy-Backs. The issuer has a num-ber of alternatives available in connection with imple-menting the share buy-back process to mitigate the im-pact of the retail flowback. Specifically, the issuer mayenter the market directly through direct market pur-chases, implement a so-called 10b-5-1 program wherethe purchases are placed through a broker under a de-fined set of criteria, or have one more intermediariesconduct open-market purchases on the issuer’s behalf.To the extent that these open-market purchases are notsignificant enough to mitigate or impact the negativeimplications of the retail flowback, other more signifi-cant alternatives are available to the issuer. For ex-ample, the issuer may determine to launch a public ten-der offer for a designated number or dollar amount ofits outstanding shares. In addition to the manner of therepurchases, the issuer will also need to separately con-sider how the repurchases will be funded. Dependingon the relative size of the repurchase activity, the issuermay rely simply on cash-on-hand or need to pursue acredit facility or other leverage to implement the buy-back. The structure, timing, and manner of implement-ing share repurchases should be discussed with counselin connection with the pursuit of the listing or initialpublic offering transaction and taken into account inthe issuer’s disclosure.

Conclusion. Unlisted REITs pursuing a listing trans-action should consider the potential implications asso-ciated with the retail flowback issue. A number of op-tions are available to mitigate the risks associated withthis issue. Unlisted REITs should consult with their le-gal and financial advisers regarding the most appropri-ate strategy to address the retail flowback issue basedon the vehicle’s individual facts and circumstances.

Spencer Johnson is a partner in King & Spald-ing’s Atlanta office and a member of thefirm’s Capital Transactions and Real Estate Prac-tice Group. Tony Rothermel is a partner in King& Spalding’s New York office and a member ofthe firm’s Capital Transactions and Real EstatePractice Group. Keith Townsend is a partnerin King & Spalding’s Atlanta office and a mem-ber of the firm’s Corporate Practice Group.

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3-5-13 COPYRIGHT � 2013 BY THE BUREAU OF NATIONAL AFFAIRS, INC. REAL ISSN 1944-9453