Neighboring states Delaware and Maryland are miles apart when it comes to laws affecting REITs

Editor’s Note: Where a real estate company is formed can have a dramatic impact on its governance. Maryland is by far the most popular state in which to organize a REIT, while Delaware has been a haven for large businesses other than REITs. Real Estate Portfolio asked a Maryland-based and a Delaware-based attorney to highlight the advantages each state has for a real estate company operating in that jurisdiction.

Delaware: Jurisdiction of Flexibility

The major mutual funds figured it out. Since 1995, major players such as Vanguard, Franklin and the Delaware Group of Funds have relocated from jurisdictions such as Maryland and Massachusetts to Delaware. By doing so, mutual funds have taken advantage of the many benefits provided by the Delaware Business Trust Act (DBTA). For many reasons, REITs can look to the DBTA to gain the same benefits.

Adopted in 1988, the DBTA offers the greatest flexibility any organization could want or need. Based on the concept of freedom of contract, parties to a business trust are free to structure their transaction with few statutory restrictions. Yet, at the same time, the parties receive statutory certainty and protection. Moreover, the Delaware legislature readily responds to legal practitioners who regularly monitor and suggest updates to the DBTA to address current business issues.

Why Choose Delaware?

Delaware routinely has been the jurisdiction of choice for forming business entities. Parties to a transaction seek the stability and reliability of Delaware law, the national reputation of the Delaware Court of Chancery, and the high-tech capability of the Delaware Secretary of State’s Division of Corporations. When other jurisdictions attempt to come up with reasons as to why an organization should choose their jurisdictions, comparisons regularly are made to Delaware’s corporate law.

Comments to the effect that provisions found in the statutes of non-Delaware jurisdictions validate principles, authorize actions, clarify powers and reject Delaware corporate doctrines, may be accurate. However, this completely ignores one basic fact: the DBTA is available and the Delaware Business Borrower Trust can be used by a REIT. Essentially, many of Delaware’s corporate law doctrines and standards that claimed to be adverse to REITs in fact need not even apply. Instead, under the DBTA, parties to the business trust can choose what should apply, which actions are authorized, how actions are authorized and the powers of each party to the business trust. The DBTA provides the optimal flexibility for the parties, the deal and the drafters.

As a result of the DBTA’s flexibility, parties to the business trust can begin to structure their transaction with what is the equivalent of a blank slate. For example, consider a statutory provision that guides a board of directors in what actions are to be taken (or not taken, for that matter) when the organization is an acquisition target. Under the DBTA, the parties can establish the standards they wish to apply. Or, the parties can consider a presumption with respect to standards of conduct applicable to management. Under the DBTA, parties address in the business trust agreement the standards of behavior that will apply to one another and to the enterprise.

What about a provision that establishes procedures for shareholder meetings? Under the DBTA, the parties to the business trust are free to determine how, when and even if shareholder meetings will be held. After all, under the DBTA, shareholders do not even have to be given voting rights.

The examples are endless; the lesson is simple. The parties do not need to choose from the traditional corporate law statutory provisions because it is the law of the contract (as provided in the Business Trust Agreement) that controls. The DBTA allows parties to address in the business trust agreement how the organization will operate.

In addition, the business trust agreement should address how members of management should handle existing, and potentially competing, businesses. Likewise, the business trust agreement may address how to deal with opportunities presented to an individual party that would also benefit the overall venture. Under these circumstances, the DBTA provides the ability to anticipate and draft the appropriate provisions unique to the parties’ understandings and the business issues that may be faced by a particular REIT.

Cutting Edge Technology

Available technology provides the ultimate form of flexibility. In Delaware, computers can be linked directly with the office of the Delaware Secretary of State. A business trust (or other entity) can be formed directly through a computer link; no other service providers are required. Certified documents and good standing certificates can be obtained and printed in the time it takes to press the requisite buttons on the computer keyboard. These capabilities, and the flexibility they provide, prove to be enormously helpful when parties are in the throes of a closing.

A Court of Equity

When parties are at the formation stage, possible future litigation is not likely to be a primary consideration. However, problems often arise during operations. When formed as a Delaware business trust, parties automatically receive the benefit of the stability and predictability of the Delaware Court of Chancery.

There are no juries in the Delaware Court of Chancery. A chancellor presides over the dispute. Former practicing lawyers experienced in issues involving business entities and investors and the chancellors have the ability to understand, analyze and evaluate complex business issues and disputes.

Disputes involving a Delaware business trust REIT are heard before sophisticated judges who deal constantly with business and investor disputes. These disputes are not heard by a more typical judge who may deal with problems ranging from traffic accidents to criminal actions in the morning and then have to face your REIT dispute at the end of the day. Having the Delaware Court of Chancery’s depth of experience in dealing exclusively with business disputes is reassuring. The parties can trust in a consistent approach based on well-developed Delaware law.

The Delaware Court of Chancery understands the importance of honoring the terms agreed upon by the parties to an organization. If the agreement addresses the issue in dispute, it should control the situation. If it does not address the issue, the Delaware Court of Chancery will look to the DBTA. Should the DBTA not address the issue, the Delaware Court of Chancery is directed by the DBTA to look to trust law. There is no automatic deference to Delaware corporate law and its potentially formal requirements.

Finally, the Delaware Court of Chancery is a court of equity. As a result, the chancellors can exercise their equitable powers and order actions necessary to reflect modern business needs. Punitive damages are not one of the equitable choices. There are no punitive damages in the Delaware Court of Chancery.

In sum, the Delaware business trust is the vehicle of choice. Just as it has worked for the major mutual funds, the DBTA can be used effectively and reliably to address issues that are of particular concern to REITs.

Ellisa Opstbaum Habbart is partner-in-charge of the Wilmington, DE office of Stradley Ronon Stevens & Young, LLP. She is the co-author of Delaware Limited Liability Company Forms and Practice Manual. In addition, she counsels attorneys and in-house counsel across the country and internationally on legal issues involving Delaware alternative business entities.

MARYLAND: The Forum of Choice

In 1960, when Congress enacted the original REIT sections of the Internal Revenue Code, federal income tax benefits for REITs were extended only to entities operating as trusts. Three years later, in order to create a state law vehicle to take advantage of the new federal tax provisions, Maryland enacted the first state REIT statute, the “Maryland REIT Law.” Abbreviated REIT statutes have since been enacted by California, Illinois, Ohio and Texas. Some states, like Delaware, have enacted business trust statutes that are not specific to REITs.

In 1976, the federal income tax benefits for REITs were extended to corporations meeting the requirements of Sections 856 through 860 of the Internal Revenue Code. Thus, it is now possible to form both a “trust REIT” and a “corporate REIT.” In this regard, there are two principal state law issues: choice of the most appropriate form of entity—trust vs. corporation—and choice of the jurisdiction of formation.

The first important issue in the choice of entity is state taxation. Depending on the amount of the property involved, the differences in state taxes between using a trust and a corporation can be significant. Another important issue is the possible liability of shareholders for obligations of the entity. With a corporation, there is no doubt on this score. With a trust, however, there are occasional decisions raising questions of shareholder (beneficiary) liability. Maryland specifically addresses this issue by providing that a shareholder is not liable for the obligations of a REIT.

Maryland Trust REITs

For a trust REIT, Maryland has a clear advantage over the Delaware general business trust statute for several reasons:

• Maryland has a separate statute that applies to trust REITs.
• In Delaware, a REIT is required to “at all times have at least one trustee which, in the case of a natural person, shall be a person who is a resident of this state or which, in all other cases, has its principal place of business in this state.” There is no such requirement in Maryland.
• Maryland limits the liability of trustees and officers for monetary damages in suits by or on behalf of the REIT or by its shareholders. The Maryland REIT Law permits a trust REIT to indemnify and advance expenses to its trustees and officers to the same expansive extent permitted for directors and officers of Maryland corporations.
• Maryland permits trustees, without shareholder approval, to amend the declaration of trust to cause a trust REIT to continue to qualify as a REIT under the Internal Revenue Code.
• The Maryland Business Combination Act (which includes a five-year moratorium on transactions with an interested stockholder, and supermajority vote requirements for business combinations thereafter) applies to a Maryland REIT, unless it opts out of the statute. The Maryland Control Share Acquisition Act also includes REITs and is believed to have the lowest trigger (10 percent) of any state control share acquisition statute.

Moreover, the unsolicited takeover provisions of the Maryland General Corporation Law (MGCL), as well as the MGCL provisions on director duties in an acquisition of control and validation of poison pills (including “slow hand” provisions), advance notice bylaws and stockholder-requested special meeting procedures are specifically made applicable to trust REITs.

Recognizing these advantages, many trust REITs have formed in Maryland in recent years. While some open-end mutual funds have formed as Delaware business trusts, these are very different entities from REITs. They are basically investment pools—not operating companies—whose shares must be continuously available for sale and redemption. Thus, the Investment Company Act of 1940 permits these companies to forego stockholder meetings and certain votes.

Maryland Corporate REITs

Just as there are for trust REITs, Maryland has several advantages over Delaware for corporate REITs:

• Maryland has no franchise tax. In Delaware, the annual franchise tax for a public company can be as much as $150,000.
• Maryland has a statutory standard of conduct, based on former Section 8.30 of the Model Business Corporation Act, requiring a director to perform his duties in good faith, in a manner he reasonably believes to be in the best interests of the corporation and with the care of an ordinarily prudent person in a like position under similar circumstances.
• The Maryland statute provides that directors are not subject to a higher duty or greater scrutiny in connection with an acquisition of control than in any other context, which is directly contrary to Delaware case law. Further, the MGCL validates just saying “no” to a takeover proposal. The MGCL also validates stockholder rights plans, including “slow-hand” provisions of up to 180 days. Although it has long upheld rights plans, the Delaware Supreme Court has recently invalidated “slow-hand” provisions.
• The board of directors of a Maryland corporation may be given exclusive power to adopt, amend or repeal the bylaws. It is therefore likely that a Maryland court would uphold this same power for the board of trustees of a trust REIT.
• Maryland permits the charter of a corporation to include a provision permitting the board, without stockholder approval, to amend the charter to increase or decrease the aggregate number of authorized shares of stock or the number of authorized shares of any class of stock.
• The MGCL permits a corporation with a class of equity securities registered under the Securities Exchange Act of 1934 and at least three independent directors to elect to be subject to any or all of five provisions. The provisions are a staggered board, a two-thirds vote requirement for removing a director, a requirement that the number of directors be fixed only by vote of the directors, a requirement that a vacancy on the board be filled for the remainder of the full term by the class of directors in which the vacancy occurred, and a majority requirement for the calling of a special meeting of stockholders.
• A Maryland corporation may issue shares of its stock to up to 100 persons without consideration for the purpose of qualifying the corporation as a REIT under the Internal Revenue Code. In addition, a corporation may issue stock, convertible securities, warrants or options in exchange for future labor or services.
• Maryland employs the more modern Model Act test for dividends, permitting a corporation, subject to any restriction in its charter, to make any distribution authorized by its board of directors if, after the distribution, the corporation would not be insolvent in either the “equity sense” or the “balance sheet sense.”
• Maryland case law establishes the universal demand rule in all stockholder derivative suits.

One commonly stated advantage of incorporating in Delaware is that it has a well-developed body of case law, which may lend greater certainty to corporate planning. However, there are several hundred federal and state cases interpreting Maryland corporate law. Maryland has a legislative history of nearly 40 years of specific concern for REITs, and the state’s lawyers and judges are aware of the special legislative concern for REITs. The courts in Maryland are, therefore, likely to approach cases involving Maryland REITs with the same concern that courts in Delaware have tradi- tionally approached cases involving Delaware operating companies.