*This is the first part of an eight-part series covering the commercial and legal considerations of REIT listings in India
Setting up a Real Estate Investment Trust (REIT) involves a number of synchronised actions by all parties to the REIT including the Sponsors, Sponsor Group, Trustee, Manager, Special Purpose Vehicles (SPVs) and their respective stakeholders.
Apart from settling the trust, one of the principal obligations of the Sponsors includes contribution of the initial portfolio of assets to the REIT (immediately preceding the closure of the public issue). While the assets may be transferred through various means, the favoured (and tax efficient) option is for the Sponsor to swap its shares in the SPVs housing the portfolio assets in exchange for REIT Units. Thus, the REIT becomes the shareholder and owner of the assets, the Sponsors become Unitholders of the REIT and the REIT Manager (which is typically controlled/ managed by the Sponsors), is entrusted with the responsibility of managing the affairs of the newly acquired assets, through an investment management framework.
The extensive restructuring and M&A activity that necessarily precedes a REIT IPO makes the REIT's transition into the listed regime more complex, requiring all existing and familiar processes to fall away and give way to a new management, new hierarchy, new model of governance and a new order. The Sponsors who were hitherto responsible for business decisions of the portfolio assets have to step away and make room for the newly appointed Manager. However, Sponsors ceding control is not quite as simple as severing the proverbial umbilical cord as the erstwhile management continues to remain in the fray, albeit in a different role – as Unitholders. With a lack of regulatory clarity and a multitude of stakeholders having overlapping roles and obligations – navigating conflicting allegiances assumes significant importance.
Shareholders v. Unitholders – Whose Interests to Protect?
The board of directors of the Manager are most likely to find themselves in a piquant position upon listing given the divergent nature of their obligations. While the Manager is required to protect the interests of the REIT's Unitholders under the REIT Regulations, the board of the Manager also owes a fiduciary obligation to its shareholders under company law. The interests of the Manager's shareholders (which in most cases is likely to comprise the Sponsors) and that of the Unitholders need not always be aligned.
The board of the Manager is likely to be faced with a number of conflicting prospects from time to time – such as evaluating proposals for acquisition/ sale of assets from or to the Sponsor, exercising the REIT's right of first offer / right of first refusal arrangements with the Sponsor, approving terms of borrowings from the Sponsor, and exercising potential indemnity claims against Sponsors under the asset acquisition agreements in the event of a breach.
In case of a conflict of interest, there is no clear legal mandate as to whether the directors are expected to balance interests of both stakeholders or prioritise interests of one over the other. While jurisdictions like Singapore have expressly codified the directors' obligation to prioritise interests of Unitholders over the interests of the REIT Manager and its shareholders, Indian regulations remain silent.
This issue is further exacerbated if there are independent directors on the board of the Manager. The REIT Regulations mandate that 50% of the board of the Manager comprise of independent directors – ostensibly to protect the interest of Unitholders. Paradoxically, the independent directors are appointed by the shareholders of the Manager (and not the Unitholders whose interests they are mandated to protect) and can therefore also be removed by the Manager's shareholders – providing little regulatory protection in the discharge of their duties towards Unitholders.
Admittedly, the REIT Regulations have an explicit built-in mechanism that acts as a check on the functioning of a Manager by authorising Unitholders to remove the Manager for not performing its duties. Practically, though, given dispersed Unitholding patterns, dependence on the management for business continuity, challenges associated with finding a replacement manager, impact on stock price, as well as regulatory approval for changing the Manager, Unitholders are unlikely to retire the Manager in a hurry. Further, this mechanism does not address the lacuna in the regulatory framework with respect to a director's statutory liability to different sets of stakeholders.
Blurred Lines – The Problem with Wearing One Too Many Hats
Given the new order of roles and obligations of the REIT's various stakeholders as a result of the IPO, some stakeholders are likely to end up donning multiple hats – as common directors on the boards of the Sponsors and Manager or Sponsors and SPVs, hence representing diverse stakeholders. While some jurisdictions bar Sponsors/ Sponsor nominees from holding executive positions on the board of the Manager, Indian regulations only restrict interested parties from voting on matters where they are conflicted. This does not however preclude situations of conflict which are not put to vote. For instance, since the REIT and its Sponsors will continue to operate in the same line of business, common directors when approached with business proposals will be faced with the predicament of evaluating prospects suitable for two diverse interested parties.
Further, Sponsor directors on the board of the Manager/ SPVs are likely to be in perpetual possession of material information not available to other Unitholders. With the SEBI regulations on insider trading yet to take into account REIT structures, Sponsors trading in Units while in possession of such information must be done with due care and caution, with appropriate walls and safeguards to ensure compliance with the REIT's internal trading code and the SEBI regulations on insider trading.
Traversing the Legal Conundrum
While structuring a REIT, it is imperative that potential situations of conflict/ divergence are anticipated and assessed early on in the transaction and that the REIT and its stakeholders are armed with well-thought-out decision-making frameworks, a governance model with defined reporting structures, and policies to help them deftly navigate these legal quandaries. With no 'one size fits all' answer, each framework will need to be carefully tailored to suit the transaction structure, commercial requirements as well as the regulatory intent and expectation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.