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

The amendments to Form 8-K adopted earlier this year by the Securities and Exchange Commission became effective on August 23, 2004. We summarized these amendments, and the compliance challenges they present, in our REIT Alert Preparing for the Form 8-K Accelerated and Expanded Reporting Requirements (July 22, 2004).* Public real estate operating companies face several questions that are specific to their business operations as they apply the new Form 8-K reporting requirements. Among these questions are:

• 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?
• 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?
• How does the requirement to report material asset impairments apply to dispositions of real estate assets?

The discussion that follows refers specifically to public REITs, but may apply to REOCs and other companies engaged in real estate activities if they are subject to SEC reporting requirements.

Item 1.01 of Form 8-K requires companies to report when they enter into or amend a material definitive agreement not made in the ordinary course of the company’s business, and to file 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 file the agreement as an exhibit, relying on the fact that the agreement was made in the ordinary course of its business,^† and our July 22 REIT Alert suggested that this interpretation could be available. Recently, however, members of the staff of the SEC’s Division of Corporation Finance have advised us that, when interpreting the new disclosure requirements of Item 1.01 (and Item 1.02, which applies to terminations of material definitive agreements), the staff 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 staff has historically applied this position to require REITs and other companies engaged in real estate activities to file financial 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 staff has also applied this position to require REITs to file Form 8-Ks to report significant 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 staff’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 staff 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 definitive 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 file financial 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 "significant" real estate assets (generally, those at the 20% level or more) under Items 2.01 and 9.01 (formerly Items 2 and 7, respectively).

As noted earlier, Item 1.01 of Form 8-K requires companies to report when they enter into or amend a material definitive agreement not made in the ordinary course of business, and to file 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 staff 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 file 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 significant liability if it is not satisfied 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 defines a material definitive 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

. . . a material definitive 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 satisfied [emphasis added].

Item 1.01 therefore applies at the time when the parties enter 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 Section 1.01 do not extend to non-binding letters of intent, even if they contain binding provisions (such as confidentiality 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:

• 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;
• 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
• The obligation of the buyer to purchase the property does not become enforceable by the seller until the due diligence condition has been satisfied 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 specified date or, in other cases, that the buyer will give written notice to the seller that it has completed its due diligence and intends to proceed with the acquisition.**

In light of the definition of "material definitive 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 generally 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, affect 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 first 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 different results, due to the peculiar nature of this type of agreement.

• As a general matter, if the REIT determines that the agreement is a material definitive agreement under the Form 8-K definition because it provides for enforceable rights or obligations that are material to the REIT, Item 1.01 requires the REIT to file a Form 8-K report within four business days after entering into the agreement.
• However, if the REIT determines that the enforceable rights or obligations contained in the agreement are not material to the REIT when it first enters into the agreement, then Item 1.01 would not require a Form 8-K report at that time.
• If the REIT determines that no Item 1.01 report is due when it first 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 definition of material definitive agreement in Form 8-K. Whether an agreement meets the requirements of that definition 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 first 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 sufficient 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 first enters into the agreement is such that its rights and/or obligations under the agreement are not material even if the transaction is of significant magnitude.

In these latter cases, we note that the result would be similar in effect to the treatment of the transaction under Rule 3-14, under which real estate acquisitions that would be "significant" 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 satisfied 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 satisfied or waived because the probability that the buyer would exercise its right to acquire the property is not sufficiently 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 first 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 satisfied, 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 staff will depend largely on the facts and circumstances of the specific agreement and transaction.

The REIT should assess the risk that SEC staff or investors may reach different conclusions on materiality with the benefit 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 file a required Item 1.01 or 1.02 Form 8-K report, especially where REIT does not fall within the safe harbor for late Form 8-K filings 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 different 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 first 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 definitive 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 fit 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 first 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 definitive 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 staff’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 specific SEC staff 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 July 22 REIT Alert, SEC rules contain a variety of quantitative standards in different contexts, but these vary significantly. Further, SEC Staff 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 financial 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 specific 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 definitive 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 definitive 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 satisfied. 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.

Additional Practical Considerations. When REITs file a Form 8-K to report entry into a material definitive agreement, we expect that in many cases they will choose to file the purchase and sale agreement as an exhibit with the Form 8-K in order to eliminate questions about whether deferring filing the exhibit might have affected the completeness of the disclosure in the Form 8-K. However, SEC rules permit companies to postpone the exhibit filing until their next periodic report is due.

It is currently unclear how the new Form 8-K reporting requirements will affect 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 confidentiality provisions when negotiating purchase and sale agreements in order to ensure that there will not be a conflict between those provisions and any potential Form 8-K reporting obligations that may apply to the REIT.

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 file a report under Item 2.06 if the conclusion concerning the material charge is made in connection with the preparation, review or audit of financial statements at the end of a fiscal 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 financial 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 satisfied, the REIT may be required to file 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.

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 filing, the effective scope of the safe harbor has a number of significant limitations. Many of these are summarized in our July 22 REIT Alert. One limitation of the safe harbor is that it ceases to apply on the due date of the first 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 filing 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 financial reporting.

The new Form 8-K rules require continuous monitoring of many different aspects of a REIT’s business, finances 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 difficult 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.

* Copies of that REIT Alert may be obtained on the Goodwin Procter LLP website under "Knowledge Center>Goodwin Publications> REITs and Real Estate Capital Markets."

† 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.

** These are, of course generalizations. Real estate purchase and sale agreements vary significantly 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.

John O. Newell contributed to the preparation of this article

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