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Recent developments in Hong Kong and Singapore are stimulating growth in REIT activity. But the regulatory environment can still be improved, argue John Sullivan and Hayden Flinn.
This article was published in International Financial Law Review (IFLR) March 2006.
Introduction
Now is an exciting time for real estate investment trusts (REITs) in Asia. There are eight REITs listed in Singapore and three in Hong Kong, including the much publicised Link REIT. There is increasing investor demand for securitised property and strong potential for growth, given the current low levels of property securitisation in the region.
The regulatory environment is also changing fast. There have been important developments in 2005 in Hong Kong and Singapore. But there are also a number of aspects of the regulatory environment that can be improved.
The evolution of REIT regulation will continue as both Hong Kong and Singapore position themselves as a hub for new regional REIT listings (particularly for China), and as investor appetite for new products continues to grow.
This evolution will be quick – much faster than at the same stage in mature markets like Australia and the US. And regulators would do well to heed the experience in those markets, where many of the emerging issues for Hong Kong and Singapore were thought through during the development of REITs in the 1980s and 1990s. This is particularly the case in Australia, which uses similar trust-based structures to those used in Hong Kong and Singapore, and can provide several clear pointers as to how regulators in the region’s newest REITs markets might help those markets grow.
The regulatory environment
The regulatory framework for REITs in Singapore was established in July 2002 with the issue of the first edition of the Property Fund Guidelines. REITs are administered by the Monetary Authority of Singapore (MAS) and the SGX-ST. They are governed by the general securities laws as well as specific regulation – the Code on Collective Investment Schemes and the Property Fund Guidelines.
In Hong Kong the framework was established later, in August 2003, with the issue of the Code on Real Estate Investment Trusts. REITs come under the auspices of the Securities and Futures Commission (SFC) and the Hong Kong Stock Exchange (HKSE). Like Singapore, REITs are subject to additional regulation– the Code on Real Estate Investment Trusts.
REITs are heavily regulated in both jurisdictions. In particular, there are detailed rules on their legal structure, the REIT manager and trustee, investment restrictions, gearing limits and minimum distribution requirements.
Recent changes
Hong Kong and Singapore have both made positive changes in 2005. They have cleared the way for overseas acquisitions by REITs and introduced greater flexibility in relation to borrowing. This has been balanced by enhanced corporate governance and disclosure requirements and increased oversight of managers and trustees.
The key changes to the Hong Kong REIT code, introduced in June 2005, include allowing REITs to invest in overseas real estate and not just in Hong Kong. To facilitate this, the REIT need no longer own 100% of all real estate although it must have majority control of the properties. However, requirements of managers have increased and detailed due diligence investigations on investments have been mandated. There must also be enhanced disclosures in offer documents and by the manager regarding overseas markets and the associated risks. Meanwhile, the maximum borrowing ratio for REITs has increased from 35% to 45% of the total gross asset value of the trust.
The main changes to the Singapore Property Fund Guidelines, introduced in November 2005, are:
- increased requirements for REIT managers, such as minimum capital requirements, senior management experience and mandated activities to be performed in Singapore. Longer term, MAS plans legislative changes to introduce a specific licensing framework for managers similar to Hong Kong and Australia
- enhanced corporate governance. Importantly, trust deeds must allow removal of REIT managers by approval of 50% of unitholders present and voting (with no unitholders excluded from voting)
- expanded requirements for interested party transactions. Two independent valuations are now required before an interested party transaction occurs
- increased disclosure requirements for acquisition and disposal fees to REIT managers, as well as of REITs’ tenant profiles
- the easing of overseas investment by allowing partial ownership of properties through special purpose vehicles. This is subject to various investor protection safeguards
- an average leverage limit of 35% of a REIT’s total asset value, increasing to 60% where the REIT discloses a credit rating from a major rating agency, and
- approval for REITs to develop properties they intend to hold on completion, subject to an overall limit of 10% on developments and investment in uncompleted properties.
Improvements
Yet, a pressing need for improvements in the rules remains. There is no legislation or regulatory oversight in relation to REIT takeovers in either Singapore or Hong Kong. And none of the REITs in Singapore or Hong Kong have provisions in their trust deeds to regulate takeovers.
This issue was highlighted recently by press speculation of a possible takeover of the Link REIT. The threat of takeover matters both to investors, who may be disadvantaged, and also to REIT managers whose valuable management rights maybe affected. For example, a successful takeover could allow the acquirer to remove the REIT manager by exercising the voting rights attaching to the units bought.
As a trust, REITs have a different legal structure to a company. However, there are compelling arguments to treat them equally for the purposes of takeover law.
Economically, there is little difference between a listed property company and a listed property trust and, from the investor’s point of view, there is little difference between holding shares in a company or units in a trust. Their basic rights are very similar (as to voting, distributions and trading their securities).
The core principles that underpin takeover law for companies are equally relevant to trusts. Investors in both should be given all information to make an informed decision about a bid. This includes information about the bidder’s identity, the offer terms and the effects on the entity. And investors should have a reasonable opportunity to participate equally in any control premium and other benefits.
Certainly, if there were to be a takeover of the Link REIT, the 50,000 small investors who might miss out on a share of any control premium would take little comfort in the argument that a slightly different legal structure should deprive them of equitable treatment.
The anomaly becomes even clearer when you consider that in both Singapore and Hong Kong property is commonly held through company structures. Shareholders in the property holding company have the full protection of takeover law. Unitholders in a REIT have none.
Small improvements came in July last year when Singapore securities law was amended to include substantial holder notification provisions (at a 5% level) for REITs listed on SGX-ST. And in December, the Hong Kong SFC released a policy requiring REITs to include substantial holder provisions in trust deeds (also at the 5% level).
These changes bring Singapore and Hong Kong into line with other markets. But the Hong Kong disclosure regime for interests in REITs should be enacted through statutory provisions. And, while substantial holder provisions are helpful and part of the wider takeover regulation package, they do not protect investors enough.
The Australian experience
Takeover legislation was introduced for listed property trusts in Australia in 1999. During the 1980s and 1990s, the absence of takeover legislation was dealt with by trusts including provisions in trust deeds that replicated the takeover provisions applicable to companies.
This contractual approach proved less effective than legislation. From a market perspective, it was less satisfactory - there was a lack of uniformity because each trust had its own particular takeover clause. As a contractual mechanism, it could only bind registered unitholders, which left avenues for avoidance. The provisions might not catch parties acting in concert to acquire units, nor investors holding through nominees. In addition, the statutory role of the regulator in relation to company takeovers had to be replicated for the trust using the trustee or the manager, which raised potential conflict of interest issues.
There were a number of high-profile takeovers of listed property trusts considered by the courts. The courts were prepared to give effect to trust deed takeover provisions, although outcomes depended heavily on the facts and the wording of the provisions.
Against this background, a series of legislative inquiries considered the issue. In 1998, a senate inquiry recommended extension of takeover laws to listed trusts. And in 1999 the takeover law was changed to apply equally to companies and listed trusts (effective from March 2000). Since then, there have been several high profile takeovers under the new regime, which has operated effectively.
The way forward
Based on the Australian experience there is a case for introducing formal regulatory controls on takeovers of REITs in Hong Kong and Singapore in an equivalent way to listed companies. In both jurisdictions, this would require amendments to the takeover codes.
An alternative, but less effective, solution would be to mandate in the REIT Code/Property Fund Guidelines a standard takeover clause for all REIT trust deeds. The clause would provide sanctions for breach and a personal right in all unitholders and the manager/trustee to enforce them. This would introduce contractual takeover protection but without some of the key difficulties encountered in the Australian experience.
Failing regulatory change, REIT managers should give serious consideration to including provisions in their trust deeds to at least confer minimum protection.
Other improvements
Conversely, as a REIT market track record develops in Singapore and Hong Kong some of the restrictions now imposed may usefully be relaxed.
For example, REITs must have very detailed investment restrictions. All, or at least the great majority, of a REIT’s assets must be held as real estate. But the Australian experience suggests that REITs can be easily adapted to accommodate wider asset classes like infrastructure. An infrastructure fund can be listed as a company in Singapore but not as a REIT in either Singapore or Hong Kong.
Relaxing investment restrictions to allow infrastructure REITs would be beneficial in terms of overall market growth. It would also allow new products to be offered to infrastructure investors in both markets, who could enjoy the diversification, liquidity and other benefits of the REIT structure.
A single, responsible entity
Responsibility for operation of a REIT is divided between a manager and trustee. This structure is intended to protect investors. It envisages that the trustee will supervise the activities of the manager who has day-to-day control.
However, the structure is complex and can create confusion for investors, and between the two parties, as to who is ultimately responsible. It reduces the accountability of both to investors and allows blame shuffling if something goes wrong. There were a number of high profile Australian Court cases involving listed property trusts where this was an issue.
After extensive review, the similar trustee/manager system that applied in Australia was replaced in 1998 with a single responsible entity structure. This has worked well. While not an immediate priority, there would be advantages in adopting such a structure longer term in Hong Kong and Singapore.
Removal of pre-vetting
Securities law in both Singapore and Hong Kong requires pre-vetting by the regulators before an offer document can be issued to the public. This is time consuming, particularly for REITs that have high disclosure burdens and are prescriptively regulated.
An alternative approach is to place the onus on REIT managers to themselves determine the disclosures required to satisfy prescribed disclosure standards, but subject to a regulatory stop order power and sanctions if the offer document is inaccurate or incomplete. This approach, which is a feature of some regulatory systems, is consistent with a more market-driven approach to disclosure.
Clear offer documents
Similarly, under current practice, offer documents in both Hong Kong and Singapore tend to be very long, because issuers try to cover all information that might be required by regulators and investors. This is particularly evident in relation to REITs. For example, the English versions of the offering circulars for the three REITs listed on HKSE all exceeded 400 pages. This is more than twice the size of comparable documents internationally.
Regulatory encouragement for shorter, clearer and better laid out offer documents would make them more useful to investors. Allowing incorporation by reference for easily accessible public information would assist this objective as well.
John Sullivan is a Sydney M&A partner with Mallesons Stephen Jaques, Hayden Flinn is a senior associate based in Mallesons Hong Kong office. The authors would like to acknowledge the contribution of Tim Blue, Partner and Simon Cowan, Solicitor to the preparation of this article.