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October 22, 2018

REIT Advisor – October 2018


Five Reasons to Consider an IP Audit

Kathleen E. McCarthy

An IP audit can help ensure that policies, contracts, and procedures are up-to-date and identify potential problems to be fixed, thereby reducing litigation risks. For REITs in particular, an IP audit can help in at least five areas:

  1. New Trade Secret Laws May Affect Non-Compete & Confidentiality Contracts.

    New laws1Three years ago, the federal Defend Trade Secrets Act (DTSA) became law, supplementing existing state claims with a federal civil cause of action for trade secret misappropriation. 18 U.S.C. § 1831 et seq. Massachusetts passed a new trade secret law in August 2018, leaving New York as the only state without a statute, although New York common law claims are available. See report on new Massachusetts statute at https://www.bna.com/massachusetts-adopts-uniform-n73014481815/.  and increased job-hopping have led to an uptick in trade secret disputes and litigation. For example, trade secret misappropriation litigation is now underway between CBRE and its former Los Angeles-based “Team Rizika” (now operating as Beta Retail) with arguments in the pleadings to date focused on the terms of the parties’ agreements and the downloading of information from Box.com accounts.2CBRE, Inc. v. Rizika, Case No. 2:18-cv-01730-MWF-AS (C.D. Cal.).

    A trade secret related audit could include (a) identifying any potential trade secrets so that they can be properly managed and kept secret; (b) securing or amending nondisclosure and non-compete agreements for key personnel as needed. Defend Trade Secrets Act whistleblower protections require the relevant employee agreements to include specific notices. The length and reasonableness of a non-compete agreement should be assessed under the applicable state law. Agreements should be periodically reviewed to ensure that they reflect current company ownership and employee responsibilities. Companies seeking to hire employees from competitors should develop intake procedures to ensure that any agreements are complied with and that files and data belonging to the competitor do not come along with the new employee. 

    While REITs may have legal counsel with responsibilities specific to deals, employment, and even social media, trademarks, and advertising, rarely is counsel designated as having responsibility for protecting or monitoring a company’s trade secrets. Appointment of trade secret counsel as well as an audit of the company’s trade secrets, relevant policies, and agreements can help secure available protections and reduce the risks of a dispute.

  2. Vendors Are Doing Their Own Audits.

    Dozens of cases have been filed by vendors against companies sharing passwords or access to the vendor’s data, information, reports, photographs and analysis beyond the limits set by the parties’ contracts. In one notable case 15 years ago, a jury awarded nearly $20 million in statutory damages for distribution of written investment analysis reports beyond the parties’ contract terms.3 Lowry’s Reports, Inc. v. Legg Mason, Inc., 271 F. Supp. 2d 737 (D. Md. 2003). The case settled before an appeal was decided. Desire to meet a deadline or the ease with which information can be shared can lead even good-intentioned employees to go beyond the applicable contract terms and company policies. Technology today makes it possible and even easy for the vendors to remotely monitor and audit company use of the vendors’ platforms, with any significant changes in user access or behavior flagged for review by the vendor. Vendor contracts are not uniform and the parameters applicable to use of different platforms or reports vary depending upon the terms of use in the applicable contract, which can be confusing for employees when some information and reports can be shared widely within the company and other information and reports cannot be so shared. An audit can help identify what contracts are currently in play, what terms apply, and whether new training and procedures should be implemented to ensure compliance. Issues can be flagged so that revisions to the contract language are negotiated before renewal and contracts more accurately reflect how the company wants to use the information.

  3. Photographers Are Filing Law Suits, Lots of Law Suits.

    Hundreds of cases have been filed by photographers seeking recovery for unauthorized use of photographs on company websites. Even among some design and marketing professionals, there can be misunderstandings regarding the right to use images easily sourced online. Photographers own the copyrights in their photographs, even if the photograph appears in search engine image results. Stock photography licenses are generally inexpensive but also have specific usage terms and termination dates. Unless there is a written assignment or other agreement such as a license permitting the use, in most circumstances, businesses using photographs commercially without permission could well be sued. An audit can help track down what licenses are in place and what terms apply, as well as whether images are being used without a license so that those images can be either licensed or replaced.

  4. Social Media and Domain Name Accounts Are Owned / Controlled By Those Who Know the Passwords.

    A company’s website and corresponding email account can be held hostage by a former consultant, website designer, or employee, if that person registered the domain, has all of the relevant information to access the account, and refuses to turn the information over to the company. In one reported case, the consultant demanded $10,000 for the information and then redirected the company website to a pornographic site when the company refused to pay this ransom. In that case, the federal authorities were called and the consultant was arrested.4USA v. Tso, Case 2:16-cr-01502-DGC (D. Ariz.), indictment filed December 13, 2016. This problem can occur with social media accounts as well as with domain names. BH Media Group recently sued a former employee on various grounds, including trade secret misappropriation, asserting that the former employee had changed the login information on a company Twitter account during his employ and then took the account and its thousands of followers with him when he left.5BH Media Group, Inc. v. Bitter 7:18-cv-00388-MFU (W.D. Va.), complaint filed August 6, 2018  Whether or not the Twitter account details count as “trade secrets” is subject to debate, but regardless, BH Media Group had to file suit to try to regain control over a Twitter account it considered to be important to its business. An IP audit can help prevent the need to go to the authorities or to court to keep the company’s website and social media pages within the company’s control. Any important accounts can be identified and steps taken to secure control and access.

  5. Trademarks Are Territorial.

    Trademarks can be overlooked when expanding a business and opening new offices in new locations. But trademarks are territorial and the right to use a mark or name in one jurisdiction does not guaranty that the mark or name can be used elsewhere. If the company has grown or is planning to grow, perhaps through a series of acquisitions in a new region, an IP audit can identify gaps in the company trademark portfolio and potential trademark problems in jurisdictions of interest, so that a plan can be put into place to allow the business to either use the same marks and names or to clear and register jurisdiction-specific marks and names if needed.

Externally Managed REITs – Identifying and Minimizing Conflicts

Tony Rothermel, Spencer Johnson and Robert Grue

REITs increasingly attract investors across the world, with a global market cap of over $2 trillion U.S. dollars. That number represents a growth rate of more than 200% since just 2010. Between 2010 and 2016, the REIT market has grown over 146% in the U.S. alone, the most mature REIT market in the world. Given the rising popularity of REITs as an investment vehicle and the introduction of institutional investors, REIT management structures and fees have encountered increasing scrutiny by investors in recent years. 

One area of focus is the decision between internal and external management structures. In the 1980s, U.S. REITs tended to contract the management function primarily to outside advisors and managers. In contrast, U.S. REITs now favor internal management. In spite of the trend towards internal management, around 15% of U.S. REITs remain externally managed. Often, these are non-traded REITs that have yet to list on an exchange (and thus are not subject to the heightened scrutiny of large and influential investors). At this stage, sponsors (i.e., the individuals who organize the REIT in exchange for equity capital) tend to favor a sponsor-affiliated firm to manage the REIT. However, the vast majority of these REITs internalize their advisory and management functions prior to listing on an exchange, commonly known as an “internalization” transaction. While a REIT may internalize management for a number of reasons, a primary influence is the public’s perception of external management structures as afflicted with potential conflicts of interest.

Non-traded REITs often feature advisors and managers (who are responsible for the most important decisions of the REIT, including acquisition of investments and oversight of the portfolio’s operations) who share common ownership with the sponsor. For example, an article published in The Journal of Wealth Management featured a structure chart of Inland American Real Estate Trust, Inc., which revealed that the individuals who owned the sponsor also owned all entities that provided services to the REIT. The issue is that the sponsor then effectively can dictate the fees paid by investors to the service providers and reap the benefit of those fees. Of particular concern, REITs often compensate advisors with sales commissions and acquisition and investment fees. Those commissions and fees may incentivize external advisors to increase debt and to acquire additional, and potentially unnecessarily risky, assets in an attempt to maximize fees. Research of externally managed REITs suggests there may be validity to these concerns, as one study by Ernst & Young found that externally managed REITs raised 30% of their current market capital through subsequent equity raises vs. 13% for internally managed REITs. Additionally, management fees for externally managed REITs typically exceed 1% of net asset value while fees for internally managed REITs are often less than 0.5%. This is not to say an external management structure is without its benefits, which include the potential of broader management resources, pipeline opportunities and efficiencies of scale for the larger REIT sponsors. 

The potential conflicts of interest often cited in connection with external management structures have also been the focus of recent shareholder litigation. In the 2017 case H&N Management Group, Inc. & Aff. Cos Frozen Money Plan v. Crouch, shareholders filed a derivative suit against an externally-managed REIT, alleging, among other things, that the board of directors had breached their fiduciary duties by renewing a management agreement annually and approving an internalization transaction whereby (i) the Compensation Committee was not adequately informed of the terms and potential impact of the management agreement renewal (meeting only briefly as a formality), (ii) the Compensation Committee could not make an objective decision on the renewal given conflicts of interest (non-renewal would directly affect another REIT that shared the same manager and board members), (iii) the Compensation Committee did not retain an independent advisor to evaluate the renewals, (iv) the Compensation Committee received information only from a self-interested manager, and (v) as to the internalization approval, the board formed a joint committee (between the two REITs) that allowed a conflicted executive to lead the internalization transaction (that executive was an officer of the manager and of the two REITs and, consequently, would receive a direct benefit by approving the transaction). The Delaware Court of Chancery found the shareholders had adequately alleged that the board was uninformed in renewing the management agreement and that they had made sufficient allegations to overcome a motion for summary judgment as to whether the directors were adequately informed about the internalization transaction.

Crouch provides us with several key takeaways. In an effort to minimize potential conflicts of interest, the Boards of externally managed REITs should take time to consider a proposed internalization transaction, incorporate disinterested parties, including independent advisors, in the decision making, and ensure that independent advisors are properly managed throughout the process. In particular, a Board forming a special committee should choose objective members carefully, provide a clear mandate, promote the use of independent advisors and legal counsel, and encourage a process that results in arm’s length bargaining (including the ability of the committee to investigate proposed activities subject to potential conflicts of interest). By employing these practices, REIT Boards may provide enhanced value to their shareholder base and also avoid financially costly and time-consuming litigation.