Due in part to CMBS market requirements, the majority of the owners in tenant in common ("TIC" or "TICS") real estate syndications are single purpose, single member, single asset entities. While this structure works well at the TICS' initial acquisition of the property and financing thereof, problems may arise when the TICS sells the property to a third party purchaser.
Where represented by savvy counsel, the purchaser will seek representations and warranties from its seller, the TICS, as to various conditions relating to the real estate -- for example, parties in possession, environmental conditions and the absence of liens, litigation and governmental violations. Many purchasers, particularly institutional investors such as REITs, will require that such representations and warranties survive beyond the completion of the sale for a specified period. Once the purchaser and the TICS agree on the representations and warranties that will be given by the TICS and the post-closing survival period for the same, the prudent purchaser will ask itself an important question, "What assets will be available to settle any claim relating to such representations and warranties?"
In most cases, each TIC will have sold its only asset -- its tenant in common interest in the real estate -- and either distributed the proceeds to its member(s) or partner(s) or used the proceeds to purchase other real estate as part of a tax-deferred exchange. In either event, the sale proceeds are likely to be unavailable to the purchaser in settlement of any post-closing liability of the TIC (the TIC sponsor should strive to negotiate a "floor" and "ceiling" with respect to the TICS' post-closing liability for breach of representations and warranties claims and any other items for which the TICS retain post-closing liability under the real estate sales contract (collectively, "TIC Post-Closing Liability").
This situation is not unique to TIC syndications, as many commercial properties are owned by single asset entities. However, there are several characteristics of TICS that exacerbate the problem in the minds of potential purchasers.
First, many purchasers rely (whether advisably or not) on the idea that their single asset seller, and more importantly its parent company, will take responsibility for post-closing liability claims for fear of sullying its reputation. There is seemingly little "reputation protection" available with TICS, for whom this transaction may be the last (or only) one in which they participate. Further, while the TIC sponsor may be concerned about protecting its reputation, several factors - see discussion below - hinder the sponsor's ability to "bail out" the TICS in these circumstances.
The second and most significant difference is the number of "sellers" involved. In a TIC syndication, there can be as many as 35 "sellers" of the property, none of whom (in a well-drafted contract) is liable to the purchaser for claims exceeding their respective TIC interest. As a result, the purchaser faces the daunting reality of having to sue up to 35 different entities to recover on any post-closing liability claims.
These factors, when fully considered, may lead the cautious purchaser to discuss with the TICS (or more likely, the TIC sponsor) other security available for use in satisfying potential TIC Post-Closing Liability (Such discussion may also involve changes to the economics of the transaction to account for such lack of security). While creative lawyers and dealmakers may identify other possibilities, the most obvious forms of security that may be considered in these circumstances are (1) indemnity agreements, (2) cash reserves or other cash equivalents and (3) insurance. Each of these is discussed in turn.
Indemnity Agreements
Since an indemnity from the TIC is meaningless given the TIC's lack of assets, there are two possible sources for an indemnity to the purchaser related to TIC Post-Closing Liability -- the TIC's member(s) or partner(s) (each a "TIC Principal") and the TIC sponsor (or any affiliate of the sponsor). There are inherent problems with each of these possibilities.
The TIC Principal is unlikely to be motivated to provide this indemnity, as doing so obviously increases the potential for personal liability in a transaction where typically one of the main selling points is the lack of personal liability to the TIC Principal. Even if this obstacle can be overcome, indemnities from the TIC Principals are unlikely to give the purchaser much comfort for two reasons: (i) the purchaser must be convinced the TIC Principals have sufficient assets to satisfy any claims and (ii) indemnities from up to 35 TIC Principals lead to the same litigation challenges noted above.
For these reasons, the purchaser may request that the TIC sponsor provide the indemnity. While it may be tempting for the sponsor to do so in an effort to resolve the issue (and presumably obtain the favorable terms being offered by the purchaser), a TIC sponsor's indemnity of TIC Post-Closing Liability raises serious tax concerns. If the sponsor were to provide an indemnity relating to the TIC Post-Closing Liability -- for which the sponsor, absent such indemnity, has no liability to the purchaser - such arrangement might be viewed as creating a partnership between the sponsor and the TICS, with the result that any tax-deferred exchange done by the TICS (either in their initial purchase and/or their sale of the property) being disallowed by the Internal Revenue Service.
If the TICS (or the TIC Principals) agree to backstop the indemnity given by the sponsor to the purchaser with their own indemnity or contribution agreement, the potential risk in having their tax-deferred exchange invalidated remains unchanged. The same result may also obtain where the sponsor retains ownership as a TIC and agrees to indemnify the purchaser for all TIC Post-Closing Liability, as any commitment by an individual TIC to assume more liability than for which it would otherwise be responsible gives rise to potential partnership characterization. In these circumstances, the potential risk in jeopardizing the TICS' tax-deferred exchanges may outweigh the benefit of assuaging the purchaser's fears of inadequate security for the TIC Post-Closing Liability.
Cash Reserves
Maintaining cash reserves (generally at the TIC sponsor or affiliated property manager level) adequate to satisfy all (or a significant portion) of the TIC Post-Closing Liability is a relatively simple concept made complex where the TICS want to use their sale proceeds to purchase replacement property in a tax-deferred exchange. Most often, the TICS will need all of their available sale proceeds for their subsequent purchase(s) and do not want to delay receiving such proceeds until the survival period for the TIC Post-Closing Liability has elapsed, which may be later than the 180-day period during which the TICS must acquire their replacement property. Additionally, returning cash to the TICS after the completion of the sale could result in such cash being characterized as "boot" on which the TICS are liable for payment of tax, even where such cash is returned before the TIC has completed its tax-deferred exchange with the balance of the sale proceeds received at closing. The same set of problems will be present if the TICS make a portion of the purchase price unearned until, or only payable upon, the expiration of a specified period post-closing with no TIC Post-Closing Liability claims being made.
A different issue is present where funds in TIC sponsor and/or lender escrows or reserve accounts ("Reserve Funds") are held by the TIC sponsor (or affiliated property manager) after closing rather than being returned to the TICS. In most cases, these funds will have been taxed when earned by the TICS, even though they were "phantom income" to the TICS. As a result, there is in theory no tax-deferral necessary or available on the Reserve Funds and returning the same to the TICS weeks or months after closing should not give rise to any "boot" issues.
However, as a practical matter, the TICS will generally want to use their portion of the Reserve Funds in their subsequent tax-deferred exchange, thus presenting the same "delay in receipt" problem as encountered with sale proceeds. If the TICS can be convinced to forego use of these Reserve Funds as part of their replacement property purchases, making such Reserve Funds available for use in settling TIC Post-Closing Liability claims provides an inexpensive and easily implemented solution to this "adequate security" problem.
A brief discussion on the use of letters of credit or other cash equivalents is warranted. The main obstacle (other than issuance costs) preventing the TICS from purchasing cash equivalents is the security typically required by the issuer. Given their lack of assets, the issuer will likely require a significant cash reserve or other collateral be placed with it as a condition to issuance of such letter of credit, and persuading the TICS to provide the same and collecting it for the benefit of the issuer seems likely to be more trouble that it is worth. If the TIC sponsor pays the issuance fees for the letter of credit and/or provides the requisite security to the issuer thereof, then the same "partnership characterization" potential exists as discussed above with respect to TIC sponsor indemnities.
Insurance
Environmental liability insurance and so-called "M&A representations & warranties" insurance have the potential to be used in mitigating the risk of TIC Post-Closing Liability claims (title insurance can also provide some protection but will generally be obtained in every transaction). Assuming the most significant TIC Post-Closing Liability -- in terms of potential damage and expenses -- relates to environmental pollution, environmental liability insurance can provide the purchaser with a funding source to satisfy such claims (a modified insurance product may also be available to backstop the seller's environmental representations and warranties). A complete discussion of environmental liability insurance is beyond the scope of this article, but such insurance typically does not require a long issuance period and can generally be obtained even where known environmental risks are present.
Mergers and acquisitions ("M&A") transactions frequently feature so-called "representations & warranties" insurance in which the insurer assumes the risk that the representations and warranties of the selling company were untrue when made. A complete discussion of such M&A representations & warranties insurance is beyond the scope of this article, but there are other components of insurance sometimes issued in M&A deals -- i.e., loss-mitigation insurance for contingent liabilities - that could be obtained to provide protection to real estate purchasers.
M&A representations & warranties insurance has not been widely used in "pure" real estate transactions. However, this insurance has been investigated by at least one TIC sponsor. The draft policy issued to this TIC sponsor was based on a M&A representations & warranties policy (each M&A representations and warranties policy is different to account for the specific representations and warranties being insured).
In large part because of the novelty of the concept, the TIC sponsor was unable to obtain a policy that would have provided adequate coverage for the purchaser. However, if an effort is made to educate insurers on the coverage being sought, the unique features of the TIC ownership structure and the relatively low level of risk involved (frequently claims will only be allowable where the TIC had knowledge of a condition and failed to report the same, and the TICS will generally be the least-informed parties in the transaction), there is no reason that M&A-style representations and warranties insurance policies should not be obtainable for TIC deals.
In summary, the issue of providing security to purchasers for post-closing liability of single asset TICS is likely to be one that vexes many TIC sponsors in the future, particularly as more TIC deals reach the end of their holding periods. Some of the typical types of security provided in real estate transactions for post-closing liability - indemnity agreements and escrows of sale proceeds -- cannot be easily implemented in TIC deals. However, there are other forms of security -- sponsor/lender reserve funds, environmental liability insurance and M&A representations and warranties insurance -- that offer considerable promise for use in providing security for the post-closing liability of TICS.
