Real estate investment trusts are providing a glimmer of hope for Asia's troubled property lawyers. But can they resurrect an ailing industry? Stephen Mulrenan reports
History of REITs
1961
Created by the USCongress
1971
General Property Trust (GPT) begins in Australia, Asia-Pacific's first REIT
2000
May Singapore releases REIT guidelines
2000
November Japanese amendments to Investment Trust Law pave way for Asian REITs
2001
September Japan's first trusts, the Office Building Fund of Japan and the Japan Real Estate Investment Corporation, started trading on the Tokyo Stock Exchange
2002
Korean legislation passed to form asset management companies (which in turn could launch REITs), but to date no 'normal' REITs are listed
2002
May Singapore's first REIT, CapitaMall Trust, launched
At about 9.30pm local time on 9 October, Taipei 101 - aka Taipei Financial Center - topped out at 509.2 metres when its final spire segment was raised into place.
In doing so, the 101-storey tower superceded Kuala Lumpur's Petronas Towers and officially became the world's tallest building.
Although Taipei 101 will only hold the title for the next three years - until Jin Mao Building opens its doors in Shanghai - the Taiwanese government knows a good PR vehicle when it sees it.
Back in July, it announced plans to allow the owners of Taipei 101 to securitise its annual rental of NT$120m (US$3.6m) in what will be the jurisdiction's first REIT. The 101 REIT expects to launch early in the New Year when the ministry of finance finalises regulations and implementation procedures.
The Government hopes it will bring much needed liquidity to the real estate market, enabling investment in diverse real estate assets.
But Taiwan is just the latest jurisdiction in Asia to jump on the REIT bandwagon. Successful launches of REITs have occurred in Singapore, Japan, South Korea and Australia, while recent developments in China, Hong Kong, India and Malaysia point to the possibility of REITs in these markets.
Asian taste?
Property ownership is traditionally seen by Asians as the key to wealth and power.
Offering liquidity, security and diversity benefits, real estate securities potentially enable a broader base of Asian investors to own tangible assets in a market that has experienced little trading in recent years. And governments can play their part in nurturing a successful REIT environment by establishing a strong legislative framework and offering incentives.
The level of interest was clearly on show recently at the REIT World Asia 2003 Conference in Singapore. Held at the Hilton Hotel from 20-22 October, the event lured sponsors of the calibre of Deutsche Bank Group, HSBC, and Macquarie Bank.
"Just have a look at the delegate list," said Hilary Cordell of Paul Hastings Janofsky & Walker - official legal sponsor of the Conference.
Speaking on the first day of the Conference was Pua Seck Guan, CEO of CapitaMall Trust Management Ltd (CMT).
In addition to discussing the regulatory hurdles to REITs and investor education, he also provided an insight into the launch of REITs in Singapore. And he should know. CMT was Singapore's first REIT and was a mixture of suburban retail malls and a specialised IT retail centre. It began trading on the SGX in July last year.
Singapore's second, the Ascendas REIT (A-REIT), consisted of a pool of industrial and business park buildings and made its debut on 19 November 2002. Kok Huat Goh, CEO of Ascendas MGM Funds Management Ltd, was also on hand at the conference to discuss what can next be expected in the Singapore real estate cycle.
Both the CMT and A-REIT achieved a better-than-expected subscription rate of about five times for their initial public offers, signifying a major interest in these new investment vehicles. And this has been the case since the Monetary Authority of Singapore (MAS) released guidelines for REITs in May 2000.
The first two trusts - or S-REITs - were launched by government-linked companies (GLCs), with the overall sense of optimism for Singapore's economy boosting demand and prices in the property sector.
This has continued unabated into 2003. In July, Singapore's (and Southeast Asia's) largest banking group, DBS Bank, scored a coup by snatching Fortune REIT, the maiden property trust vehicle of Hong Kong billionaire Li Ka-shing, for listing on its exchange. Launched by Hong Kong's Cheung Kong (Holdings) Ltd, Fortune REIT was the first Singapore-listed property trust investing in Hong Kong properties and the first cross-border property trust in Asia.
The offer proceeds - an approximate total of HK$1.04bn (US$133m) - together with monies raised from the subscription of units by Cheung Kong and other strategic investors, were primarily used to fund the purchase of the five Hong Kong shopping malls from Cheung Kong.
Using lawyers out of both its Hong Kong (led by Clive Rough, head of Asian structured finance) and Singapore offices (managing partner David Simpson), Freshfields Bruckhaus Deringer advised DBS Bank as global coordinator, lead underwriter and sole bookrunner on the deal.
"It was an exciting opportunity to have worked with DBS and Cheung Kong on this deal as it's the first ever REIT transaction involving Hong Kong properties," Rough said.
Other advisers included Baker & McKenzie acting on behalf of Cheung Kong, Allen & Gledhill (as to Singapore law) and Linklaters (as to Hong Kong law), which acted for the manager of Fortune REIT, and Allen & Overy's JLV firm in Singapore, Shook Lin & Bok, which acted for Bermuda Trust - the trustee of Fortune REIT.
Although REITs constitute a very new investment product in the Singapore market, the success of the first two S-REITs suggest that local retail investors have been quick to appreciate their benefits. With the success of Fortune REIT, and spurred by talk of falling behind arch-rival Singapore, Hong Kong's Securities and Futures Commission (SFC) has also been spurred to complete its own REIT Code in 2003.
The Code, effective from August, is expected to generate significant investors' interest in Hong Kong - which beforehand possessed no rules and regulations on REITs.
"The Code does not have the force of law but any failure to comply with the Code may adversely affect on a person's fitness and properness involving in the business of a REIT or the suitability of a REIT to remain authorised by the SFC," says Francis Li, a partner with Koo and Partners/Paul Hastings.
The SFC will be responsible for authorising REITs as collective investment schemes in Hong Kong, including the vetting of constitutional and offering documents and the monitoring of ongoing compliance with the Code.
Partner Scott Carnachan of Deacons says: "It is encouraging to see that the SFC adopted a large number of the comments from market participants during its consultation process earlier this year in order to provide a more attractive framework for property owners and investors."
Says Li: "As a listing vehicle, the REITs are also subject to the listing and ongoing compliance requirements set by the Stock Exchange of Hong Kong."
As such, and in response to the Code change and the completion of Fortune, the HKSE amended its listing rules from 1 September. The amendments create a listing and trading platform for SFC-authorised collective investment schemes; clarifies the respective regulatory roles of the SFC and HKSE; and streamlines the listing process for SFC authorised collective investment schemes.
The combination of all these factors, says Freshfields' Rough, is encouraging. "We expect to see a lot more activity in the REIT sector in Hong Kong," he says.
Baker & McKenzie's Milton Cheng, who was lead partner advising Cheung Kong on Fortune, agrees: "We believe this deal, particularly in light of the recent introduction of REIT regulatory framework, leads the way for similar transactions in Hong Kong."
Adds Carnachan: "It was important that Hong Kong develop a framework for authorising REITs, both as a defensive measure and as a natural development of its financial markets. Given the size of the property market here and the number of active developers, together with the potential for China-oriented REITs down the track, Hong Kong remains well positioned to develop a vibrant and successful REITs market."
And Hong Kong's property industry could certainly do with some good news, although Paul Hastings' Cordell believes the bottom of the market has already been seen there.
"The market is turning but it is early days," she says. "A real estate agent recently told me that they had had their highest monthly commissions for the last six years and I've seen a distinct turnaround in the last two to three months."
Lessons and challenges
The number of Asian REITs has grown from zero to 12 in two short years, with a combined value approaching US$5bn. Given that this particular alternative investment vehicle was little known to investors in the Asia Pacific region as recently as 2000, it is little wonder REITs have enjoyed the media exposure they have.
But the market for raising money by securitising property rentals in Asia is still dwarfed by Australia's (about US$25bn) and is nowhere near the US market of US$155bn.
In his keynote address at the REIT World Asia 2003 Conference, Nic Lyons, CEO of GPT Management Ltd and Lend Lease Real Estate Investments, argued that Asian jurisdictions must address the issues already negotiated in Australia and the US if their REITs are to succced.
One primary lesson for Asia from the US experience, he said, is that REITs need to be positioned as income rather than growth vehicles. Many Asian companies, up to their necks in bad debt but still keen to follow their US and Australian counterparts, will find that REITs are subject to natural real estate cycles and impressive returns today can just as quickly disappear tomorrow.
Hong Kong-based Andrew Harrow, head of Allen & Overy's international capital markets practice in Asia, singles out two trends as defining the style of work lately: a shorter execution period and increasing due diligence.
"Windows that appear do so for only a short period of time, so issuers or borrowers want quicker deal time so they can act on that. The due diligence process is also longer and more intense, even in offshore transactions," he says.
The reason, he says, is the "once burnt, twice shy" factor. "In certain jurisdictions where there hasn't been a lot of activity, or where they may have suffered from the 1997 financial crisis, these are the first offerings coming to the market. The banks want to make sure everything is fully and properly disclosed."
For the three Asian countries that have launched REITs - Japan, Korea and Singapore - there are still obstacles to be overcome. These include the lack of other high-quality properties to be injected into REITs in Japan, the high barrier of entry created by the minimum required capital of Won 50 billion in Korea, and the conservative 35% cap on gearing in Singapore.
In other jurisdictions, the Philippines has shown a degree of interest in REITs as has China, although the state of its immature legislation makes it near impossible to set up the listing of property trusts.
In Thailand, meanwhile, the development of Thai Mutual Funds has been held back by the lack of significant assets available in the market. Direct property ownership still requires a majority Thai partner.
Malaysian property trusts based on the Australian model were established in 1986. However, the formation of a mere three trusts is all the Malaysian government has to show for its legislation, with investors judging their properties as undesirable assets.
This tendency of property owners trying to palm off inferior properties into trusts while retaining good ones in their own portfolios remains a major stumbling block for proponents of REITs to overcome in Asia. Getting owners to part with good buildings, and sell them into trusts at prices that would provide the necessary yield to attract investors, may yet see the Asian REIT market overtake that of Australia.
This points to a fundamental pricing gap between buyers and sellers. Paul Hastings' Cordell speaks from the experience of managing the Hong Kong operations of First American Title Insurance Company, which is primarily involved in commercial property acquisitions by funds in Hong Kong and Korea. She makes the point: "There are discrepancies between how owners and investors value property in Hong Kong. It will take some time, like most things, for people to be educated."
Another factor that may hinder the development of an Asian REIT market is the underperformance of US REIT stocks in the last year, reducing the appetite for acquisitions in Asia and abroad.
But Cordell is confident that in Hong Kong in particular, a steady yield will ultimately convince investors of the benefit of REITs.
"There are a lot of properties in Hong Kong that are largely illiquid assets for many people and there can now be a disposal of interests in those businesses," she says.
Driven by investors' need for steady, high-yield products, the outlook for the Asian REITs market looks bright. But it is likely to take some time to develop in jurisdictions that haven't been exposed to it - with new rules needing time to be digested, and transactions needing sufficient long lead time due to their extensive documentation requirements.
Whether or not REITs are the right solution for Asian economies remains to be seen, and is dependent on factors such as the quality and availability of real estate assets, the level of government and private participation, and the value of technology stocks, among others.
Freshfields' Rough for one is very interested to see what happens. "If they take off in Hong Kong, they'll be a good source of alternative work for us," he says. "But it's a competitive market; we won't be making a killing on this. You need the property expertise, the experience of listing on the stock exchange and the experience of having worked on these types of products in other jurisdictions."
Carnachan agrees: "The timing for any IPO is always critical and law firms, along with other service providers, need to respond. Successful establishment of REITs requires legal expertise in property transactions, establishing investment funds, and stock exchange listings. Established relationships with the regulators can also play an important part in meeting tight timelines."
2003 Key news and deals
November 2003
CC appoints real estate head
Clifford Chance signals continued investment in its distressed debt practice in Asia by luring Paul Hastings Janofsky & Walker partner Gary Hand to its Tokyo office. He will advise international funds in structuring acquisitions and financings of hard asset portfolios
September 2003
HKSE amends listing rules for REITs
Listing process for Securities and Futures Commission-authorised collective investment schemes streamlined, and the regulatory roles of the SFC and HKSE clarified
Cheung Kong completes the sale of five Hong Kong shopping malls to Singapore's Fortune REIT, for approximately HK$1.038bn
June 2003
CapitaMall deal
Clifford Chance Wong advised arranger HypoVereinsbank in its second commercial mortgage-backed securitisation for CapitaMall Trust (CMT), Singapore's first listed REIT, in a S$349m (US$199m) deal comprising US$72m floating rate notes and S$200m fixed rate notes.
In-house Q&A
The property interests of the Hutchison Whampoa Property and Hotel Group comprise Hongkong & Whampoa Dock Company Ltd, Hutchison Properties Ltd and Cavendish International Holdings Ltd. Head group general counsel Edith Shih talks to ALB
How long have you been in your current role?
We set up at the beginning of September 10 years ago and I've been here since the beginning. Beforehand, I was the general manager for business development and strategic planning for Hutchison and I was in that position for about three years.
What's your training background?
I'm a qualified lawyer. Initially, I trained in the UK and then Hong Kong, but they were the same place during those days. I also trained in Australia.
How is your in-house legal department structured?
When we first started 10 years ago, my mandate was to build the legal affairs department. I started with myself then I continued to hire assistants who were all stationed at head office, so we looked after the entire company out of head office. We've built up the subsidiary legal departments over time. In the beginning, I did it by sending my head office legal counsel to a specific country to help set up a subsidiary legal department and then to hire from outside.
How many people do you have now?
I'm never able to keep track but today we're about 130 worldwide - probably about 32 in Hong Kong and the rest outside.
Each subsidiary group calls itself general counsel and because of business requirements some other ones might call themselves legal managers. It would be a dozen at least, if not more.
How does the reporting process work?
Usually, other than Europe, everybody reports to the head office in Hong Kong. For example, the retail group head office is in Hong Kong and has lawyers in Hong Kong, Taiwan, the UK and the Netherlands. So the subsidiary lawyers report back to the Hong Kong office.
In the telecom international group, they have lawyers in Hong Kong, there are lawyers in India, seven or eight in Israel, they have some in Argentina, Paraguay and Sri Lanka, and they also all report back to Hong Kong. Now, Europe is different because Europe is actually under me - so the Italians, the British, the Swedes, Danish, Austrians, they report to me direct but they have their own general counsel that would look after their routine business.
Do you prefer to maintain responsibility for some transactions?
We have this policy - basically, with major acquisitions there is a dollar amount and there is a transaction-nature option. Anything involving a third party - for example, a joint-venture agreement, they come to the head office for clearance. We have parameters for shareholder relationships that we like to influence throughout the group. Banking is done out of the head office because we're the central bank of the whole group.
What's your approach to outsourcing work?
I keep on telling my team that if we've got to outsource everything, then we're useless and don't have a reason for being here. But we can't do everything ourselves. We use a large number of outside law firms. We use the major international firms - each is used for its expertise in a particular area.
Do you operate a panel?
There is a so-called panel, yes, but then every time somebody wants to appoint a lawyer they come to me. It's really because - on a group-wide basis - although a law firm's on the panel or has been used in the past, people wouldn't know whether on any particular day we're having a quarrel with that particular law firm or whether we've already given so much to the specific team to do that we don't want to add to their workload. So, they invariably come back to me.
What types of work do you tend to keep in-house and what do you tend to outsource?
It varies. I can't say: "all sale and purchases are done in-house". With the large M&A transactions, for example, we always work with a law firm outside to make sure - especially as the company we're buying may be outside of Hong Kong. But we also do major ones in-house [when] these are straightforward transactions, where we know the other party and we don't anticipate a protracted negotiation.
But we don't have a policy for the nature of what goes out or the dollar amount. The dollar amount is not a good parameter because even if you acquire something with very little money it might come along with a lot of liability.
FIRM PROFILE
Deacons - change to cope with changes
"The sentiment of the market property has been improving in the past two or three months. Property lawyers are always the first to feel the upturn with an increase in activity," Lilian Chiang, head of the Property Department of Deacons, says.
Unlike some of their competitors who significantly reduced the size of their property departments, the headcount of the Property Department of Deacons has remained at around 50 for some years.
"With the passing away of our partner, Jimmy Wu, after his brave long battle against cancer, our department now has a total of 11 lawyers. Apart from Peter Aherne who is a well-known property lawyer, Wai Pat Wong with nearly 50 years' of experience behind him and myself, all our other team members are solid well-experienced lawyers who have been qualified for over six years. We are looking for good and competent property lawyers to join us as we are still expanding," she says.
The focus of the Property Department of Deacons has been changing to cope with the volatile property market. Most of the clients of Deacons' Property Department are major banks and large corporations in Hong Kong. Apart from general conveyancing works, such as sale and purchase, mortgages, leasing, joint ventures, project developments, project financing and advice on property related matters in Hong Kong, the Property Department of Deacons are frequently instructed to deal with matters relating to real property in The People's Republic of China.
Despite the poor property market for the past two years, the Property Department of Deacons continued to receive instructions to act in many significant property transactions. Notably, Peter Aherne acted for the vendor in the sale of the Office Tower at Site C of Olympic Station, Kowloon and Lilian Chiang acted in the global public tender of Tung Ying Building, Tsim Sha Tsui, each with a value of over HK$1bn. In addition, Deacons continue to act in the transfer of mortgage portfolios between lenders. Deacons have completed a significant number of such transactions in recent years and they are at present acting for a major lender in Hong Kong in their proposed takeover of the entire mortgage portfolio of another major lender.
The Property Department of Deacons also acted for many major banks in Hong Kong in an increasing number of complicated mortgagee sales. A notable case handled by Lilian involved the sale of the 'Genesis', No.23 Severn Road, Hong Kong, one of the most luxurious houses on the Peak, first by global public tender and then by private treaty.
As the property market slowly recovers, the primary property market is also becoming active. In the private sector, Deacons have long-standing relationships with many major property developers in Hong Kong. "We are at present acting for a number of developers in their sale of their property developments in Hong Kong. The number of sale and purchase concluded recently is steadily increasing as confidence returns to the market," says Lilian. In the public sector, Deacons has been appointed the legal adviser in the preparation of complex legal documentation for the Tenants Purchase Scheme for the fourth consecutive phase involving 21 Estates totalling 168 Blocks.
Despite the fact that many people believe that with the abolition of conveyancing scale fees and the promulgation of the Land Titles Bill, the role of property lawyers will be diminishing, Lilian remains optimistic. "The effect of the Land Titles Bill is yet to be seen. Good property lawyers will always have a major role to play in the commercial world. Large commercial transactions will invariably involve real property," she says. "So long as the quality of our service is high and our fees are competitive, we are confident that the Property Department of Deacons will remain the leader in the market," she adds.
Deacons has recently been appointed as legal adviser in the proposed sale of the prestigious Hyatt Regency Hotel. The property is valued in excess of HK$3bn and is anticipated that it will be the highlight of the last quarter of 2003.
Peter Aherne, who is the Chairman of the Law Society's Land Titles Bill Working Party, says: "There are still a number of important issues to resolve in the drafting of the Land Title Bill and in which the Law Society is in consultation with the Government. Assuming they can be overcome satisfactorily, the implementation of title registration will enhance property investment in Hong Kong by providing greater certainty as to title and reducing or eliminating delays in the acquisition process due to the current need to resolve title defects most of which are of a technical nature."
The latest development in the market are regulations permitting in the market the establishment of real estate investment trusts (REITs). It is again expected that property lawyers will have an important role to play in the establishment of REITs. "We are ready. Deacons can offer a one-stop service to those who wish to establish REITs. Our Financial Service Practice Group has a lot of experience in setting up a wide range of funds and investment products and our Corporate Finance Practice Group has a successful corporate finance and equity capital market practice. They will work together closely with the Property Department in the establishment of REITs which requires legal expertise in these three areas," Lilian concludes.
FIRM PROFILE
Major legal issues concerning securitisation of real estate assets in Japan
by Takashi Toichi and Atsutoshi Maeda of Anderson Mori
Introduction
As the market for securitisation of real estate assets in Japan continues to grow, so too does the legal debate surrounding appropriate interpretation of Japanese laws that govern such transactions. Most of the legal issues pertaining to securitisation depend on long-established interpretations of the Civil Code, relevant insolvency laws, and general legal principles, and so - given that real estate securitisation has not itself been the subject of extensive interpretative consideration in this context - there still exist certain areas where relevant laws and applicable precedents are not well established and therefore do not well serve the purpose of facilitating real estate asset securitisations.
In this article, we address two major legal issues pertaining to real estate asset securitisations: (1) risk of denial under the Civil Code and the relevant insolvency laws; and (2) 'true sales' or 'security transactions'. In this context, we aim to introduce an interpretation of the Civil Code and relevant insolvency laws consistent with the aim of facilitating real estate asset securitisation.
Risk of denial
In real estate asset financings - notably where an originator seeks financing through transfer of real estate assets - the originator may at times find itself in a precarious financial position (ie, its debts exceed its assets). Under the Civil Code and relevant insolvency legislation a transfer of assets can be denied if the transfer harms the originator's general creditors. Before an originator becomes subject to insolvency procedures, a transfer of assets from an originator having financial difficulties may be subject to the risk that the transfer will be denied by the originator's general creditors0in case it fell within certain statutorily-defined criteria. Furthermore if, after origination, an originator becomes subject to insolvency procedures there is an additional risk that the transfer will be denied by the originator's trustee in insolvency (kanzai nin), who may insist that the transaction harmed general creditors or else fell within certain statutorily-defined criteria.
Under the prevailing interpretation of the Civil Code and relevant insolvency legislation real estate assets transferred to a third party for consideration less than fair market value become subject to denial. A long-standing Supreme Court decision established that the foregoing is true even if the real estate assets are transferred for consideration equal to their fair market value. This decision only applies to real estate assets and not to other types of assets such as loan receivables or movables. The Court's decision was based upon the reasoning that even if a transaction is completed at fair market value, if real estate assets are converted into cash (a type of asset more readily embezzled than real property) a transfer will harm the originator's general creditors and consequently the transaction should be subject to denial. This interpretation has been widely criticised because of the artificial distinction it draws between real estate assets and other types of assets, such as stable loan receivables and movables. Nonetheless, it remains in effect and therefore real estate asset transactions involving originators in poor financial condition are invariably subject to a risk that the origination will be denied if the originator subsequently becomes subject to insolvency procedures.
Significantly, however, the prevailing view among scholars and practitioners is that there should be certain categories of transactions where an originator's general creditors would not be harmed by a transaction completed at fair market value, and therefore transfers will not be subject to denial by the general creditors of the originator before the commencement of the insolvency or the originator's trustee in insolvency. These include transactions in which:
- useful assets for the originator were purchased with the consideration received through the transfer of the real estate assets
- most of the consideration received for the transferred real estate assets was used to repay the mortgagees of the transferred real estate assets
- consideration received for the transferred real estate assets was used to fund the creditors under the debt restructuring conducted under the generally accepted rules without initiation of a statutory insolvency procedure (shiteki-seiri)
It is important to note that efforts to amend the Bankruptcy Law - a key piece of insolvency legislation - are currently underway. Under the interim draft of the amendments of the Bankruptcy Law - published for public comment, provisions governing the denial of fair market value real estate asset transactions are clarified by stipulating that, as a general principle, fair market value transfers will not be subject to denial by the originator's trustee in insolvency except in certain specified cases. Although the final draft of the amendments has not yet been released, we hope that the exceptions will be cast narrowly in order to facilitate real estate assets securitisations.
True sale or security transaction
It is essential in real estate securitisations that a transfer of the subject real estate assets from the originator to the special purpose company (SPC) - including the beneficial interest, if a trust structure is used -constitutes a 'true sale'. Whether or not the transfer of the subject real estate is subsequently re-characterised by the originator's trustee as a security transaction rather than a 'true sale' has significant ramifications in the event that insolvency procedures are subsequently commenced against the originator. If the transfer is not re-characterised as a security transaction then, apart from the issue of denial by the trustee, the subject real estate is no longer an asset of the originator. Therefore, the trustee is less likely to proceed against the transferred real estate for a source of payment to general creditors. Conversely, if the transfer is so re-characterised, subject real estate assets will constitute a part of the originator's assets and therefore become potentially subject to various statutory restrictions under insolvency procedures, such as orders for suspending foreclosure (tanpoken jikko kinshi) or for extinguishing securities (tanpoken shoumestu seikyu). Particularly in cases of statutory corporate reorganization (kaisha kosei tetsuzuki), a security holder's right to foreclosure becomes severely restricted.
In order to minimise these legal risks, parties in real estate securitisations endeavour to establish a 'true sale' of the subject property. In this section, we illustrate the factors that affect whether or not a transaction constitutes a 'true sale' in the context of a sale/leaseback real estate securitisation. In such a transaction, the SPC's cash flow is derived from the rent income attributable to the subject real estate. Consequently, we focus our discussion below on whether rent claims from the SPC should be payable during an originator's insolvency.
Significant factors in determining whether a transaction constitutes a 'true sale' include trade terms, the parties' underlying interests in the transaction, the purpose of the financing, the existence or non-existence of a repurchase option/obligation, and the perfection of the transfer (with respect to a real estate transfer, this would involve registration on a real estate registry). In the case of a sale/leaseback transaction, in addition to these general factors, the appropriateness of consideration for the transfer and rent is of particular importance. If the transfer price or rent deviates significantly from fair market value, the transaction will generally not be deemed to be a 'true sale'. Similarly, if the rent payment terms are found to constitute a leasing payment in the 'full pay out method', the sale/leaseback may be re-characterised as a finance lease of the subject real estate. Finally, if the lease imposes irregular obligations on the originator, such as an obligation with respect to additions and betterments that the real estate's owner would ordinarily undertake, such terms may support the conclusion that the deal was not a 'true sale' but a security transaction.
For example, during the corporate reorganisation procedures commenced in 2001 by Mycal Corporation - a large chain retailer - a true sale issue of commercial mortgage-back securities (CMBS) for shopping centres drew broad attention in the Japanese business and legal communities. The source of refunding for these CMBS was rent from the shopping centre, payable by Mycal. Although Mycal continued to make rent payments throughout the period that it was subject to reorganization procedures, at certain points the trustees announced that (1) the whole transaction might be re-characterised as a highly specific finance leasing of the building; and (2) they were considering whether the rent should be regarded as 'kosei tampoken', a security right under the reorganization procedure, and not as 'kyoeki saiken', a claim payable when due. In light of these announcements, a number of legal opinions were exchanged, some of which were publicised, and it was seriously contemplated that the trustees would re-characterise the CMBS transaction as the creation of a security - an eventuality that would likely have brought significant instability to the general CMBS market. Based on publicly available information, the trustees regarded, among others, the following facts as problematic:
- the transfer price of the subject real estate may have been determined based on financing required by Mycal, rather than on actual fair market value
- the initial rent may have been determined based on the ability of Mycal to make such payments
- rent was changeable as if for the purpose of refinancing
- the cancellation fee was extraordinarily high
Despite the fact that a court judgment on this issue would have removed much of the uncertainty, this dispute was concluded by extra-judicial settlement, whereby the trustees agreed not to construe the rent claim as 'kosei tampoken' (payment of which are suspended during the procedure). In the absence of a court ruling on the issue, however, there remains legal ambiguity in structuring asset-backed financings and, in particular, in structuring real estate securitisation transactions to satisfy the 'true sale' requirement.
Conclusion
Although parties in various real estate finance transactions have always struggled to minimise legal risks such as those referenced above by constructing well-designed securitisation schemes, there remains particular ambiguity surrounding insolvency procedures and real estate securitisations that careful scheme design alone cannot eliminate. We therefore hope for amendments to the relevant insolvency laws - a possibility, given the current review of the Bankruptcy Law - and for new court decisions to reduce the legal ambiguity inherent in real estate securitisations, thereby further enhancing the market for such transactions.
Takashi Toichi and Atsutoshi Maeda specialise in corporate law and structured finance.
E-mails: takashi.toichi@andersonmori.com and atsutoshi.maeda@andersonmori.com