Taiwan

Taiwan's Ministry of Finance (MOF) recently approved its first real estate securitization project. The project is based on the securitization of the building, land and rental income streams of the IBM building, a commercial building in Taipei. This deal is Taiwan's first approved real estate securitization project, and represents another milestone in the development of Taiwan's securitization market.

In a real estate securitization deal, an originator transfers the relevant real estate property to a trustee, typically a bank (in Taiwan, a trust is not a distinct legal entity from the trustee). The trustee then issues notes to investors, with full recourse against the entrusted building, land and tenancy agreements. The project must be structured pursuant to a securitization plan in compliance with the Real Estate Securitization Law (the RESL) and approved by the MOF. To comply with the RESL, the plan must provide details for various transactions to transfer the title of the building and the land from the originator to the trustee. The originator's right, title and interest in the tenancy agreements will also be assigned to the trust. These transactions, however, trigger requirements under other laws or create an apparent incongruity among different laws.

Some of the legal issues encountered (thus far) in this deal are likely to recur in future real estate securitization projects in Taiwan.

Revocable transactions in bankruptcy

Issues of revocable transactions arise under the interface of laws governing bankruptcy, fraudulent conveyance and creditor relationships, with regards to the RESL. In a real estate securitization project, the risk is whether the transfer of the real properties to the trustee, and the issuance of the notes by the trustee, can withstand a legal challenge in bankruptcy by the creditors of a bankrupt originator. In other words, investors in the enterprise must have enough assurance that assets backing their investments are bankruptcy remote, vis-à-vis the originator's creditors.

Several laws provide a court with the authority to set aside transactions that unfairly prejudice the rights of a debtor's creditors in a subsequent transfer or entrust the debtor's properties to a third-party beneficiary (in this case, the trustee). These laws (the revocable transaction provisions) are summarized below:

Article 6 of the Taiwan Trust Law provides that the creditors of a debtor may petition a court to set aside or revoke the transfer or entrustment of the entrusted assets to the beneficiary, if the transfer or entrustment is prejudiced against the interests of such creditors or their claims against such debtor. In this event, the revocation granted by the court may not affect the benefit already received by the beneficiary except for undue benefits and situations where the beneficiary knew the acquisition of the benefit was detrimental to the rights of the creditor. Furthermore, according to paragraph III of the same Article, a transfer of assets in the form of entrustment will be prima facie prejudicial against creditors' rights and interests, if the debtor or its estate is bankrupt within six months after the transfer of the relevant properties. If a transfer or entrustment of assets is revoked by a court, the relevant assets will be subject to recovery and be included in the estate of the debtor.
Article 244 of the Taiwan Civil Code states that, if a gratuitous act done by a debtor is likely to be prejudicial against the rights of its creditor, the creditor may petition to a court to set aside or revoke that act. Paragraph 2 of the same article states that, even if the debtor performs a non-gratuitous act, if the debtor does so knowing that it is likely to be prejudicial to the rights of its creditor, the creditor may petition to the court to set aside or revoke the act, but only if the beneficiary of that act also knew of the circumstances of its receipt of such benefits.
Pursuant to Article 78 of the Taiwan Bankruptcy Law, a receiver in bankruptcy may also petition to a court for the invalidation of any act done by the debtor before the final adjudication of the bankruptcy, if the act prejudices the claims of the creditors of the debtor.

Although the revocable transaction provisions have existed for some time, there were no court rulings analogous to a securitization project. The drafting of the RESL provided some guidance for courts to interpret these disparate bodies of laws, but not enough. For example, Article 66 of the RESL states that paragraph III of Article 6 of the Taiwan Trust Laws (setting out a prima facie prejudicial transfer of property) is not applicable to a real estate securitization deal, but does not otherwise address other problematic provisions of Article 6. After extensive communication with the relevant authorities, it seems that the competent authorities will not deem the transfer of assets to the trustee in their securitization project as a false conveyance. Of course, as the laws are not yet unified, similar discussions may have to be conducted for subsequent deals.

Bankruptcy of the trustee

If the entrusted assets are considered the assets of the trustee due to re-characterization or revocation, the entrusted assets will be subject to the claims of the creditors of the trustee.

Pursuant to Article 4 of the RESL, the originator must transfer the ownership and related rights of its real estate to the trustee, who will in turn issue trust certificates representing the rights and interests of the entrusted assets. The principle of this arrangement is to separate the entrusted assets of the originator from the other assets of the originator, and to protect the holders of the trust certificates in the event of bankruptcy, insolvency and other similar proceedings of the originator. The Taiwanese Trust Law further states that the entrusted assets are not considered assets of the trustee in case of death or bankruptcy of the trustee. Therefore, in normal circumstances, although the trustee holds legal title to the subject real estate, the creditors of the trustee will nonetheless have no legal claims to the entrusted assets. However, to protect the rights of the creditors of the originator, the entrusted assets may be subject to the recourse of the creditors of the originator, if the entrustment is deemed as means of prejudice against the rights of the creditors of the originator and revoked or re-characterized by a court in bankruptcy.

Uncertainty of future interest

The issue of future interests arises from the distinction between transfers of the subject property versus the transfer of future economic rights generated by that property. In a real estate securitization deal, this means that the trustee may be unable to collect the proceeds of the transferred assets upon maturity if the object of the transfer is future credit (such as the right to collect rent from the tenants).

According to the court precedents in Taiwan, the transfer of future credit is simply a transfer of credit but not a transfer of right of the property (for example, ownership and the effect of the transfer occurs only upon maturity of the future credit). Before maturity, the transferred future credit is still considered to be the asset of the transferor (that is, the originator) and potentially subject to rights of the originator's creditors. So, because a rent obligation does not mature until it is due, the trustee's rights to collect future rents may, in theory, be barred in bankruptcy by the originator's creditors. There are no legal precedents adjudicating this issue, and the RESL does not address this point, so the trustee will bear a risk of legal uncertainty if it is assigned the obligation to collect rent.

Also, the trustee also is not able to collect rents due to an inadvertent termination of the tenancy agreements caused by the entrustment of the property. Article 425 of the Taiwan Civil Code provides that the transfer of ownership of the real estate from a transferor to a transferee does not affect the rights of a tenant and the validity of an existing tenancy agreement, unless such tenancy agreement is for more than five years, or does not have a fixed term, and is not notarized. It is not clear whether or not a transfer of ownership under Article 425 of the Civil Code includes the transfer of ownership due to entrustment. Legal precedents from the District Court state that entrustment would be included. However, the High Court and the Supreme Court in Taiwan have not yet opined on the same issue, so legal uncertainty still remains. If ultimately decided, it would be surprising if the transfer of ownership in Article 425 of the Civil Code did not include entrustment (and thereby render existing tenancy agreements invalid), considering the ultimate goal of Article 425 of the Civil Code is to protect the interests of tenants.

Preferential creditor claims

In addition to the limitations on the rights of the trustee over the subject property and the future income of that property, the rights of the trustee may be limited further by statutory preferential claims. Under Taiwanese laws, the mortgage right of a contractor arising from its work contract (for important repairs executed on a structure or work) has priority in bankruptcy to the extent of the increased value of the structure or work created by the repair. Government taxes in relation to the building and the land also have priorities over the rights of other creditors or rights of mortgage.

In general, the RESL or the MOF requires the preferential claims against the real estate, including taxes and pre-existing mortgage rights, to be extinguished or properly accounted for (through the creation of reserves). So proper due diligence should be done to itemize the liens that must be extinguished or otherwise dealt with to the satisfaction of the MOF. In cases of prior mortgage rights, where business conditions allow, it may be possible simply to obtain an affidavit from the mortgagor not to exercise such mortgage rights during the period of the securitization project.

Enforcing trust security against a defaulting trustee

Under Taiwan laws, the titleholder of real estate is the legal owner of the real estate and has the right to freely dispose of the real estate properties. In a real estate securitization deal under the RESL, the title of the building and the land would be transferred from the originator to the trustee. After the transfer, unless the entrustment is revoked or re-characterized by court, the trustee will own and have the right to sell the building and the land in accordance with the terms and conditions set out in the trust agreement. The actual time required for disposing of the building and the land will mainly depend on the sale price and the Taiwan real estate market at the time of sale.

Except for the conditions discussed under the previous sections, the remaining trust security (that is, the cash in the account owned by the trust) can be enforced by the trustee for the benefit of the investors in accordance with the relevant provisions of the trust agreement, the Civil Code and other Taiwanese laws and regulations.

If the trustee refuses to enforce the trust security for the benefit of the investors upon the occurrence of security enforcement events as stipulated in the typical securitization deal, the applicable remedies pursuant to relevant Taiwan laws and regulations are:

The originator or the beneficiary (in this case, the investors) can petition the court to discharge the defaulting trustee. A new trustee may be selected by the originator or appointed by court upon petition by the related parties or a prosecutor.
For a real estate securitization project, the competent authority may also replace the defaulting trustee in accordance with Article 55 of the RESL.
Damages caused by the defaulting trustee can be recovered by the originator or the investors from the Defaulting Trustee, pursuant to Article 22 of the Trust Law, breach of contract under the Civil Code and/or other provisions of the rulings applicable to trustees.

Relevance of accounting treatment

According to Taiwan's accounting principles, a typical real estate securitization deal could be recognized as a financing for financial reporting purposes, if the originator has the right to buy back or redeem the building and the land. Under this treatment, the building and the land will still be listed on the balance sheet of the originator after closing. In practice, listing properties on a company's balance sheet is not legal evidence of ownership of those properties, and the building and the land would not be enforceable by the originator's creditors purely based on such information being listed on the originator's balance sheet (provided that the building and the land are clearly noted as entrusted to the trustee). However, a risk of legal uncertainty remains, as there is no court precedent or regulation directly addressing this matter. According to the views of various scholars, and the legal analyses in several bankruptcy court judgments, the financial statements prepared in conformity with the general accounting principles should only be used as a reference and do not conclusively determine ownership. The courts, however, will probably independently analyze and evaluate whether the legal act at issue (that is, the entrustment of the building, the land and other securities) has unfairly prejudiced the interests of the originator's creditor.

Loan

According to the RESL, a trustee may acquire loans for the benefit of the investors, provided that the acquisition of loans is explicitly allowed in the trust agreement, and the purpose of the loans is limited to the operation of the trust (the trust restrictions). If loans are made for the operation of the trust, and if the trust agreement allows it, such loans will be valid and effective, and the trustee will be liable for their repayment. However, if the purpose of the loans is not the operation of the trust, or if the trust agreement specifically prohibits borrowing money, then the loans are deemed illegitimate. The legal effect of illegitimate loans is undefined by any laws or judicial rulings, but possible results could be as follows:

The trust restrictions are mandatory, so any consequences of their violation will have no effect on the trust's assets, and would be borne solely by the trustee. There are no court precedents regarding the enforceability of trust restrictions (that is, whether the law prohibiting such actions is a mandatory restriction or an arbitrary restriction), so it is still uncertain whether illegitimate loans would be valid. If it is deemed as a mandatory restriction by court, then actions violating trust restrictions would be invalid. If the court makes such a ruling, any loans made by the trustee will have no effect whatsoever on the trust and any consequences of such actions shall be borne by the trustee itself.
The trust restrictions are arbitrary, and the effect of such loan is subject to the court's ruling. Courts determine the effects of an action violating an arbitrary restriction on a case-by-case basis, and there are no court precedents regarding the effects of trustees making illegitimate loans on behalf of the trust. If loans are adjudicated on this basis, the outcome could be one of the following
- The loan has no effect on the trust under agency laws
According to the principles of agency under Taiwan laws, any actions of an unauthorized agent have no effect whatsoever on the person that the agent is purportedly acting on behalf of. If this principle is applied to a real estate securitization deal, the act of the trustee making loans on behalf of the trust will have no effect at all on the trust, and the trustee would be solely held responsible. However, whether or not the relationship between a trust and the trustee is an agency relationship under Taiwan law is still subject to interpretation by the courts.
- The loans are binding on the trust, but investors may claim damages against both the trustee and the lender
If the trust restrictions are not mandatory and the law of agency is not applicable to a typical real estate securitization deal, the loans could have binding effort on the trust. However, in these circumstances, both the lender and the trustee may be jointly and severally liable to the investors for damages caused by the violation of the trust restrictions, with the damages being the amount of the illegitimate loans. Therefore, the interests of the investors would ultimately not be diluted by the illegitimate loans. Again, whether or not the loan could be claimed as damages would have to be determined by the courts.

Assess the risks

There are many apparent incongruities between the RESL and existing laws and precedents. We have identified and discussed some of the legal risks we encountered in our transaction that may recur in future deals. These are principally risks of legal uncertainty that would probably be clarified by court interpretation or further amendment to the relevant laws. But, for the moment, they remain uncertainties that the parties must consider and address when structuring a real securitization project. Based upon our understanding with the relevant authorities, the securities issued in connection with a real estate securitization project are valid and enforceable as long as the securitization plan offers proper mechanisms to mitigate all possible risks. Those mechanisms have to be reviewed by the authorities and rating agent (if any) to ensure that legal risks are mitigated or eliminated, so that the investors' interests can be properly protected.

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