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.
Author
biographies
David Chuang
LCS & Partners
David Chuang is a partner at LCS & Partners. He is admitted
in Taiwan and focuses his practice on securitization, banking and
general corporate law. Chuang is a graduate of Duke University
Graduate School of Law (LLM) and National Taiwan University (LLB).
Chuang has published numerous articles on securitization
regulations in Taiwan and is a recognized expert in his fields of
practice.
Vicky Lee
LCS & Partners
Vicky Lee is a counsel at LCS & Partners. She is admitted in
Taiwan and focuses her practice on securitization, banking,
intellectual property rights and general corporate law. Lee is a
graduate of the Law School at Soochow University (LLM). She also
received a PhD degree in microbiology and immunology from
University of Michigan.
LCS & PARTNERS
102, Kuang Fu South Road, 11th
Floor
Taipei 106,
Taiwan, ROC
Tel: +8862 2711 3232
Fax: +8862 2711 8282
www.lcs.com.tw