Friday, September 25, 2009

DIP Financing, Bankruptcy Concerns For Transactional Real Estate Lawyers

By S.H. Spencer Compton and Andrew D. Jaeger
New York Law Journal

September 25, 2009

It has been said that capitalism without bankruptcy would be like Christianity without hell (or, perhaps, more properly, purgatory). There must be a place of punishment and redemption in order to maintain faith in both God and capital markets.

As the current economic cycle wears on (and on), as tenants either renegotiate their rents or default, many borrowers are unable to meet their debt obligations and are seeking relief in the federal bankruptcy courts. Young real estate lawyers today have little or no experience with bankruptcy matters, having only practiced in healthy, even exuberant, financial climates. This article will attempt to familiarize real estate lawyers with the basic elements of real estate related issues in connection with bankruptcies that may arise in their transactional practices. It is not intended to be an in-depth discussion of bankruptcy law, but rather a primer for real estate lawyers who find themselves working alongside bankruptcy lawyers.

A Few Definitions

Debtor in Possession: The debtor which remains in control of operations.

Exit Financing: Financing under a plan of reorganization that allows the debtor to exit bankruptcy.

Petition: (Bankruptcy Petition or Petition for Relief). The document that commences a bankruptcy proceeding.

Plan of Reorganization: A plan that sets forth the manner in which a bankrupt company intends to satisfy its creditors and exit bankruptcy.

Prepackaged Bankruptcy: A bankruptcy case in which the debtor and certain of its creditors agree to the terms of a plan of reorganization before filing a bankruptcy petition. The court then confirms the plan and the company emerges from bankruptcy quickly.

Pre-Petition Debt: Debt incurred by the debtor before a bankruptcy filing.

Post-Petition Debt: Debt incurred by the debtor after a bankruptcy filing.

Rollups: Pre-Petition Debt that is combined with/converted into post-petition debt as a condition to providing additional financing to the debtor.

Section 363 Sale: A sale of debtor assets free and clear of liens pursuant to Section 363 of the Bankruptcy Code.

Stalking Horse: A proposed buyer chosen by the debtor to make an initial bid on the debtor's asset(s). The stalking horse sets the bar that other bidders have to bid against, often in an auction setting. The court generally grants expense reimbursement and/or a break-up fee to the stalking horse.

Chapter 11 Reorganization

Chapter 11 of the Bankruptcy Code governs the reorganization of debtor entities, and while there are other types of bankruptcies, this article will focus on certain transactional issues related to Chapter 11 filings.

The goal of a Chapter 11 filing is to de-lever the debtor through the plan of reorganization process, with the hopes of turning it into a profitable venture. To give the debtor necessary time to propose a plan, the debtor is given the exclusive right to file a plan for a set period and Section 362 of the Bankruptcy Code imposes an automatic stay on all creditor collection/foreclosure efforts.

An effective reorganization will likely require additional capital which may be obtained in two ways. The debtor may sell assets pursuant to Section 363, which will be discussed below. Where practicable, the debtor also may seek Debtor in Possession (DIP) financing. Section 364 authorizes a debtor to borrow money to preserve the estate or to further the debtor's rehabilitation efforts. Most lenders extend DIP financing on a secured basis. While the collateral may not typically be comprised of material real estate, there are transactions where real estate can be a significant part of the collateral.

There are two types of DIP financing: defensive DIP loans extended by existing secured lenders to protect their collateral and the value of their pre-petition claims, and third-party DIPs extended by lenders seeking high returns. In addition to the traditional lender motives (e.g., collecting fees, an attractive rate of return and adequate security), potential DIP lenders may be induced by the opportunity to gain access to non-public information, to influence the debtor's management decisions, and/or to acquire equity in the debtor upon exiting bankruptcy. DIP loans can be profitable due to the debtor's immediate need for working capital. Additionally, a lender can be more certain of repayment because of DIP loan protections under the Bankruptcy Code.

DIP Financing

Section 364 provides four levels of secured financing:

• First: A super-priority claim over other administrative expenses (Section 364(c)(1)); (administrative expenses typically include legal and other professional and consulting fees plus other post-petition expenses);

• Second: A lien on unencumbered assets of the debtor (Section 364(c)(2));

• Third: A junior lien on already encumbered assets (Section 364(c)(3)); and

• Fourth: A senior or equal lien on previously encumbered assets—a priming lien (Section 364(d)).

A court will examine the loan terms to ensure that they are fair and reasonable. The court will only authorize a higher level of security if credit cannot be obtained at the lower level. The court may authorize a junior lien on the debtor's assets even where the senior lien documents prohibit a junior lien. A priming lien usually only occurs when a pre-petition senior lender becomes the DIP lender and primes itself or if adequate protection is provided to the pre-petition senior lender.

Mortgage/Deed of Trust

Whether a DIP loan is adequately perfected by its court-ordered lien pursuant to Section 364 of the Bankruptcy Code or whether mortgages or deeds of trust are required to perfect the DIP lien on real property can be a source of debate between real estate and bankruptcy attorneys.

Bankruptcy attorneys will assert that the Section 364 lien on all the debtor's assets provides adequate security for the DIP loan and that, if the debtor defaults, the Bankruptcy Court will enforce the order granting such lien. Furthermore, mortgages and deeds of trust are expensive and time-consuming in a situation where lack of funds and urgency prevail.

Nevertheless, real estate attorneys will ask: How can we be sure that a state court would honor the DIP lender's lien where no mortgage/deed of trust is of record? Doesn't a mortgage/deed of trust need to be recorded in accordance with applicable state law? Doesn't applicable mortgage tax have to be paid?

Further, what if in a bankruptcy with multiple debtors, an SPE subsidiary is dismissed from the bankruptcy case? If the Bankruptcy Court no longer has jurisdiction, how can a DIP lender enforce its lien in state court when there is no mortgage or deed of trust?

All of the foregoing appear to be questions of first impression. We have found no case law to answer them.

Although the real estate attorneys' concerns may be myriad and well-founded, in the absence of further collateral-specific issues (such as breaks in the chain of recorded title due to poorly documented corporate mergers and acquisitions), the cost, complexity and delay of creating and recording mortgages or deeds of trust are often prohibitive.

363 Sales

Another way a debtor can raise operating capital is to sell assets. Section 363 of the Bankruptcy Code allows a debtor to sell property in the ordinary course of business without court approval (Section 363(c)); or other than in the ordinary course of business with court approval (Section 363(b)). The court is empowered to order these sales to be made free and clear of existing liens (Section 363(f)).

Most often, to maximize the value of the asset to be sold, a debtor will negotiate an asset purchase agreement with a potential purchaser who will then act as a stalking horse. After evaluating all offers, the debtor enters into a contract with a proposed purchaser, which is subject to both Bankruptcy Court approval and to being out-bid, sometimes in an auction-like process. Although the stalking horse purchaser may get outbid, it nonetheless gains several advantages. The stalking horse bidder will likely receive a break up fee and expense reimbursement as well as enjoying an inside track with the debtor, official committees, counsel and their advisers.

Alternatively, rather than use the stalking horse method, the debtor can proceed straight to auction with the outcome subject to Bankruptcy Court approval.

Exit Financing and Asset Sales

Exit financing is a loan made pursuant to a confirmed plan of reorganization in connection with the debtor's exit from bankruptcy. It is analogous to a take out loan entered into after completion of construction to pay off a higher cost construction loan. Exit financing may pay off the DIP loan, certain creditors and fund operations. Unlike DIP financing, there is no lien created by the Bankruptcy Court order. Accordingly, mortgages/deeds-of-trust are required to create the lender's lien. Exit financing, however, does not require payment of mortgage tax (Section 1146(a)).

Additionally, a debtor may sell assets pursuant to a confirmed plan of reorganization. A sale pursuant to a confirmed plan of reorganization does not require the payment of transfer taxes (Section 1146(a)) and may be free and clear of liens (Section 363(f)).

Practitioners should be aware of a recent case concerning the court-ordered exemption from mortgage recording taxes and/or transfer taxes arising out of a Section 363 sale. Section 1146(a) exempts from stamp or similar taxes the delivery of a transfer instrument under a confirmed plan. The issue is whether "under a confirmed plan" includes a transfer prior to but in accordance with a subsequently confirmed plan.

In Florida Dept of Revenue v. Piccadilly Cafeterias Inc., 128 S. Ct. 2326 (2008), a transfer was made by a debtor prior to a confirmed plan. The Bankruptcy Court, Federal District Court and the U.S. Court of Appeals for the Eleventh Circuit all held that the transfer was exempt under Section 1146(a). The Supreme Court reversed, holding that to be eligible for the Section 1146(a) exemption, the plan must have been previously approved.

Title Insurance Concerns

Title insurance will likely be unavailable to the DIP lender without recorded mortgages or deeds of trust. What risks does this present? In addition to raising state court enforceability questions, a Bankruptcy Court order does not confirm the ownership of real estate, the quality of title or, in some cases, the existence or priority of pre-existing liens. Furthermore, creditors improperly or not noticed in the bankruptcy action may not be bound by the Bankruptcy Court order authorizing the DIP financing.

Whether the transaction is a sale, a DIP financing or exit financing, involving the title insurance company early on in the transaction is advantageous. The title insurance company will review the motion, the Bankruptcy Court order and the parties noticed. The real estate attorney should point out to its client that, despite a Bankruptcy Court order authorizing a sale "free and clear" of liens, local municipalities have consistently refused to honor the Bankruptcy Court order as it applies to real estate taxes. Accordingly, real estate taxes will probably have to be paid to be removed from a municipality's tax rolls.

Because the sale of real estate in a Section 363 sale is unlikely to be in the ordinary course of business, the title insurance company will probably require court approval to insure the transaction. This might not apply where the debtor is a homebuilder or a condominium sponsor, but the outcome will be fact-specific.

A recent court decision is giving title insurance companies concerns. In it, the Bankruptcy Appellate Panel for the Ninth Circuit reversed a lower court order and held that the senior lien holder could not purchase the real property free and clear of a junior lien, notwithstanding the junior lien holder's failure to obtain a stay pending appeal of the sale order. In Re PW, LLC, 391 B.R. 25 (9th Cir. BAP 2008). As a result, title insurance companies are now taking a much closer look at Bankruptcy Courts' "free and clear" orders before agreeing to insure.

Last, there is often confusion surrounding the statutory 10-day stay of the Bankruptcy Court order for the sale of property and the 10-day right of appeal period. It is important to distinguish between these two different 10-day periods.1

A Bankruptcy Court order for the sale of property is stayed for 10 days. However, this may be waived by the court. (Rule 6004(g)). Note that the waiver of the stay does not vitiate the 10-day appeal period. This separate and distinct 10-day period may not be waived by the court. (Rule 8002). Generally, title insurance companies will not insure over the 10-day appeal period and will require that the order become final to insure. See In Re PW, LLC, 31 B.R. 25 (2008).

S.H. Spencer Compton is a senior vice-president and special counsel, and Andrew D. Jaeger is a senior vice-president and counsel, both at First American Title Insurance Company of New York. Diane Meyers, counsel at Paul, Weiss, Rifkind, Wharton & Garrison, contributed to this article.

Endnotes:

1. The 10-day period for the stay and the 10-day appeal period will both increase to 14 days on Dec. 1, 2009, unless Congress enacts legislation to reject, modify, or defer the proposed amendments.

Tuesday, September 22, 2009

Cap Rate Calculations - How do investors determine ROI in an unsteady market?

By Eric B. Garfield, MAI, MRICS, and Matthew T. VanEck

A capitalization rate is the overall or non-financed return on a real estate investment, akin to the return on total assets in accounting terms. A cap rate is calculated as a mathematical relationship between net operating income and an asset’s value. Most commonly cap rates are extracted from transactions of buyers and sellers competing in a marketplace; but they are related to the current state of capital markets as well as the future growth outlook. So how can real estate professionals extract cap rates in today’s market, where few sales exist?

Generally, cap rates are derived from real property sales via the formula cap rate (RO) = NOI ÷ value. In first quarter 2008, this cap rate derivation may have sufficed. However, since then, the conclusions would be misstated not only because of changes in time, but also because of the subprime lending crisis’ impact and U.S. capital markets’ failure. Thus, real estate professionals not only must be able to interpret market data, but they also must understand the capital markets’ effect on cap rates — especially in illiquid markets, where sales data is limited.

Credit Crisis and Cap Rates
The relationship between cap rates and their respective capital markets often is overlooked. Leverage, or the effect of borrowed funds on return on investment, is a key component of a cap rate. Leverage generally varies from market to market and is affected by supply and demand as well as interest rates.

As a reminder, it is noteworthy that cap rates and discount rates, or internal rates of return, are not mutually exclusive. A discount rate is a measure of investment performance over a holding period that accounts for risk and return on capital. Cap rates not only account for return on capital, but also return of capital. A discount rate can be built up from a cap rate if income and growth both change at a constant rate. The buildup is derived by the formula Y = R + CR, where Y = discount (yield) rate, R = cap rate, and CR = constant rate of change.

Thus, if a market-extracted cap rate is 7 percent and the market constant rate of change is 3 percent, the discount rate is 10 percent. This calculation represents an investor’s yield expectations on investment, but not return of investment. Return of investment must be calculated separately.

Since the 2008 financial meltdown, the commercial mortgage-backed securities market essentially has stopped functioning, halting most available financing for commercial real estate. Thus, how is the lack of leverage in determining a cap rate accounted for and how do the pre-crash cap rates differ from the post-crash cap rates? A look at appraisal mathematicians L.W. Ellwood’s and Charles B. Akerson’s analyses provides a quantifiable explanation.

The Anatomy of a Cap Rate
Cap rate quantification began with Ellwood, who is credited with developing financial valuation models at a time when appraisers commonly were using physical residual techniques such as land and buildings. In 1959, Ellwood published “Ellwood Tables for Real Estate Appraising and Financing,” which showed that by analyzing market mortgage terms and equity yields for a particular property, an appraiser could identify a suitable cap rate and thus property value. This valuation technique became known as mortgage-equity analysis. Ellwood’s method allowed appraisers to incorporate and explain financing’s impact on value.

From his research, Ellwood created a formula that “builds up” a property’s cap rate on the basis of assumptions concerning mortgage and equity requirements. Using Ellwood’s formula, a cap rate results through application of an investor’s equity yield requirements, structure of debt, total change in income over the projection period, and change in total property value over the projection period. The resulting cap rate is then divided by NOI to produce a value estimate that explicitly reflects the property’s financial considerations. (See “Ellwood’s Formula.”)

One flaw of Ellwood’s formula is its complexity. It not only requires capital markets knowledge, but also algebraic operations. Several years later, Charles Akerson simplified Ellwood’s formula by altering the calculations to a series of simple arithmetic steps based on a band of investment calculations in his article “Ellwood Without Algebra,” in the July 1970 issue of The Appraisal Journal. The Akerson formula uses similar components to build up a cap rate; however, it succeeds in simplifying the steps without sacrificing results. (See “Akerson Format.”)

Sensitivity to Leverage
In addition to providing a helpful mortgage-equity valuation technique, Akerson’s formula also can be used to illustrate the effects of financial leverage or debt on a particular investment. Leverage can be measured by the loan-to-value ratio (M). An LTV change can increase or decrease the equity return (Ye) depending on the specific terms: The higher the risk to the investor, the higher the equity rate an investor will seek to compensate. Leverage is considered positive when the cap rate is greater than the mortgage cap rate or mortgage constant (Rm), while negative leverage occurs when the cap rate is lower than the mortgage cap rate.

Using the Akerson model, the effect of leverage change on equity yield rates can be illustrated. (See “Akerson Format in Action.”) Assume that NOI is level at $100,000 and the subject property can be financed with a 75 percent loan paid monthly at 8 percent annual interest over 25 years. The required market return on equity for 75 percent financing is 14 percent, and the property is expected to be sold in year 10, at which time the value is expected to have increased (∆) by 10 percent. Thus, M = .75, E = .25, Rm = .092618 (The present value per payment of $1 at 8 percent annual interest, amortized monthly over 25 years), Ye = .14 and ∆ = .10. The percentage of loan paid off in the holding period (P) can be determined by dividing the amortization rate of the 8-percent, 25-year full-term loan by the amortization rate of the 8-percent, 10-year holding-period loan. The percentage of loan paid off in the holding period is thus equal to 19.24 percent. The sinking fund factor (the future value per payment of $1 amortized annually over 10 years at 14 percent equity investment rate) is 0.0517. In applying the Akerson formula, the resulting overall cap rate is .0918 or 9.18 percent. At a level NOI of $100,000, the value of the subject property is $1,100,000 rounded. (See chart 5.)

In this example, if the LTV is increased from 75 percent to 80 percent, the equity yield rate will increase as well from 14 percent to 15.09 percent at the same value estimate and at the same cap rate (chart 1). Since there is greater risk when less money is put down, an investor requires a higher equity yield rate for the same return. If the required equity return is unchanged, a higher value will result due to an increase in leverage and a decline in the cap rate (chart 2). Similar relationships exist with changes in the mortgage constant or equity yield rate. Increases in the mortgage constant produce decreases in the equity yield rate. Thus, leverage analysis is important as risk levels directly impact the returns to equity.

Application in 2009
So what does this mean in the current market? Consider this example: Two apartment properties were sold in July 2008 for $1 million each. The properties sold at cap rates of about 6.50 percent. The properties were financed with new loans at 65 percent of value at interest rates of 6.00 percent for 25 years.

How would these transactions differ if they occurred in June 2009? By example, two lenders still active in the market currently quote 55 to 65 percent LTV ratios with interest rates of 6.50 to 7.50 percent (and rising) for these deals. If investors desire the same equity yields, what are the effects on value?

Based on the transaction terms and cap rates at which the apartments sold in 2008, the respective equity yield rate is about 9.00 percent and the mortgage constant is 7.73 percent at 65 percent LTV, 6.00 percent interest for 25 years, and at a 6.50 percent cap rate, all else remaining constant (chart 3).

In holding the investor’s equity yield rate constant in the current credit crisis scenario, an average increase of interest rates by 100 basis points along with a 5 percent LTV ratio decline results in a 68 basis point increase in cap rates to 7.18 percent. The cap rate increase from market conditions results in a June 2009 value of $900,000 (rounded); a value decline of 10 percent from the pre-credit crisis scenario value of $1 million in this example (chart 4).

As revealed through dissection of Ellwood’s and Akerson’s formulas, a cap rate is more than merely the NOI divided by its selling price. As Akerson said in his Appraisal Journal article, “Understanding the composition of the cap rate is the key to understanding and applying mortgage-equity capitalization. Once the anatomy of the capitalization rate is exposed, the rationale of the method becomes apparent.”

By making sense of cap rate sensitivity, one gains a better understanding of how changes in financial markets correspond to changes in investment perceptions of the future, and more importantly, where the market seems to be headed in times of economic turbulence.


Ellwood’s Formula

Ro = YE – M (YE + P1/Sn – RM) – DO1/Sn

(1+ DIJ) or (K)

Ro = cap rate that is used to convert income into value
YE = equity discount or yield rate is rate of return on equity capital
M = loan-to-value ratio is ratio between a mortgage loan and a property’s value
P = percentage of loan paid off in holding period
1/Sn = sinking fund factor is an element in yield and change formulas that converts the total change in capital value over the projection period into an annual percentage
Rm = mortgage capitalization rate or mortgage constant reflects the relationship between annual debt service to the principal amount of the mortgage loan
∆O = change in total property value over the projection period
∆I = total change in income over the projection period
J = an income stabilization factor used to convert an income stream changing on a curvilinear basis into its level equivalent
K = an income stabilization factor used to convert an income stream changing at a constant ratio into its stable or level equivalent

Source: The Appraisal of Real Estate, 13th edition

Akerson Format
Loan ratio (M) x annual constant (RM)
+ Equity ratio (1-M) x equity yield rate (YE)
- Loan ratio (M) x % paid off in projection period (P) x 1/Sn
= Basic rate (r)
+ Depreciation or – gain x 1/Sn
= Overall cap rate (RO)


Table 1 - Akerson Format Steps

Increase in LTV to 80%, with cap rate constant at 9.18%

1 M x Rm

2 + E x Ye

3 - M x P x 1/Sn

4 = r

5 +/- Dep/(Gain) x 1/Sn

6 = Ro

1 0.80 x 0.0926 = 0.0741

2 + 0.20 x 0.1509 = 0.0302

3 - 0.80 x 0.1924 x 0.0490 = -0.0075

4 = r 0.0967

5 +/- 0.10 x 0.0490 = -0.0049

6 = 0.0918

Cap rate 9.18%

NOI $100,000

Value $1,088,955

Rounded $1,100,000

Table 2 - Akerson Format Steps

Increase in LTV from 75% to 80% with Ye at 14%

1 M x Rm

2 + E x Ye

3 - M x P x 1/Sn

4 = r

5 +/- Dep/(Gain) x 1/Sn

6 = Ro

1 0.80 x 0.0926 = 0.0741

2 + 0.20 x 0.1400 = 0.0280

3 - 0.80 x 0.1924 x 0.0517 = -0.0080

4 = r 0.0941

5 +/- 0.10 x 0.0517 = -0.0052

6 = 0.0890

Cap rate 8.90%

NOI $100,000

Value $1,124,042

Rounded $1,125,000

Table 3 - Akerson Format Steps

Apartment Sale Example - Original Sale

1 M x Rm

2 + E x Ye

3 - M x P x 1/Sn

4 = r

5 +/- Dep/(Gain) x 1/Sn

6 = Ro

1 0.65 x 0.0773 = 0.0503

2 + 0.35 x 0.0898 = 0.0314

3 - 0.65 x 0.2365 x 0.0659 = -0.0101

4 = r 0.0716

5 +/- 0.10 x 0.0659 = -0.0066

6 = 0.0650

Cap rate 6.50%

NOI $64,970

Value $1,000,000

Table 4- Akerson Format Steps

Apartment Sale Example — June 2009 Sale

1 M x Rm

2 + E x Ye

3 - M x P x 1/Sn

4 = r

5 +/- Dep/(Gain) x 1/Sn

6 = Ro

1 0.50 x 0.0930 = 0.0465

2 + 0.50 x 0.0898 = 0.0449

3 - 0.50 x 0.3323 x 0.0659 = -0.0109

4 = r 0.0805

5 +/- -0.05 x 0.0659 = 0.0033

6 = 0.0838

Cap rate 8.38%

NOI $64,970

Value $775,608

Table 5 -Akerson Format Steps

LTV at 75% and Ye at 14%

1 M x Rm

2 + E x Ye

3 - M x P x 1/Sn

4 = r

5 +/- Dep/(Gain) x 1/Sn

6 = Ro

1 0.75 x 0.0926 = 0.0695

2 + 0.25 x 0.1400 = 0.0350

3 - 0.75 x 0.1924 x 0.0517 = -0.0075

4 = r 0.0970

5 +/- 0.10 x 0.052 = -0.0052

6 = 0.0918

Cap rate 9.18%

NOI $100,000

Value $1,088,955

Rounded $1,100,000

Proposed Technical Corrections To New Power of Attorney Law

By Sanford J. Schlesinger and W. Gyongyi Gulyas

New York Law Journal

September 22, 2009

New York's new power of attorney law,1 which took effect on Sept. 1, 2009, has made extensive changes to New York's power of attorney law. Some of these changes to the law promise to be beneficial. Other changes promise to be, at best, problematic.

Some of these problematic changes to the law will be addressed by a proposed technical corrections bill, which has been passed by the New York State Assembly and is currently pending a vote in the New York State Senate, if these corrections are enacted.2 However, other issues will not be addressed, including the new law's relatively complex requirements for a principal to grant powers to an agent to make gifts and transfer property. These complex requirements may protect some principals from having their assets misused, but they also will make it more difficult for all principals to execute a valid power of attorney.

The new law recommends, in a number of its provisions, that a principal should have an attorney supervise the execution of a power of attorney, and particularly, the new Statutory Major Gifts Rider (SMGR). However, the new law's requirements are so complex that they virtually require that a principal have an attorney, or risk executing a power of attorney which is invalid or has unintended results. Additionally, this quality of the law itself may have unforeseen results (e.g., cause more powers of attorney to be found invalid or ineffective for their purposes; make powers of attorney a less useful tool, and discourage principals from using them; and/or lead to increased litigation), because not all principals have the means, disposition, or awareness to obtain legal counsel.

The Proposals

The proposed technical corrections bill includes corrections of minor drafting errors, added clarification that standards for third parties' "reasonable" acceptance applies only to the statutory short form power of attorney, and a provision for the Law Revision Commission3 to conduct a follow-up study of the new law's implementation and use. The most significant of the proposed technical corrections are the following, however.

1. Elimination of two problematic "default" provisions:

a. Default revocation of all of a principal's existing power(s) of attorney, whenever a principal executes a new power of attorney, unless the principal has affirmatively preserved such a prior power of attorney in the new power of attorney instrument. The proposed technical correction would eliminate this provision, and substitute a provision that states that a prior power of attorney will not be revoked unless a principal has given written notice to the agent of its revocation.4

b. Default revocation of a prior, existing agent's authority to act separately from a new agent appointed in a new power of attorney who has the same authority, unless the principal has affirmatively stated in the new power of attorney's "Modifications" section that the prior agent may act separately. The proposed technical correction would eliminate this requirement that a principal must indicate, in the new power of attorney, whether the agent appointed in the prior power of attorney is to act "together or separately"5 with a new agent, or the prior agent will be required to act jointly with the new agent by default.6

The current law's first default provision, if it is not "corrected" as proposed, would allow a new limited power of attorney (e.g., executed specifically for a real estate transaction) to revoke a principal's broad general durable power of attorney. Additionally, it would allow any new power of attorney to revoke power(s) of attorney that a principal is required to preserve by contract (e.g., certain powers of attorney "coupled with an interest," such as those given to condominium and cooperative apartment boards).

The current law's second default provision, if it is not "corrected" as proposed, could change existing independent agents' authority to act separately to require joint action by the agents simply by operation of law and with no notice to the agents, which may be contrary to a principal's intent. Therefore, both of the proposed technical corrections to these default provisions are recommended, as described above, because they would be more likely than the current law's provisions to produce a result consistent with a principal's intent, and less likely to produce a result inconsistent with a principal's intent due to mere mistake or oversight.

2. Correction of the law's apparently ineffective "exception" for use of other forms of power of attorney by business entities.

Many business entities commonly use limited powers of attorney for limited purposes (e.g., real estate transactions). These limited powers of attorney generally would not meet the new law's requirements. The new law provides an exception for the use of such other forms by an "individual" not defined as a "person" under the law. However, because all powers of attorney are necessarily executed and used by a "person," even when on a business entity's behalf, the language of this exception does not appear to be effective for its purpose. The proposed technical correction would eliminate the current law's problematic reference to an individual who is not a person, and substitute a "principal who is not an individual."7 This technical correction is recommended, because it would make the exception effective for its purpose.

3. Deletion of the law's requirements that a valid, written revocation of a power of attorney must be signed and dated, and delivered to a third party that the principal has reason to believe has received, retained or acted upon, the power of attorney.8

This is a troubling proposed technical correction. It is unclear why the Legislature would want an unsigned, undated, written revocation of a power of attorney, only possessed by an agent, to be generally effective. It is highly unlikely that a competent principal would be capable of executing a valid "written" revocation, but not be capable and willing to sign and date it (and if a principal is incapacitated, his or her written revocation should not be honored. This is notwithstanding the current law's provision that an incapacitated principal's revocation of a power of attorney will be honored, unless the principal has been declared incapacitated pursuant to Article 81 of the Mental Hygiene Law).9 Additionally, this proposed technical correction would make it easier for a fraudulent revocation to be created and used by an agent, or others, as a defense against legal liability for failing to act properly.

4. Reduction of the maximum amount of minor "customary" gifts that an agent is allowed to continue to make under the "personal and family maintenance power" to a maximum aggregate total of $500 per year,10 from the current maximum of $500 per year, per donee.

This proposed technical correction is not recommended, because many principals' "customary" annual gifts to individuals and charities already may exceed the proposed new $500 maximum for such continued gifts. If this proposed technical correction is enacted, such a principal would no longer be capable of granting his or her agent the power to continue to make the principal's previously "customary" gifts by simply initialing the "personal and family maintenance" power, and would be virtually required to meet the new statute's requirements for grants of gifting and property transfer powers (i.e., two disinterested witnesses would be required for any such grant, and the principal would be required to execute the new SMGR whenever he or she uses the new statutory short form power of attorney to make such a grant).

These requirements would generally require that a principal retain an attorney to properly execute a power of attorney that correctly effectuates his or her intent. This expense would be onerous, and possibly exceed the cost-benefits to be gained, for many principals of average means and whose annual gifts are relatively minor. If the law makes execution of valid powers of attorney more complex in this way, and particularly, increases the instances in which average individuals would be required to execute a SMGR (which the law states should be supervised by an attorney), it could actually serve to discourage many principals from executing powers of attorney. This would defeat at least one public policy goal of the law, which is to encourage more members of the public to use powers of attorney.

Issues Not Addressed

The proposed technical corrections bill does not address the following issues with the new law, however, which should be corrected.

• The misleading information contained in the "Caution to the Principal" notice and new §5-1511 of the law that a principal may revoke a power at will, if of sound mind. This is not true of contractual powers of attorney.

• The requirement that any valid power of attorney contain the "exact" statutory language of the mandatory notices to the principal and agent. This requirement may result in otherwise valid powers of attorney being declared invalid for non-substantive deviations from this language, when a requirement of "substantial compliance" would probably be adequate.11

• The absence of provisions for a monitor's reimbursement for expenses, or for the monitor to receive notification that he or she has been appointed a monitor. These omissions will probably diminish the effectiveness of the new monitor role.

• The explicit authorization of special proceedings as the "exclusive remedy" for the unreasonable failure of a third party to honor a statutory short form power of attorney. This provision, and the restriction of such special proceedings to orders of injunctive relief to compel acceptance of a power of attorney, may limit a principal's access to the court system under certain circumstances.

• The inconsistent replacement of "arbitration," as used in the prior law, with "alternative dispute resolution." This is a less significant "issue," but one that should be corrected, nonetheless. The Legislature has substituted "alternative dispute resolution" for "arbitration" in two powers, "Benefits from governmental or civil or military service" and "Major gifts [et al.]." However, it has not made this substitution in the remaining powers that still refer to "arbitration."

Important to Remember

1. New York's new power of attorney law has complex requirements for making gifts and transfers of property, important default provisions, and retroactive provisions which will affect existing powers of attorney.12

2. Principals are not required to use the statutory short form power of attorney, and should carefully consider the benefits and drawbacks of using this form. The benefits of using the statutory short form include its statutory protections (most significantly, third parties' required "reasonable" acceptance of the form), and its standard, approved language.

The drawbacks of using the statutory short form may include its requirement for concurrent execution of a SMGR, when a principal wishes to grant an agent meaningful powers to gift and transfer property. This form is generally considered complex, and the requirement that it be executed concurrently with the statutory short form power of attorney would appear to require that new versions of both forms would need to be executed any time revisions to either form are needed. In contrast, a non-statutory power of attorney would allow a principal to grant an agent all powers in the power of attorney itself, without the need to execute a second, concurrent form. However, a non-statutory power of attorney may also contain non-standard language which could lead to unanticipated interpretations, or findings of invalidity.

3. A valid power of attorney executed prior to the effective date of the new law will remain valid under, and receive certain retroactive benefits of, the new law. Therefore, in some cases, it may be prudent for certain principals who already have an existing, valid power of attorney, not to execute a new power of attorney, but to rely on the power of attorney they already have.

4. Additionally, powers of attorney valid in other states will be honored in New York. Therefore, in some cases, it may be prudent for certain principals to execute a power of attorney in another state that is valid under the laws of that state. However, the potential for conflict of laws issues to arise should be noted, and prevented by careful drafting.

5. Particularly because of the new law's complex requirements for granting powers to make gifts and transfer property, a revocable trust may be a preferable alternative to a new power of attorney. Depending on a client's needs, executing a revocable lifetime trust could provide a principal with more flexibility and fewer limitations than a new power of attorney under the new law. However, such trusts present their own complexities and issues, including those associated with the transfer of assets to the trust.

Conclusion

New York's new power of attorney law introduces many beneficial new provisions to the law. However, the complexities of the new power of attorney law may serve to discourage principals' use of the statutory short form because of the SMGR requirement, and/or powers of attorney in general, and may lead to principals executing powers of attorney which are invalid, or have unintended consequences. Clearly, the new power of attorney law is a work in progress, which must be watched closely.

Sanford J. Schlesinger is a founding partner of Schlesinger Gannon & Lazetera and a fellow of the American College of Trust and Estate Counsel. W. Gyongyi Gulyas is an associate at the firm.

Endnotes:

1. Chapter 644 of the Laws of 2008, signed into law on Jan. 27, 2009, amending the New York General Obligations Law ("N.Y. Gen. Oblig. Law") Article 5, Title 15.

2. Legislative Bill No. A8392, passed by the New York State Assembly on June 15, 2009, and Legislative Bill No. S5910, in the New York State Senate.

3. The Law Revision Commission is a long-standing agency which was created by the state Legislature to review and recommend reforms in the law. The new power of attorney law largely resulted from an approximately eight-year study of the current law by the commission (which includes members of the state Legislature), and its recommendations.

4. Legislative Bill Nos. A8392 and S5910, §2, amending N.Y. Gen. Oblig. Law §5-1511(6), and §3, amending N.Y. Gen. Oblig. Law §5-1513(1)(e).

5. Legislative Bill Nos. A8392 and S5910, §3, amending N.Y. Gen. Oblig. Law §5-1513(1)(e).

6. N.Y. Gen. Oblig. Law §5-1508.

7. Legislative Bill Nos. A8392 and S5910, §14, amending N.Y. Gen. Oblig. Law §5-1501B(4).

8. Legislative Bill Nos. A8392 and S5910, §1, amending N.Y. Gen. Oblig. Law §5-1511(3)(b), §2, amending N.Y. Gen. Oblig. Law §5-1511(6), and §3, amending N.Y. Gen. Oblig. Law §5-1513(1)(e).

9. N.Y. Gen. Oblig. Law §5-1511(3)(b)(1).

10. Legislative Bill Nos. A8392 and S5910, §5, amending N.Y. Gen. Oblig. Law §5-1513(1)(f)(2)(I), §6, amending N.Y. Gen. Oblig. Law §5-1513(1)(h), §7, amending N.Y. Gen. Oblig. Law §5-1514(10), and §8, amending N.Y. Gen. Oblig. Law §5-1502(I)(14).

11. Similar to "substantial" compliance in the Uniform Power of Attorney Act (2006) §301.

12. See the first part of this two-part article on Sept. 17, 2009, for a discussion of these provisions.

Wednesday, September 16, 2009

Bankruptcy of a Co-Lender Or Subordinate Lender

New York Law Journal
By Jeffrey B. Steiner and Zachary Samton
September 16, 2009

Over the past year, in this column, we have examined several different issues related to troubled real estate loans, primarily in connection with borrower defaults and lender remedies. The credit crisis, however, has affected mortgagees as well as mortgagors. If, in the context of a participated, syndicated, tranched or senior/junior loan structure, one of the lenders were to file a petition for relief under the Bankruptcy Code,1 the automatic stay afforded such lender could have material consequences to the other lenders, especially in a circumstance where the loan or underlying collateral was itself troubled. As banks and other financial institutions fail, the issue of lender bankruptcy has become more prevalent in the finance industry.

One of the most fundamental protections afforded entities that file for bankruptcy is the imposition of the automatic stay, which prohibits creditors from commencing or continuing nearly all efforts to enforce debts or perfect security interests in property of the debtor.2 The automatic stay is designed to give a debtor "breathing room" in order to focus on either reorganizing its business or conducting an orderly liquidation of its assets in bankruptcy. In situations where the automatic stay applies, a creditor must move for relief from the automatic stay prior to engaging in activities designed to enforce its debt.

Failure to seek relief from the stay may result in a bankruptcy court awarding a debtor actual damages, including costs and attorney's fees, as well as punitive damages, in appropriate circumstances.3 Actions taken in violation of the automatic stay are generally void; however, courts may grant retroactive relief from the stay in limited circumstances.4

If the automatic stay is applicable, a creditor must seek relief from the stay based on certain grounds enumerated in Bankruptcy Code §362(d). The two grounds that may apply to a senior lender seeking relief in order to foreclose a bankrupt junior lender's lien are: (1) "for cause"5 or (2) if the debtor has no equity in the subject property and the subject property is not necessary for the bankrupt junior lender's effective reorganization.6 Aside from "lack of adequate protection,"7 the phrase "for cause" is not defined in the Bankruptcy Code.8

There is a split in authority as to whether the automatic stay is applicable in a circumstance where a senior lender is attempting to foreclose on a property subject to a junior mortgage after the junior lender has filed for bankruptcy. Inasmuch as the subject junior mortgage still has value (in the most basic sense, if the market value of the underlying property exceeds the outstanding principal balance of the first mortgage loan) and is an asset of the bankruptcy estate, the automatic stay could prevent the first mortgagee from exercising its remedies and completing a foreclosure against the underlying borrower. The majority of relevant decisions appear to hold that the automatic stay does indeed apply9 and that a senior lender must petition the court for relief from the stay before it can foreclose out the junior lender's mortgage. Bankruptcy has long been an issue for lenders structuring complex transactions, but such concerns have typically been focused on the borrower, not another lender in the stack.

In In re Three Strokes Limited Partnership10 a senior lender was prevented from completing a non-judicial foreclosure that was commenced before the junior lender voluntarily filed its Chapter 11 case. The court held that the bankrupt junior lender's second lien was a "cognizable property interest" protected by the automatic stay and that an intercreditor and subordination agreement entered into by the lenders did not extinguish said property interest. As such, the senior lender was required to seek relief from the stay before continuing with its foreclosure.

Certain courts, however, have found that the automatic stay does not apply to a senior lender foreclosing a bankrupt junior lender's lien. In Farmers Bank v. March11 the court found that the automatic stay was intended to protect "debtors" and although under the protection of the bankruptcy court, the junior mortgagee was a "lender" in respect to the collateral property, not a "debtor" (and the senior lender was not its "creditor"), and, therefore, its second mortgage interest was not subject to the automatic stay.

In another situation, where a senior lender commenced foreclosure against its borrower, but did not name or serve a necessary bankrupt party, thereby leaving its security interest undisturbed, the court found that as the debtor would remain in the same position, no interest of the bankrupt estate was affected and therefore the automatic stay did not apply.12 However, the case law is not well developed on whether such a foreclosure would constitute a violation of the automatic stay and a cautious lender may want to seek relief from the stay.

Given the potential negative consequences of failing to seek relief from the automatic stay, a prudent first mortgagee is well advised to seek relief from the stay "out of an abundance of caution" rather than risk wasting time and effort on a foreclosure that may be overturned. Additionally, a first mortgagee may choose to petition the court for relief from the stay rather than risk punitive damages for willfully continuing with a foreclosure of a bankrupt junior lender's lien. If, however, the market value of the underlying property has declined below the outstanding balance of the first mortgage, the second mortgage loan is essentially unsecured and may not be considered an asset of the bankrupt estate.

Generally, bankruptcy courts will lift the stay if the bankrupt junior lender has no equity in its lien. It will be difficult, if not impossible, for a bankrupt junior lender to prove to the court that its unsecured lien is "necessary for an effective reorganization." However, a bankrupt junior lender may argue that rather than conducting a hasty foreclosure sale of the underlying collateral that will result in no return to the junior lender, a properly marketed sale of the collateral will result in a higher sale price and, ultimately, provide some return on the junior lien. Obviously, this analysis would vary on a case-by-case basis.

Developments in the structure of modern commercial mortgage loans have attempted to mitigate the risk of borrower bankruptcy from the underwriting process. In standard non-recourse loans, carve-out guaranties, for example, typically include a provision triggering full recourse to a deep-pocket guarantor if the borrower goes into bankruptcy, whether voluntarily or not.

The concern is that, among other things, absent a methodology for limiting a borrower's ability to seek bankruptcy protection, it can use the threat of filing to obtain concessions from a lender. Although not as well developed, there are certain mitigants a lender may employ to deter co-lender bankruptcy. Frequently, intercreditor agreements contain language requiring that any assignee or acquirer of a lender's position be "qualified."

The requirements for qualification include, among other things, a net worth significant enough to make bankruptcy unlikely. Of course, such protections only go so far, and many of the recently failed banks and financial institutions would have "qualified" only months or even weeks before their collapse.

Another context in which issues involving the automatic stay and a lender's bankruptcy arise involves loan participations. In a participated loan, typically there is only one mortgage, with two or more lenders owning participation interests therein. The note and mortgage are usually in the name of the originating lender and each participant is issued a participation certificate (and not a separate lien or mortgage) and becomes party to a participation agreement (sometimes called a participation and servicing agreement).

A participation agreement assigns the position of "controlling holder" or "lead lender" to one of the participants and memorializes the relationship among the lenders, including what actions the controlling holder may take without consent of the other participants. As the mortgage and note in a participated loan is normally in the name of only one participant (the originating lender) and the controlling holder is generally entitled to make certain unilateral decisions, a bankruptcy of the named mortgagee or controlling holder could significantly affect the participant group's interest and the administration of the loan.

The Bankruptcy Code addresses certain concerns of a participant in a loan where the named mortgagee has filed for protection of the court. As a limitation on the definition of what is deemed to be property of the debtor estate (as set forth in Bankruptcy Code §541(a)), Bankruptcy Code §541(d) states:

Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest, such as a mortgage secured by real property, or an interest in such a mortgage, sold by the debtor but as to which the debtor retains legal title to service or supervise the servicing of such mortgage or interest, becomes property of the estate under subsection (a)(1) or (2) of this section only to the extent of the debtor's legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.

The effect of Bankruptcy Code §541(d) is to prevent a bankruptcy trustee from challenging a loan participation and asserting that the entire mortgage loan is an asset of the debtor's estate (as it would be held in the name of the debtor).

The court in In re Coronet Capital Co.,13 however, distinguished between a true participation interest protected by Bankruptcy Code §541(d) and a mere loan to the originating lender, disguised as a participation, which would not benefit from such protection. The debtor in In re Coronet originated a mortgage loan secured by a multifamily building in Brooklyn and then sold a 90.91 percent "participation" interest to another real estate investor.

The terms of the supposed participation agreement required the debtor to pay interest to the participant whether or not the underlying borrower made its interest payment. Furthermore, the debtor continued to make interest payments to the participant after the underlying borrower defaulted and ceased paying the required debt service. The obligation of the debtor to pay the participant interest regardless of a default by the underlying borrower was a de facto guaranty by the debtor.

The court in In re Coronet established a four factor test to determine whether a sale of an interest in a loan was a participation, entitled to the protections of Bankruptcy Code §541(d), or a loan to the originating lender, subject to the automatic stay.

The factors denoting the intent to create a loan and not a proper participation were held to be (i) the existence of a guarantee of repayment by the lead lender to a participant, (ii) the participation that lasts for a shorter or longer period than the underlying obligation, (iii) different payment arrangements between borrower and lead lender and lead lender and participant, and (iv) a discrepancy between the interest rate due on the underlying note and interest rate specified in the participation. As the subject arrangement clearly violated the first factor, the court found that the "participation" was in fact a loan and denied the participant's motion for relief from the stay.

Even if a participant's interest is protected by Bankruptcy Code §541(d), the administration of the loan may be jeopardized by the bankruptcy of a controlling lender. If the underlying mortgage loan requires decisions to be made by the controlling lender, such controlling lender's bankruptcy may adversely affect its ability to manage the loan, thereby endangering the investment of the other participants. A well drafted participation agreement should contemplate such an event and include the bankruptcy or insolvency of a controlling lender as a trigger to automatically assign the position of controlling lender to the next-in-line participant.

Given the increased complexity of financing arrangements in recent years, lenders who participate in multiparty lending agreements are well advised to carefully consider the potential impact of a bankruptcy of a co-lender. As the above cases indicate, there are risks for both senior and junior lenders should another co-lender file for bankruptcy. The automatic stay is a powerful protection for a debtor, and a lender must be aware of the financial strength of not only the borrower but the other participating lenders as well, lest that lender find itself unable to employ the remedies it had bargained for.

Jeffrey B. Steiner is a member of DLA Piper LLP (US), and Zachary Samton is counsel to the firm. Christopher J. Baum, an associate with the firm, assisted in the preparation of this article.

1. 11 U.S.C. §101, et seq. (2006).

2. See 11 U.S.C. §362.

3. See 11 U.S.C. §§105(a), 362(k)(1); see also In re Spookyworld Inc., 346 F.3d 1, 8 (1st Cir. 2003) (noting the split among courts as to whether punitive damages can be imposed on a creditor when the debtor is a corporation).

4. See Michael J. Lichtenstein, Violations of the Automatic Stay: Void or Voidable?, 23-May AM. BANKR. INST. J. 20 (May 2004) (discussing the consequences of actions taken in violation of the automatic stay and differing approaches that courts use in determining the validity of those actions).

5. See 11 U.S.C. §362(d)(1).

6. See 11 U.S.C. §362(d)(2). If the bankrupt junior lender has filed a chapter 7 bankruptcy case, then the senior creditor will only have to show that the bankrupt junior lender's lien is unsecured because the debtor's assets will be liquidated and there is no prospect of reorganization.

7. See 11 U.S.C. §361 (defining adequate protection).

8. See In re Kerns, 111 B.R. 777, 787 (S.D. Ind. 1990); see also In re Robinson, 169 B.R. 356 (E.D. Va. 1994) (setting forth a balancing test to determine whether cause exists to lift the automatic stay).

9. In re Cardinal Indus. Inc., 105 B.R. 834 (Bankr. S.D. Ohio 1989); In re Fidelity Mortgage Investors, 550 F.2d 47 (2d Cir. 1976).

10. 397 B.R. 804, 808 (Bankr. N.D. Tex. 2008).

11. 140 B.R. 387 (E.D. Va. 1992), aff'd, 988 F.2d 498 (4th Cir. 1993).

12. In re Comcoach Corp., 698 F.2d 571 (2d Cir. 1983); see also In re Geris, 973 F.2d 318, 320-21 (4th Cir. 1992) (allowing a noteholder to foreclose on a deed of trust while leaving the debtor/guarantor's obligation under a note securing the deed of trust in tact). But see In re Bialac, 712 F.2d 426 (9th Cir. 1983) (holding that a violation of the automatic stay occurred even though the debtor was not named in the foreclosure action because the foreclosure affected the debtor's equitable right to cure and redeem the foreclosed note).

13. In re Coronet Capital Co., 142 B.R. 78 (Bankr. S.D.N.Y. 1992).

Tuesday, September 15, 2009

United States: Sovereign Wealth Funds And U.S. Real Estate Investment

15 September 2009

Article by David Richards

Given the credit crisis in the American economy, with paralysis in U.S. capital markets preventing domestic buyers from financing commercial real estate purchases in the ordinary course, American real estate sellers increasingly view sovereign wealth funds (SWFs) without a need to borrow as potential buyers. These SWFs—entities established or controlled by a sovereign government and funded with foreign currency that is normally invested in overseas assets for the long-term—are flush with cash, mostly from the now-ended (or at least interrupted) era of high oil prices that resulted in an accumulation of wealth. As evidenced by last year's SWF investments in the Chrysler building (Abu Dhabi Investment Authority, $800 million, for a 90% stake) and the General Motors building (Kuwait and Qatar Investment Authorities, $1.12 billion, a 40% stake) in New York City, many SWFs are now searching for investment alternatives to U.S. Treasury bills and other such risk-free bonds, which formerly helped absorb these large global imbalances.

The New Regulations

New Department of the Treasury regulations for the first time explicitly include the acquisition of U.S. real estate in the definition of "covered transactions" that may possibly require pre-closing review by the federal government's 14-member, inter-agency Committee on Foreign Investment in the United States (CFIUS). Regulations Pertaining to Mergers, Acquisitions, and Takeovers by Foreign Persons, 73 Fed. Reg. 70,702 (Nov. 21, 2008) (eff. Dec. 22, 2008) (codified at 31 C.F.R. Part 800). The consequences are dramatic. Now, if an investment in American real estate requires review by CFIUS, and application is not made or approval not received, the transaction under contract may be blocked or, if already closed, even reversed by the President of the United States. Several foreign acquisitions (none involving only real estate) have been restructured in CFIUS mitigation proceedings, and others have been withdrawn before being formally denied. See David Marchick and Matthew Slaughter, Global FDI Policy: Correcting a Protectionist Drift, CSR No. 34, June 2008, Council on Foreign Relations, p. 29.

The question for the real estate industry and its legal practitioners is whether the prospect of heightened CFIUS review will deter SWFs that desire to put petro-dollars into American soil. Will a protectionist reflex, in response to perceived political rather than commercial threats, block the otherwise desirable flow of foreign investment funds into an asset class starved for such investment?

Foreign investment in U.S. real property has been subject to increasing regluations during the last three decades, from the International Investment and Trade in Services Survey Act of 1976, Pub L. No. 94-472, 90 Stat. 2059 (IISA), through the Agricultural Foreign Investment Disclosure Act of 1978, Pub. L. 95-460, 92 Stat. 1263 (codified at 7 U.S.C. 3501 et seq.) (AFIDA), the Foreign Investment in Real Property Tax Act of 1980, Pub. L. 96-499, 94 Stat. 2682 (FIRPTA), and the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248, 96 Stat. 324 (TEFRA). This federal legislation itself is layered on top of historical state restrictions on such inward investment. See American Bar Assn, Real Property, Probate and Trust Section, Foreign Investment in U.S. Real Estate: A Comprehensive Guide (Timothy Powers, ed., 1990). The aims of these older federal enactments were varied. Some legislation was designed to gather information about the volume and sources of foreign investment (IISA and AFIDA). Other statutes were meant to prevent nonresident alien persons and entities from escaping the capital gains taxes imposed on American real estate sellers similarly situated (FIRPTA and TEFRA). However, none of these earlier laws permitted the government to block any particular acquisition or to demand potentially public exposure of information about the property buyer and its investment motives, and none mentioned "national security."

Unlike these prior federal legislative restrictions, the new CFIUS regulations are not primarily commercial or economic in nature. Their objectives are political or even military, and they would almost certainly not have been enacted without the national trauma of 9/11. These regulations are an outgrowth of the Foreign Investment and National Security Act of 2007 (FINSA), Pub. L. No. 110-49, 121 Stat. 246 (effective Oct. 24, 2007), which expanded the scope of the Exon-Florio Amendment of 1988 to the Defense Production Act of 1950, 50 U.S.C. app. 2170. Under Exon-Florio, the President of the United States is authorized to suspend, prohibit, or reverse any transaction that might result in foreign control of a U.S. business if national security interests would be impaired. FINSA added to the range of CFIUS considerations the question of whether foreign governments controlling SWFs are in compliance with U.S. and multilateral counterterrorism, proliferation, and export control regimes.

CFIUS was established in 1975, is chaired by the Secretary of the Treasury, and includes the Attorney General, the Secretaries of Homeland Security, Commerce, Defense, State, and Energy, the U.S. Trade Representative, the Director of the Office of Science and Technology Policy, the Director of the Office of Management and Budget, the Chairman of the Council of Economic Advisors, and three assistants to the President. See 73 Fed. Reg. 70,702. CFIUS is tasked with reviewing these proposed commercial transactions for national security implications, but neither the Defense Production Act as amended nor the new CFIUS regulations define "national security" or "homeland security." This leaves CFIUS with broad discretion to decide whether a real estate acquisition that is a "covered transaction" has such security implications.

Sovereign Wealth Funds

Sovereign wealth funds have been investing in the United States, largely without public discussion, let alone significant challenge, for more than three decades (the first seems to be the Kuwait Investment Board, established in 1953). In publicly disclosed equity transactions in 2007 alone, SWFs invested $92 billion throughout the world (almost 31 times their aggregate investment in 2000). With control of $3 trillion in worldwide assets, the net worth of the SWFs taken together equate to the fourth largest economy in the world, after the European Union, the United States, and Japan. Before the autumn 2008 collapse in the world economy, this number was expected to more than triple by 2012. See Susan B. Bastress, "Sovereign Wealth Funds: Applicability of CFIUS to Investments in US Real Estate," Continuing Professional Education Proceedings of the American College of Real Estate Lawyers, Annual Meeting, October 23-25, 2008, p. 47, and International Monetary Fund, Sovereign Wealth Funds—A Work Agenda (Feb. 29, 2008), available at www.imf.org/external/np/pp/eng/2008/022908.pdf.

A June 2008 report by the consulting firm Monitor Group of Cambridge, Massachusetts, Assessing the Risks: The Behaviors of Sovereign Wealth Funds in the Global Economy, analyzed 33 years of reported investments of sovereign wealth funds, identifying 1,100 transactions with an aggregate value exceeding $250 billion. According to this study, these SWFs, far from being primarily passive investors, sought "controlling" interests, majority ownership or board seats, or contractual rights to vote in decisions on material matters in a substantial number of acquisitions from 2000 onward.

9/11 and New Law

Most Americans were probably unaware of CFIUS and its mission until the Dubai Ports World transaction in 2006. This transaction, which had actually been approved by CFIUS, became a highly public controversy, over the prospect of having a Middle Eastern country—Dubai, a member of the United Arab Emirates—operating U.S. ports of entry through acquisition of a United Kingdom company that supplies port management services. It followed a similar debate in July 2005, when China's National Offshore Oil Corporation made an unsolicited bid for Unocal.

The Dubai Ports World controversy sparked a call for closer scrutiny of transactions respecting sensitive security assets such as seaports, which led to Congress's passage of FINSA in October 2007. FINSA made three major changes in the scope of Exon-Florio: first, reviews of foreign transactions involving both "critical technologies" and "critical infrastructure" were explicitly included; second, changes were made to CFIUS's method of review of "foreign government-controlled transactions" if such a government or an entity controlled thereby would acquire control of a U.S. business; and third, as eventually detailed in the new CFIUS regulations, the operation of improved real estate—whether a single shopping center, an office building, or even a warehouse—was formally and explicitly included in the definition of a "U.S. business." See Foreign Investment and National Security Act of 2007, Public Law 110-49, 121 Stat. 246, hereinafter "FINSA", §2(a)(4), (6), and (7). Now, any such proposed transaction with an SWF is automatically required to go through both an initial 30-day review period and a second tier 45-day investigation, unless the Secretary of the Treasury and the head of CFIUS's lead agency (which may be Treasury or another agency, depending on the nature of the proposed investment) jointly issue a written finding of no adverse impact on national security. 73 Fed. Reg. 70,702. For purposes of CFIUS review under FINSA, SWFs are defined as "foreign government entities." See Treasury Department News Release, HP-823 (2/13/08), 31 C.F.R. §800.213 and 800.214, and 73 Fed. Reg. 70,708-70,709.

Before FINSA's passage, the acquisition by a foreign person of 10% or less of an entity's voting securities was widely considered to be exempt, but FINSA has clarified (if that is the word) the definition of "control" by adding a negative test: that there be evidence that the acquisition's purpose is "solely for investment." The new CFIUS regulations are a further effort to explicate those fact patterns that trigger the requirement for CFIUS review, with detailed definitions of (among other words and phrases) "covered transaction," "foreign person, "control," and "U.S. business."

Despite the new definitions, the overall scheme promulgated by the Treasury Department in the new CFIUS regulations promotes only subjective determinations, after consideration of all relevant factors, with few bright lines or clearly safe harbors. CFIUS could not possibly review all potential U.S. acquisitions by foreign investors, and certainly does not want to do so. Instead, it leaves final judgment about whether to file for such review to the asset sellers, their foreign potential buyers, and the parties' respective counsel.

The CFIUS Application Process

CFIUS may itself initiate a unilateral review of a transaction of which it has become aware through press reports or otherwise. However, requesting a filing before or after a transaction has closed or applications for review by potential buyers or sellers are voluntary; there is no requirement that the parties to a "covered transaction" submit a notice to CFIUS. Confidentiality in the CFIUS review process is promised but seemingly not guaranteed. Although CFIUS does not issue opinions or make public disclosures about its notifications to participants in the review process, and information gathered is exempt from discovery under the Freedom of Information Act, disclosure is permitted and thus possible in connection with a congressional hearing or an administrative or judicial proceeding.

Testing the waters prior to filing an application is possible. The CFIUS regulations encourage the parties to consult with CFIUS staff and member agencies on an informal basis even before filing a voluntary notice (which the Treasury estimates requires about 100 hours of filer preparation time—see 73 Fed. Reg. 21,867 (April 23, 2008)). If, in response to a voluntary notice, CFIUS determines that the transaction is not a "covered transaction" or is a "covered transaction" but CFIUS has decided not to recommend that the President act, then presidential authority to block the transaction or to order divestment will not be exercised. 31 C.F.R. §800.601 and 73 Fed. Reg 70,714-70,715. If the proposed real estate transaction arguably has "national security" implications, then it may be a "covered transaction," and filing a voluntary notice under 31 C.F.R. § 800.401 is highly recommended.

If a transaction party, with or without CFIUS guidance in response to a voluntary notice, decides CFIUS review is warranted (or, given the potential negative consequences, just prudent), it must file an application with CFIUS, transmitted in hard copy and by e-mail. There is no filing fee. With application for the "covered transaction" in hand, CFIUS conducts a 30-day review to determine the potential for impairment (probable or possible) of American national security interests. If the CFIUS suggests measures that could mitigate or otherwise avoid potential threats identified by the review, the parties are encouraged to negotiate with the lead agency and enter into a written mitigation agreement. In 2003, for example, a mitigation agreement was negotiated for Global Crossing Ltd.'s transfer of communication systems to a Singapore company. The agreement consists of 35 closely printed pages and was signed not only by the transaction parties but also by the Federal Bureau of Investigation, the Department of Justice, the Department of Defense, and the Department of Homeland Security. Unusual for such agreements, this one was made public, for reasons related to licensing by the Federal Communications Commission, and is available on the FCC web site. In re Global Crossing, 18 F.C.C.R. 20,301 (Oct. 8, 2003). Not surprisingly, post-acquisition breaches of a mitigation agreement allow the imposition of substantial penalties and sanctions.

If threats are identified and measures to mitigate are not agreed to by the parties, a more intensive 45-day "investigation" ensues (as mentioned, this second-tier review now occurs automatically when an SWF is involved). [Questions: If SWF involved and mitigation is agreed to, is there still a 45-day investigation? - Yes, but abortable if SWF volunteers to mitigate in mid-investigation--See FINSA §2(5)] When the CFIUS investigation is completed, the President of the United States has an additional 15-day period to review the findings. The President may take any action recommended by CFIUS or that the President deems necessary, which can include suspending or even nullifying the transaction. If an acquisition for which no CFIUS application was made comes to the attention of CFIUS after it has closed and CFIUS recommends that it be blocked, in the case of a transaction, the President has the power to compel its reversal.

CFIUS, SWFs, and Real Estate

As noted above, the new CFIUS regulations have the potential to reach any American real estate transaction in which a SWF is involved. Thus, the parties to the transaction (and their respective counsel) must carefully analyze the transaction to determine whether it warrants a voluntary notice or application for CFIUS review.

This is a judgment call, and the risks of a misjudgment either way are patent. If election is made by the American seller and the SWF buyer not to file a voluntary notice or to apply for CFIUS review, on the grounds that national security interests are not implicated, rival bidders or CFIUS itself might take a different view, leading to a fight, perhaps a public one. Alternatively, the mandated statutory review and investigation periods necessarily mean that submission of a proposed transaction to CFIUS review involves significant time passage if not delay, otherwise avoidable administrative costs and legal fees, and potentially adverse political (and again public) controversy that could kill or significantly alter the deal. Any sale that could not be unwound with the original seller would then become a distress sale by the SWF. Also, mitigation measures might be demanded by CFIUS that alter the economic calculations of one or both parties (such as retaining professional property managers as proof that the acquisition is "solely for investment purposes"). Furthermore, the CFIUS regulations subject the SWF buyer to new disclosure requirements in the application process, far beyond anything required under IISA and AFIDA. The additional requirements include a structural graphic identifying parent entities in the chain of beneficial control, and biographical information about the SWF's board of directors, senior management members, and ultimate beneficial owners with stakes of 5% or more. 31 C.F.R. §§800.402(a)(1)(v)(A) and 800.402(c)(6)(vi), and 73 Fed. Reg. 70,713.

Reporting Guidelines Through Definitions

What help does the text of the CFIUS regulations give to a real estate lawyer seeking to advise an American real estate owner client on whether submission to the CFIUS process is mandatory, or even merely prudent? Such guidance is to be found there but only after methodically and doggedly running the gauntlet of the applicable definitions of the regulations' key terms.

The CFIUS regulations do not specifically define "national security" or its analogue in the regulations, "homeland security." If the U.S. realty is acquired as an incidental part of the acquisition of the owner/occupant of that property that is a "U.S. business," then it seems reasonable to assume that CFIUS analysis will be informed primarily, though not exclusively, by the "national security" and "homeland security" aspects of the operations of the owner's U.S. business. The regulations, however, lack any specificity in considering whether the purchase of a building is a "covered transaction" if the owner-occupied building is without "homeland security" issues or implications, or if it is leased to one or more tenants with such issues or implications, or if it is leased only to tenants without any such issues or implications. CFIUS is apparently preparing material for public guidance on what transaction types have raised "national security" and "homeland security" issues during past CFIUS reviews. Nevertheless, comprehending the phrases "national security" and "homeland security," in the analysis of the appropriateness of the transaction at hand for federal review, is presently an exercise in the application of common sense and past experience only.

After considering "homeland security" issues, if the incoming controlling interest of the analyzed real estate acquisition is not 100%, it may be necessary to review the question of "control." The new CFIUS regulations set forth facts and circumstances under which much less than 50% of overall voting power can constitute control and trigger the review and investigation requirements. 31 C.F.R. § 800.204. Unlike the bright-line definition of control in many Internal Revenue Code provisions, the CFIUS regulations define control as:

the power, direct or indirect, whether or not exercised, through the ownership of a majority or a dominant minority of the total outstanding voting interest in an entity, board representation, proxy voting, a special share, contractual arrangements, formal or informal arrangements to act in concert, or other means, to determine, direct, or decide important matters affecting an entity; in particular, but without limitation, to determine, direct, take, reach, or cause decisions regarding the following matters, or any other similarly important matters affecting an entity,

and the very first such matter is "(1) The sale, lease, mortgage, pledge, or other transfer of any of the tangible or intangible principal assets of the entity, whether or not in the ordinary course of business." Id. Frankly, it is hard to imagine an SWF investing in American real estate without the power to "control" the disposition of that primary asset, and in any real estate partnership or joint venture a partner with access to its own armed forces and security services would probably have control in any sense of that word.

The next key concept, when the sale is not simply of the improved real estate to a special purpose entity formed by the SWF for its acquisition, is that of a "U.S. business." The new CFIUS regulations define a "U.S. business" as any "entity" engaged in interstate commerce in the United States. 31 C.F.R. § 226. They define "entity" to include effectively any corporation or corporate division, partnership, branch, government agency, or other organization formed under U.S. or foreign law, and any assets operated by any of the foregoing as a business undertaking in a particular location, even if those assets are not organized as a separate legal entity. 31 C.F.R. § 211. Given the holding in Jones v. United States, 529 U.S. 848 (2000) (federal statute covering any building "used in interstate or foreign commerce or in any activity affecting interstate or foreign commerce" interpreted to exclude owner-occupied houses, but to include buildings that were rented), it seems doubtful that the "interstate commerce" qualification on characterization as a "U.S. business" would exclude commercial rental real estate, or even residential rental real estate, although it would seem to exclude owner-occupied houses—if the proximity of such houses to "critical infrastructure" does not raise "national security" issues.

There seems to be no question that "national security" is at issue if the real estate asset to be acquired consists in whole or part of "critical infrastructure" or houses the manufacture or storage of "critical technologies." Under the new regulations, "critical infrastructure" is defined as meaning "a system or asset, whether physical or virtual, so vital to the United States that the incapacity or destruction of the particular system or asset of the entity over which control is acquired pursuant to that covered transaction would have a debilitating impact on national security." 31 C.F.R. § 800.208. The CFIUS regulations do not relate its definition to specific industrial sectors. Although the President's National Strategy for the Physical Protection of Critical Infrastructure and Key Assets, published by the White House in February 2003 http://www.dhs.gov/xlibrary/assets/Physical_Strategy.pdf, does not include rental real estate as one of the 13 specified industry sectors, it does speak of "key assets," including prominent office buildings (460 skyscrapers), shopping centers, sports stadiums, and important privately owned buildings.

"Critical technologies" include defense articles or defense services; items controlled under multilateral regimes for reasons of national security, such as chemical and biological weapons proliferation, nuclear nonproliferation, or missile technology, "as well as those that are controlled for reasons of regional stability or surreptitious listening"; nuclear equipment, components, material, software, and technology; and federally designated select agents and toxins. 31 C.F.R. § 800.209.

The final and most fundamental definition in the CFIUS regulations, and the simplest to understand, is "transaction." Its definition includes, among other things, the proposed or consummated acquisition of an ownership interest in an entity or the formation of a joint venture. 31 C.F.R. § 800.224.

Real Estate Transaction Types

The treatment of exemplary real estate transactions (or their analogues) and whether they are deemed to be "covered" is to be found at scattered places in the new CFIUS regulations. Real estate lawyers, of course, will default to thinking instead about the various types of property that might be purchased.

1. For owner-occupied real estate, a transaction involving the acquisition of "control" of a "U.S. business" that is not involved in rental property in this country, whether or not it incidentally owns and occupies U.S. realty, is definitely a "covered transaction. 31 C.F.R. § 800.207.

2. In an unusual burst of clarity, the regulations specifically exclude unimproved land, if acquired singly with no other assets, from characterization as a "covered transaction," because such land is not a "U.S. business." 31 C.F.R. § 800.302(c), ex. 1, subsection (b). A variation on this theme is to be found in 31 C.F.R. § 800.301(c), which purports to cover transactions that result or could result in control by a foreign person of any part of an entity or of assets, if such part of an entity or assets constitutes a U.S. business. Example 3, however, excludes from covered transactions a "start-up or 'greenfield'" investment if the United States, when a U.S. subsidiary is newly formed by a foreign parent to establish a U.S. operating business and the subsidiary separately acquires unimproved land for the construction of a plant for the new business, while also procuring separately from other vendors and sources the necessary supplies, technology, and operating personnel. Id. Again, because the bare land is not itself a "business" and does not at the time of acquisition support a "business," the acquisition is not one of a U.S. business under the definition.

3. As for currently unused buildings, the regulations contain two examples, with a fact pattern varied in the second to suggest the range of considerations in determining whether the purchase of such an improved property is a "covered transaction." Example 6 in 31 C.F.R. § 800.301(c) speaks of the acquisition, from a corporation that is a U.S. business, of an empty warehouse facility. If the acquisition is limited to the physical facility alone "and would not include customer lists, intellectual property, or other proprietary information, or other intangible assets or the transfer of personnel," and there are no other "relevant facts," "the facility is not an entity and therefore not a U.S. business, and the proposed acquisition of the facility is not a covered transaction." Of course, the "relevant facts" could be the proximity of the facility to critical infrastructure.

Example 7 assumes the same facts, but now has the buyer acquire "the personnel, customer list, equipment, and inventory management software used to operate the facility." Id. The example concludes that, under these altered circumstances, the foreign investor is indeed acquiring a U.S. business, and thus this is a covered transaction. It should be noted that the assumed facts in example 5 in 31 C.F.R. § 800.302(c) suggest that the acquisition would be a "covered transaction" if the warehouse and personnel were idle for a year because of the seller's bankruptcy at the time of the foreign person's acquisition, but the warehouse and its equipment were still in working condition and the customer list and software were still current and key personnel had agreed to return if the warehouse were reopened.

The differences between 31 C.F.R. § 800.301(c)'s examples 6 and 7 are relatively easily understood, but neither of them gives a clear answer with respect to the much more common acquisition of a vacant U.S. commercial rental building following the departure of its most recent 100% tenant, with no employees, or inventory management software or specialized equipment required to rent the building anew.

4. Buildings leased to tenants, such as a commercial office building or shopping center actively operated by employees of the owner seem clearly intended to be covered by the new CFIUS regulations, by analogy to the warehouse in example 7 cited above. Nowhere does 31 C.F.R. Part 800 discuss the rental to one or more tenants of a building as necessarily constituting a "U.S. business." However, 31 C.F.R. § 800.211 (when combined with the definition of "U.S. business" in 31 C.F.R. § 800.226) declares that "assets (whether or not organized as a separate legal entity) operated by [an entity] . . . as a business undertaking[s] in a particular location or for particular . . . services" are a "U.S. business."

5. What about a net leased building? Income tax law holdings have found that very limited U.S. real estate rental activities, such as fee ownership of a single net leased building managed by independent contractors, do not rise to the level of a business. See Neill v. Commissioner, 46 B.T.A. 197 (1942); Rev. Rul. 73-522, 1973-2 C.B. 226. However, the CFIUS regulations make no reference to this type of analysis or standard. Perhaps CFIUS would conclude that an SWF's acquisition of "control" of a net leased building is a "covered transaction," even though leased to a tenant not controlled by the foreign investor and even though operated by a separate management company not owned by the foreign investor. Alternatively, the parties to the transaction might argue that the purchase of a net leased building, without the purchase of its tenant, the tenant's assets, the property management company, or other proprietary assets or systems of the tenant, and without the employment of the building's personnel, is not a "covered transaction" since the SWF does not own or control any of the business operations in the building. The argument continues that the transaction is more appropriately analogized to the empty warehouse of 31 C.F.R. § 800.301(c)'s example 6 cited above.

This argument for CFIUS avoidance is buttressed by the discussion of the foreign investor as tenant in the CFIUS regulations: "transaction" includes a "long-term lease under which a lessee makes substantially all business decisions concerning the operation of a leased entity, as if it were the owner." 31 C.F.R. § 800.224(f). Thus, if an SWF is a net lessee, making such decisions, its entry as tenant into such a transaction makes such entry a "covered transaction." It would be inconsistent for CFIUS to conclude that an SWF net lease landlord is making such decisions when the net lease terms are otherwise identical, so that purchase by an SWF of a net leased building (when the non-"controlled" tenant is making those same operational decisions) is likewise a covered transaction.

6. Forming a joint venture or partnership or other multi-party entity with an SWF is clearly a covered transaction, if the SWF might exercise the requisite "control." The regulations specifically describe a "joint venture in which the parties enter into a contractual or other similar arrangement, including an agreement on the establishment of a new entity, but only if one or more of the parties contributes a U.S. business and a foreign person could control that U.S. business by means of the joint venture" as a covered transaction. 31 C.F.R. § 800.301(d). This would seem to cover virtually every contribution of commercial (occupied) U.S. real estate into a joint enterprise (no matter the entity type) in which the SWF is the finance venturer or a controlling partner.

7. Because this article is about SWFs as investors in U.S. real estate, it does not discuss in detail (a) entry into a lease as tenant (see 31 C.F.R. § 800.224(f), with no further discussion or definition of what constitutes a "long-term lease"), or (b) entry into a lease as landlord (if the SWF already owns the rental building, this would not seem to be a "transaction," because the foreign person's right to receive periodic cash payments of rent from the U.S. business is not the acquisition of a "U.S. business"(compare example 2 in 31 C.F.R. § 800.301(d)), or (c) making a loan (31 C.F.R. § 800.303 holds that a "foreign person" lender such as an SWF, making a loan, even if secured by a mortgage, is not entering into a "covered transaction," absent other evidence of the acquisition of "control" at the date of the loan). The regulations go on to note that CFIUS will accept notices respecting review when "because of imminent or actual default or other condition, there is a significant possibility that the foreign person may obtain control of a U.S. business as a result of the default or other condition," so foreclosure of that loan may be blocked if "national security" is involved because the mortgaged asset is "critical infrastructure" or houses "critical technologies." C.F.R. §800.303(a)(1) and 73 Fed. Reg. 70,710-70,711.

Going Forward

In its news release accompanying the first publication of the proposed rules in April 2008, the Treasury stated that "[t]hese regulations reflect America's strong and continued commitment to safeguarding U.S. national security in a manner that reinforces the longstanding U.S. policy of welcoming foreign investment." U.S. Dep't of Treasury, Treasury Issues Proposed CFIUS Regulations, (Apr. 21, 2008) (quoting Ass't Sec. for Int'l Affairs Clay Lowery). Based on the number of filings in 2007-2008, CFIUS expects an average of 120 notices annually (fewer than ten percent of all foreign acquisitions of U.S. businesses are the subject of notification), of which not more than a dozen would be expected to be subject to protracted investigation or a mitigation agreement, 73 Fed. Reg. 21,868, and CFIUS does not expect the new regulations to materially increase the number of transactions it reviews. 73 Fed. Reg. 70,702.

Citicorp Center in New York and Sears Tower in Chicago have both been alleged terror targets, discovered to have been slated for destruction on Al-Qaeda computers. To date none of the alleged plots had the terrorists first investing in such trophy buildings after filing biographical summaries with CFIUS. More seriously, CFIUS did not intervene in the Chrysler and GM Building investments in New York City by SWFs, so the fact that a building is occupied and can be destroyed is seemingly not by itself sufficient to raise national security issue.

Thus, it seems unlikely that many real estate transactions will figure in the CFIUS process, although virtually all are now swept within the detailed CFIUS regulations' orbit. Clearly, whether or not presented in a voluntary notice of a proposed real estate purchase by an SWF, CFIUS is likely to take into account all the facts and circumstances, including, but not limited to, whether the building was a major structure or otherwise enjoys iconic status; whether the division of security responsibilities between landlord and tenants is unusual in any way; whether the nature of the business sector in which it (or its primary tenants) is employed evidences "national" or "homeland security" issues; whether the improved real estate itself is somehow "critical infrastructure;" and the past and present political reputation of the nation controlling the SWF. The counsel to the real estate's seller and buyer should make the same review in deciding how to proceed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Wednesday, September 2, 2009

How Mortgage Disclosure Improvement Act Has Changed Residential Closings

By Todd R. Pajonas and Matthew K. Scheriff
New York aw Journal
September 02, 2009

"The nine most terrifying words in the English language are, 'I'm from the government and I'm here to help.'"

These words were uttered by our 40th President, Ronald Reagan, to a group of Future Farmers of America in 1988. Regardless of your political party affiliation, the Mortgage Disclosure Improvement Act of 2008 (MDIA), which has now taken effect for mortgage applications taken on or after June 30, 2009, illustrates the ways in which the government sometimes "helps" us.

Among other things, MDIA provides rules governing when certain fees may be collected in conjunction with a mortgage loan application, the timeliness of the Truth-in-Lending (TIL) disclosures, and requirements for re-disclosing the TIL when a consumer's annual percentage rate has changed since the previous disclosure.

The new law affects any funds borrowed by consumers for all mortgage loans secured by a dwelling, except a home equity line of credit or a loan secured for business purposes. Therefore, it is of utmost importance for anyone involved in residential real estate to have an understanding of the requirements brought about by MDIA. The changes can affect the loan application process, closing preparation procedures, and timeliness of funds. This especially holds true for states such as New York, where attorneys routinely calculate out closing adjustments while sitting at the settlement table. Certain changes to closing charges previously disclosed to a consumer in their Truth-in-Lending Disclosure statement could result in a closing being adjourned and a very unhappy client.

In addition to the changes in closing procedures, mortgage banks, institutional lenders, and mortgage brokers will all have to modify their application processes, fee collection policies, disclosure processes and record-keeping systems to insure compliance with MDIA. Knowing that the pendulum has now swung to more conservative underwriting practices, some lenders may adopt procedures that are more restrictive than MDIA provides allowing them to err on the side of caution.

On July 30, 2008, the Board of Governors of the Federal Reserve System published a final rule amending 12 CFR 226, which is better known as Regulation Z. The purpose of Regulation Z, among other things, is to promote the informed use of consumer credit by requiring disclosures about its terms and costs, and to allow consumers to cancel certain credit transactions involving dwelling-secured mortgage loans. The changes made on July 30, 2008, affected the Truth in Lending Act (TILA) 15 USC 1601, as well as the Home Ownership and Equity Protection Act (HOEPA).

However, also on July 30, 2008, Congress enacted the Housing and Economic Recovery Act of 2008, known as the Mortgage Disclosure Improvement Act of 2008, which also provided for amendments to TILA. Accordingly, the Board of Governors of the Federal Reserve System subsequently made a further revision to Regulation Z to comply with the changes mandated by Congress in HOEPA. The changes required by MDIA can be broken down into three different areas: 1) What types of transactions are affected by MDIA? 2) What are the initial Truth-in-Lending disclosure requirements? and 3) What are the requirements when a disclosure needs to be amended?

What types of transactions are affected by MDIA? Initially, the changes enacted by the board were designed to protect consumers for transactions involving their principal dwelling. However, MDIA expanded the requirement to include all "mortgage transactions subject to the Real Estate Settlement Procedures Act (RESPA) that is secured by the consumer's dwelling, other than a home equity line of credit…." 12 CFR 226.19(a)(1)(i). Since RESPA, which is codified at 12 USC 2602, governs almost every loan made on a one-to-four family dwelling in the United States, it stands to reason that virtually every one-to-four family residential loan has the capacity to fall within the confines of MDIA unless there is a specific exception.

Currently, home equity lines of credit (HELOCs) are not subject to MDIA and may be provided by lending institutions without concern for the additional disclosure requirements. It is possible that there may yet be supplemental legislation adding them to MDIA in some form.

MDIA concerns itself primarily with transactions where there is an extension of consumer credit secured by a dwelling, regardless of who occupies the dwelling. Accordingly, if you were purchasing a retirement condominium for your parents, the provisions of MDIA would apply to the transaction. However, both the Truth in Lending Act and Regulation Z do not apply to credit extensions that are primarily for business purposes. For example, 12 CFR 226.3(a)(1) specifically provides that Regulation Z does not apply to "[a]n extension of credit primarily for a business, commercial or agricultural purpose." Consequently, if a property which would otherwise fall under the purview of RESPA was purchased with the sole intent to provide investment income, it would be exempt from the requirements of MDIA.

On a practical note, it may become all the more important for a consumer to properly decide his true intent in borrowing. The interest rate of a mortgage loan can vary widely depending on the use of a property—if it is used for a primary residence, second home, or rental property. It is not uncommon for borrowers to "fudge" this information in order to obtain lower loans. If the consumer changes his or her intended use of the property from an exempt business use to a personal use, upon hearing about the different interest rate, a TIL disclosure would be required. This "change of heart" could lead to a delay in closing.

What are the initial Truth-in-Lending disclosure requirements? The primary function of a Truth-in-Lending disclosure is to provide the consumer with information necessary to make an informed choice about his loan. Among other items a TIL disclosure provides consumers with the annual percentage rate (APR), finance charges, the amount financed, and the total amount of payments required to satisfy the loan. The APR represents the actual present value of the money to be borrowed over the length of the mortgage term. It can be affected by items such as certain fees, points, and mortgage insurance, but is not affected by such items as title insurance premiums, property appraisals and document preparation.

Previously a mortgage lender had to provide a consumer with a copy of the TIL before the loan closed. MDIA has now replaced that requirement with a more rigid time frame of providing that a TIL disclosure must be received by the consumer at least three business days prior to the collection of any fee except a credit reporting fee.

From a functional standpoint, this initial early disclosure can cause some delay in the underwriting process for a consumer. Previously, lenders would collect a fee to run a credit report and order an appraisal of the subject property once a mortgage application was completed by a prospective borrower. The new early disclosure rules now prohibit lenders from collecting the appraisal fee until this period has expired. As most lenders are reluctant to advance the appraisal fee prior to collecting it from the consumer, and the consumer is prohibited in most cases from choosing or paying the appraiser directly, the appraisal must wait until the fulfillment of the early TIL disclosure.

Moreover, the three business days begin to run from when the consumer receives the TIL disclosure, not from when it is sent to them. For example, this means that if a lender sends the TIL disclosure by regular mail it must account for the period of time it takes for the TIL to be delivered. Many lenders now use secure e-mail systems to communicate with their clients allowing them to forward the TIL and receive an electronic confirmation of receipt; that allows them to begin counting the three business days immediately. Most lenders provide a waiting period of at least five to six business days if a TIL is mailed to a client in order to account for the delivery time.

Furthermore, the new MDIA disclosure rules are sometimes referred to as the 3-7-3 disclosure model because of the additional time periods that can be involved in the loan process 12 CFR 226.19(a)(2). In addition to the initial waiting period of three business days for the initial disclosure a consumer must also wait at least seven business days from the initial disclosure in order to consummate the mortgage loan. However, unlike the three-business-day waiting period for the initial disclosure, the seven-business-day waiting period begins to run from when the consumer receives the TIL disclosure or when it is mailed. Accordingly, a TIL disclosure which has been sent by regular mail on a Monday could yield a consummated loan by the following Wednesday. The Federal Reserve Board allows a three-day "presumption of receipt" by the consumer if the TIL disclosure is sent by regular mail.

Last, MDIA provides for additional verbiage to be contained on the TIL disclosure form in a clear and conspicuous manner as follows: "You are not required to complete this agreement merely because you have received these disclosures or signed a loan application."

What are the requirements when a disclosure needs to be amended?

The final portion of the 3-7-3 disclosure model, and perhaps the most important, is the need to "re-disclose" the TIL under certain circumstances. Previous to MDIA, once a lender made a TIL disclosure a consumer would not receive an updated or corrected TIL until he was signing the loan documentation. MDIA now provides that the TIL disclosure become an ongoing disclosure if changes to the loan cause the interest rate to change more than a certain amount, depending on the type of loan.

MDIA provides two different APR differential tolerances depending on if the loan is a "regular transaction" or "irregular transaction." An APR is considered accurate if it does not vary above or below the last disclosed APR by more than .125 percent in a regular transaction. A regular transaction can be defined as most loans with a single advance of funds.

An irregular transaction is best described as a mortgage loan that includes one or more of the following features: multiple advances, irregular payment periods, or irregular payment amounts (other than those first and final payments which may be irregular due to a partial month payment). These loans will need a TIL re-disclosure if the last disclosed APR varies above or below .250 percent. Multiple advances are normally associated with construction loans. While loans with irregular payment periods are uncommon, loans with irregular payment amounts occur quite often. For example, payment amounts can vary if the loan is an ARM with a discounted or premium start rate, or the loan is either a fixed rate or ARM loan and has mortgage insurance which varies periodically and/or automatically terminates after a certain period of time. A loan will not be considered irregular merely because it has a variable or adjustable rate.

The TIL re-disclosure for an APR variation outside of the tolerances set for a regular or irregular loan follows the same format as the initial TIL disclosure. However, assuming that the seven-business-day period before consummation has passed, the TIL re-disclosure must be received by the consumer at least three business days prior to consummating the loan. Accordingly, if a TIL re-disclosure is placed in the mail the closing could be delayed by six business days. Therefore, it is critical for lenders, attorneys and closing agents to provide accurate closing charges to mitigate the potential delays in closing the transaction. There is also disagreement about whether MDIA only provides for a re-disclosure when the APR goes above the tolerance or whether it is necessary if it falls below the tolerance as well.

Last, MDIA does allow consumers to shorten or waive the waiting period provided in 12 CFR 226.19(a)(2) in cases of a bona fide personal financial emergency 12 CFR 226.19(a)(3). To shorten or waive the waiting period, the consumer must provide the creditor a written dated statement that describes the specific emergency, specifically modifies or waives the waiting period, and bears the signature of all consumers who will be primarily liable for the loan. Lenders are prohibited from providing preprinted forms to assist consumers with this waiver. A lender must provide a final accurate APR to the consumer in order for this waiver to be compliant.

Conclusion

The Mortgage Disclosure Improvement Act has been enacted to enhance consumer protection by requiring accurate and timely disclosures of the mortgage-related costs to borrowers, while also establishing certain waiting periods to ensure that borrowers are allowed time to contemplate the proposed terms. Obviously the legislation is well intended to help safeguard the consumer. However, many clients are still focused on "how quickly can I close." Therefore, lenders, attorneys and closing agents will have to be well versed in the additional disclosure requirements and time periods in order to avoid closing delays and to remain in compliance with the new legislation.

Todd R. Pajonas, a lawyer, and Matthew K. Scheriff, CPA, are private mortgage bankers with Stamford, Conn.-based Luxury Mortgage Corp.